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Come See The Havoc Caused by Calling Sovereign Debt "Risk Free"

It's time to bid au revoir to another idealistic European fiction.

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Banks in euro zone countries have not been required to hold back any capital as a hedge against bonds issued by the governments of euro zone nations.

But reality has intervened. First Greece, then Ireland, received massive bailout packages. The danger of imminent sovereign default was real. The notion that such instruments could be treated as "risk-free" proved to be a fantasy.

"Risk Free" may have been a lovely idea. Like a world without war. Or the dissolution of national borders, as a grand utopian marketplace sprung forth from the soil that had hosted some the 20th Century's worst nightmares.

It didn't work out that way. A unified monetary policy simply did not accord with the radically different fiscal policies of the EU's member states. Historically divergent worldviews, rooted in cultural traditions of long-standing, could not be reconciled with academic theories of postmodern multiculturalism.

The language may seem abstract—but the results were very concrete:

"The fixed risk weight of zero percent ... has, in our view, played a direct role in the excessive build up of low-quality sovereign debt in bank portfolios as well as of high levels of debt in certain sovereigns," wrote Achim Kassow, of Commerzbank, in a research paper for the European Parliament."

Or, as noted by a former investment banker, who is now a consultant to the European Union: "Is it right that the regulatory framework governing all types of financial institution in the EU should continue with the fiction that debts of EU-penalized governments are risk- free?"

The results of economic policy driven by fiction—or a mixture of politics and idealism—were every bit as bad as you would expect.

And the efficacy of the regulatory gymnastics, now being called upon to solve problems of such an enormous scale, is rightly in question.

Policy changes driven by Basel III will add additional capital requirements, as well as new stress tests for banks, but as Sharon Bowles, the British chairperson of the economic affairs committee of The European Parliament, acknowledges: "We have got a big hole that we have to address."

For those who are optimistic about changes to the regulatory frame, the Reuters article notes "Remedies come at a cost, however. Better quality ratings from the credit rating agencies would help flag risks in government bonds, experts say, but this contradicts a push among regulators to dilute the influence of ratings on financial markets."

But that problem—the issues associated with policy contradictions related to credit rating agencies—is merely a footnote.

Make no mistake: The core issue here will be increased sovereign borrowing costs. Once the policies that support a fantasy view of risk are removed, the market driven price of lending will increase for the sovereign nations most likely to default.

The solution—like the problem itself—will be painful.

To wit: The Reuters article cites an Austrian financial consultant who sensibly observes that "Forcing euro zone banks to set aside capital to cover less- rated debt would impact interest rates and financing volumes for the broader economy."

And by "broader economy" we might infer the economic activity of the eurozone itself—which is now the largest consolidated economy in the world.

As Reuters notes: "Ending the anomaly, however, will come at such a cost for lenders, markets and the economy that policymakers will still err on the side of caution."

To call it an "anomaly" is to miss the point.

Moving away from the delusional policies of "risk free" sovereign debt capital requirements is a de facto admission of the major structural flaws inherent in the very idea of a European monetary union.

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