Crises are never caused by building excessive exposure to high-risk assets. Crises can only happen when investors, government bodies, and households accumulate risk in assets where most believe there is little to no risk.
The 2008 crisis did not occur due to subprime mortgages. Those were the tips of the iceberg. Moreover, Freddie Mac and Fannie Mae, state-owned entities, guaranteed a sizable portion of the subprime mortgage packages, which prompted numerous investors and banks to invest in them. Nobody can anticipate a crisis stemming from the potential decline in the Nvidia share price or the value of Bitcoin. In fact, if the 2008 crisis had been created by subprime mortgages, it would have been absorbed and offset in less than two weeks.
The only asset that can really create a crisis is the part of banks’ balance sheets that is considered “no risk” and, as such, requires no capital to finance their holdings: government bonds. When the price of sovereign bonds swiftly declines, the banks’ balance sheet rapidly shrinks. Even if central banks conduct quantitative easing, the spillover effect on other assets leads to the abrupt destruction of the money base and lending.
The collapse in the price of the allegedly safest asset, government bonds, comes when investors must sell their existing holdings and fail to purchase the new supply issued by the states. Persistent inflation consumes the real returns of previously purchased bonds, leading to the emergence of evident solvency problems.
In summary, a financial crisis serves as evidence of the state’s insolvency. When the lowest-risk asset abruptly loses value, the entire asset base of commercial banks dissolves and falls faster than the ability to issue shares or bank bonds. In fact, banks are unable to increase capital or add debt due to the declining demand for sovereign bonds, as banks are perceived as a leveraged bet on government debt.
Banks do not cause financial crises. What creates a crisis is regulation, which always considers lending to governments a “no-risk,” “no capital required” investment even when solvency ratios are poor. Because the currency and government debt are inextricably linked, the financial crisis first manifests in the currency, which loses its purchasing power and leads to elevated inflation, and then in sovereign bonds.
Keynesianism and the MMT fallacy have driven global public debt to record levels. Furthermore, the burden of unfunded liabilities is even larger than the trillions of dollars of government debt issued. The United States’ unfunded liabilities exceed 600% of GDP, according to the Financial Report of the United States Government, February 2024. In the European Union, according to Eurostat, France and Germany each accumulate unfunded liabilities that exceed 350% of GDP.
According to Claudio Borio of the Bank for International Settlements, a government debt glut may cause a bond market correction that could spill over into other assets. Reuters reports that large government budget deficits suggest that sovereign debt could rise by a third by 2028 to approach $130 trillion, according to the Institute of International Finance (IIF) financial services trade group.
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