'Inflating a Sovereign Debt Bubble'

The Financial Times has an article making the same point that George Melloan made the other day in the Wall Street Journal: when regulators force banks to hold more government bonds, it ends up making it easier for the government to borrow and spend. Writes José Maria Brandão de Brito: "this amounts to a private subsidy to the state. Since any subsidy distorts decisions towards greater profligacy, government debt will probably swell, possibly to unsustainable levels. Politicians – like everyone else – are prone to moral hazard, meaning that – given the opportunity – they stand ready to engage in excessive spending. This is especially so in situations such as the present one, when the prospect of a sluggish recovery or protracted stagnation exerts great pressure on governments to revive economic growth. How relevant is this subsidisation effect? Recent reports suggest banks would have to tie-up about 10 per cent of total assets in government bonds to comply with the FSA standard. If the US were to adhere to this yardstick, its banks would be forced to take up about 20 per cent of the overall federal debt stock. That would generate a large and persistent downward pressure on US federal debt yields – big enough to preclude the discipline otherwise imposed by the market to rein in excessive government expenditure...The risk is that the new rules end up inflating a sovereign debt bubble."