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Since the beginning of September, it seems that we are riding on a boulevard of broken financial dreams into the next episode of a ‘global financial drama’. But this time, it is not a drowning private sector that drags down the banking and financial sector, but the ‘savior’ governments who have to be rescued. In fact, it seems that a new class of toxic assets has evolved - namely government bonds. In times of ample bailout liquidity and regulatory tightening, these toxic assets initially were thought of as profitable safe havens. But it turns out exactly these ‘safe havens’ are drowning, dragging down the soundness of their respective banking systems.

How did we get here and why is this new situation so dangerous for the economic prospects of the Eurozone and the global economy?

Several commentators have been criticizing rating agencies for downgrading sovereign debt ratings. However, the current situation and subsequent challenges associated with refinancing government debt are not new; it has been the rule of thumb that, during a period of economic decline or stagnation, expenditures for social policies increase and tax revenues decrease, dragging the overall nominal government balance. In this context, it is questionable why there have been only a few concerns about public debt positions at the outset of the global financial crisis when governments all over the world started to pump trillions of Euros and Dollars into financial markets and respective stabilization programs without addressing long lasting structural challenges.

Criticizing the ‘savior’ of the financial system at the outset of a crisis would not only have been perceived as inappropriate, but also would have put the rescue of the financial system at risk. In this regard, rating agencies had no reason to point to emerging risks during this time. Therefore criticizing governments and these institutions for their misconduct and blaming them for their opportunistic behavior is a blind alley.

Looking closer, the critics of rating agencies and advocates of stricter regulation might miss an important point. Although enhanced competition among these bodies and more stringent government oversight of these institutions might help to upgrade the prevailing system, it will certainly not solve the problem. In order to create a more sustainable framework, we should be concerned with how to upgrade current economic foresight techniques and how to make these rating agencies more immune to existing pressure from vested political and special interests.

But how does this relate to the current predicament? Easing monetary conditions at the outset of the financial crisis has certainly been an adequate measure to combat the possibility of a full-fledged credit crunch. In this situation, however, implementing expansionary fiscal policies in combination with tighter financial regulation to restore confidence in the economy might be regarded as counterproductive. When credit-financed consumption and investment levels are decreasing, revitalizing the ‘credit cycle’ is urgently needed to stabilize households’ and firms’ expectations. However, instead of providing credit and other financial debt instruments to the private sector, most financial market investors are fleeing, seemingly blindly, into government bonds, gold, safe haven currencies, and commodities. In fact, banks have been hoarding government bonds and other safe assets similar to how they lent money before to households during the housing bubble.

This leads to a boom in safe asset classes, which are not subject to strict financial regulation and are perceived to be less risky than private credits. While government bonds provide relatively safe assets to fight faltering balance sheets, they have also seemingly been crowding out private investment and credits. Additionally, stricter regulation of banking and financial transactions, as proposed by the Basel Committee, EU Commission and the Dodd-Frank-Act, have biased bank lending activities towards bonds and worsened credit supply conditions. It seems that governments have hit the brakes on bank lending and thus the economic recovery.

As that economic recovery in the Eurozone and the US slows, the next credit crunch, this time in government bonds, is about to hit. There seems to be no other way out, except to draw on central banks and their ability to bailout banks and governments once again. This mechanism works quite smoothly as long as central banks provide sufficient monetary means and net creditors to the EU and the US do not leave. However, in order to prevent a complete financial burn out, policy makers of the G-20 will have to find common ground and start cooperating on sound and well coordinated macro-financial regulatory policies. This implies a fundamental shift in and restructuring of financial regulatory policies and enhanced macro-financial coordination, which might come at the expense of short-run economic sacrifices. However, since this inevitable adjustment process is politically unpalatable, it seems that we have to accept living through these boom-bust episodes for quite some time.

Andreas Kern is visiting Assistant Professor at the Georgetown Public Policy Institute. He teaches in the areas of international political economy and development economics.