All I am hearing from Washington right now is:
We are pressing leveraged banks to reduce their exposure to eurorisk by selling their risky European government bonds off to other private-sector investors.
That is a good thing from the perspective of avoiding another financial crisis here in the U.S. that would push us into a full-fledged depression. Risky eurozone government debt should be held by those who are not already in the business of becoming highly leveraged and dancing as close as they can to the edge of failure.
That, however, does not change the fact that when Wall Street banks shed their eurorisk that the net risk-bearing capacity of the private market is diminished, and that in the current situation a reduction in the market's risk-bearing capacity widens spreads and is contractionary.
What Washington should be doing right now is saying: We will bear some of the eurorisk, and we--as your regulators--require that you raise more capital so that you can cope with and bear the rest.
Right now fiscal austerity is contractionary, monetary austerity is contractionary, and banking austerity--requiring finance to cut back on leverage by shrinking assets rather than raising capital--is contractionary as well.
I believe it was September 2007 when George Akerlof and Peter Diamond pointed out to me that while each individual bank didn't care at the margin whether it reduced its leverage by shrinking its assets or raising its capital, the rest of us collectively had a mighty interest that they raise their capital. The paradox of thrift applies to the macroeconomic consequences of changes in savings rates. There is a paradox of safety which applies to the macroeconomic consequences of changes in risk-bearing capacity as well. It is when every financial institution scrambles to hold a safer portfolio that things become the most unsafe of all.