The evolving Greek debt tragedy illustrates the subtle nature of the financial sector's risk management process. On the surface, its risk analysis seems to have been a dismal failure, apparently unable to anticipate obvious problems. But in practice the financial sector seems to have largely succeeded in transferring its potential losses to taxpayers.

Greece's creditors have had a nasty scare, but they seem to be coming through more-or-less unscathed. Risk management turns out to have little to do with the intrinsic riskiness of the underlying investment, but rather is a political assessment of the feasibility of socialising the losses.

When Greece joined the Euro, there was no good economic reason why it should have been able to borrow at essentially the same interest rate as Germany. The Euro was a currency union, but each country was still responsible for its own debts, and Greece was always much more likely to get into trouble than the staid and disciplined Germans.

Nevertheless, Greece borrowed at close to the German rate until a little over a year ago. Being a member of the Euro took away the discipline that a country with its own exchange rate has, where profligate fiscal policies would depreciate its exchange rate and raise its borrowing interest rate.

Sure enough, the low interest rate encouraged the Greeks to over-extend and live beyond their means, resulting in government debt exceeding 150% of GDP. Financial markets were ready to oblige them. For their part, the credit rating agencies failed to anticipate any problems: one major agency kept Greece at investment grade until early this year.

As the debt built up, financial markets did not progressively come to a realisation of unsustainability, with graduated price signals to reflect increasing risk perceptions. Rather, they swung quickly from uncomprehending insouciance to total panic.

Of course, the changing assessment feeds on itself. At low interest rates the debt might seem sustainable. When interest rates move up, the unsustainability becomes blindingly obvious.

But all that was predictable enough. More importantly, this sudden volte-face is self-serving: if financial markets can convince the European authorities that their panic is so severe and all-encompassing that it will cause widespread contagion and threaten the future of the Euro itself, then they will be rescued by the taxpayers.

Indeed, this new contagion assessment has a perverse consistency. Having initially been unable to distinguish between the credit risk of Germany and Greece, now the financial markets purportedly are unable to distinguish between the credit risk of Greece (almost certain to eventually require massive restructuring) and Italy (probably OK).

There is, unfortunately, no operational method by which this debt crisis can be treated for what it really is: foolish lending to a small, globally-unimportant country. If Greece's creditors can make things sound sufficiently disastrous, they will be saved.

They seem to have succeeded. The head of the European Central Bank opposes asking creditors to take a haircut on their debt. Larry Summers, former head of President Obama's National Economic Council, argues that 'there must be a clear commitment that, whatever else happens, no big financial institution in any country will be allowed to fail'. Perhaps more surprising, left-of-centre economists such as Joe Stiglitz and Jeff Sachs are making much the same argument.

It used to be said that capitalism without bankruptcy was like Christianity without hell: there is no incentive to do the right thing. It is never a good time to remove this sort of moral hazard and restore longer-term principles by allowing Greece to declare default. If this opportunity ever existed, it was early last year when the problems in Greece first emerged. Now the financial sector (and in particular the bankers' lobby group, the Institute for International Finance) has had more than a year to promote the idea that Greek default would be disastrous for the whole world.

In a curious way, the financial sector has been able to justify its original assessment that Greek debt was only marginally more risky, ultimately, than German. But how much longer can the financial sector hold governments and taxpayers to ransom in this way?

Photo by Flickr user redjar.