Thu 5/31/12 4:30 PM – Correction

I had incorrectly written earlier today that European banks that had bought sovereign debt in their country, due in large part to the carrot and stick incentives of the European Central Bank (ECB) as well as politicans in their country and which are now seeing the value of bonds decline face greater capital requirements as a result of the lower value of their sovereign bond holdings.

I am corrected by an article on the CNBC home page this afternoon which states that European countries have allowed their banks to ignore sovereign debt in calculating their capital requirements.

Given the extremely high level of sovereign debt holdings by many European banks, especially in the problem countries of Greece, Spain and Italy, this is a dangerous and short-sighted allowance. It is still another example of how government interference in markets distorts a true picture and produces greater problems than it solves, all for kicking the can down the road so as to avoid dealing with the real problems.

Banks are doing interest rate arbitrage when what they should be doing is helping to grow their economy by lending the money they got from the ECB to small businesses and individuals.