Saturday, July 4, 2015

Greece vs Puerto Rico and what's "systemic."

How is a Greek default different from a Puerto Rican default?

Answer: because Puerto Rico doesn't have its own banking system. It can't shut down banks. Banks in Puerto Rico are not loaded up on Puerto Rico debt, so depositors are not in danger if the state government defaults.

Puerto Rico, like Greece, uses a common currency. But there is no question of PRexit, that people wake up one morning and their dollar bank accounts are suddenly PR Peso bank accounts. So they have no reason to run and get cash out.

Banks in New York are also not loaded up on Puerto Rico debt. US bank regulators haven't said that those banks can pretend Puerto Rico debt is risk free.

If a Puerto Rican bank fails, any large US bank can quickly take it over and keep it running.

A Puerto Rican government default will be a mess. Just like the default of a large business in Puerto Rico. But it will not mean a bank run, crisis, and economic paralysis.

So here is a big lesson of the Greek debacle: In a currency union, sovereign debt must be able to default, without shutting down the banks, just as corporations default. Banks must not be loaded up on their country's sovereign debt. Bank regulation must treat sovereign default just like corporate default. It can happen, and banks must diversified and capitalized to survive it.  Banks must be free to operate across borders.  A common currency needs a firm commitment that it will not be abandoned.

In financial regulation, the big debate rages over what is "systemic,"  with the latest absurd idea to extend that designation to equity asset managers. (More later.) All that discussion starts with statements that  sovereign debt or anything backed by sovereign debt or sovereign guarantees is safe and per se not "systemic." Sovereign debt still counts as risk free in almost all banking regulation.

Greece should reinforce the lesson: Sovereign debt is a prime source of "systemic" danger. That is especially true of small governments in a currency union. A government is just a highly leveraged financial institution and insurance company.

Wrong answers:

- Fiscal union. The US is not necessarily going to bail out Puerto Rico. Or Illinois. Or their creditors. People keep saying a currency union needs fiscal union, but it is not so.

- National deposit insurance is really not central either. The banks operating in Puerto Rico are not in danger, so they don't need deposit insurance protection.

Update: A colleague pointed me to this excellent article on banks holding their own sovereign debt by Lucrezia Reichlin and Luis Garicano.

25 comments:

  1. It's obvious that bank regulators don't know what the proper risk weights should be. It was particularly egregious to treat Greek sovereign debt as riskless, but there have been other regulatory miscalculations - even in the US. If we give a low risk weight to home loans, the result is housing bubbles and reduced lending to businesses. There must be a way to make banks safe, even in Europe, without needing regulators who can make accurate determinations of risk weights.

    ReplyDelete
    Replies
    1. John actually defends a pretty simple solution which I quite like that ends with these risk weight shenanigans. 100% equity financed banks. From there on, you no longer need Core tier 1 capital vs risk weighted assets used for the solvency ratios currently used for banks. Equity falls within the tier 1 classification, so efectively banks 100% equity would mean banks fully financed by core tier 1 capital.

      Delete
    2. Ricardo,

      I never received a straight answer from John, so maybe you can answer a question - is the 100% equity financing for banks a requirement to be maintained in real time?

      For instance, bank sells $100,000 in shares to mutual fund A and lends out that $100,000 at interest. Suppose the market value of outstanding shares falls to $90,000. How does a bank get back to 100% equity financing? Or should a bank retain the ability to value the loans it holds at whatever value they chose?

      The implicit assumption seems to be that the value of the liabilities of a bank (it's equity) will move in lockstep with the value of it's assets (the loans that it holds). I don't think that is a valid assumption for several reasons:

      1. Most mutual funds cannot hold a mix of debt and equity and so you get built in segregation between potential debt buyers and potential equity buyers.

      2. Banks (like any other enterprise) use debt for other reasons - capital improvements (new office buildings, etc.). How many large capital improvement projects do you know of that are financed entirely with equity?

      Delete
  2. In my opinion, a Fiscal Union does not imply bailing out every country/region/city of the European Union, but it implies the existence of European debt. If Greek banks had European debt in their portfolios instead of Greek debt, I agree on that, we would not have bank runs and economic paralysis. But first you need European debt and before that a Fiscal Union.

    ReplyDelete
    Replies
    1. We can approximate European debt with a portfolio of sovereign debt, if the regulators get the weights right. I don't think that it's possible, which is a reason to support proposals such as the one by Ricardo and Hausmann which creates an international reserve asset which is a GDP-weighted mix.

      Delete
    2. I agree on the impossibility to get the weights right in a portfolio of sovereign debt, but I neither like the GDP-weighted international reserve asset option. At some point the countries with higher GDP could be the ones more indebted...like Italy in Europe.

      Delete
  3. John, one of the things i learned at Chicago that was hammered into me by Fischer Black is that it is always useful to think of international issues as intrastate issues in the US. It is often then easy to see the difference between the two. The independent banking systems and, when sovereign debt is guaranteed de facto or de jure, fiscal policies are two big differences between US states (or territories) and countries within a monetary union. You nailed it. Unfortunately, the analytical simplicity of a situation seldom translates into clear and simple public discourse.

    ReplyDelete
    Replies
    1. Nothing against Fischer Black, but the important distinction is that with intrastate issues, there is a higher court in the land to act as an arbitrator (the Federal court system). This is not the case with international issues.

      Delete
    2. I think this analogy is worth pursuing. Although the US has a monetary union the fiscal union is at the federal level and the states and localities have discretion on taxation and wages at their respective levels. How are productivity imbalances handled in the US? The same way as anywhere else that has a monetary union: fiscal transfers, labor migration, and changes in local wages.

      The EZ, despite its migration friendly treaty, has 1/10th the labor mobility seen in the US as measured by # of people who worked elsewhere (another US state or foreign country as the case may be) the previous year. The US has seen numerous population shifts based on economics: the early western migration, the Gold Rush, the shift from New England to the Sun Belt, and more recently oil-boom-related migrations, to name a few.

      Employers are also mobile. Furniture manufacturers moved from Western NY state to the South decades ago. GE once had 14,000 employees in the town of Pittsfield, MA. Now it's gone. Boeing is moving ops to SC. Beretta moved to TN. If the wages don't adjust the employers migrate to the lower wages.

      We should be thinking about why BMW hasn't seen an economic benefit to moving a plant to Greece. Why is that mechanism broken?

      The public sector is a larger part of the European economies and the labor laws greatly favor labor. Wages aren't sticky so much as encased like flies in amber.

      The US, having a larger and less regulated private sector relatively unencumbered by unions, has greater wage flexibility than EZ countries.

      Nevertheless, the US still has interstate fiscal transfers but they're mediated through the central government and few citizens give it a second thought. Is the State of NY frothing over the fact that it gets back less federal dollars than it pays, and that the difference is going to Kentucky?

      The question in my mind, then, is whether the euro's woes are due to a failure of labor-related adjustment mechanisms to mitigate the need for transfers or the fact that the fiscal transfers are so obvious to the public? Probably both.

      Anyway, that's my uninformed view and I'm sticking to it.

      I'm reserving judgment on the effect of Puerto Rico. We need to give "what is not seen" a chance to be seen.

      Delete
  4. The argument behind a unified fiscal policy in Europe is basically one where fiscal transfers can offset the impact of a single monetary policy. A monetary policy right for Germany, may not be right for Greece. However, with a single monetary policy, the hands of each government to implement independent fiscal policy are tied up to the single monetary policy settings. You need a system where government funds can be directed towards where they are needed (as well as the help of automatic stabilisers). Also Germans would be happy providing more funds to Greece if they could have some say in how it was invested (ie that it does not go into government waste, housing booms, propping up inefficient welfare systems etc.) In the German corporatist system, there are strong links between government, unions, corporations and banks. You might say, government fine tuning does not work. Well, it has to large degree in the German system. What does not work in the US, sometimes works elsewhere - that probably requires anthropological and certainly historical knowledge. There is also a democratic aspect to this. Both Greeks and Germans would have a stake and say in a unified system fiscal system, but not in a solely monetary one.

    What fiscal union would provide Greece is the trading with a hard currency, something that eluded it in the pre-euro past, together with transfers and institutional reform that would arise with fiscal union. For Germany it would provide more assurance that its surpluses in need of a return would be channelled to and through sound institutional structures.

    ReplyDelete
    Replies
    1. Anonymous,

      "However, with a single monetary policy, the hands of each government to implement independent fiscal policy are tied up to the single monetary policy settings."

      You are presuming that a government needs to borrow to implement fiscal policy.

      John is saying that a local government needs the ability to borrow and then default on those loans. I believe that a local government needs the ability to sell equity.

      With debt defaults, investors are exposed to discretionary political risks - government refuses to pay back lenders even if it has the means to do so.

      With equity, investors are exposed to macroeconomic risk only.

      Delete
  5. I don't thing this is the classical example of a bank run...people are not withdrawing their money because they thing the bank is not healthy: it's because they thing their savings will disappear when the government legislates an enforced currency exchange from euros to new drachmas.

    Even if bank portfolios where invested in swiss debt denominated in swiss francs, people would keep withdrawing cash. Just imagine you were Greek and you had your savings in euros in an Athens branch of Credit Suisse...what would you do? The real issue here is the health of Greek public finances, not their banks.

    ReplyDelete
    Replies
    1. "The real issue here is the health of Greek public finances, not their banks."

      My understanding is that the real practical problem is that the ECB is saying that they will shut down the Greek banks on Monday morning. It may have come to this because the Greek banks are holding Greek sovereign debt.

      Delete
  6. BJohn,

    "So here is a big lesson of the Greek debacle: In a currency union, sovereign debt must be able to default, without shutting down the banks, just as corporations default. Banks must not be loaded up on their country's sovereign debt. Bank regulation must treat sovereign default just like corporate default."

    Wrong. Wrong. and Wrong Again. The reason is very simple - the sovereign (for instance the United States government) serves as the final arbitrator in any corporate / personal bankruptcy proceeding.

    A default by the sovereign can shut down it's own system of courts rendering all debt contracts (public and private) null and void since that sovereign may not be able to pay it's own employees (judges, lawyers, clerks, etc.).

    "Fiscal union. The US is not necessarily going to bail out Puerto Rico. Or Illinois. Or their creditors. People keep saying a currency union needs fiscal union, but it is not so."

    Yes the U. S. is going to bail out Puerto Rico in this sense - If Puerto Rico would go bankrupt and be unable to maintain it's own system of courts, law enforcement, etc., the U. S. government would step in to provide those services.

    Do you honestly think the U. S. government would sit on it's hands if the Puerto Rican government was shut down?

    ReplyDelete
  7. In the medium term the Greeks can replace their existing banks with some other form of payment clearing system. Any of the big credit card companies could do it by making it easier for payments to be made onto accounts. (E.g. I could pay for my Starbucks coffee by transferring money from my Mastercard account to the store's Mastercard account.) Digital payments with a paper trail would even help the Greek government by improving tax collection. An American or Canadian bank, or private equity fund, might be willing to take a flyer and put up a few billion to fund a payments system. The big problem on Monday morning is likely to be the complete absence of any liquidity anywhere in the Greek economy and everything grinds to a halt.

    ReplyDelete
  8. "Sovereign debt is a prime source of "systemic" danger. That is especially true of small governments in a currency union."

    Does not this strengthen the case for fiscal union? Greece is forced to stomach policies that are really driven by what is needed in the bigger economies of Europe, especially Germany. (And a bit of habit in Germany's policy making. During the Deutsch Mark era, Germany maintained a strong currency, one of the most stable, and generally attained its preferred inflation levels and adjusted aggregate demand through prices and incomes policies achievable through its corporatist centralised wage fixation system.)

    But the point is if the better part of fiscal policy is managed centrally, there is less chance of a government default, and if it happened, a government default in one of the member countries bringing down the system. Greece's small economy is prone to trade deficits and is highly vulnerable to swings in the prices of crucial imports. This can easily effect aggregate demand and therefore tax revenues and the government's position. This is not so true for Germany, and would not be for a unified Europe. A centralised fiscal policy reduces the chance of a sovereign default and the allows for the implementation of policy that tackles the union as a whole, not just have one country dominate the positions of others with the others forced to stomach it (although of course, to some degree that will still continue, but it would be mitigated somewhat, by adjustment done centrally including through automatic stabilisers).

    So what is the difference between a European country in a single currency area and a US state, such as Illinois? I am not American, but my guess is that life could go on if a US state went bankrupt. In a European country things would just stop working. Is it because in Europe they are used to the state running a larger proportion of production, or is it because in the US there is a large federal government structure which can offset dysfunction in one of the states? I'm not sure.

    ReplyDelete
    Replies
    1. Anonymous,

      "..is it because in the US there is a large federal government structure which can offset dysfunction in one of the states..."

      Bingo, you hit the nail on the head. The U. S. federal government can (and has) in a time of dis-function in one of it's member states served as a law enforcement agency (see U. S. armed forces national guard and reserve).

      In addition, the U. S. federal court system is in the position to serve as a binding arbitrator between a state and it's creditors.

      Delete
  9. Professor Cochrane: Thanks for the insightful post. Could you elaborate on your statement that, "A government is just a highly leveraged financial institution and insurance company"? I need to be able to explain when I parrot it later! :-)

    ReplyDelete
  10. Just for the record, we missed the ability to default largely because we did not have real banks in the models in which fiscal union was the stabilizer. The next generation models are being built now.

    ReplyDelete
  11. Richard BessererJuly 5, 2015 at 11:45 PM

    Don't forget as well that most of the borrowing done by Athens was blatantly fraudulent, with no real intention to re-pay.

    ReplyDelete
  12. This is a really excellent post, summarizing the issues so much better than anything I've read in months.

    A related additional point is that the central bank got drawn into this political mess through its risk-ignoring collateral policy. No wonder Greek banks loaded up on short-term bills and whatever is left outstanding in bonds if they could simply hand them over to the ECB in refinancing operations and later ELA. Acknowledging the Greek government's de facto default now by raising haircuts or rejecting Greek debt as collateral altogether will inmediately pull the trigger. That is something which should simply not be the job of an independent central bank. Issues like these will only become worse if they also take on the role as regulator...

    ReplyDelete
  13. Thanks for your information about the Puerto bank debts and other related information.Your post is really useful one for me

    ReplyDelete
  14. Perhaps I'm wrong but I don't think that just because PR uses dollars equates to them being in a currency union with the United States. Perhaps we need to distinguish between currency union and monetary union (the Eurozone). Do we consider nations who Dollarize their economies (Ecuador for example) as being in a currency union with the U.S.?

    ReplyDelete
    Replies
    1. Puerto Rico is not a state of the United States but it is a commonwealth. This is one of the reasons why Puerto Rico uses the US dollar. The government of Puerto Rico falls under the US Congress. I don't agree with you that the Puerto Rico dollar does not equate to the US dollar because Puerto Rico is technically part of the US. They might have a different way of banking but they are still somewhat equal.

      Delete
  15. While bailouts (Illinois, PR) should be frowned upon, I would say the U.S, does have fiscal union as well as a common currency. The "poor" states (South Carolina, Louisiana, etc) receive much more in federal spending than they send back in federal taxes. The "rich" states (New York, New Jersey, California, etc) pay much more in federal taxes than they receive back in federal spending. Hence, the Feds, in effect, redistribute money from "rich to poor" such that Louisiana, for example, doesn't become like Greece. The "United States of Europe" doesn't have this fiscal rebalancing mechanism.

    ReplyDelete

Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.