Wednesday, August 19, 2015

Europa hat die Banken missbraucht

An editorial in Süddeutche Zeitung, on Greece, banks and the Euro, summarizing some recent blog posts.

I don't speak German, so I don't know how the translation went, but it sounds great to me:

Die jüngste Griechenland-Krise rückt das größte Strukturproblem des Euro in den Vordergrund: Unter dem Dach einer gemeinsamen Währung müssen Staaten genauso wie Firmen pleitegehen können. Banken müssen international offen sein, sie dürfen nicht vollgepackt sein mit den Schuldtiteln lokaler Regierungen. So war der Euro ursprünglich konzipiert. Leider haben Europas Politiker die erste Prämisse vergessen und sind zur zweiten gar nicht erst vorgedrungen. Jetzt ist es Zeit, beides in Angriff zu nehmen.... 
The English version:

Greek Lessons for a Healthy Euro

The most recent Greek crisis brings to the foreground the main structural problem of the euro: Under a common currency sovereigns must default just like corporations default. And banks must be open internationally, not stuffed with local governments’ debts.

This is how the euro was initially conceived. Alas, europe’s leaders forgot about the first and never got around to the second. It’s time to fix both.

If Volkswagen defaults on its debts and goes bankrupt, nobody dreams that it therefore has to leave the euro zone and start paying its workers in Volkswagen marks. In a currency union, governments cannot print their way out of trouble, so they are just like companies.

When Greece got in to trouble, the first bailout went to the German and French banks who had bought lots of Greek debt. Those debts were all transferred to official holders, meaning, indirectly the German taxpayer.

Why, with the 2008 financial crisis already in the rear view mirror, were European banks — too big to fail, apparently — allowed to load up on Greek debt, to the point that they had to be bailed out? Why did europe’s bank regulators let banks hold sovereign debt as a risk free asset?

The problem has only gotten worse. Greek banks are stuffed with Greek government debt. That’s why there was a run. Greeks, knowing their banks will fail if the government defaults, rush to get money out. They have stopped paying their mortgages, as they have stopped paying taxes, and stopped paying each other. The economy is plummeting. Even with the banks now supposedly open, capital controls remain in place so Greeks cannot pay for imports. And savvy Greeks know there is still a chance of Grexit, deal failure, depositor “bail-ins,” and tightened capital controls. They would be fools to put money back in banks.

A modern economy cannot function without banks. Greece will not restart its economy, restart its tax collections, and restart any hope of paying its debts without completely open and trustworthy banks.

Banking across Europe should be open, and divorced from local government debt. A Greek should be able to put his or her euros in a pan-european bank, whose assets are diversified across Europe and will not even hiccup if Greece’s government defaults. A Greek business should be able to borrow from the same bank, whose deposits come from all over Europe. If a Greek bank fails, any European bank should be able to come in and operate it the next morning. And the Greek government should have no right to grab deposits, force banks to buy its debts, or change the currency of those deposits.

If this had been the case, there would have been no run. The Greek economy would not have collapsed. And then Europe could have been a lot tougher with the Greek government about repayment.

This is how the United States works. When states and cities in the U.S. default — such as Detroit, Puerto Rico, or, possibly Illinois — there is no run on the banks, and banks do not fail or close. Why? Because nobody dreams that defaulting states or cities must secede from the dollar zone and invent a new currency.  State and city governments cannot force state banks to lend them money, and cannot grab or redenominate deposits. Americans can easily put money in Federally chartered, nationally diversified banks that are immune from state  and local government defaults.

As a result, when one of our state governments gets in fiscal trouble, nobody thinks they need to rush to their bank to get their money out, there is no “contagion,” and much less pressure for bailouts.

This was how the euro was supposed to be set up. Many economists have been warning about it for years. But governments like to use their banks as piggy banks, and it never happened.

Greece is not the end. Italian and Spanish banks are just as loaded up with their governments’ debts, and just as prone to a run. There is time to de-fuse this bomb slowly, but that time will run out.

Sovereign default without exit and open banking are the key requirements for the european currency union. A currency union does not need “fiscal union.” The US did not bail out the city of Detroit, or states when they failed. A currency union does not require similar economies. Panama uses the US dollar. A currency union does not need countries to have similar cultures, values, economic development, or productivity. A currency union does not need political union.  Europe used gold as the common currency for centuries, centuries when Kings defaulted frequently.

Many people say that small countries need their own currencies, so they can artfully devalue. But a century’s worth of devaluations and inflations did not produce a Greek growth miracle. There is no exchange rate at which Greece’s government workers will start exporting Porsches to Stuttgart.  Rather, it was binding themselves to the euro that produced a boom, only sadly wasted.

Greece off the euro will be a disaster. Drachmas will surely not be convertible, so Greece will end up like Cuba or Venezuela, with government workers and pensioners paid in worthless local currency, and everyone who can get paper euros operating on a cash basis.  No efficient large businesses can work in such an economy.  Greece’s only hope is to liberalize its economy, open to Europe, grow strongly, and pay back its debts.

The euro is a great and worthy project, and a necessary precursor to healthy open economies in small countries of a globalized world. It’s time to finish building it as originally conceived, not turn it into a bailout union.

Mr. Cochrane is a Senior Fellow of the Hoover Institution at Stanford University.


  1. The notion of "systemic banks" or "too-big-to-fail" banks seems to be missing from the op-ed. There is such a thing as systemic risk. No amount of slicing and dicing can change the fact that investment of any sort carries risk and that there are risks that can affect a huge part of a huge economy, even of the economy of the United States.
    Another bit of information that is worth knowing is the amount that German banks lost in the subprime market in the US, relative to the amount they lost in lending to Greece. Moreover, one should bear in mind the fact that German banks pre-crisis had a lot more "political" members on their boards than Greek banks. Perhaps that explains why they had to be bailed out of Greek government debt.
    George J. Georganas

  2. John,

    "If Volkswagen defaults on its debts and goes bankrupt, nobody dreams that it therefore has to leave the euro zone and start paying its workers in Volkswagen marks."

    If Volkswagen (or Puerto Rico, or Chicago, or Detroit) defaults on it's loans, there is a system of courts and laws to resolve the claims of both creditor and debtor.

    Where does that legal authority reside in a currency union that lacks fiscal union? Who's democratically elected lawmakers should be charged with creating laws that apply to the Greek government?

    Finally, it's as if you believe that a bankruptcy is some millisecond long event where debtors simply walk away from their debts without prejudice and lenders are left with no recourse. In the corporate world, that is never the case. In the world of sovereigns, that's how wars are started.

  3. Professor.... did you leave Chicago for greener pastures? :-)
    It says in the article, under "Der Autor - The Author":
    "John H. Cochrane, 57, forscht am Hoover Institute der Stanford Universität, Kalifornien, in den Bereichen Makroökonomie, Geldtheorie und Finanzwirtschaft. Vorher war er als Professor in Chicago tätig. In seinen jüngsten Publikationen geht es um die Staatsschuldenstruktur der USA und die Kosten und Nutzen der Regulierung von Finanzmärkten."

    John Cochrane, 57 (57? really?), is a researcher at the Hoover Institution of Stanford University, California, in the areas of macroeconomics, monetary economics and finance. *Previously* (that's the "vorher" word in German) (emphasis mine) he was a professor in Chicago. In his most recent publications, he deals with the structure of the US public debt and the costs and benefits of financial market regulation.

    So, there you have it... the good editors in Munich deleted you from the Booth faculty list...:-)... at 57...

  4. "Many people say that small countries need their own currencies, so they can artfully devalue. But a century’s worth of devaluations and inflations did not produce a Greek growth miracle. There is no exchange rate at which Greece’s government workers will start exporting Porsches to Stuttgart. Rather, it was binding themselves to the euro that produced a boom, only sadly wasted."

    If Greece could somehow put to referendum going back in a time machine and doing it all over again, but this time staying out of the Euro monetary union, do you think they would? Do you think they'd be better off today if they'd taken a different path? Even if not ideal, at least better off than where they are now?

    What about the citizens of Italy, Ireland, Spain, Portugal and Cyprus? Would they do it all over again, or do you think they'd take a different path knowing what they know now?

    Do you think the world's citizens have soured on this kind of monetary experiment for decades to come?

  5. This pulls things together for me better than the blog posts.

    I wonder if the French and German banks were all that systemically important during the first crisis or if DSK, having his eye on the Presidency of France, wouldn't allow French banks to go under. The IMF analysts back then were saying the same things they're saying now but if DSK had listened to them he could kiss his electoral prospects goodbye. All for naught; if he had settled for screwing the taxpayers of Europe instead of any woman with a pulse it might have worked out for him.

  6. The SZ is one of the most left-wing newspapers in Germany. I'm kind of surprised that they heard your voice. It must be because of this specific topic and this specific opinion. Most other freshwater opinions regarding other topics would never be printed in the SZ.

    "But a century’s worth of devaluations and inflations did not produce a Greek growth miracle. [...] Greece off the euro will be a disaster."

    I don't see the logic in that. Centuries with drachmas did not produce a disaster, so why would it be a disaster now? It seems to be the disaster started with the euro.

    "There is no exchange rate at which Greece’s government workers will start exporting Porsches to Stuttgart."

    This is really polemic. You don't really highlight a realistic path how Greece can ever be competitive again without leaving the euro. And no "liberalizing its economy" is not the answer for Greece because the Greek politicians have never done this and never will.

    1. If stating an obvious fact is to be construed as "polemic", I for one wish to know what reasonably plausible path would turn Greece into an Porsche-exporting powerhouse.

    2. You need to study the history of Greece pre-Euro. It was a story of crisis and devaluation with little industrial development.

      Greece needs institutional, that includes financial, reform. This would be best achieved at the European wide level. IThis is a big part of what the European project is about - bringing up the standards of living in the Southern periphery to those of the northern powerhouses (the German speaking economies, the Benelux, and Scandinavia). This requires a transfer of capital from the surplus countries in the north to the south. But for that to happen and not have vast amounts of liquidity thrown down a bottomless pit, there has to be institutional reform. The Euro is a part of this process towards integration and reform - it must be made to succeed.

      What John has given us is some practical proposals which I believe do not involve Treaty changes, and therefore less tricky than, for example, measures that involve fiscal or political union. They would also reassure German savers and taxpayers, who actually, really want to help Greece.

      What we are seeing here is an economist actually coming up with helpful ideas, and very good ones.

  7. Regulators are certainly to blame for designating all euro government bonds as "risk-free" debt, but in this case the Greek banks are hardly innocent - starting late last year when the former government looked shaky, they called all their favorite clients to urge them to borrow more, whether they needed to or not, because they were certain of a debt haircut down the line.

    And for the record, both Mundell and Phelps have long advocated banning banks from holding bonds of their own sovereign - the temptation to stuff new issues down their throats is too great to resist. Whence, incidentally, the existence of "Chinese walls" between investment banks and their trust departments - in practice these are Japanese ricepaper screens, but the principle is sound.

  8. Prof. Cochrane - if you use the "one page" option on the link you provided you get to >>
    >>> where you also find the "read in English" option, which does get to your text (clearly typeset by German-speakers, but otherwise perfect). Great article, thanks.

  9. Frank: I think you’re correct in pointing out that the lack of a clear resolution authority could be a problem, but I think it’s not much of a problem. Markets deal with the issue of unenforceable and/or incomplete contracts all the time. In an ideal world a sovereign borrower would negotiate enforceable contracts with lenders, specifying remedies in the event of default. But in the real world, it’s hard to see who would enforce the contract. (Hard, but not impossible. After all, trade agreements are a kind of contract made with sovereigns that are “enforced” through things like the WTO.) In practice, sovereign debt may be governed by a default clause saying, “If we decide not to pay you back, you don’t get paid back.” Default would still be a costly option since the borrower reputation would suffer. The default risk should, however, be priced into the deal.

    To get to the previous comment (George C, I think), I don’t see how this presents an issue of systematic risk. No prudently run pan-national bank subject to effective capital requirements would load up on the debt of any country that had even the smallest chance of default. Even if you think there is some correlation between sovereign risk (e.g., the risk of Portuguese default is correlated with the risk of Spanish default), you can still diversify away from the problem.

    The meme about “no currency union without fiscal and banking union” seems to reflect a lack of imagination about how it might work. It matters because a currency union could be a really good way of creating a money that has a standard value and so serves as effective medium of exchange, unit of account and store of value. I think it was John who said in an earlier post that a meter is a meter all over the world, which is nice.

    1. Mike,

      Thanks for your response.

      "The meme about no currency union without fiscal and banking union seems to reflect a lack of imagination about how it might work."

      My own opinion on how it might work is that sovereign governments don't sell bonds to begin with. Why should a government sell a security offering a promise for repayment only to renege on that repayment at a later date? It just seems counterproductive and deceptive to me.

      "It matters because a currency union could be a really good way of creating a money that has a standard value..."

      I don't have a problem with a currency union or a shared central bank. I just think that sovereigns selling bonds under a common currency is a bad idea without some overriding legal authority.

  10. A great post.

    The Euro is an important project that must be made to succeed, and a hard currency is something that the southern periphery had always wanted pre-Euro for very good reasons,
    but which always proved elusive. To return to the pre-Euro days is unacceptable. We know where that led, and was not industrial development and higher living standards. You have also properly dismissed the so-called optimal currency arguments as red-herrings. The real problems in the south of Europe relate to institutional and industrial/trading structures; the Euro is part of the process of fixing these and ensuring that capital flows from the north to the south in a way that can contribute to long term investment. German savers and taxpayers will be happy to help out Greece, and want to, if they are assured that this liquidity is not thrown down a bottomless pit. That requires institutional reforms that ensure that capital can be chanelled in such a way. The reforms to the financial system in Europe you describe, ultimately leading to financial integration, are ones which should not require a treaty change or associated referenda. They are therefore politically possible.

    The northern European powerhouses are socialist countries with large welfare states and centralised wage fixation systems, of which many would not like ideas coming from the Chicago School. Dr Schauble is well known for not being impressed by economists and their sticky price rational expectations optimisation models, and generally does not seek advice from them. But these countries do understand the importance of hard currency (remember the Deutsch Mark) and responsible financial and monetary practice. These are probably the best managed economies in the world.

    But your ideas here are good ones, and I hope they reach where it counts.

  11. you may be correct about the economics, but it doesn't matter: the economics are irrelevant. This is where you are wrong: 'This was how the euro was supposed to be set up.' No, it never was. The EU is a collectivist centralising political project and the euro is merely a device used by those pursuing that project. They don't care about the economic reality: the euro failing without political and fiscal union is fine by them since that advances their agenda. But that agenda is immoral, impractical and for that reason is already producing the authoritarian practises that socialist agendas must alway end up in and not wanted by europeans, who do not want a european washington telling them what to do. All your comparisons with your fedaral state system is therefore completely irrelevant. The only question is how far down the disastrous political union we will be forced and how awful a civil war will be required to get out of it. .


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