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| Source: Wall Street Journal; Getty Images |
Greece suffered a run on its banks, closing them on June 29. Payments froze and the economy was paralyzed. Greek banks reopened on July 20 with the help of the European Central Bank. But many restrictions, including those on cash withdrawals and international money transfers, remain. The crash in the Greek stock market when it reopened Aug. 3 reminds us that Greece’s economy and financial system are still in awful shape.
Greece’s banking crisis revealed the main structural problem of the eurozone: A currency union must isolate banks from sovereign debt. To fix this central structural problem, Europe must open its nation-based banking system, recognize that sovereign debt is risky and stop letting countries use national banks to fund national deficits.
If Detroit, Puerto Rico or even Illinois defaults on its debts, there is no run on the banks. Why? Because nobody dreams that defaulting U.S. states or cities must secede from the dollar zone and invent a new currency. Also, U.S. state and city governments cannot force state or local 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.
Depositors in the eurozone don’t share this privilege....For the rest, you have to go to WSJ, Hoover (ungated) or wait 30 days until I'm allowed to post it here.
Lucrezia Reichlin and Luis Garicano have an excellent Project Syndicate piece on the same topic.
Writing contest: This is our first paragraph. The Journal's editors thought it was better with latest news first. Which works better?
Insulating Greek banks from Greek politicians can only be beneficial. However, if Greece runs a balance of payments or “external” deficit for long enough, its banks will run out of reserves and go bust. E.g. when a Greek buys a Mercedes for $20k, $20k of reserves move from some bank in Greece to some bank in Germany.
ReplyDeleteLikewise if Illinois run an external deficit for long enough, banks that operated solely in Illinois would go bust, i.e. their liabilities would exceed their assets if they had made silly loans. In contrast, if their loans were well judged, then assets AND liabilities of those banks would shrink to an extent that made them no longer viable: they’d get taken over. Same would go for a bank in Illinois which was a branch of a nationwide bank: if it had made wise loans, its assets and liabilities would shrink to too near zero. So head office would close it.
Bank branches are constantly opening and closing in US states and UK counties. When closures exceed openings I suspect the above external deficit will be the cause in some cases.
Banking is like a Ponzi scheme: as long as there’s plenty of new deposits, a bank can get away with silly loans. But when the deposits shrink, the skeletons in the cupboard become visible.
Also the external deficit of US states is limited by the fact that labour mobility in the US is ten times that of the EU. That’s according to an article in the Economist (link below).
http://www.economist.com/blogs/freeexchange/2014/01/european-labour-mobility
Ralph, I'm sorry, this is wrong. A trade deficit is not financed by bank reserves alone. If Greece wants to run a trade deficit, it must run a capital account surplus. It gets reserves by selling assets or borrowing money.
Delete
DeleteThese issues associated with Bank's having their asset risk exposure concentrated in one geographical part of a currency area are much less likely to occur where the banks have there own branches evenly spread out over a currency area.
there is a video here that talks about the Eurosystem not discriminating on trade balances. https://www.youtube.com/watch?v=kMC_Ns4sJSw
Delete(not my video)
John,
ReplyDeleteYour recent blogs on the topic are among the most insightful commentary I have read on the euro crisis coming from the Anglo-Saxon sphere. You are spot on on how the local banks' exposure to their local sovereign is the root of the crisis, not a lack of fiscal or political union in the euro area.
The only thing I would add is the political economy angle. Local elites have huge incentives to retain "localist" banking systems that not only buy their debt without questions but stuff their boards with former politicians and grant loans to businessmen who make political donations to the right people. Luis Garicano and coauthors have written very insightful papers on the politisation of regional banks for the case of Spain.
I agree. A lot of American economists do not seem to properly understand the reasons why Eurozone countries joined the Euro and why they want to stay in it, and it seems do not really want to understand the reasons. They just use it as an excuse to justify the use of their pet models.
DeleteThese series of posts have been much more thoughtful and the policy ideas good ones.
John,
ReplyDelete"The Journal's editors thought it was better with latest news first. Which works better?"
Neither.
"If Detroit, Puerto Rico or even Illinois defaults on its debts, there is no run on the banks."
That would depend on how large a position any one bank holds in that debt. Also, even if a single bank holds a large position in Detroit debt, deposit insurance may cover some or all of the losses. Picture a single bank holding a large position in Detroit debt offering no deposit insurance and having no access to central bank lender of last resort funds. I think you can say with a fair amount of certainty that a default by the city of Detroit could lead to a run on that bank.
"Greece’s banking crisis revealed the main structural problem of the eurozone: A currency union must isolate banks from sovereign debt."
You have got it backwards. Greece's banking crisis revealed the main structural problem of the Eurozone - A sovereign must isolate itself from the shared central bank, meaning the sovereign never sells debt.
FYI Google has a deal to ungate wsj try top link https://www.google.com/search?q=Greece%E2%80%99s+Ills+Require+a+Banking+Fix&oq=Greece%E2%80%99s+Ills+Require+a+Banking+Fix&aqs=chrome..69i57j69i60.383j0j4&sourceid=chrome&es_sm=93&ie=UTF-8
ReplyDeleteThanks. Yes there are ways to get around it. They specifically asked me not to post for 30 days so I'll abide by that.
DeleteThis sort of thing makes me glad I'm American. A common currency doesn't make sense without fiscal and financial integration, which in turn require restrictions on domestic policy. It seems to me that to make the Euro work, you need a degree of political integration that is inconsistent with national sovereignty.
ReplyDeleteI'm starting to think that the Euro is doomed. The political economy just doesn't work.
The ECB has done basically the opposite of what Cochrane says with LTRO, but was very succesful. Italian Banks bought 430 billions of BTP for instance and yields went from 4% to 2%. Now Bank of Italy is buying 150 billions of BTP with QE and this pushes yields down some more and Italian banks are just fine (the stock exchange is up 25% in 2015, best in the world after Pakistan)
ReplyDeleteSo, why does it work the opposite for Greece ? The ECB excluded it from QE and Tsipras started a fight without any plan B, so he scared the greeks and they took 100 billions out of the local banks etc...
Greece is not representative of how the Euro works. The ECB buys debt by the truckloads for everybody except Tsipras, yields are low even in Portugal, the Euro is down 20% and money is piling into Euro assets.
Why do you use Greece to judge the whole thing ? It is an outlayer
I agree the ECB has been successful in achieving the short term goal of lowering peripheral yields but as you said, this was first achieved via the LTRO which strengthened the sovereign-bank loop. While one can point to today's low yield levels and proclaim it a success, I would argue that this short term success came at a price - a potential time bomb later should the situation deteriorate.
DeleteGreece is a simple example of what could happen to Italy, Spain or a number of other countries. Italy's debt/gdp ratio is above 130%, hardly a comforting level. It's relatively stable now but what would happen if someone like Berlusconi came to power again? or Beppe Grillo and the Five star movement, which is openly sceptical of the Euro project. What of Podemos in Spain or LePen in France?
The virtuous circle of lower yields would reverse and these countries would very quickly face the downward spiral Greece has experienced. For all the short term success the ECB has had, none of the structural problems in the Eurozone have been addressed and the eurozone is very poorly prepared for the next global economic downturn.
I'm not sure there are any easy solutions to this problem but tackling the sovereign-bank loop is absolutely crucial for long term stability. Maybe one starting point could be to cap the amount of "domestic" gov't debt a bank could hold. Ideally there should be no distinction at all between a French, German or Italian bank but such pan Eurowide diversification is not going to happen overnight.
So one could start by forcing banks to hold a diversified portfolio of Eurozone gov't bonds. "Italian" banks would be forced to hold German bonds, French bonds etc. and would be limited to the amount of Italian gov't bonds they could hold (some deviation from the market share). This coupled with a eurozone wide deposit insurance would be a good start to breaking the bank-sovereign loop
While I have been critical of how the Greek state has been operating for decades, see also my comment on Steve Williamson's last post, I feel the need to set the record straight. The Greek systemic banks were not state-owned, and their decision to buy Greek sovereign debt was driven by the pursuit of a high return relative to perceived risk. Moreover, the bank run was driven not by a concern about their losses in the case ofbdefault, but precisely by loss of access to liquidity by the ECB and defaults by private borrowers who have loans in Euros and would now get paid in local currency. How does one insulate against that?
ReplyDeleteConstantine,
Delete"...their decision to buy Greek sovereign debt was driven by the pursuit of a high return relative to perceived risk..."
"...precisely by loss of access to liquidity by the ECB and defaults by private borrowers who have loans in Euros..."
"How does one insulate against that?"
Simple:
Step #1: Get the Greek government out of the borrowing business altogether. That forces Greek banks to look to the private sector for lending opportunities
Step #2: Reduce the perceived risk of lending to the private sector. That means using fiscal policy (tax & / or spending policy) to either reduce private after tax cost of debt service and / or raise private incomes.
O/T: Dr. Cochrane, in case you missed this, I thought you might be interested in this new post by Dr. Mark Sadowski on his findings about "the age of ZIRP" (one concluding sentence fragment below as a teaser):
ReplyDelete"...tax cuts have had the perverse effect of leading to less economic growth and, similarly, that tax increases have led to increased economic growth.”
"Writing contest: ... Which works better?"
ReplyDeleteStart with the conclusion. Any sort of "advocacy" writing should never leave the reader in doubt about where you are going and why it matters. You are not writing a mystery novel. You are not presenting a mathematical proof going from assumptions to conclusions. You are not trying to show your personal cleverness.
By starting with the most recent news first you engage the reader and tell them why what follows is important to them and it gives the reader a reference framework. Those of us whose background is in math and physics have a tendency to try to argue from principles to conclusions but that is not easy for the reader to follow because at each stage of the argument they are left to wonder: "where is this going and why is this sentence important to the journey"
When I do advocacy writing for court I try to tell the court in the first three or four short sentences (the shorter the better) what I am asking for and why on the basis of fairness my client should win. After that I can lay out the details of fact and law.
Absalon,
DeleteWhat you are saying works well for public speaking. People tend to have short attention spans and so getting to the point right from the beginning is beneficial.
With for profit writing (fiction or non-fiction) that is not necessarily the correct way to go about things. As a newspaper editor with an article spanning a number of pages, I don't want my readership reading the first part of the article, disagreeing with point being advocated, and skipping the rest simply because I want them to start on page 1 and move ahead to page 5 where my advertisements are located.
The difference between an American State and a European one is that only the latter can sequester Bank assets. Thus, whereas American Banks can diversify reserve assets without attracting predation, some European Banks, where voters might put lunatics in power, can't afford to be complacent and thus load up on the IOUs of their potential predator.
ReplyDeleteThe real heavy lifting in the Eurogroup was to be done by the 'Euro-Plus' mechanisms, the 'Maastricht 2' proposals, such that Competitiveness and the Debt-brake get written into national law and, moreover, there is peer-review of national budgets- i.e. fiscal policy making turns into a sort of A.A intervention with your boss and mom and dad and biggest clients all showing up.
It may be that Tsipras is starting to see the utility of Europlus (his party were the only ones to protest Greece signing up for it in 2011, as a condition for getting money) which is that if you have a charismatic rival in your party, you can send him for the peer-review where he gets waterboarded by the Finns and Lithuanians and so on till he finally resigns and runs away or turns into an on-message Moonie.