Greece and Banking, the oped

Source: Wall Street Journal; Getty Images

A Wall Street Journal Oped with Andy Atkeson, summarizing many points already made on this blog. This was published August 5, so today I'm allowed to post it in its entirety. You've probably seen it already, but this blog is in part an archive. If not, here is the whole thing, with my preferred first paragraph.
Local pdf here.

Greece's Ills [and, more importantly, the Euro's] Require a Banking Fix 

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. A Greek cannot, without a foreign address, put money in a bank insulated from the Greek government and its politics. When Greece’s banks fail, international banks can’t step in to offer safe banking services independently of the Greek government.

European bank regulations encourage banks to invest heavily in their own country’s bonds, even when they have lousy ratings. The flawed banking architecture of Europe’s currency union pretends that sovereign default will never happen. Wise Europeans have known about these flaws for years, but the system was never fixed because it allows indebted countries to finance large debts.

This is the euro’s central fault. A currency union must treat sovereign default just like corporate or household default: Defaulters do not leave the currency union, and banks must treat sovereign debt cautiously. When Europeans can put their money into well-diversified pan-European banks, protected from interference from national governments, inevitable sovereign defaults will not spark runs, or destroy local banks and economies. And government bailouts will be far less tempting.

That is the long-term fix, but how does the eurozone get out of its current mess? The ECB’s latest Greek bailout deal is focused on long-run structural reforms, asset sales, budget targets and illusory tax increases. It might at best revive growth in a year or so.

But without well-functioning banks, Greece’s economy will collapse long before such growth arrives. To revive the banks and the economy, Greeks must know their money is safe, now and in the future. So safe that Greeks put money back in the banks, pay debts and seamlessly make payments—with no chance of a euro exit, tightened capital controls that impede international payments or depositor “bail-ins,” a polite word for the government grabbing deposits.

The United States offers a precedent. The U.S. economy ground to a standstill in the banking panic of 1933. The administration of Franklin D. Roosevelt closed America’s banks with a national banking holiday to stem the bank run. It then took immediate steps to restore confidence with the clear promises of the Emergency Banking Act of 1933 to resolve insolvent banks, promises backed up by the remarkable rhetoric of FDR’s first fireside chat and the intact borrowing power of the federal government. When banks reopened, Americans lined up to redeposit their money. In the 1980s, the U.S. deregulated banks to allow extensive branch and interstate banking, further isolating local banks from local troubles.

Europe is headed toward bailing out both the Greek government and Greece’s struggling banks. Instead, Europe should resolve and recapitalize the banks alone, put them under private European ownership and control, and insulate them from further Greek government interference. Then Europe can let Greece default, if need be, without another bank run.

Then move on to Italian and Spanish banks, which are similarly larded up with government debts and are threatening the euro. These banks can still be defused slowly, selling their government debts, without huge bailouts.

Europe needs well-diversified, pan-European banks, which must treat low-grade government debt just as gingerly as they treat low-grade corporate debt. Call it a banking union, or, better, open banking. The Greek tragedy can serve to revive the long-dormant but necessary completion of Europe’s admirable common-currency project.

Historical Fiction

Steve Williamson has a very nice post "Historical Fiction", rebutting the claim, largely by Paul Krugman, that the late 1970s Keynesian macroeconomics with adaptive expectations was vindicated in describing the Reagan-Volker era disinflation.

The claims were startling, to say the least, as they sharply contradict received wisdom in just about every macro textbook: The Keynesian IS-LM model, whatever its other virtues or faults, failed to predict how quickly inflation would take off in the 1970, as the expectations-adjusted Phillips curve shifted up. It then failed to predict just how quickly inflation would be beaten in the 1980s. It predicted agonizing decades of unemployment. Instead, expectations adjusted down again, the inflation battle ended quickly. The intellectual battle ended with rational expectations and forward-looking models at the center of macroeconomics for 30 years.

Just who said what in memos or opeds 40 years ago is somewhat of a fodder for a big blog debate, which I won't cover here.

Steve posted a graph from an interesting 1980 James Tobin paper simulating what would happen. This is a nicer source than old memos or opeds from the early 1980s warning of impeding doom. Memos and opeds are opinions. Simulations capture models.

The graph:

Source: James Tobin, BPEA. 

I thought it would be more effective to contrast this graph with the actual data, rather than rely on your memories of what happened.

The black lines are the Tobin simulation. The blue lines are what actually happened. (I'm not good enough with photoshop to superimpose the graphs, so I read Tobin's data off his chart.)

The two curves parallel in 81 to 83, with reality moving much faster. But In 1984 it all falls apart. You can see the "Phillips curve shift" in the classic rational expectations story; the booming recovery that followed the 82 recession.

And you can see the crucial Keynesian prediction error: After the monetary tightening is over in 1986, no, we do not need years and years of grinding 10% unemployment.

So, conventional history is, it turns out, right after all. Adaptive-expectations ISLM models and their interpreters were predicting years and years of unemployment to quash inflation, and it didn't happen.


One can debate 1981 to 1983. Here reality followed the general pattern, moving down a Phillips curve. Perhaps that is the success.  But the move was much quicker than Tobin's simulation. One might crow that inflation was conquered much more quickly than Keynesians predicted. But perhaps the actual monetary contraction may have been larger than what Tobin assumed, and assuming a harsher contraction would have sent the economy down the same curve faster?

Tobin describes his simulation thus:

The story is as follows: beginning in 1980:1 the government takes monetary and fiscal measures that gradually reduce the quarterly rate of increase of nominal income, MV. It is reduced in ten years from 12 percent a year to the noninflationary rate of 2 percent a year, the assumed sustainable rate of growth of real GNP. The inertia of inflation is modeled by the average of inflation rates over the preceding eight quarters. The actual inflation rate each quarter is this average plus or minus a term that depends on the unemployment rate, U, relative to the NAIRU, assumed to be 6 percent. This term is (6/U(-1) - 1). It implies a Phillips curve slope of one-sixth a quarter, two-thirds a year at U = 6 and has the usual curvature.

So, I think the answer is no. A faster monetary contraction leaves the 8 quarter lag of inflation in place, so you'll get even bigger unemployment and not much contraction in inflation. If someone else wants to redo Tobin's simulation with the actual 81-83 inflation, that would be interesting. But it is a bit tangential to the central story, 1984. You can also see here in the highlighted passage (my emphasis) how adaptive expectations are crucial to the story.

Now, let's be fair to Tobin. Yes, as quoted by Steve, he came out in favor of "Incomes policies," which used to be a nice euphemism for wage and price controls, but have an even more Orwellian ring these days. But Tobin also wrote, just following this graph,

This is not a prediction! It is a cautionary tale. The simulation is a reference path, against which policymakers must weigh their hunches that the assumed policy, applied resolutely and irrevocably, would bring speedier and less costly results. There are several reasons that disinflation might occur more rapidly. When unemployment remains so high so long, bankruptcies and plant closings, prospective as well as actual, might lead to more precipitous collapse of wage and price patterns than have been experienced in the United States since 1932. Moreover, the very threat of a scenario like figure 6 may induce wage-price behavior that yields a happier outcome. A simulated scenario with rational rather than adaptive expectations of inflation would show speedier disinflation and smaller unemployment cost, to a degree that depends on the duration of contractual inertia, explicit or implicit.

My emphasis. Now, having seen only one big Phillips curve failure in the 1970s, it might be reasonable for policy-oriented people not to jettison their entire theoretical framework in one blow. And this Tobin piece, using adaptive expectations, does incorporate some of the lessons of the 1970s. In the 1960s, Keynesians used a fixed Phillips curve. Friedman famously pointed out that it would not stay fixed -- but even Friedman (1968) had adaptive expectations in mind. For policy purposes it might make sense to integrate over models and adapt slowly, an attitude I just recommended in present circumstances.

You can see Tobin clearly seeing the possibilities, and clearly seeing the conclusions that we would come to after seeing the "happier outcome." That he had not come to these conclusions before the fact is understandable.

That contemporary commentators should forget or obfuscate this history, in an effort to resuscitate a comfortable, politically convenient, but failed economics of their youth, is less forgivable.

I don't want to fully endorse the classic resolution of 1984. Lots of other things changed, in particular deregulation and a big tax reform in the air. There was a lot of new technology. Financial deregulation was kicking in. We may find someday that such "supply side" changes were behind the 1980s boom. And we may jettison or radically reunderstand the Phillips curve, even with the free expectations parameter to play around with. It certainly has fallen apart lately (here, here and many more). But ISLM / adaptive expectations as an eternal truth just doesn't hold up. It really did fail in the 70s, and again in the 80s.

PS: The chart using actual inflation FYI

Whither inflation?

(Note: This post uses mathjax to display equations and has several graphs. I've noticed that the blog gets picked up here and there and mangled along the way. If you can't read it or see the graphs, come back to the original .)

The news reports from Jackson Hole are very interesting. Fed officials are grappling with a tough question: what will happen to inflation? Why is there so little inflation now? How will a rate rise affect inflation? How can we trust models of the latter that are so wrong on the former?

Well, why don't we turn to the most utterly standard model for the answers to this question -- the sticky-price intertemporal substitution model. (It's often called "new-Keynesian" but I'm trying to avoid that word since its operation and predictions turn out to be diametrically opposed to anything "Keyneisan," as we'll see.)

Here is the model's answer:

Response of inflation (red) and output (black) to a permanent rise in interest rates (blue). 

The blue line supposes a step function rise in nominal interest rates. The red line plots the response of inflation and the black line plots output.  The solid lines plot the answer to the standard question, what if the Fed suddenly and unexpectedly raises rates? But the Fed is not suddenly and unexpectedly doing anything, so the dashed lines plot answers to the much more relevant question: what if the Fed tells us long in advance that the rate rise is coming?

According to this standard model, the answer is clear: Inflation rises throughout the episode, smoothly joining the higher nominal interest rate. Output declines.

The model: \begin{equation} x_{t} =E_{t}x_{t+1}-\sigma(i_{t}-E_{t}\pi_{t+1}) \label{one} \end{equation} \begin{equation} \pi_{t} =\beta E_{t}\pi_{t+1}+\kappa x_{t} \label{two} \end{equation} where \(x\) denotes the output gap, \(i\) is the nominal interest rate, and \(\pi\) is inflation. The solution  is \begin{equation} \pi_{t+1}=\frac{\kappa\sigma}{\lambda_{1}-\lambda_{2}}E_{t+1}\left[ i_{t}+\sum _{j=1}^{\infty}\lambda_{1}^{-j}i_{t-j}+\sum_{j=1}^{\infty}\lambda_{2} ^{j}E_{t+1}i_{t+j}\right] \label{three} \end{equation} \begin{equation*} x_{t+1}=\frac{\sigma}{\lambda_{1}-\lambda_{2}}E_{t+1}\left[ (1-\beta\lambda_1^{-1}) \sum _{j=0}^{\infty}\lambda_{1}^{-j}i_{t-j}+(1-\beta \lambda_2^{-1}) \sum_{j=1}^{\infty}\lambda_{2}^{j}E_{t+1}i_{t+j}\right] \end{equation*} where \[ \lambda_{1} =\frac{1}{2} \left( 1+\beta+\kappa\sigma +\sqrt{\left( 1+\beta+\kappa\sigma\right)^{2}-4\beta}\right) > 1 \] \[ \lambda_{2} =\frac{1}{2}\left( 1+\beta+\kappa\sigma -\sqrt{\left( 1+\beta+\kappa\sigma\right)^{2}-4\beta}\right) < 1. \] I use \(\beta = 0.97, \ \kappa = 0.2, \ \sigma = 0.3 \) to make the plot. As you see from \((\ref{three}\)), inflation is a two-sided geometrically-weighted moving average of the nominal interest rate, with positive weights. So the basic picture is not sensitive to parameter values.

The expected and unexpected lines are the same once the announcement is made. This standard model embodies exactly zero of the rational expectations idea that unexpected policy moves matter more than expected policy moves. (That's not an endorsement, it's a fact about the model.)

The Neo-Fisherian hypothesis and sticky prices

A bit of context. In some earlier blog posts (start here) I explored the "neo-Fisherian" idea that perhaps raising interest rates raises inflation. The idea is simple. The nominal interest rate is the real rate plus expected inflation, \[ i_t = r_t + E_t \pi_{t+1} \] In the long run, real rates are independent of monetary policy. This "Fisher relation" is a steady state of any model -- higher interest rates correspond to higher inflation.

However, is it a stable steady state, or unstable? If the nominal interest rate is stuck, say, at zero, do tiny bits of inflation spiral away from the Fisher equation? Or do blips in inflation melt away and converge steadily towards the interest rate? I'll call the latter the "long-run" Fisherian view. Even if that is true, perhaps an interest rate rise temporarily lowers inflation, and then inflation catches up in the long run. That's the "short-run" Fisherian question.

One might suspect that the new-Fisherian idea is true for flexible prices, but that sticky prices lead to a failure of either the short-run or long-run neo-Fisherian hypothesis. The graph shows that this supposition is absolutely false. The most utterly standard modern model of sticky prices generates a short-run and long-run neo-Fisherian response. And reduces output along the way.

Multiple equilibria and other issues 

Obviously, it's not that easy. There are about a hundred objections. The most obvious: this model with a fixed interest rate target has multiple equilibria. On the date of the announcement of the policy change, inflation and output can jump.

Inflation response to an interest rate rise: multiple equilibria

The picture shows some of the possibilities when people learn rates will rise three periods ahead of the actual rise. The solid red line is the response I showed above. The dashed red lines show what happens if there is an additional "sunspot" jump in inflation, which can happen in these models.

Math: You can add an arbitrary \(\lambda_{1}^{-t}\delta_\tau \) to the impulse-response function given by (\(\ref{three}\)), where \(\tau\) is the time of the announcement (\(\tau=-3\) in the graph), and it still obeys equations \( ( \ref{one})-(\ref{two})\). These are impulse response functions and sunspots must be unexepected. So the only issue is the jump on announcement. Response functions are thereafter unique.

A huge amount of academic effort is expended on pruning these equilibria (me too), which I won't talk about here. The bottom two lines show that it is possible to get a temporarily lower inflation response out of the model, if you can get a negative "sunspot" to coincide with the policy announcement.

But I think the plot says we're mostly wasting our time on this issue. The alternative equilibria have the biggest effect on inflation when the policy is announced, not when the policy actually happens. But we do not see big changes in inflation when the Fed makes announcements.  The Fed is not at all worried about inflation past that is slowly cooling as the day of the rise approaches, as these equilibria show. It's worried about inflation or deflation future in response to the actual rate rise.

The graph suggests to me that most of the "sensible" equilibria are pretty near the solid line.

The graph also shows that all the multiple equilibria are stable, and thus neo-Fisherian. At best we can have a short-run discussion. In the long run, a rate rise raises inflation in any equilibrium of this model.

Yeah, there's lots more here -- what about Taylor rules, stochastic exits from the zero bound, off-equilibrium threats, QE, better Phillips curves with lagged inflation terms, habits in the IS curve, credit constraints, investment and capital, learning dynamics, fiscal policy, and so on and so on. This is a blog post, so we'll stop here. The paper to follow will deal with some of this.

And the point is made. The basic simplest model makes a sharp and surprising prediction. Maybe that prediction is wrong because one or another epicycle matters. But I don't think much current discussion recognizes that this is the starting point, and you need patches to recover the opposite sign, not the other way around.

Data and models

I started with the observation that it would be nice if the model we use to analyze the rate rise gave a vaguely plausible description of recent reality.

The graph shows the Federal Funds rate (green), the 10 year bond rate (red) and core CPI inflation (blue).

The conventional way of reading this graph is that inflation is unstable, and so needs the Fed to actively adjust rates. Inflation is like a broom held upside down, with inflation on the top and the funds rate on the bottom. When inflation declines a bit, the Fed drives the funds rate down to push inflation back up, just as you would follow a falling broom. When inflation rises a bit, the Fed similarly quickly raises the funds rate.

That view represents the conventional doctrine, that an interest rate peg is unstable, and will lead quickly to either hyperinflation (Milton Friedman's famous 1968 analysis) or to a deflationary "spiral" or "vortex."

And this instability view predicts what will happen should the Fed deliberately raise rates. Raising rates is like deliberately moving the bottom of the broom. The top moves the other way, lowering inflation. When inflation is low enough, the Fed then quickly lowers rates to stop the broom from tipping off.

But in 2008, interest rates hit zero. The broom handle could not move. The conventional view predicted that the broom will topple. Traditional Keynesians warned that a deflationary "spiral" or "vortex" would break out. Traditional monetarists looked at QE, and warned hyperinflation would break out.

(I added the 10 year rate as an indicator of expected inflation, and to emphasize how little effect QE had. $3 trillion dollars of bond purchases later, good luck seeing anything but a steady downward trend in 10 year rates.)

The amazing thing about the last 7 years in the US and Europe -- and 20 in Japan -- is that nothing happened! After the recession ended, inflation continued its gently downward trend.

This is monetary economics Michelson–Morley moment. We set off what were supposed to be atomic bombs -- reserves rose from $50 billion to $3,000 billion, the crucial stabilizer of interest rate movements was stuck, and nothing happened.  

Oh sure, you can try to patch it up. Maybe we discover after the fact that wages are eternally sticky, even for 7 to 20 years while half the population changes jobs, so, sorry, that deflation vortex we predicted can't happen after all. Maybe the Fed is so wise it neatly steered the economy between the Great Deflationary Vortex on one side with just enough of the Hyperinflationary Quantitative Easing on the other to produce quiet. Maybe the great Fiscal Stimulus really did have a multipler of 6 or so (needed to be self-financing, as some claimed) and just offset the Deflationary Vortex.

But when the seas are so quiet, and the tiller has been locked at 0 for seven years, it's awfully hard to take seriously the Captain's stories of great typhoons, vortices, and hyperwhales narrowly avoided by great skill and daring.

Occam's razor says, let us take the facts seriously: An interest peg is stable after all.  The classic theories that predict instability of an interest rate peg -- and consequently that higher rates will lead to lower inflation -- are just wrong, at least in our circumstances (important qualifier follows).

But if those classic theories failed dramatically, what can take their place? Fortunately, I started this post with just one such theory. The utterly standard sticky-price model, sitting in Mike Woodford's and Jordi Gali's textbooks, predicts exactly what happened: inflation is stable under a peg, and thus raising interest rates to a new peg will raise inflation.

The difference between traditional Keynesian or Monetarist models and this modern sticky-price model is deep and essential. In this model, people are forward-looking. In the standard unstable traditional-Keynesian or Monetarist model, people look backward. When written in equations, the traditional "IS" curve (\(\ref{one}\)) does not have \(E_t x_{t+1} \) or \(E_t\pi_{t+1}\) in it, and the "Phillips curve" (\(\ref{two}\)) has past inflation in it,
not expected future inflation.

Forward looking people generates stability, and backward looking people generates instability. If you drove a car by looking in the rear-view mirror, the car may indeed regularly veer off the road, unless the Fed sitting next to you yells about things to come and stabilizes the car. But when people drive looking through the front windshield, cars are quite stable, reverting to the middle of the road when the wind buffets them to one side or the other.

The response function is also consistent with the experience of a few countries such as Sweden which did raise rates and swiftly abandoned the effort. Those rises didn't do much either way to inflation, but they did lower output. Just as the graph says.

What to do? A robust approach

I will not follow the standard economists' approach -- here's my bright new idea, the government should follow my advice tomorrow. Is this right? Maybe. Maybe not. I'm working on it, and hoping by that and this blog post to encourage others to do so as well.

But if you're running the Fed, you don't have the luxury of waiting for research. You have to face an uncomfortable fact, which the news out of Jackson hole says they're facing: They don't really know what will happen or how the economy works. Nor does anyone else. They know that their own forecasts and models have been wrong 7 years in a row -- as has everyone elses', except a few bloggers with remarkably spotty memories -- so pinpoint structural forecasts of what will happen by raising rates made by those same models and logic are darn suspect.

A robust policy decision should integrate over possibilities. So as far as I'll go is that this is a decent possibility, and should add to the caution over raising rates. Raising rates if there is a fire -- actual inflation -- might be sensible. Raising rates because of inflation forecasts from models that have been wrong seven years in a row seems a bit diceyer.

Of course, there is a bit of divergence in goals as well. The Fed wants more inflation, so might take this model as more reason to tighten. And if this model is right, the Fed will produce the inflation which it desires and can then congratulate itself for foreseeing!

I like zero.  Zero rates are pretty darn good. Zero inflation is pretty darn good too. We get the Friedman-optimal quantity of money. And more. Financial stability: With no interest cost, people and businesses hold a lot of money, and don’t conjure complex but fragile cash-management schemes. Three trillion dollars of reserves are three trillion dollars of narrow banking. Taxes: You don’t pay taxes on inflationary gains and taxes erode less of the return on investments.  We don't suffer sticky-price distortions from the economy.  Yeah, growth is too slow, but monetary policy has nothing to do with long-run growth.

So, face it, the outcomes we desire from monetary policy are just about perfect. We don't really know how this happened, but we should savor it while it lasts.

This last point might be the main one. The model I showed above is utterly standard, as is the main result. "New-Keynesian" papers about the "zero bound" have been analyzing this state for nearly 20 years. The result that inflation is stable around the steady state is at least 20 years old.  All the effort, however, has been about how to escape the zero bound. But why? If a very low interest peg is stable, and achieves the optimum quantity of money, why not leave it alone? OK, there's this multiple equilibrium technicality, but that hardly seems reason to go back to "normal."

The only real concern is that some hidden force might be building up to upend this delightful state of affairs. That's behind most calls for raising rates. But clearly, nobody knows with any certainty what that force might be or how to adjust policy levers to head it off.

One warning. In the above model, the interest rate peg is stable only so long as fiscal policy is solvent. Technically, I assume that fiscal surpluses are enough to pay off government debt at whatever inflation or deflation occurs.  Historically, pegs have fallen apart many times, and always when the government did not have the fiscal resources or fiscal desire to support them. The statement "an interest rate peg is stable" needs this huge asterisk.

Phillips art

The Wall Street Journal gets a prize for Art in Economics for their Phillips curve article. Abstract expressionist division, not contemporary realism, alas.

Source: Wall Street Journal

(For the uninitiated: There is supposed to be a stable negatively sloped curve here by which higher inflation comes with lower unemployment. Beyond that correlation, most policy economists read it as cause and effect, higher unemployment begets lower inflation and vice versa. The point of the article is how little reality conforms to that bedrock belief.)

Too much debt, part II

"China to flood economy with cash" reads today's WSJ headline. When you read the article, however, you find it's not quite true. China to flood economy with debt is more accurate.

The expected move to free up more funds for lending—by reducing the deposits banks must hold in reserve—is directly aimed at countering the effects of a weaker currency,

The People’s Bank of China’s latest planned move, which could come before the end of this month or early next month, would involve a half-percentage-point reduction in banks’ reserve-requirement ratio, potentially releasing 678 billion yuan ($106.2 billion) in funds for banks to make loans.

I had hoped the world learned this lesson in the financial crisis. Equity is great. When things go bad, shareholders lose value by prices falling, but they cannot run and the firm cannot fail if it does not pay equity holders.

Financial crises are always and everywhere about debt, especially short term debt. Lending more, encouraging more bank leverage, reducing reserves and margin requirements, means that when the downturn comes a needless wave of runs and defaults follows.

Inevitably, it seems, another downturn will come, another set of books will have been found to have been cooked, and then we will find out who lent too much money to whom. US investment banks, 2008, strike one. Greece, 2010, strike 2. China, 2015, strike 3? Do we no longer bother closing the barn doors even after the horse leaves?

This story should also give one pause about the wisdom of "macro-prudential" policy, by which wise central bankers are supposed to presciently open and close the spigots of leverage to manage asset prices.

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.

Greenspan for Capital

Alan Greenspan joins the high-capital banking club, in an intriguing FT editorial

If average bank capital in 2008 had been, say, 20 or even 30 per cent of assets (instead of the recent levels of 10 to 11 per cent), serial debt default contagion would arguably never have been triggered. Had Bear Stearns and Lehman Brothers continued as capital-conscious partnerships, a paradigm under which both thrived, they would probably still be in business. The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will suppress bank earnings and lending. History, however, suggests otherwise.

20 to 30 percent used to be the sort of thing one could not say in public without being branded some sort of nut.

Alan also echoes the main point. Banks need lots of regulators micromanaging their investment decisions, because taxpayers pick up the bag for their too-high debts. Banks with lots of capital do not need asset micro-regulation:

...An important collateral pay-off for higher equity in the years ahead could be a significant reduction in bank supervision and regulation.

Lawmakers and regulators, given elevated capital buffers, need to be far less concerned about the quality of the banks’ loan and securities portfolios since any losses would be absorbed by shareholders, not taxpayers. This would enable the Dodd-Frank Act on financial regulation of 2010 to be shelved, ending its potential to distort the markets — a potential seen in the recent decline in market liquidity and flexibility.

A double bravo.

However, to be honest, I have to nitpick a bit on what seems like the right answer for some of the wrong reasons.


Alan seems to argue that the rate of return to equity is independent of leverage:

Banks compete for equity capital against all other businesses....

In the wake of banking crises over the decades, rates of return on bank equity dipped but soon returned to their narrow range. ...

What makes the stability of banks’ rate of return since 1870 especially striking is the fact that the ratio of equity capital to assets was undergoing a significant contraction followed by a modest recovery. Bank equity as a percentage of assets, for example, declined from 36 per cent in 1870 to 7 per cent in 1950..Since then, the ratio has drifted up to today’s 11 per cent. 

So if history is any guide, a gradual rise in regulatory capital requirements as a percentage of assets (in the context of a continued stable rate of return on equity capital) will not suppress phased-in earnings..

There is an exam question in here: what seems wrong? Answer: Competition for equity capital should drive the risk adjusted rate of return for bank equity to be the same as for other businesses. If banks issue more capital, the raw rate of return to equity should decline. So should the variability (beta, risk) of that return. (Other things held constant, which may well be why the historical record is muddy.)

In fact, Alan seems precisely to be making the banks' argument. They claim that the return on equity capital is independent of leverage. They have to pay (say) 10% to shareholders, but only 1% to debt holders, so debt is a cheaper source of financing. Banks claim that forcing them to issue more expensive capital will force them to raise loan rates and strangle lending. Which, curiously, Alan seems to be endorsing. Though he starts with

The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will suppress bank earnings and lending. History, however, suggests otherwise.

He follows up with

...bank net income as a percentage of assets will be competitively pressed higher, as it has been in the past, just enough to offset the costs of higher equity requirements. Loan-to-deposit interest rate spreads will widen and/or non-interest earnings will increase.

Ok, so earnings may not be affected, but a rise in loan-to-deposit spreads is exactly what the banks are warning of, and it's hard to see how that would not "suppress bank lending."

All this only happens if investors demand the same return to equity no matter what leverage, and competition then forces banks to deliver that return. This proposition is precisely what advocates (such as myself) or more capital deny. Investors are not that dumb, they demand a competitive risk adjusted rate of return. More capitalized banks will deliver lower rates of return -- and equally lower risk. Bank "stock" will look very much like long term bonds and become the cornerstone of safe portfolios. So we get all of Greenspan's benefits and none of the downside.

Of course, this is just an editorial. He may have meant "risk adjusted" return, and was trying to simplify language.