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