They bet; they lost

2011-12-17 10:02

The euro crisis threatening the global economy is not about nations going broke. It’s not even about saving the euro. It’s about saving the banks, for the second time in three years.

The banks need to be saved not because they bought toxic assets such as subprime mortgages or government debts of Greece, Ireland, Italy, Portugal or Spain, and not because they are too large, overrated or under-regulated.

They are in trouble because they bought risky securities with other people’s money, and they have to pay it back. They borrowed to gamble, lost yet another fortune and are facing a massive run.

A run in, say, Italy would force its government to bail out banks. The nation can’t print euros, so it would have to go back to its own money to do so – that is, abandon the common currency.

Why not let the banks fail? Because they control the financial highways that connect borrowers and lenders, savers and investors.

Consider the analogy of actual highways: If petrol stations had to close down because of gambling losses, the economy would shut down, too. The right solution is for the government to prohibit gambling by systemically important facilitators of trade, whether they’re petrol stations or banks.

But how? Simple. Tell the banks that they can no longer borrow to invest in risky assets while promising creditors full – and often immediate – repayment. Nor can they borrow to invest in “safe” assets, such as government bonds. In fact, they can’t borrow in any way, shape or form. Instead, limit them to their sole legitimate purpose – intermediation.

Bankers might wonder how that would work. Banks have always borrowed and gambled, they might say. Not so. The US has about 8?000 bank-like institutions called mutual funds, none of which borrow.

Such unleveraged mutual funds, which handle about 25% of all traffic on our financial highways, came through the crisis with no problem.

True, some mutual funds do borrow. They are mostly money market funds, which duplicitously guarantee investors a share price of at least a dollar. Not surprisingly, these leveraged money-market mutual funds were the ones that ran into trouble in 2008.

Imagine Europe today if its banks had no leverage, but instead operated solely as mutual funds – what I call limited-purpose banks – whose investors shared in all gains and losses. There would be no crisis.

The funds’ shareholders would already have suffered capital losses on government bonds, cursed the gods, yelled at their spouses and gone about their business. No mutual fund would have gone broke. The financial highways would be wide open.

German Chancellor Angela Merkel and French President Nicolas Sarkozy would not be constantly trying to prop up the value of government bonds in order to save the banks and, thereby, rescue the euro. With limited-purpose banking, the banks (now mutual funds) would never need to be saved, and the euro would be secure.

Instead, Merkel and Sarkozy are working on the wrong side of the balance sheet. They are trying to fix the banks’ assets when they need to restructure the liabilities. Transforming the banks into mutual funds whose only liability is owners’ equity is a lot easier than managing fiscal behaviour across 17 nations.

Last week’s agreement to limit the deficits of euro member nations is unlikely to achieve real fiscal discipline. With a bit of manipulative semantics, governments can meet or beat their deficit targets without changing underlying policies.

Governments are adept at choosing words to hide their true liabilities. The US has excelled at this, racking up colossal implicit and unofficial debts. Its fiscal gap is 22 times its official debt.

Pledging to balance phony books is far different from, for example, giving Italian bondholders first claim on government revenue – an idea my Boston University colleague Cristophe Chamley proposes. Sovereigns’ failure to do so makes plain that their unofficial debts are as real as the official ones.

Italy’s Prime Minister Mario Monti would do well to lobby for fiscal-gap accounting and targeting, thanks largely to the nations past and recent pension reforms.

Getting Europe to change its fiscal accounting and policy, though, could take decades and won’t reduce the danger of a bank run. The only way to avoid such a disaster is to recognise that leveraged financial intermediation is unsafe at any speed, shut it down immediately and replace it with limited-purpose banking.

» Kotlikoff, a professor of economics at Boston University and is a columnist for Bloomberg View. The opinions expressed are his own.


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