The euro crisis threatening the global economy is not about countries 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 saving not because they bought toxic assets such as subprime mortgages or the 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 the Italian government to bail out banks. The country 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 gas 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 are gas stations or banks.
But how? Simple: Tell banks 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 U.S. has roughly 8,000 bank-like institutions called mutual funds, none of which borrow. Such unleveraged mutual funds, which handle about 25 percent 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 one 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 with no threat of closure.
Angela Merkel and 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. As I recently discussed, transforming the banks into mutual funds whose only liability is owners’ equity is a lot easier than managing fiscal behavior across 17 countries.
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 their underlying policies, as I noted in a recent article.
Governments are adept at choosing words to hide their true liabilities. The U.S. has excelled at this game, racking up colossal implicit and unofficial debts. Its fiscal gap -- the present value difference between everything the government has promised to pay and all the revenue it’s likely to collect -- 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.
Mario Monti, Italy’s new prime minister, would do well to lobby for fiscal-gap accounting and targeting. On such a basis, Italy may be in better fiscal shape than France and is far better off than the U.S., thanks largely to its 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, with horrendous global economic costs, is to recognize that leveraged financial intermediation is unsafe at any speed, shut it down immediately and replace it with limited-purpose banking.
(Laurence Kotlikoff, a professor of economics at Boston University, is a Bloomberg View columnist. The opinions expressed are his own.)
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