Social Security rules are complicated and change often. For the most recent “Ask Larry” columns, check out maximizemysocialsecurity.com/ask-larry.
Editor’s Note: While readers of Making Sen$e and the Rundown know Larry Kotlikoff as our resident Social Security guru (he answers questions as “Ask Larry” every Monday), he has an ample list of other credits in economics.
Today, Larry Kotlikoff argues that the European and world powers need to take a different approach to Greece’s debt. He suggests that Greece ought to adopt Limited Purpose Banking, an idea he’s discussed on Making Sen$e in the past. Limited Purpose Banking, he argues, would remove much of the risk from the banking industry and create greater transparency. Then, he says, Greece ought to default.
Whether or not Greece’s principal creditors, the Troika—Germany plus the other Eurozone countries, the European Central Bank, and the IMF—put yet another finger into Greece’s disintegrating fiscal dike, the long-run outcome won’t change. Greece will keep defaulting big time on its official debt. Greece has already defaulted three times in the past five years, although these defaults have been described as “bailouts” and “debt relief.” Each bailout comes with conditions, which are routinely ignored, generally out of necessity.
In the Soviet Union workers had a sad joke. “The state pretends to pay us, and we pretend to work.” The sad joke for Greece is, “Our creditors pretend to collect, and we pretend to comply.”
Greece has a well-advertised huge public debt totaling 180 percent of GDP. Five years back it was 130 percent of GDP. Whether the 180 percent figure accurately reflects the three recent bailouts is unclear. It is clear, however, that Greece’s fiscal problems extend far beyond officially reported government debt.
Greece’s long-term implicit but unofficial fiscal commitments to Greek citizens—the folks who vote, as opposed to its external creditors with no votes—are huge. They include employing vast numbers of public workers, financing everyone’s healthcare, and paying significant pensions to a population that is rapidly aging thanks to three factors—an extremely low fertility rate (1.4), a very high rate of emigration (particularly of skilled young Greek workers), and the retirement of the Greek baby boom generation. This is not to mention the country’s two-ton gorilla: an ongoing great depression marked by 25 percent unemployment.
The German view of the ongoing Greek debt crisis and the country’s demand for more concessions runs as follows:
“Das genügt! (Enough already!) Greece must finally cut its spending, collect its taxes, and repay its foreign creditors. We Germans won’t provide more concessions. As for Greek debt default, it will unravel the European Union and undermine peaceful co-existence. So you Greeks do as you’re told!”
Reality check. Getting Greece to “behave” is not Germany’s job, and the years-long effort to do so is radicalizing the entire EU, resurrecting nationalistic tendencies long thought dead. The only realistic answer is to cut Greece loose and let it formally default with no backdoor bailouts by the European Central Bank.
This path supposedly holds great risks. Greek banks will lose their major asset—Greek government bonds—producing runs (in which a large number of customers withdraw their deposits simultaneously due to concerns about the bank’s solvency) that can spread across the continent and even overseas. This will further damage the Greek economy and could produce another major global recession or worse.
In other words, the so-called Greek crisis is not really about Greece but about the chance that if Greece does what it clearly must do, namely default, its banking system and everyone else’s will collapse. If that’s the case, we need to fix the banking system, not Greece, and let Greece fix itself.
But can a bank run in relatively tiny Greece represent such a big concern? Yes. Recall the December 2013 banking crisis in Cyprus, whose economy is peanut-sized. The prospect of Cypriot bank runs triggering more bank runs throughout the Eurozone sent shivers down European Central Bank chairman, Mario Draghi’s, spine. He quickly came to the rescue with a bailout for Cyprus. Draghi was not taking a chance, however small, of a massive collective loss of trust like that triggered by Lehman Brothers’ bankruptcy.
But why is the banking system so fragile? The answer is simple. No other industry in the world operates so deeply in the dark. No other industry provides so little disclosure of what it owes and owns. No other industry has such eye-popping leverage—leverage that is little changed despite Dodd-Frank, Basel III, the Vickers Commission and other so-called U.S. and international banking reforms. And no other industry engages in such rampant and unabashed deceit, corruption, malfeasance and political bribery.
Pervasive opacity, extreme leverage (how much banks borrow in order to lend) and rarely prosecuted criminality—those are the terrible hallmarks of the world’s Wall Streets. One can’t conceive of a more dangerous way to run any economic sector—let alone one that constitutes a critical public good—namely the financial exchange system.
The Greeks fully understand their potential to gravely damage EU unity and the global built-to-fail, faith-based banking system. Indeed, this is their main negotiating trump card. But blackmailing their partners and abjuring major fiscal reform is not in Greece’s long-term interest. Nor is it in the interest of other EU members to perpetually police Greece’s fiscal behavior.
What’s needed is a way for Greece to default without bringing down the Greek financial system, let alone the overall financial exchange.
My answer is Limited Purpose Banking (LPB), an idea that I propose and discuss in depth in my 2012 book, “Jimmy Stewart is Dead,” and have discussed on the Making Sen$e page in the past. (To reassure skeptics, I’d point out that LPB has been endorsed by a veritable Who’s Who of top economists, including five Nobel Laureates).
LPB requires all banks and other financial institutions to operate as 100 percent equity-financed mutual funds. That is, LPB would turn banks into one thing and one thing only: companies that issue mutual funds. You put your money in a mutual fund; the mutual takes the money and buys assets with it—stocks, bonds, real estate, commodities, whatever. Your account (or your mutual fund) is simply worth what the assets are.
Using mutual funds as financial middlemen is something we all do when we invest in our 401(k)s, IRAs, and other retirement accounts.
In place of banks that borrow money to invest (in things we don’t know about), Greeks banks would use mutual funds that sell shares to get money to invest (in things that are fully disclosed), thus eliminating any potential for systemic financial collapse. After all, if you never borrow, then you never owe anything. Mutual funds would have nothing to pay back even in the worst of economic times.
Although all mutual funds would be debt-free and transparent, they would differ based on their type of investments. In the U.S., we have over 10,000 equity-financed mutual funds—more mutual funds than banks—investing in all manner of assets, including mortgages. Northern Europe has, incidentally, used mutual funds, called covered bonds, to finance mortgages for over two hundred years. And race tracks around the world have used equity-financed mutual funds, called Parimutuel betting, for well over a century to safely organize derivate betting (in this case, bets derived on which horses win or place).
If Greece were to adopt Limited Purpose Banking, which it could do with the help of the European Central Bank, its financial middlemen wouldn’t be borrowing money to buy government bonds. Instead, Greek government bond mutual funds would sell shares to the public and buy Greek government bonds at the prevailing market price.
And if the Greek government defaults on those bonds? Well, the investors in the mutual funds holding those bonds will see the value of their mutual funds drop. But the mutual fund itself would never go under, because, to repeat, it owes nothing to nobody. As a result, the financial highway would be protected against government debt default. Moreover, there would be no need for Greece to print money to bail out its banks, and thus, no need for Greece to abandon the Euro.
Einstein defined insanity as repeating the same thing and expecting different results. The Troika needs to take a different approach with Greece, namely the Troika needs to help Greece adopt Limited Purpose Banking and let Greece set its own fiscal course.