Monday, September 24, 2012

Joseph Stiglitz: Time running out for EU to fix financial system

As reported in a Bloomberg article, Nobel prize winning economist Joseph Stiglitz says that time is running out for the EU to fix its financial system and he provides a broad blueprint for what the solution should look like.

European nations must share past debts to lift the burden of high interest rates on Spain and Greece and implement a banking union with deposit insurance to prevent capital flight, said Nobel Prize-winning economist Joseph Stiglitz
“If you don’t do that, you have this adverse dynamic: the weak countries get weaker and the whole system falls apart,” Stiglitz said today in an interview in Geneva. “And this has to be done fairly quickly” because in a couple of years, “there won’t be any money in Spanish banks.”...
“You have to have some form of mutualization of past debts,” said Stiglitz ... Delaying the implementation of a banking framework will see the situation in Europe deteriorate, he said. 
“The Spanish banks will be very weak if you wait that long,” he said. “The system may fail completely or lending will become so constrained that the economy will go further down and you’re involved in a vicious downward spiral. Things are bad now, and they’re going to be getting worse.”...
He isn’t optimistic because Europe’s policy makers lack urgency and continue to focus on austerity. 
“I haven’t heard from the critical people in Germany and France that, no, austerity isn’t going to work, that we need a new strategy, that we need a political settlement,” he said.
Regular readers know that your humble blogger agrees with Professor Stiglitz that austerity is not the solution for what ails the EU (or UK or US for that matter).

Austerity is a policy that results from the adoption of the Japanese model for handling a bank solvency led financial crisis and the decision to protect bank book capital levels and banker bonuses at all costs.

By definition, austerity negatively impacts the real economy.  In this case, austerity is just one of several  transmission channels, like zero interest rate policies, by which the Japanese model is relentlessly crushing the real EU economy.

Regular readers know that I disagree with Professor Stiglitz on the need for sharing past debts.

I disagree because our modern financial system is designed so that the banks can and should absorb all the losses on the excess debt.  Banks should because no one forced them to take on an exposure to a borrower who could not repay their debt.

As shown by Iceland, if the banks absorb all the losses on the excess debt today, the real economy is protected.  Iceland achieved this by requiring the banks to take losses equal to what they would have experienced if borrowers had gone through the long drawn out process of defaulting, filing for bankruptcy and the banks subsequently foreclosing.

By design, banks have deposit insurance and access to central bank funding.  As a result, banks can absorb the losses and continue operating and supporting the real economy even if absorbing the losses leaves them with low or negative book capital levels.

Deposit insurance effectively makes the taxpayers the silent equity partners while banks are rebuilding their book capital levels.

Professor Stiglitz properly identifies the need for EU-wide deposit insurance.  This is needed because EU policymakers have threatened to kick Greece out of the EU and in doing so have created the possibility of redenomination risk (deposit insurance is honored, but in a currency worth far less than the euro).

The source for the EU-wide deposit insurance should be the remaining funds in the European Financial Stability Fund and the European Stability Mechanism.  These funds should back each country's deposit guarantee.

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