Is Leverage the Problem (Again)?

So the European Monetary Union is (slowly failing). Nations are reaching ever-closer to default, bringing about the prospect of shockwaves and turmoil throughout the region and the world. Why can’t nations just default? Well — they can. But policy-makers fear the consequences of blowing holes in the balance sheets of too-big-to-fail megabanks. Sovereign default would lead to the same problems as in 2008 — margin calls on banks’ highly leveraged positions, fire sales, a market crash, and the deaths (and potential bailouts) of many global financial institutions.

From Lawrence Kotlikoff:

Sovereign defaults are only the proximate cause of this euro-killing nightmare. The real culprit is bank leverage. If the lenders had no debt, sovereign defaults would reduce the value of their equity, but wouldn’t shut them down, thereby destroying the financial-intermediation system.

Non-leveraged banks are, effectively, mutual funds. If appropriately regulated, mutual funds don’t make promises they can’t keep and never go bankrupt. Yet they can readily handle all manner of financial intermediation as 10,000 of them in the U.S. make abundantly clear.

Countries get into trouble, just like households and firms. Similarly, nations should be permitted to default without threatening the global economy. Forcing the banks to operate with 100 percent equity by transforming them into mutual funds – – as I have advocated in my Purple Financial Plan – is the answer to Europe’s growing sovereign-debt crisis.

In a nutshell, the ECB tells the banks: “No more borrowing to buy risky assets, including sovereign debt, and forcing taxpayers to take the hit when things go south. You’re now limited to marketing mutual funds, including ones that hold nothing but cash and will constitute our new payment system.”

Now I don’t doubt that this is a very good idea that could potentially restore meritocracy — allowing good businesses to succeed and bad ones to fail. But would it solve the problems at the heart of the Eurozone?

In a word — no. As was noted at the Eurozone’s inception, the chasm opened up between a nation’s fiscal policy (as determined by a nation’s government), and its monetary policy (as determined by the ECB) necessarily leads to crisis, because monetary policy cannot be tailored to each economy’s individual needs. Kotlikoff’s suggestion would reduce systemic risk to the banking system (largely a good thing), but would merely postpone the choice that European policy makers will have to make — integration, or fracture.