A PROPOSAL TO END EUROPE´S DEBT CRISIS / THE FINANCIAL TIMES COMMENT & ANALYSIS ( A MUST READ )

June 13, 2012 6:58 pm
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A proposal to end Europe’s debt crisis
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By Christophe Chamley and Laurence Kotlikoff

The eurozone’s sovereign debt crisis has become a full-fledged banking crisis, as more and more depositors of the sickest countries – Greece, Portugal, Spain, and Italy – withdraw their money from their broken banks.

The eurozone’s healthy members – essentially Germany – have tried to stop this downward spiral. They have lent money to sick members, helped fund the European Financial Stability Facility, forgiven debts, risked future inflation by letting the European Central Bank lend troubled banks tonnes of freshly printed euros, and allowed sick countries’ central banks to borrow huge sums from the Bundesbank.

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But the Germans face the Samaritan’s dilemma: help fosters dependency and encourages requests for more assistance. To counter this moral hazard, each rescue comes with tougher strings attached. Both pride and politics are keeping Greece and the others from taking help on these toughening terms. Meanwhile, the situation worsens as people discover simple ways, such as remotely opening up mutual fund accounts in the US, to move their money abroad.




.There is, however, a truly new way to cut Europe’s vicious cycle, which would fix the banks for good and allow countries choosing to default to do so without bringing down their banks or leaving the euro. It is called limited purpose banking.



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LPB transforms all banks into mutual fund holding companies that do one thing only – issue 100 per cent equity-financed mutual funds.




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These mutual funds (unit trusts) give investors shares, not IOUs, in exchange for their money. The mutual funds then invest these monies in the securities in which they specialise, such as mortgages, small business loans, corporate stock, sovereign bonds and cash.




.In moving money from those who buy the mutual funds’ shares to those who sell securities to the mutual funds, mutual funds act like small banks. But they are small banks that cannot fail because they never borrow. Conduct all financial intermediation through LPB mutual funds and you have an entire banking system that never fails. Add a regulator that verifies and discloses on the web, in real time, all the securities held by the mutual funds, and you have a banking system that people can trust.



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Mutual fund banking already accounts for 30 per cent of all intermediation in the US. It is also very similar to the two-century old covered bond mortgage system in Denmark, Germany and Sweden.



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Under LPB, bank runs threatening the payment system are a thing of the past. The payment system is based on cash mutual funds. Cash mutual funds hold only cash and are naturally backed to the buck (or the euro). All other mutual funds fluctuate in value and make no promises they cannot keep.




.People would write cheques on their cash mutual funds and use debit cards issued by the cash mutual funds to withdraw money or make purchases. They can always access their cash and can always sell their non-cash mutual fund shares at prevailing market prices.




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LPB does not eliminate market risk, but risk averse households will find many safe mutual funds in which to invest. What LPB does eliminate is counterparty risk (eg widespread bank failures) – arguably, a significant cause of market risk.



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Were the ECB to facilitate the quick conversion of eurozone banks to equity-financed mutual funds, the eurozone’s sovereign debt crisis would end instantly. So would Germany’s Good Samaritan problem. LPB mutual funds cannot fail, so they cannot extort assistance.





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Sovereign bond defaults, if they occurred, would hurt shareholders of mutual funds holding those bonds, but would not threaten the financial system. These shareholders would have purchased their shares knowing the risks, as well as the potential return from their investments. Countries that defaulted would, of course, face higher borrowing costs in the future but, like commercial defaults, sovereign defaults would not cause huge collateral damage.



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The one-off costs of quickly switching from the current banking system to LPB are trivial compared to the economic damage the eurozone bank run is causing. The benefits, moreover, could make LPB attractive well beyond the eurozone.
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The writers are economists at Boston University


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Copyright The Financial Times Limited 2012