Posted by: Dirk | July 19, 2012

Open Letters and Closed Minds?


Hans-Werner Sinn and others have written an open letter (published at FAZ). They say that the banking union is not a good idea and that banks must be allowed to fail. They are against the socialization of bank debt. Their main argument is that bank liabilities in the euro zone are three times as much as sovereign (government) debt and, in the five countries in crisis alone, are in the trillions of euros (Die Bankschulden sind fast dreimal so groß wie die Staatsschulden und liegen in den fünf Krisenländern im Bereich von mehreren Billionen Euro.). Huge losses are about to come, and tax payers shouldn’t be the ones that have to absorb them.

This text strikes me as rather unscientific. The total amount of debt is not important as long as lenders can repay. If households, firms, banks or governments cannot repay, then the distribution of debt matters. €100,000 of household debt is a different thing in Germany compared to, say, Spain. In the euro zone, it is the private debt that is the real problem. Real estate bubbles in Spain and Ireland have led to large chunks of non-performing loans. These in turn would lead to bankruptcy of those institutions that financed that lending, except that they are too big to fail. Let me summarize here. They should not have become too big to fail, and they should not have been allowed to borrow so much money and put most of their eggs into one single basket (real estate).

Now, from the macroeconomics perspective you cannot let the whole banking system go bankrupt just like that because of mistakes in the credit system. The payment system is vital to the economy, and destroying all or most banks would mean destroying the payment system. A lot of damage would be done to the economy as the creation of loans will fall to levels that are compatible only with much lower incomes and hence output. So, the financial market is unstable by default and only by regulation can be made stable, which is and was the point of Hyman Minsky.

In return, another group of economists have published this open letter at They make another point which has something to do with demand in times of crisis:

Only by breaking the link between the refinancing of banks and the solvency of national governments will it be possible to stabilise the supply of credit in crisis countries. If the refinancing of banks – and the insurance of bank deposits – can be made independent of the financial state of the respective domiciling country, national sovereign crises can be decoupled from the private sector financing. In this way, contractionary demand shocks induced by corrective national fiscal policy can be softened by a broadening of the supply of credit. A European backbone to the refinancing of banks will dampen the impact of the coming fiscal consolidation. An indispensable requirement for this is a set of uniform regulatory banking standards which are implemented by a single European authority.

In short, if banks are bailed-out by the European Union, then fiscal consolidation will not be as harmful as it is now. For me, that sounds like a second best argument. Better would be banking union plus a big European government budget at the order of, say, a third of European GDP. However, that proposal would go down when most of the (German) population is still under the false impression that it was the debtor countries’ fault.

Hans-Werner Sinn, by the way, was arguing in the years before the crisis that Germany would import too much and should export more, lamenting the capital outflows that he saw as being caused by supply side problems in the country. His 2004 book was called “Can we save Germany?” (link). His forthcoming book is on the TARGET 2 (im)balances, which I find quite irrelevant since they are a symptom and not a cause. His last one – “Casino Kapitalismus” – was probably not so bad, but falls into the category of too little too late. There are many economists who think that economists get where they are by merit. This explanation is harder to uphold by the month. Other explanations are creeping in, like a false belief in mathematical models or ideology, which are discussed by Tony Lawson in an article in the Open Journal Economic Thought.

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