There are probably a number of reasons why bank leverage (the amount of lending banks do in proportion to their capital) increased rapidly in the 00s: reduced regulation, underestimation of systemic risk as a result of the Great Moderation, a search for yield when interest rates were low, simple greed. Bank profits rose, and so did the incomes of those working for them. However the consequence of excessive leverage was inevitable: a major global financial crisis. Banks had to be bailed out using public funds.
This produced a large negative demand shock which monetary policy was not able to counteract, because nominal interest rates fell to zero. In the US and UK governments undertook substantial fiscal stimulus to dampen the recession, but this, the recession and bank bailouts raised levels of public debt. As Reinhart and Rogoff show, credit booms and bust generally lead to public debt crises.
In recent research Alan Taylor and co-authors go further. They show that recessions are deeper and more prolonged if they are accompanied by a financial crisis, they are deeper and longer still if that financial crisis is preceded by a credit boom, and finally “the path of recovery is worse still when a credit-fueled crisis coincides with elevated public debt levels”.
Yet we need to be careful to avoid seeing some kind of inevitability here. For a start, following this recession there was no public debt crisis outside of the Eurozone. There was widespread concern about debt, which led to fiscal contraction, but no crisis. Prompt action that avoided a crisis, some would say. But we should be suspicious here. As Paul Krugman notes, this concern about debt was largely down to “the influence of the Very Serious People, whose views on economics tend in turn to be driven largely by the financial industry”. This financial industry got some of its economics seriously wrong, as Krugman notes here. I’ve also suggested that there may be self interest at play: finance needed to change the story from bank regulation. Even more cynically big banks needed lower debt levels to make their next bailout credible, so it could carry on enjoying high wages via an implicit subsidy. So, outside the Eurozone, was concern about debt real, imagined or manufactured?
In the Eurozone there was a debt crisis. Everyone agrees the Greek government had overspent. But this crisis could have been resolved fairly quickly, if the Greek government had immediately defaulted on its debt, and the ECB had offered unlimited support for other solvent governments. However Greek default would have led to large losses for European banks, and possibly created a second financial crisis. As a result, default was initially resisted in Greece (to allow banks time to minimise the damage) and avoided elsewhere, and instead draconian austerity policies were imposed in the Eurozone periphery.
In a very direct sense, banks created austerity in the Eurozone. If that sounds like an outlandish conspiracy theory to you, here is Philippe Legrain, former advisor to the European Commission President:
“The primary cause of the crisis was the reckless lending of German and French banks (both directly and through local banks) to Spanish and Irish homeowners, Portuguese consumers and the Greek government. But by insisting that Greek, Irish, Portuguese and Spanish taxpayers pay in full for those banks’ mistakes, Chancellor Angela Merkel’s government and its handmaidens in Brussels have systematically privileged the interests of German and French banks over those of euro zone citizens.”
Furthermore we know the political influence of the banks is huge: here I talk about the US and UK, but it seems unlikely that this does not also apply to the Eurozone. So in the Eurozone we had a second recession, which was the direct result of austerity. Eventually the ECB agreed to (in principle) provide unlimited support to solvent Eurozone governments, but not before austerity had been hardwired in the form of a new fiscal compact. Changes in bank regulation have fallen far short of what is required to avoid another crisis, as banks warned that increasing regulation would restrict their ability to lend, and therefore prolong the recession. The earnings of bank employees quickly recovered and resumed their rapid rise (see here, or here).
Rather than seeing the financial crisis and austerity as two essentially separate stories, the needs and influence of the banks connect the two. Now there are many things missing from this story that I am sure are important, such as opportunism from those who wanted a smaller state. However one rather neat feature of this account is that it requires very few ‘exogenous shocks’. Indeed you could even argue that something like Greece was bound to happen somewhere, and so even this was endogenous to the story. As Mark Blyth writes, “what starts with the banks ends with the banks”.
About 1,700 bank lobbyists work in Brussels, whereas no representatives of the 28 million European unemployed work there as lobbyists!
As if the French, Irish, Spanish, Greek, Portuguese and other governments wanted to let the banks go bust. Why didn't their governments otherwise overrule Germany? They would have had a majority in the European council and ECB.ReplyDelete
Probably because governments in those countries wanted to bail out their own banks too.
After Lehman, all governments decided there was no alternative. Except Iceland, but than Iceland couldn't bring down the world economy and as a non EU country, it was easy for them to let the UK and Netherlands (initially) pay the bill.
«In a very direct sense, banks created austerity in the Eurozone. [ ... ] Furthermore we know the political influence of the banks is huge:»ReplyDelete
The story as far as it goes is the same in the USA, Australia, etc.
But I read it completelly differently: that governments in many countries did whatever they could to push banks to lend recklessly. and when the crash came, the banks most likely and justifiably told governments that they better be bailed out and their bonus pools refilled or the entire story would be published on newspaper front pages.
There is an interesting comment by a random person who claims to have been working in the financial sector that corroborates part of the story:
«As long as the FCA is a creature of the Treasury and subject to the dictat of the Government of the day there will be no effective regulation of the Banks. I was in the Building Society sector for many years and was horrified at the compliance of my employers who, when the Government of the day said jump merely asked "How High". 100% loans, self-certification all encouraged by successive Governments to create a housing lead boost to the economy. There was no way that the FSA was ever going to reveal that the Emperor was not wearing any clothes and the same will apply to the new alphabet soup regulators. The minute it suits the Treasury to give the economy a "fix" of the easy money drug to which it had become addicted they will all roll over to have their tummies tickled - and of course line up their future banking
sinecures and knighthoods.»
Banking, like armaments and energy, is a "state interest" sector, where there is a significant veil of private ownership, but state policy drives their policy. If anything else because the rewards (e.g. the 0.25% discount rate at the central banks for worthless collateral) are so sweet.
Sometimes the big people in those sectors think that they can buy or threaten the political establishment that drives state policy, but they are usually wrong, and only in states with a weak political establishment the corporate mafias of banking, armaments or energy business become dominant.
There is however an esquisitely European dimension to this part of the story, one that is often forgotten:
«reckless lending of German and French banks (both directly and through local banks) to Spanish and Irish homeowners, Portuguese consumers and the Greek government. But by insisting that Greek, Irish, Portuguese and Spanish taxpayers pay in full for those banks’ mistakes, Chancellor Angela Merkel’s government and its handmaidens in Brussels have systematically privileged the interests of German and French banks over those of euro zone citizens.»
The story is that Ireland and Greece in particular, but also Portugal and Spain (and southern Italy) have benefited from enormous transfer payments from the major EU economies, under "solidarity", plus extraordinary forbearance for example for Ireland's role as a tax evasion base.
These enormous transfers, mostly German money, and forbearance, have transformed most of Ireland an enriched a substantial part of the (extremely corrupt) Greek (and souther Italian) elites, and helped quite a bit in Spain and somewhat in Portugal. It is often forgotten that just before the crisis Irish GDP (and perhaps even GNP) per head was higher than the German one.
For Ireland and Greece to turn around and laugh in the face of Germany after all that Germany had done for the poorer countries of the EU and trigger the failure of most of their biggest banks was simply not acceptable, and I think that at least the Irish government's otherwise insane decisions probably owed also to realizing that.
This comment has been removed by the author.ReplyDelete
Austerity has been done in order to pay back the money German baks lent to Greece, Portugal etc. and that's true. However, there's something missing in the analysis: austerity has been necessary because of the single currency regime. The countries who suffered, did so because of their large trade deficits. At this point, if you have your own currency, the exchange rate adjusts. With the euro, the only solution is to apply austerity measures. In fact, they have a double effect: they kill domestic demand (less imports) while increasing competitiveness through wage-cuts due to mass unemployment (more exports).ReplyDelete
To sum up, austerity was necessary to rebalance the trade deficit of the eurozone periphery countries.
Countries like Greece have a combination of problems. Overborrowing but also the fact that that overborrowing was used to create artificial non sustainable local demand (and growth) that made the economy look properly functioning while in fact it did not.ReplyDelete
Both have to be adressed. The overborrowing probably by a write off, the other things in other ways.
On top of that there was an asset/collateral bubble. Correct the above 2 and you would end up with lower asset prices and lower value of collateral. Sort of multiplier while getting things in order again. Goes into the financial industry, but also goes into pensions/savings and therefor consumption.
All should be sorted out. 2 and 3 (mainly) are local issues.
Greece effectively doesnot pay interest at the moment and the other issues are nowhere near from solved. Assetprices (for normal people, read RE) still tanking and 30% (and rising) unemployment. What QE all over the palce did was effectively creating a bubble here or maybe better avoids that the bubbles that there are becuase of the resetting can be deflated (which is more or less a condition for a reset).
The country was simply managed into the ground and is now still mismanaged.
How sustainable are paying 50% of your income in all sorts of taxes, while hardly getting anything back in return. Looks a politicl disaster in the making to me (only open question if it is a right disaster or a left disaster). And with fall out likely to the EU(and Euro).
Simon says “As Reinhart and Rogoff show, credit booms and bust generally lead to public debt crises.” Hilarious. Simon: where did they “show” this? On that spreadsheet they messed up?ReplyDelete
As for their other pronouncements on debt, they’re pure garbage.
If you look at the prominent politicians who either were in investment banking themselves or whose father was I would start a list that looks like this: Cameron, Clegg, Rupert Harrison, Nigel Farage, Lord Freud, Sajid Javid.ReplyDelete
These are not 'Thatcher's children' as is often said - I can see no evidence Thatcher knew a jot about banking - rather, they are Davos men.
And the Osborne family probably wallpapered the interior of their family homes as thoroughly as he is wallpapering over the cracks of their economic policy.
“The primary cause of the crisis was the reckless lending of German and French banks (both directly and through local banks) to Spanish and Irish homeowners,ReplyDelete
This is the generally very good Legrain at his worst IMO. "Both directly and through local banks"???? As anyone who looks at the numbers knows, Spanish homeowners borrowed from Spanish banks - nobody else had material market share except (maybe, barely) Barclays through Banco Zaragozano.
Irish homeowners borrowed overwhelmingly from Irish banks and RBS - Irish *developers* borrowed from German banks, but these loans were *not* paid by Irish taxpayers - they were written off, and paid by German regional taxpayers via SoFFin.
Presumably he is using "both directly and through local banks" as his get-out here, but this makes it impossible to stand up his "recklessly" accusation. For the French and German banks to be "reckless", he needs to claim that it's "reckless" for them to lend to the Spanish and Irish banking system. But he doesn't realise how strong a claim this is. French and German banks weren't providers of long term financing to the Spanish or Irish banks - they didn't buy their bonds. They extended overnight payments system credit, which was the counterpart of the big current account deficits. Most of this credit was repo - in other words it was collateralised. That's the opposite of "reckless" and it certainly doesn't support the implication that the French and German banks were taking risks for reward. And the only way for the French and German banks to have borne the losses would have been for the Irish and Spanish banks to be put into insolvency, which does not strike me as the sort of thing that the locals would thank you for.
Ireland and Spain had a recession because they had a housing market collapse. The Irish and Spanish homeowners/taxpayers/depositors (three names for basically the same bunch of people). Because it was their houses that had the bubble
Also this isn't true.ReplyDelete
However Greek default would have led to large losses for European banks, and possibly created a second financial crisis
It would not, and this was well known at the time, as all the large European banks had published their GGB exposures. In only two cases were the exposures material compared to total capital, and these were both cases where French banks owned Greek subsidiaries; they would have protected themselves by allowing the subsidiary to go bust. As I say, this was well known at the time. The issue was that the Greek banking system itself (and the Cypriot) was so exposed to GGBs that it would have collapsed, and this was also regarded as probably being bad for Greek economic prospects. The ECB also had GGB exposures (via the Securities Markets Program) larger than its capital.
But (again, everyone who was round at the time knows this and it distresses me to see history forgotten so soon), the reason why the Greek default was postponed had nothing to do with this. It was postponed because it was believed that a coalition could be put together (the EFSF, ESM and similar ideas) for Greece's Eurozone neighbours to bail it out. We spent a year finding out that this wasn't politically or constitutionally possible, but it was worth trying - particularly since it's actually what should have happened.
But this crisis could have been resolved fairly quickly, if the Greek government had immediately defaulted on its debt, and the ECB had offered unlimited support for other solvent governments.
is not true. The Greek government would have needed to reach primary balance - it was only servicing debt from EFSF loans anyway - so it is not obvious that default would have made the austerity any smaller or the adjustment period any quicker. And the second clause is wilfully ignoring the political and constitutional realities. "Offered unlimited support" is something that the ECB is specifically not permitted to do. If your suggested solution involves rewriting the ECB treaty, you can solve all sorts of problems.
1) I agree that an immediate Greek default might not in itself have seriously threatened German and French banks. But they would have made losses, and so I suspect they would have lobbied against default.Delete
2) An immediate and total default would have required support from the Troika to allow Greece time to reach primary surplus, and perhaps also to support Greek banks. But in my view it would have been better than an attempt to avoid default, given the degree of austerity that this came with.
3) The ECB's OFT programme could have happened two years earlier.
«"Offered unlimited support" is something that the ECB is specifically not permitted to do. If your suggested solution involves rewriting the ECB treaty, you can solve all sorts of problems.»ReplyDelete
Perhaps not the ECB then, perhaps the governments.
A little know detail here is that for example the German government and German constitutional court are not against offering unlimited support to other EU governments, they are against doing so through monetary policy and the central bank, which is unelected.
Their thesis is that bailing out other EU countries is a fiscal policy decision and must be taken by an elected body that can then be defeated at elections if voters object to that decision.
So the treaties need amendment only in the case where EU governments want to make sure that they can instruct the "independent" ECB to hand out free money to whomever they want without making it a tax-and/or-spend decision subject to ratification to their voters.
«The issue was that the Greek banking system itself (and the Cypriot) was so exposed to GGBs that it would have collapsed, and this was also regarded as probably being bad for Greek economic prospects. The ECB also had GGB exposures (via the Securities Markets Program) larger than its capital.»ReplyDelete
Greece was a bit of a special case in that its government debt was particularly "distressed", but in general the PIGS also had huge private debts, and it is amazing how some (usually conservative, aligned) people forget that private debt matters as much as public debt (in part because of crony politics it becomes public debt in the first stages of a crisis).
And the big deal in most of these countries was indeed private debt, as government debt to GDP ratios were usually modest.
And the private debt was largely funded or securitized and sold to/by "core" country banks. A lot of the PIGS private banks had a business model similar to that of Northern Rock (the UK is one of the PIGS, but obviously it gets very special treatment) or Countrywide.
Plus "core" country banks used to have a significant exposure to PIGS government debt anyhow, because it had AAA ratings; it ended up in the hands of national banks because the "core" country banks started selling it massively, and the government of each PIGS country "encouraged" their national banks to buy it back.
«The country was simply managed into the ground and is now still mismanaged.»ReplyDelete
And here my usual story: Greece's government was democratically elected, and if voters choose to endorse crony scammers as they did in Greece, they should suffer the consequences.
Voters are accountable for the parliamentary majorities they elect.
They cannot elect a series of governments of plunderers and then when the consequences happen legitimately cry over it. Democracy makes voters accountable to give the incentive to choose better next time.
Democratic countries rules by voters who learn to choose well, to avoid being seduced by spivs and fantastists, do well; those ruled by voters who make bad choices out of complicity or stupidity do badly.
Simon, I have an issue with your comment that "the consequences of excessive leverage were inevitable: a major financial crisis"ReplyDelete
Your comments suggest that the crash could have and should have been predicted by many. The opposite is true as most academics sung the praises of financial market deregulation and globalisation.
Can you show that you felt this way before 2007?
I didn't write a blog before 2010, and I don't think I wrote anything about finance. That would be true of most academics. I think if you had shown academics the data on leverage I link to, most would have been worried. Of course most academics (me included) did not see this data - very few did.Delete
But why are you interested in what academics thought at the time? Even if they did miss the consequences of deregulation - like some high profile names - are they not allowed to change their minds?
In that case perhaps academics should ponder on why they never looked at publicly available data such as bank Financial Statements and M4/M3 accounts from Central Banks. IIRC, M4 was rising at about 25% a year for a few years from Bank of England data. That was never noteworthy?Delete
Both of those showed the rate at which borrowing was increasing very clearly.
Speaking as someone that studied and later taught economics at undergrad level, what's the point of economists if they don't look at the basic building blocks of the economy? I was encouraged as a 16 y/o starting to study the subject to keep a personal record of inflation, money supply, GDP changes and unemployment by my teacher.
For better or worse, most academics spend their time doing research, and not monitoring data. But plenty of economists do spend their time monitoring the data, and for them you pose a very good question.Delete
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