By Matthew Nolan*
In a previous article, we discussed the eruption of the Global Financial Crisis in broad terms.
This discussion enabled us to take the lessons from the crisis, and other crises in the past, to figure out where regulation may need to head in the future.
However, while our discussion helps explain what happened in September 2008, and how it stung the global economy throughout 2009, it doesn’t explain what has happened since.
Although there was a brief recovery in 2009/10, this had faltered by mid-2010, and economies around the world have tracked sideways since.
So why has this crisis persisted?
Is this a general feature of financial crises, were mistakes made by policy makers, or has the world changed for good? Increasingly during 2007/08, financial institutions appeared to be risky and this came to a head following the events of September 2008.
This riskiness is illustrated by credit default swaps1 from Australiasian banks – as there was no Australiasian-specific banking crisis, these CDSs give us an indication of the impact on “general” bank riskiness.
However, when the run on the shadow banking system got into full swing, the Federal Reserve and US Treasury realised that they had dropped the ball.
When a bank run is occurring, the central bank and government have effectively lost credibility with regards to their ability to protect the financial sector.
Realising they had lost credibility, the Fed and US Treasury did everything they could to regain it. By mid-2009, both institutions had regained credibility, and could now concentrate on improving regulation.
The overarching goal of regulation since then has been to better protect financial markets, while also making sure that the financial sector is has to pay for this “insurance” over the course of the economic cycle.
At the same time, a bunch of sovereign governments within the Eurozone had become increasingly indebted.
This didn’t seem like too much of a concern, as the Euro region as a whole was perfectly capable of paying off that debt if required. Furthermore this liability was viewed as being tied between countries in the Eurozone – given the monetary union between that existed.
However, unlike Australia or the United States where all the states within the union will backstop one who is in trouble, the European Union wasn’t constructed in the same way.
The banking systems were still separate and the governments were independent.
This issue became apparent when Greece’s insolvency started to bite in early 2010, and by mid-2010 the European Debt Crisis (EDC) had kicked off. The Eurozone was a political project wrapped up in economic clothing – the monetary union was supposed to enforce discipline and help the different countries integrate, but the countries involved were not willing to take on any of the costs associated with this integration.
Instead, the risks involved with the European project were hidden, and in case of the Greek government fraudulent behaviour occurred to hide the level of debt and the risks involved.
Once markets realised the fact that individual countries would be liable for their own debt, a quiet bank run started – a bank run that has still not stopped.
The crisis intensified as the ECB showed its determination to lift interest rates in the middle of a recession, followed by clear statements that the ECB would not aid the banking system.
Adding to the concern, were the contradictory statements made by politicians in the region, and an unwillingness by the ECB to state that it would protect the Euro currency. Neither the politicians nor the ECB seemed to appreciate the fact that many potential investors were truly uncertain whether the Euro would continue as a currency.
I was doing a presentation when panic started to take hold in financial market during August 2011. There I was asked whether the news coming out of Europe that day would lead to a second leg of the financial crisis – which it in fact did.
My response was that I didn’t believe it would, as it would take an inconceivable level of incompetence for that to happen, and if it did, it would be fodder for a large number of pop economics books in the future.
But I’ve had to revise my views – it turns out that policy makers in large economies can be more incompetent than I’d previously imagined.
Or to be less flippant, the design of the Eurozone was such that the question of who is ultimately liable for the debt accumulated in the Eurozone, and as result the riskiness of that debt, is now very uncertain.
Since Mario Draghi took over control of the ECB in November 2011, matters have improved. He explicitly stated that the Euro would remain as a currency and that the ECB would help support struggling European economies.
But while the actions of the ECB have improved, the fundamental issue of governance in the Eurozone is still a mess.
Although it may be politically convenient for politicians to ignore these issues, the slow quiet bank run occurring within Europe is not allowing the global economy to get out of second gear.
There are other important parts to the story, namely:
1. There are complex processes at work, whereby financial crises by their very nature have a relatively persistent effect on the economy.
2. Given what has happened in Europe, it could be argued that monetary and fiscal policy have been too tight in other countries (such as New Zealand and the United States).
Given the changes that have occurred in measures such as stock prices and CDSs, the most compelling argument is that poor policy choices in Europe have been behind the persistence of weak economic growth. After all, the policy choices of non-European central banks and governments were based on an expectation that the Eurozone would not jeopardise its own solvency and would commit to the Euro’s future as a currency – a belief in the flexibility of institutions in Europe that seems to have been excessive.
If the persistence of the crisis is largely due to policy uncertainty and, generally, bad policy in Europe then the world has not changed permanently.
Furthermore, it does not imply that prolonged weakness is something that has to happen following financial crises.
Instead the persistence of this crisis is due to mistakes – mistakes that we can study and that, hopefully, society will not make again.
But there is a darker side to this explanation. With policy makers in Europe either unwilling or unable to fully deal with what is going on, the negative impact of the crisis will continue to be with us for some time to come.
So we have painted a story where the Fed’s unwillingness to commit as a lender of last resort was the catalyst for the crisis, and the ECB’s current unwillingness to provide a similar commitment is the reason the crisis continues.
However, these points do not tell us how all this debt built up or what “should” be done. We will discuss that issue further in the next article.
1. Credit default swaps (CDSs) are essentially insurance against the failure of a loan you make to the bank – for example if CDSs are at 100, you could pay 1% of the value of the loan to insure it against default. The actual CDS value depends on a bunch of related factors, such as default risk, the ability of the insurer to pay, and market liquidity. However, changes in CDSs can be seen as indicative of stress in the banking sector.