Every politician, central bank, and regulator in the developed world spent 2008 and 2009 saying, “This must never happen again.” “This” was the financial meltdown that almost took down the world economy. They differed in their proposed solutions but held one demand in common: Banks must never again take the kind of highly leveraged risks in exotic securities that were widespread at the tail end of the housing bubble. Financial institutions should instead build a large buffer of risk-free investments that will always be liquid and never result in losses.
The favored buffer: government bonds. The economic consensus after the financial collapse was that banks should lend more money to governments. Politicians and regulators demanded it, twisted arms, and wrote new rules to make it happen.
In the last chapter of my 2009 book Financial Fiasco, I wrote: “If the government’s capital requirements favor certain ways of holding assets, all banks will hold their assets in those ways, and they will all be struck by the same type of problems at the same time.…After each crisis, the authorities investigate what worked better and then force market players to conform to this ‘best practice.’ All these attempts to make the system as safe as possible really make it extremely sensitive to small blows and changes.”
Since 2009 this warning has been tested on a continent-wide scale. European governments told banks that sovereign bonds were risk-free, that they didn’t need to be backed by additional capital, and that they were necessary. The new liquidity requirements in the Basel III agreement on global regulatory standards, written in response to the financial crisis, obligated banks to hold more government bonds on their balance sheets. The banks predictably loaded up. When the European Central Bank (ECB) lent financial institutions €442 billion in June 2009, they used half the amount to buy still more government bonds.
At the end of 2010, Europe’s 90 biggest banks had lent more than €760 billion to the PIIGS countries—Portugal, Italy, Ireland, Greece, and Spain. As I write this, due to the losses from those bonds, the entire European banking system is on the verge of collapse.
The problem is not faulty valuations of particular securities; those have been wrong before, and they will be wrong again. The problem is the false conceit that regulators can protect financial markets from risk simply by deciding what is less risky, then getting everybody to march in that one direction. This approach just gives every bank the same weakness. If the defense is breached, everybody will tumble to the ground together.
The euro crisis has followed the pattern of the 2007–08 financial crisis almost perfectly: Both were the result of cheap money, dangerous homogeneity, and the promise of bailouts. When problems appeared, the rule of law and bureaucratic predictability were replaced with erratic and contradictory behavior by policy makers, making it impossible for investors to plan for the long term.
European authorities did not begin regulating in favor of government bonds in 2009. Their interpretation of previous Basel rules assumed that a bank’s exposure to risk through the holding of sovereign debt in its own currency was zero. Government bonds that were rated AAA- and AA- never required additional capital to cover them. American regulations were similar: Banks had to hold capital against all the other assets on their balance sheets but not against sovereign debt. Even low-rated foreign government bonds were subsidized in this way. Debt from, say, Russia or Turkey required no more than 2 percent to 4 percent of the bond’s value in buffer capital, whereas a loan to a company holding the same investment rating required around 8 percent. “This is at the core of the crisis,” said Hans Hoogervorst, chairman of the International Accounting Standards Board, at an industry conference in September 2011. “It was, I think, the biggest accounting scam in history.”
Markets also began to ignore important differences between euro governments when considering the risk of sovereign bonds, assuming that if weaker governments started wobbling on their bonds, the euro zone’s stronger governments would bail them out. Sovereign bonds were subsidized by regulation and capital requirements, then guaranteed as essentially too big to fail.
There were no formal guarantees that a government in trouble would be bailed out. In fact, politicians insisted that no such thing would ever happen. But markets look at what you do, not what you say. The whole system was built on the promise of bailouts. European banks could buy the bonds of any euro-denominated country and hand them over to the central bank as collateral for new loans. The bank treated all these bonds the same. That sent a powerful message about what would happen when things went bad.
Before the euro system was created, investors usually kept one eye on the financial track record of European governments. If countries had a recent history of recklessness and default, markets demanded higher interest rates for lending to them. The euro system changed this. Now traditionally profligate countries like Greece and Spain were protected under tightwad Germany’s credit umbrella, and all participating governments could borrow liberally at a low rate.
Interest rates started to converge in 1995, in anticipation of the new currency established four years later. At that time, the yield on a Greek 10-year bond was 18 percent. Italy’s 10-year bonds were at 12 percent, and Spain and Portugal were at 11 percent, compared to just 7 percent for Germany. The interest-rate penalty for fiscally irresponsible borrowing was a powerful incentive not to borrow too much. But by 2005 the yields for all these countries were just below 4 percent. This was a triumph for the euro, ECB President Jean Claude Trichet boasted at the time. “Yields are driven by common news,” he said at a 2005 conference in New York, “and only a very small fraction can still be explained by local risk factors.”
But by trying to subsidize these local risk factors out of existence, European planners only encouraged deadbeats to be more reckless. Now governments could live with and even add to an already huge debt burden without swallowing the medicine of reform. Many of the countries in Southern Europe lost ground on the export market, especially to Asian countries, but they did not respond by liberalizing markets or increasing competition to stimulate productivity. They just imported more, increased the size of their governments, and raised wages.
From 1997 to 2007, government expenditure increased by around 6 percent annually in Spain, Portugal, and Greece, while population remained mostly stable. Spending increased by 4 percent a year in Italy, even while the economy shrank. Most important, Italy, Greece, Spain, and Portugal rapidly increased unit labor costs, an important measure of competitiveness. Greece’s unit labor costs, adjusted for inflation, increased by 34 percent from 2000 to 2009; Italy’s rose by 32 percent.