Financial Crisis II

European governments fail to learn from history.

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.

Greek Tragedy

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.

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  • Xiver||

    As a dog returns to his vomit, so a fool returns to his folly.
    Proverbs 26:11

  • o3||

    so God hates recycling?

  • Ken Shultz||

    This must never happen again.

    The economic cycle will take downturns again in the future, and there isn't anything anyone can do to stop it.

    Might as well try to stop the birds flying south for the winter.

  • WTF||

    The economic cycle will take downturns again in the future, and there isn't anything anyone can do to stop it.

    Top. Men.

  • Aresen||

    Might as well try to stop the birds flying south for the winter.

    With Global Warming, we might succeed in that. :)

  • ||

    That's just what you Canadians want, isn't it? All the birds, all the time? Finally, the Canadian geese will truly be only yours.

  • Dr. Frankenstein||

    How is that a bad thing?

  • Tman||

    Please take those stupid geese permanently. I hate those stupid poop machines with a passion.

  • ||

    they arrest homeless guys that eat those shit machines. Guy feeds himself, but with the wrong bird...

  • Dr. Frankenstein||

    Gambol lockdown. But seriously they're not exactly endangered animals.

  • ||

    The economic cycle taking a downturn =/= massive sovereign debt crises that threaten the entire global financial system. It takes a consortium of central planners to turn the former into the latter, which was, I think, the entire point of this analysis.

  • NotSure||

    A good read that lists the multiple problems that some of these European countries are facing.

    If one has followed all the recent elections in Europe, one will spot how voters have voted for the party not in government, "left wing" governments are replace with a "right wing" party and vice versa. The voters are clearly desperate and cling on to the hope that voting in a new bunch of guys will fix the mess of the previous bunch left behind.

  • Dr. Thaddeus Tingleberry||

    The bare notion of deficit spending, or more particularly, of a physical medium {currency} which represents debt at issuance, ineluctably results, no matter how much central meddling, with mathematical certainty, a stage in which the system's productive capacity is squelched by its debt service - and one may include, in a broad sense therein, the payment of interest + principal, opportunity costs, and factually regressive taxation.

    An auspicious portent would be the selective application of leeches to the jowls of Warren Buffett, however, and this is something which shoulde no doubt unite partisans of all fins and feathers.

    - TPT

  • ||

    You may be on to something, but you need more dependent clauses and commas.

  • Dr. Thaddeus Tingleberry||

    I have little doubt as to the truth of your assertion, Sir, but, alas, it is true that I shall not.

    I am subject to a rather ignominious contract with the House of Rothschild limiting my useage of certain articles of clothing, references to Otto von Bismarck, and indeed, to certain grammatical and ordinal conventionalities, contributing, I daresay, to a certain a priori morbundity to the semantic sequelae which has heretofore been engendered.

    Notwithstanding the above, I am steadfast in recommending Occam's Razors for your shaving, weight loss, and economic policy needs.

    Respectfully,

    TPT

  • Old Mexican||

    Re: Dr. Thaddeus Tingleberry,

    The bare notion of deficit spending, or more particularly, of a physical medium {currency} which represents debt at issuance, ineluctably results, no matter how much central meddling, with mathematical certainty, a stage in which the system's productive capacity is squelched by its debt service - and one may include, in a broad sense therein, the payment of interest + principal, opportunity costs, and factually regressive taxation.


    In other words, the printing of money by the central banks encourages people to put themselves in hock and creates inflation.

  • ||

    Well put--in short, the amount of support Central Banks and their "Quantitative Easing" (money printing, monetization of debt, etc) can provide to prop up an economy are finite.

  • ||

    "is" finite.

    d'oh.

  • Jerryskids||

    Yeah, except this is a rather humorous refutation of the certainty of this happening anytime soon.

  • Aresen||

    Historically, every great banking house fails eventually, either from their own errors or government actions.

    This has been going on since Sulla decapitated (literally!) the bankers of the Roman Equestian order. (And probably before that.)

    The Medicis lent too much to French princes; the Fuggers lent to German barons and the Hapsburgs, the Bank of America lent to Wall Street speculators, Lehman Bros financed American homeowners.

  • Bill Dalasio||

    Of course, when you get right down to it, the infinite time bankruptcy rate of ANY company is 1.

  • Pro Libertate||

    So if they push government bonds, does that mean to the exclusion of a more diverse portfolio?

  • ||

    Maybe it just means more monopoly money.

  • JW||

    FUCK YOU SQUIRRELS.

  • JW||

    "All this has happened before, and all of it will happen again."

  • Dr. Thaddeus Tingleberry||

    Life, verily, is hard, but it is twice as hard when your prognostications are derived from Battlestar Galactica.

    - TPT

  • Raistlin||

    So say we all.

  • Ken Shultz||

    I think the squirrels don't like quotation marks in italics.

    This gets past the squirrels

    "This gets past the squirrels"

    "This doesn't get past the squirrels"

  • Ken Shultz||

    I didn't mean to post that; it was supposed to be a test.

    For some reason, it didn't like my quote today when the quotes were in italics. It might be when you're quoting from a paste--with the extra slanted quote marks, if you know what I mean.

  • Dr. Thaddeus Tingleberry||

    I note with some dismay the tacit acceptance of squirrel rape attested to herein. Wiser men than myself have noted that the relative paucity of squirrel rape in our society is one of a rather humble collection of items which distinguish us from the lower animals - the squirrels, for the most part, excepted, of course.

    -TPT

  • robc||

    Weaseling out of things is what separates us from the animals...except the weasel.

    pre-registration I would have posted that as Homer Simpson. Now you will have no clue where that quote came from.

  • Soc Indv Sparky||

    I tried the same thing in another post and it got rejected. The quote was from a paste so maybe you're right there.

  • robc||

    The extra slanted quotation marks are a microsoft wordism (probably). So that might be the problem.

  • Restoras||

    extra slanted quote marks
    Racist.

  • kinnath||

    Same problem over and over again...

    Prevention of small forest fires leads to build up of underbrush leading an eventual conflaguration...

    Levees stop the annual cycle of floods along the Mississippi and eventually record setting rain falls drive the river over the levees resulting in widespread catastrophic destruction...

    The road to hell is paved with good intentions.

  • Paul.||

    Levees stop the annual cycle of floods along the Mississippi and eventually record setting rain falls drive the river over the levees resulting in widespread catastrophic destruction...

    Interesting... I made the flood-wall comparison in regards to financial regulations to someone a couple of years ago. They just stared at me with a 'wha?' look in their eyes.

  • shrike||

    Great article.

    Over leverage is the mark of the end of all business cycles.

  • NotSure||

    You clearly did not read the article.

  • Paul.||

    Shrike, that's a bit like saying everyone dies due to lack of oxygen to the brain... yeah... businesses and banks fail because they run out of money. That much is true.

  • Mr. FIFY||

    shrike idolizes Soros and Buffett, so whatever he says is specious bullshit.

  • Old Mexican||

    But by trying to subsidize these local risk factors out of existence, European planners only encouraged deadbeats to be more reckless.


    That is the indictment on the Euro and, in the end, its crude epitaph: "Born to bail out dead beats and died so."

  • Old Mexican||

    Since the Germans are no longer willing to fund reckless governments, they will have to impose discipline on Southern European spending policies from afar.


    And, obviously, the governments of said nations and their clueless populations will blame the Germans and their stinginess.

    I mean, it has become pretty common to blame the Germans for something someone else did. Isn't that interesting?

  • ||

    Germany seems smart, but at the government level how smart is 'smart?'

    So who leads they way? Or do we end up where we were in 2008 but worse... Will there be any medicine administered at any point?

  • NotSure||

    If you just compared France and Germany: in Germany inflation is still seen as something that needs to be combated, not sacrificed by short term political gain, the French liked to soften their Franc without much fuss. In France one is considered conservative if you raise the retirement age by 2 years, even though all the rest of Sarkozy is pretty much what the socialist party does, in Germany they have much more prominent pro business parties. In Germany they have much less of a problem of permanent students with degrees in Sociology or Philosophy.

    Which of the two do you think is better off ?

  • Old Mexican||

    Spain and Ireland actually reduced their public debt before 2008. But their private sectors made up for it by borrowing like mad. When the ECB created a single euro-wide short-term interest rate[...][it lead] to a large housing bubble.


    Well, excuse me but you're committing a fallacy of composition here, my friend. Just because people borrowed to buy houses they could not afford does not translate to "private sectors borrowing like mad."

    Ireland then made the mistake of guaranteeing all its banks, which ruined public finances.


    So much for the "the low tax rate ruined Ireland" canard forwarded by Shrikey-shrieky.

  • NotSure||

    Don't you know, high tax rates are what capitalism is all about, Shrike the millionaire capitalist has assured me of that.

  • ||

    "All paper currency eventually returns to it's true value."

  • Paul.||

    Worth less than the paper it's printed on?

  • ||

    It's obvious, from the Spain and Ireland examples, that the problem was not national government borrowing; it was the Euro itself. The Euro was designed to make French and German exports artificially cheap by flooding the rest of the Eurozone with credit. It worked. The problem was not laziness or profligacy; it was bad money.

  • Brett L||

    Wha? You say the French and Germans gamed the system for themselves whilst the Brits encouraged everyone but the Brits to dive in with both feet? Throw in the Pope and this could be any given century in Europe from 1100 on.

  • ||

    I am sorry but this is incorrect.

    The Euro was a quid-pro-quo between Mitterand and Kohl to get the French to acquiesce in German unity. The French feared that the Bundesbank of a united Germany would de facto set the interest rates for the whole of Europe based solely on the demands of the German economy. It was couched in economic terms but the Euro was a political project.

    Germany went into the Euro overvalued, brutally exposing the various deficiencies of the German economy and creating a recession. It was only around 2005 that remedies began to work.

  • C. S. P. Schofield||

    Philandering Bastard,

    That's certainly a POV with some justification, but I think it misses the mark. The Political Class in Europe have been lusting after all kinds of Social Engineering nonsense since WWI, if not earlier. In the aftermath of WWII there was a steady (and obviously doomed, BTW) movement toward a overarching superstate that would be largely beyond the control of any body of voters.

    My frank reaction to the news of the European Union was incredulity, but as I read more about it I came to see that it was as inevitable as the return of a bad burrito. My Lefty friends were scathing about my stated opinion of the Union's viability;

    "Do you really thing the French haven't forgiven the Germans for WWII?" they would ask.

    My answer was "The French haven't forgiven the Germans for siding with Wellington."

    The Political Class in Europe are a bunch of wankers who think themselves placed on Earth by Providence to rule their lessers. I hope the coming crash buries them.

  • ||

    C.S.P. Schofield,

    I was addressing the idea that the Euro was a conspiracy to impose Franco-German dominance over Europe. That is simply false. I know because I was there when it came about.

    I don't share your pessimism wrt the European project. There has always been tension between a pan-European elite and centrifugal local concerns going back to Charlemagne. The European Union has done a lot to solidify the unifying aspects. Passport-free travel and automatic residency and work permit come to mind. Basically every citizen of the EU has a Greencard for every other EU country.

    This has changed the outlook very much on the ground level as well as in Brussels. Poles work in Britain and Germany, Germans do contract work in Poland, Czechs build Audis etc. The public perception is easily 20 years behind the curve in this regard.

    The only ones who are still going on about WW2 are English soccer fans - every time they lose against the mannschaft ;-)

  • C. S. P. Schofield||

    We'll see. The U.S. didn't achieve any real stability until we had fought the civil war that the division between Plantation-Aristocracy in the South and the rest of the country made inevitable. I'll believe that the European Union is stable AFTER they have THEIR civil war. It may not be France against Germany, but I think it will come.

  • ||

    Interesting. I never looked at it this way.
    I'd argue that the civil war you are talking about is what we call European history. The destabilizing factor has always been Germany in its various guises.

    A united Germany is too large to fit in yet too small to be a hegemon - hence the destabilization. European history to a large extent is about this dilemma. Take Germany out of the equation by fracturing her and you have broadly similar powers like France, GB and Spain reaching a stakemate and thus an equilibrium.

    Introduce an unified Germany and all bets are off. You can ally yourself with the big beast or you can try to form an alliance with the others. What you end up with is a prisoner's dilemma. Stability can not be achieved this way.

    Here is where the EU comes into play. It allows Germany to be big without being threatening. In this regard the EU has been an astounding success. There has never before been a time when France, Poland and Germnay have been at peace simultaneously (peace being defined here strategically as opposed to some temporary accomosation).

  • tipuasher||

    Hey thanks for putting this together. I know it would have taken you a while.
    http://TORONTOFLOOD2006CLASSACTION.COM

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