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.
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.
Such an economic approach hurts exports and growth, especially considering that the euro zone's most important economy, Germany, was pushing ahead with labor market reforms while holding unit labor costs down. Portugal, France, Italy, and Greece bought more than they sold and paid for it all with loans, private and public. Between 2000 and 2010, Portugal increased its public debt as a share of GDP from 49 percent to 93 percent, France from 57 percent to 82 percent, Italy from 109 percent to 118 percent, and Greece from 103 percent to 145 percent.
Some governments that are now experiencing crises were not as reckless with public finances. 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, the level was much too low for these two rapidly growing countries, leading to a large housing bubble. When housing prices crashed, so did the countries' banks. Ireland then made the mistake of guaranteeing all its banks, which ruined public finances.
When financial markets ground to a halt in 2008, banks had to reduce their leverage. Debt was once again perceived as risky, causing a balance-of-payments crisis for several euro zone nations. Greece, Portugal, and Ireland were bailed out by their European partners, but this only increased debt burdens and spread concerns about long-term sustainability.
When fears about big economies like Italy and Spain began to surface, markets started worrying that even mighty Germany might not be able to bail everybody out. As of late February, Germany's 10-year yield on government bonds was below 2 percent, but the convergence that Trichet, the ECB's president, once boasted about was no more: Spain's 10-year yield was at 5.3 percent, Italy's was at 5.6 percent, Ireland's at 8 percent, Portugal at 12 percent, and Greece at a stunning 33 percent.
Climate of Confusion
This balance-of-payments crisis could have been solved if prices and wages had been reduced to the levels of 10 years ago, before they were inflated. Such austerity would have increased exports, reduced imports, and attracted more capital from abroad. But regulated labor markets prevented costs from coming down rapidly in most crisis economies, except for Ireland and the Baltic countries. Meanwhile, bailouts and ECB purchases of Italian and Spanish government bonds reduced the pressure on those countries to reform. In Italy unit labor costs have actually increased during the crisis.
Officially, euro zone technocrats kept saying they would never bail out a flagging member. But as soon as Greece got into trouble, it received a bailout, on May 2, 2010. Trichet insisted at the time that fiscal discipline would be upheld because the ECB would never accept government bonds rated as "junk" as collateral for new loans. That lasted until May 3. Confidence was further undermined by E.U.-wide "stress tests" in the summers of 2010 and 2011 that were supposed to reveal the soundness of the continent's banks but instead gave premature clean bills of health to at least two large banks that went on to fail: Allied Irish Banks (which went under in 2010) and Dexia (which failed in 2011).
The problem wasn't that E.U. managers didn't move quickly enough in the crisis; it was that they seemed to move in all directions at once. The E.U. settled on a nominally voluntary write-down of Greek debt owed to private creditors, but this involved a lot of subsidies and arm twisting. First the write-down amounted to a 21 percent haircut, then it became 50 percent, and now it looks like it might be even more, minus the voluntary aspect. When the Greek write-down spooked investors who feared they would have to accept losses on other countries' debt, the E.U. made another U-turn. At the end of 2011, leaders insisted that Greece was an exception and that private bondholders would not have to bear losses in future restructurings of sovereign debt.
Whatever the E.U. says today, we have no idea what kind of rules and interventions will be in place tomorrow. That is the worst climate for investment. "It's impossible to invest by looking at real data and the potential of different assets," one British banker tells me. "Instead we make money by trying to predict what politicians and central banks will be doing."
Future economic historians will puzzle over how European leaders turned a small liquidity problem in tiny Greece into a continent-wide risk of collapse in two short years. The E.U. could have let Greece default. It would have been ugly for some banks, which would have had to be wound down or recapitalized, but such tough medicine would have created healthy incentives for the future and fostered predictability rather than uncertainty.
Instead, Greece was bailed out, and a climate of political uncertainty has prevailed ever since. Which banks are most exposed? Will there be another bailout for Greece, and then another, or will it finally default? Will there be a bailout for the next country in line, or not? Will private bondholders be forced to bear losses, or not? It's hardly surprising that in this atmosphere of utter uncertainty, investors began to confuse Greece's problems with those of countries, such as Italy and Spain, that are not insolvent but merely illiquid.
Instead of confronting the problems and cutting its losses, Europe has continued to play a game of double or nothing. Just before Christmas 2011, the ECB lent €489 billion for three years to European banks at a 1 percent interest rate and in February handed over another €530 billion. The ECB is now grossly leveraged. It wouldn't take very big losses on loans to stressed banks and governments for the central bank's capital base to be wiped out, and in need of a bailout itself. The ECB's loans might have saved Europe from a credit crunch in the short term, but it was also an attempt to get banks to start lending to governments again. As the optimistic French President Nicolas Sarkozy put it in December, "Italian banks will be able to borrow at 1 percent, while the Italian state is borrowing at 6 to 7 percent. It doesn't take a financial specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate."
There you have the euro zone solution to the problem of banks lending too much to governments: get the banks to lend even more. If the financial institutions prove too reluctant, the ECB will just lend them more money, guaranteed by taxpayers and printing presses, so that they loosen up the purse strings.
The only reasonable long-term solution to this mess is market discipline. If lenders know they have to bear their own losses should loans go bad, they will be more cautious with their money. The crisis economies of Southern Europe need to reduce expenses by increasing the retirement age, increase growth by liberalizing product and labor markets while reducing wages and prices to competitive levels. They also should change a worst-of-both-worlds system of very high taxes (Italy is the 170th worst out of 183 countries on total corporate tax rates, according to the World Bank) and lax collection.
But the E.U. is not ready to force governments to live within their means, and the guarantees are just getting larger. Since the Germans are no longer willing to fund reckless governments, they will have to impose discipline on Southern European spending policies from afar. The current idea seems to be getting unelected bureaucrats in Brussels to inspect the budgets of democratic governments and then levy economic punishments against the reckless.
What happens when leaders don't fall in line? Get rid of them, seems to be the drastic answer. The E.U. brain trust has already helped push out democratically elected officials in Greece and Italy by delaying finance deals and temporarily suspending ECB purchases of sovereign bonds. Who has replaced them? Technocrats who promise to do what it takes. This whole process of handing weak economies money but taking control of their policies is the equivalent of giving your teenage son your credit card, then insisting on following him around everywhere to make sure that he doesn't use it. He is almost guaranteed to wreak havoc, kicking off a spiral of humiliation and recrimination.
The "Machine From Hell"
Europe's dismantling of borders and trade barriers since the end of the Cold War has been an astounding success. After a 20th century of war and genocide, to come out on the other side in peace and unity was a cooperative triumph.
But not all forms of cooperation contribute to a spirit of community. If cooperation entails a power struggle over who gets to take money out of the public coffers or who gets to decide things for others, it can create tension and hostility. Right now we are in a situation where Germany pays and decides, a set-up disliked by both contributor and receiver. Greeks and Italians face harsh austerity measures, tax increases and unemployment, and the decisions are being made in Brussels and Berlin. Protesters cry "E.U. out of Greece," the German embassy in Athens has been defaced with swastikas, and pictures of Chancellor Angela Merkel often get touched up with a Hitler moustache. The Greek deputy prime minister pinned the crisis on Germany in a February 2010 BBC interview, saying the country stole Greece's gold reserves during World War II.
On the other side of the conflict, it is now once again politically possible in Germany to talk about Southern Europeans as lazy, corrupt cheats. "Sell your islands, you bankrupt Greeks…and the Acropolis too," ran a headline in the popular German tabloid Bild, atop an article featuring interviews with MPs from Germany's governing coalition.
Some of the worst aspects of modern European history are back again. Protesters, populists, and nationalists are gaining ground. And this is just at the beginning of the crisis. The years to come will bring more recession and austerity, if not an outright collapse. What happens if there are chaotic government bankruptcies, if banks fail, and if people don't get their social security checks and salary payments? What happens in young democracies where there is no trust in politicians?
The banking system in parts of Southern Europe survives only because of cheap loans from the ECB. Insolvency, along with regulatory capital requirements, is forcing banks to shrink on a historic scale. Morgan Stanley is forecasting a near-term deleveraging on the order of €1.5 trillion to €2.5 trillion for European banks as a whole. This would include a cut in lending of up to €1 trillion. Households will not be able to borrow, and small and medium-sized enterprises will be denied the loans they need to stay in business.
European banks and governments are in a lethal embrace. Banks are in bad shape partly because they have lent so much money to desperate governments. Those governments become weaker every time they bail out the banks, making both parties look even riskier. "It seems we have created a machine from hell that we cannot turn off," a senior German official quoted by the Financial Times concluded at a dinner in Brussels in late 2011.
One traditional approach to reducing a mountain of debt is to grow your way out of it. But at today's levels of indebtedness, that would require much more growth than is conceivable. Merely to maintain current ratios of debt to GDP a decade from now, for example, France would need a nominal growth rate (including inflation) of 4.6 percent a year, Italy 5.4 percent, the United States 5.9 percent, Britain 6.4 percent, and Portugal 13.2 percent. If we wanted debt levels to be reduced to a safer level of 60 percent of GDP, France would have to grow by 6.4 percent annually for a decade, Italy by 9.2 percent, the U.S. by 8.9 percent, Britain by 6.6 percent, and Portugal by 19.9 percent.
Debt is a drag on growth, since the government's thirst for resources leaves less for households and private businesses. Higher taxes, inflation, and political uncertainty all follow logically in debt's wake. After looking at 44 countries' experience over 200 years, economists Kenneth Rogoff of Harvard and Carmen Reinhart of the Peterson Institute for International Economics reported in a February 2011 paper published by the National Bureau of Economic Research that when public debt is higher than 90 percent of GDP, median growth falls by 1 percent and average growth falls even more.
The timing couldn't be worse, given the even-bigger debts that changing demographics are inflicting on ill-prepared retirement and health care systems. In the U.S., the number of workers per retiree is projected to decline from 4.5 today to 3 in 2035. In the E.U. the number is slated to go from 3.5 today to 2 in 2035. We will have less work and less tax revenue to pay for more old-age pensions and health care.
As is now customary during a recession, the governments of the U.S., Britain, Europe, and emerging markets like China have flooded the system with cheap money, on a larger scale than ever, with record stimulus packages, zero interest rates, and the printing of money. Since banks are still mending and not eager to lend, low interest rates mean more credit is being diverted to more opaque nonbank channels, i.e., the shadow banking system, where big corporations can easily fund themselves. The Financial Times summed up the results this way in September 2011: "Big companies get capital too easily, while bank-reliant smaller companies get none."
The European debt crisis is not really a new crisis but a continuation, because we never solved the old financial crisis. Debts that were unsustainable in 2008 did not become any less unsustainable just because they were loaded onto governments; the difference just meant that what was once a private-sector crisis has now become public. Instead of winding down failed banks and putting bankrupt companies out of their misery, governments propped them up and bailed them out. Instead of letting asset prices return to levels where people were interested in buying, central banks inflated prices with zero interest rates and quantitative easing. The result is that markets can't function properly. Investors are terrified by every new development, especially the risk that governments themselves are running out of money.
The German economist Hans-Werner Sinn has compared this alarming state of affairs to past failures at managing politically popular exchange rates. "This aspect, too, calls to mind the times when governments tried to maintain inappropriate exchange rates, or used up their reserves to temporarily stabilize them, causing even larger disruptions when they had to give up," Sinn wrote in an October 2011 article on the Centre for Economic Policy Research website Vox. "A frightening scenario is, therefore, that each new flaring of the crisis will drain more money from the creditors' purses, until they run empty."
Investors no longer profit by allocating money to the best ideas and businesses; they profit by trying to predict what the euro zone's leaders are going to do next, or what the Federal Reserve might do. In just a few years, "we have gone from economic policy to a political economy," says Kent Janér, a manager at the Swedish hedge fund Brummers & Partners. It is not a market in which supply and demand set the prices anymore; it is a political process in which governments are calling the shots. Will they support this or that? For how long? For how much?
Banks have deposited more than $600 billion at the European Central Bank at awful interest rates because they don't dare do anything else with the money. Another $1.6 trillion is sitting at the Federal Reserve.
Governments are fighting fire with fire, debt with debt, and the consequences of easy money and government guarantees with even easier money and bigger guarantees. Banks and their creditors came away from the 2008 crisis with the impression that they will always be guaranteed by the government. If no serious changes are made, this understanding will stick. And since banks know they will be saved if they make mistakes, governments are trying to regulate them so that they don't trip themselves up in the first place. Rather than giving banks freedom to act and the responsibility to sink or swim on their own, governments are doing the opposite: giving banks a helping hand while tying their hands and feet.
This is no longer a financial crisis, or even a debt crisis. This is now a political crisis, a crisis of governments. Not just because loose monetary policies, guarantees, and regulation fostered the crisis, or because runaway spending and lack of reform deepened it in Europe. It is a crisis of governments because markets and voters have lost faith in government's ability to clean up the mess. Investors don't trust politicians to get their financial houses in order or to produce economic growth, and voters are growing ever more cynical as politicians who promised them everything are starting to admit they can't deliver.
Johan Norberg is a senior fellow at the Cato Institute, who writes from his native Sweden. This article is adapted, by permission of the Cato Institute, from a new chapter in the paperback edition of his book Financial Fiasco: How America's Infatuation with Homeownership and Easy Money Created the Economic Crisis.