Financial Crisis and the Failure of Economic Theory

Jorge Turmo Arnal

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781317317432
• Edition: 1
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

The global financial crisis of 2008 was largely unpredicted. If economic theory has a role to play in predicting future catastrophes then the methods we rely on need to change. The authors of this study propose a new theory of economics based on more detailed understanding of how and why people behave as they do within their environment. This anthropological approach uses the strengths of many existing economic theories, including Keynesian and Austrian economics, to present a new framework for anticipating and averting the financial crises of the future.

1 THE FINANCIAL CRISIS AND MODERN ECONOMICS: FROM SURPRISE TO PUZZLEMENT

Main Figures of the Crisis

One of the most salient features of the current crisis is that there were no warning signs. We had been living through a long period of growth in the majority of developed countries. During the last twenty years economic crises seemed to affect only developing countries. Those who lived in North America and Europe believed that they were immune to crisis. Only Japan had suffered a long period of stagnation and lost its position as a leader among developed countries. At the beginning of the 1990s Japan was the world’s second biggest economy and it rivalled the US GDP, but ten years later this challenge had vanished.

The dotcom crisis was temporary because it mainly focused on some technological companies and it affected only these companies. The crisis drove the stock market to a peak followed by a sudden stop and fall. Many investors lost their money, but the overall economy did not suffer a downturn. Unemployment increases only affected workers in the tech companies.

The creation of the euro was a success even though some experts warned that the Eurozone was not an optimal currency area.¹ For many years the euro was beneficial for all its members: some countries could borrow at a very low interest rate while others increased their exports considerably. This success attracted other European countries to join this promising project.

At the same time China was growing considerably and world trade was increasing. China needed raw materials to grow and increased its direct investment in African and South American countries that lacked capital. Now China is a factor of stability and well-being for the whole world economy. The US economy grew and continued to be the largest market in the world, the best place to invest, and the dream of hundreds of thousands of immigrants from all over the world. Thus, on the eve of the crisis we seemed to have been living in what many have considered in retrospect a paradise.

The crisis that started in 2008 has affected mainly developed economies. It has reduced production and has rendered a lot of capital equipment useless. Millions of workers have been laid off and have undergone serious difficulties re-entering the job market. Household income has shrunk and the demand side of the economy has suffered. In addition, confidence has disappeared, making business activity much more difficult and hampering a possible economic recovery. More important still, the crisis has been long-lasting and has caused a lot of distress. The US and Canada have recovered faster while the Japanese economy has stagnated again and the European Union is in a painful situation. Additionally, it is unknown whether we have reached the bottom yet.

The change has been so dramatic that we now have to approach the evolution of our economies in a different way. This is not a normal crisis and we have started to use the term ‘The Great Recession’ to describe it. In fact, we are witnessing a structural change that exceeds by far the size of an economic crisis and it is reshaping the whole economic system. This is why we have to explain it very carefully. We have to bear in mind that contrary to the dotcom crisis, the current crisis was first a financial phenomenon that afterwards affected production and employment. There has not been a mismatch between the demand and supply side in only one sector: it has been a systemic change, the consequences of which will last for decades.

As a consequence of large amounts of very risky mortgage loans, in September 2007, US bank Countrywide Financial underwent liquidity problems that it could not afford and a bank run took place. The Federal Reserve was forced to intervene and Countrywide was sold to Bank of America. On the other side of the Atlantic, Northern Rock could not meet its obligations and the Bank of England gave it liquidity support. Then, the Bank of England tried to sell it, but no financial institution was willing to take it over and Northern Rock was nationalized.

The problem of Countrywide Financial was the increased number of foreclosures it could not handle, but it was not the only firm that was struggling. The mortgage-backed securities that allowed mortgage loans to increase considerably became increasingly illiquid as foreclosures rose. Facing the risk of more financial entities being affected, the US Treasury opened a new facility in March 2008 to allow banks to obtain Treasury notes with their mortgage-backed securities. But the timing of the solution was too late for Bear Sterns, which was taken over by JP Morgan due to its urgent liquidity problems.

Meanwhile the Bank of England, aware of the same problem, followed the US Treasury by accepting mortgage-backed securities from banks that needed liquidity. Both last resort lenders were facing the same challenge. The step that ignites the process is that a financial institution cannot meet the liquidity demands of its customers because it has committed too much money in medium- and long-term loans. When these loans prove to be less safe than expected and their repayment becomes doubtful the risk of a bank run increases. To avoid it, the monetary authority must inject liquidity to help the bank survive on its own. But in some cases the problem is not one of liquidity but of solvency and the third step is to find a buyer willing to recapitalize and stabilize the bank. If there is none, as in the case of Northern Rock, the monetary authority has to nationalize it.

The measures taken could not stop the process. In September 2008, the weakness of the mortgage-backed loans threatened Fannie Mae and Freddie Mac forcing the US Federal Housing Finance Agency to take control of them. Both are federally owned banks whose aim was to ease the access to the housing market for the US population. They were not obliged to bear a lot of risk to maximize the profits of their shareholders, but just the opposite: it was supposed they would behave conservatively. It is very difficult to explain why they performed so badly before the crisis, unless we suppose they shared the same mistaken theoretical background and incorrect procedures and practices as private financial institutions.

In the same month, Lehman Brothers filed for bankruptcy, dismissing the implicit rule that it was too big to fail. This was a turning point in the financial crisis because the US Treasury refused to rescue it. The US Treasury was intending to send a message of strength, but instead it unleashed a perfect storm. Stock markets plummeted all around the world and the Bank of England and the Federal Reserve injected billions of pounds and dollars into the banking system. Many financial institutions were partly or fully nationalized, although only temporarily. Meanwhile, the European Central Bank was silent and did not act.

The refusal to bail out Lehman Brothers was a disaster for the whole economy and banks realized that they had to merge to survive, otherwise they would be nationalized. Lloyds TSB took over HBOS and Bradford & Bingley was nationalized in the UK; Merrill Lynch was sold to Bank of America; Washington Mutual was controlled by the Federal authorities and partly sold to JP Morgan Chase in the US.

The financial crisis reached the rest of Europe as well. In September the government of Iceland decided to nationalize Glitnir Bank. The decision shed light on the fact that the whole Icelandic banking system was on the edge of a cliff because their liabilities were far larger than their assets. The government was forced to nationalize all financial institutions. In 2006 Fortis carried out the takeover of the Dutch bank ABN and failed to manage it successfully. Thus, in a rescue effort, 49 per cent of its shares were bought by the governments of Belgium, the Netherlands and Luxembourg.

The wave spread to more countries. The German government bailed out Hypo Real Estate, the largest property lender in the country. The Irish government, whose banks had been attracting deposits from all around the world, decided to guarantee all of them. The decision proved to be a mistake, because it converted the private debt of the banks to their customers into the public debt of the Irish people. The consequences of the decision are still with us. The Russian government, whose central bank is not independent, opened a large loan facility to Russian banks. In the US the Troubled Asset Relief Program was put in place, aimed at buying bank assets in exchange for liquidity when required. More examples of the same were Wachovia Bank, which was taken over by Wells Fargo and Sovereign Bank by Banco Santander in the US. Dexia, a Belgian group, was put under control of the Belgian, French and Luxemburg governments. The government of the UK became the owner of Royal Bank of Scotland, HBOS and Lloyds TSB when it bought half of their shares.

The economic policy measures adopted by central banks avoided a systemic banking crisis, except in Iceland in 2008 and Cyprus in 2013, but the cost was very large. The IMF has estimated² the fiscal cost of the measures taken by the governments. Its estimation includes capital injections in weakly capitalized banks, guarantees for financial sector liabilities, purchases of assets whose markets have dried up, and central bank support through credit lines to financial institutions. In advanced economies the average has been 50.4 per cent of the GDP. The UK has spent 81.6 per cent of its GDP and Sweden 69.7 per cent. The US has devoted 81 per cent but Canada just 25.1 per cent. In Germany the figure is 22 per cent, in France 19.2 per cent and in Ireland 267 per cent. It is worth mentioning that among the countries that have been rescued since then, namely Ireland, Greece, Portugal and Spain, only Ireland has spent a large percentage of its GDP in helping its financial institutions. We should ask ourselves whether a stronger public intervention in Greece, Portugal and Spain in 2010 could have fared better.

The financial storm, the public money spent on bank rescues and bailouts, and the turbulence generated by the lack of confidence among financial institutions caused severe erosion in developed economies. The GDP figures of 2009 were ugly. Japan decreased by 5.5 per cent, the US by 3.5 per cent and Canada by 2.8 per cent. In Europe, the decrease was 2.6 per cent in France, 3.5 per cent in Spain, 4.9 per cent in the UK and 5.0 per cent in Germany. In sharp contrast, China’s GDP rose by 9.2 per cent. Concerns about the crisis peaked and uncertainty spread, but experts were confident that the crisis would be over soon.

In 2010 Germany’s GDP increased by 4.0 per cent, the US by 2.4 per cent, Japan by 4.7 per cent and the UK by 1.8 per cent. The growth in France was 1.6 per cent and in Italy 1.7 per cent. It seemed that the worst was behind us and the world economy was recovering. But there was another slowdown in 2011. GDP growth in the UK was 1.0 per cent, in Italy 0.5 per cent, in France 1.7 per cent, in the US 1.8 per cent and in Germany 3.1 per cent. Japan showed a decrease of 0.5 per cent. Experts were not able to predict future events. Some of them believed that the slowdown would be temporary, while others feared a double dip in developed countries. The figures of 2012 have confirmed the worst hypothesis. France has not grown at all, and in the UK the increase has been a reduced 0.3 per cent. The German economy grew by 0.9 per cent, far less than the previous years, and in Italy the GDP has decreased by 2.4 per cent. Only the Japanese economy, at 1.9 per cent, and the US, at 2.2 per cent, have performed well. Many experts believed by the end of 2010³ that the economy of developed countries was rebounding, but the figures of 2011 and 2012 do not back this assumption. We can say that the US has escaped from the crisis although it is not at full strength yet. The Japanese economy is experiencing ups and downs without a definite trend, while the main countries of the European Union are suffering a double dip recession. The crisis has not finished yet and it may be long-lasting.

The Great Depression started in 1929 in the US and hit Europe in 1930. It ended, depending on the country, in 1934–5. Our current Great Recession started in 2008 and is still with us. The length of both is very similar. The consequences of the Great Depression were large and affected not only economic variables, but society, politics, even literature. One dramatic change was the economic theory displayed in Keynes’s General Theory. Our discipline changed forever. Will the Great Recession drive a similar change ? As we will explain at a later stage, economic theory has exhibited many weaknesses throughout the crisis. We must learn from them and we must review our conventional and widely shared wisdom. The performance of our economic theories must improve.

While output grew slowly or decreased, another problem complicated the situation. In some countries the Great Recession dramatically decreased tax revenues, forcing governments to borrow money in international financial markets. But agents in these markets were very reluctant to lend money because of a deep lack of confidence. The interbank market dried up and banks did not trust each other. Thus, a growing demand for borrowing by national governments facing large public deficits could not be met. As a consequence, several European countries were pushed to the brink of default and asked the European Union for help.

The first was Greece, whose actual public deficit had been masked for years using creative accounting procedures. After the elections in 2009 the new government that came into power admitted the correct amount of its deficit and its public debt. Greece suddenly became unable to service its public debt because the access to financial markets became very difficult. Every Greek bank suffered a severe outflow of capital and the confidence in the Greek economy plummeted along with CDS prices, while the spread of interest rates skyrocketed. The new figures led rating agencies to downgrade the level of the Greek debt by several steps and the financing of public and private Greek debt was driven to a point of no return. The Greek government had no alternative but to turn to the EU and the IMF for help. The European Union led the process and in May 2010 a package of 120 billion Euros was agreed upon. Greece agreed to a very severe adjustment plan that included public expenditure cuts, an increase in the retirement age, privatizations of public firms, salary cuts for civil servants, and so on. Since the Greek economy did not recover, they could not afford the payment of the loans and another rescue package, including a default, was agreed on in 2012. Since then the Greek economy has been under scrutiny and has undergone a painful process of negotiations, riots and a severe downturn in GDP. Three years after, the Great Recession is hurting Greek people and the future is grim. A continuous decrease of living standards is causing widespread social distress.

The second case was Ireland. As we have explained, the government decided to guarantee all the deposits in Irish banks. It was a huge mistake. The banks had earned a lot of money by investing in high-risk products. When risk materialized, the value of the toxic assets in their balances fell to zero and they could not meet their obligations. The guarantee of the Irish government helped the banks survive but it turned private debt into public debt and the fiscal deficit peaked to 30 per cent of GDP. Ireland called for help too. In November 2010 an 85 billion Euro rescue plan was designed to help Ireland. The obligations were very similar to Greece’s: wage and expenditure cuts, an increase in the retirement age, etc. The government approved the plan and they were immediately defeated in the general elections that took place in January 2011, among protests and riots. The Irish GDP decreased along with wages and living standards. Many Irish people were forced to emigrate. Fortunately, the real side of the Irish economy was able to adapt to the new circumstances without further decline in production. Two years later Ireland has been able to borrow again in the international capital markets, but the microeconomic consequences of the crisis have not disappeared yet.

The third was Portugal. In March 2011 the government of the Socialist Party tried to pass a law in the Parliament to cut public expenses, civil servant wages and to increase the age of retirement. The population did not accept this and the project was defeated because the other parties did not want to share the burden of the responsibility. Prime Minister Jose Socrates resigned and called for elections in which his party was dealt a severe defeat. The winning Social Democrat Party realized that there were no other options and, like Greece and Ireland, called for help. In May a 78 Billion Euro rescue package was approved. The memorandum of understanding they signed included the same measures that the Parliament had rejected two months before. Two years later, Portugal is experiencing its own Great Recession, its economy is depressed and further sacrifices have been imposed on the population in order to receive European loans.

From June of 2011 on, the Spanish risk premium peaked. International investors believed that debt repayment was doubtful and that there was a risk of default. In addition, Spanish savings banks proved to be very weak and poorly capitalized. The percentage of housing sector assets was very large in their balances. These assets had been very profitable during the housing boom, but they became toxic once the bubble burst. The mergers that took place from ...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• Acknowledgements
• List of Figures
• Introduction
• 1 The Financial Crisis and Modern Economics: From Surprise to Puzzlement
• 2 A Different Look at Economic Theory: The Anthropological Approach
• 3 The ‘Building Blocks’ of Modern Economics: We Do Really Need a Meta-Theory
• 4 The Meta-Theory at Work: A Case Study in Growth Theory and Real Business Cycle Theory
• 5 Governments and the Financial Crisis: Making Economic Policy in the Dark
• 6 Explaining More Complex Phenomena: The Financial System
• Final Remarks
• Notes
• Works Cited
• Index