A Financial Crisis Manual

Reflections and the Road Ahead

Dimitrios D. Thomakos, Platon Monokroussos, Konstantinos I. Nikolopoulos, Dimitrios D. Thomakos, Platon Monokroussos, Konstantinos I. Nikolopoulos, Dimitrios D. Thomakos, Platon Monokroussos, Konstantinos I. Nikolopoulos

• Publisher: Palgrave Macmillan
• Year: 2016
• ISBN:
  9781137448309
• Topic: Business
• Subtopic: International Business
• Index: Business

The recent financial crisis has generated many structural changes within the economy. Many issues are ongoing, and the question of how to recover from the crisis, and how to avoid another one, are continually addressed by scholars and practitioners everywhere. Where there is much discussion within academic and practitioner circles, there is not always adequate interaction between these schools of research.This book provides a thorough overview of the recent financial crisis from the perspective of both industry practitioners and academics specialising in the area. The first part provides practitioner insight on the crisis, and explores the causes and effects and of the recession, European public financing, ECB monetary policy and the Euro, the repression of financial markets, and financial stability. Part two focuses on the case of Greece, as a country still heavily impacted by the crisis, which has undergone various unorthodox policies imposed by the IMF, the ECB the EU. The third part provides insight from researchers and academics, covering an array of Economic theories and revealing new economics architectures available for the future.With informed views from both financial industry practitioners and academics, this book discusses current issues and implementable solutions for a faster post-crisis recovery.

Part I

The Industry Perspective

1

A Retrospective on the Great Recession: Causes, Effects and Prospects

Inachos Lazos

1 Introductory remarks

The term crisis is missing from the title of this analysis on purpose, as it is, in all likelihood, among the most abused terms used to describe global and domestic economic developments since the US subprime and the Lehman collapse. This in as far as it denotes an ephemeral phenomenon, a temporary deviation from the norm to which conditions are expected to revert. In turn, while it is universally hoped that economies do return to a path to prosperity, the sequence of events that has shaken the world since 2007 is much more accurately described as continuous, deterministic and evolutionary, rather than accidental and discrete break-downs of limited time span. The lessons and implications should also be interpreted under this light.

2 Macroeconomic and institutional asymmetries in the euro area prior to the Great Recession

As it applies to the euro area, this framework suggests that structural macroeconomic and institutional asymmetries existed, and with a growing tendency, in the long period that preceded the Great Recession that started in 2008. This is almost definitional: the single market was (and remains) incomplete, particularly in regards to financial services; policy making is bound by the local political economies with very little centralized power and governance at the EU level; fiscal management was overwhelmingly local, to mention but a few components. Without doubt, such a set-up produces asymmetries throughout the euro area member state economies. What is more, the one institution that truly possesses indisputable supra-national and uniform authority – the European Central Bank – has ironically been exposing and compounding such asymmetries by applying homogeneous monetary policy to still heterogeneous national economies.

In tracing back the root causes of the crisis, a few basic thoughts are warranted. First, the contributing factors were not discreet but continuous and intertwined. Second, the Eurozone was and is not on a planet of its own, but also interacts with the global economy. This exposes it to dynamics and imbalances that are global in nature and also affects its degrees of freedom in applying remedial policy.

More specifically, during the previous decade the integration into the world economy of several billion emerging market consumers came along with what has been characterized as a global debt super cycle. Developed economies, led by the United States, became consumers of first and last resort, as emerging economy savings were recycled back to them via the levered system. At the same time as the demand function in developed economies was overheating, the supply side was subjected to the effects of the so-called Great Moderation as low cost producers in lower income countries came online and gained global market share, while keeping inflation muted despite overheating demand.

The levered systems of the developed economies on both sides of the Atlantic adjusted by turning their attention to the non-tradable sectors, primarily the real estate market where bubbles formed. In certain countries such as the United States and Spain these became obvious to the naked eye. Nonetheless, this phenomenon is also evident to the present day in countries such France and even Greece. In the decade since the introduction of the euro, France turned from a current account surplus economy into a deficit one as investment was directed away from tradables and competitiveness lost. Likewise in Greece, where a real estate bubble per se might be harder to identify, capital expenditure and credit were overwhelmingly directed to the non-tradable sectors. To different degrees the productive capacity of these economies was hollowed out as a matter of underinvestment. Policy makers failed to anticipate and identify these dynamics in time, and it appears that they are still misunderstanding them today. The institutions and the political economy of Eurozone member states were unprepared to face not only the challenges of participation in a monetary union, but also the medium and longer term consequences of a rapidly globalizing economy.

This of course concerns both the north and the south of Europe, albeit from opposite directions. Savers in the north, having shifted their own demand function sustainably downward through a permanently understated exchange rate, demanded higher returns on their excessive savings and the only way to achieve that was by their levered systems recycling savings through the bubble-zones of the south. Meanwhile, the global backdrop mirrored these developments and imbalances grew everywhere, in the form of sizeable current account deficits or surpluses financed via the global credit system that recycled and channeled an unprecedented “savings glut” wherever in the world it could achieve even marginally higher returns, even for the wrong reasons.

3 Leading indicators and financial markets ahead of the Great Recession

Whether this dynamic in and of itself constituted a leading indicator of the imminent breakdown it is debatable for several reasons. First, a number of tectonic shifts were genuinely occurring in the world: the unprecedented integration of the global economy with its billions of consumers, savers and labor; technological progress that was the stuff of dreams only a few years back; financial innovation and the deepest and most liquid financial markets the world had ever seen. Second, the path of the “crisis” was almost certainly not pre-set. In that sense, while deterministic, the trajectory of the European as well as the global economy was highly dependent on the fiscal and monetary policy reaction function and its associated errors and biases. To that end, financial markets and practitioners had to not only predict fundamental economic developments, but more overwhelmingly than ever, the human error element behind policy decisions. It would have been impossible, and arguably irrational for financial markets to predict an ex-post error such as the collapse of Lehman Brothers. Yet having been burnt once, when the distress moved on to Europe’s doorstep with the onset of the Greek crisis market practitioners were forced to weigh probabilities differently. As tensions escalated, genuinely poor decision making, political and economic institutional failure in the south of Europe ultimately led markets to entirely shift their ex-ante probabilistic assessment to the negative side, unless proven otherwise. And that is when a dissolution of the euro took on self-fulfilling properties, most acutely manifested in the domestic capital flight witnessed in Germany, where savers scrambled to acquire “risk-free” financial assets such as German Bunds that in some form would survive currency dissolution, or leaving the euro altogether and seeking refuge in the Swiss franc, which skyrocketed.

The ultimate collapse of a currency occurs when domestic savers lose faith and seek refuge elsewhere, thus provoking a capital flight that fatally erodes its value. That is, when the European Central Bank finally came in and Mario Draghi, in August 2012 delivered his “whatever it takes” speech, which arrested the self-destruction sequence the Eurozone had been engaged in. Financial markets for a long period of time had not considered such developments as likely on the whole, as the conditional probabilities were exceedingly low. However, once the unlikely event sequences began materializing, ex-ante probabilities for the next serial mistake rose sharply and rapidly to match the accurate ex-post probabilities of the previously unexpected events that had just occurred – against the odds.

4 Regulator and policy maker responsibility for the Great Recession

There is little doubt that most agents involved in macro- and micro-economic management at various levels, and particularly the regulators and policy makers, contributed to the dislocation, in two main ways. First, pre-emptive measures proved de facto inadequate to prevent the dislocation from occurring in the first place. Second, reactive measures were too slow to become adequate as the policy maker optimization function was at least partly constrained by the local political economies and ideological rigidities. These not only aggravated the situation, but also even stronger response across domains. Policy makers and regulators stood idly watching a dramatic amount of credit being channeled to non-productivity enhancing non-tradable sectors, which steadily eroded external competitiveness. In turn, the financial system was lax enough to such credit creation in ways that clearly under-priced risk exposures, both at a sectoral level as well as, perhaps more importantly, at a macro-prudential level.

This trifecta could simply not go on forever, and the paths were twofold: a gradual improvement and reversal via incremental policy adjustment at multiple levels, or a sudden stop through a shock. On the monetary front, extraordinary accommodation was required to stabilize the global financial system. Central banks led by the Federal Reserve and the Bank of England engaged in concerted efforts that served to both expand money supply, but, equally important, to warehouse assets via outright purchases that allowed price discovery at levels that broke the vicious downward economic spiral. Furthermore, in the United States primarily and the United Kingdom secondarily this was accompanied by upfront fiscal accommodation as well as rigorous bank recapitalization. By contrast, European policy makers, led by the northern countries and Germany, at best worked toward and applied a hesitant and, at times, contradictory policy mix, which remarkably saw even ECB rate hikes as late as 2011. In short, fiscal adjustment in the Eurozone was strong and immediate, while the central bank’s balance sheet was allowed to contract again, after growing significantly through emergency lending.

The rather myopic European policy reaction has exacerbated the adjustment burden. While in the United States and the United Kingdom the main post-crisis challenge resides on the monetary front, and rate setting, as the balance sheet remains enormous by historical standards, in Europe the frontloaded fiscal consolidation generated a much worse nominal growth trade-off. European policy makers seem to have failed to appreciate and, to a much lesser extent, react to the detrimental effects of sharply weakened aggregate demand. In other words, they have largely misread the binding constraints of the Eurozone macro economy by choosing the path of voluntary domestic demand depression as an adjustment avenue. External demand has not been sufficient to sustainably lift the single currency area out of recession: as a result, investment spending has not been sufficiently strong to boost growth and productivity. From its side, the monetary policy response was timid, and thus broadly unable to offset the observed tightening of financial conditions and the depressive impact of fiscal adjustment. Consequently, the true binding constraint, which is no other than nominal growth, is manifesting itself both via substantial inflation undershoot as well as real growth hysteresis.

Clearly, post-crisis is not where the Eurozone is. By contrast, it can be argued that the euro area economy is right in the middle of an existential crisis, which from acute has now become chronic. This is because policy inadequacy thus far will have to be overcompensated in the future by actions that may challenge even further the Eurozone institutional infrastructure, at both local as well as supranational level. It is critical for European policy makers to offer a demand impulse and use both monetary as well as fiscal tools to achieve this. Fiscal adjustment has to take a back seat at the same time as structural reforms boost long-term growth potential while upsetting current vested interest structures at all levels. External demand has to be supported by a weaker currency and the most effective and immediate way to achieve this in the near term is via monetary accommodation. Markets were already discounting this prospect before the ECB formally announced its quantitative easing program and as a result compressed euro yields to record lows. This has rejuvenated inflows into the area, while preserving substantially affordable funding costs for the sovereigns, corporates and households.

Obvious or not, there is not a great degree of variation to the policy prescription that leads to recovery. Now, as ever, it rests firmly in the hands of policy makers to create the conditions for – and to steer the private economy into – a positive future trajectory: their actions my well determine the success or the failure of the common currency area.

5 Policy response to the Great Recession

The response to the crisis in the United States was comprehensive, frontloaded and overwhelming. It should be certain that breaking an acute deflationary shock requires as much in principle. The US response consisted of both a significant fiscal stimulus as well as an unprecedented monetary stimulus. While the purpose of the former was rather more straightforward in supporting the demand side of the economy, the latter was and remains a bit more elaborate, as it involves manipulation of both the price as well as the quantity of money. The unsterilized Treasury bond purchases by the Federal Reserve strongly suppressed interest rates while expanding money supply. The Bank of England acted similarly. Furthermore, the Federal Reserve became the buyer of last resort for securities that were being sold at distressed prices in the downward market spiral, and whose ex-post valuation would ultimately be inconsistent with the objective of an economic recovery. The Fed thus embarked on a vast purchasing program that encompassed an alphabet soup of securities, for which it provided a market as well as “warehousing” facility, possibly until maturity. Last but no...

Table of contents

• Cover
• Title
• Introduction
• Part I  The Industry Perspective
• Part II  The Case of Greece
• Part III  Crisis Economics and the Road Ahead
• Afterword: The road Ahead
• Index