The Limits of Surveillance and Financial Market Failure

Lessons from the Euro-Area Crisis

K. Shigehara, K. Shigehara

• Editorial: Palgrave Macmillan
• Año: 2014
• ISBN:
  9781137471475
• Categoría: Business
• Categoría: Financial Services

This book examines the effectiveness of surveillance by international institutions for financial crisis prevention. It discusses issues relating to designing effective micro- and macro-prudential policies, their mixes and their coordination with monetary policies for achieving financial stability while promoting better macroeconomic performance.

Part I

1

The Limits of Surveillance and Financial Market Failure: Some Fundamental Issues Arising from the Euro-Area Crisis

Kumiharu Shigehara

Just a few years after the outbreak of the global financial and economic crisis which originated from the US housing market debacle, another financial crisis erupted in the OECD area, this time in the euro area. It was triggered by a sudden loss of market confidence in the sustainability of Greek government debt finance. The crisis soon spread to Ireland and Portugal,¹ and, by the middle of 2011, Spain and Italy were affected by mounting market concern about their sovereign debt. Unlike Greece, several of the latter countries had over the years maintained general government net financial balances in a better form than other member countries, such as Germany and France, which have not suffered from acute financial market stress. But in many of them, private-sector saving shortages relative to domestic investment were covered over years by capital inflows from abroad to match persistent current account deficits.

A principal underlying cause of the external deficits was nominal wage increases far above labour productivity growth and the resulting inflation of unit labour costs leading to a significant erosion of competitiveness against trading partners and, in particular, Germany. In some of these countries, notably Ireland and Spain, the accumulation of the household/corporate sector debt was associated with housing market bubbles. After the burst of these bubbles, the real as well as the perceived need for an injection of public funds to reinforce the capital base of unsound banks, as well as to protect bank depositors, started to erode the soundness of public finance, and strain suddenly developed in their government debt financing. In fact, financial market participants started to discriminate across euro-area sovereign bonds only from around the second half of 2008, following the financial market turmoil that erupted in the USA around mid-2007.

Why was the crisis in the euro area not anticipated in time to prevent it?

While the detailed records of regional surveillance conducted before the outbreak of the euro-area crisis within the frameworks of the European Community and euro-area based institutions are not accessible to outside observers, the European Central Bank (ECB) publicly acknowledged that, in addition to the lack of rigorous implementation of the Stability and Growth Pact, “the economic governance framework was also unable to prevent the emergence of excessive macroeconomic imbalances in the euro area” under the heading “The Lack of Macroeconomic Surveillance” in the section entitled “Economic Governance in the Euro Area – Why a Quantum Leap Is Required” in the article “The Reform of Economic Governance in the Euro Area – Essential Elements” (Monthly Bulletin March 2011).²

Besides regional institutions engaged in surveillance of the euro area, the International Monetary Fund (IMF) as a principal global institution has been in charge of the surveillance of individual member countries and the euro area as a whole so as to ensure global financial stability and the promotion of economic growth.³

My review of the back numbers of the IMF flagship publication World Economic Outlook (WEO) conveys the impression that the IMF’s early warning function in the run-up to the euro-area crisis was not satisfactory (see Appendix 1). A far more systematic post mortem was conducted by Pisani-Ferry et al. and the result was reported in The 2011 TSR Study – An Evaluation of IMF Surveillance of the Euro Area, in which they noted:

In general IMF surveillance failed to take fully into account the implications of being in a currency union both for national policies and for the governance of the euro area, whose weaknesses were not fundamentally criticized.⁴

Another international institution which has been engaged in the surveillance of individual member countries and the euro area is the OECD. Unlike at the IMF, a systematic exercise by outside experts to review the OECD’s (published and unpublished) documents for surveillance on euro-area member countries and the area as a whole have not been carried out at the OECD. However, my review of the back numbers of its flagship publication, Economic Outlook (EO), since 2000 suggests that the OECD issued warnings about some emerging fundamental problems in several euro-area member countries at a fairly early stage (see Appendix 1). For example, in the December 2001 EO, the erosion of Italy’s competitive position was discussed as a matter of the OECD’s particular concern in the country note on Italy (p.67). In the subsequent issues of EO, the evolution of Italy’s competitiveness and related policy issues regularly featured the country notes, with particular attention paid to divergent developments in relative unit labour costs.

However, such warnings were ignored by national policy-makers. As a matter of fact, the correction of imbalances in the euro area was set in motion essentially under financial market pressures which forced deficit countries to adopt fiscal consolidation⁵ as well as through the market-induced financial deleveraging of the private sector in these countries, pointing to the importance of financial market discipline which unfortunately started to play its role with a long delay and too abruptly. The resultant contraction of domestic demand in the deficit countries has been a main cause of their wage and price deflation and current account improvements. Euro-area surplus countries’ contribution⁶ has so far basically been limited to financial assistance through existing and new European facilities⁷ together with IMF loans.⁸ Faster domestic demand expansion in surplus countries should facilitate intra-euro-area current account adjustment processes and the narrowing of differentials in cost and price competitiveness in the euro area, but it has not been taking place under single monetary policy geared to the objective of maintaining area-wide inflation “below but close to 2 percent”. There is a view that the ECB should raise its inflation objective to a higher rate,⁹ but it is not clear that such a policy will be helpful. The IMF view on this point is not very clear.¹⁰ Its recommendation regarding the role of structural policies in Germany appears to be more convincing,¹¹ but its effects may require time before they start to visibly attenuate the economic and social costs of adjustment in deficit countries.¹²

Immediately after the start of European monetary union (EMU), issues arising from divergent cyclical positions in individual euro-area member countries out of line with its common monetary policy were discussed in some detail in a special section about the European Union (EU) of the EO June 2001 issue.¹³ The OECD argued there:

If fiscal policy does not play a stabilizing role, the unwinding of excess demand is by default left to market forces. Ireland, the Netherland and Spain are already experiencing much faster growth in unit labour costs in the total economy than other members of the monetary union, and this loss in competitiveness vis-à-vis their euro partners is likely to persist in the coming years. The eventual gradual weakening of net external balance will act to reduce the extent of the overheating, though this might take a relatively long time. While this “gold standard” type adjustment mechanism will ultimately prove effective, it will inevitably result in important structural changes in the economies affected, notably the allocation of resources away from their traded goods sectors. This will require the institutional structure in the smaller countries to be efficient in reallocating resources from declining to growing sectors. Reliance on market forces to deal with overheating thus call for reforms in product and labour markets to increase the capacity of the economy to adjust smoothly to changed circumstances. Furthermore, there is a possibility that real interest rates shaped by area-wide nominal rates and high domestic inflation will result in excessive credit expansion, leading to unsustainable increases in property values and in investment and capital stocks. This points to a risk of balance sheet problems in the wake of overheating. Supervisory policies need to ensure that financial systems maintain diversified portfolios and strong capital bases so as to be resilient as overheating ends.¹⁴

However, the records of national and international bank supervisors since the publication of the EO of June 2001 show that they were behind the curve. Are there reasons for believing that they will do a good job next time?

Moreover, one cannot be optimistic about the effectiveness of surveillance at the global level by the IMF and the OECD¹⁵ as well as at the regional level (within the frameworks of the euro area and the European Community in the case of the current crisis in Europe)¹⁶ given political reality in individual nations.¹⁷ In the end it may continue to be financial market forces which oblige national policy-makers to adopt adjustment policy measures which are necessary but disliked by electorates. This raises the question of how to make financial markets more forward-looking to prevent abrupt changes in market conditions and the disruption of real economic activities.

With this issue in mind, efforts have been strengthened over the years to facilitate the diffusion of surveillance documents by international institutions, at a remarkable pace at the IMF, though much less so at the OECD. However, published versions of their warnings are “sanitized” and as such are sometimes not considered to be fully reliable and credible by the financial markets.¹⁸ On the other hand, any strong messages from public institutions, particularly from those that are directly engaged in policy-making (such as the ECB),¹⁹ involve the risk of upsetting the financial markets and adding to their volatility. The balancing act here is extremely difficult.

A lesson learnt from a series of crises in Latin America since the early1980s and the Asian crisis in the late 1990s was that efforts should be strengthened to improve statistical information about debtor countries in the non-OECD area and its dissemination to financial market participants and the outside world more generally. However, the global financial crisis of 2007–2009 originated in the USA, where data on household debt and other data are fully available to financial market participants. Statistics not just on fiscal deficits but on external imbalances and such underlying determinants of imbalances as cost and inflation divergences among euro-area member countries have also been readily obtainable by financial market participants.

Why were these data regarding underlying imbalances across euro-area member countries developing over so many years after the start of the euro not properly reflected in market prices of their euro-denominated government debt instruments? Were there reasons for financial market participants to believe that emerging problem countries in the euro area would be bailed out in one way or another without losses on their part? What was the significance of the “no bail-out” clause of the Maastricht Treaty?²⁰

It is true that banks are allowed to attach a zero-risk weight to sovereign debt under the standardized approach of Basel II, which was carried over into Basel III. Moreover, while the internal ratings-based approach within the Basel II framework did try to encourage large and sophisticated banks to be more discriminating in their sovereign exposures, the EU’s Capital Requirements Directives introduced a generalized zero-risk weight for all EU central government debt denominated and funded in domestic currency.²¹

That said, market prices should have been differentiated if markets had perceived that countries with unsustainable fiscal positions would not be bailed out and private investors would be forced to incur losses.²²

Another issue relates to differentials for nominal interest rates on private-sector debt which is not subjected to the zero-risk weighting under the standardized approach of Basel arrangements nor covered by the EU’s Capital Requirements Directives. Why did they remain narrow among euro-area countries despite inflation differentials among them, thus distorting financial resource allocation within the euro area for an extended period? The two financial crises originating in the OECD area suggest that sufficient statistical information flows will not guarantee the good functioning of OECD financial markets if they are left to function with their inherent dynamics.²³

There is a saying in Japan that “There is no risk in crossing a road if you are walking in a group.” Will the use of public funds in bailing out troubled banks and protecting depositors and institutional investors that has taken place, and is likely to continue, to deal with the current euro-area crisis induce new episodes of herd behaviour on the part of financial market participants?²⁴

Do these observations made and the questions raised here imply that financial crises are bound to happen again in the OECD area as well as in the rest of the world in the future? Should we remain resigned?

Notes

1. In May 2010, Greece became the first euro-area country to receive financial assistance from the EU and the IMF in exchange for implem...

Índice

• Cover
• Title Page
• Copyright
• Contents
• List of Tables and Figures
• Preface and Acknowledgements
• Notes on Contributors
• Part I
• Part II
• Part III
• Part IV
• Part V
• Part VI
• Annex 1: Conference Programme
• Annex 2: Contributors to the Conference
• Index