The news has a certain dismal familiarity. Bank bankruptcies and forced mergers, paralysis in the interbank market, reduced central bank collateral standards for extending loans, U.S. swap lines to foreign governments, and calls for limits on short-selling evoke the precarious financial conditions just before the bankruptcy of Lehman Brothers. Not everything is the same, of course. Most importantly, the rise in government debt levels and substantial monetary expansion undertaken in response to the last crisis will make it more difficult to cope with the next one.
Signs of financial distress don’t mean that a disastrous crisis is inevitable. But they do underline the urgency of taking steps to reduce risk taking and prepare for bad times ahead. While the Europeans have to sort out their own problems, the United States has a critical interest in helping to achieve a solution—a collapse of the euro would have disastrous implications for the country.
It’s the derivatives, stupid
As in 2008, a boom has generated a large stock of liabilities of dubious worth—subprime loans then, European sovereign bonds now—with banks incurring large exposure to eurozone risk directly and through credit default swaps (CDS) and other derivatives. European banks have sold $238 billion in credit default swaps on bonds issued by the governments of vulnerable European countries—Greece, Ireland, Italy, Portugal, and Spain. U.S. banks have provided $518 billion in guarantees, mostly also in the form of credit default swaps, on the government, bank, and corporate debt of these countries. Banks tend to hedge a substantial portion of their CDS exposure, and it can be devilishly difficult to determine their net exposure to speculative instruments. For example, after a lengthy data slog, one analysis concludes that we can say very little “about the extent and form of U.S. banks’ exposure” to Europe.
Unfortunately, a very large share of both speculative and hedging transactions is with a small number of financial institutions, since 74 percent of global CDS trades involve just twenty banks. If several of these banks experience massive losses simultaneously, all banks’ hedges against their exposure may become worthless.
How such counterparty risk can undermine the value of hedges during a systemic crisis was demonstrated in 2008, when U.S. banks relied on the American Insurance Group (AIG) for protection from losses on their subprime loans. As these loans went south and AIG ran out of cash to post collateral on its CDS exposure, the government had to take over the firm to avoid a cascade of counterparty defaults that could have cost banks tens of billions of dollars. Absent U.S. government intervention, support for commercial banks, and help in arranging sales of bankrupt institutions, the financial system could have imploded, heralding the onset of a 1930s-style economic collapse.
It doesn’t help that complex derivatives have made it difficult for owners and managers of financial institutions to ensure adequate control over the risks their subordinates undertake (see UBS in 2008) or even to ensure compliance with legal norms for the treatment of customer accounts (see MF Global).
Are the governments now in power to blame? To some extent, it’s bad luck: Greece didn’t have to cheat on its fiscal accounts, and the tensions within the eurozone are the result of forces set in motion a decade ago. Nevertheless, the failure to adequately curtail bank risk taking or achieve transparency in derivatives markets, despite the dramatic and painful lesson provided by the last financial crisis, is part of the reason we are where we are today.
Are we out of ammo?
Decisive actions in 2008–09 by fiscal and monetary authorities to stave off another Great Depression expended a lot of ammunition that we can no longer use today. Our ability to cope with any negative shock, let alone a major financial crisis, is vastly diminished.
Essential fiscal stimulus to boost demand and avoid a more prolonged slowdown has increased government debt levels. U.S. government debt has risen by more than 25 percentage points compared to GDP, and German government debt by 5 percentage points, since the end of 2007. This rise in indebtedness has eroded support for further fiscal action.
Monetary policy also faces more severe constraints than three years ago. The federal funds rate was lowered from 5.25 percent in August 2007 to nearly zero by December 2008, where it remains today. Obviously there is little room left to lower it further. The Federal Reserve’s massive expansion of the money supply (referred to as “quantitative easing”) helped support demand without any harbinger of inflation, but resistance is building to further such measures.
Across the pond, the European Central Bank’s (ECB’s) main interest rate on refinancing operations sits at 1 percent, but at least monetary authorities have apparently given up on misguided efforts to raise rates in the face of economic stagnation. The ECB theoretically has a number of stimulatory measures that it can undertake, including large-scale purchases of government bonds of countries in trouble. So far it has gotten its feet wet with limited bond purchases and substantial loans to banks, but more determined efforts will require greater political agreement on Europe’s common responsibility for the plight of vulnerable countries.
Monetary authorities, including the ECB, recognize their responsibility to rescue banks to stave off financial collapse, but no one appears committed to rescuing illiquid sovereigns, whatever the consequences for growth and welfare. The prescribed solution relies instead on loans from the European Financial Stability Facility and the International Monetary Fund (IMF)—whose resources are completely inadequate to deal with the problems of Italy and Spain—and on austerity measures and structural reforms in the periphery.
The fundamental barrier to addressing the crisis, however, is neither high debt levels nor a loss of effectiveness of monetary policy, but rather political dysfunction. In 2008–09, the United States was at the epicenter of the crisis, and Congress, the administration, and the Federal Reserve cooperated to rescue systemically important firms and banks, and to provide the fiscal and monetary stimulus required to support economic activity.
Today, however, politicians are in great disarray on both sides of the ocean. The ECB and European governments are playing a game of chicken to determine who will take the first and most risky step in providing resources to vulnerable countries. Surplus countries in Europe are determined to avoid subsidizing their “profligate” southern neighbors, while the latter face a decade of austerity to restore competitiveness and fiscal balance—which their populations understandably resist. In the United States, a divided Congress appears barely capable of permitting the government to function on a day-to-day basis, never mind forging a coherent long-term fiscal program or providing the resources required to buttress the IMF.
What to do?
The memory of a narrowly avoided disaster in 2008 should spur everyone to take preemptive steps to head off the next crisis and to prepare for the worst. Avoiding a collapse of the euro requires a radical shift in the European mind-set away from excessive reliance on austerity and more emphasis on growth-enhancing reforms including expansionary policies in the European core, a point made in Paradigm Lost and more recently eloquently argued by Martin Wolf, among others.
Assembling new financial resources that could be used to meaningfully intervene in the economies of the larger countries in trouble, as needed, is also critical. Such resources should only be provided in the context of commitments by individual governments and by the eurozone as a whole to a program that promises a return to creditworthiness—that is, renewed growth in countries now threatened by recession and default. The United States needs to take the lead in assembling these resources.
In addition, continued rapid growth and large current account surpluses in emerging economies have positioned them to help finance a concerted rescue plan, should industrial country governments find the political will to formulate one. Still, cash-rich but nevertheless poor countries will not be willing to assist heavily indebted but nevertheless rich countries without getting something in return. For example, they may demand greater influence in international institutions and more say in negotiations over international economic issues.
The United States can help protect itself from crisis fallout through more vigorous action to limit risk taking by major financial institutions. Thus regulators must overcome banks’ resistance to controls on their financial gambles, such as rules that prevent banks that accept public deposits from trading on their own accounts.
Similarly, more progress is required to improve transparency in derivatives markets, notably by moving most over-the-counter transactions to central clearinghouses that could provide greater insurance against counterparty failure, requiring firms to post collateral daily to cover their risk and centralizing the reporting of transactions .
Decisive action is essential to avoid a severe crisis, but the political will to act appears to be lacking. As Europe teeters on the brink of disaster, it would be a tragedy if we failed to demonstrate the same determination that authorities showed in confronting the financial meltdown three years ago.
William Shaw is a visiting scholar in Carnegie’s International Economics Program.
