This book explains the path that made the North Atlantic economy became so brittle that the failure of a medium-sized US investment bank precipitated a crisis, and the ensuing policy lessons. While enormous amounts have been written about the crisis, the focus has been either on what happened during the crisis and the lessons from that immediate experience or broader discussions of the failure of capitalism, rather than examining the historical context that led to this particular event. Symptomatic of this approach is that the US and Euro area legs of the North Atlantic crisis have often been treated as separate events, whereas the approach taken here underlines that there was a single crisis in which both sides of the North Atlantic were parasitically intertwined. A massive expansion in lending by banks in the Euro area core helped fuel financial booms in the Euro area periphery and the US housing market. When the resulting bubbles burst, they generated deep recessions on both sides of the North Atlantic that leeched into the rest of the world.
These financial excesses emanated from misguided financial reforms in Europe and in the United States driven by US deregulatory zeal and fractured Euro area policy processes. Both regions embarked upon radical financial reforms starting in the 1980s. In Europe the objective was to create a unified banking system. A key moment for the Euro area banking system 1996 decision by the Basel Committee on Bank Supervision to allow larger banks to use their internal risk models to calculate capital buffers for investment banking. This decision largely reflected the belief of the US Federal Reserve that market discipline worked better than government regulation, and that internal models represented a powerful method for banks to assess risk. In reality, the core Euro area mega-banks manipulated their internal models to reduce their capital buffers and redeploy the unused capital to back new loans. The resulting rapid expansion in lending went largely into investment banking in the United States and commercial loans in the periphery of Europe, regions that were seen as major growth opportunities. National regulators missed the erosion of capital buffers as they were focused on promoting their own national champions.
While lax regulation was allowing the European banks to expand, in the United States the distortions came from differences in rules between regulated and shadow banks. The regulated banks were saved from the excesses in Europe as they were required to hold large (and expensive) capital buffers against loans. However, this stricter system also gave them strong incentives to sell mortgages (and similarly standardized loans) to US investment and European universal banks whose capital buffers were thinner and business models less sound. A key moment for the US banking system was the 2003 decision by the Securities and Exchange Commission (SEC) to widen the collateral allowed in repurchase agreements. Repos were a way of obtaining dollar cash by temporarily loaning out safe assets with an agreement to repurchase them later at a fixed price. By the early 2000s, however, the market was being constrained by a dwindling supply of collateral. The SEC decision had the intended effect of expanding the repo market and making it more liquid. However, it also helped fund and internationalize the US housing bubble. By allowing mortgage-backed securities to be used as collateral for repos, it increased the demand for high-yielding mortgages, a demand that was satisfied by creating inadequately supervised subprime loans. By allowing foreign currency bonds to be used as collateral, the decision simultaneously increased the presence of European banks in US markets. The confluence led to a massive North Atlantic financial drift of European money into the US housing bubble.
The financial “yin” of more lending by banks with increasingly inadequate capital buffers was complemented by a macroeconomic “yang” as lower interest rates encouraged higher spending and borrowing by firms and households. The introduction of the Euro in 1999 and a surge in loans from the Euro area core led to a rapid fall in borrowing costs in the Euro periphery. In countries such as Italy, Spain, Greece, and Portugal that had always had high interest rates, lenders started charging similar rates to Germany and France. This result was a debt-financed boom in southern Europe that the northern mega-banks were happy to underwrite.1 The macroeconomic “yang” explains why Euro area lending was concentrated in the periphery, even though the increased bank lending power was mainly in the core.
The US housing boom had an equally important macroeconomic “yang”, as a steady fall in borrowing costs and inadequate supervision of mortgage terms allowed individuals to take on unwise loans. Major foreign financial inflows helped to drive down borrowing costs that fueled the housing bubble. A significant part of these inflows came from China and other emerging markets that built up reserves to protect themselves from financial instability and to support undervalued exchange rates.2 An equally potent force, however, was financial inflows from European banks as they expanded into US markets. The Federal Reserve allowed easy financing conditions to continue because policymakers focused on inflation, which remained quiescent, even as house prices and the trade deficit soared. Again, the financial “yin” and the macroeconomic “yang” fed off each other.
One lesson is that financial regulation needs to be both tighter and more consistent across institutions. In response, regulations were tightened in both the Euro area and the United States. Higher capital buffers have been complemented by new requirements on liquidity.3 Addition capital buffers have been added on “too big to fail” banks, repos, and securitizations, and US regulation has been extended to investment banks, the institutions at the heart of the shadow banking system. What has been less emphasized, however, is the remaining gap in the strength of regulation of major banks between Euro area and the United States. While both regions are under the same basic capital rules (Basel 3), the Europeans chose a stripped down version while US policymakers voluntarily added additional safeguards. In the Euro area, capital buffers of the mega-banks continue to be calculated using internal risk models which amplify financial booms and busts, allow banks to skimp on capital buffers, and afford the mega-banks a competitive advantage over their small competitors. And while there are plans to introduce more stringent rules in 2018 the devil will be in the details. By contrast, for the large US banks the results from internal risk models are constrained since they also need to comply with simpler and more transparent calculations of capital adequacy. Further reform of the Euro area banking supervision is urgently needed to lower risks of future lending booms, reduce the role of the mega-banks, and to avoid the potential for trans-Atlantic financial flows to restart exploiting regulatory differences. In the United States, the priority is to avoid rolling back tougher regulation of large banks, including investment banking.
The unsustainable macrofinancial booms on both sides of the North Atlantic were missed as a result of a series of intellectual blinkers associated with the pro-market ethos of the period. The flawed design of the Euro area failed to provide sufficient support for countries in crisis, turning a recession into a depression. More generally, three intellectual undercurrents were particularly important in creating a compartmentalized approach to policy-making that diverted the eyes of the policy community from the increasing risks. The efficient markets hypothesis eroded belief in the importance of financial regulation which allowed policymakers to sign off on internal risk models; analysis of the great moderation in output volatility led central banks to overestimate the effectiveness of monetary policy; and benign neglect led to a downgrade of international economic policy cooperation. These blinkers added to the size and costs of the crisis by causing policy-makers to miss the risks from trans-Atlantic financial capital flows and from the fractured design of the Euro area. The system that appeared to be so elegant and efficient turned out not to be robust as an intellectual bubble blinded policymakers to the growing macrofinancial bubbles. These orthodoxies were embodied in state-of-the-art dynamic stochastic general equilibrium models that remain in wide use. The difficulty in adapting them to include more realistic features means that there is a risk that policymakers will continue to embrace the intellectual errors of the past.
A more comprehensive reboot of macroeconomics and policy regimes is needed. This will involve a wider canvas than the pre-crisis emphasis on inflation, business cycles, and monetary policy; more integration between those responsible for monetary policy, fiscal policy, financial stability, and structural reforms; and a more inclusive approach to macroeconomic analysis that can move beyond the self-centered, hyper-rational homo economicus and accepts that crowds can exhibit madness as well as wisdom. Turning to policies, one specific area where more government scrutiny is needed is on international debt flows, where rapid inflows followed by even faster outflows have driven a regular cycle of ever larger international crises, starting with the break-up of the Bretton Woods fixed exchange rate system in the early 1970s and culminating in the North Atlantic crisis almost forty years later. Finally, while some of the flaws in the design of the Euro area have been repaired, more needs to be done to ensure that the area can respond more smoothly to shocks in members, including completing the banking union.
An important legacy of the North Atlantic crisis has been an erosion in confidence in experts in general and economic experts in particular. This has been seen in the strength of populist parties at the ballot box. The failure to anticipate and avoid the crisis undermined the credibility of policy makers, including central banks. It is striking that no central bank has publicly apologized for the North Atlantic debacle despite that fact the preservation of financial stability is one of their basic responsibilities. It is simply not good enough to explain that inflation did not send the right signals and move on. Or to hide behind mathematical formulae that contain crucial simplifications. The crisis was a systemic failure of macroeconomics that requires a systemic revamp beyond tougher bank regulation.
The most important lesson from the North Atlantic crisis, however, may be the inability of financial policies on their own, including the introduction of the Euro, to create prosperity. A striking feature of the time between 1985 and 2008 was that financial deregulation was not accompanied by aggressive programs to improve the workings of the real economy of the type pursued in the 1980s by President Reagan in the United States and Prime Minister Thatcher in the United Kingdom. In the absence of structural reforms that provided new investment opportunities, financial deregulation simply pushed more money into the same places. Rather than being used to create more productive capacity, the additional lending was largely frittered away, mainly on higher land and house prices. Similarly, the massive expansion in mortgage-backed securities was driven by differences in regulation and had few social benefits, in contrast to earlier developments such as the emergence of junk bonds in the 1980s which, for all of the accompanying excesses, allowed small firms to access the bond market. Because it was filling a genuine economic need, the junk bond market continues to be vibrant to this day, in stark contrast to the moribund private securitization market.
There is a need to see economic progress in a more balanced manner, in which the financial sector provides an essential support to underlying changes in the real economy. This view that financial sector should be a support for real activity contrasts with the growing belief over the crisis that the financial sector was, in and of itself, a route to greater prosperity. The belief in financial alchemy, in which clever financial transactions can on their own create wealth without the tedious need to create new businesses or ideas, is a characteristic of most financial bubbles. The main difference in the case of the North Atlantic crisis was not the degree of self-deception but rather the sheer size of the economies that were involved. The enormous associated costs, however, underline the need to ensure that this experienced is not repeated. Hence the need for a more wide-ranging policy reboot from financial regulators, macroeconomic policymakers, and European leaders.
A final message from this narrative is the importance of being appropriately skeptical about financial improvements that create greater market opportunities for banks. Many of the crucial regulatory missteps involved reforms that allowed banks more latitude. Private banks pushed for the 1996 decision to allow capital buffers for market risks to be calculated using internal risk models and the 2003 decision that widened the eligible collateral for repo agreements. These changes made perfect sense from a certain perspective. Internal models were theoretically a better way of calculating risk, just as the US repo market was genuinely being limited by existing collateral rules. However, these narrow benefits turned out to be miniscule when set against the wider costs coming from excessively small capital buffers that internal models produced and the incentives to mass-produce high-yielding mortgages that the change in repo rules generated. Just as the epitaph to the Trojan war was to “beware of Greeks bearing gifts”, the epitaph to the North Atlantic crisis should be “beware of bankers proffering improvements”.