Arestis karakitsos financial stability in the aftermath of the great recession (2013)

List of Figures and TablesFigures 2.3 Percentage deviation of real wage rate from productivity 4.3 China, monetary financial institutions, uses of funds, loans, 5.7 Median price of existi

Financial Stability in the Aftermath of the ‘Great Recession’

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3 The Theoretical Framework That Underpins the Origins of

6 Anaemic Recovery: The Vicious Circle of Consumption and

8 Lessons From the ‘Great Recession’ for Both Theory and

List of Figures and Tables

Figures

2.3 Percentage deviation of real wage rate from productivity

4.3 China, monetary financial institutions, uses of funds, loans,

5.7 Median price of existing homes relative to nominal per

vi

List of Figures and Tables vii

6.13 Degree of debt leverage: Corporate sector debt as a

Tables

Introduction

1.1 The purpose of the book

The 1990s was seen as probably the best decade since the 1960s; it washeralded as the beginning of a new era based on the success of the cap-italist system The success of the 1990s was attributed to free markets,which, it is claimed, produced an optimal allocation of resources The neo-liberal, model along with the Efficient Markets Hypothesis and the newconsensus macroeconomics models, were credited with the success The USeconomy expanded for a period of ten years, the longest ever recorded by

an industrialised country The macroeconomic performance was stunning:both inflation and unemployment fell to new lows and short- and long-term interest rates fell to levels that had not been observed since the 1960s.The stock market produced enormous gains, particularly in the areas oftechnology, media and telecommunications There was widespread accep-tance of the idea that this time was different The enthusiasts dubbed itthe ‘new economy’ where seemingly large productivity gains increased therate of growth of potential output, thereby making possible the reduction in

Yet the optimism did not last With the beginning of the new millenniumand, more precisely, in March 2001, the stock market crashed with theNasdaq suffering unprecedented losses, comparable to those experienced inthe 1930s Astute observers remarked that the internet bubble had imploded,but the consensus view was that everything was normal The consensus viewgained widespread support as the recession that followed was shallow andshort-lived Pundits asserted that had the internet been a bubble, it wouldhave had devastating effects on the economy The small impact of the stockmarket on the economy was taken as prima facie evidence in support ofthe view that the internet was not a bubble The fact that the recovery thatfollowed the 2001 recession was anaemic did not cause any concern to theconsensus, which continued to hold the view that internet was not a bubble.After all, the previous recession in the early 1990s was also anaemic Policy

1

2 Financial Stability after the ‘Great Recession’

makers and central banks did not react any different than in previous sions Alan Greenspan, the then Chairman of the Federal Reserve System(Fed), was adamant that there was no reason to change policies Targetingthe growth in asset prices would have required the central bank to outsmartinvestors, a task that was regarded as impossible This led to the emergence ofthe doctrine that it is better for central banks to deal with the consequences

reces-of a bubble than to try to prevent it, which was immediately accepted byalmost all of the major central banks But Alan Greenspan fearing the worstreacted with an unprecedented monetary stimulus; the fed funds rate wascut no less than 13 times to 1 per cent from 6.5 per cent

With a prodigious fiscal and monetary stimulus, the anaemic recoveryfinally became sustainable The nightmare of an asset and debt deflationhad been averted! However, the new cycle was again short-lived After theboom in 2004, growth slowed to below potential and the USA finally suc-cumbed to recession at the end of 2007 Astute observers again pointed outthat what the Fed had achieved was to transform the internet into a housingbubble that would soon burst, dragging the economy to the dreaded assetand debt deflation process that had plagued the US economy in the 1930sand Japan in the 1990s However, such views were brushed aside and pol-icy makers continued with the policy of ‘business as usual’ Alan Greenspankept interest rates at the 1 per cent level until mid-2004 and then removedthe accommodation bias too slowly, thereby fuelling the housing bubble.For astute observers the role of the housing market was telling The hous-ing market ameliorated the early 2001 recession thanks to the prodigiousmonetary stimulus The prognosis was that the bursting of the housing bub-ble would have a disastrous effect on the stock market Ben Bernanke, AlanGreenspan’s successor at the helm of the Fed, carried on with the same speed

in removing the accommodation bias But he was too late in lowering rates

by at least eight months High interest rates had already inflicted a ble blow to the housing market, which had peaked at the end of 2005 Yet

terri-up to 2007 the fall in house prices was orderly and the Fed saw no son to alter the course of its monetary policy The summer of 2007 saw theeruption of the credit crisis and the Fed began a policy of aggressive easing,but it was too late The financial system became insolvent and it had to bebailed out to prevent a complete meltdown The economy fell into a deepdecline that was dubbed the ‘great recession’ In March 2009 the ObamaAdministration made a U-turn in term of its attitude and policies in rela-tion to financial institutions It rejected a House bill that had aimed to taxthe bonuses of Wall Street; it adopted a ‘business-as-usual’ model for banks;and it allowed them to price their distressed assets at their own discretion bypurging the standard mark-to-market method This boosted confidence, trig-gering a period of restocking by companies on a worldwide basis With theadoption of substantial fiscal and monetary stimuli by all important govern-ments a recovery emerged But after a year the recovery once again ran out

rea-of steam This led to the development rea-of a sovereign debt crisis in Europeand policy makers adopted austerity measures to deal with the new crisis,thus further undermining the recovery At the time of writing Europe hasfallen back into recession and the question now is whether it will drag therest of the world back into recession.

Housing was not the only asset bubble Commodities were another bubblethat went unchecked in the first half of 2008 when the USA was already in amild recession This bubble burst when the USA fell off the cliff in the secondhalf of 2008, dragging the global economy into recession With the recovery

in 2009 the commodities bubble re-emerged as it was widely believed that

sustain growth even as the western world experienced little or no growth.The renewed commodities bubble dealt a terrible blow to BRIC countries

as inflation, which had been reignited because of overheating, accelerated

to dangerous levels, thereby triggering an aggressively tight monetary icy As a result, the BRIC countries are now slowing rapidly at a time whenEurope is falling into recession and the US economy is experiencing only aweak recovery

pol-Policy makers have opted for a stricter regulatory environment as a means

of preventing another systemic crisis For example, and in the US case, theDodd–Frank Act, and at the international level the Basel III have emerged,along with similar measures in other countries that will be discussed atlength in chapter 9

The purpose of this book is to throw light on the causes of the credit crisisand the ensuing ‘great recession’ It traces the origins of the ‘great recession’

in the USA and outlines the distributional effects, deregulation and financialliberalisation that laid the foundations for the financial engineering, whichassumed gigantic dimensions following the repeal of the Glass–Steagall Act

in 1999 The book examines the emergence of the excessive liquidity that hasfinanced a series of bubbles over the past ten years But it also investigates therole played by the growing redistribution of income in encouraging excessiveleverage in the banking sector which enabled the personal sector to becomeover-indebted and therefore vulnerable to shocks

At a deeper and more theoretical level the book examines the roleplayed by the Efficient Market Hypothesis (EMH) and the New ConsensusMacroeconomics in providing the intellectual basis for the neo-liberal modeland the policies pursued by central banks and the fiscal authorities It dealswith the issue of whether such conduct of monetary policy leads to insta-bility and how future monetary policy should be formulated to avoid themistakes of the past Furthermore the book examines the reasons for theanaemic recovery and compares and contrasts it with the anaemic recov-ery of the two previous cycles It also investigates the sovereign debt crisisthat has plagued Europe and why it has developed there rather than in theUSA It also considers the contagion channels from the euro area debt crisis

4 Financial Stability after the ‘Great Recession’

to the rest of the world and the risks of a US sovereign debt crisis for theworld economy The book examines the role of financial stability and how

it should best be served At the same time it offers an analysis of the ulations that are under progress in many countries as a means of deterringanother systemic crisis and the lessons, in terms of both theory and policythat can be learned

reg-1.2 The issues covered in the book

The credit crisis of 2007–09 was the worst since the Great Depression ofthe 1930s The US housing market appears to be the clear culprit for thismess, but should this sector be regarded as the cause or the symptom ofthe crisis? This is the first major issue to be considered in this book It isargued that the cause of the current malaise has its roots back in the 1970sand the early 1980s when the policy of deregulation and financial liberal-isation began in the USA and the UK and then spread to other countries.The share of labour to GDP had been on an uptrend for more than 50years, but this trend reversed with the first oil shock in 1973–74 Incomeredistribution from wage earners to profits, particularly so to the profits offinancial companies, has been taking place ever since This growing incomeinequality has forced households to borrow increasingly large amounts in

an effort to maintain their standards of living Deregulation and financialliberalisation laid the foundations for financial engineering that ultimatelymade possible the over-indebtedness of the personal sector The subprimemarket was simply the pinnacle of this huge appetite for borrowing Allthat would not have been possible had it not been for the rise of the EMH,namely the theoretical premise that unfettered markets promote ‘efficiency’and an optimal allocation of resources In such a system all markets clearinstantly, making disequilibria in labour and financial assets highly unlikely.The implication of this theoretical premise is that unemployment is theresult of trade union activity, minimum wage laws and the unemploymentbenefits paid to the unemployed If all of these barriers were to be dropped,then the wage rate would fall to levels that unemployment would becomezero, save for frictional unemployment, namely some unemployment thatwould exist because employees do not have the required skills to take avail-able jobs or simply because they choose to be unemployed as they preferleisure to employment at that level of the wage rate Similarly, in finan-cial markets the implication of the EMH is that bubbles are unlikely todevelop The EMH reached pre-eminence in the 1990s, the ‘golden era’ ofthe neo-liberal school of thought However, events in the 2000s challengedthe validity of these premises The bursting of the internet bubble in 2000shook the financial system, but perseverance with the EMH led to an evenmore damaging bubble, in the housing sector The bursting of this bubble led

to the near-collapse of the financial system and the ensuing ‘great recession’

However, this situation also had other contributory factors, namely tional imbalances, errors in the conduct of monetary policy and the role ofthe credit rating institutions.

interna-The EMH was regarded as an extreme hypothesis, at least in academia, andtherefore one key question is what was the theoretical model upon whichcentral banks based their policies This is the third major issue covered inthis book The Grand Neoclassical Synthesis lost its appeal in the 1970ssince it was increasingly thought that it was unable to explain what washappening in the real world Great efforts were subsequently put into thedevelopment of models based on optimising behaviour that could explainnominal rigidities in labour and product markets in the context of rationalexpectations and yet be able to explain the real world This led to the devel-opment of New Consensus Macroeconomics (NCM) models, which haveprovided the intellectual basis for the conduct of monetary policy from the1990s onwards The pillars of the NCM models are that inflation is underthe control of the central banks, whereas growth and unemployment arenot, in the long run Moreover, the control of inflation helps to stabilisethe economy around its potential output path, which is exogenous to thesystem, and is influenced by matters such as multi-factor productivity andthe growth of the labour force The policy implications of the NCM mod-els are that by placing inflation targeting at the top of the policy agenda itupgraded monetary policy and downgraded fiscal policy as a tool of stabili-sation The principal objective of fiscal policy was to balance the budget andtrim public debt, in the belief that doing so would shrink the ‘inefficient’public sector and enable the corresponding expansion of the ‘efficient’ pri-vate sector However, the ‘great recession’ has now cast doubt on the wisdom

of inflation targeting to the exclusion of other targets One key question

is whether monetary policy should also aim to affect the output gap andeven asset prices in an effort to stabilise the economy and achieve financialstability Another key question is whether the policies pursued by centralbanks operating under the assumptions of NCM lead to instability Anothermajor drawback of the NCM models is that monetary aggregates, liquidity,and banking are not necessary as long as we know how central banks setthe short-term interest rates The implication of this is that the objective offinancial stability cannot be served by inflation targeting

There can be no bubble unless there is a corresponding expansion ofcredit to finance it In traditional bubbles, such as occurred in Japan in the1980s, the Asian–Russian crisis in 1997–98 and China recently, the expan-sion of credit was reflected in monetary aggregates Hence the bubble could

be detected by central banks and monitored through measures of ity Yet there was no increase in monetary aggregates in the USA and othercountries where housing bubbles emerged How is this possible? This is thesecond major issue covered in this book Financial engineering made thatpossible by creating the liquidity and hence the credit that was required to

liquid-6 Financial Stability after the ‘Great Recession’

finance the bubbles; it led to the development and growth of a parallel orshadow banking which was outside the control of the monetary authorities.Central banks, therefore, did not detect the bubbles and did not monitorthe corresponding expansion of liquidity and credit Hence, the Fed andother central banks were taken by surprise when the housing bubbles burstaround the world The most important development in terms of the finan-cial liberalisation of the USA was the repeal of the Glass–Steagall Act in

1999, which had been introduced in 1933 with the aim of separating mercial from investment banking There was a simple rationale behind thisact Its aim was to permit investment banks to take as much risk as theyliked with their own capital and the degree of leverage they wanted to take,but not with the deposits of ordinary savers These would be placed withcommercial banks who would be subjected to strict regulation over the risksthey would be permitted to take Sure enough, in the period between the1930s and the late 1990s, when it was in force, the Glass–Steagall Act pre-vented any systemic financial crisis By contrast, the period after its repealled to a series of bubbles, each one being a transformation of the previousone Thus the housing bubble is a transformation of the internet bubble andthe commodities bubble is a transformation of the housing bubble

com-The credit crisis of August 2007 and the ensuing ‘great recession’unleashed an asset and debt deflation process for the personal sector notonly in the USA, but also in other countries Thus another issue that arises

is how important is the deflation process in accounting for the hithertoanaemic nature of the recovery This is yet another issue covered in thisbook The asset and debt deflation process is common practice following theballooning and the bursting of an asset bubble The bubble on this occasionwas related to the housing market, which in the USA peaked at the end of

2005 The fall in house prices was initially orderly, but it became disorderlyfrom mid-2007 onwards The essence of the asset and debt deflation process

is that a plunge in the prices of one important constituent component ofpersonal sector wealth, such as housing, leaves households with negativeequity, meaning that the value of the house is less than the mortgage Thisdestruction of wealth forces households to save a higher proportion of theircurrent income in an effort to repay the excess debt and rebuild the impairedwealth This will involve the shrinkage of the liability side of the personalsector balance sheet in order to match the impaired asset side and bringthe system back to equilibrium For this reason the asset and debt defla-tion process is also called deleveraging in the jargon of financial markets.The process is a long and painful one as consumers have no access to cap-ital markets and the result is many years of subdued consumption growth.One way of ameliorating the adverse impact of the asset and debt deflationprocess on the housing market and the economy is through mortgage refi-nancing at lower interest rates However, this channel may be thwarted by anegative spiral of falling house prices and foreclosures The more precipitous

the decline in house prices is, the greater the number of foreclosures, as morehouseholds are caught in the insolvency net with their houses foreclosed bylenders and put up for sale in the market This negative spiral may swamp thepositive impact of mortgage refinancing, leading to a free-fall in house prices.But there may be yet another reason for the so far anaemic recovery, whichmay be acting in addition to the constraints that the housing market isimposing on the consumer This is the role that is played by expectations inaffecting the decision of companies to hire and invest This is another mat-ter that will be considered in this book Companies are aware of the assetand debt deflation process in the personal sector As a result, in their deci-sions in terms of hiring and investment they form expectations of low finaldemand and, in particular, of consumption This is a self-fulfilling prophecythat leads to a vicious circle of low consumption and low investment Thusanother reason for the anaemic recovery is the deficiency of demand Thiscan only be resolved by a stimulus coming from outside the system, such

as external demand (that is, exports) or a fiscal stimulus But such a fiscalstimulus has not materialized yet; even worse, the dangers of the fiscal-cliffare still there With Europe falling into recession and China slowing in 2012there is little hope that foreign demand can provide an alternative stimulus

to the US economy

In the midst of the credit crisis many governments around the worldbailed out their financial systems The aim of these actions was to avert aninsolvent financial system from triggering its own meltdown However, bybailing out their insolvent financial systems, governments have threatenedtheir own solvency This has resulted in the transformation of the bankingcrisis into a sovereign debt crisis This may be another reason for the so faranaemic recovery; it even involves the risk of throwing the world economyback to recession Although the USA poses a far greater risk than the EU interms of its budget deficit and the level of federal debt, a sovereign debt crisisemerged in the euro area rather than in the USA This paradox is the result

of the different policies pursued in the EU and the USA and their monetaryunion structure Because of the importance of such matters the book willattempt to consider a number of key issues: the causes of the euro area debtcrisis; why the crisis has dragged on for so long; what, if any, has been wrongwith the policies that have been pursued to resolve the crisis; the existence ofalternative viable policies; and the channels through which the crisis couldspread to other parts of the world

An important issue is what lessons should be drawn from the credit sis in terms of both theory and policy As stated earlier, for many of theworld’s leading central banks inflation targeting has been the single mostimportant goal of monetary policy; sometimes to the exclusion of all othertargets In this respect, recent experience suggests that price stability doesnot guarantee the stability of the economy as a whole and even less sothe goal of financial stability Microprudential policy was the basis of the

cri-8 Financial Stability after the ‘Great Recession’

regulatory framework prior to the credit crisis But in the aftermath of thecrisis macroprudential policies are emerging as the necessary tool to deterfuture systemic crises There are a wide range of macroprudential policies:time-varying capital requirements; higher-quality capital; corrective actiontargeted at capital as opposed to capital ratios; contingent capital; the regu-lation of debt maturity; and the regulation of the shadow banking system

We therefore discuss the new regulatory framework that is emerging at somelength, emphasising the recent initiative on this front by President BarackObama, summarised under the acronym of the ‘Volcker Rule’ This initiativeemerged as the Dodd–Frank Act of 2010, and it is the focus of the discussion

on this front, along with other similar schemes proposed and implementedaround the globe

The most important lesson for economic theory is that the initial tance of the EMH has been largely discredited by the events that led to the

accep-‘great recession’ Moreover, the New Consensus Macroeconomics models are

in need of reformulation – something that is addressed by this book

1.3 The structure of the book

Chapter 2 examines the causes of the credit crisis and the ensuing ‘greatrecession’ This was the pinnacle of a long process of deregulation, finan-cial liberalisation and financial innovation that started in the 1970s in theUSA and the UK and spread to the rest of the world through the supposedlysuperior intellectual model of the EMH The emphasis is on the link betweenthe EMH and the practical aspects of deregulation and financial liberalisa-tion, which facilitated the development of financially innovative products.These structural changes in the US and UK economies, which then spread toother countries, would not have been possible had it not been for the redis-tribution process of income from wages to profits and, in particular, those

of the financial sector; a process that has so far remained unchecked Theseare the main causes of the crisis But it is argued that there were also a num-ber of contributory factors: international financial imbalances, the monetarypolicy pursued at the time, and the role played by the credit rating agen-cies All of these factors accentuated the process that resulted in the ‘greatrecession’

Chapter 3 explains the theoretical framework that underpinned the gins of the ‘great recession’ The New Consensus Macroeconomics (NCM)

ori-or neo-Wicksellian models have fori-ormed the intellectual basis of the way theeconomy works and how monetary policy should be formulated in theoryand practice These developments in economic theory and the practice ofeconomic policy are responsible for the credit crisis and the ensuing ‘greatrecession’ This chapter analyses the drawbacks of the NCM models In par-ticular, it considers that the absence of banking and monetary aggregatesfrom the NCM models is one reason why central banks failed to detect and

monitor the expansion in credit that financed the internet and housingbubbles However, the pre-eminence of inflation targeting in the westernworld, which enabled the ballooning of these bubbles, is because one fea-ture of the NCM models is that the control of inflation is under the control

of the central bank, whereas growth and unemployment are not under suchcontrol; they are supply-determined variables in the long run This chapterdiscusses all these issues and then offers a reformulation of the NCM modelsthat attempts to rectify their deficiencies The long-term properties of thereformulated model show that it is consistent and can explain the stylisedfacts of the ‘great recession’

Income redistribution, deregulation, financial liberalisation and tion sowed the seeds for a runaway expansion of liquidity and, accordingly,

innova-of debt leverage in the various sectors innova-of the economy, starting in the ing and corporate sectors and finally engulfing the personal sector Theprocess through which excessive liquidity was created is analysed in detail

bank-in Chapter 4 Excessive liquidity gradually changed the nature of the lastthree business cycles from demand- and supply-led, which was the norm inthe post-Second World War era, to asset-led business cycles These asset-ledcycles created the conditions for the ballooning of successive bubbles: theinternet, housing and commodities bubbles Each bubble is a transforma-tion of the previous one because the liquidity that has financed the previousbubble is not drained from the system Each bubble is pricked when a centralbank raises interest rates to combat gently rising inflation Moreover, on eachoccasion that a bubble bursts central banks pump more liquidity into thesystem in an effort to avert the asset and debt deflation process that wouldotherwise plunge the economy into a deflationary spiral This policy leads toinstability both in the financial system and in the economy – an instabilitythat is highlighted in the context of the NCM model, which forms the intel-lectual basis of the policies pursued by present-day central banks Instabilityarises as the economy becomes progressively more leveraged This tends toincrease the response of net wealth to interest rates and profitability Theinstability occurs not simply when a central bank single-mindedly pursues

an inflation target, but also when it pursues the dual targets of inflation andthe output gap But the instability can be averted if in addition to inflationand the output gap central banks pursue a mild wealth target

With the exception of the first year, the recovery of the western worldfrom the ‘great recession’ has so far been weak, a feature that has beenshared in the two previous business cycles The causes of the current anaemicrecovery are analysed in two consecutive chapters Chapter 5 examinesthe constraints that the poor conditions of the housing market impose onthe levels of consumer expenditure It is argued that to appreciate theseconstraints the traditional approach of viewing housing as a capital goodmust be dropped and housing should rather be viewed as a speculativeasset, akin to equities This new theorising is necessary as in the traditional

10 Financial Stability after the ‘Great Recession’

approach bubbles cannot exist However, even within this framework thehuge impact of housing on the economy in the last recession cannot beexplained, unless the pro-cyclical pattern of the savings ratio, advocated bythe Life Cycle and the Permanent Income Hypotheses, is rejected in favour of

a counter-cyclical pattern Chapter 5 puts all of these issues into perspective.First, it builds up a theoretical framework to analyse the speculative nature

of housing and by so doing new avenues emerge through which housingcan affect the economy The chapter then offers an overview of the housingmarket in the last business cycle and considers it in the perspective of pre-vious cycles This enables an appreciation of the contrasting role played bythe housing sector in the early 2000s recession, in which it ameliorated mat-ters, and in the recent one, in which it has had an aggravating effect Thischapter then examines the contributory role of the Fed in the expansion ofliquidity and the fuelling of the housing bubble Although both commonsense and most economist commentators agree that housing was a bubble,there is still a minority who continue to maintain that housing was never

a bubble This chapter examines these arguments and offers new evidencethat housing was indeed a bubble Finally, it analyses the impact of housing

on consumption and the economy as a whole, and assesses the prospects forthe housing market

Chapter 6 investigates the second reason for the current anaemic state

of the global recovery This is the interaction of investment and tion, thereby providing a coherent explanation of the causes of the anaemicrecovery It is argued that although the balance sheet of the US corporate sec-tor is healthy, firms are reluctant to hire and invest (that is, expand capacity)because they have expectations of weak consumption levels Such expec-tations become a self-fulfilling prophecy leading to a vicious circle of lowconsumption and low investment, and thereby trapping the economy into

consump-a deflconsump-ationconsump-ary spirconsump-al To escconsump-ape from this vicious circle it is necessconsump-ary tointroduce a stimulus to demand As both the BRIC countries and Europeare slowing, while US monetary policy is already too accommodative, theonly alternative is to provide a boost from fiscal policy But this may not

be forthcoming, at least in the short run, as the sovereign debt crisis inEurope has made governments reluctant to pursue easy fiscal policy Thischapter analyses the short- and long-term determinants of investment anduses this framework to assess the different causes of the anaemic recovery

in the last three business cycles The main thesis advanced in this chapter isthat the last three business cycles have all been influenced by excessive liq-uidity, which has created imbalances in different sectors, but because of theinterdependence of the various sectors the result is the same – an anaemicrecovery The framework of the short- and long-term determinants enables

us to propose a formal set of relationships, which are estimated for the period1949–2002 The chapter then produces a number of simulation exercises in

an attempt to examine the likely impact on investment when the short-runand the long-run factors are put together.

Chapter 7 analyses the sovereign debt crisis The global credit crisis hasforced governments to bail out their financial systems and pursue easyfiscal policy, in some cases with a prodigious stimulus, to alleviate theensued recession As a result, governments in many advanced economieshave become over-indebted, threatening to become themselves insolventand accordingly causing relevant problems to the global financial system,thereby posing the risk of another deep and, perhaps, protracted recession.This chapter analyses the causes of the European Monetary Union (EMU)debt crisis, the reasons for the persistence of the crisis, scrutinises the reme-dial treatment applied to date, offering alternative viable solutions to thecrisis and examining the channels through which the EMU debt crisis mightspread to the USA and the rest of the world

In particular, the peripheral sovereign debt crisis is a core banking crisis

in disguise, as the single currency brought about divergence of real nitudes, such as productivity and unit labour costs, between the peripheryand the core This was manifested in growing current account deficits inthe periphery, the mirror image of which was current account surpluses inthe core Core banks recycled these surpluses in the form of loans to theperiphery The EMU debt crisis has been allowed to drag on mainly because

mag-of the insistence on the Private Sector Involvement (PSI) The PSI risk, byraising the costs of borrowing for sovereigns with large projected debt, wasintended to improve governance, serve as a disincentive to fiscal profligacy,guard against moral hazard and reduce the risk of future crises However,

in reality, the PSI risk has had the unintended consequence of spreadingthe crisis from Greece to other countries Chapter 7 then assesses the twoattempts to implement the PSI in the case of Greece It analyses the prob-lems of ‘free riding’ and the resulting low level of participation in the PSI andassesses the impact of Collective Action Clauses as a method for improvingthe level of participation in the PSI It then offers a viable solution to theGreek crisis that would cost the EU the same amount of money as they havealready committed, but would make the Greek debt sustainable immediatelyrather than in 2020 and would also be better for the banks The chapterthen analyses international contagion A credit crisis in the EU would bemanifested as a shortage of liquidity, but the cause is elevated bank creditrisk, which would infect simultaneously the interbank, repo and certificates

of deposits markets It will then infect the credit default swaps market andmoney market funds markets

Chapter 8 draws the theoretical and policy lessons from the recent rience Within the framework of the NCM models the policies that led us

expe-to this calamity are the upgrading of monetary policy and the ing of fiscal policy as tools of stabilisation One major objective of monetary

downgrad-12 Financial Stability after the ‘Great Recession’

policy is ‘maintaining price stability’ (King, 2005, p 2) Moreover, policymakers strongly believed that a monetary policy aimed at achieving pricestability was the key to the successful management of aggregate demand.The obvious policy implication is that the focus of monetary policy to meetthe single objective of inflation should be abandoned The lessons for theoryare the EMH should be rejected, whereas the NCM models would need to bereformulated

Chapter 9 gives a detailed discussion of the new regulatory environmentthat policy makers attempt to put in place to avert another credit crisis.Financial stability is the focus of this chapter In particular, this chapter dis-cusses the Volcker rule that developed into the Dodd–Frank Act of 2010;the regulatory developments in the UK, Europe and other countries and theinternational developments that have come to be known as Basel III

Origins of the ‘Great Recession’

2.1 Introduction

The purpose of this chapter is to discuss the origins of the crisis that emerged

in August 2007, which we now know as the ‘great recession’ The focus is

on the emphasis given to the Efficient Market Hypothesis (EMH), namelythat all unfettered markets clear continuously, thereby making it highlyunlikely that disequilibria, such as bubbles, will be the root of the crisis.Indeed, in terms of the EMH framework, economic policy designed to elimi-nate bubbles would lead to a situation of ‘financial repression’, which would

be regarded as a very regrettable outcome Ever since the early 1970s, whengovernments across the world succeeded in implementing financial liberali-sation initiatives, in particular in the USA and the UK, the focus has been oncreating financial markets that are free from any policy interference This isbased on the belief that liberalised financial markets are very innovative, andsure enough they are; indeed they were Over the period prior to the ‘greatrecession’ and after the intense period of financial liberalisation especially

in the USA, great strides were seen in the development and extension ofnew forms of securitisation and use of derivatives This was a financial engi-neering practice, which led to the growth of collateralised debt instruments,especially so in the form of collateralised mortgages

The experience with financial liberalisation is that it caused a number ofdeep financial crises and problems unparalleled in world financial history,

in terms of both their depth and frequency However, most significantly forthe purposes of this contribution, it was the experience of the USA in rela-tion to financial liberalisation that is most telling in relation to the cause

of the current crisis The crisis cannot be explained solely in terms of cial liberalisation The size of the financial sector is also important In thisrespect, it is important to note the enormous redistribution that had takenplace in the countries at the centre of the crisis In the 25 years to August

finan-2007 there was significant redistribution from wage earners to the financialsector That redistribution, along with the measures to introduce financial

13

14 Financial Stability after the ‘Great Recession’

liberalisation, produced the new financial engineering, rooted in the USA asmentioned above, which led to an extraordinary mispricing of risk, were

factors We isolate three of them: the international imbalances, mainly as

a result of the growth of China, the monetary policy pursued by countriesover the period leading to the crisis, and the role played by the credit ratingagencies The ‘great recession’, in our terminology, led to massive state sup-port along with a subsequent deterioration of the public finances in most ofthe affected countries

Significant income redistribution effects from wages to the profits of thefinancial sector and US financial liberalisation attempts, along with thefinancial innovations that followed them, have been causes of the ‘greatrecession’ In Arestis and Karakitsos (2011b) we deal extensively with theseissues and show that all these factors were the main causes of the ‘greatrecession’ In section 2.2 we briefly summarise the main causes of the ‘greatrecession’ Furthermore, and as in Arestis and Karakitsos (op cit.), we con-sider and discuss the contributory factors, namely international imbalancesand monetary policy We suggest, nonetheless, in the process that a thirdcontributory feature is relevant; namely, the role played by the credit rat-ing agencies We discuss the contributory features in section 2.3 before wesummarise and conclude in section 2.4

2.2 The main features of the ‘great recession’

In discussing the origins of the current crisis we are very much aware ofthe limitations of current macroeconomics Indeed, we agree with the con-clusion of Minsky (1982), who argued more than three decades ago that

‘from the perspective of the standard economic theory of Keynes’s day andthe presently dominant neoclassical theory, both financial crises and seriousfluctuations of output and employment are anomalies: the theory offers noexplanation of these phenomena’ (p 60; see, also, Arestis, 2009)

The ‘great recession’ has been caused by US policies of financial alisation and the financial innovations that followed in their wake Thatwas greatly helped by significant income redistribution effects from wages

liber-to profits of the financial secliber-tor An interesting statistic on this score isreported in Philippon and Reshef (2009) in the case of the USA This isthe pronounced above-average rise in the salaries of those employed infinance Relative wages, the ratio of the wage bill in the financial sector

to its full-time-equivalent employment share, enjoyed a steep increase inthe period from the mid-1980s to 2006 What explains this development isderegulation in a causal way, followed by financial innovation The impact

of deregulation accounts for 83 per cent of the change in wages Indeed,wages in the financial sector are higher than in other sectors, even after con-trolling for levels of education Similar but less pronounced financial shares

are relevant in the UK, Canada, Germany and Japan, among others In Chinafinancial intermediary shares to GDP increased from 1.6 per cent in 1980 to5.4 per cent in 2008 (Greenspan, 2010, p 15).

Three other factors – the international financial imbalances, the monetarypolicy pursued at the time, and the role played by the credit rating agencies –can be suggested as factors that exacerbated, rather than caused, the ‘greatrecession’ We take the view that although these factors were important, theywere not the original cause of the ‘great recession’ They were accentuatingthe process of financial liberalisation and financial innovation rather thanbeing part of the cause of the crisis The rest of this section will attempt to

2.2.1 Income redistribution effects

One important factor that made a significant contribution to the ‘great sion’ emerged from the steady but sharp rise in inequality, especially in the

had reached close to a post-Second World War high before the onset of therecession while real wages had fallen even behind increases in productivity.The declining wage and rising profits share were compounded by anotherlong-term economic trend: the increasing concentration of earnings at thetop, especially in the financial sector Figures 2.1 to 2.5 make the case vividly.Figures 2.1 and 2.2 make the point in the case of the UK (both figuresare from Lansley, 2010) Figure 2.1 clearly shows the falling share of wages,while Figure 2.2 shows clearly how wages fell below productivity Figure 2.3makes the case of the increasing shortfall of the real wage rate from produc-tivity since the early 1970s in the case of the USA The real wage rate fell70

Figure 2.2 UK wages relative to productivity

Source: Oxford Economics.

Percent dev of real wage

Unemployment % of labour force (12-month lead)

Figure 2.3 Percentage deviation of real wage rate from productivity (January

1968 = 100) and unemployment

Source: Authors’ calculations based on the US National Income and Product Accounts (NIPA),

Bureau of Economic Analysis, December 2009.

Compensation of employees as % of GDP Wage and salaries as % of GDP Employers' contributions as % of GDP (RHS)

Figure 2.4 Compensation of employees and its components

Source: Authors’ calculations based on the US National Income and Product Accounts (NIPA),

Bureau of Economic Analysis, December 2009.

Corporate profits with IVA & CCA as % of nominal GDP

Figure 2.5 Corporate profits as percentage of nominal GDP

Source: Arestis and Karakitsos (2010b).

18 Financial Stability after the ‘Great Recession’

well behind productivity in the aftermath of the Second World War, ing its maximum shortfall of around 15 per cent during the period of theKorean War But the gap closed between that time and the early 1970s whenthe real wage rate hit an all-time high, increasing by more than 5 per centthan productivity in April 1972 In the aftermath of the first oil shock thereal wage rate once more fell behind productivity, suggesting that employ-ees bore the brunt of the redistribution of income from the USA to theoil-producing countries Rising and high unemployment forced this redis-tribution of income Unemployment soared from 3.5 per cent of the labourforce in early 1970 to nearly 11 per cent in the midst of the 1980–82 reces-sion (see Figure 2.3) However, as the price of oil and unemployment fell inthe 1980s the real wage rate caught up once more with productivity gains

reach-By the spring of 1999, the time of the repeal of the 1933 Glass–Steagall Act,the gap between the real wage rate and productivity had once again beeneliminated Fluctuations in unemployment caused by the early 1990s reces-sion and the subsequent anaemic recovery contributed to an oscillating realwage rate around productivity, but on an upward trend Nonetheless, thereal wage rate fell behind productivity following the burst of the internetand housing bubbles and the resultant increase in unemployment, hitting

Lehman Brothers in September 2008

These unfavourable trends in the real wage rate are reflected in part in thewages and salaries of private and government employees Figure 2.4 showsthat wages and salaries as a percentage of GDP did not improve as much asthe real wage rate in the golden post-Second World War era until the 1970s.Over the period the share of wages and salaries to GDP increased by only

3 per cent, from 50.5 per cent to 53.5 per cent However, in the period fromthe beginning of the 1970s to present the share of wages and salaries to GDPfell by an astonishing 9 per cent, falling to just 44.5 per cent by the end of

2009 Wages and salaries improved their share only in the period 1994–2001

In spite of these unfavourable trends in the real wage rate and wages andsalaries, since the 1970s, the compensation of employees, which includes,

in addition to wages and salaries, employer contributions for governmentsocial security and employee pension and insurance funds, gives a morecomplicated picture The compensation of employees improved in the post-Second World War era, increasing from 54.5 per cent to GDP in 1948 tonearly 70 per cent by the early 1980s (see Figure 2.4) But since that time

it has declined to 65.5 per cent Hence, the net loss of the compensation

of employees since financial liberalisation is only 3.5 per cent, compared to

9 per cent in wages and salaries and a greater than 10 per cent shortfall in thereal wage rate to productivity The smaller deterioration in the compensation

of employees to wages and salaries, however, is partly the result of higheremployer contributions for government social security and employee pen-sion and insurance funds These contributions have more than quadrupled

in the post-Second World War era from 2.3 per cent of GDP to 10.6 per cent(see Figure 2.4) Nonetheless, the share of employer contributions to GDPhas increased by only a tiny fraction (that is, 0.5 per cent) since the finan-cial liberalisation of the early 1980s, thereby confirming the redistribution

of income from employees to employers

Figure 2.5 shows the increasing share of profits in relation to income inthe case of the USA and also in the case of the rest of the world, and, moreprecisely, in the case of the financial sector We note from Figure 2.5 that thebottom of profitability at the end of 2001 hit an all-time low This down-trend may be the result of shifting production abroad, which gathered pace

in the era of globalisation, but also reflects the increasing challenge of theUSA from other industrialised countries, such as Japan, Europe and, recently,China However, the bleak picture of non-financial profitability is not shared

by other subcategories Financial companies, in particular, have seen a sharpuptrend in their profitability since 1982, recording nearly a six fold increase(see Figure 2.5) The financial deregulation, which had begun in the 1970sbut continued at that time, highlighted particularly by the repeal of the 1933Glass–Steagall Act in 1999, both discussed below, certainly contributed to thelong-term improvement of the profitability of financial companies Thesedevelopments are at the heart of the ‘great recession’ as they enabled thecreation of liquidity that financed the housing bubble, but also the internetand other bubbles of less importance, including in the areas of commodities,shipping and private equity Now that the house bubble has burst anddeleverage is taking place, it is very likely that the long-term uptrend inthe profitability of financial companies will be reversed Similar observationscan be made in Europe, excluding the UK, where in 2007 Germany’s financeminister encouraged European companies to ‘give workers a fairer share of

their soaring profits’ (Financial Times, 28 February 2007).

The rising share of profits aped financial institutions thereby ing leveraging (the debt to assets ratio) and high risk-taking in financialinstitutions In the words of the chairman of the UK Financial ServicesAuthority,

increas-There has thus been an increasingly ‘financialisation’ of the economy,

an increasing role for the financial sector Financial firms as a result haveaccounted for an increased share of GDP, of corporate profits, and of stockmarket capitalisation And there has been a sharp rise in income differen-tial between many employees in the financial sector and average incomesacross the whole of the economy (Turner, 2010, p 6)

This promoted the financial engineering based on the US subprime gages, as explained in what follows in the rest of this section Theseare important distributional effects, which are not accounted for by theprevailing view of theoretical macroeconomics and the economic policy

mort-20 Financial Stability after the ‘Great Recession’

implications of this framework, essentially monetary policy in the form ofinterest rate manipulation to hit a set inflation target

This redistribution was greatly assisted by attempts at financial tion in many countries around the world Of particular importance for thepurposes of our discussion was the financial liberalisation framework in theUSA Both the redistribution referred to above and the financial liberalisationpolicies led to a period of financial engineering in the USA, which spreadworldwide to produce the current ‘great recession’ In the next sections weturn our discussion to financial liberalisation essentially in the USA, and thefinancial engineering there, in an attempt to complete our explanation ofthe origins of the current crisis

liberalisa-2.2.2 US financial liberalisation and financial engineering

Financial liberalisation in the USA began in the 1970s – more precisely in

1977, when the USA started to deregulate its financial system There was thederegulation of commissions for stock trading in 1977 to begin with, andsubsequently investment banks were allowed to introduce unsecured cur-rent accounts The removal of Regulation Q in the 1980s followed, that isremoving the placing of ceilings on retail-deposit interest rates The repeal

of the key regulation Glass–Steagall Act of 1933 in 1999 (promoted by the

US financial sector, using as their main argument the Big Bang of 1986 inthe UK) was the most important aspect of US financial liberalisation forthe purposes of the question in hand The final step in the process was theCommodity Futures Modernisation Act (CFMA) of December 2000, whichrepealed the Shad-Johnson jurisdictional accord, which in 1982 had bannedsingle-stock short selling, the financial instrument that allows selling nowbut delivering in the future All these financial liberalisation attempts wereimportant in promoting financial innovations in the US financial markets

We discuss their importance before we turn our attention to the financialengineering that emerged directly from them and caused the financial crisis

When fixed commissions were in place, investment banks would bookstock trades for their customers; the introduction of deregulation meantgreater competition, entry by low-cost brokers and thinner margins Then,from the late 1970s onwards, investment banks were allowed to begin

to invade the commercial bank territory, through the creation of ‘moneymarket’ accounts (current accounts that were unsecured) The removal ofRegulation Q allowed a fluctuation in interest rates, thereby forcing com-mercial banks to compete for deposits on price, which led them to pursuenew lines of business Such new business was to respond to the investmentbanks’ needs for short-term funding It created, however, a financial crisis inthe 1970s and 1980s when savings banks were unable to fund themselves

in view of the narrowing of the margins of lending and borrowing rates.Investment banks moved into the origination and distribution of complex

derivative securities, such as collateralised bond obligations (normal ment bonds backed by pools of junk bonds) However, this did not prove agreat success and this move collapsed in the second half of the 1980s.Nevertheless the originate-and-distribute failure was followed by a newinitiative of asset-backed and mortgage-backed securities, which gained aclientele in the 1990s This was partially enabled by the relaxation of the

invest-1933 Glass–Steagall Act in 1987 (see further details below), when the FederalReserve Bank (the Fed) allowed 5 per cent of bank deposits to be used forinvestment banking, and then further promoted in 1996 when 25 per cent

of deposits were allowed to be used for the same purpose This resulted inthe introduction of complex financial instruments such as the Broad IndexSecured Trust Offering (BISTRO), a bundle of credit derivatives based onpools of corporate bonds, and later the Collateralised Mortgage Obligations(CMOs) based on pools of subprime mortgages and Collateralised Debt Obli-gations (CDOs) based on other debt BISTRO was not a great success largelybecause of the corporate sector’s booms and recessions at that time However,CMOs and CDOs, which were based on mortgages and other assets, became

a success due to the steady growth of the housing market This was the firstcause of the crisis: the originate-and-distribute model of securitisation andthe extensive use of leverage

This raises the issue of the difference between ‘originate-and-distribute’and ‘originate-and-hold’ models In the originate-and-hold model bankloans are held in the banks’ own portfolios In the originate-and-distribute(or originate-to-securitise) model bank loans are re-packaged and sold toother banks, foreign banks and the domestic and foreign personal sector.The latter model transfers the loan risk from the bank to whoever buys theasset-backed securities (ABS) Then the Commodity Futures ModernizationAct (CFMA) of December 2000 emerged This act deregulated single-stockfutures trading, and provided assurances that products offered by bankinginstitutions would not be regulated as futures contracts CFMA enabled andlegitimised credit-default swaps (CDSs, credit derivative contracts betweentwo parties, whereby there is a guarantee in the case of default), therebycreating a potentially massive vector for the transmission of financial riskthroughout the global system

The apotheosis of the financial liberalisation in the USA, however, hadalready been reached with the repeal of the 1933 Glass–Steagall Act in 1999.The 1933 Act had been designed to avoid the experience of the 1920s and1930s in terms of the emergence of conflicts of interest between the com-mercial and the investment arms of large financial conglomerates (whereby

Glass–Steagall Act was to separate the activities of commercial banks and therisk-taking ‘investment or merchant’ banks and also to establish the strictregulation of the financial services industry The act prevented investmentbanks from taking deposits and commercial banks from conducting security

22 Financial Stability after the ‘Great Recession’

business, like principal trading, underwriting and securities lending Thegoal was to avoid a repetition of the speculative, leveraged excesses of the1920s and 1930s, which had produced the stock market boom of the 1920sand led to its eventual crash in 1929 This boom had been fuelled by cheapcredit from the banks

The introduction of the act in 1933 meant that without access to retaildeposits and with money market instruments being tightly regulated, invest-ment banks funded themselves using their partners’ capital The repeal of theact in 1999 changed all of this: it enabled investment banks to branch intonew activities; and it allowed commercial banks to encroach on the invest-ment banks’ other traditional preserves It was not just commercial banksthat introduced such activities; insurance companies, such as the AmericanInternational Group (AIG), and hedge funds were also heavily involved.Haldane (2010, Chart 2) shows clearly that the 1933 Act was effective fromthe 1930s to the late 1980s when, as mentioned above, the US authoritiesbegan to relax it at the same time as the redistribution effects and attempts

at financial liberalisation began In fact, the level of concentration in the

US banking sector remained broadly flat over that period The repeal of the

1933 Act in 1999, which allowed commercial and investment banks to gle together, had the dramatic effect of increasing the share of the top threelargest US banks, which rose from 10 per cent to 40 per cent in the periodbetween 1990 and 2007 Interestingly enough, that dramatic increase in thesize of the largest firms in US banking is not mirrored in other industries.Haldane (op cit.) remarks that ‘The largest banking firms are far larger, andhave grown faster, than the largest firms in other industries’, so that ‘the too-big-to-fail problem has not just returned but flourished’ (p 9) Furthermore,Haldane (op cit.) shows that ‘A similar trend is discernible internationally:the share of the top five largest banks in the assets of the largest 1000 bankshas risen from around 8 per cent in 1998 to double that in 2009’ (p 9).Another interesting and relevant observation is that the non-bank less reg-ulated and supervised mortgage lenders contributed disproportionately tothe boom in mortgages Dagher and Fu (2011) demonstrate this propositionand show that while in 2003 the non-bank mortgage lenders accounted forone-third of mortgage lending, they contributed more than 60 per cent tothe increase in mortgage lending between 2003 and 2005 In the light of thisfinding the same authors suggest that more stringent regulation could haveaverted some of the volatility in the housing market

min-The repeal of the Glass–Steagall Act in 1999 allowed the merging of mercial and investment banking, thereby enabling financial institutions toseparate loan origination from loan portfolio; hence the description of the

use risk management in their attempt to dispose of their loan portfolio ally, the levels of risk aversion in the sector fell sharply, thereby producing

Actu-the mispricing of risk that led to Actu-the credit crisis in 2007–08 This was tered by a new financial architecture in the form of securitisation and slicingrisk through the repackaging of subprime mortgages, which were turned intoinstruments such as CMOs and CDOs This underpricing of risk came aboutthrough low risk spreads whereby there was a substantial decline in the dif-ferentials between risky assets and safe assets It came about particularly overthe long period 2001–05 of unusually low nominal, and very low real, inter-est rates But even over the longer period from the late 1980s/early 1990s to

fos-2007, macroeconomic risks were reduced substantially as a result of the ‘greatmoderation’ or ‘great stability’ era of low and stable inflation and steadygrowth

Furthermore, financial institutions can now provide risky loans without

applying the three Cs: Collateral, Credit history and Character (whether theperson or institution will be able to pay the loan off even in hard times) Thisfostered a new activity that relied on interlinked securities mainly emerging

mortgage is a financial innovation designed to extend home ownership torisky borrowers This term refers to borrowers who are perceived to be riskierthan the average borrower because of their poor credit history Rising homeprices encouraged remortgaging, thereby leading to a substantial expansion

of the subprime mortgage market The growth of loans in the subprime gage market was substantial As a percentage of total mortgages we had thefollowing phenomenal increase: 1994: 5 per cent; 1996: 9 per cent; 1999:

mort-13 per cent; 2006: 20 per cent; 2007: 47 per cent Clearly, the world ofCMOs and CDOs exploded at a stunning pace between around 2004 and

It should also be noted that between 1998 and 2007 mortgage debt as a centage of disposable income increased by more than half – from 61 per cent

Banks proceeded to set up trusts or limited liability companies with smallcapital bases, that is, separate legal entities, known as Structural InvestmentVehicles (SIVs) Parallel banking, or the so-called shadow banking system,was thereby created outside the control and the regulatory umbrella of theauthorities This SIVs operation was financed by borrowing from the shortend of the capital markets at a rate linked to the interbank interest rate(Libor) The short-term capital raised in this manner was used by the SIVs

to buy the risky segment of the loan portfolio of the mother company, cipally risky mortgages This risky loan portfolio was then repackaged in theform of CMOs and CDOs and sold on to other banks and the personal sector,both to domestic and foreign investors – in terms of the latter it was mainly

than the long-term rate, the high commissions that were charged for theseservices meant that big profits were secured, and the housing market turnedinto a bubble It is true that after the collapse of the internet bubble in March

24 Financial Stability after the ‘Great Recession’

2000 there was considerable fear, especially in the USA, that a period of pricedeflation might ensue That fear, especially on the part of monetary policymakers, along with the apparent world glut of savings (Bernanke, 2005), led

to a period of low nominal policy interest rates as just suggested

When the yield curve was inverted, that is long-term interest rates becamelower than short-term rates, the subprime mortgage market simply col-lapsed This occurred following a period of a policy of rising interest rates(mid-2004 to mid-August 2007) after a prolonged period of abnormally lowinterest rates (initially 1997–98 but more aggressively after the internet bub-ble of March 2000 and even more so after November 2001, until the Fedbegan to raise interest rates in 2004) The subprime mortgage market beganits downward direction soon afterwards; this occurred by late 2005 when thehousing market peaked and housing prices began to decline That processwas accelerating, increasingly dramatically, by early 2007 The collapse ofthe subprime mortgage market by mid-2007 also meant the end of the hous-ing boom and the bursting of the housing bubble The defaults on mortgagesspread to investment banks and commercial banks in the USA and across theworld through the elaborate network of CMOs and CDOs One pertinentquestion that arises from this analysis is why regulators appeared to havebeen ignorant of banks’ reliance on the parallel banking sector in 2007 andbeforehand, when clearly they should not have been It must surely be thecase that the regulation regime at the time must have been totally indifferentand ineffective

Furthermore, the repeal of the 1933 Glass–Steagall Act in 1999 enhancedthe securitisation process and the slicing of risk through the repackag-

were turned into Collateralised Mortgage Obligations (CMOs), CollateralisedBond Obligations (CBOs), Collateralised Loan Obligations (CLOs), Collater-alised Debt Obligations (CDOs); also Credit Default Swaps (CDSs), which arederivatives that provide insurance against a bond failure, and other forms of

which financial institutions bundle a large number of loans, especially gages, to create securities, which are sold in the capital markets to financialinvestors Financial institutions thereby earn fees and remove the loans fromtheir own books, which enables them to avoid tying up their capital forthe life of the loans The investors receive the interest on the securities andcapital payments from the borrowers Mortgage-backed securities were con-sidered to be riskier than other forms of securities in view of their repaymentsmade largely by low-income households (see Tett, 2009, and Evans, 2010, forfurther details)

mort-The securitisation process and the integration of banking with capital ket developments, including the repo market, was greatly helped by thedevelopment and rapid expansion of the shadow banking system in the USA.Based essentially in the USA, the shadow banking system has had a profoundinfluence upon the global financial system The shadow banking system

mar-comprises essentially the institutional investors and the non-financial firmsmarket It is a (highly liquid) market outside the deposit insurance banking(see, for example, Gorton, 2010, for fuller details) More precisely, shadowbanks are intermediaries between investors and borrowers, profiting fromfees and differences in interest rates between those paid by investors andthose received from borrowers (Adrian and Shin, 2009) They have high lev-els of leverage and maturity mismatches but no direct or indirect access to

a lender of last resort Such activities were structured specifically to avoidregulations and capital requirements imposed on banks Shadow-bank insti-tutions ‘include (among others) hedge funds, money market funds, pensionfunds, insurance companies and to some extent the large custodians such as

of the shadow banking system is the market for repurchase agreements –the so-called ‘repo’ market A ‘repo’ is essentially a short-term collateralisedloan in which the lender buys the collateral at the time of the loan, and

it is repurchased by the borrower at the maturity date with a ‘haircut’ Thelatter acts as a buffer in case the borrower cannot repay the loan and thecollateral becomes difficult to sell The repo market ‘represents a financialinnovation that escaped the regulatory burden imposed on traditional bankdeposits It is important to recognise, however, that the implicit safety nettilts the playing field toward such inherently fragile arrangements’; it is nowestimated to be ‘about $2 trillion in size’ (Lacker, 2011, p 3)

In fact, by the time of the ‘great recession’ the US shadow banking system

‘[had grown] in gross terms to be larger than the traditional banking sector’(King, 2010b) It is now estimated that the shadow banking has expanded

grown to a gross size of nearly $20 trillion in March 2008, which was icantly larger than the liabilities of the traditional banking system’ (p 4)

signif-In fact, ‘At the eve of the financial crisis, the volume of credit diated by the shadow banking system was close to $20 trillion, or nearlytwice as large as the volume of credit intermediated by the traditional bank-ing system at roughly $11 trillion’ (p 650) The same authors suggest that

interme-in July 2010, ‘the comparable figures are $16 and $13 trillion, respectively’(p 65) Interestingly enough, Singh and Aitken (op cit.) show that the size

of the shadow banking system was at least 50 per cent larger than previouslyestimated, once appropriate adjustment to account for ‘rehypothecation’ is

note that ‘rehypothecation’ declined between end-2007 and end-2009 fromabout $4.5 trillion to $2 trillion in the case of the seven largest US brokerdealers This is because banks have become more risk averse over the period.The enormous expansion of the shadow banking system, nonetheless,was not a parallel universe unto itself, but instead depended critically onbackstop liquidity support, both contractual and reputational, from largebanking organisations, whose access to the safety net made them more

26 Financial Stability after the ‘Great Recession’

willing to accept tail risk That in turn meant that large subprime lossesunexpectedly boomeranged back onto the balance sheets of bank holdingcompanies Perhaps most importantly, the magnitude of the overinvest-ment in housing collectively generated by these sources of moral hazardwas underestimated and emerged only gradually as the fall in residentialinvestment unfolded (Lacker, 2010, p 4)

This underpricing of risk came about through low risk spreads whereby therewas a substantial decline in the differentials between risky assets and safeassets It came about particularly over the long period 2001–05 of unusu-ally low nominal, and very low real, interest rates But even over the longerperiod from the late 1980s/early 1990s to 2007, macroeconomic risks werereduced substantially in view of the ‘great moderation’ or ‘great stability’era of low and stable inflation and steady growth The world of CMOs,CDOs and other asset repackages, along with the repo market, exploded

at a stunning rate between around 2004 and 2007 with substantial

Inside Mortgage Finance Publications (2009), by the first quarter of 2007 thevalue of outstanding subprime mortgage securities was more than $900 bil-lion, which represented a six fold increase since 2001 Virtually all of thesubprime originations were securitised, when it was only half in 2000 (see,also, Greenspan, 2010)

The sale of CMOs, CDOs and other relevant securitised assets to tional investors made the US housing bubble a global problem and providedthe transmission mechanism for the contagion of the rest of the world Thecollapse of the subprime market spilled over into the real economy through

break-down of trust between the financial sector and households occurred, mostspecifically in the case of the subprime mortgage holders As the losses onthese mortgages and other toxic assets accumulated, banks lost trust in oneanother, which led to the freezing of the interbank lending market in thesecond half of 2007 These problems further constrained the ability of thebanking sector to lend to the real economy Bank failures ensued, which fur-

economy tightened further, leading to corporate distress because of the nificant lack of bank credit; trade credit provided between firms also dried

sig-up Actually the first disruption of credit markets is dated as 7 August 2007,when ‘the French bank BNP Paribas suspended redemption of shares held

in some of its money market funds’ (Mishkin, 2011, p 50) What actuallypromoted the run on the banks in late 2007 and into 2008 were devel-opments in the shadow banking system In contrast to the classic normalbank run, when a bank cannot convert long-term assets into cash to satisfythe withdrawal of deposits, the case of the shadow banking system is dif-ferent As shown above, the short-term liabilities of the shadow banking

system, which is in the form of short-term ‘repo’ borrowing, are backed

up by mortgage-based securities as collateral; these securities are, of course,long-term assets In the process, though, the value of the shadow bankingsystem collateral is revised at increasingly higher rates Indeed, as the value

of mortgage-backed securities fell and uncertainty about their future valueincreased, the value of the collateral increased to levels as high as 50 per cent

of the loan In other words, as a result the same amount of collateral ported less borrowing and therefore a higher haircut Inevitably a period ofdeleveraging ensued, with institutions forced to sell off assets whose value

All this was accentuated during the course of 2008, especially so afterthe collapse of the Lehman Brothers on 15 September 2008 The authori-ties allowed Lehman Brothers to fail in an attempt to prevent moral hazard

It was also argued at the time that Lehman Brothers was insolvent and thatthe institution not as systemically important as other institutions; it was alsoexplained after the event that the Fed did not in fact have the legal authority

to bail out this institution (Bordo and Landon-Lane, 2010, p 46) That ticular incident turned the liquidity crisis into a confidence crisis, causingpanic in capital markets and a virtual freeze in global trade Another impor-tant factor was the revelation at the time that the American InternationalGroup (AIG), which had provided insurance for a large share of existingCDOs, especially mortgage-backed securities, was unable to deliver its con-tractual obligations It was bailed out and nationalised on 16 September

par-2008 by the authorities who feared the systemic implications for alised default swaps (insurance contracts on securities) if AIG were allowed

collater-to fail On the same day there was a run on the Reserve Primary Fund money

began its operations with $700 billion being provided for the purchase ofmortgage-backed securities from the banks in an attempt to restore levels ofbank lending In the event it transpired that ‘most of the funds were used

to recapitalise the banks’ (Bordo and Landon-Lane, 2010, p 45) Mishkin(2011) emphasises two of the most important implications of those events:the first implication is that they ‘showed that risk taking was far greater thanmost market participants could have imagined’ (p 55) The second implica-tion is that those events ‘raised serious doubts that the U.S governmenthad the capability to manage the crisis’ (p 55) In summary, ‘Banks began tohoard cash and were unwilling to lend cash to each other, despite huge injec-tions of liquidity into the financial system by the European Central Bank, theBank of England, and the Federal Reserve The subprime crisis had become

a full-fledged, global financial crisis’ (p 56) There was, thus, a widespreadcollapse of confidence in the banking systems in the industrialised world,especially in the interbank market, with the money markets becoming dys-functional The result was the disruption of the transmission mechanism

28 Financial Stability after the ‘Great Recession’

of monetary policy This led to an unprecedented and synchronised turn in business and consumer confidence around the world and there,therefore, ensued a significant drop in the level of aggregate demand A full-fledged global credit crunch and stock market crash emerged, as interbanklending was effectively frozen as banks became concerned that no financialinstitutions were safe anymore

down-The events elaborated above took place not only within countries, but

significant and synchronous severe global downturn emerged – the so-called

‘great recession’ The seriousness of the economic situation can be furtherhighlighted by the estimated $4.1 trillion losses in the world financial sys-tem, less than half of which were formally written off The total cost ofthe financial crisis has been calculated to be anywhere between one andfive times the value of annual GDP For the global economy this wouldimply a loss of up to $200 trillion (Haldane, 2010, p 4) IMF (2010a) pro-vides further relevant statistics in terms of output and unemployment acrosscountries Output and unemployment responses during the ‘great recession’differed markedly across advanced countries Output dropped by more than

8 per cent in Ireland but by only half as much in Spain Unemploymentincreased by 7.5 per cent in both countries By contrast, in Germany outputdropped by 7 per cent, while unemployment decreased over the same period.Given these figures it is no wonder central banks around the world have ini-tiated unconventional monetary policies to help their financial markets toovercome their financial difficulties (see, for example, Borio and Disyatat,2009) Furthermore governments around the globe, with different degrees

of intervention and enthusiasm, have attempted to contain the depth of thecrisis through ‘stimulus packages’, both fiscal and monetary, and to revivethe real economy (see, for example, Arestis and Karakitsos, 2010a)

We turn our attention next to the contributory factors to the crisis,beginning with international imbalances

2.3 Contributory features of the ‘great recession’

As mentioned above, there were three contributory features of the ‘greatrecession’: international imbalances, monetary policy and the role of thecredit rating agencies We begin with the international imbalances

light of inadequate consumer finance, thereby creating a great deal of ings Substantial trade surpluses emerged in these countries, which helped

sav-to keep sav-total demand in line with supply By contrast, countries importingthese manufactured goods ran trade deficits and required low saving rates tobalance their economies As a result, high-saving countries created employ-ment and low-saving countries enjoyed faster consumption growth fuelled

by the increase in cheap imports

The ‘privilege’ enjoyed by the US dollar as the world’s currency encouragedand enabled that amount of savings to be channeled principally into theUSA, which helped to put downward pressure on US interest rates In addi-tion, the increasing allocation of manufacturing jobs to the relatively low-wage areas of Asia, and China in particular, where a well-educated low-costworkforce was protected by the rule of law, and the combination with devel-oped world technology, helped to keep down the level of wages and hencelow inflationary pressures in the USA and elsewhere This, along with thechanneling of savings into the USA, also enabled low-to-mid-income house-holds in the USA to increase their reliance on credit as a means of survival.These factors, in particular the massive flows of capital into western finan-cial markets, especially the USA, pushed down interest rates, which alongwith the low interest rate policy pursued by the Fed over the same period,encouraged risk-taking on an extraordinary scale, and enabled US house-holds to live well beyond their means At the same time low interest rateshelped to push up asset prices, especially house prices, thereby enabling thefinancial sector to explode Banks expanded their balance sheets substan-tially; and as King (2010) put it: ‘In the five years up to 2007, the balancesheets of the largest UK banks nearly trebled The build-up of risk came tothreaten the stability of the entire financial system’ (p 4) The explosion ofthe banking sector enabled lending to households and businesses to expandsubstantially along with lending to other banks All of these imbalancescreated a more buoyant market for financial institutions, thereby feedingthe originate-and-distribute culture and machine (see Arestis and Karakitsos,2010a for further details)

An important lesson follows from this experience, which is that theinterests of the private financial sector are inconsistent with those of thewhole economy Consequently, regulation of the financial sector by bodiesaccountable to the public should be carefully considered and implemented.Such required reform should, of course, entail regulation and relevantrestructure not merely of the domestic banking system but also of the inter-national monetary system The role of domestic regulation is considered

in Chapter 9 in this book It is, though, imperative to consider the sibility of regulating the international monetary system at this juncture

pos-in view of the analysis pos-in this subsection Global imbalances contributed

to the development of previous economic crises, and were an importantitem on the agenda at the Bretton Woods conference in 1944 Indeed,

30 Financial Stability after the ‘Great Recession’

Keynes (1980) recognised the asymmetry of the obligations imposed on thecountries involved with the problem of adjusting international imbalances.Keynes (op cit.) argues, ‘To begin with, the social strain of an adjust-ment downwards is much greater than that of an adjustment upwards’,but also

the process of adjustment is compulsory for the debtor and voluntary forthe creditor If the creditor does not choose to make, or allow, his share

of the adjustment, he suffers no inconvenience For whilst a country’sreserve cannot fall below zero, there is no ceiling which sets an upperlimit The same is true for international loans if they are to be the means

of adjustment The debtor must borrow; the creditor is under no suchcompulsion (p 6)

In terms of the current international imbalances they have been allowed

to continue for a long period in light of the USA’s privileged position asthe issuer of the world’s reserve currency The ‘great recession’ experienceclearly implies that designing an international monetary system to avoidthe problems alluded to by Keynes (op cit.) is long overdue

One way forward is Keynes’s (1980) proposal for an International rency Union (ICU) with member central banks holding ‘clearing accounts’

Cur-in a new Cur-institution, the International ClearCur-ing Bank (ICB) The latter wouldissue ‘bank money’, the bancor Each national currency would have a fixed,but adjustable relation to the bancor Residual international transactionswould be settled through these accounts The object of the ICB would be tomaintain balance-of-payments equilibria between each of its members andthe rest of the world Persistent overdrafts and credits in the ICB’s accountswould reflect deficits and surpluses in the balance-of-payments accounts ofthe countries involved The aim of the ICU framework should be to bringsimultaneous pressure on surplus countries to reduce their surpluses, and ondeficit countries to reduce their deficits This aim was reflected in the rulesdesigned to govern the quantity and distribution of bancors One impor-tant ingredient of this proposal is the suggestion ‘that central control ofcapital movements, both inward and outward, should be permanent feature

of the post-war system’; and this should be ‘part of a uniform multilateral

agreement by which movements of capital can be controlled at both sides’

(Keynes, op cit., p 52) Under current arrangements the best mechanismwhereby this can be achieved is through the IMF in close collaboration withthe G20 (which produces almost 90 per cent of global GDP) In April 2009,the G20 agreed to a new policy coordination framework with the IMF Thiscould become the platform for a new initiative along the lines just suggested

2.3.2 Monetary policy

The other feature suggested earlier is the particular monetary policy sued over the period of the financial innovations as described above More

pur-specifically, this feature springs from the focus of economic policy, and etary policy in particular, on price stability, and inflation targeting as themain framework of this type of policy, to the exclusion of any other objec-tives Monetary policy is thereby geared to frequent interest rate changes

mon-as a vehicle for controlling inflation It should be noted, though, that the

US monetary authorities never pursued inflation targeting in the ner required by the theoretical framework The constitution of the Fedrequires the pursuit of monetary policy for the achievement of a num-ber of objectives, not merely that of price stability The latter objective isrequired by the inflation-targeting theoretical framework and adopted by theinflation-targeting countries Still, the manipulation of the rate of interesthas been at the forefront of monetary policy in the USA

man-The impact of this policy has been the creation of enormous liquidityand household debt in the major economies, which reached unsustainable

so after the burst of the IT bubble in March 2000 when central banks, led

by the Fed, pursued highly accommodative monetary policies to avoid adeep recession Looking at debt statistics (see, BIS, 2008, p 29), we find thefollowing: between 1998 and 2002 the level of outstanding household debt,including mortgage debt, in the UK was 72.0 per cent of GDP; between 2003and 2007 it shot to 94.3 per cent of GDP; in the same periods, outstandinghousehold debt jumped from 76.7 per cent to GDP to 97.6 per cent of GDP inthe case of the US; and in the Euro Area from 48.5 to 56.6 respectively Thissuggests that while monetary policy did not play a role in causing the crisis

it was, nonetheless, largely responsible for its promotion and continuation

It should be clear that the dominant argument that increased liquidity

is always beneficial may not be borne out in all circumstances ing marginal utility and associated increased financial activity relative toreal economic activity, along with speculation, create increasing dangers ofdestabilising herd behaviour This implies that an ‘optimal level’ of liquidity

Diminish-is evident However, there Diminish-is a serious complication in that although ‘an mal level of liquidity, with increased liquidity and speculation valuable up

opti-to a point but not beyond that point’ there is nonetheless ‘the complicationfor practical policy makers that the point of optimal benefit is impossible

to define with any precision, that it varies by market, and that we havehighly imperfect instruments through which to gain the benefits withoutthe disadvantages’ (Turner, 2010, p 28) The enormous liquidity created overthe period in view of the monetary policy pursued at the time, must havesurpassed the ‘optimal level’ to which we have just referred

It is also important to note that the credit part of liquidity played a ticularly important role in promoting the ‘great recession’, as is shown bySchularick and Taylor (2009) It is the case, though, that policy makersand proponents of the current macroeconomic paradigm, the ‘New Con-sensus’ theoretical framework in macroeconomics, do not take credit andmoney seriously; they have no role to play in monetary policy Indeed, the

par-32 Financial Stability after the ‘Great Recession’

proponents believe firmly that macroeconomic outcomes are independent

of any financial factors They ignore that ‘financial factors can have a strong,distinct, and sometimes even dominant impact on the economy’ (Schularick

a role in producing financial instability, closely related to the propositionthat ‘financial crises are credit booms gone wrong’, which is often attributed

to Minsky (1977) Interestingly enough, Schularick and Taylor (2009) duce evidence to support this view Utilising a linear probability model,along with a probit model, they conclude ‘that a credit boom over the pre-vious five years is indicative of a heightened risk of a financial crisis’ (p 20),and that ‘the use of credit aggregates, rather than monetary aggregates, is ofcrucial importance’ a result that leads to the further conclusion that ‘credit

pro-is a superior predictor, because it better captures important, time-varyingfeatures of bank balance sheets such as leverage and non-monetary liabili-ties’ (p 22) One important implication of these results for monetary policypurposes is that to the extent financial stability is the focus of monetary pol-icy then a better instrument to focus on is credit aggregates in view of itssuperior power to predict incipient crises Even policy makers recognise theimportance of the ‘credit view’ of financial crises For example the chairman

of the UK’s Financial Services Authority has expressed a firm interest in thisview along with the suggestion of the importance to regulate credit (see, forexample, Turner, 2009)

As a result of these developments, the transmission mechanism of tary policy has changed: the build-up of household debt and asset holdingshas made household expenditure more sensitive to short-term changes ininterest rates Furthermore, the current high debt levels, combined with thedifficulties being experienced in the ‘real’ sector, imply that lenders andequity holders stay away from the marketplace; not forgetting the presenceand magnitude of toxic assets, which pose real problems that still need to

mone-be sorted out The dangers with this type of conduct of monetary policyare clear since frequent changes in interest rates can have serious effects:low interest rates cause bubbles; high interest rates work through apply-ing economic pressures on vulnerable social groups There are, thus, severedistributional effects (see Arestis and Karakitsos, 2010a, for further details)

It should also be noted that a monolithic concentration on price ity does not guarantee the economic stability of the economy (King, 2009;IMF, 2009) In fact, it can lead to economic instability (see, also, Blanchard

stabil-et al., 2010 and Karakitsos, 2010) Indeed, assstabil-et bubbles are often preceded

by periods of price stability A few examples make this point very well: USA1929; Japan 1990s; South East Asia 1997; and the USA again in 2007 In all

of these cases, price stability was followed by the bursting of a bubble Itseems clear therefore that in their overseeing of policy central banks shouldmove beyond a monolithic focus on price stability It is also relevant to note

at this point that placing a focus solely on interest rate variations to prick a

bubble cannot be relied upon This is for the simple reason that since such anattempt would require quite substantial changes in the rate of interest, therest of the economy would be bound to be seriously and adversely affected.

We have argued elsewhere that it might be more appropriate to targetnet wealth rather than inflation, for monetary policy purposes (Arestis and

and fall of asset prices on the economy and is not a target of asset pricesper se – equities or houses Net wealth is an ideal variable to monitor (andcontrol) bubbles simply because it is at the heart of the transmission mech-anism of asset prices and debt to consumption Economic policy should betightened/loosened as the ratio of net wealth to disposable income, over aperiod of time, is above/below a predetermined threshold This would allowasset price booms, but it would prevent them from becoming bubbles thatwill ultimately burst with significant adverse consequences for the economy

as a whole Such an approach will also help regulate financial engineering,since the central bank will monitor the implications of financial innovations

as they impact on net wealth, even if it is ignorant of them (as in the case

of SIVs) The level of financial engineering is so complex that central banksexperience difficulty in measuring, monitoring and controlling the total liq-uidity in the economy A net wealth target will check the consequences ofthis liquidity, while not impeding the financial engineering of the banks

2.3.3 The role of credit rating institutions

global credit crisis and in the subsequent sovereign debt crisis, which hasassumed gigantic proportions in the EU, thereby attracting criticism forboth The increasing power of credit rating agencies was first observed inthe USA where they were granted the official designation of ‘NationallyRecognised Statistical Rating Organisations’ Their role in the economy is toforecast the probability of default during the repayment period of the issuer

of a debt liability While credit rating agencies provide information on theaudit quality, namely on the probability of default of financial products, theysay nothing in relation to the potential systemic risk of such debt The latterbeing the danger of a chain reaction that emanates from a number of finan-cial institutions faced with serious difficulties It follows that while it may berational for firms and investors to be guided by ratings in their investmentdecisions, they can destabilise the financial markets at a systemic level in theprocess

This is not the only criticism that has been leveled against the CRAs Theyhave also been accused as bestowing AAA credit rating to toxic assets, whichwere thereby treated as completely safe It is true that the complex structure

of the CMO and CDO markets complicated the task of credit rating tutions, which erroneously assigned AAA-status to many worthless papers

insti-In fact, some 80 per cent of the total value of CMOs and CDOs were given