Underlying Causes of the Crisis: The Build-Up of Risks and Imbalances
One would like to know “THE” cause of the crisis; however, the run up to the crisis is a complex issue. There is not a unique cause but a series of factors, both at macroeconomic and microeconomic level, that contributed to the build-up of risks and imbalances and drove the expansion of the financial system: abundant global liquidity, rapid credit growth, credits backed by the value of the collateral, high levels of leverage, real estate bubbles, deregulation, financial innovation, technological development, the euro, globalization, supervision too focused on individual institutions and not on the global picture, originate-to-distribute model of lending, complex and opaque financial products like collateralized default obligations (CDOs), conflicts of interest of rating agencies, incentives for short term risk taking, maturity mismatches in banks’ balance sheets, and so on. This situation created the breeding ground for the problems to quickly spread throughout the whole financial system through domino effects and feedback loops once a bubble eventually burst.
Why was this allowed to happen or why were measures not taken beforehand to avoid the disaster? The underlying economic expansion and a good economic outlook worked as cushion to hide the build-up of underlying risks, imbalances, and inefficiencies. When the economic conditions weakened, those underlying risks became devastating. This chapter provides some examples of how some flaws in the construction of the euro led to the build-up of macroeconomic imbalances and risks. An annex provides additional information about the role of the business cycle and the rise in inequality.
The Framework of the Single Currency
The creation of the euro in 1999 was one of EU’s most far-reaching achievements. The euro became one of Europe’s defining symbols at home and across the globe and constitutes a milestone for the economic, social, and environmental well-being of European citizens. However, following the global financial crisis and, in particular the European sovereign debt crisis, the positive mood toward the euro has become more contained.
In macroeconomic terms, the creation of the single currency meant that a central authority, the European Central Bank (ECB), would apply a unique monetary policy to all euro area Member States. To ensure that the monetary policy does not have divergent effects across the single currency area, Member States have to comply with a series of convergence criteria in terms of inflation, public finance, and interest rates before joining the euro.
Fiscal policy—government expenditure and taxation—remained the responsibility of national authorities. Given the safeguard of the large single monetary area, some Member States could be “tempted” to go beyond the limits of sound fiscal policies. To avoid such an undesirable outcome stemming from a moral hazard situation (see Section 1.4), fiscal discipline was ensured through the Stability and Growth Pact (SGP) enshrined in the Treaty on the Functioning of the European Union.
The Pact establishes a cap for public debt and deficit of 60 and 3 percent of gross domestic product (GDP) respectively. The Commission monitors that Member States comply with the SGP.1
The Build-Up of Imbalances
In the first years following the adoption of the euro, the economy seemed to perform fine and euro area government bond yields quickly converged (Figure 2.1). However, this convergence was driven more by institutional arrangements than by economic fundamentals. For instance, all euro area government bonds were accepted by the ECB in its repo operation as having the maximum quality, irrespective of actual economic governance and macroeconomic (im)balances. Similarly, banks were not required to back government bonds with capital as they were considered to have the highest quality—in other words, no risk—independently of the issuing country.
Figure 2.1 Yields on 10-year government bonds, percentage
In the 1990s, governments were paying different interest rates according to the features of their economies. The negotiations toward the single currency and the final adoption of the euro in 1999 led to a convergence across euro area countries in the rates asked by investors for providing funds.
Source: ECB.
Usually, government bond yields provide an indication of the market perception about the risks and economic strength of a country. However, the euro “equalized” all government bonds and eliminated the risk premium. According to government bond yields, the economic performance of Ireland, Italy, or Spain was very similar to the one of Germany, France, or the UK. A selection of indicators including inflation, unit labor cost or current account balance enables to assess if that was really the case.
The ECB aims at keeping inflation below, but close to, 2 percent. Data indicate that average euro area inflation remained around 2 percent since the creation of the euro until the outbreak of the crisis (Figure 2.2, left-hand panel); however, a wide dispersion across individual countries is also observed. Inflation ranged from 1 percent in Germany, Austria, and the Netherlands to 4 or 5 percent in Greece, Ireland, and Spain. Some countries tended to remain on the upper end of the range and some others on the lower end. Consequently, between 2000 and 2008, an increasing divergence in cumulative inflation is observed across countries (Figure 2.2, right-hand panel).
Figure 2.2 Inflation rate, monthly data, percentage
Although annual inflation is volatile, some countries tend to operate with higher inflation than others. Over the years, a large gap is observed in cumulative inflation. This can have significant effects in the international competitive position of euro area countries because they cannot depreciate or appreciate their currency.
Source: ECB and own calculations.
Higher inflation rates do not necessarily decrease the purchasing power of citizens provided that salaries follow a similar path. However, if the increases in salaries and inflation are not accompanied by an equivalent increase in productivity, the international competitive position of the country will deteriorate with respect to other countries with lower inflation rates.
Figure 2.3 Unit labor cost, quarterly data, percentage
As in the case of inflation, an increasing gap is observed in the cumulative increase of unit labor cost across euro area countries. This can be an important source of international economic tensions.
Source: ECB and own calculations.
Similar dynamics are observed in the unit labor cost: by 2008, the labor cost had increased 20 percent more than the euro area average in Ireland, Greece, and Spain while it had decreased in Germany and Austria (Figure 2.3).
High inflation rates and increased unit labor costs deteriorate the international competitiveness of a country resulting in domestic companies encountering increased difficulties to export their products. Moreover, local producers are confronted with imported foreign products with potentially lower prices. Countries with low inflation and low increases in unit labor costs are faced with the opposite situation. These dynamics are reflected in the current account balances. By 2008, “deficit” countries—such as Greece, Spain, and Portugal—had accumulated a negative current account balance equivalent to 100 percent of their GDP while “surplus” countries—such as Germany and the Netherlands—had a positive balance of over 60 percent (Figure 2.4).
Figure 2.4 Current account balance, percentage of GDP
The diverging international competitive position of the various countries is also observed in the cumulative imbalances in the current account. This can be another source of economic tensions.
Source: ECB and own calculations.
In Chapter 1, we saw how the different sectors are interconnected and how virtuous and vicious circles can amplify the strengths or weaknesses in an economy. Similar interconnections and feedback effects can also occur at international level. For instance, the dynamics observed in the current account were reinforced through the financing side: Surplus countries found themselves with excess funding, which was lent to deficit countries so that they could finance the purchases of goods and services produced or provided precisely by those surplus countries.
The Spanish housing bubble is an illustration of the interconnections across euro area countries. In 2006, the turnover in the construction sector amounted to €810 billion in the EU as a whole. The turnover of Spanish companies was €280 billion or 35 percent of the total, while the turnover of German and French companies was almost six times lower (€40 billion and €55 billion respectively). The Spanish buildings were equipped with German dishwashers, ovens and other electrical appliances—with brands like Bosch, Miele, or Siemens. Given the buoyant economy, many Spanish workers and entrepreneurs bought new cars, in many cases, from German and French producers—from manufacturers like Renault, Citroën, Volkswagen, Audi, Mercedes, or BMW. Purchasing or building a real estate usually requires obtaining a loan. The Spanish banks were able to provide the financing needed thanks to the cheap interbank credit obtained from German and French banks, which had abundant liquidity due to the buoyance of domestic industries, which were selling their products to Spain. Spanish households were keen to take up loans at considerably lower interest rates than the rates paid before the introduction of the euro (cf. Figure 2.1).
Although in Germany and France there was not such a housing bubble like the one in Spain, the cheap credit generated in surplus countries contributed to the build-up of bubbles in deficit countries. In other words, the financial cycle amplified the economic cycle (see Annex 2.1). Moreover, an important share of the economic dynamism observed in surplus countries stemmed from purchases generated in deficit countries. When problems arise, the agents with a stronger negotiation position—usually the lenders—tend to shift the burden to the other counterpart—the borrowers. However, in reality, there is often a joint responsibility and, given the complex interconnections among economic sectors and countries, a working solution requires a systemic approach. Acknowledging this situation was the first step to foster a robust recovery: The financial and economic crisis required a joint and coordinated reaction at European and global level as individual actions would patently be ineffective.
The Risks Uncovered
Data on inflation, unit labor costs or current account balances demonstrate that the financial convergence following the introduction of the euro did not necessarily mean a convergence in the economic performance of participating countries. The outbreak of the crisis uncovered the accumulated imbalances and structural weaknesses in some countries. Investors reassessed the specificities of each country and started to ask for differentiated risk premiums on government bonds (Figure 2.5).
In the late 90s, sovereign bond yields converged artificially—due to the new institutional arrangement and somehow disconnected from fundamentals—and did not reflect the actual risks of individual economies. However, it can be argued that the yields observed in 2010 and 2011 were not justified by the actual economic fundamentals either. This amplified reaction was rather signaling high levels of uncertainty.
Conclusions
The crisis revealed the instable equilibrium of the euro area and some structural weaknesses that were concealed by a thriving economy or, at least, by the “great moderation.”2 The European economies implemented a prompt reaction to address the more pressing problems and some structural weaknesses (see Chapters 3 and 4). However, reversing the imbalances accumulated over the years will require some time and should involve both surplus and deficit countries. A comprehensive reaction was needed to avoid that problems emerge again in the future, probably in an amplified form (see Sections C to E). In this chapter, we have seen some of the underlying weaknesses of the European economy; in the next chapter, we discuss how the crisis unfolded. Before that, we briefly discuss in an Annex two additional structural issues that have played a role in the emergence of the crisis: the financial cycle and the raise in inequality.
Figure 2.5 Yields on 10-year government bonds, percentage
The crisis uncovered the differences in economic performance across euro area countries. As a consequence, investors asked differentiated borrowing rates to each country. In some cases, borrowing costs became prohibitively expensive. In the early 2000s, yields were not reflecting the fundamental economic features of each country. Similarly, it is also quite likely that the turmoil and panic of the crisis led to rates not entirely consistent with fundamentals. In other words, financial markets do not necessarily operate with perfect rationality and information as in text books.
Source: ECB.
Annex 2.1 Other Drivers: The Financial Cycle and the Rise in Inequality
Besides the imbalances, two other factors are important underlining forces explaining the origins of the crisis but that initially may have received less attention: the influence of the financial cycle and an increasing unequal distribution of capital and income.
The Financial Cycle
There is an increasing amount of literature interested in analyzing and explaining how the financial cycle matters for systemic banking crises, major macroeconomic dislocations, and serious economic damage.3 This line of research argues that a focus on the business cycle is not enough to capture the evolution of the global economy in recent years. The financial cycle has become a major driver of the macroeconomy and can help explain the poor growth observed in many advanced economies.
The financial cycle refers to joint fluctuations in a wide set of financial variables. Although there is no consensus on an exact definition, the financial cycles are characterized by four features. First, financial cycles are much longer than business cycles (15 to 20 years for financial cycles compared to 1 to 8 years for business cycles). Second, peaks in the financial cycle are often observed simultaneously to banking crises or significant financial turmoil. Third, the financial cycle is mainly driven by global developments such as global liquidity.4 and, therefore, it tends to be synchronized across countries. And fourth, an increase in the length and the amplitude of the financial cycle is observed since the early 1980s (Figure A2.1). It has been argued that recent macroeconomic, monetary, and regulatory policy decisions—that is, seemingly stable macroeconomic conditions, an ease monetary stance or financial liberalization—may have disregarded the developments in credit.
The financial cycle seems to be linked to leverage and property prices. Given the differences in duration, the business and the financial cycle may diverge for some time; that is, the financial cycle may seem not to affect the evolution of GDP. However, high private sector debt—generated throughout the financial cycle—end up affecting economic growth—the business cycle—by generating deep recessions when financial booms are exhausted and turned into busts.
Figure A2.1 The financial and business cycle in the United States
The financial cycle has a much longer duration and a wider amplitude than the business cycle. The change in the business cycle can have strong and long-lasting effects in the business cycle.
Source: Bureau of Economic Analysis; Drehmann, Borio, and Tsatsaronis (2012); and own calculations.
The financial cycle is also linked to the phenomenon of the debt trap and of “unfinished recessions.” Low interest rates may be used to stimulate the economy. However, if the financial cycle is not taken into account, an accommodative monetary policy for too long may encourage the taking-on of even more debt and lead to a larger recession down the road.
The Rise in Inequality
An increasing concentration of capital and income in fewer hands can be mentioned as another important underlying factor of the crisis. This rise in inequality is intertwined with the financial cycle. Indeed, the erosion in the purchasing power of the middle class was compensated by increasing debt levels that allowed to artificially maintain spending. Top income individuals may have promoted the recourse of households to debt—sometimes through intermediaries—as a way of obtaining profitability out of their savings. The eventual bust of the financial bubble led to a significant deceleration in economic activity due to a contraction in consumption, which put it closer to the actual spending capacity of households; the contraction in spending was further exacerbated by the debt overhang confronted by many households.5
How does inequality impact economic activity? This is explained by the fact that lower income individuals have a higher propensity to consume than high income individuals. Put it differently, as explained by Hanauer (2012), economic activity or GDP growth is generated by the spending capacity of consumers. While an individual company may prefer the lowest salaries as possible, on aggregate, higher salaries imply larger sales. Already in the early 19th century Henry Ford implemented such a labor philosophy by offering a daily wage of $5 when competitors were paying $2.34. This measure allowed workers to afford the cars they were producing and ultimately had a positive impact on the company and the local economy.6 This is an example about the interconnections of the sectors in the economy and the potential generation of virtuous circles which was discussed in Chapter 1. Examples of authors who argue about how inequality impacts economic growth are Krugman (2013); Mian and Sufi (2014); IMF (2014); Stiglitz (2012); Piketty (2014); Ostry and Berg (2014); and OECD (2014).
Wilkinson (2011) and Wilkinson and Pikett (2009) provide a comprehensive overview of how high levels of inequality are harmful not only for the economy but also for the society. They rely on a wide range of indicators such as physical health, mental health, drug abuse, education, imprisonment, obesity, social mobility, trust and community life, violence, teenage pregnancies, and child well-being.
1 For further details about the SGP, see Chapter 8.
2 Note that macroeconomic imbalances are neither a new phenomenon nor exclusive of the euro area. Wikipedia provides a good survey of global imbalances episodes since the 19th century (https://en.wikipedia.org/wiki/Global_imbalances); see also Bracke et al. (2008) or Varoufakis (2011). The great moderation refers to the period starting in the mid-1980s characterized by a reduction in the volatility of business cycle fluctuations (https://en.wikipedia.org/wiki/Great_Moderation).
3 See, for instance, BIS (2014); Borio (2012); Borio (2013); Drehmann, Borio, and Tsatsaronis (2012).
4 See, for instance, Chung et al. (2014).
5 See also Section 3.1 about subprime borrowers and Section 1.2 about the increasing leverage across sectors.
6 For further details, see Wikipedia (Henry Ford).