The Great Financial Crisis
Part III: The aftermath (Free)
From Tuomas Malinen on Geopolitics and the Economy.
The Great Financial Crisis (GFC) of 2007-2008 (2012) led to several notable repercussions. In this last installment to the miniseries on the GFC, I outline the main ones. They were: changes to the central bank policies and the fate of the Eurozone and European banks.
If you have not, I urge you to check the two prior entries to the series (this and this) before diving into this. This post will replace the last Daily Thought of this week.
Aftermath I: Central Bank Policies
After the Federal Reserve had “invented” quantitative easing (actually the Bank of Japan did, in 2013) during the GFC, the programs became an integral part of the monetary policy toolkit of all major central banks. The Fed ran three sequential QE programs, of which the last was concluded (ending net purchases) in October 2014, only to be restarted in October 2019 and with never-before-seen ferocity in March 2020. All the major central banks followed the Fed’s example, with the Bank of England starting its QE program in March 2009, the Bank of Japan (BoJ) in October 2010 (for the second time), the European Central Bank (ECB) in March 2015, and the People’s Bank of China (PBoC) in July 2015.
These programs had two dire consequences. First, they introduced a purely artificial, non-market-based source of liquidity into the financial markets. Second, they had a massive impact on the prices (yields) of sovereign and corporate bonds, whose prices started to differ from their normal, market-based prices.
Moreover, the Bank of Japan (BoJ) and the ECB started to experiment with negative interest rates. The ECB pushed rates to negative on 11 June 2014 and the BOJ on 29 January 2016. Central banks control short-term interest rates in an economy by setting the rate banks receive on their deposits, that is, on the reserves they hold at the central bank. The central bank sets the interest on the reserves and controls it by buying and selling securities in the markets, if necessary. Banks make the majority of their profits from the interest rate differential between lending and borrowing (deposit taking). Specifically, the difference between lending and deposit rates determines a bank’s profitability. However, with very low interest rates, this difference becomes non-existent, and with negative rates, it can invert completely. When a central bank drops rates to negative, banks need to pay interest on their central bank reserves. But they are usually not relieved of the obligation to pay interest on customer deposits, who tend to be reluctant to pay interest on money they place at a bank. If banks are forced to pay interest on loans and receive interest on deposits, their whole earnings logic goes haywire. When the profit margins of banks are squeezed, they start to cut back on lending, which further damages the profitability of banks. Moreover, because low and negative interest rate policies hurt the profitability of banks, they tend to target non-profitable firms (or "zombies") in their lending practices to avert any further losses (see the example of Japan).
So, what central banks did during the fateful 10 years, from late 2008 till 2018, was that they took a direct, pronounced, and active role in the capital markets to an extreme never seen before. QE and low interest rates, altering the yields in the capital markets, also altered the structure of income flows in the economy. Because they increased the prices of financial assets and pushed borrowing costs down, rich households, who tend to have more financial assets and collateral for borrowing, benefited, while savers and poor households mostly lost. Yet, their most destructive feature was that they distorted capital flows, leading to misallocation of capital.
These policies reached their (current) pinnacle during the Corona crisis in the spring of 2020, when the Federal Reserve effectively became the U.S. financial markets. This also marked an end point in the corruption of the Fed, which its creators had feared over a hundred years ago. In the spring of 2020, these fears materialized in full after the Fed effectively socialized the U.S. capital markets, using and greatly widening the policies created during the GFC.
Aftermath II: European "debt" crisis and the fate of the euro
The "European debt crisis" that rattled the world in 2010-2012 was, in essence, a large regional banking crisis caused by both the instability of the common currency and the GFC. The Panic of 2008 constituted a 'sudden stop' for many weaker members of the Eurozone. The flow of private capital turned from speculative use in the periphery of the Eurozone to the safety of the stronger nations, like Germany and Finland, and Great Britain and the US. In other words, the GFC started a capital flight from the peripheral countries of the Eurozone.
The beginnings
In 2010, it was unexpectedly revealed that the public finances of Greece were on perilous ground. When joining the Eurozone, the Greek government had 'dressed up' its finances, with the help of Goldman Sachs, to appear fiscally sound as required for the euro entry. When it was revealed that the Greek government had more debt than it had notified, deposits started to flee the country. It needed foreign investors to fund its budget deficit of around 10.8 percent of GDP in 2010. Because the country was in the grips of a capital flight, this became impossible.
European leaders thus faced a dilemma. A default of Greece would be likely to topple major European, mostly French, German, and Greek, banks that had lent to the Greek government, and it would have been likely to lead to the exit of Greece from the Eurozone. Banks in the US had also provided credit default swaps against Greek government default. The US mutual funds had hundreds of billions of dollars invested in Europe and especially in French banks.
The risk of a contagion, that is, the crisis spreading mistrust across the banking sector of Europe but also that of the US, was obvious. Essentially, a default of one country could lead to speculation of further defaults and euro exits or even a collapse of the common currency. The world had also just recovered (partially) from the collapse of trust within the banking sector during the GFC. Thus, European leaders, with the support of the Obama administration, decided that the risk to the banking sector was too big and that the default of Greece should be averted. Thus, a governmental bailout, strictly forbidden in the Treaty of the Functioning of the European Union (TFEU) Article 125, was orchestrated.
On 2 May, 2010, the IMF and euro area governments decided to create a €110 billion rescue program for Greece. They also created an opaque European Financial Stability Facility, or EFSF, on 11 May 2010, with a maximum operation length of three years. It sat outside the EU law (it was located in Luxembourg), which, technically at least, allowed it to operate without breaking the TFEU. But this did not calm the markets, which is why a permanent bailout mechanism, the European Stability Mechanism, or ESM, was agreed at the EU summit between 24 and 25 March 2011. It operated with a paid-in-equity of €80 billion and issued bonds, but the euro area states were on the hook for €700 billion of losses in equity capital if necessary.
In response to the money from the bailout funds, Greece was forced to conduct extremely painful austerity measures. During one of the first bailout meetings, a representative of the IMF (International Monetary Fund) said that the only way for Greece to survive was through dismantling her welfare state. But the European leaders demanded that too. They could not tell their constituents (voters) that they're giving the money to Greece, mostly to bailout their own banks, on easy terms.
There needed to be suffering, and there was. Greece was subjected to one of the harshest austerity measures any country, under the IMF emergency loan programs, had ever seen. The IMF had followed a rather straightforward recipe for handling economic crises for decades. Over-indebted countries needed to restructure their economies, but their debt levels also needed to be cut and exchange rate pegs dismantled. But, obviously, this time around none of this was possible. Greece should not default, and it especially should not leave the euro. In essence, the IMF broke its own decades-old practices in the Greek bailout. According to the IMF's Independent Evaluation Office, the Fund bent its rules and was subject to political pressure in the Greece rescue (see also Reuters).
The Finnish decision
Another pivotal moment in the Eurozone saga arrived in April 2011. During the spring it had become clear that Greece would need another injection of bailout money. This had angered many European citizens, and a mutiny, especially among the mid-sized countries of the Eurozone, against the second bailout was brewing. Almost as if commissioned, Finland held a parliamentary election on 17 April 2011, as the only creditor country in Europe to have elections during that year. The True Finns party had gathered a large support by taking a hard stance against the second bailout of Greece. A rebellion against the policies twisting mutually agreed rules (the TFEU) of the European leaders was culminated by a landslide rise in the support of the True Finns. Basically overnight, they became the second largest party in Finland. However, as so often in the EU, the voice of the people was not heard.
Jyrki Katainen, as the leader of the National Coalition Party (the biggest party after the election), started leading the government negotiations. According to several unofficial sources, the only non-negotiable prerequisite of the True Finns to enter the government was, unsurprisingly, that Finland does not support the second bailout of Greece. The True Finns were left out of the government, which consisted of several parties across the aisle, and it became one of the most dysfunctional governments Finland had ever had. The newly elected government accepted the second bailout of Greece but demanded collateral, basically a form of a credit default swap, against the default of Greece. Greece and the rest of the Eurozone governments reluctantly accepted the collateral, which effectively broke all hopes for a coalition of mid-sized member countries against the bailouts (there were three more coming). Before the elections in Finland in April 2011, a blocking minority, from the other dissatisfied Eurozone governments, against decisions in the EFSF and ESM was forming.
We will never know for sure, whether such a coalition would have formed with the possible lead of Finland. But we failed to even try by disregarding the rather clear-cut democratic voice of the people of Finland. The decision on this lies solely on the feet of one man, Jyrki Katainen. Probably as a reward for this, Jyrki Katainen became the European Commission Vice-President for Jobs, Growth, Investment, and Competitiveness in 2014. In 2019, then Finance Minister and the main enforcer of the Greek collateral pact, Jutta Urpilainen, became the Commissioner of International Partnerships. To note, rumors were abound in the Finnish Finance Ministry that during the critical days after the 2011 elections, then Finance Minister Jyrki Katainen would have received a call from Berlin stating that a small Nordic country will not cause a Central-European banking crisis.
The end-game of the “debt” crisis
What made the Finnish elections in April 2011 so crucial was the direction the Eurozone took after that. It was the last chance to return to principles and, actually, to the letter of the TFEU. That is, to enforce the no bailout rule and, possibly, create an exit mechanism. German and French banks were already saved with the first bailout of Greece in 2010; the balance sheet of the ECB was close to empty, and the political capital for sustaining the euro was strong across Europe. If Greece had defaulted and exited in 2011, Europe would have most likely experienced a severe banking crisis (this is why the crisis was actually a banking crisis masked, for political reasons, as a debt crisis). Failing banks would have needed to be run down or recapitalized. There might have been a contagion, and some other countries could have exited the euro as well. But, with the help of the ECB, the panic could have been contained. This is exactly what happened in July 2012, when the ECB president Mario Draghi promised to do "whatever it takes" to save the euro. It stopped the contagion, and it would have probably stopped the contagion even if Greece had exited the euro in 2011.
But, instead of a Eurozone with strong, re-capitalized banks and clear rules for exiting the bloc, the banking sector of the Eurozone zombified through semi-legal and ineffective bailout structures and starving member countries. The Finnish general election truly was a turning point, because after it, all possibilities to build a strong Eurozone based on the rules of the TFEU were lost. It is likely that it was the decision that doomed the euro and the EU, even though we do not understand it yet.
Conclusion: The crisis that changed the world
There were two main detrimental outcomes that came out of the GFC. The first one was the central bank policies, programs of QE, and zero/negative interest rates. They simply perverted our financial system. Those who do not understand how financial systems work hailed at these central banking “innovations”. But, like stated by one of the most famous financial scholars, Hyman Minsky, stability is destabilizing. This means that if we teach the financial institutions and investors that a savior will appear if they screw up, they will take bigger and bigger risks. This is called moral hazard, which is an economics term describing excess risks investors take when they know they don’t need to bear the full consequences of their actions.
The market bailout policies, enacted by Alan Greenspan after the Black Monday of 1987, were pushed into hyperdrive during the GFC and the Corona crisis. The central banking policies invented during the GFC led us to a path that can lead only to two outcomes:
The full socialization (nationalization) of the financial markets by the central banks.
An (eventual) epic collapse of the financial system.
This is simply, because modern financial system is unable to stand without the continuous backing of central banks. This was seen last during the second wave of the Global Financial Crisis in March/April 2023, when the Fed threw a kitchen sink at the U.S. banking system after a failure of just two regional lenders. They did it because they knew that there was a risk of nationwide banking run and a collapse of the U.S. financial system. There was this risk, because their actions had turned the U.S. financial system fragile. Instability through stability. Just recently, this fragility in the U.S. banking system has re-surfaced.
The second detrimental outcome was the zombification of the European banking sector. From the March 2019 blog-entry of GnS Economics:
The response of the European authorities to the financial crash of 2008 was notably different from that of the US. While around 165 banks failed in the U.S. in 2008 and 2009, only a few banks failed in Europe, and those were mostly concentrated in one country, Iceland, where the whole banking sector collapsed.
In total, 114 banks received government support in Europe during the crisis. The recovery of the European banking sector from the crisis was notably slow. However, this should not have come as a surprise. Europe had failed to heed the lessons of Japan. If ailing banks are not wound down or re-capitalized properly, they will linger in the economy as “zombies”, slowly poisoning the economy.
Banks were also allowed to carry non-performing loans and assets on their balance sheet. This meant that:
Banks held defaulted loans on their balance sheets instead of writing them off.
Assets, like mortgage-backed CDOs, that had lost most or all of their value could be held on the balance sheet based on their “nominal value”, that is, at their purchase price.
Thus, effectively, the European banking sector transitioned from ‘mark-to-market’, where the value of their assets was based on actual daily market quotes, to “mark-to-fantasy”, where banks could arbitrarily determine the value of their assets. This helped to create zombie banks all over Europe.
The full costs of these grave and deliberate politics-driven actions are yet to be seen.
The GFC changed the world in many ways, for the worse. It could have gone the other way. It could have yielded a strong global banking sector and a strong economic recovery. Instead, our economies zombified and banking sectors turned fragile. The GFC sowed the seed for a much worse financial crisis. We dodged that bullet in the fall of 2022 and in March 2023. I am skeptical whether we can dodge the third one.
Disclaimer:
The information contained herein is current as at the date of this entry. The information presented here is considered reliable, but its accuracy is not guaranteed. Changes may occur in the circumstances after the date of this entry and the information contained in this post may not hold true in the future.
No information contained in this entry should be construed as investment advice. GnS Economics nor Tuomas Malinen cannot be held responsible for errors or omissions in the data presented. Readers should always consult their own personal financial or investment advisor before making any investment decision, and readers using this post do so solely at their own risk.
Readers must make an independent assessment of the risks involved and of the legal, tax, business, financial or other consequences of their actions. GnS Economics nor Tuomas Malinen cannot be held i) responsible for any decision taken, act or omission; or ii) liable for damages caused by such measures.