22 April 2014

Simon Wren-Lewis: The banks and austerity - A simple story of the last ten years

On his mainly macro blog, Wren-Lewis argues that rather than seeing the financial crisis and austerity as two essentially separate stories, the needs and influence of the banks connect the two.

 

There are probably a number of reasons why bank leverage increased rapidly in the 2000s: reduced regulation, underestimation of systemic risk as a result of the Great Moderation, a search for yield when interest rates were low, simple greed. Bank profits rose, and so did the incomes of those working for them. However the consequence of excessive leverage was inevitable: a major global financial crisis. Banks had to be bailed out using public funds.

This produced a large negative demand shock which monetary policy was not able to counteract, because nominal interest rates fell to zero. In the US and UK governments undertook substantial fiscal stimulus to dampen the recession, but this, the recession and bank bailouts raised levels of public debt.

In recent research Alan Taylor and co-authors go further. They show that recessions are deeper and more prolonged if they are accompanied by a financial crisis, they are deeper and longer still if that financial crisis is preceded by a credit boom, and finally "the path of recovery is worse still when a credit-fueled crisis coincides with elevated public debt levels". 

In the eurozone there was a debt crisis. Everyone agrees the Greek government had overspent. But this crisis could have been resolved fairly quickly, if the Greek government had immediately defaulted on its debt, and the ECB had offered unlimited support for other solvent governments. However Greek default would have led to large losses for European banks, and possibly created a second financial crisis. As a result, default was initially resisted in Greece (to allow banks time to minimise the damage) and avoided elsewhere, and instead draconian austerity policies were imposed in the eurozone periphery.

In a very direct sense, banks created austerity in the eurozone. If that sounds like an outlandish conspiracy theory to you, here is Philippe Legrain, former advisor to the European Commission President:

"The primary cause of the crisis was the reckless lending of German and French banks (both directly and through local banks) to Spanish and Irish homeowners, Portuguese consumers and the Greek government. But by insisting that Greek, Irish, Portuguese and Spanish taxpayers pay in full for those banks’ mistakes, Chancellor Angela Merkel’s government and its handmaidens in Brussels have systematically privileged the interests of German and French banks over those of eurozone citizens."

Furthermore we know the political influence of the banks is huge: here I talk about the US and UK, but it seems unlikely that this does not also apply to the Eurozone. So in the Eurozone we had a second recession, which was the direct result of austerity. Eventually the ECB agreed to (in principle) provide unlimited support to solvent Eurozone governments, but not before austerity had been hardwired in the form of a new fiscal compact. Changes in bank regulation have fallen far short of what is required to avoid another crisis, as banks warned that increasing regulation would restrict their ability to lend, and therefore prolong the recession. The earnings of bank employees quickly recovered and resumed their rapid rise.

Full blog post

© Simon Wren-Lewis