Major Crisis, Minor Reforms

Jomo Kwame Sundaram

The 2008-2009 financial breakdown, precipitated by the US housing mortgage crisis, has triggered an extended stagnation in the developed economies, initially postponed in much of the developing world by high primary commodity prices until 2014. Yet, the financial crisis and protracted economic slowdown since has not led to profound changes in the conventional wisdom or policy prescriptions, especially at the international level, despite global economic integration since the 1980s.

To be sure, the spread of the crisis caused the G20 group of US-selected important economies to convene for the first time at a heads of government level in a mid-November 2008 White House summit instigated by then French President Sarkozy. Various national initiatives to save their financial sectors were followed by a Gordon Brown UK initiative to significantly augment IMF resources. Soon, however, the appearance of supposed ‘green shoots of recovery’ led to premature abandonment of fiscal recovery efforts, reinforced by Eurozone fiscal rules, the powerful influence of financial rentier interests and bogus academic claims of impending doom due to public debt growth.

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Overcharged: The High Cost of High Finance

Gerald Epstein and Juan Antonio Montecino

Gerald Epstein is a professor of economics and Co-Director of the Political Economy Research Institute (PERI) at the University of Massachusetts Amherst. Juan Antonio Montecino is a doctoral student in economics at the University of Massachusetts Amherst. This is an excerpt from a report Epstein and Montecino wrote for the Roosevelt Institute. The full report is available here.

A healthy financial system is one that channels finance to productive investment, helps families save for and finance big expenses such as higher education and retirement, provides products such as insurance to help reduce risk, creates sufficient amounts of useful liquidity, runs an efficient payments mechanism, and generates financial innovations to do all these useful things more cheaply and effectively. All of these functions are crucial to a stable and productive market economy. But after decades of deregulation, the current U.S. financial system has evolved into a highly speculative system that has failed rather spectacularly at performing these critical tasks.

What has this flawed financial system cost the U.S. economy? How much have American families, taxpayers, and businesses been “overcharged” as a result of these questionable financial activities? In this report, we estimate these costs by analyzing three components: (1) rents, or excess profits; (2) misallocation costs, or the price of diverting resources away from more productive activities; and (3) crisis costs, meaning the cost of the 2008 financial crisis. Adding these together, we estimate that the financial system will impose an excess cost of as much as $22.7 trillion between 1990 and 2023, making finance in its current form a net drag on the American economy.

First, we estimate the rents obtained by the financial sector. Through a variety of mechanisms including anticompetitive practices, the marketing of excessively complex and risky products, government subsidies such as financial bailouts, and even fraudulent activities, bankers receive excess pay and profits for the services they provide to customers. By overcharging for products and services, financial firms grab a bigger slice of the economic pie at the expense of their customers and taxpayers. We estimate that the total cost of financial rents amounted to $3.6 trillion–$4.2 trillion between 1990 and 2005.

Second are misallocation costs. Speculative finance does not just grab a bigger slice of the pie; its structure and activities are often destructive, meaning it also shrinks the size of the economic pie by reducing growth. This is most obvious in the case of the financial crisis, but speculative finance harms the economy on a daily basis. It does this by growing too large, utilizing too many skilled and productive workers, imposing short-term orientations on businesses, and starving some businesses and households of needed credit. We estimate that the cost of misallocating human and financial resources amounted to $2.6 trillion–$3.9 trillion between 1990 and 2005.

Adding rent and misallocation costs, we show that, even without taking into account the financial crisis, the financial system cost between $6.3 trillion and $8.2 trillion more than the benefits it provided during the period 1990–2005.

On top of this is the massive cost of the financial crisis itself, which most analysts agree was largely associated with the practices of speculative finance. If we add conservative Federal Reserve estimates of the cost of the crisis in terms of lost output ($6.5 trillion–$14.5 trillion), it brings the total amount of “overcharging” to somewhere between $12.9 trillion and $22.7 trillion. This amount represents between $40,000 and $70,000 for every man, woman, and child in the U.S., or between $105,000 and $184,000 for the typical American family. Without this loss, the typical American household would have doubled its wealth at retirement.

These excess costs of finance can be reduced and the financial sector can once again play a more productive role in society. To accomplish this, we need three complementary approaches: improved financial regulation, building on what Dodd-Frank has already accomplished; a restructuring of the financial system to better serve the needs of our communities, small businesses, households, and public entities; and public financial alternatives, such as cooperative banks and specialized public financial institutions , to level the playing field.

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The Vote for Brexit: Reykjavik-on-Thames, Redux?

Nina Eichacker

Nina Eichacker is a lecturer in economics at Bentley University. She has written previously for Triple Crisis on German financialization and the eurozone crisis and on financial liberalization and Iceland’s financial crisis.

On October 8, 2008, the British Chancellor issued the “Landsbanki Freezing Order 2008,” freezing the assets of Landsbanki, one of Iceland’s three largest banks, after the Icelandic Finance Minister’s statement that Iceland would not guarantee UK citizens’ deposits in Landsbanki’s retail banks, after it had gone into receivership. The British Treasury and Financial Supervision Authority (FSA) froze billions of pounds sterling in Landsbanki’s assets in Britain. Icelandic banks had been badly overleveraged: In 2007, Icelandic GDP was $16.3 billion dollars; Icelandic banks held $176 billion in assets, $166 billion in liabilities, and owned three times as many foreign assets as domestic ones (Buiter and Sibert, 2011, Aliber, 2011). Consequences of this crisis included billions of dollars in banks’, firms’, and households’ losses on bank shares, economy-wide recession, austerity policies and international pressure for the Icelandic government to guarantee banks’ liabilities with taxpayers’ money.

On November 13, 2008, Willem Buiter wrote a post sub-titled “Is London Really Reykjavik-on-Thames?” arguing that the UK should consider the risk of similar financial events occurring. The UK was also a small global economy with an outsize financial sector relative to total GDP, though UK banks’ balance sheets were only 450% of UK GDP, compared to Icelandic banks’ 900% of GDP (Buiter, 2008). External assets and liabilities of UK banks were large: 400% of GDP in gross external assets and liabilities, compared to Iceland’s 800% and the United States’ 100% (Buiter, 2008). Buiter argued further that most UK banks in 2008 were very vulnerable to a banking crisis, followed by sovereign-debt and currency crises (Buiter 2008). UK banks had the potential to set off another triple crisis. This didn’t come to pass: banks like Lloyds and HBOS received large bailouts, the government oversaw mergers of smaller banks into larger banks, and mandated banks’ sale of shares to raise capital, and improve overall bank resilience, while the Bank of England engaged in expansionary monetary policy.

Could Brexit or the vote to leave bring about that potential crisis?

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Taking the Blinders Off, Part 1

Susan Schroeder is a lecturer in the Department of Political Economy, University of Sydney, Australia, and author of Public Credit Rating Agencies: Increasing Capital Investment and Lending Stability in Volatile Markets (Palgrave Macmillan, 2015). This is the first part of a three-part article, originally published in the July/August 2016 issue of Dollars & Sense magazine.

How private credit rating agencies reinforce global economic instability—and what we can do about it.

Susan Schroeder

The role that credit rating agencies played in the global financial crisis is no secret. One memorable scene in The Big Short depicted an employee of Standard & Poor’s (S&P)—one of the “big three” rating agencies, with Moody’s and Fitch—as being blinded by conflict of interest in her evaluation of mortgage-backed securities. In a visual gag, she is depicted as having just come from the eye doctor, wearing literal blinders as she is quizzed by the film’s protagonists about how S&P could give the highest ratings—AAA—for securities based on bundled subprime mortgages. “If we don’t give the ratings, they’ll go to Moody’s, right down the block.”

In the wake of the financial crisis, rating agencies have faced growing public concerns about their ability to evaluate credit risk. Investors who lost large sums on investments involving structured financial products, such as mortgage-backed securities (MBSs), have sued the rating agencies. The agencies had assessed MBSs as having very low levels of risk prior to the crisis. But this is not the first instance when the products of the ratings industry have come under suspicion. In the Penn Central crisis of the 1970s, the financial instrument involved was commercial paper. In the Latin American debt crisis of the 1980s, it was sovereign debt. In the early 2000s, at Enron and Parmalat, it was corporate bonds. In the most recent financial crisis, it was collateralized debt obligations and, in some countries, sovereign debt as well.

The role of credit in an economy is a double-edged sword. During a business-cycle upswing, credit facilitates investment and economic growth. As a cycle matures, credit becomes a burden and debt servicing becomes more problematic. If firms are forced to sell assets en masse to obtain the means to service debts, the economy is exposed to “debt deflation”—a fall in the level of prices, contraction in the profits and net worth of firms, and a reduction in output and employment. Changes in credit ratings over the course of a cycle have a tendency to exacerbate both the upswings and downswings.

How should credit risk be evaluated in the context of an ever-changing macroeconomic environment? One way is to assume a market economy is inherently stable and self-regulating. Credit risk is evaluated in the context of recent experience, with that context occasionally revisited for possible revision.  Another way is to assume the economy is inherently unstable and not self-correcting. This is something that economists John Maynard Keynes and Hyman Minsky understood well, but that mainstream economists now treat as heretical. Although assuming instability seems more plausible, assuming stability makes it easier to use quantitative techniques and computing power. When rating agencies are processing information on thousands of credit issuers, speed matters. But it comes at the cost of accuracy and ability to foresee crises.

A public credit rating agency could support the development of better credit risk-assessment by using Minsky’s “Financial Instability Hypothesis” to create more sensitive methods of detecting changes in the overall economy, particularly instability generated by risk-taking behavior of individual firms and investors. By more accurately evaluating changes in the macroeconomic context, such an agency could do a better job of assessing firms’ levels of risk, and thereby reduce the danger they pose to the broader economy.

Why Can’t Private Credit Rating Agencies Solve the Problem?

Credit ratings are a form of credit risk-assessment—an opinion about the ability of a borrower to service its debt. These opinions, however, have the ability to destabilize financial markets and economies like no other. The three largest credit-rating agencies—Moody’s, Standard & Poor’s, and Fitch—dominate the global market for this service. Taken together, their global market share, in terms of the value of all rated securities, is more than 95%. They issue opinions on the liabilities of governments, non-financial corporations, financial firms like insurance companies and banks, and even universities. They are separate from credit reference or consumer reporting agencies, sometimes referred to as “credit bureaus,” which issue assessments about individual consumers.

Credit ratings are supposed to address the imbalance (or, in economic lingo, “asymmetry”) of information that exists between borrowers and lenders. Borrowers are thought to hold the most complete information about changes in their ability to service debt, whereas lenders only become aware of this after a time lag. Ratings may shorten the lag, even if they do not eliminate it. Credit risk-assessments are conducted in a way that borrowers and financial instruments can be compared and ranked according to their relative riskiness.  This way, the ratings refine the process by which different firms’ cost of raising capital is established and improve market efficiency and liquidity. At least that’s how it’s supposed to work.

Flaws in the rating methods arise from conflicts of interest, lack of transparency, and changes that coincide with and amplify the business cycle (“pro-cyclicality”). For instance, the agencies’ very business model, in which issuers pay the agencies for assessments of creditworthiness (known as the “issuer-pays” model) generates conflicts of interest. Such conflicts are thought to have contributed to the overly rosy ratings of structured products prior to the financial crisis (e.g., the highest, or “AAA,” ratings for residential mortgage-backed securities), as the agent from S&P in The Big Short made clear. The lack of information about the agencies’ methods and processes made it hard for investors to scrutinize their decisions. The pro-cyclicality of rating changes is striking, as credit risk-assessments are intended to be “through-the-cycle” or impervious to cyclical behavior of the economy. Why is this?

A key flaw with many credit-assessment methods is that the assumptions they make to process data from thousands of borrowers—to make their own quantitative techniques work—are the same assumptions that envision a market economy as inherently stable. For instance, assessment methods often employ traditional statistics that rely on the notion of stable relationships between possible outcomes and their probability of occurrence. That is, the purchase of a security is seen as similar to placing a bet at a roulette table. All the different possible outcomes, and their relative probabilities, are fixed. In real life, the probability distributions describing the riskiness of different securities are not necessarily stable if the broader market economy is inherently unstable. And, given the recent global financial crisis, not many people would be easily convinced that market economies are inherently stable.

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Paul Krugman Crosses the Line

Gerald Epstein

In his recent New York Times opinion column, “Sanders Over the Edge” (4/8/16), economist Paul Krugman offers his readers a basketful of misinformation on important economic matters about which he should – and probably does – know better. The column contains a large number of snipes and a great deal of innuendo against Bernie Sanders and his supporters, but here I focus on his claims about “Too Big To Fail” (TBTF) banks, their role – non-role, according to Krugman –  in the financial crisis, and Sanders’ understanding of the policy tools available to deal with them. Krugman’s claims about these issues are misleading, almost certainly wrong, and, in my view, call into question the credibility of his New York Times column as a source of economic information and analysis.

Krugman starts here:

“Bernie is becoming a Bernie Bro.” I’ll leave it to others to dissect this one. Moving on:

“Let me illustrate the point … by talking about bank reform.

“The easy slogan here is ‘Break up the big banks.’ It’s obvious why this slogan is appealing from a political point of view: Wall Street supplies an excellent cast of villains. But were big banks really at the heart of the financial crisis, and would breaking them up protect us from future crises? Many analysts concluded years ago that the answers to both questions were no.”

As you can see by following Krugman’s link here, this is not, what Krugman suggests it is: it is not a link to an article quoting multiple analysts presenting strong arguments with evidence that large banks were not responsible for the crisis. It is a link to an opinion piece by Paul Krugman himself. Period.

And, moreover, in this linked piece, Krugman is far more circumspect and uncertain of the answers than if implied in his statement “that many analysts concluded years ago.” So, who are these “many analysts”? On what basis did they reach their conclusions?

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German Financialization and the Eurozone Crisis

Nina Eichacker

Nina Eichacker is a lecturer in economics at Bentley University. This blog post summarizes her recent Political Economy Research Institute (PERI) working paper “German Financialization, the Global Financial Crisis, and the Eurozone Crisis.” Her previous blog post, on financial liberalization and Iceland’s financial crisis, is available here.

Many studies of the Eurozone crisis focus on peripheral European states’ current account deficits, or German neo-mercantilist policies that promoted export surpluses. However, German financialization and input on the eurozone’s financial architecture promoted deficits, increased systemic risk, and facilitated the onset of Europe’s subsequent crises.

Increasing German financial sector competition encouraged German banks’ increasing securitization and participation in global capital markets. Regional liberalization created new marketplaces for German finance and increased crisis risk as current accounts diverged between Europe’s core and periphery. After the global financial crisis of 2008, German losses on international securitized assets prompted retrenchment of lending, paving the way for the eurozone’s sovereign debt crisis. Rethinking how financial liberalization facilitated German and European financial crises may prevent the eurozone from repeating these performances in the future.

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Banking on Bonds, Part 2

This is the second of two excerpts from a recent paper on the role of “repurchase agreements” (or “repos”) in the eurozone crisis, co-authored Daniela Gabor and Cornel Ban. Gabor is an associate professor in the Faculty of Business and Law at the University of Western England-Bristol. Ban is an Assistant Professor of International Relations and Co-Director of the Global Economic Governance Initiative at Boston University.

This part describes the behavior of the European Central Bank in the repo market—for example, tightening the standards for use of repos as borrowing collateral by embattled private banks—which had a perverse (pro-cyclical) impact in the eurozone crisis. Part 1, explaining repos are and their growing importance, is available here. The full text is available on the GEGI website.

Collateral Damage in the European Sovereign Debt Crisis

Daniela Gabor and Cornel Ban

The financial crisis which erupted in 2007 has fragmented the GC repo market in Eurozone government bonds … There is consequently a German GC market, a French GC market and so on, but there is no longer a eurozone GC market, except for oneday repos, where credit risk is minimal. (European Repo Council, 2013)

While US scholars and policy-makers have dedicated close attention to the run on US repo markets following Lehman Brothers’ collapse (Gorton and Metrick, 2012; Krishnamurthy et al., 2014) and the FSB (2012) put repo markets on its shadow banking agenda, scholarship on the systemic fragilities in European repo markets is in its infancy. Although the crisis reversed the Europeanization of sovereign collateral, as suggested in the quote above, the few studies dealing with European repo markets (Mancini et al., 2013; Boissel et al., 2014) do not engage with the impact on collateral markets.

The paucity of research on this topic is striking considering that by 2012, Portugal, Greece and Ireland provided 0.1 per cent of total repo collateral, sharply down from the 3.5 per cent share in 2008 (see Figure 2), and that Eurex (a large CCP) eliminated GIP government bonds from its GC Pooling basket (Mancini et al., 2013). Repo participants also reduced the use of German government bonds, for the opposite reason: in times of uncertainty, investors become reluctant to part with highly liquid assets.

Thus, the insight from the US-based literature on repo markets that government bonds preserve their high-quality collateral status in crisis, when repo lenders stop accepting privately issued securities, does not apply to Europe (Pozsar, 2014). The eurozone crisis shows that governments are also vulnerable to repo market tensions because the private rules that govern collateral and the incentives of systemic repo market participants are inherently destabilizing.

In the eurozone crisis, Member States faced not only destabilizing repo market dynamics, but also a central bank whose collateral policies were pro-cyclical at critical junctures. This clashes with the conventional description of the ECB’s crisis interventions, which emphasizes that its measures helped stabilize repo and collateral markets (ECB, 2010; Drudi et al., 2012; BIS, 2011). The narrative goes like this: throughout 2008 and 2009, the ECB acted counter-cyclically by extending the pool of eligible collateral (lowering the credit rating threshold from A! to BBB!), a measure meant to help leveraged European banks facing severe funding problems (ECB, 2015a). This allowed banks to take ‘bad’ collateral to the ECB’s long-term lending facilities and use high-quality collateral in private repos. Policy action contained potential runs in periphery collateral markets, restoring confidence in the collateral qualities of GIIPs government debt. The several long-term refinancing operations (LTROs) enabled banks to fund government debt portfolios, increasing demand and therefore liquidity in those markets. The OMT finally dealt with unfounded fears of a eurozone break-up in 2012.

A repo lens complicates this account. When examined through collateral practices, the ECB’s crisis interventions were often pro-cyclical. At critical moments, the central bank made margin calls, raised haircuts and tightened collateral standards. Indeed, in those moments the ECB behaved just like a private repo market participant – a ‘shadow bank’ – that disregards the systemic implications of its collateral practices.

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Banking on Bonds: The New Links Between States and Markets

This is the first of two excerpts from a recent paper, co-authored by Daniela Gabor and Cornel Ban and published in the Journal of Common Market Studies, on the role of “repurchase agreements” (or “repos”) in the eurozone crisis. Gabor is an associate professor in the Faculty of Business and Law at the University of Western England-Bristol. Ban is an assistant professor of International Relations and Co-Director of the Global Economic Governance Initiative at Boston University.

Part 1 explains what repos are and how their importance has grown in recent years. Part 2, to be posted next week, describes the behavior of the European Central Bank in the repo market—for example, tightening the standards for use of repos as borrowing collateral by embattled private banks—which had a perverse (pro-cyclical) impact in the eurozone crisis. The full paper is available on the GEGI website.

Part 1: How Repos Work

Daniela Gabor and Cornel Ban

The ‘repurchase agreement’ (often referred to as ‘repo’) has become a key financial device for contemporary capitalism. Though the legal and formal definitions of a repo transaction can make it sound quite complex, it most simply can be thought of as a (usually short-term) secured loan. In a repo transaction one institution (the lender) agrees to buy an asset from another institution (the borrower) and sell the asset back to the borrower at a pre-agreed price on a pre-agreed future date (a day, a week or more). The lender takes a fee (repo interest rate payment) for ‘buying’ the asset in question and can sell the asset in the case that the borrower does not live up to the promise to repurchase it. The fundamental purpose of this circular transaction is to lend and borrow funds (and, in some cases, securities). While financial institutions use it to raise finance, central banks use it in monetary policy.

To illustrate, suppose Deutsche Bank (DB), acting as a borrower, sells assets to a buyer (Allianz), acting as a lender, and commits to repurchasing those assets later (see Figure 1). Allianz becomes the temporary owner of the assets, which also serve as collateral, and Deutsche Bank has temporary access to cash funding. DB and Allianz also agree that the purchase price is less than the market value of collateral (€100) – in this case a 5 per cent difference, known as a haircut. This provides a buffer against market fluctuations and incentivizes borrowers to adhere to their promise to buy securities back. In our example, DB provides €100 worth of collateral to ‘insure’ a loan of €95. When the repurchase takes place, DB pays €95 plus a ‘fee’ or interest payment in exchange for the assets it had sold.

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From “Boring” Banking to “Roaring” Banking, Part 3

Gerald Epstein

This is the final installment of a three part interview with regular Triple Crisis contributor Gerald Epstein, of the Political Economic Research Institute (PERI) at the University of Massachusetts-Amherst. This part focuses on why there have not been more significant reforms since the financial crash and Great Recession, and on a reform agenda for today. Parts 1 and 2 are available here and here.

Dollars & Sense: Of course, bubbles burst and exacerbate the severity of downturns. One of the amazing things about the aftermath of the recent crisis has been the apparent imperviousness of the financial sector to serious reform—especially in contrast to the Great Crash of 1929 and the Great Depression. How do you make sense of that?

Gerald Epstein: You have to use a political economy approach to understand the sources of political support for finance. I call these multilayered sources of support the “bankers’ club.”

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From “Boring” Banking to “Roaring” Banking, Part 2

Gerald Epstein

This is the second part of a three part interview with regular Triple Crisis contributor Gerald Epstein, of the Political Economic Research Institute (PERI) at the University of Massachusetts-Amherst. This part focuses on the performance of the financial sector, against the key claims that are made by mainstream economists about its socially constructive role, during the era of “roaring” banking. Part 1 is available here.

Dollars & Sense: How does the performance of the financial sector measure up, during this most recent era of deregulated finance?

Gerald Epstein: If you look at the textbook description of the positive roles that finance plays, basically it comes down to six things: channel savings to productive investment, provide mechanisms for households to save for retirement, help businesses and households reduce risk, provide stable and flexible liquidity, provide an efficient payments mechanism, and come up with new financial innovations, that will make it cheaper, simpler, and better to do all these other five things. If you go through the way finance operated in the period of “roaring” banking, one can raise questions about the productive role of banking in all of these dimensions.

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