Nicolas Véron

Ten Years after the 2008 Financial Crisis: Op-ed in People's Daily

I wrote this op-ed for People's Daily, which posted it online and published a slightly abridged Chinese version in print on May 15.

Did the 2008 Financial Crisis Change the World?

The financial crisis that culminated a decade ago with the bankruptcy of Lehman Brothers was a major shock to the world, by several measures the greatest since the end of World War II. Its ramifications have been complex, and it is still too early for a definitive assessment. Still, the ten-year anniversary provides an opportunity to take stock. The surprise is how limited the lasting impact appears to be, in the United States and arguably also in Asia. The only large economic region where the crisis has been unquestionably transformational is in Europe.

First, a bit of semantics. The expression “global financial crisis” has been widely used, but there really was no such thing. A North Atlantic financial crisis, encompassing the United States and Europe, started in 2007 and climaxed into outright panic from mid-September to mid-October 2008. In the rest of the world, there was no financial instability, but a severe if brief negative economic shock in late 2008 and early 2009. There and in the United States, the crisis was over by 2010. In the euro area, by contrast, it was amplified by fault lines in the regional monetary union’s incomplete policy architecture, and lasted considerably longer as a consequence, arguably until mid-2017. Only then was the last remaining significant pocket of euro-area financial system fragility eventually resolved, namely the Italian financial sector restructuring epitomized by the closure of two large banks and the public rescue of a third one.

Now for the durable consequences. In the United States, some analysts argue that the crisis paved the way for the illiberal, protectionist turn of the Republican Party and the Trump presidency, but this is highly debatable. An increasing body of social science research suggests that the drivers of the 2016 Trump victory had more to do with identity than economics, and responded to developments that predated the crisis. In this analysis, many white males in the Unites States feel their traditional collective social dominance increasingly under attack, from outside by the rise of China and the corresponding erosion of America’s global preeminence, and from inside by the increasing racial and gender diversity of U.S. society. Both these trends started long before 2008. The post-2008 “Great Recession” changed the lives of millions of Americans, but did not fundamentally alter the structures of America’s economy and society, in striking contrast to the Great Depression of the 1930s which ushered in a spectacular expansion of the economic role of the Federal Government and a radical transformation of the U.S. financial system. In comparison with the New Deal legislation, the Dodd-Frank Act of 2010 was an adjustment at the margin, and may still be at least partly reversed.

The structural consequences of the 2008 shock may last somewhat longer in China. The Chinese authorities’ response to the shock was a massive stimulus, mainly channeled through the banking system, which greatly expanded debt in the Chinese economy. Meanwhile, the debt challenge remains for China to reduce this leverage without compromising stability.

In Europe, however, crisis-induced changes have been profound and permanent. This was the first large-scale economic crisis since the introduction of the euro in the late 1990s, and it almost led to the monetary area’s breaking up, in 2011-12 when Italy and Spain came close to losing sovereign debt market access, and again during the Greek aftershock episode of 2015. While euro area leaders dithered for far too long, they eventually thrashed out a firm policy response in 2012 with the creation of a large common financial assistance fund, the European Stability Mechanism, and the pooling of banking-sector oversight from the national to the euro-area level, a complex project known as banking union which has now been operational for several years. This greater integration, in turn, was a key driver of the British government’s ill-fated decision to submit the United Kingdom’s EU membership to referendum in June 2016, resulting in the ongoing drama of Brexit. As a result, the European Union will never be the same again, no matter how these developments may further unfold.

From a global perspective, the crisis appears to have slowed the pace of cross-border trade and economic integration, but the more recent data suggest that this impact may have been temporary rather than permanent. If so, and on the whole, the world will have weathered the 2008 crisis rather well. But once again, it is still a bit too early to be certain. 

Completing Europe’s Banking Union Means Breaking the Bank-Sovereign Vicious Circle

This blog post coauthored with Isabel Schnabel was published this week by PIIE, Bruegel and Vox. 

Several euro area leaders, including the German chancellor, her finance minister, and the French president, have recently referred to the need to “complete the banking union.” These public calls echo those made in more formal settings, in intergovernmental meetings and European Commission communications over the last half decade. They inevitably raise the question of what criteria should be used to assess the banking union’s completeness. A narrow interpretation, based on euro area leaders’ past commitments, equates it with breaking the bank-sovereign vicious circle; a more ambitious long-term vision for complete banking union implies the removal of all cross-border distortions within the euro area banking market. Even the minimalist version, however, entails more reforms than those publicly under current consideration.

“Banking union” has become a widely used expression to refer to the project of shifting banking-sector policy instruments from the national to the European level, but there is no official or legal definition of what it is or should be. Its first recorded use in public was made outside of officialdom (albeit on a suggestion from a European Commission official, Maarten Verwey), and it was gradually popularized in expert circles and the media. Euro area leaders endorsed banking union as their policy at a landmark summit in late June 2012, but waited almost a year until adopting the expression itself.

The Bank-Sovereign Vicious Circle Forms through Direct and Indirect Financial Linkages

The same leaders, however, associated banking union from the start with a clearly stated objective, namely that “[i]t is imperative to break the vicious circle between banks and sovereigns.” That sentence opened the June 2012 summit statement, and was identically repeated on several subsequent occasions. It refers to the mechanism, first observed by International Monetary Fund (IMF) scholars in 2009 and then increasingly acknowledged in European policy discussions, by which sovereign risk and bank risk are highly correlated with each other in Europe’s monetary union. Thus, a major banking-sector problem will cause fiscal distress (as happened in Ireland and Cyprus), and conversely, reckless fiscal management will result in a credit squeeze (as in Greece); the ensuing financial fragmentation across country borders impairs the operation of area-wide monetary policy and ultimately risks a break-up of the monetary union, giving rise to redenomination risk. This vicious circle, also referred to as the euro area’s “doom loop,” is best understood as a combination of direct and indirect financial linkages, summarized in the following chart. (Olivier Blanchard, then the IMF’s chief economist, appears to have been the first to produce this depiction of the bank-sovereign vicious circle in the summer of 2011, in internal IMF material that has unfortunately not been published.)

Selected contagion channels between banks and sovereigns in the euro area

A “complete” banking union, then, must include a policy framework in which the bank-sovereign vicious circle is broken. This is evidently not yet the case, as many of the above depicted linkages have remained essentially intact since the start of banking union almost six years ago. Deposit insurance is still national, as have been ad hoc schemes to support failing banks and their creditors. (In just one country, Italy, and in the past year only, these have included national liability guarantees, the precautionary recapitalization of one major bank, and the reimbursement of losses incurred by retail savers and investors in senior debt). Meanwhile, most euro area banks still exhibit significant home bias in their sovereign exposures, namely the fact that their direct credit exposures to euro-area sovereigns remains concentrated in their home country. Furthermore, most euro area banks retain a largely domestic footprint, implying powerful indirect linkages through the domestic economy. In addition, a surprisingly large number of them are controlled or otherwise influenced by national governments and/or politics, which reinforces the bank-sovereign nexus. For example, a very significant share of the German banking system is directly controlled by local or state governments.

The Ideal Single-Market Banking Union: Worthwhile, But Remote Prospect

A maximalist version of “completing the banking union” would remove all national determinants of banks’ activity and business models, thus fulfilling the promise of a perfect internal market in which all cross-border competitive distortions have been eliminated. (The privatization of publicly-owned banks could be viewed as an integral part of that agenda.) The United States comes close to a seamlessly integrated banking market—a surprisingly recent development, which followed the deregulation and reforms of the 1980s and 1990s. Relevant distortions in Europe include wide national variations in banking regulation, taxation, accounting, auditing, insolvency law (both for banks and their clients), and the policy frameworks for pensions and housing finance, to name only a few. This maximalist agenda, which may be labeled a “single-market banking union,” has many things in common with the European Commission’s ongoing effort towards a capital markets union. Like the latter, it is a worthwhile long-term project that cannot realistically be completed any time soon.

The Realistic Approach to Completing Banking Union: Breaking the Vicious Circle

But a single-market banking union may be placing the bar too high for proclaiming the project “completed.” The bank-sovereign vicious circle can arguably be broken with a much more limited package of policies that would address the critical linkages pictured above. This comparatively more modest approach may be called a “no-doom-loop banking union:” falling far short of the fully-fledged single-market banking union, but good enough to declare mission accomplished with a straight face. A recent Franco-German euro report, to which we both contributed, outlines one possible way to do that. It suggests:

• a European deposit insurance scheme that guarantees all covered deposits in the euro area identically and unconditionally (banks’ contributing fees would remain differentiated on a national basis, to account for the differences that will persist as long as a single-market banking union is not achieved);
• sovereign concentration charges, i.e. a regulatory incentive for euro area banks to diversify their sovereign exposures within the area but away from their home country; and
• phasing out restrictions on cross-border pooling of capital and liquidity by multinational banks within the euro area, thus encouraging cross-border integration that will mitigate the indirect linkages.

Implementing such an agenda would inevitably entail a long transition period, but the corresponding policy choices are sufficiently straightforward and commonly understood for policymakers to make binding decisions shortly.

Banking policy steps currently under active discussion in the euro area including tackling non-performing loans that are a legacy of the past decade of crisis and those that will arise in the future; setting in motion a quasi-fiscal backstop to the Single Resolution Fund, a commitment all member states made in 2013; and finalizing the banking legislation proposed by the European Commission in November 2016 and whose subsequent discussion has stalled. All of these steps would be useful, even necessary, but none of them, even taken together, would plausibly amount to “completing the banking union.” For that, the very lowest threshold would be to effectively break the bank-sovereign vicious circle: politically more challenging for sure, but still doable this year if political leaders take their own banking-union-completion slogan seriously.