Economic policy reactions

In its early stage, the fi nancial crisis was rather perceived mainly as a liquidity problem. In particular this attitude was held by the European Central Bank (ECB) [Schmidt et al. 2011, p. 140]. Soon all major central banks recognized how se-vere the banking crisis was. Th ey began to loosen monetary policy and provide liquidity in all possible ways.

In the US Fed cut its target federal funds rates and has kept it at a range of 0–25 percent since December 2008 [Calomiris, Eisenbeis & Litan 2011, p. 2]. Fed provided a broad variety of liquidity measures to the market participants. Among these were [Hogan 2012, p. 11]:

– Term Auction Facility (TAF) that helped shore up liquidity of troubled banks whilst preserving some form of anonymity,

– Special Purpose Vehicle (SPV), the Federal Reserve Bank of New York, and its Commercial Paper Funding Facility created in order to alleviate shrink-ing demand for Commercial Paper from the Money Market Mutual Funds, – Th e Money Market Mutual Funds were backed by the Fed establishing the

Money Market Mutual Fund Liquidity Facility (AMLF).

With the policy rate at a zero level Fed continued its easy monetary policy by implementing non-standard quantitative easing (QE). In the fi rst stage of this op-eration (QE1) it reversed its sales of government securities, added to its portfolio longer term T-bonds and began purchasing housing related agency mortgage-backed securities from Freddie, Fannie and Ginnie Mae [Calomiris et al. 2011, p. 35]. Fed continued its liquidity injections by deciding to implement QE2 and later on introducing an operation known as “operation twist”. Operation twist consists of [Calomiris et al. 2011, p. 36]:

– selling short term treasuries and reinvesting the revenue to purchase longer term T-bonds and

18 A similar situation was seen in Iceland, which was on the brink of fi nancial meltdown.

– reinvesting maturing agency and mortgage related assets in new housing re-lated assets.

Th ese Fed actions, prompt reductions of the federal funds rate and the Administration fi scal expansion package (Table 3.5 and 3.6) saved the American fi -nancial intermediation system from an implosion. Th e size of liquidity created together with unprecedented US budget defi cit and high public debt, threatens future stability of the US domestic and global fi nancial system. As such, it has had an impact on new Central European market economies. Other central banks fol-lowed the Fed actions (Table 3.4) with European Central Bank being reluctant to use the most aggressive types of actions (QE). In the European context the most hit was the banking sector – commercial banks play a major role in the fi nancial intermediation system.¹⁹

19 Before the crisis, in EU15 the stock of loans to the private sector surpassed 97% of GDP, while in the US it was 51%. Stock market capitalization (% of GDP) was 58% and 95% respec-tively. Source: [ECB Monthly Bulletin 2004, May].

Table 3.5. Major fi nancial counter crisis measures in selected developed countries in Sep. 2008 – Jan. 2009

Source: [Schmidt et al. 2011, p. 147].

Table 3.6. Major fi scal cost of counter crisis measures in selected developed countries in 2008

Selected

countries Capital injections Guarantees Total of measures

announced Total (% of GDP)

the US $250 bn $700 bn 5.1

the UK ₤50 bn ₤250 bn ₤400 bn 28.6

Germany €70 bn €400 bn €480 bn 19.8

Ireland €450 bn €450 bn 235.7

Source: [Schmidt et al. 2011, p. 147].

In the EU, Ireland was the fi rst country that felt the heavy repercussions from the global crisis. Ireland had to introduce idiosyncratic policy measures towards the domestic banking sector. Th ose measures were “bold, quick, painful and deci-sive, the moves that were everything that the European solutions were not” [Lord 2011, p. 64]. A number of Irish banks went bankrupt because of their reckless growth, driven by overseas expansion, too high a risk appetite and, fi nally, due to a faulty policy of lax lending to the real estate sector in a bubble. When the scale of their risky exposures and bad loans became evident, the Irish government de-cided one-sidedly to guarantee all bank deposits, to avoid bank runs. Th e EMU partners of Ireland had no choice but to follow suit. As the next step, the Irish government was de facto forced to nationalize fi ve out of six [largest] commercial banks and subsequently recapitalize them. Th e total fi scal cost of this interven-tion, coupled with the slowdown of the Irish economy, resulted in more than 32 per cent of GDP budget defi cit in 2009 [Kowalski 2012, p. 30].

In 2009 in order to proceed with banking sector restructuring the Irish gov-ernment created the National Asset Management Agency (NAMA). Th e agency was modeled on the bad bank set up in Sweden of the early 1990s.²⁰ Th e NAMA eff ectively slimmed down the ailing sector [Lord 2011, p. 65]. Th e transparent mechanism used (Figure 3.9), triggered a swift process of unveiling the actual scale of the Irish banking sector failure. Another advantage of the NAMA

20 Th e diff erence between the Irish way and the banking crisis resolution used at the be-ginning of 1990s in Sweden is that in Sweden NAMA, capitalized by the state, paid high pric-es for the problem assets and this way partly recapitalized the ailing banks. I owe this note to C. Wihlborg.

Figure 3.9. Th e Irish NAMA-based approach to banking sector restructuring No private capital available – the government rescuing the banking sector

on its own terms

The banks’ losses triggered the need for new capital

Commercial banks’ big losses unveiled

Irish commercial banks forced to sell NAMA assets at very low price

proach was the downsizing of the banking sector to a reasonable scale in terms of the Irish GDP.

Th e NAMA was criticized for the actions taken [Lord 2011]. According to Lord [2011, pp. 65–66] the public and private cost of restructuring was very high and its uniform, “one size fi ts all” approach disregarded the nuances of particu-lar bank’s individual situations (Figure 3.9). Th e scale of recapitalization needs forced the Irish government to apply to the IMF and the EMU for bailout. Total fi nancing from the European states and the IMF reached in Ireland €15,000 per capita and was second, only aft er Greece (€21,800) so far [the Economist 2013a, p. 63]. Recapitalization and deleveraging of Irish banks was done through three parallel strategies [Sen 2011; Lord 2011, pp. 66–67]:

– liability management exercises (LME), – raising fresh equity and debt,

– divesting assets from the balance sheet.

Th e LME were implemented through a legal act and allowed, in certain cases, the haircut of junior bondholders bonds to 10% of their original level. Th ere were also numerous cases of bond for equity swaps. While these steps gradually rein-troduced confi dence in the Irish banking sector, they also permitted the private and fi scal costs of rescuing the Irish fi nancial intermediation sector to materialize.

Th e Irish banking sector crisis sheds light on the negative externalities of gov-ernmental sector policies of the 1980s and 1990s. Consecutive Irish governments orchestrated and supported the development of the banking sector as one of the Irish national champion industries, oft en using fi scal incentives. As a result the Irish banking sector became signifi cantly oversized compared on the size of the economy and its domestic needs. Its failure brought the country economy to the brink of collapse and resulted in heavy rescue costs.

Th e example of Ireland shows the scale of problems in the EU banking sector.

In other countries the public rescue operations were not that spectacular but also required high and orchestrated fi scal spending. Th e most publicized were cases of bank failures and consolidations in Belgium, Germany and Greece.²¹

Th e scale of fi scal rescue operations caused widespread public debate concern-ing both the issues of guilt and general economic governance on both sides of the Atlantic. Budget defi cits and public debt levels focus attention because they are summary measures of government involvement in the economy on the one hand and indicate current and future public sector borrowing requirement on the other. In the case of the EMU, the member states only have fi scal policy instru-ments at their national disposal. Discretionary use of fi scal policy instruinstru-ments, however, is limited by specifi c EU rules. At the outset of the crisis, in 2007, the 3% budget defi cit criterion was fulfi lled by 10 out of the 12 EMU countries, with 6 countries out of 10 having budget surplus (Figure 3.10). Th e best performers

21 See the excellent review of the European crisis evolvement by Schmidt et al. [2011].

in this respect were Finland and Luxembourg, 5.2% and 3.7% of GDP, respec-tively [Kowalski 2012].

In 2007, only Greece and Portugal exceeded the level of 3% (6.7% and 3.2%

of GDP respectively). Th e fi nancial and economic consequences in Europe af-fected the general government fi nancial balances (GGFB) of the EMU countries in diff erent ways. In its peak in 2009–2010, only Finland and Luxembourg did not exceed the 3% level (Figure 3.10). Th e gravest GGFB downturn took place in Ireland (32.4% of GDP), Greece (15.6%), Spain (11.1%), Portugal (10.9%) and France (7.5%) (Figure 3.10). In the U.S., whose defi cit peaked at 11.9% in 2009, the situation was diff erent from the EMU because it could control its own national fi scal and monetary policies. In subsequent years (2010–2012), all the countries tried to sort out their public fi nance conditions. Greece, however, does not fall into the latter category, having found itself on the verge of bankruptcy aft er the revised data became public.

Consecutive budget defi cits stemming from fi nancial sector public rescue operations and recession were refl ected in growing public debt levels. Accord-ing to Eurostat data, in 2007 there were only 5 EMU countries, namely Luxem-bourg – 6.7%, the Republic of Ireland – 25%, Finland – 35.2%, Spain – 36.1%, and the Netherlands – 45.3% that maintained the debt to GDP ratio on a level Figure 3.10. General government fi nancial balances as % of GDP in 2007–2012

(estimate)

2007 2008 2009 2010 2011 2012

Surplus (+) or deficit (–) as a per cent of nominal GDP

Germany

lower than the 60% of GDP. Other countries had higher debt levels, to a greater or lesser extent; Austria, with its 60.7%, had the lowest deviation from the 60%

level, while Belgium, Italy and Greece produced the highest i.e., 84.2%, 103.6%

and 105.4%, respectively. In the fi rst crisis-ridden year, all EMU countries, ex-cept Finland, increased the debt to GDP ratio in comparison with the level of 2007. In contrast, in 2011, the U.S. increased its debt burden by 64 percentage points against the level of 2007. In the two years that followed, as a reaction to the crisis and as a consequence of the increased public fi nance sector defi cits, the countries augmented the levels of their debt. Th e lowest level of debt increase in 2010 as compared to 2007 was the share of Italy, Belgium and Austria, which amounted to 114.9, 115, and 119 percentage points of the 2007 level respective-ly. Th e highest public debt increase during the 2007–2010 period was the share of Ireland – 385 percentage points higher than the 2007 level, Spain – 166, the Netherlands and Finland – about 138, as well as Portugal and Greece – 136 and 137 percentage points respectively.

Th e fi nancial market participants, based on new information regarding the quality of macroeconomic data reduced investment in the treasury securities of Greece and other southern EMU countries; they rightly perceived such invest-ments as a threat to their own credit rating. As more data about the Greek mac-roeconomic accounting fraud were released, and due to the delayed ECOFIN and ECB reactions, a negative sentiment towards most debt by the European Com-munity countries began to surface. As a result, the banking sectors were hit again, especially the French and Italian, the most involved in the treasury securities of the EMU countries of the highest debt to GDP ratios. It consequently meant the need to off er further public aid to the contaminated banks.

Contrary to the EMU countries, policymakers in the U.S. had more room for maneuver in their use of fi scal instruments [Kowalski & Shachmurove 2013].

As the crisis deepened, the U.S. responded with aggressive expansionary fi scal measures (see Table 3.5). Th is was clearly evidenced by the near quadrupling of the U.S. defi cit relative to GDP. In the initial year of the crisis, 2007, the U.S. had a defi cit to GDP ratio of –2.9%. By 2009, once the full scale of the crisis was ap-parent, this fi gure leapt to –11.9% (Figure 3.10). With the passage of the Trou-bled Asset Relief Program (TARP) in late 2008 and the American Recovery and Reinvestment Act (ARRA) of 2009, the federal U.S. government attempted to improve the worsening economic situation [Kowalski & Shachmurove 2013].

Th ese programs account for the rapid increase in U.S. defi cit to GDP ratio. Th e fl exible and discretionary use of fi scal instruments allowed the U.S. government to implement massive public spending, although some, such as Krugman and Stiglitz, advocated an even larger stimulus. Th e level of defi cit in the U.S. in 2009 (–12.9%), relative to the EMU economies, ranks it amongst the largest (Figure 3.10). While Ireland, by far, saw the largest deterioration (to the level of –32.4%), in 2012 the U.S. had the highest budget defi cit of –8.5%. Even at the height of the

crisis, with the exception of Ireland and Greece, no EMU countries saw defi cit levels near that of the U.S.