As emergency meetings of Heads of State to address the Euro zone crisis have seemingly become recurrent events, the crisis in the Euro zone lingers on stubbornly and might possibly become more serious with borrowing costs for Italy and Spain, reaching unsustainably high levels. As ever bolder proposals proliferate to put an end to the crisis, it is important to look back at the history of the crisis and try to identify its root causes. A working paper by Justin Lin and myself addresses this question and, in particular, the extent to which it was driven by the global financial crisis and by factors internal to Europe, notably the adoption of the common currency.
In a previous installment, we explored one particular past financial crisis which resembles the current tensions in the Euro Zone in key aspects—specifically, the 2001 collapse of Argentina’s currency board. Taking history as our guide, we discuss the lessons that can be learned from past crises and potential steps policymakers can take.
Implications for the euro zone
Until even as short as a month ago, the possibility of a breakdown of the European monetary union triggered by an exit of one or more of its members had been considered no more than a tail risk scenario. The odds of such an outcome are now seen to have grown, as market concerns continue to focus on economic and financial fundamentals of the peripheral Euro Area members that, similar to Argentina, failed to satisfy the preconditions of a sustainable membership in the currency union. Given the significant economic and financial interlinkages within the Euro Area, and the key role of Europe in the global economy (Figure 1), potential fallout from such a breakdown would be much more profound for the region as a whole and the rest of the world, compared to any crisis experienced in the past.
Figure 1. Exposure to Peripheral European Countries
The very foundations of the European monetary union have been severely shaken by the ongoing financial crisis and doubts surrounding its future have intensified. In this two part series, we explore the following issues: What are the key vulnerabilities underlying a shared currency union? What can we learn from past experiences and what would the impact be if the crisis escalates? And what policy measures should be taken?
Fragility of “hard” exchange rate pegs
A monetary union can bring large benefits in terms of trade, low inflation, and lower borrowing costs, but it comes with tight strings attached. As an extreme form of a hard exchange rate peg, it is vulnerable to “sudden stops” (De Grauwe, 2009 ). History is full of illustrations of the demands placed on an economy by hard exchange rate pegs, such as dollarization and currency boards. To be sustainable, a hard peg must be accompanied by fiscal discipline and labor and product market flexibility, since monetary and exchange rate policies can no longer be used to respond to shocks and safeguard competitiveness. The lack of these preconditions not only undermines the sustainability of the regime, but also impedes the recovery from an ensuing crisis in the wake of its collapse.
Systemic financial crises require swift and comprehensive solutions by the government. In 2008 it quickly became clear that characterizing the U.S. securitization crisis as one of liquidity was inaccurate, and hoping that it would be cured by auctioning off increasingly poorly collateralized central bank loans to distressed firms was futile. That led to -TARP- a plan to repurchase troubled assets from banks, which quickly evolved into a bank recapitalization plan when it became clear pricing toxic assets was nearly impossible.
More recently, Spanish banking system has seen its situation worsen, partly because of Madrid’s failure to force an earlier cleanup of bad debts stemming from a real estate bust. Austerity measures to remedy the region’s debt crisis have since led to greater deterioration of Spanish bank balance sheets, as more and more Spanish businesses folded and homeowners went into foreclosure. Over the weekend Spain became the largest euro-zone nation to seek an international bailout, and the 17-nation currency area agreed to lend Madrid up to $125 billion for its bank rescue fund. At this point there is little disagreement that there needs to be a broad-based approach to resolve the Spanish bank insolvency problem, but not as much discussion over the form it should take.
Is the landscape of innovation, traditionally concentrated in a handful of OECD countries, shifting worldwide? To what extent has the recent economic crisis affected this change? And what may be the implications of this shift for global growth?
It was to tackle some of these pressing questions that a high-level symposium, bringing together policymakers from developing and developed countries including from Vietnam, Brazil and China; leading academics including Harvard University’s Philippe Aghion; and experts met in Paris in January 2012 at the invitation of the OECD and the Growth Dialogue, in partnership with the World Bank Institute.
Innovation has long been identified as central to sustained economic growth. With 2012 real GDP growth forecast globally at
A clear pattern of 'two speed recovery' emerged from the global economic crisis: although the East Asian economies saw a drop of nearly 4 percentage points in their GDP growth to 8.5 percent in 2008 and a further decline to 7.5 percent in 2009, they rebounded quickly to 9.7 percent in 2010. At the same time, however, growth in high income countries fell by 6.6 percentage points during 2008-09, from 2.7 percent in 2007 to -3.9 in 2009. Moreover, these economies are not yet out of the woods given the sovereign debt crises in the Euro Area. This is one of the many fascinating patterns revealed in the newly updated online version of the World Development Indicators.
What is more striking is that low income countries (LICs) have been resilient during the crises, more so than in the past. The annual GDP growth rate for low income countries declined less than 1 percentage point in 2008, standing at 4.7 percent in 2009 and quickly recovered to 5.9 percent in 2010. In particular, Ethiopia, Mozambique, Tanzania, and Zambia have shown robust growth of 6 to 11 percent throughout this period. Similar conclusions were presented in Didier, Hevia and Schmukler April 2011.
Conventional wisdom has it that compensation in the financial industry is responsible for much of the credit crisis. For instance, Paul Krugman states that “reforming bankers’ compensation is the single best thing we can do to prevent another financial crisis a few years down the road.” Unfortunately, the facts are stubborn and they do not fit this conventional wisdom.
Rüdiger Fahlenbrach and I study the incentives of bank CEOs before the start of the crisis and how the performance of banks is related to these incentives in a paper published in the Journal of Financial Economics. Our sample includes 95 large banks for which we have detailed information on CEO compensation, option holdings, and equity holdings. The paper shows that the value of the shares held by CEOs in the companies they managed in 2006 was roughly ten times the value of their total annual compensation. Such large holdings dwarfed annual bonuses (see Table 1). Experts in governance would have argued before the crisis that the interests of these CEOs were well aligned with the interests of the shareholders because they had so much skin in the game. The CEOs of Lehman Brothers and Bear Stearns had equity holdings in their firms worth approximately one billion dollars in 2006. With such holdings, it would have made little sense for CEOs to take actions that knowingly decreased shareholder wealth.
The history of political thought has been, in a sense, a tussle between two ideas regarding who should govern: the idea that experts should rule and the idea that the people should rule themselves. It has been a never-ending tussle, and just when you think the idea that the people can and should rule has won, we see established democracies tossing out elected governments and installing rule by technocrats. The issue is important for this blog for a simple reason: in international development, the belief that experts know best and should shape public policy in developing countries is as difficult to kick as an addiction to cocaine.
So, let’s be clear: while the allurement of technocratic competence in a crisis is understandable it remains just a trifle absurd to suppose that technocratic competence can replace democratic politics rather than being its humble servant. Experts have a huge role in a crisis, financial or otherwise, but to believe that finding a path out of a crisis is the sole business of experts is not only wrong but naïve. For, the response to a crisis is inherently and inescapably political. And this is true on at least two levels.