THE THIRD phase of the financial crisis has become acute. In the first phase, from July 2007 to September 2008, certain money markets seized up, costs of credit for financial institutions rose, and a series of such institutions (e.g. Northern Rock, Bear Stearns) came under pressure. Phase one ended, and phase two began in September 2008 with the nationalisation of Fannie Mae and Freddie Mac. This event, in which equity-holders were wiped out and bondholders spared, ended all prospect of under-capitalised financial institutions being recapitalised by private sector decision-making (through some combination of equity injections and debt-equity swaps). The immediate result was the bankruptcy of Lehman Brothers and other financial institutions. Governments around the Western world foolishly and hubristically decided that, rather than imposing losses on bondholders, they would recapitalise firms themselves and offer sovereign guarantees to bank bonds. This exercise in denial transferred the massive losses of the banking sector onto the balance sheets of governments.
Phase three saw governments themselves dragged down by these sovereign guarantees, beginning with Greece (the Dubai crisis of November 2009 was slightly different in nature, and I won’t explore it here). Greece was intrinsically distressed because the government was over-borrowed. But if other Eurozone governments had not found their balance sheets stretched by guarantees to their banks, the Greek crisis would not have occurred in the same way, because there would have been no serious doubt that other Eurozone members would assist the Greeks. The Greek crisis was an indirect result of the guarantees given to the banks. A more direct example is Ireland, where the sovereign, in itself, was not particularly over-borrowed. The Irish problem was a problem of the Irish banking sector, and that the costs to the Irish sovereign of supporting that banking sector were more than the sovereign could bear.
BANKS HOLD SOVEREIGN DEBT
In both the Greek and Irish cases a further banking crisis-related issue was that banks are major holders of government debt. So if governments were to default, banks would suffer losses. In a context in which it has (quite wrongly) come to be unthinkable that any bank should go bust, losses for banks are regarded as dangerous. If Portugal were to default, or even if its bonds had to be marked down significantly, then banks, particularly Spanish banks, would make losses. Since Spanish banks could already be in trouble, dragging down the Spanish government, this is regarded as dangerous.
It should be plain now that the financial crisis was not the result of some temporary technical glitch in markets, or some manipulative speculators. There are real losses involved, reflecting real changes to the long-term expected growth paths of economies. During the 2000s many people lent out a great deal of money on the basis of wrong predictions about future growth paths. That included holders of bank bonds, government bonds, and bank deposits. The bank bondholders and government bondholders particularly included pension funds. Of course, depositors and those saving for pensions are ordinary people. They are ordinary people that had invested in products – banks and pensions – that had lost so much money that in certain cases they could not service their debts. So some of these depositors and pension savers should have lost some of their money – specifically, those that had invested in the wrong companies.
It was not in Britain’s interest to bail out Ireland. That was simply part of the overall strategy of denial. If Ireland had not been bailed out, it would have imposed losses on senior bondholders. The bondholders that lost money would have included foreign bondholders. Governments in those countries might be forced to provide extra capital injections into their banks if they were not to accept losses for their bondholders. Taxpayers in smaller states, experiencing losses in this way, might wonder why they were supporting their foreign bondholders when taxpayers abroad allowed their bondholders to lose. The whole denial strategy, refusing to allow bondholders to lose money, might have begun to unwind.
CASCADING LOSSES FOR BANKS
Where do we go now? One likely route is that we inflate. The consequence of inflation will be that holders of fixed income investments – depositors and bondholders – will lose some of their money. It would have been better if only those that had deposited in the wrong institutions had lost money. But if it is politically impossible that some depositors will lose, then it is politically easy for all of them to lose – through high inflation. (Losses for depositors in particular are quite likely to be materially greater under inflation than any plausible losses they could have made if banks had entered administration.) Another possibility is that the whole strategy does indeed unwind, with losses on bondholders in certain states cascading into losses for many banks. Because states chose to guarantee bonds, bank failures will now constitute sovereign defaults. That could involve chaos in certain countries – possibly including constitutional dislocations (e.g. in Greece or Portugal).
One extreme version of this scenario would be that German taxpayers decide (quite justifiably) that the whole outrageous farrago has gone far enough and the Germans give up on the euro. That could potentially result in a significant reversal of EU integration, perhaps including a withdrawal, over time, to a core of seven or eight member states. That may sound somewhat overblown, but is precisely what Merkel, Van Rompuy and Lagarde have warned of in recent weeks. It is not out of the question any more. That in turn would involve the unwinding of the denial strategy across much of Europe, with bank bondholders losing out. Under that scenario, it would be difficult for the British sovereign to avoid coming under pressure, despite the good work the Coalition has done in addressing the deficit. It is thus extremely urgent that we devise credible mechanisms in the UK for imposing losses on the bondholders of our banks in orderly special administration regimes.
More likely, however, is that, having committed so much to the strategy (having gone “all in”), wealthier governments now see it through and provide huge bailout funds to support Portugal, Belgium and perhaps even Spain in the short term, but then impose losses from 2013 onwards, when the German constitutional court has already clarified that a new haircutting procedure will be required. The only way the euro can survive is if the Germans get their new treaty, with credible mechanisms for imposing losses on bondholders and high degrees of fiscal coordination. It’s ultimately still about the politics – just. But only just.
Andrew Lilico is chief economist at Policy Exchange