Wulff: Business as Usual Won’t Do

    by Dirk Ehnts

Reuters reports German president Christian Wulff attacks the banking sector for not learning from the crisis:

Die Ursachen der Finanzkrise seien nicht beseitigt, warnte das Staatsoberhaupt am Donnerstag auf dem Deutschen Bankentag in Berlin: “Ohne einen grundlegenden Kurswechsel drohen neue Finanzkrisen.” Noch eine Rettungsaktion mit Steuermilliarden könne sich der Staat nicht leisten.

The sources of the financial crisis are not neutralized, Wulff warned and is quoted to have said: ‘Without a major change of policy new financial crises loom’. Another bail-out by the tax-payer would be impossible. This reminds me of former president Horst Köhler, who said the same thing in November 2008, as reported by the Spiegel:

Als Konsequenz aus der Finanzmarktkrise forderte Köhler eine “grundlegende Erneuerung des Bankgewerbes”. Teile der Finanzbranche hätten sich von der Realwirtschaft abgekoppelt.

So, as a consequence of the financial crisis Köhler demands a ‘fundamental reconstruction of the banking sector’. Parts of the financial sector have uncoupled from the real economy.

Do We Trust Markets?

The big picture in the background is this: politicians have deregulated the financial sector since the 90s, shifting responsibility to the financial sector. These have behaved irresponsible, and now politicians are under pressure to do something. The German president, by the way, is not a politician but the highest representative of the country and as such without political power. Therefore, he has no leverage on the bankers and of course everybody knows that.

This is exactly where macroeconomic becomes relevant. Do we ‘trust’ markets, or do we embed those markets in a regulatory environment? We know about market frenzies, animal spirits and herding behavior. Nevertheless, the policy consensus was to let the market regulate itself, which led to serious under-regulation. European banks invested too much money in the periphery, mostly into real estate. These investments did not increase competitiveness in the respective country, which would have helped to repay those huge foreign loans.

Foundations of Sand

When it became clear that the real estate was build on sand, the bubble burst and countries like Ireland and Spain got into trouble. It is important to analyze what exactly happened and how incentives could be so misaligned as to produce such a situation. Sadly, there is no financial crisis commission in Europe as there was in the US.

This is sad because it seems that banking has been completely transformed in the last decade. By securitizing loans and then entering into repos, the financial sector can create additional money. Also, derivatives can be used to balance risks, while in the background counter-party risk increases. This is new, and most central banks have not understood what this means. Alan Greenspan cut through the complexity by arguing that the markets work well and would be able to better deal with risk. This was a simple idea on a complex issue. However, the complex issue is still there, while the idea is discredited.

High Speeds without Brakes

The new thing about securitized loans is that banks can make a loan, collect a provision, and then sell it to somebody else. It is mainly off the books then, and the bank can proceed to repeatedly making additional loans. The hand brake is removed, banks don’t need to borrow fresh money to make loans. Loaning money becomes a race, since banks can supply credit indefinitely. Where before the amount of savings attracted from customers in a competitive environment (more or less) provided a ceiling, international capital markets now stood ready to buy up securitized loans and provide fresh money for another round of loans.

The financial crisis was the result of too much lending to the wrong customers. It is not the total amount of debt that is the problem, it is the distribution of debt. Households that are not able to repay hold too much debt, they shouldn’t have been able to borrow as much in the first place. Macroeconomic theory is not without fault: many people believed that low interest rates are good for business, while in fact they weren’t.

Crowding Out

Too little attention had been paid to the amount of lending going on. Foreign capital inflows in the US crowded out the savings of US households, which found out that yields were below the US inflation rate. The managers of US savings had to move into more risky assets in order to increase the purchasing power of their US clients, ultimately investing hundreds of billions in mortgage-back securities.

The money supply, or better credit supply, is neglected in inflation-targeting models like those of Michael Woodford. Nevertheless, given some interest rate the amount of credit lent is not trivial. Lending too much at low interest rates, where it becomes hard to screen borrowers, can lead to a fall in the natural rate of interest in the future, since credit has been used to promote non-productive investment. This would mean that the natural rate of interest is not exogenous any more, since it is determined at least partly by the credit supply of the past. The New Neo-classical Synthesis is then an edifice built on an assumption which reality has proven to be wrong – the natural rate of interest is not independent from the past’s monetary policy.

Past as Prolog

There is a huge gap in monetary macroeconomics. It becomes very obvious in Europe, where inflation is now way above the 2% ceiling set by the ECB. While some regions experience strong inflation, others are in deflationary territory or somewhere between. The countries which have borrowed strongly from abroad in the recent past have lower inflation rates than the group of net exporters. How can this be, if money is neutral and capital flows from the past should have no influence on economic activity today?

 Dr. Dirk Ehnts is a research assistant at the Carl-von-Ossietzky University of Oldenburg (Germany). His focus is on economic integration and economic geography, covering trade, macro and development. He is working at the chair for international economics since 2006 and has recently co-authored a book on Innovation and International Economic Relations (in German). Ehnts has written at his own blog since 2007: Econblog 101.  Curriculum Vitae.