Financial and Monetary Policy Studies 42 Beniamino Moro Victor A. Beker Modern Financial Crises Argentina, United States and Europe Financial and Monetary Policy Studies Volume 42 SeriesEditor AnsgarBelke,Essen,Germany More information about this series at http://www.springer.com/series/5982 Beniamino Moro (cid:129) Victor A. Beker Modern Financial Crises Argentina, United States and Europe BeniaminoMoro VictorA.Beker DepartmentofEconomics DepartmentofEconomics andBusiness UniversityofBelgranoandUniversity UniversityofCagliari ofBuenosAires Cagliari,Italy BuenosAires,Argentina ISSN0921-8580 ISSN2197-1889 (electronic) FinancialandMonetaryPolicyStudies ISBN978-3-319-20990-6 ISBN978-3-319-20991-3 (eBook) DOI10.1007/978-3-319-20991-3 LibraryofCongressControlNumber:2015946316 SpringerChamHeidelbergNewYorkDordrechtLondon ©SpringerInternationalPublishingSwitzerland2016 Thisworkissubjecttocopyright.AllrightsarereservedbythePublisher,whetherthewholeorpartof the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilarmethodologynowknownorhereafterdeveloped. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publicationdoesnotimply,evenintheabsenceofaspecificstatement,thatsuchnamesareexempt fromtherelevantprotectivelawsandregulationsandthereforefreeforgeneraluse. Thepublisher,theauthorsandtheeditorsaresafetoassumethattheadviceandinformationinthis book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained hereinorforanyerrorsoromissionsthatmayhavebeenmade. Printedonacid-freepaper Springer International Publishing AG Switzerland is part of Springer Science+Business Media (www.springer.com) Preface This book is devoted to the analysis of the three main financial crises which happened in the present century. The first one was the 2001 Argentina’s default onitsexternaldebt;thesecondwastheAmericansubprimecrisis;andthethirdwas the European public debt and banking crisis. In fact, the recent Great Crisis has extendedovertwoperiods:thefirstonecoveredthe2007–2009subprimecrisisin theUSA,whilethesecondtooktheformofatwinsovereigndebtandbankingcrisis inEuropeafter2010andinsomerespectspersistsin2015. Theseeventshaveledtoincreasinginterestonthesubjectoffinancialcrises,to which economists had paid almost no attention during the optimistic years of the so-called Great Moderation, which cover the last two decades of the twentieth century following the two oil crises that happened in the 1970s. However, as ReinhartandRogoffexhaustivelyshow,financialcrisesandsovereigndebtdefaults are far fromstrange eventsineconomichistory, inboth lessdevelopedaswell as developedcountries. While in 2003, Padma Desai, from Columbia University, could still assert that therewasabigdifferenceinthedebtmanagementbetweendevelopedandemerg- ingcountries,eventsafter2007showthatthisisnolongervalid.Inspiteofbeing endowed with a sophisticated network of financial institutions and supervisory regulatory agencies, the US economy was hit by a financial crisis that has much incommonwithpreviousepisodesinemergingcountries.Thesamehashappened intheEuropeanUnioninthelastyears.Moreover,thepoliciesbeingundertakenby crisis-hitcountriesaresimilartothoseArgentinatriedin2001initsdesperateeffort tosavethepeso-dollarpeg. Undoubtedly, the financial crisis damaged the reputation of economics. The institutional changes that made the 2007–2008 crisis possible were inspired by the mainstream belief based on the self-reliance of utter competition, rationality, and efficiency; the same origins had the analytical models used to build the subprimemortgagesecuritizationpyramidthatnearlyblewupthefinancialsystem intheUSA. v vi Preface Thepurposeofthisbookisthreefold.First,togiveapictureofthreeepisodesof modern financial crises. Second, to analyze what went wrong with mainstream economic theory, which noteven took into consideration the possibility ofsuch a kindofeconomicturmoil.Third,toreviewmacroeconomictheory,byreevaluating Keynes’s original contribution, on one side, and by taking account of the most insightful analysis of Neoclassical theory, on the other. We point out the need to rebuilt macroeconomics with a view on studying economic illness of modern economies,ratherthantryingtoprovetheirlongruntendencytoequilibrium. Studyingeconomicpathologiesandhowtocurethemshouldbeencouragedin bothKeynesianandNeoclassicalschoolsofthought,whilefewerresourcesshould be devoted to merely showing why an economy is in good health. It is time to recover the contributions on economic crises by authors like John Kenneth Gal- braith, Charles Kindleberger, John Maynard Keynes, and Milton Friedman. They cannotbeignoredbyanyeconomistnowadays. Thebookisorganizedasfollows.PartI,whichcontainsonlyChap.1,introduces onthemaincharacteristicsoffinancialcrises.Itisthecombinationofasymmetric information and illiquidity that gives rise to the possibility of a banking crisis, a situationwherebyalldepositorswanttheircashback.Asecurities-basedfinancial systemhasthesameattributesastheclassicbankingbusinessmodel.Inbothcases, a financial crisis is associated with an increase in demand for liquidity or more liquidsecurities.Thisputsstrainonthebalancesheetsofthoseintermediarieswho provideliquidityinfinancialmarkets:theirassetsfallinvalue,includingsovereign bondsoftroubledcountries,andtheirliabilitiesincreaseinvalue.Torestoretheir ownfinancialequilibrium,thoseintermediariesselltheirassetsinasituationwhere buyers are relatively fewer. Securities prices fall further, and this causes “panic,” the “flight to quality,” the “run,” or whatever one chooses to call it. Short-term creditdriesup,includingthenormallystraightforwardrepurchaseagreement(“the run on repo”), interbank lending, and commercial paper markets. This panic is usuallyfollowedbyaverysharprecession. PartII,whichcontainsChap.2,isdevotedtotheanalysisofthe2001Argentine default. A detailed presentation is made of the events which led to Argentina’s external debt repudiation. In particular, the role of the IMF is pointed out and the lessonswhichemergefromthisexperienceareemphasized.Infact,itisverydifficult tounderstandhowArgentina’sexternaldebtlargelyincreasedinthe1990sdespite justcomingoutfromdefaultwithouttakingintoaccountthatinthe1990sArgentina wasconsideredthebestpupiloftheIMF,theWorldBank,andtheUSgovernment. TheIMFplayedakeyroleinrestoringconfidenceinArgentinabycapitalmarkets. So,itseemstobeclearthataprimaryresponsibilityinthe2001publicsectordebt crisis was played by the IMF endorsement of an economic scheme which was doomedtofail. PartIIIis devoted totheAmerican2007–2009subprime crisis.Itcontainstwo chapters.Chapter3discussestheAmericansubprimemeltdown.Theroleofbanks and rating agencies that created and certified as almost risk-free securities assets that were actually highly risky—as the events after 2007 overwhelmingly showed—is pointed out. Credit rating agencies played in the American crisis the Preface vii same role as the IMF played in the Argentine case: to induce lenders to put their moneyintobuyingsecuritiesofdoubtfulcollectability.Inparticular,theroleofthe so-called shadow banking system which emerged during the last 30 years is highlightedaswellasitsresponsibilityincreatingtheconditionsforapanic. Chapter4explainsthatthistimethepanicfirstlytookplaceintherepomarket, which suffered a run when “depositors” required increasing haircuts. Fears of insolvency reduced interbank lending, and this so-called “run on repo” caused temporary disruptions in the pricing system of short-term debt markets. The subsequent crisis reduced the pool of assets considered acceptable as collateral, resulting in a liquidity shortage. With declining asset values and increasing hair- cuts, the US banking system was effectively insolvent for the first time since the GreatDepression. Part IV is devoted to the European debt crisis. It contains three chapters. Chapter 5 analyzes how, via the banking system, the financial contagion was extended from the USA to Europe. In fact, we observe the extension of the Great CrisisfromtheinternationalbankingsystemtotheEuropeansovereigndebts.The problemisthattheexpansionaryfiscalpoliciesofdeficitspendingimplementedby most States to tackle the crisis have created very large public deficits. To save banks,privatedebtbecamepublicdebt.Atthesametime,withdeterioratingpublic finances,sovereignriskhasincreasedandworsenedbank’sbalancesheets.Infact, it is really a sequence of interactions between sovereign problems and banking problems.Thefullexplanationoftheseinteractionsalsofocusesontheimbalances of European Monetary Union (EMU) countries balance-of-payments. The European crisis has shown that it can spread quickly among closely integrated economies,eitherthroughthetradechannelorthefinancialchannel,orboth. Chapter6 explainswhy, inthe European crisis, TARGET2 payment system of EMUcountriesbecamecrucial,reflectingfundingstressinthebankingsystemsof most crisis-hit countries. In this context, the ECB has assumed a crucial role to overcome the financial crisis. Anyway, a deep depression followed the financial turmoil. To promote a full economic recovery in Europe, a strict interconnection betweensinglecountriesfiscalpoliciesandtheECB’sautonomousmonetarypolicy is necessary. In this regard, in the medium term, a successful crisis resolution requiresmorepoliticalintegrationofEMUcountries,whichshouldincludeafiscal unionandabankingunion.However,intheshortrun,apromptrecoveryisessential to get out of trouble, and this requires that surplus countries (specially Germany) expandaggregatedemandandletdomesticwagesandtheensuinginternalinflation rateincrease. Chapter7makesadistinctionbetweenafirstgroupofEuropeancountrieswhose debt problems have roots before 2007, but did not worsen significantly after that year, and a second one of new highly indebted countries. Among them, Spain appears as a special case. The development of the indebtedness process in these three different types ofcountriesallowsisolatingthe factors which weredetermi- nant in each case. The conclusion is that the European indebtedness process does not accept a unique explanation and that its solution will necessarily require resourcetransfersfromtherichertothepoorercountriesoftheEurozone. viii Preface PartVisdevotedtotheimpactoftheGreatCrisisoneconomicthought.Italso contains three chapters. Chapter 8 deals with the theoretical debate on the Great Crisis,whichcontrastKeynesiantoNeoclassicaleconomists.AccordingtoKeynes- ians,thecentralcauseoftheprofession’sfailuretoforecasttherecentGreatCrisis is the abandoning of Keynesian theory, and the prevailing of monetarism and neoclassical vision that whatever happens in a market economy must be right. AccordingtoNeoclassicals,instead,economicmodelsdonotjustfailtopredictthe timingoffinancialcrises,theysaythatwecannot.Keynesianssuggestthatdeficit spending is the right policy to put the economic system in a full employment equilibrium path, while Neoclassicals think that fiscal stimulus is only a bad way to transfer money from taxpayers to inefficient bureaucrats, policymakers, and zombie firms. Anyway, Keynesians and Neoclassicals share the opinion that we needamoretighteningregulationoffinancialmarkets.Commercialbanks,whoare allowed tomanagesystemiccontracts likebankdeposits,andforthatreason they have access to the lender of last resort, should be kept strictly separated from investment banks, hedge funds, and other financial speculative institutions, none ofwhichshouldbeconsideredtoobigtofail. ThepurposeofChap.9isthreefold.First,itseekstoclarifywhateconomicsis guiltyof;second,tospelloutwhatsortofscienceeconomicsis,whatislegitimate toexpectfromitandwhatisnot;and,third,todiscusstheflawsofeconomicsand howtocorrect them.Itisarguedthatwhathappened withthecrisiswasacaseof malpracticebyhundredsofprofessionalsinbanksandratingagenciesthatcreated andcertifiedasvirtuallyrisk-freesecuritiesassetsthatwereactuallyhighlyrisky,as the events after 2007 overwhelmingly demonstrated. Such a massive case of malpracticeexposeddeepfailuresintheregulatorysystem. Chapter10discussestheimpact oftheUSfinancialcrisisoneconomictheory. Ananalysisismadeoftheresponsibilityofeconomicsandeconomistsinthecrisis andhowtoredirecteconomicsresearchagendatoaddressrealeconomicproblems instead of building elegant models with little, if any, relationship with policy and practical issues. In particular, the predictability capability of standard economic modelsisdiscussed.Suggestionsineconomictheorizingaremadesoastoprevent thecrisisfromhappeningagain.Whatthisimpliesformacroeconomicsisempha- sized. Readers are reminded of the origin of macroeconomics as a branch of economics; a claim is made to reevaluate Keynes’ original contribution to eco- nomic analysis and to return to Keynes’ thoughts, which have been ignored or misstatedduringthepast40years. Finally,PartVIcontainstwochapters.Chapter11dealswithcurrentissuesand policies regarding the last updated developments of the three crises dealt with in thisbook:inArgentina,UnitedStates,andEurope.Argentinarestructureditsdebt in2005withasignificantreduction,whichwasacceptedby76%ofthecreditors andresumedpaymenttothem.In2010,aseconddebtswapwasofferedwhichwas acceptedbyanother17%ofthecreditors.So,only7%ofthebondholdersrejected thetermsofthedebtexchanges,whichanywayposessomeopenquestions.Inthe USA,theconsequencesoftheDodd–FrankActareanalyzed,whileintheEMUit still remains unsolved a near-defaulting situation for Greece. For all the other Preface ix EMU’s countries, the recent quantitative easing monetary policy implemented by the ECB succeeded to calm financial markets and created the right environment necessarytopromoteanewEuropeaneconomicrecovery. Chapter 12 concludes with policy recommendations to avoid crises from hap- pening again as well as on the economic theory research agenda. The role in the crises of institutions like the IMF, the banking system, and ratings agencies is underlined as well as the need for reform of the financial system regulatory and supervisory architecture. Studying economic pathologies and how to cure them should be the core of the economics research agenda in the coming years, while fewerresourcesshouldbedevotedtomerelyshowingwhyaneconomyisingood health. BuenosAires,Argentina VictorA.Beker Cagliari,Italy BeniaminoMoro June2015