In a long, but well worth reading speech, Dr Jens Weidmann President of the Deutsche Bundesbank paints an interesting picture of what happened, and why, and what has, and needs to still be done.
I will pick out just five sections, which to me at least, resonate with the current Australian situation.
Walter Eucken, founder of the Freiburg school and a pioneer of the social market economy, condensed the liability principle into a simple formula: Whoever reaps the benefits must also bear the liability.
This tenet was so dear to him that he declared it a constitutive principle of our economic order – for, in his view, economic agents will make responsible decisions only if the liability principle is enforced.
For instance, when banks become so big that their failure could bring the entire financial system to its knees, they can rely on politicians to throw them a lifeline if they run into difficulties. Thanks to this implicit insurance policy against the risk of insolvency, the banks benefit from a funding advantage even in normal times, as investors perceive the risk of default to be lower, and the capital market, deeming them too big to fail, therefore cuts them a certain amount of slack.
Furthermore, complex financial market products and confusing market structures had caused a fog to descend on the financial markets, with the resulting lack of transparency likewise serving to help drive the mispricing of risk. As a result, many banks were therefore undercapitalised in terms of their balance sheet risk.
But the rules that apply to enterprises, banks and investors must ultimately apply to governments, too. Their purse strings also tend to be loosened if they are absolved, either in part or in full, from bearing the financial consequences of their projects. In a monetary union, the impact of one country’s debt – felt in the form of rising interest rates – becomes more widespread across all of the other member states, not only because of the single capital market but also, similarly to the response to the too-big-to-fail problem, it makes sense for member states to come to each other’s rescue during times of crisis. To this extent then, too, there is a greater incentive to run up debt.
The interest rate environment led to a “search for yield”. What’s more, thanks to the low interest rates, low-income households were also able to shoulder the debt. At the same time, homeowners’ debt levels were falling as a result of ever-rising property prices, irrespective of their mortgage repayments. In the United States, many homeowners used this opportunity to refinance and take out additional mortgages. Borrowers became all the more vulnerable to rising interest rates and falling property prices, culminating in the subprime crisis of 2007.
To make matters worse, the bursting of the property price bubble in countries such as Ireland and Spain shook the banking system, which had helped to finance the construction boom on a large scale. Negative feedback effects of government support measures included a drastic deterioration in public finances, which intensified the banking crises in these countries even further. This was because banks held sizeable amounts of bonds from their own countries.
Just like so many others, Queen Elizabeth II also asked the simple, yet not so easy to answer question during a visit to the London School of Economics in the spring of 2009:
Why did no one see it comingThe reputation of economists has undoubtedly suffered as a result of the crisis.
In his book “The Art of Thinking Clearly”, the Swiss author Rolf Dobelli writes: in 2007, economic experts painted a rosy picture for the coming years. However, twelve months later, the financial markets imploded. Asked about the crisis, the same experts enumerated its causes: monetary expansion under Greenspan, lax validation of mortgages, corrupt rating agencies, low capital requirements, and so forth. In hindsight, the reasons for the crash seem painfully obvious, and yet not a single economist (…) predicted how exactly it would unfold. On the contrary: rarely have we seen such a high incidence of hindsight experts.
The hindsight bias Dobelli goes on to write, is one of the most prevailing fallacies of all. We can aptly describe it as the ‘I told you so’ phenomenon.
And so the recent financial crisis will not have been the last crisis that we encounter. This is assured by the “This time is different” syndrome, as described by Carmen Reinhart and Kenneth Rogoff. Its core consists of the firm belief that financial crises only happen to other people in other countries; a crisis cannot occur here and now in our country. We are doing things better, we are smarter, we have learned from past mistakes.
But even if we do not fall for the “This time is different” trap, even the best economists in the world are not exactly sure what will trigger the next crisis.
