What the eurozone crisis teaches us about the subprime crisis

Consider the following:

Banks pour huge amounts of money into one particular asset class.  They are encouraged to do this by public policymakers, although there is some dispute about whether that was the main reason for their decisions.  These assets have a long tradition of doing well, although a close look at the evidence would have raised red flags.  The asset market in question suddenly takes a big dive as default risk increases sharply.  This drags down many large banks, forcing policymakers to provide assistance.

What have I just described?  The sub-prime fiasco or the PIGS sovereign debt fiasco?  I’d say both.  I’d say these two crises are essentially identical.  (I should clarify that by “essentially identical” I mean in essence, not in every detail.)

Of course the sub-prime crisis came first, so let’s consider the dominant (progressive) narrative of the sub-prime crisis.  If you read the mainstream media you will see it described as a sort of morality play; the evils of deregulation, which allowed the greedy big banks to take highly leveraged gambles with other people’s money, and then off-load the risk on to both taxpayers and unsuspecting buyers of MBSs.  Or something like that.

Obviously it would be impossible to tell a similar story for the sovereign debt crisis.  No regulator in his right mind would ever contemplate telling big banks not to buy European sovereign debt because it’s too risky.  Indeed the previous attempt at regulation (Basel II) encouraged banks to put funds into those “safe investments.”  Blaming the euro crisis on deregulation doesn’t even pass the laugh test.  The criminals were the regulators themselves.  Is the term ‘criminal’ hyperbole on my part?  Not at all.  Suppose Enron executives had used the same accounting techniques as the Greek government.  They’d all be in jail.  And as for Berlusconi, what can one say about a leader who continually passes laws exempting the Prime Minister from the very crimes he was accused of having committed?  As Keynes said:

Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.

So here’s what I wonder.  Assume the eurozone crisis was obviously not caused by deregulation and greedy bankers.  Then if the sub-prime crisis was basically identical, at least in its essence, how can deregulation be the root cause of the former crisis?  I’m not saying it’s logically impossible, but doesn’t it seem much more likely that there’s a deeper systemic problem, which transcends this glib cliche?  I’m going to leave you with two very different items, which together seem to point to the flaws in our financial system being very deeply ingrained, far too deep to fix with any sort of politically plausible “reforms.”

The first is a heartfelt lament by Steve Waldman, from the recent Kauffman Foundation blogger’s conference.  Steve wonders why after all the outrage in late 2008, nothing fundamental has actually changed.  Even with Obama elected in 2008 and taking office along with a heavily Democratic Congress.

The other item is a very funny Jon Stewart routine (courtesy of Greg Mankiw.)   He shows that one of the progressive political figures who showed the greatest outrage, then left the government, set up his own investment company, used leverage even greater than Lehman Brothers, used political pull to fight off the regulators when they complained, and eventually drove his firm into a messy bankruptcy.

Why is all this so hard to change?  Why didn’t we just adopt the Canadian model, which never has these problems?  I don’t really know, but something tells me that the problems go much deeper than you might imagine when reading cliched morality tales about “deregulation.”

PS.  Of course you and I know that the real problem was (mostly) nominal; tight money turned medium size debt fiascoes into catastrophic financial crises.


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47 Responses to “What the eurozone crisis teaches us about the subprime crisis”

  1. Gravatar of Mark Mark
    16. November 2011 at 07:36

    “PS. Of course you and I know that the real problem was (mostly) nominal; tight money turned medium size debt fiascoes into catastrophic financial crises.”

    I was waiting for the money shot the whole time.

  2. Gravatar of K K
    16. November 2011 at 08:26

    Scott: “Why didn’t we just adopt the Canadian model, which never has these problems?”

    Whoa! Did you miss the $30Bn of asset backed commercial paper (ABCP) backed by subprime CDOs and 30X levered LSS (leveraged super senior) tranches that would have taken down the Canadian financial system (and done some major damage on Wall Street) if the Canadian government hadn’t stepped in to backstop it all? Canadians are every bit as levered as Americans. Just that *all* of our mortgage risk sits on the government balance sheet (CMHC our version of your GSEs) which has pushed off the day of reckoning.

    The real question is *why* do the regulators/legislators fail? I see a few important answers:

    1) The regulations are viewed as a price of explicit/implicit government support. A corollary is that if you follow the rules you will be entitled to a bailout. This means that the incentive is to maximize profit subject to following the rules, rather than maximizing profit relative to total actual risk. Profit maximization becomes a way to arbitrage the rules rather than a sane optimization. This process will automatically exploit every conceivable regulatory defect, and thereby shift the maximum possible expected loss onto the public balance sheet. The lower tail of risk simply isn’t there in the risk takers optimization calculation. Once you take away the incentive to actually *think* about the real risk one is taking, you guarantee failure in the most spectacular way conceivable and at the greatest possible cost to everyone else.

    2) Essentially they are corrupt. The legislators are in many cases quite directly on the take. The regulators are preparing careers on Wall Street.

    The solution is not to add regulation (see 1 above) or regulators (see 2). The solution is to get rid of both and to end all ties between government and the financial sector. That includes ending deposit insurance. There are excellent ways to accomplish this that would result in a far more efficient economy than our current disaster of a financial system. But that’s probably OT.

  3. Gravatar of ssumner ssumner
    16. November 2011 at 09:15

    Mark, I saved the best for last.

    K, I completely disagree. We’ve had three huge banking collapses in the past 100 years. Canada has had zero. The difference is like day and night. They never went in for the subprime madness.

  4. Gravatar of John John
    16. November 2011 at 09:24

    Scott, just as clarification for the ignorant, what is it about the Canadian system that supposedly prevents this? Is it their regulatory structure? Also can we clarify what ‘this’ is? Bubbles encouraged by public policy makers? I thought freshwater types didn’t believe in bubbles.

  5. Gravatar of K K
    16. November 2011 at 09:30

    Scott: we are slower on the uptake. CMHC was massively slashing underwriting standards (0% down, 40 yr amortization). It’s just that they were a few years behind the curve. Can you point to anything particularly clever about Canadian regulation or are you just basing it on the lack of explosions historically. If you want to understand the historical performance you are better off looking a way higher oligopoly profits due to enormous barriers to entry. You can’t just open a bank in Canada, you know. You need to be a serious player.

    And while you may completely disagree with my take on Canada (we’ll see how that plays out over the next few years – I’m making a note of this disagreement) that wasn’t at all the main point of my comment. Do you *completely* disagree with all of it?

  6. Gravatar of K K
    16. November 2011 at 09:54

    And like I said, Scott. Canadian banks don’t have *any* mortgage risk. Any mortgage with less than 25% down is government guaranteed. 100% of it. Is that what you find to be such a good idea?

  7. Gravatar of Morgan Warstler Morgan Warstler
    16. November 2011 at 10:02

    Mother F’er!

    I’m telling ya, the most fitting rational narrative for this stuff is MINE.

    The 81-99% OWN MORE STUFF than everybody else put together. They ALL VOTE, and they make up the Tea Party.

    It is so dumb that Waldman and Stewart don’t just EAT IT, and accept that the 81-99% DESERVE TO BE THE BOSS.

    The the 81-99% alone have the resources and wherewithal to chew up the top 1%, and THEREFORE the deep thinkers who put themselves out there as logical rational people….

    HAVE TO COUNSEL the bottom who they claim to support to FOLLOW the Tea Party.

    You can’t claim to be a political chess player and simultaneously gloss over the “MONOPOLY OF POWER” is spread out over the 81-99%.

    They are LYING.

    Waldman isn’t what he claims to be, anyone talking about taking down the top 1%, who doesn’t CHASE the Tea Party – is just talking.

  8. Gravatar of John John
    16. November 2011 at 10:21

    “Forcing policy makers to provide assistance.” Really? It seems like if they hadn’t provided assistance the market would have worked to solve the underlying problems. The banks that bought the sub-prime assets would have had to eat losses, some would have gone out of business, and the more far sighted would have been able to take over and pick up the pieces. Creative destruction in action.

    Instead of that the governments of the US and Europe decided to fight markets and undercut the notion of private property. No economic system will work if people aren’t held accountable for their actions

  9. Gravatar of W. Peden W. Peden
    16. November 2011 at 10:29

    John,

    Agreed. The entire financial system was MASSIVELY destabilised in the long-run by the bailouts of 2008. Barring unlikely free-market reforms or crippling regulations, we are on our way to another financial crisis caused by taxpayer-subsidised risk-taking.

  10. Gravatar of Vincent Vincent
    16. November 2011 at 10:42

    knowing that the “canadian model” is essentially heavy regulation, i’m having a hard time reconciling those two statements:

    - “Why didn’t we just adopt the Canadian model, which never has these problems?”

    - “[...] the problems go much deeper than you might imagine when reading cliched morality tales about “deregulation”

    also, back when the american financial system *was* heavily regulated, was there ever a comparable crisis?

  11. Gravatar of dwb dwb
    16. November 2011 at 10:46

    I think that the parallels between the subprime crisis and the soveriegn crisis are only superficial. lax lending standards (“liar loans”), no one (including regulators) were minding the store or doing due diligence. thats a form of too-easy money. real-estate is boom and bust, has been and always will be. Everyone is complicit. Its not DEregulation, but failure to enforce the regs we already had.

    europe is the opposite. yes, greece has some issues – but for it to spread to Italy and France, its because all of Europe is effectively borrowing in deutchmarks and ECB is not acting as a lender of last resort. Germany keeps worrying about hyperinflation of the weimar republic while everyone else is worried about the failure of the gold standard.

    Most of europe would be fine if money was easier.

    http://www.spiegel.de/international/europe/0,1518,797666,00.html

  12. Gravatar of Morgan Warstler Morgan Warstler
    16. November 2011 at 11:00

    UK adopts rudimentary version of my Auction the Unemployed plan:

    http://www.guardian.co.uk/society/2011/nov/16/young-jobseekers-work-pay-unemployment

  13. Gravatar of ssumner ssumner
    16. November 2011 at 11:08

    John, “This” is certainly not bubbles. I believe in the EMH, but others call any sharp rise in asset prices a bubble. By that definition Canada has them too. “This” is a big banking crisis that leads to bank failures and/or costly bailouts. That’s what Canada lacks.

    I assume their regulatory structure plays a role, although culture and other factors also might play a role. The history of US branching laws also hurts us.

    K, I shouldn’t have said I completely disagree. I would be thrilled if we broke all ties between banks and government, but I just don’t see that happening. So I still see the Canadian system as the lesser of evils. Suppose they have a huge crisis in the next 5 years and we don’t. I’d still say their sytem is way better, as that would be 1/3 as many big crises as we’ve had in the last 100 years.

    You said;

    “And like I said, Scott. Canadian banks don’t have *any* mortgage risk. Any mortgage with less than 25% down is government guaranteed. 100% of it. Is that what you find to be such a good idea?”

    How much has this cost the government? And I thought they didn’t allow mortgages of less than 20% w/o mortgage insurance.

    We are also more reckless in commerical lending, which is what caused many of the bank failures in the US during this crisis.

    More to come . . .

  14. Gravatar of dtoh dtoh
    16. November 2011 at 11:10

    TBTF will never go away.

    Therefore, you have to control leverage. The easy and elegant way to do this is to allow the Fed to flexibly set equity (i.e.capital) reserve ratios for assets depending on asset class, maturity, length of holding, etc.

  15. Gravatar of dwb dwb
    16. November 2011 at 11:37

    TBTF will never go away.

    Therefore, you have to control leverage. The easy and elegant way to do this is to allow the Fed to flexibly set equity (i.e.capital) reserve ratios for assets depending on asset class, maturity, length of holding, etc.

    The fed and OCC already have this power. between basel requirements, stress tests, power to veto dividend and other capital spends, and other levers, they have effective control over leverage now. its ony to what extent they are using it.

    as far as TBTF, thats a false argument. If we have a bunch of small savings and loans all geared towards the same market – real estate – it causes the same problems and can be just as costly. look back at how much was spent on the S&L crisis and the ensuing recession.

  16. Gravatar of Becky Hargrove Becky Hargrove
    16. November 2011 at 11:49

    I enjoyed both of the videos very much, and Steve’s discussion about policy entrepreneurs certainly is food for thought. His point about bloggers producing social capital is spot on. Unfortunately, book publishing can no longer fulfill the job of persuation in society that it once did, but the Internet takes on that role and much more. Steve need not worry about anyone thinking of the blogosphere as just entertainment. In the future, lines between work, socialization, education and political participation will all be blurred, and today’s discussions show how that might happen.

  17. Gravatar of Morgan Warstler Morgan Warstler
    16. November 2011 at 11:56

    Thanksgiving dinner costs up 13%!

    http://green.autoblog.com/2011/11/15/abc-news-says-gas-prices-might-affect-holiday-spending/

  18. Gravatar of Luis H Arroyo Luis H Arroyo
    16. November 2011 at 12:10

    Scott. if I understand you, you are saying that the euro crisis and the subprime crisis have the same roots.
    I agree with you until some degree. That the iliquidity produces insolvency.

  19. Gravatar of dtoh dtoh
    16. November 2011 at 12:13

    The latest Basel recs have not been implemented. They’re inflexible, too complicated, will never catch up to the market, and take 10 years to change.

    The Fed needs the flexibility to be able to for example boost the capital reserve ratio to 70% on any MBS securities backed by loans in South Florida, or set it to zero when the economy is in the crapper.

    The S&L crisis was bad because unlike TBTF, the S&Ls got not an implicit guarantee but an explicit guarantee. The way to implement effective equity reserve ratios is to tie it to an explicit guarantee and make it mandatory for any institution that is TB(or too important)TF and make it voluntary for any other institutions that want to join.

  20. Gravatar of ChacoKevy ChacoKevy
    16. November 2011 at 12:27

    Morgan: The source for the Thanksgiving price increase story.

    http://www.fb.org/index.php?action=newsroom.news&year=2011&file=nr1110.html

    ““Turkey prices are higher this year primarily due to strong consumer demand both here in the U.S. and globally,” said John Anderson, an AFBF senior economist.”

    ““Demand for U.S. dairy products has been strong throughout the year and continues to influence retail prices, as demand for higher-quality food products grows globally,” Anderson said.”

    There’s more, but the analyst indicates increases in both costs and demand. Of course, depends if you believe the narrative of an industry advocate.

  21. Gravatar of Jon Redden Jon Redden
    16. November 2011 at 13:00

    I guess the real question is: What is the next “supposedly safe” investment vehicle (after packaged mortgages and sovereign debt) and how can I short it :)

  22. Gravatar of Silas Barta Silas Barta
    16. November 2011 at 13:13

    Consider the following:

    Central banks pour huge amounts of money into targeting one particular econometric. They are encouraged to do this by Scott_Sumner, although there is some dispute about whether that was the main reason for their decisions. This econometric has a long tradition of correlating with good economic times, although a close look at the evidence would have raised red flags.

    Then, the correlation breaks down and they regret having equated expectation of NGDP with economic goodness.

  23. Gravatar of Doc Merlin Doc Merlin
    16. November 2011 at 13:31

    “K, I completely disagree. We’ve had three huge banking collapses in the past 100 years. Canada has had zero. The difference is like day and night. They never went in for the subprime madness.”

    1) They don’t have /any/ small banks. Our system on the other had has looser standards for small banks.

    2) They don’t have almost any government debt. We have crap-tons.

    3) Their banks are largely self regulated. Ours mostly see regulation as an opportunity for arbitrage.

  24. Gravatar of Doc Merlin Doc Merlin
    16. November 2011 at 13:34

    @Silas Bartas:
    “Then, the correlation breaks down and they regret having equated expectation of NGDP with economic goodness.”

    Not quite. Its more that the least harm a central bank can do is target long term NGDP. The federal government can still do lots of harm.

  25. Gravatar of Doc Merlin Doc Merlin
    16. November 2011 at 13:35

    @John Redden
    ‘I guess the real question is: What is the next “supposedly safe” investment vehicle (after packaged mortgages and sovereign debt) and how can I short it’

    a) A 4 year college degree.
    b) You can’t.

  26. Gravatar of Morgan Warstler Morgan Warstler
    16. November 2011 at 13:55

    ChacoKevy,

    I believe my own profoundly keen shoppers nose.

    Mostly, I just like reminding Scott how easy it is to RHETORICALLY FORCE him into adopting my more conservative approach to targeting NGDP.

    He’s down to 4.5%, he’ll go to 4%, hopefully before Nov 2012.

  27. Gravatar of K K
    16. November 2011 at 13:58

    Scott: You’re right. It went from 25% to 20% during the bubble because banks didn’t want to be saddled with (ridiculously under-priced) mortgage insurance.

    Either way, we are not going to worry about the 20%+ down mortgages. Not exactly where the losses are going to happen. So the Canadian banks have a ready source of large risk free profits which makes them more risk averse to commercial loans. Also, Canadian banks somehow don’t pay interest on checking or overnight *savings* deposits and haven’t done so for almost 20 years. So the “Canadian solution” is to set up an oligopoly so powerful that the resulting massive flow of rents makes them averse to actual risk taking endeavors. “Fees ‘R’ Us”. Is this less costly than the occasional blowup? It’s certainly less visible which is cool from a banker’s perspective.

    Also CMHC’s liabilities (a *massive* portfolio of all the mortgage risk in all of Canada) aren’t marked to market. Nobody’s daily p&l, no fear. Just perfect stability and complacency. And nowhere to go but up, up, up.

    dwb: I completely agree with you on TBTF. If derivatives had *anything* to do with the meltdown it was in that they enabled a much greater degree of diversification which resulted in balance sheet homogenization across the financial industry. After a while, everyone has the same balance sheet and are exposed to exactly the same disaster. The only difference is the amount of leverage (institutional risk tolerance). That’s not very resilient, but the size of individual institutions has nothing to do with it.

  28. Gravatar of Morgan Warstler Morgan Warstler
    16. November 2011 at 14:09

    JPMorgan Chase & Co. (JPM) and Goldman Sachs Group Inc. (GS), among the world’s biggest traders of credit derivatives, disclosed to shareholders that they have sold protection on more than $5 trillion of debt globally.
    Just don’t ask them how much of that was issued by Greece, Italy, Ireland, Portugal and Spain, known as the GIIPS.
    As concerns mount that those countries may not be creditworthy, investors are being kept in the dark about how much risk U.S. banks face from a default. Firms including Goldman Sachs and JPMorgan don’t provide a full picture of potential losses and gains in such a scenario, giving only net numbers or excluding some derivatives altogether.
    “If you don’t have to, generally people don’t see the advantage to doing it,” said Richard Lindsey, a former director of market regulation at the U.S. Securities and Exchange Commission who worked at Bear Stearns Cos. from 1999 through 2006. “On the other hand, if there were a run on Goldman Sachs tomorrow because the rumor was that they had exposure to Greece, you’d see them produce those numbers.”

    http://www.bloomberg.com/news/2011-11-16/jpmorgan-joins-goldman-keeping-investors-in-dark-on-italy-derivatives-risk.html

  29. Gravatar of dwb dwb
    16. November 2011 at 14:16

    The Fed needs the flexibility to be able to for example boost the capital reserve ratio to 70% on any MBS securities backed by loans in South Florida, or set it to zero when the economy is in the crapper.

    again, they have that flexibility now. large banks use internal models for risk capital charges. the fed or occ can look at their assumptions and say “be more conservative.” then we have the stress tests. most bank’s credit models are driven by unemployment – and the fed could say “hold enough capital to withstand a 13% unemployment rate.” The Fed has veto power over bank capital plans and have said no to shareholder repurchases and dividends to boost capital.

    Now, if you actually wait until the economy is in the crapper to “set it to zero” you are already two steps behind. The market will reflect the probability of a recession before GDP actually prints, and the bonds will be worth less (but not necessarily worthless!). secondly, you want your internal model to try to predict what the market value will be if there is a recession, well before the market foresees a recession.

    oh, and at origination time when the bank or GSE is writing the loan, the Fed and OCC have a lot to say about thise processes too.

    now, hindsight is 20-20, and most bank models run on hindsight. The fed could have said: please run a scenario where unemployment is 10% and home prices are down 33%. I was in meetings back in 2005 where mild scenarios like HPI down 5% two years running were discussed and were laughed at as riduculously improbable.

    and granted, the stress tests that were run were not stressful enough, in my opinion.

    but the point is, they already have the power to regulate capital and leverage as much as they want. the problem is: getting people to take ridiculously improbable scenarios seriously (like, gasp, the breakup of the Euro); and 2)thinking these scenarios up – past performance does not predict future results.

  30. Gravatar of ssumner ssumner
    16. November 2011 at 15:27

    John, Yes, “forcing” was too strong. I meant that countries felt forced to do this. Arguably they should not have, but the reality is that deflation always makes governments much more intrusive and statist. If you love statism you should love deflation.

    Vincent, You said;

    “knowing that the “canadian model” is essentially heavy regulation, I’m having a hard time reconciling those two statements:”

    Make a list of all the regulations affecting US banking, and all the regulations affecting Canadian banking. I bet the US list is 5 times longer. I’m no expert on Canada, but the Canadian blogger Nick Rowe once said that it wasn’t a question of more regulation or less regulation but different regulation.

    dwb, I disagree, I think it was mostly tight money in both cases, with some irresponsible borrowing in each case (subprime mortgages in the US, Greece and Italy in Europe.)

    Morgan, Interesting program in the UK.

    dtoh, As long as we have TBTF and FDIC, we will probably have banking crises. Unless we get very skilled at regulation. Don’t forget that after the previous crisis we raised capital requirements, and it didn’t stop this crisis.

    I’m not saying higher capital requirements are a bad idea, just not sure it will solve the problem.

    Becky, good point about blogging.

    Morgan, I hate turkey anyway. Last year I had a sushi Thanksgiving.

    Luis, Liquidity is an issue, but not the big problem.

    dtoh, You said;

    “The Fed needs the flexibility to be able to for example boost the capital reserve ratio to 70% on any MBS securities backed by loans in South Florida, or set it to zero when the economy is in the crapper.”

    I don’t see the Congressmen from South Florida approving this plan.

    Jon, US T-bonds?

    Silas, I don’t see any red flags, do you? In any case, I’m not suggesting an investment. And finally, that criticism could be made against any monetary policy, which makes it meaningless.

    Doc Merlin, I implicitly mentioned the small banks via my branching comment. I agree with point three. Point 2 is irrelevant to our banking problems (but is a valid criticism of the US.)

    K, I’m not an expert on Canada, so perhaps the costs are as big as you suggest. Is it illegal for foreign banks to have branches in Canada?

    Oddly, I agree with you on one point. The actual losses from the banking crisis are not as high as most people assume. The TARP loans were repaid, and the recession was due more to tight money than banking distress. So I’ll keep an open mind on the Canada issue.

    Morgan, Interesting. The more I learn the more convinced I become that the ECB must do something. If they must act, how about NGDP targeting?

  31. Gravatar of Richard W Richard W
    16. November 2011 at 16:04

    It seems to me that when it comes to a national banking sector we basically have two options.

    1/ You can have a highly competitive banks that drive down costs though competition. The banks will struggle to generate a return so will increase leverage and risk. Good for consumers, but they are vulnerable to a liquidity squeeze and systemic collapse. Government tries to regulate from a competitive perspective.

    2/ An uncompetitive banking sector. No need for the banks to take on excessive risk to generate returns. Bad for consumers, but the banks are not as vulnerable in a squeeze because they are not so leveraged. Government tries to regulate from a bank safety perspective.

    Trying to get safety and competition appears to be irreconcilable. It seems as if it is one or the other.

  32. Gravatar of K K
    16. November 2011 at 17:44

    Richard W:

    I think that’s a false dilemma. It’s not competition that causes excessive risk taking. It is the moral hazard that comes from being able to dump your losses on the public balance sheet. If we want risk/return optimizing banks we need to let them live and die with their risk. As long as we have deposit insurance and implicit guarantees we will continue to oscillate wildly between massive financial sector profits and massive financial sector bailouts. Bankers *love* free market capitalism. Let’s give it to them.

  33. Gravatar of Morgan Warstler Morgan Warstler
    16. November 2011 at 18:58

    http://thenextweb.com/shareables/2011/11/16/mind-blown-this-guy-broke-jeopardys-all-time-record-with-an-app/

  34. Gravatar of Peter N Peter N
    16. November 2011 at 20:41

    I don’t think you should be so quick to say the Euro crisis isn’t the bursting of a bubble. Spain had a huge property bubble as did Ireland and the UK. Greece had an economy bubble.

    They believed their economy could service a certain level of debt. They issued debt accordingly and a lot of the debt was bought by Greek banks, using “wealth” created by the stimulus of the deficit spending (on the enormously expensive Olympics for example).

    Another way to look at is that Germany and France ran large trade surpluses with the PIIGS (not a good idea inside a currency union), and loaned them the money to finance the corresponding deficits. Both sides were under the illusion that they were getting richer. German banks had lots of nice safe government bonds, and the PIIGS had goods at subsidized prices and low interest rates, since they were borrowing in Euros. This free lunch will be rather expensive.

    Now the Germans are afraid they won’t be able to afford to retire, and the Greeks know they won’t.

    As for the innocence of the banks:

    “Morgan Stanley, calculates that of the €8,000bn funding that is currently in place for the largest 91 eurozone banks, some 58 per cent needs to be rolled over in the next two years. More startling still, some 47 per cent of this funding is less than a year in duration. Much of that is in euros.”

    This was while leveraged 40 to 1!

    German banks are still leveraged over 30 to 1. This is worse than Lehman and Bear. So there is a parallel – enormous unsupervised bank leverage financed short term.

    Perhaps every bubble is bubbly in its own way. What they have in common is a great mass of people discovering they weren’t nearly as rich as they thought they were, because of a sudden devaluation of one or more asset classes.

  35. Gravatar of ssumner ssumner
    17. November 2011 at 18:24

    Richard, You said;

    “Good for consumers, but they are vulnerable to a liquidity squeeze and systemic collapse.”

    Note that the two big systemic problems (1930-33 and 2008-09) occurred in a period of sharply falling NGDP. Stabilize NGDP and we may not have systemic collapses, just individual banks that fail.

    Or maybe we still would have systemic problems. There’s only one way to find out.

    K, I agree that the moral hazard problem is underrated.

    Peter, You said;

    “I don’t think you should be so quick to say the Euro crisis isn’t the bursting of a bubble.”

    I don’t think I said it wasn’t the bursting of a bubble, I said it clearly wasn’t due to deregulation. The villains were the regulators. I agree they ran up excessive government debts, although all the debts except Greece would be payable with steady Eurozone NGDP growth. Greece is a hopeless case.

    None of your comments on leverage in any way contradict my claim about the sovereign debt crisis.

  36. Gravatar of magic magic
    17. November 2011 at 22:29

    looks like the EU is already in recession: http://ricardianambivalence.com/2011/11/18/eu-gdp-forecast-recession/

    i doubt the US or asia can resist what looks likely to be a heavy recession in the world’s largest economy.

  37. Gravatar of ssumner ssumner
    18. November 2011 at 18:51

    magic, That could be right–it’s interesting how the US is beginning to diverge. You might be right about the US being unable to avoid being pulled in, but right now the Fed seems a bit more motivated to act.

  38. Gravatar of The cause of the crisis The cause of the crisis
    19. November 2011 at 19:24

    [...] been thinking about this after reading this remarkable observation from Scott Sumner: Consider the [...]

  39. Gravatar of a2lbd a2lbd
    22. November 2011 at 04:52

    I quite see your point. Now, IMHO I do see that one can find a link between deregulation, subprimes crisis and eurozone crisis.

    First off, I do agree on your point that what little regulation was done,actually served to feed already frenzied beasts (i.e. the european governments debts).
    However this was also a direct consquence of the initial deregulation movement :
    1/ As deregulation occured, the numbers of investment opportunitues grew a thousand times. As a result, it was actually getting more an more difficult to accuretaly assess the risk of one asset as it was lost into zillions of other investment opportunities.
    2/ Many investments opportunities meant that were poorly evaluated on the risk side since there were so numerous and overlapping one onto the other, that in the end, there were no other choices for credit rating agencies to grant Eurozone government bonds a AAA rating while actually not all government were equals..

    A strongest regulation would have enforced a better legibility of the financial markets. Poor assets would not have passed as good or strong, and as a result rating agencies would have degraded some government bonds not this year but a good 10 years ago.

  40. Gravatar of John Thacker John Thacker
    22. November 2011 at 06:39

    a2lbd:

    How did deregulation increase “the number of investment opportunities a thousand times?”

    The only deregulation– as opposed to lots of new regulation– was to get rid of something that Canada had never had, and Canada never had problems. It’s a red herring, like focusing on the CRA as the root of all evil.

    And I completely fail to see how extra government regulation would cause ratings agencies to downgrade more government bonds. Isn’t that contrary to the (short-term, at least) interest of all governments? Therefore, shouldn’t you expect, all things being equal, that the more government power and regulation there is, the more pressure and power and regulation there would be to keep government bonds rated highly?

    Just look at the response of the US and French governments to downgrades and threats of downgrades.

    If you want ratings agencies to feel free to downgrade governments, then you would want to reduce the power of those governments over the agencies, not increase it. The (federally recognized) ratings agencies have privileged legal and regulatory positions; presumably the governments gets something out of it.

  41. Gravatar of Scott Sumner Scott Sumner
    22. November 2011 at 07:10

    a2lbd, I agree with John’s response. I’d add that the US banking system was very highly regulated over the past few decades. The problem is that the regulations were not effective, indeed many worsened the problem (FDIC, TBTF, the GSEs, FHS, CRA, etc etc.) I don’t claim they caused all the problems, but to the extent they had an influence, it was toward making it worse. So if regualtion made things worse, why wouldn’t more regualtion have made things even worse?

  42. Gravatar of John Thacker John Thacker
    22. November 2011 at 07:16

    Also, I’d like to add that the real problematic “increase in investment opportunities” was the creation of the Euro itself.

    Wasn’t the whole point of the Euro, from the Greek and Italian perspective, to allow them to borrow using Germany and France’s AAA debt rating? I have a hard time imagining governments allowing anything other than that– otherwise, then the Mediterranean countries wouldn’t have signed up.

    There’s simply no point in Greece and Italy throwing away their ability to devalue their currency if they weren’t going to get the AAA debt rating. Of course, that’s why they had the Maastricht requirements– another kind of regulation that didn’t work.

    The Euro was an exercise in putting the cart before the horse in order to create EUropeans from Germans, Italians, et al. It might even have worked, if a monetary crisis hadn’t hit, since it was drawing them closer together.

  43. Gravatar of John Thacker John Thacker
    22. November 2011 at 07:19

    So *of course* the internationally agreed regulation was going to specify that the Greeks and Italians got to use Germany and France’s AAA rating. What else was it going to do? “More regulation” could not possibly have changed that; the interest of the European governments was for regulation to *enforce* the AAA rating, not allow it to drop.

    It’s one thing to expect governments to restrain private corporations (they sometimes do that, and sometimes don’t.) But to expect governments to restrain themselves, and give ratings agencies more power through regulation to downgrade the governments? Unlikely.

  44. Gravatar of a2lbd a2lbd
    22. November 2011 at 12:17

    John, Scott,

    My point on credit rating agencies is this one:
    let’s imagine on a highway without any speed limit a police car whose job is only to measure the dangerosity of cars speeding past it and whose capability is only to send warning message to other cars on who is dangerous and who can be considered as safe. The only way the police car can assess the speed at which cars are running is to follow them.
    As a result, this police car is most of the time focusing on high speed sports car as potential danger and, since it has to speed up to get a clear look at them, it overlooks the dangerosity of huge trucks also going too fast for comfort but by far and large at a much lower relative speed.
    The police car thereby does not have any means to really have a look either at the engine of the fast cars or type of fuels or tyres the fast car are using, because they just do not have time for it : traffic is just to dense on this higway with too many exchange slopes.(this sort of explain the subprime debacle). Furthermore it is completely oblivious of the trucks state, always assuming that they are safe. The information it broadcast to other cars is thereby partial and ultimately biased.
    A speed limit on the highway would clearly help the police car to really understand who is supposedly going to fst and who is not.

    Now the question is what the speed limit should be…that is crucial and should be carefully considered : too low and the traffic will be congested, too high and the police car will be faced with the exact same dilemna.

    I’m European, French actually. I am quite pissed at the current credit rating agencies’ bashing that our politicians are voicing at present. But I also condider that there the same credit rating agencies have twice proven that they are inneficients.
    I feel it is a sad joke that they were not able to identify the subprime meltdown in advance and I am really furious that they have not downgraded France’s credit note when our level of debt was on the brink of reason that is ten years ago…

    I am not as knowledgeable as you guys on financial markets. My gut feeling is that deregulation combined with globalisation and lax monetary policies sent everyone in the market speeding. Until some motors broke irremediably…and we are all now crawling…

    There is something rotten in the financial kingdom and the lack of a ruling body to set it right is, IMHO quite worrisome.

    John

    I do believe that you are misreading the creation of the euro in the sense that there is no cart and no horses in the european union construction. You can’t force an ass to drink if he’s not thirsty. Likewise, you can expect european integration to play by itself. You have to gamble for it.
    Euro is a gamble. In my opinion a bold move but an astute one. I am all in favor of European federalism. And in the absence of any clear cultural will, starting with a monetary union was the only natural first step.
    The current dire straits are really interesting. It’s double or quit time. One should see the outcome. My vote is for double…

  45. Gravatar of Scott Sumner Scott Sumner
    24. November 2011 at 07:11

    a2ldb, I am just as frustrated with the regulation of our system as you are, but don’t see it quite the same way. We did have speed limits–Basel 2 set capital requirements. The rating agencies did miss the problem, but that’s to be expected any time the markets also miss he problem.

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