英国论文网:British and Dutch GDP:The spread of the cri

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The spread of the crisis to the rest of the world

12 November 2008
Iceland’s banking system is ruined. GDP is down 65% in euro terms. Many companiesface bankruptcy; others think of moving abroad. A third of the populationis considering emigration. The British and Dutch governments demand compensation,amounting to over 100% of Icelandic GDP, for their citizens who held
high-interest deposits in local branches of Icelandic banks. Europe’s leadersurgently need to take step to prevent similar things from happening to smallnations with big banking sectors.
Iceland experienced the deepest and most rapid financial crisis recorded in peacetime
英国论文网when its three major banks all collapsed in the same week in October 2008.
It is the first developed country to request assistance from the IMF in 30 years.
Following the use of anti-terror laws by the UK authorities against the Icelandicbank Landsbanki and the Icelandic authorities on 7 October, the Icelandic paymentsystem effectively came to a standstill, with extreme difficulties in transferringmoney between Iceland and abroad. For an economy as dependent on importsand exports as Iceland this has been catastrophic.While it is now possible to transfer money with some difficulty, the Icelandiccurrency market is now operating under capital controls while the governmentseeksfunding to re-float the Icelandic krona under the supervision of theIMF. There are stillmultiple simultaneous exchange rates for the krona.Negotiations with the IMF have finished, but at the time of writing the IMF hasdelayed a formal decision. Icelandic authorities claim this is due to pressurefromthe UK and Netherlands to compensate the citizens who deposited money inBritish and Dutch branches of the Icelandic bank Icesave. The net losses on thoseaccounts may exceed the Icelandic GDP, and the two governments are demandingthat the Icelandic government pay a substantial portion of that. The likely outcomewould be sovereign default.
How did we get here? Inflation targeting gone wrong
The original reasons for Iceland’s failure are series of policy mistakes dating backto the beginning of the decade.
The first casualty of the crisis:
Jon Danielsson
London School of Economic
The first main cause of the crisis was the use of inflation targeting. Throughoutthe period of inflation targeting, inflation was generally above its target rate. In
response, the central bank kept rates high, exceeding 15% at times.In a small economy like Iceland, high interest rates encourage domestic firmsand households to borrow in foreign currency; it also attracts carry traders speculatingagainst ‘uncovered interest parity’. The result was a large foreign-currencyinflow. This lead to a sharp exchange rate appreciation that gave Icelanders anillusion of wealth and doubly rewarding the carry traders. The currency inflowsalso encouraged economic growth and inflation; outcomes that induced theCentral Bank to raise interest rates further.The end result was a bubble caused by the interaction of high domestic interestrates, currency appreciation, and capital inflows. While the stylized facts about#p#分页标题#e#
currency inflows suggest that they should lead to lower domestic prices, in Icelandthe impact was opposite.
Why did inflation targeting fail?
The reasons for the failure of inflation targeting are not completely clear. A keyreason seems to be that foreign currency effectively became a part of the localmoney supply and the rapidly appreciating exchange-rate lead directly to thecreation of new sectors of the economy.
The exchange rate became increasingly out of touch with economic fundamentals,with a rapid depreciation of the currency inevitable. This should havebeen clear to the Central Bank, which wasted several good opportunities to preventexchange rate appreciations and build up reserves.
Peculiar Central Bank governance structure
Adding to this is the peculiar governance structure of the Central Bank of Iceland.
Uniquely, it does not have one but three governors. One or more of those has generally
been a former politician. Consequently, the governance of the Central Bank
of Iceland has always been perceived to be closely tied to the central government,
raising doubts about its independence. Currently, the chairman of the board of
governors is a former long-standing Prime Minister. Central bank governorsshould of course be absolutely impartial, and having a politician as a governorcreates a perception of politicization of central bank decisions.In addition, such governance structure carries with it unfortunate consequencesthat become especially visible in the financial crisis. By choosing governors based ontheir political background rather than economic or financial expertise, the CentralBank may be perceived to be ill-equipped to deal with an economy in crisis.
Oversized banking sector
The second factor in the implosion of the Icelandic economy was the size of its
banking sector. Before the crisis, the Icelandic banks had foreign assets worth
10 The First Global Financial Crisis of the 21st Century Part IIaround 10 times the Icelandic GDP, with debts to match. In normal economic circumstancesthis is not a cause for worry, so long as the banks are prudently run.Indeed, the Icelandic banks were better capitalized and with a lower exposure to
high risk assets than many of their European counterparts.If banks are too big to save, failure is a self-fulfilling prophecyIn this crisis, the strength of a bank’s balance sheet is of little consequence. What
matters is the explicit or implicit guarantee provided by the state to the banks toback up their assets andprovide liquidity. Therefore, the size of the state relative
to the size of the banks becomes the crucial factor. If the banks become too big to
save, their failure becomes a self-fulfilling prophecy.
The relative size of the Icelandic banking system means that the government
was in no position to guarantee the banks, unlike in other European countries.
This effect was further escalated and the collapse brought forward by the failure of#p#分页标题#e#
the Central Bank to extend its foreign currency reserves.
The final collapse was brought on by the bankruptcy of almost the entire
Icelandic banking system. We may never know if the collapse of the banks was
inevitable, but the manner in which they went into bankruptcy turned out to be
extremely damaging to the Icelandic economy, and indeed damaging to the economy
of the United Kingdom and other European countries. The final damage to
both Iceland and the rest of the European economies would have been preventable
if the authorities of these countries have acted more prudently.
While at the time of writing it is somewhat difficult to estimate the recovery
rate from the sale of private sector assets, a common estimate for the net loss to
foreign creditors because of private debt of Icelandic entities is in excess of $40 billion.
The Icelandic authorities did not appreciate the seriousness of the situation in
spite of being repeatedly warned, both in domestic and foreign reports. One
prominent but typical example is Buiter and Sibert (2008). In addition, the
Icelandic authorities communicated badly with their international counterparts,
leading to an atmosphere of mistrust.
The UK authorities, exasperated with responses from Iceland overreacted, using
antiterrorist laws to take over Icelandic assets, and causing the bankruptcy of the
remaining Icelandic bank. Ultimately, this led to Iceland’s pariah status in the
financial system.
British and Dutch claims on the Icelandic government
The current difficulties facing Iceland relate to its dispute with the Netherlands
and the UK over high interest savings accounts, Icesave. Landsbanki set these savings
accounts up as a branch of the Icelandic entity, meaning they were regulated
and insured in Iceland, not in the UK or the Netherlands.
Icesave offered interest rates much above those prevailing in the market at the
time, often 50% more than offered by British high street banks. In turn, this
attracted £4.5 billion in the UK with close to £1 billion in the Netherlands.
The first casualty of the crisis: Iceland 11
Landsbanki operated these saving accounts under local UK and Dutch branches of
the Icelandic entity, meaning they were primarily regulated and insured in
Iceland, although also falling under local authorities in the UK and the
Netherlands. Hence the Icelandic, British and Dutch regulators approved its operations
and allowed it to continue attracting substantial inflows of money. Since
the difficulties facing Landsbanki were well documented, the financial regulators
of the three countries are at fault for allowing it to continue attracting funds.
Landsbanki went into administration following the emergency legislation in
Iceland. The final losses related to Icesave are not available at the time of writing,#p#分页标题#e#
but recovery rates are expected to be low, with total losses expected to be close to
£5 billion. The amount in the Icelandic deposit insurance fund only covers a small
fraction of these losses.
Both the Dutch and the UK governments have sought to recover the losses to
their savers from the Icelandic government. Their demands are threefold. First,
that it use the deposit insurance fund to compensate deposit holders in
Icesave. Second, that it make good on the amounts promised by the insurance
fund, around EUR 20,000. Finally, that it make good on all losses. The last claim
is based on emergency legislation passed in Iceland October 6, and the fact that
the government of Iceland has promised to compensate Icelandic deposit holders
the full amount, and it cannot discriminate between Icelandic and European
deposit holders.
Murky legal situation
The legal picture however is unclear. Under European law 1% of deposits go into
a deposit insurance fund, providing savers with a protection of ⇔20,000 in case of
bank failure. Apparently, the European law did not foresee the possibility of a
whole banking system collapsing nor spell out the legal obligation of governments
to top up the deposit insurance fund. Furthermore, the legal impact of the
Icelandic emergency law is unclear. Consequently, the Icelandic government is
disputing some of the British and Dutch claims.
Blood out of a rock
Regardless of the legal issues, the ability of the Icelandic Government to meet
these claims is very limited. The damage to the Icelandic economy is extensive.
The economy is expected to contract by around 15% and the exchange rate has
fallen sharply. By using exchange rates obtained from the ECB November 7 the
Icelandic GDP is about EUR 5.5 billion, at 200 kronas per euro. In euro terms GDP
has fallen by 65%. (This calculation is based on the Icelandic GDP falling from
1,300 billion Icelandic kronas to 1,105 and a Euro exchange rate of 200. One year
ago, the exchange rate was 83. In domestic currency terms the Icelandic GDP has
contracted by 15% due to the crisis, in Euro terms 65%.)1
12 The First Global Financial Crisis of the 21st Century Part II
1 This calculation is based on the Icelandic GDP falling from 1,300 billion Icelandic krona to 1,105 and a Euro
exchange rate of 200. One year ago, the exchange rate was 83. In domestic currency terms the Icelandic GDP
has contracted by 15% due to the crisis, in Euro terms 65%.
The total losses to Icesave may therefore exceed the Icelandic GDP. While the
amount being claimed by the UK and the Netherlands governments is unclear, it
may approximate 100% of the Icelandic GDP. By comparison, the total amount of
reparations payments demanded of Germany following World War I was around
85% of GDP.2
Resolution and the way forward#p#分页标题#e#
Any resolution of the immediate problems facing Iceland is dependent on the UK
and the Netherlands settling with Iceland. Unfortunately, the ability of the
Icelandic government to meet their current demands is very much in doubt.
Opinion polls in Iceland indicate that one third of the population is considering
emigration. Further economic hardship due to Icesave obligations may make that
expression of opinion a reality. Meanwhile, many companies are facing bankruptcy
and others are contemplating moving their headquarters and operations
With the youngest and most highly educated part of the population emigrating
along with many of its successful manufacturing and export companies, it is hard
to see how the Icelandic State could service the debt created by the Icesave obligations
to the UK and the Netherlands, making government default likely.
The economic rationale for continuing to pursue the Icesave case with the current
vigor is therefore very much in doubt. If a reasonable settlement cannot be
reached, and with the legal questions still uncertain, it would be better for all three
parties to have this dispute settled by the courts rather than by force as now.
Willem Buiter and Anne Sibert (2008) ‘The Icelandic banking crisis and what to do
about it: The lender of last resort theory of optimal currency areas’. CEPR Policy
Insight No. 26.
Webb, Steven (1988) ‘Latin American debt today and German reparations after
World War I – a comparison’, Review of World Economics.
The first casualty of the crisis: Iceland 13
2 Initial reparation demands from Germany were close to 200% of GDP, but quickly lowered to around 85%. See
e.g. Webb (1988) for comparisons of German reparation payments and emerging market debt repayments.

Iceland: The future is in the EU
Philip Lane
Trinity College Dublin and CEPR
6 November 2008
Iceland is undergoing a traumatic financial crisis. This column argues that the
http://www.ukthesis.org/dissertation_writing/main anchor for its recovery strategy should be EU membership and entry into the
euro area.
Iceland is undergoing a traumatic financial crisis. In just a few weeks, it has seen
the collapse of its currency and its banking system, plus a spectacular decline in
its international reputation and its diplomatic relations with long-standing international
partners. Much of the current debate revolves around the attribution of
blame for its predicament, and there is certainly much to be learned from a rigorous
forensic enquiry into the origins and mechanics of the crisis. Although
Iceland ultimately proved unable to ensure the survival of a banking system with
a balance sheet that was ten times the size of its GDP, the debate about whether#p#分页标题#e#
its demise was inevitable is sure to remain intensely contested.1,2
However, this debate should not overshadow the important process of setting a
strategy for the recovery of the Icelandic economy and ensuring that the risks of
a future crisis are minimised.
To this end, it seems clear from the outside (and also to many in Iceland) that
the main anchor for its future strategy should be membership of the EU and, once
the Maastricht criteria are fulfilled, entry into the euro area.
This is not to claim that membership of the EU and the euro area is a panacea.
Indeed, the current members of the euro area are not immune to the international
financial crisis and important weaknesses in the financial stability framework
for the euro area have been vividly highlighted by recent events.
In particular, the combination of international banking with national-level
supervisory and stability systems has been shown to represent substantial risks to
European taxpayers. Indeed, Iceland and the existing members of the monetary
union would have much to gain from the promotion of cross-national consolidation
in the banking sector, delivering a smaller number of large banks that would
1 Buiter and Sibert (2008) provide an excellent account of the vulnerability of the Icelandic banking system in
view of the limited capacity of the Icelandic authorities to act as a lender of last resort in respect of the Icelandic
banks’ considerable foreign-currency positions. Portes (2008) argues that better crisis management by the
Icelandic authorities may have avoided the collapse.
2 This article is based on a presentation to the Reinventing Bretton Woods Committee conference held in
Reykjavik on October 28th 2008 ‘Testing Times for the International Financial System: Inflation, Global Turmoil,
New Challenges for Small Open Economies’
hold more diversified loan books, reducing exposure to country-specific and
sector-specific shocks. For this to happen, national governments will have to agree
ex ante on burden sharing rules in order to ensure that such banks would be
backed by a sufficiently large fiscal base. In related fashion, the supervision and
regulation of such banks would have to be designed in order to ensure that such
banks are operated on a truly pan-European basis rather than being organised as a
hierarchy of a parent national bank that takes precedence over its international
branches and affiliates in the event of a crisis.
Membership of the euro area also involves macroeconomic policy challenges
for member countries. The absence of a flexible exchange rate has the potential to
make the adjustment to country-specific asymmetric shocks more difficult. For
countries such as Iceland that are highly reliant on a small number of export sectors,
this can be a non-trivial problem. However, the flexibility of the Icelandic#p#分页标题#e#
labour market is a key compensating factor, with a coordinated approach to wage
setting allowing real wages to fall during downturns and rising international
labour mobility providing an additional adjustment mechanism.
Moreover, the potential gains from a flexible exchange rate are surely dominated
by the capacity for financial shocks to drive currencies away from the values
that would be justified by current macroeconomic fundamentals. While the role
of risk premium shocks is most dramatic during crisis episodes, it is also an everpresent
factor during more tranquil periods, especially for small currencies that are
thinly traded in less-liquid markets. The consequences of such shocks have been
scaled up by the rapid growth in cross-border investment positions over the last
decade: the balance sheet impact of currency fluctuations in many cases dominates
their impact on trade volumes.
The current crisis has also illustrated that banking supervision and crisis
management are very demanding tasks that pose a challenge even to the largest
countries that have deep talent pools. It is plausible that very small countries do
not attain the ‘minimum efficient scale’ to run these systems in an effective manner.
For these reasons, the logic of very small countries participating in monetary
unions is compelling. The rationale of membership is even stronger for a country
– such as Iceland – that has suffered damage to its credibility as the sponsor of a
national currency.
It is important to emphasise that there is no close substitute for membership of
the euro area. In particular, unilateral euroisation or the adoption of a currency
board would represent much weaker forms of monetary discipline, since such
regimes are more easily reversed in the event of a crisis. These routes are much
more expensive from a fiscal viewpoint relative to joining a multilateral monetary
union as a fully-integrated member.
Moreover, the importance of EU membership should not be discounted, even
in the narrow context of a discussion about the monetary regime. In particular,
the multi-dimensional commitments that are involved in EU membership have
the effect of embedding each member country in a deep institutional and intergovernmental
network set of relations with other EU member countries. The
current crisis has highlighted that Iceland’s relations with other European countries
proved to be relatively weak under the stress of a crisis situation and many
problems could have been avoided if it had enjoyed a better level of comprehension
and empathy among its European neighbours.
16 The First Global Financial Crisis of the 21st Century Part II
Although membership of the EU and the euro area cannot be achieved in the
very short run, announcing an intention to enter the process of applying for#p#分页标题#e#
membership would have an immediate stabilising benefit for the Icelandic economy.
In addition, the anchor of medium-term entry into the EMU would enable
the Icelandic central bank to pursue a managed float system during the transition
period in an environment in which it need not prove its capacity to independently
deliver a long-term nominal anchor for the Icelandic economy.
The current crisis also raises questions about the appropriateness of the ‘exchange
rate stability’ criterion in determining whether a country is ready to join the euro
area. Under the existing rules, a country must spend two years inside the ERM II
mechanism before it can enter the EMU. Recent weeks have shown that even
countries with excellent macroeconomic fundamentals are vulnerable to major
currency shocks. In this new environment, it seems expensive to impose a twoyear
currency stability test on countries that wish to join the euro.
Finally, Iceland’s entry into the EU and the euro area should be welcomed by
the existing member countries. In particular, the Icelandic financial collapse has
imposed heavy losses on many investors across Europe and contributed to the
instability of international credit markets. All member countries stand to gain
from a better-integrated financial system.
Willem Buiter and Ann Sibert (2008), ‘Iceland’s banking collapse: Predictable end
and lessons for other vulnerable nations,’ VoxEU.org. 30 October 2008.
Richard Portes, ‘The shocking errors behind Iceland’s meltdown’, Financial
Times, 13 October 2008.
Iceland: The future is in the EU 17

Iceland faces the music
Gylfi Zoega
Birkbeck College, University of London
27 November 2008
Iceland’s meltdown was caused by the rapid emergence of an oversized banking
sector and accompanying domestic credit creation, asset bubbles and excessive
indebtedness that all this encouraged. This column draws lessons from this crisis
and suggests Iceland should join the EU if it wants to stand a chance at keeping
its well-educated young people from emigrating.
Iceland’s borrowing in international credit markets during the period 2003–2007
propelled a macroeconomic expansion as well as the very rapid expansion of the
banking sector.1 Borrowing was also undertaken to fund leveraged buy-outs of
foreign companies as well as the buying of domestic assets. There developed the
biggest stock market bubble in the OECD while house prices doubled.
The banking development was ominous. No visible measures were taken to
limit the banks’ growth during the expansionary phase. The size of the banking
sector at the end of this period was such that it dwarfed the capacity of the central
bank to act as a lender of last resort2 as well as the state’s ability to replenish#p#分页标题#e#
its capital. The banking system was also vulnerable because of its rapid expansion
and the bursting of the domestic asset price bubble.
The end
The end came quickly. In the otherwise quiet city of Reykjavik, suspicious movements
of government ministers and central bank governors were detected on
Saturday morning, 27 September. On Monday it was explained that Glitnir, the
smallest of the three larger banks, had approached the central bank for help
because of an anticipated liquidity problem in the middle of October. Lacking confidence
in the collateral offered, the central bank had decided to buy 75% of its
shares at a very low price.
Like the banks themselves, the government had claimed for months that all
three banks were liquid as well as solvent, yet when push came to shove it tackled
1 See Gylfi Zoega (2008), ‘Icelandic turbulence: A spending spree ends,’ VoxEU, 9 April.
2 See Willem Buiter and Anne Sibert (2008), ‘The Icelandic banking crisis and what to do about it,’ CEPR Policy
Insight No. 26; and ‘The collapse of Iceland’s banks: the predictable end of a non-viable business model,’
VoxEU, 30 October; also Jon Danielsson, (2008), ‘The first casualty of the crisis: Iceland,’ VoxEU, 12 November.
a pending liquidity squeeze by wiping out the shareholders of Glitnir. Credit lines
were now withdrawn from the two remaining banks. There followed an old-fashioned
bank run on the Icesave branch of the Landsbanki in the UK The
Landsbanki fell when it was unable to make payments to creditors.
The responses were chaotic. The governors of the central bank announced a
4 billion euros loan from Russia but then had to retract the story within hours.
They also decided to fix the exchange rate but without the requisite foreign currency
reserves this was an impossible task so the bank gave up within two days.
One of the governors appeared on television and stated that the Icelandic state
would not honour the foreign debt of the banks without distinguishing deposits
from loans. Telephone conversations between government ministers in Iceland
and the UK appear not to have clarified the situation.3 The British government
then seized the British operations of both the Landsbanki and Kaupthing in
London. The seizure of Kaupthing’s Singer and Friedlander automatically brought
Kaupthing into default. All three banks were now in receivership.
The foreign exchange market collapsed on October 8th. Following a period of
sporadic trading the central bank started to auction off foreign currency on
October 15th. There are plans to let it float again.
The real economy is currently responding to the turmoil; unemployment is rising
and there have been several bankruptcies and many more are imminent. There
is the realisation that not just the banks but a significant fraction of non-financial#p#分页标题#e#
firms are heavily leveraged; have used borrowing, mostly in foreign currency, to
fund investment and acquisitions. The Icelandic business model appears to have
involved transforming firms into investment funds, be they shipping companies
such as Eimskip (established 1914), airlines such as Icelandair (established in
1943), or fish-exporting companies, to name just a few examples. Exporting firms,
however, are benefiting from lower exchange rates. The future belongs to them.
The proximate cause of the economic meltdown in Iceland is the rapid emergence
of an oversized banking sector and the accompanying domestic credit creation,
asset price bubbles and high levels of indebtedness. At this point it is important to
consider the reasons why this was allowed to happen.
Monetary policy technically flawed
A sequence of interest rate rises, bringing the central bank interest rate up from
5.3% in 2003 to 15.25% in 2007 did not prevent the boom and the bubbles that
preceded the current crash. On the contrary, they appear to have fuelled the bubble
But surely it was apparent to anyone in the latter stages of the boom that it was
driven by unsustainable borrowing and that a financial crisis was fast becoming
inevitable. Iceland would have faced the music soon even in the absence of turmoil
in international credit markets. However, in spite of many observers point-
20 The First Global Financial Crisis of the 21st Century Part II
3 See report by David Ibison in the Financial Times, 24 October 2008, titled ‘Transcript challenges Darling’s claim
over Iceland compensation.’
ing this out4 (including the central bank itself!5), the course of economic policy
was not changed. There were clearly other, more profound, reasons for this inertia
and passivity in the face of peril.
Belief in own abilities and good luck
History is full of examples of nations gripped by euphoria when experiencing rapidly
rising asset prices. During the economic boom it was tempting to come up
with stories to explain the apparent success, such as the notion of superior business
acumen. However, this is a normally distributed variable and its mean does
not differ much between nations. The ability to govern a modern economy is
unfortunately also a normally distributed.
The normal distribution and the division of labour
When there are not too many people to choose from, it becomes doubly important
to pick the best candidate for every job. While the private sector has, as if led
by an invisible hand, a strong incentive to pick the most competent people for
every position, the same can not be said of certain areas within the public sector.
The appointment of former politicians to the position of central bank governor,
to take just one example, reduces the bank’s effectiveness and credibility. The danger#p#分页标题#e#
is that the individual in question has interests and policies that exceed those
fitting a central bank governor in addition to lacking many job-specific skills. And
this one example is just the tip of the iceberg!
In addition, Adam Smith’s dictum that the scale of the division of labour is
determined by the size of the market also applies to the government. There are
scale economies when it comes to running the state and small nations might benefit
from the sharing of a government, as well as the central bank!
Social pressures
We now come to an equally profound problem, which is that the small size of the population
makes it inevitable that personal relationships matter more than elsewhere.
One of the keys to success for an individual starting and sustaining his or her
career in Icelandic society has been to pledge allegiance to one of the political parties
– more recently business empires – and act in accordance with its interests. It
follows that society rewards conformity and subservience instead of independent,
critical thinking. Many players in the banking saga have interwoven personal histories
going back many decades. The privatisation of the banks, not so many years
ago, appears also to have been driven by personal affections and relationships
rather than an attempt to find competent, responsible owners.
Mancur Olson’s The Logic of Collective Action, first published in 1965,6
describes the difficulties of inducing members of large groups to behave in the
Iceland faces the music 21
4 See, amongst others, Robert Wade, ‘Iceland pays price for financial excess,’ Financial Times, 1 July 2008; Robert
Wade, ‘IMF reports uncertain outlook for Iceland,’ Financial Times, 15 July 2008; Thorvaldur Gylfason, ‘Events in
Iceland: Skating on thin ice?’ VoxEU, 7 April 2008; Gylfi Zoega, ‘A spending spree,’ VoxEU 9 April 2008; Robert
Aliber, ‘Monetary turbulence and the Icelandic economy’, lecture, University of Iceland, 5 May 2008; Thorvaldur
Gylfason, ‘Hvernig finnst þér Ísland?’, Herdubreid, 27 July 2007; Gylfi Zoega (2007), ‘Stofnanaumhverfi,
frumkvöðlakraftur og vægi grundvallaratvinnuvega,’ in Endurmótun íslenskrar utanríkisstefnu 1991–2007, ed.
Valur Ingimundarson.
5 See Central Bank of Iceland, Monetary Bulletin, years 2005–2007 (http://www.sedlabanki.is/?PageID=234).
6 Mancur Olson (1971), The Logic of Collective Action: Public Goods and the Theory of Groups, Harvard University Press.
group’s interests. Clearly, political parties need to reward their members in order
to motivate them and ensure their loyalty. The same applies to labour unions and
business empires. But the smaller the country, the smaller the total surplus income#p#分页标题#e#
that can be used in this way, while the amount needed to guarantee the loyalty of
any given individual may not be any smaller. It follows from Olson’s analysis that
the smaller the nation, the more likely it is that society will be uni-polar. As a matter
of fact, powerful individuals or parties that often rule small nations. Such a
society usually does not encourage dissent or critical thinking.
It follows that one individual’s criticism – be that of banks or the political or
economic situation – may put him in a precarious position vis-à-vis the dominant
group. The private marginal benefit of voicing your concerns and criticising is in
this case negative and much smaller than the social marginal benefit.
The same logic explains why the media may not criticise the ruling powers.
During the boom years, the media, different commentators and even some academics
lavished praise on the Icelandic bankers and other capitalists who profited
from the asset bubble. This then is the root of the problem; a cosy relationship
between businesses, politics and the media and limited checks and balances.
Everybody knows everything but no one does anything about anything!
Relations with Europe
Membership of the European Economic Areas, involving market integration and
the free mobility of factors without the participation in a common currency and
joint decision-making, made economic policy in Iceland difficult, even impossible,
to implement. The local central bank was no match for the vast flows of funds
that came into the country.
Membership of the EU might help remedy many of the problems described
above. The sharing of certain areas of government may improve the quality of
decision-making. Having greater contact with decision makers in Europe may provide
stimulus, criticism and points of comparison that may improve the quality of
decisions. The rule of law may be strengthened. The adoption of the euro will
provide monetary stability and lower interest rates.7
Iceland either has to move backwards to the time of capital controls or forwards
into the EU. It needs to choose the latter option if it wants to stand a chance at
keeping its well-educated young people from emigrating.
22 The First Global Financial Crisis of the 21st Century Part II
7 See Philip Lane (2008), ‘Iceland: The future is in the EU,’ VoxEU, 6 November.
30 October 2008
In the first half of 2008, Buiter and Sibert were invited to study Iceland’s financial
problems. They identified the ‘vulnerable quartet’ of (1) a small country with (2)
a large banking sector, (3) its own currency and (4) limited fiscal capacity – a quartet
that meant Iceland’s banking model was not viable. How right they were. This
column summarises the report, which is now available as CEPR Policy Insight No.#p#分页标题#e#
26 with an October 2008 update.
Early in 2008 we were asked by the Icelandic bank Landsbanki (now in receivership)
to write a paper on the causes of the financial problems faced by Iceland and
its banks, and on the available policy options for the banks and the Icelandic
We sent the paper to the bank towards the end of April 2008; it was titled:
“The Icelandic banking crisis and what to do about it: the lender of last resort
theory of optimal currency areas.”
On July 11, 2008, we presented a slightly updated version of the paper in
Reykjavik before an audience of economists from the central bank, the ministry of
finance, the private sector and the academic community.
It is this version of the paper that is now being made available as CEPR Policy
Insight No 26. In April and July 2008, our Icelandic interlocutors considered our
paper to be too market-sensitive to be put in the public domain and we agreed to
keep it confidential. Because the worst possible outcome has now materialised,
both for the banks and for Iceland, there is no reason not to circulate the paper
more widely, as some of its lessons have wider relevance.
A banking business model that was not viable for Iceland
Our April/July paper noted that Iceland had, in a very short period of time, created
an internationally active banking sector that was vast relative to the size of its
The collapse of Iceland’s banks:
the predictable end of a non-viable
business model
Willem Buiter and Anne Sibert
London School of Economics and Political Science,
University of Amsterdam and CEPR; Birkbeck College,
London and CEPR
very small economy. Iceland also has its own currency. Our central point was that
this ‘business model’ for Iceland was not viable.
With most of the banking system’s assets and liabilities denominated in foreign
currency, and with a large amount of short-maturity foreign-currency liabilities,
Iceland needed a foreign currency lender of last resort and market maker of last
resort to prevent funding illiquidity or market illiquidity from bringing down the
banking system. Without an effective lender of last resort and market maker of last
resort – one capable of providing sufficient liquidity in the currency in which it
is needed, even fundamentally solvent banking systems can be brought
down through either conventional bank runs by depositors and other creditors
(funding liquidity crises) or through illiquidity in the markets for its assets
(market liquidity crises).
Iceland’s two options
Iceland therefore had two options. First, it could join the EU and the EMU, making
the Eurosystem the lender of last resort and market maker of last resort. In this
case it can keep its international banking activities domiciled in Iceland. Second,#p#分页标题#e#
it could keep its own currency. In that case it should relocate its foreign currency
banking activities to the euro area.
The paper was written well before the latest intensification of the global financial
crisis that started with Lehman Brothers seeking Chapter 11 bankruptcy protection
on September 15, 2008. It does therefore not cover the final speculative attacks on
the three internationally active Icelandic banks – Glitnir, Landsbanki and Kaupthing
– and on the Icelandic currency. These attacks resulted, during October 2008, in all
three banks being put into receivership and the Icelandic authorities requesting a $2
bn loan from the IMF and a $4 bn loan from its four Nordic neighbours.
Policy mistakes Iceland made
During the final death throes of Iceland as an international banking nation, a
number of policy mistakes were made by the Icelandic authorities, especially by
the governor of the Central Bank of Iceland, David Oddsson. The decision of the
government to take a 75 percent equity stake in Glitnir on September 29 risked
turning a bank debt crisis into a sovereign debt crisis. Fortunately, Glitnir went
into receivership before its shareholders had time to approve the government
takeover. Then, on October 7, the Central Bank of Iceland announced a currency
peg for the króna without having the reserves to support. It was one of the shortest-
lived currency pegs in history. At the time of writing (28 October 2008) there
is no functioning foreign exchange market for the Icelandic króna.
In addition, outrageous bullying behaviour by the UK authorities (who invoked
the 2001 Anti-Terrorism, Crime and Security Act, passed after the September 11,
2001 terrorist attacks in the USA, to justify the freezing of the UK assets of the of
Landsbanki and Kaupthing) probably precipitated the collapse of Kaupthing – the
last Icelandic bank still standing at the time. The official excuse of the British government
for its thuggish behaviour was that the Icelandic authorities had
24 The First Global Financial Crisis of the 21st Century Part II
informed it that they would not honour Iceland’s deposit guarantees for the UK
subsidiaries of its banks. Transcripts of the key conversation on the issue between
British and Icelandic authorities suggest that, if the story of Pinocchio is anything
to go by, a lot of people in HM Treasury today have noses that are rather longer
than they used to be.
The main message of our paper is, however, that it was not the drama and mismanagement
of the last three months that brought down Iceland’s banks. Instead it
was absolutely obvious, as soon as we began, during January 2008, to study Iceland’s
problems, that its banking model was not viable. The fundamental reason was that
Iceland was the most extreme example in the world of a very small country, with its#p#分页标题#e#
own currency, and with an internationally active and internationally exposed financial
sector that is very large relative to its GDP and relative to its fiscal capacity.
Even if the banks are fundamentally solvent (in the sense that their assets, if
held to maturity, would be sufficient to cover their obligations), such a small
country – small currency configuration makes it highly unlikely that the central
bank can act as an effective foreign currency lender of last resort/market maker of
last resort. Without a credit foreign currency lender of last resort and market
maker of last resort, there is always an equilibrium in which a run brings down a
solvent system through a funding liquidity and market liquidity crisis. The only
way for a small country like Iceland to have a large internationally active banking
sector that is immune to the risk of insolvency triggered by illiquidity caused by
either traditional or modern bank runs, is for Iceland to join the EU and become
a full member of the euro area. If Iceland had a global reserve currency as its
national currency, and with the full liquidity facilities of the Eurosystem at its disposal,
no Icelandic bank could be brought down by illiquidity alone. If Iceland
was unwilling to take than step, it should not have grown a massive on-shore
internationally exposed banking sector.
This was clear in July 2008, as it was in April 2008 and in January 2008 when
we first considered these issues. We are pretty sure this ought to have been clear
in 2006, 2004 or 2000. The Icelandic banks’ business model and Iceland’s global
banking ambitions were incompatible with its tiny size and minor-league currency,
even if the banks did not have any fundamental insolvency problems.
Were the banks solvent?
Because of lack of information, we have no strong views on how fundamentally
sound the balance sheets of the three Icelandic banks were. It may be true, as argued
by Richard Portes in his Financial Times Column of 13 October 2008, that ‘Like fellow
Icelandic banks Landsbanki and Kaupthing, Glitnir was solvent. All posted good
first-half results, all had healthy capital adequacy ratios, and their dependence on
market funding was no greater than their peers’. None held any toxic securities.’
The only parties likely to have substantive knowledge of the quality of a bank’s
assets are its management, for whom truth telling may not be a dominant strategy
and, possibly, the regulator/supervisor. In this recent crisis, however, regulators
and supervisors have tended to be uninformed and out of their depth. We doubt
Iceland is an exception to this rule. The quality of the balance sheet of the three
Icelandic banks has to be viewed by outsiders as unknown.
The collapse of Iceland’s banks: the predictable end of a non-viable business model 25#p#分页标题#e#
If there is a bank solvency problem, even membership in the euro area would
not help. Only the strength of the fiscal authority standing behind the national
banks (and its willingness to put its fiscal capacity in the service of a rescue effort
for the banks) determines the banks’ chances of survival in this case. If there were
a serious banking sector solvency problem in Iceland, then with a banking sector
balance sheet to annual GDP ratio of around 900 percent, it is unlikely that the
fiscal authorities would be able to come up with the necessary capital to restore
solvency to the banking sector.
The required combined internal transfer of resources (now and in the future,
from tax payers and beneficiaries of public spending to the government) and
external transfer of resources (from domestic residents to foreign residents,
through present and future primary external surpluses) could easily overwhelm
the economic and political capacities of the country. Shifting resources from the
non-traded sectors into the traded sectors (exporting and import-competing) will
require a depreciation of the real exchange rate and may well also require a worsening
of the external terms of trade. Both are painful adjustments.
If the solvency gap of the banking system exceeds the unused fiscal capacity of
the authorities, the only choice that remains is that between banking sector insolvency
and sovereign insolvency. The Icelandic government has rightly decided
that its tax payers and the beneficiaries of its public spending programmes (who
will be hard hit in any case) deserve priority over the external and domestic creditors
of the banks (except for the insured depositors).
Conclusions, lessons and others who might be vulnerable
Iceland’s circumstances were extreme, but there are other countries suffering from
milder versions of the same fundamental inconsistent – or at least vulnerable –
(1) A small country with (2) a large, internationally exposed banking sector, (3) its
own currency and (4) limited fiscal spare capacity relative to the possible size of
the banking sector solvency gap.
Countries that come to mind are:
• Switzerland,
• Denmark,
• Sweden
and even to some extent the UK, although it is significantly larger than the others
and has a minor-league legacy reserve currency.
Ireland, Belgium, the Netherland and Luxembourg possess the advantage of
having the euro, a global reserve currency, as their national currency. Illiquidity
alone should therefore not become a fatal problem for their banking sectors. But
with limited fiscal spare capacity, their ability to address serious fundamental
banking sector insolvency issues may well be in doubt.
26 The First Global Financial Crisis of the 21st Century Part II#p#分页标题#e#
6 December 2008
The global credit crisis is testing the resilience and sustainability of emerging markets’
policies, this column warns. Even strong performers are not shielded against
pure financial contagion, although they may well recover quickly once confidence
is restored. In the future, development finance is likely to rely less on private debt.
The global credit crisis has taken some time to spread from the industrialised countries
to the emerging markets. But in October 2008, the contagion spread rapidly,
afflicting all emerging markets, without any distinction or regard to their so-called
‘fundamentals’. For believers in ‘decoupling’, the high growth rates, massive foreign
exchange (FX) reserves, balanced budgets and rising consumerism in the emerging
markets at first reassured investors. Alas, the final diagnosis was contagion. In the
end all emerging market asset classes were hit – stocks, bonds and currencies.
This column reflects on early policy lessons from the current financial crisis for
• the diagnosis of emerging market policy performance,
• the channels of crisis contagion, and
• the future of private and official development finance.
Assessing emerging markets’ performance
It is now clear that the diagnosis of emerging-market policy performance suffered
from hyperbole. Many observers ignored the fact that all that glitters in emerging
markets may not be gold,1 underplaying as they did the cyclicality and endogeneity
of important policy performance indicators.
Emerging-market growth rates: Much of the recent growth has been driven by
an extraordinary bonanza in raw material prices and low-cost financing. Many
analysts forgot that growth rates can only be sustained over the long-run when
supported by cyclically-adjusted productivity growth. Arguably, from this perspective,
many Asian countries have more sustainable growth rates than emerging
markets in other regions.
The fallout from the global credit
crisis: Contagion – emerging
markets under stress
Helmut Reisen
OECD Development Centre
1 Izquierdo, A and E. Talvi, ‘All that glitters may not be gold: assessing Latin America’s recent macroeconomic performance’,
Inter-American Development Bank, 2008
Foreign exchange reserve levels: Their durability depends very much on the
exchange rate regime. Authorities may wish to avoid a currency slump and may
need to recapitalise their banking system. But if both foreign and domestic
investors lose confidence, even very impressive levels of foreign exchange reserves
can melt away quickly, as witnessed recently in Russia. As long as reserves are
below the liabilities of the banking system (M2), individuals may rush to convert
their domestic currency deposits into foreign currency and cause a currency slump#p#分页标题#e#
once reserves are down.
Public budgets: A misjudgement common to rating agencies2 is based on the
monitoring of debt-GDP ratios and public deficits. Both debt and deficits are low
during booms, but they can shoot up quickly during crises. Tax collection flourishes
when exports and raw material prices boom but tumbles during the bust,
currency appreciation leads to the collapse of foreign-currency-denominated debt
ratios but gives way to an endogenous rise in debt ratios as currencies and GDP
growth weaken.
Not everything is negative, however. To the extent that fuel and food prices fall
due to the crisis, government budgets in many low-income countries that highly subsidise
fuel and food consumption may benefit as costly price subsidies can be reduced
(though this positive effect may be mitigated by currency depreciation). And public
debt management has improved: Brazil, for example now has a net long position in
dollars, such that a currency depreciation actually improves its net worth.
Contagion transmission
Preventing, managing and resolving financial crises requires distilling policy lessons
from recent emerging market crises that had less to do with domestic factors
and were more related to do with crisis contagion from elsewhere. Furthermore,
such policy lessons need to inform debates regarding the construction of a new
international (or regional) financial architecture.3 Crisis contagion in principle
occurs through three channels:
• Through foreign trade (sometimes known as the ‘monsoon effect’): the
monsoon effects hit small open economies easily through merchandise
trade precisely because they are both small and open to trade. Lowincome
countries will be mostly hit through the monsoon channel as
OECD recessions deepen.
• Through financial contagion, when money invested is repatriated, as
happened during the Asian crisis when weakly capitalised Japanese
banks cancelled credit lines of up to 10% of GDP at once. The process
of global deleveraging hits developing and emerging countries through
financial contagion, if currency mismatches in corporate and bank balance
sheets cause widespread company and bank failures.
• Through ‘pure’ contagion, as happened in October 2008, when a systemic
and simultaneous breakdown of money and bank markets leads
28 The First Global Financial Crisis of the 21st Century Part II
2 Reisen, H. and J. von Maltzahn, ‘Boom and Bust and Sovereign Ratings’, 1999, International Finance, 1999,
2(2), 273–93.
3 Reisen, H. , ‘After the Great Asian Slump: Towards a Coherent Approach to Global Capital Flows,’ OECD
Development Centre Policy Briefs 16, OECD Development Centre 1999.
to generalised risk aversion and the shedding of all assets that fail to
carry public guarantees.#p#分页标题#e#
Financial crises that are caused by the monsoon effect or by financial contagion
can in principle be predicted through the monitoring of macroeconomic variables
common to economically integrated countries. Pure contagion, by contrast, hits
countries regardless of the level of economic integration. Pure contagion is hard
to predict or to quantify. A wave of pure contagion, however, can be stopped more
easily by decisive policies.4 As long as the fundamentals are not permanently damaged
by pure contagion, it is sufficient to switch expectations back from red to
Financing development
As a mid-term consequence of the global credit crisis, private debt will be financed
only reluctantly and capital costs are bound to rise to incorporate higher risk.
Instead, solvent governments and public institutions will become the lenders of
last resort. The consequences for development finance and the global financial
architecture will be important. Figure 1 shows clearly how development loans by
the World Bank, the IMF, and the regional development banks had been crowded
out by private-sector lending throughout the boom decade. The supply of public
development finance will rise and regain some of the attractiveness to poor countries
that it lost during the boom period.
The fallout from the global credit crisis: Contagion – emerging markets under stress 29
4 Allen, F., Gale, D., ‘Financial contagion’, Journal of Political Economy, 2000, 108 (1), 1–33.
Figure 1 Percentage share in lending to developing countries
Source: World Bank, Global Development Finance, 2008
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
World Bank
Others official
Private creditors
However, the firepower of the international financial institutions is quite limited
and unlikely to stop ‘pure’ contagion and the global crisis. Causing a precautionary
rush by vulnerable countries to ask the international financial institutions
for help, their limited firepower paves the way for one-way bets on emerging-market
currencies. It is therefore important that these institutions finance a capital
China and India could provide a small part of their foreign exchange reserves
to the regional development banks – provided they are granted more voting
rights. Foreign exchange reserves, invested through the regional development
banks, could be leveraged as soft loans. Such action might alleviate African leaders’
concern that the global credit crisis will reduce finance available to poor countries
rather than the systemically important emerging markets.
30 The First Global Financial Crisis of the 21st Century Part II
23 October 2008
The standard pattern: capital flows into the new ‘hot’ nation, but then stop or#p#分页标题#e#
reverses forcing painful adjustment. This column presents research based on such
episodes from 181 nations during 1980–2007 and for a subset of 66 nations for the
1960–2007 period. If the pattern of the past few decades holds true, emerging market
economies may be facing a darkening future.
A pattern has often been repeated in the modern era of global finance. Global
investors turn with interest toward the latest ‘foreign’ market. Capital flows in
volume into the ‘hot’ financial market. The exchange rate tends to appreciate,
asset prices to rally, and local commodity prices to boom. These favourable asset
price movements improve national fiscal indicators and encourage domestic
credit expansion. These, in turn, exacerbate structural weaknesses in the domestic
banking sector even as those local institutions are courted by global financial institutions
seeking entry into a hot market.
But tides also go out when the fancy of global investors shift and the ‘new paradigm’
looks shop worn. Flows reverse or suddenly stop à la Calvo1 and asset prices
give back their gains, often forcing a painful adjustment on the economy.
In a recent paper, we examined the macroeconomic adjustments surrounding
episodes of sizable capital inflows in a large set of countries.2 Identifying these
‘capital flow bonanzas’ turns out to be a useful organising device for understanding
the swings in investor interest in foreign markets as reflected in asset price
booms and crashes and for predicting sovereign defaults and other crises.
The bonanza episodes
For each of 181 countries, we defined a capital flow bonanza as an episode in
which there are larger-than-normal net inflows (operationally, those inflows bigger
than the 80th percentile of the entire sample). As can be seen in the share of
countries experiencing a capital bonanza year by year plotted in the figure below,
From capital flow bonanza to
financial crash
Carmen M Reinhart and Vincent Reinhart
University of Maryland; American Enterprise Institute
1 Calvo, Guillermo A., ‘Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops,’ Journal
of Applied Economics 1, no. 1 (1998): 35–54.
2 ‘Capital Flow Bonanzas: An Encompassing View of the Past and Present,’ CEPR Discussion Paper 6996, October
32 The First Global Financial Crisis of the 21st Century Part II
3 The charts and tables below have been updated with the recently released IMF, World Economic Outlook
(October 2008).
bonanzas are clustered in time even though they were defined using country-specific
There were two eras of booms of boons over the past three decades. The first ran
from 1975 to 1982 and the world is living through the second—which appears to#p#分页标题#e#
be partially unwinding. In both, real interest rates in the financial centres of the
world were low and often negative, growth in advanced economies was sluggish,
and commodity prices were rising rapidly. Statistical evidence suggests that these
three variables are important systematic determinants of capital flow bonanzas. If
the historical pattern plays out again, capital flows may remain elevated for the
next few years, encouraged by the lagged effects of low real interest rates.
The initial wave of bonanzas had a distinct Latin American flavour, including such
countries as Brazil, Chile, and Mexico. This is an ominous precedent, in that the
first great wave of inflows in recent memory ended in the emerging market debt
crisis of the 1980s. This shows through systematically over time. Over a longer
period, capital flow bonanzas appear to help predict government defaults and
other financial crises.
Recent bonanza episodes
As for the recent experience, the table below lists the countries experiencing capital
flow bonanzas over the past three years. We applied the technique described
percent of reporting countries
181 countries, 1980 to 2008
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Figure 1 Capital Flow Bonanzas
Source: IMF, World Economic Outlook (10/08) and authors’ calculations
in our paper to the IMF forecast made earlier this month. As is evident, two main
groups of countries have been beneficiaries of outsized net inflows in recent years:
Industrial countries with house-price booms (such as Ireland, Spain, the UK, and
the US) and nations in Central and Eastern Europe expected to converge to the
centre with the enlargement of the EU (such as Bulgaria, Romania, and Slovenia).
Countries with recent notable capital inflows 2006 2007 2008
New Zealand   
South Africa   
United Kingdom   
United States   
Source: IMF, World Economic Outlook (10/08) and authors’ calculations.
Notes: For the full list of recent bonanza episodes see the paper.
Cross-checking this list with recent headlines in the financial news supports the
contention that the concept of a capital-flow bonanza may be a useful device for
identifying countries likely to undergo significant macroeconomic adjustment –
perhaps even a crisis, an issue we turn to next.
Capital flow bonanzas and financial crises
To examine the potential links with financial crises of various stripes, we constructed
a family of country-specific probabilities. For each of the 64 countries,#p#分页标题#e#
this implies four unconditional crisis probabilities, that of: default (or restructuring)
on external sovereign debt, a currency crash, and a banking crisis.4 We also
constructed the probability of each type of crisis within a window of three years
before and after the bonanza year or years, this we refer to as the conditional probability
of a crisis. If capital flow bonanzas make countries more crises prone, the
conditional probability should be greater than the unconditional probability of a
We summarise the main results and then provide illustrative examples. For the
full sample, the probability of any of the three varieties of crises conditional on a
capital flow bonanza is significantly higher than the unconditional probability.
Put differently, the incidence of a financial crisis is higher around a capital inflow
bonanza. However, separating the high income countries from the rest qualifies
From capital flow bonanza to financial crash 33
4 In the paper, we also consider inflation crises; for crisis definitions see Reinhart, Carmen M. and Kenneth S.
Rogoff, ‘This Time is Different: A Panoramic View of Eight Centuries of Financial Crises’ NBER Working Paper
13882, March 2008.
the general result. As for the high income group, there are no systematic differences
between the conditional and unconditional probabilities in the aggregate,
although there are numerous country cases where the crisis probabilities increase
markedly around a capital flow bonanza episode.
Also, to provide an indication of how commonplace is it across countries to see
bonanzas associated with a more crisis-prone environment, we also calculate what
share of countries show a higher likelihood of crisis (of each type) around bonanza
episodes. For sovereign defaults, less than half the countries (42%) record an
increase in default probabilities around capital flow bonanzas. (Here, it is important
to recall that about one-third of the countries in the sample are high income.)
In two-thirds of the countries the likelihood of a currency crash is significantly
higher around capital flow bonanzas in about 61% of the countries the probability
of a banking crises is higher around capital flow bonanzas.
Beyond these general results, Figures 2 to 4 for debt, currency, and banking
crises, respectively, present a comparison of conditional and unconditional probabilities
for individual countries, where the differences in crisis probabilities were
greatest. (Hence, the country list varies from one figure to the next).
For external sovereign default (Figure2), it is hardly surprising that there are no
high income country examples, as advanced economy governments do not
default on their sovereign debts during the sample in question. The same cannot
be said of Figures 3 and 4. While the advanced economies register much lower#p#分页标题#e#
(conditional and unconditional) crisis probabilities than their lower income counterparts,
the likelihood of crisis is higher around bonanza episodes in several
instances. Notably, Finland and Norway record a higher probability of a banking
crisis around the capital flow bonanza of the late 1980s. Recalibrating this exercise
34 The First Global Financial Crisis of the 21st Century Part II
Figure 2 Are bonanza episodes more crisis prone? Sovereign external default: 66 countries,
Sources: Authors’ calculations, Reinhart and Rogoff (2008a), and sources cited therein.
0 10 20 30 40 50 60 70
Sri Lanka
Costa Rica
Lowest income
Conditional on bonanza
Highest income
Probabilities of External Default: 1960–2007
in light of the banking crises in Iceland, Ireland, UK, Spain and US on the wake of
their capital flow bonanza of recent years would, no doubt, add new high income
entries to Figure 4, which graphs conditional and unconditional probabilities for
banking crises.
From capital flow bonanza to financial crash 35
Figure 3 Are bonanza episodes more crisis prone? Currency crashes: 66 countries, 1960–2007
0 10 20 30 40 50 60 70 80 90 100
El Salvador
Costa Rica
New Zealand
Lowest income
Conditional on bonanza
Highest income
Probabilities of a Currency Crash: 1960–2007
0 10 20 30 40 50 60 70
El Salvador
Lowest income
Conditional on bonanza
Highest income
Probabilities of a Banking Crisis: 1960–2007
Sources: Authors’ calculations, Reinhart and Rogoff (2008a), and sources cited therein.
Figure 4 Are bonanza episodes more crisis prone? Banking crises: 66 countries, 1960–2007
Sources: Authors’ calculations, Reinhart and Rogoff (2008a), and sources cited therein.
Reflections on the current conjuncture
Most emerging market economies have thus far been relatively immune to the#p#分页标题#e#
slowdown in the US. Many are basking in the economic warmth provided by high
commodity prices and low borrowing costs. If the pattern of the past few decades
holds true, however, those countries may be facing a darkening future.
36 The First Global Financial Crisis of the 21st Century Part II
10 December 2008
Emerging markets are weaker than the G7, and if they undertake expansionary
monetary and fiscal policies like the G7, inflation and capital flight are likely
surge. This column argues international financial institutions must take an
unprecedented role in bailing out emerging markets as there is the serious risk that
they resort to protectionism and nationalisation.
One can blame the G7 for incompetent financial supervision, but few would criticise
them for the rapid and decisive action taken by their central banks and fiscal
authorities after the crisis materialised.
It is too early to tell if the G7 are coming out of the quagmire any time soon,
but it is clear that the G7 have a powerful arsenal. The world is eager to buy their
public bonds at negligible interest rates, which they can then use to pump in
liquidity and bail out their financial sectors.
Emerging market woes
Unfortunately, that’s not the case in emerging market economies, or EMs in the
jargon. JP Morgan’s EMBI+ bond index, for example, has become highly volatile
and at one point recently it crossed the 1000 basis point mark (see Figure 1).
Moreover, since the third quarter 2008, when it transpired that there was no
decoupling, the EM stock market collapsed in dollar terms, and also relative to the
Dow Jones.
This shows that the EM arsenal is considerably weaker than the G7’s, and that
if they undertake an expansionary monetary and fiscal policy like the G7, inflation
and capital flight are likely surge.1 The instruments that are helpful in refloating
advanced economies could prove fatal for emerging markets!
Rapid and large liquidity funding for
emerging markets
Guillermo Calvo and Rudy Loo-Kung
Columbia University
1 For a thorough evidence about the relative disadvantage of developing economies, see Carmen Reinhart,
Kenneth Rogoff and Miguel Savastano ‘Debt Intolerance,’ Brookings Papers on Economic Activity, Economic
Studies Program, The Brookings Institution, vol. 34(2003–1), pages 1–74.
38 The First Global Financial Crisis of the 21st Century Part II
Large reserve stocks help but aren’t sufficient
The good news is that emerging markets have accumulated a sizable stock of international
reserves which they could, in principle, apply to finance an expansionary
fiscal policy for some time. To illustrate, consider the region composed by Africa,
emerging Europe and Latin America. In 2007, gross international reserves reached#p#分页标题#e#
around $1.7 trillion, while annual investment was about $1.8 trillion.
Suppose the current crisis shrinks investment by about 18% as it did, on average,
during the Asia/Russia crises.2 This would imply a fall in investment equivalent
to 1.8´0.18 = $324 billion. The stock of reserves would allow the region to offset
the potential fall in investment for an impressive 5 year period. Granted, these
are gross reserves, but the firepower is anyhow impressive.3 The same computation
for 1998, for instance, yields a much shorter period (about 2 years).
A major problem in using international reserves for credit expansion is that the
stock of reserves is usually taken by market participants as a guarantee of banking
and currency stability.
US (LHS) Euro Area (LHS) EMBI+ Yield (RHS)
Figure 1 Interest rates in the US, euro area and emerging markets
Notes: 10-year Generic Bond rates for the US and the Euro Area.
Source: Bloomberg.
2 This is likely a conservative estimate. In the sample of Sudden Stops in countries from Latin America, emerging
Europe and Asia, tracked in the JP Morgan’s EMBI, the average peak-to-through reduction in nominal investment
was about 30% during the Asia/Russia crises.
3 In some cases, international reserves net of government short-term liabilities can be substantially lower. Take for
instance, the case of Brazil. As of last October, gross reserves totaled $203 billion while public domestic shortterm
debt amounted to $134 billion (valued at the current exchange rate). Granted, most domestic debt is
denominated in reais but the currency has already suffered a very large devaluation (almost 60% against the dollar),
and there are concerns of an imminent inflation flare up. This makes it unlikely that, barring a crisis, the
authorities will be inclined to let the real devalue much further – in which case, domestic debt would be de
facto denominated in terms of foreign exchange.
Data on reserves are closely followed by the private sector because, even in a
reserves-rich region like Asia, international reserves do not exceed 45% of M2, on
average. For instance, in the above example, if reserves fall by $324 billion, the
region would have to spend about 20% of its gross reserves – a change that will
not pass unnoticed to market participants. Here is where the International
Financial Institutions (IFIs) can make a difference.
Loans from international financial institutions have the double effect of providing
a seal of approval to the credit-expansion policy, and ensuring that the#p#分页标题#e#
hard-currency backing of domestic monetary aggregates does not suffer a dramatic
reduction. Both effects go in the direction of enhancing the trust of the private
sector in domestic financial institutions. Loans from multilateral development
banks, MDBs, to the region (i.e., Africa, emerging Europe and Latin America) in
2007 were slightly higher than 12% of the $324 billion required to offset the
Sudden Stop (see Table 1). Even if all the MDBs follow the World Bank’s recent
announcement, and expand lending by a factor of four, the additional funds
would raise the MDBs’ contribution to only around 50% the above amount.
Table 1 MDBs lending to Africa, emerging Europe and Latin America (US$ billions)
2004 2005 2006 2007
Africa 9.0 7.8 10.0 11.3
Emerging Europe 7.9 8.0 8.6 9.8
Latin America 14.8 17.1 17.8 20.1
Total 31.7 32.9 36.4 41.2
Note: Figures correspond to the total of approved loans and guarantees by the World Bank, the African
Development Bank Group, the Inter-American Development Bank, the Andean Development Corporation
and the European Bank for Reconstruction and Development.
An additional difficulty is that MDB loans take a long time to be approved and
disbursed. Thus, in the short run the MDBs are unlikely to be of much help. More
promising are initiatives like the Fed’s currency swaps and the IMF Short-Term
Liquidity Facility. It is essential, though, that the sums involved are large enough
and cover a wide spectrum of emerging markets.
The good news for emerging markets is that the G7 seem to have recognised
their responsibility in generating the present financial turmoil and are coming forward
with proposals to enlarge the MDBs’ lending capacity much more aggressively
than in the past. To illustrate, during the Asia/Russian 1997/8 crises the
MDBs increased lending by 30% (instead of the 400% recently announced by the
World Bank), an amount that represented less than 5% the fall in emerging market
investment (see Figure 2).
This, in addition to the recent and programmed G20 meetings, gives us hope
that emerging markets will be offered a much more adequate cushion to a potential
Sudden Stop. Optimism, however, is tempered by the fact that this time
around emerging markets will likely be bereft of the net export channel, which
played a very important role in their rebound from previous Sudden Stops. Unlike
the 1997/98 episode, during which robust growth in the US and other advanced
economies provided a strong external demand that helped the recovery in EMs,
this time the global nature of the crisis will almost surely prevent this mechanism
to take place.
Rapid and large liquidity funding for emerging markets 39
Our analysis strongly suggests that, in the short run, first priority should be given#p#分页标题#e#
to developing liquidity facilities aimed at stopping financial unravelling in EMs.
At present, those facilities don’t seem to be either large enough, or cover a wide
enough spectrum of EMs. Time is of the essence.
As shown by the ‘Sudden Stop’ literature, slow response from the IFIs could
result in serious output and employment losses.4 The Fund appears to be well positioned
to take the lead, but its effectiveness will depend very much on getting the
unambiguous political support necessary to run the large risks that the rapid
expansion of sizable liquidity facilities is likely to entail.
If successful, the international financial institutions will have taken an
unprecedented role in bailing out emerging markets, and for the first time, in a
long time, we will be entitled to talk about a New Economic Order.
If not, and the world does not quickly recover from this crisis, there is the serious
risk that many key emerging markets resort to protectionism and nationalisation,
a major backward step for their economies and the world’s.
40 The First Global Financial Crisis of the 21st Century Part II
1996 1997 1998 1999 2000 2001 2002
Gross Investment
IFI’s Lending
Gross Investment MDBs’ Lending
Figure 2 Investment in emerging markets and MDBs lending (US$ billions)
Note: Includes Africa, emerging Asia, emerging Europe, Latin America and the Middle East. MDB’s lending
includes the total of approved loans and guarantees by the World Bank, the African Development Bank
Group, the Asian Development Bank, the Inter-American Development Bank and the European Bank for
Reconstruction and Development.
4 See, e.g., Guillermo Calvo, Emerging Capital Markets in Turmoil, MIT Press, 2005.
16 October 2008
This column examines the impact of stock market valuation changes on consumption
and investment in emerging markets. Though the effects are smaller than those
in advanced economies, emerging market policymakers ought to pay attention to
how equity price swings will transmit business cycles and impact aggregate demand.
There are a few channels through which asset price changes affect consumption.
For instance, consumption depends on peoples’ expectations of wage income and
equity price increases can signal higher income growth. Financial assets play a significant
role in peoples’ permanent (life-cycle), income so changes in the stock
market could have an effect on private consumption expenditure.
Although there is a large body of literature about the effect of asset price
changes on private consumption in advanced economies, such studies are scarce
for emerging market economies. Estimates of stock market wealth effects for a 10%#p#分页标题#e#
change in equity prices range from 0.15% – 0.3% in Japan and 0.1% – 0.3% in various
European countries to 0.3% – 0.7% in the United States (IMF 2002; Ludwig
and Sløk 2004; Slacalek 2006). Funke (2004) presents evidence of a small but statistically
significant stock market wealth effect in 16 emerging markets over
1985–2000 ranging from 0.2% to 0.4%.
To shed more light on the relationship between stock market valuation changes
and private consumption, co-authors and I estimated a simple two-step panel
model covering 1985–2007 for 22 emerging markets in the MSCI equity index (see
IMF 2008 for more details). The findings suggest that a 10% increase in the stock
market valuation would, on average, lead to an increase of real private per capita
consumption of 0.12% in the short run and 0.15 % in the long run. The nominal
impact amounts to 0.25% in the short run and 0.26% in the long run. These
results are in line with Funke (2004). Restricting the sample period to 1997–2007,
when stock market valuations exhibited large increases as a percentage of GDP,
reveals a slightly higher real stock market wealth effect. In general and as expected,
the impact is smaller than in advanced economies.
It is also of interest whether the wealth effect is different for countries that have
witnessed a stock market boom or bust. To account for this, we restricted the sample
to observations for which the equity market had increased or decreased by
more than 20% and 30%, respectively, in any given year. These findings suggest a
slightly more pronounced wealth effect.
Stock market wealth effects in
emerging market countries
Heiko Hesse
The obtained wealth effects are rough estimates and depend on other factors
that are hard to measure. First, using stock market returns is only an imperfect
proxy for household wealth. Second, the model did not take into account different
structures of financial markets and features such as its volatility or depth.
Third, the magnitude is also driven by factors such as the leverage of consumers,
duration and the degree of stock market participation. For instance, consumer
leverage is still relatively low in many emerging economies compared to some
developed economies. With respect to duration, recent stock market gains and
losses in many emerging markets have occurred very quickly, so there has been little
time for consumers to change their behaviour. If stock market increases had
materialised over a longer time period, the wealth effect may have been larger.
Overall, these findings suggest that changes in stock market valuations have a relatively
small but significant impact on consumption in emerging economies. But
consumption patterns are still mainly driven by disposable income, and so far, that#p#分页标题#e#
has been resilient to the volatility of financial markets in many countries, especially
in Asia. In addition, the housing wealth channel plays an important role in some
emerging market countries that have especially seen rapid build- ups of property
prices, and this channel was ignored in the study.
In addition to private consumption, the wealth effects of stock market valuation
changes are also relevant for a number of other key macroeconomic variables,
notably government revenues and private investment. Investment and share prices
are inherently linked. Since equity prices are forward-looking variables that convey
information about the expected value of firms, they affect investment. Higher stock
market prices also reduce the cost of capital for companies, benefiting their investments.
Results from estimating a simple model for private investment suggest that
a 10% change in stock prices would lead to about 1% change in investment, which
is a substantially stronger effect than on private consumption. This is in line with
the results of Henry (2000), who utilises the same methodology.
What are the possible implications for policy makers? With fluctuations in
stock markets affecting private consumption and investment expenditures and
therefore demand, policy makers need to pay attention to this relationship, especially
in large build-ups of asset price booms and the subsequent bust.
Furthermore, as domestic asset price prices are increasingly influenced by regional
and global factors, there is a possible transmission mechanism of business cycle
There is no one-size-fits-all approach for dealing with the consumption stock
market wealth effect. The approach should be country-specific and depend on
domestic factors such as the monetary policy framework, financial regulation, the
degree of consumer leverage (especially for retail investors), and the level of stock
market participation in the economy. For instance, a monetary policy stance in an
emerging economy that explicitly targets inflation might find it harder to lean
against asset prices than a central bank that focuses more on the growth of the
economy. The good news is that the consumption stock market wealth effect is
lower in emerging market countries than in advanced economies – but emerging
economies should not ignore its existence.
Note: The views expressed here are those of the author and do not necessarily represent
those of the IMF or IMF policy.
42 The First Global Financial Crisis of the 21st Century Part II
Funke, Norbert, 2004, ‘Is there a stock market wealth effect in emerging markets?’
Economics Letters, Vol. 83, No. 3, pp. 417–21.
Henry, Peter Blair, 2000, ‘Do Stock Market Liberalizations Cause Investment
Booms?’ Journal of Financial Economics, Vol. 58, pp. 301–34.#p#分页标题#e#
International Monetary Fund, 2002, ‘Three essays on how financial market affect
real activity,’ World Economic Outlook, World Economic and Financial Surveys,
Washington, April)
International Monetary Fund, 2008, ‘Spillovers to Emerging Equity Markets,’
(authored by L. Effie Psalida, Heiko Hesse and Tao Sun) in Global Financial
Stability Report, World Economic and Financial Surveys (Washington,
Ludwig, Alexander, and Torsten Sløk, 2004, The Relationship between Stock
Prices, House Prices and Consumption in OECD Countries, Topics in
Macroeconomics, Volume 4, No. 1.
Slacalek, Jirka, 2006, ‘International Wealth Effects,’ DIW Discussion Papers No.
596 (Berlin: German Institute for Economic Research).
Stock market wealth effects in emerging market countries 43

11 December 2008
In a future phase of the crisis, the issue of sovereign debt relief is likely to arise.
Such debt relief has historically been marked by political failure and short-term
thinking, and not delivered promising results. Drawing on recent research, this
column argues for tying debt relief to good governance goals is one way to
improve the outcome.
The global financial market crisis has fed fears that individual countries face such
serious problems that they might go broke, with this causing a cascade of national
crises. In particular, developing and emerging economies, which so far have
been regarded as being decoupled from the crisis in the industrialised world, are
endangered. Countries that may be regarded as problematic in this context are
Hungary, Pakistan and Iceland.
The IMF has loaned $15.7 billion to Hungary to help the country combat negative
fallout from the global financial crisis. Most recently, Pakistan got into deep
trouble when the country’s foreign exchange reserves shrunk dramatically and the
rupee plunged in October as the balance of payments deficit in the three months
from July 1 widened to $3.95 billion from $2.27 billion a year earlier. The decision
of the IMF to approve a US$7.6 billion credit to Pakistan to stave off a balance of
payments crisis reduces for the time being the prospect of Islamabad defaulting on
its foreign debts. Iceland received a bailout of almost $5 billion from the IMF and
the neighbouring Nordic countries.
The IMF also promised to help Latvia deal with its economic crisis after it assisted
Iceland, Hungary, Ukraine, Serbia and Pakistan.
Table 1 shows the cost of some of the bailout programmes since the mid 1990s.
Not a few analysts believe that the worst is yet to come with respect to some transition
and developing economies.
If the bailout programmes do not help quickly, one might think of an old
instrument, namely debt relief, to overcome the problem. The question is if bailing#p#分页标题#e#
out broke countries is a remedy for the tilt or rather part or even a cause of the
The political economy of debt relief
Andreas Freytag and Gernot Pehnelt
ECIPE and Friedrich-Schiller-University Jena;
GlobEcon and ECIPE
The rationale of debt relief
There are three efficiency arguments for the provision of debt relief. The first is the
so called ‘debt overhang’. It has been stated that highly indebted countries benefit
very little, if ever, from the returns on any additional investment because of the
debt service obligation. Large debt obligations can be seen as a high tax on investment,
policy reforms and development, because a significant part of the gains
from economic adjustment would go to foreign creditors and not to the country
itself. Creditors should therefore offer debt relief to countries with large stocks of
external debt in order to reduce future debt obligations. This would increase the
share of any marginal gains from economic adjustments that goes to the debtor
country and create incentives to make these adjustments. This strategy could end
up in a win-win-situation by not only easing the debt burden of debtors but also
increasing future repayments to the creditors.
Secondly, debt relief may have a stimulating effect on investment and
economic development. The clincher with respect to the resource position of
low-income countries and therefore to the capacity to pay their obligations and to
invest, is still the net resource transfer from donors, including aid. Since the reduction
of multilateral debt is partly financed by bilateral donors (e.g. through their
contributions to multilateral funds), and these contributions usually come from
the same political reservoir, namely the donors’ aid budget, there might be a tradeoff
between debt relief and official development assistance.
The third rationale for debt relief could follow different lines. If an individual
country’s bankruptcy causes investors to withdraw their capital from other countries
with similar but not identical problems, the crisis cascades and even countries
without the structural problems of the country in question are endangered.
The determinants of debt relief
Despite these arguments, past debt relief programs have been rather ineffective.
The determinants of debt relief obviously deviate from economic reasoning. It can
be argued that neither absolute poverty nor lack of access to foreign exchange
46 The First Global Financial Crisis of the 21st Century Part II
Table 1 Crises and bailout-cost
Crisis GDP (in billions) Cost* (in billions) %GDP
USA 2008 $14,312 $1.500? >10%?
Pakistan 2008 $130 $8? 6%?
Hungary 2008 $170 $16? 9%?
Argentina 2000 $299 $22 7%
Brazil 1998 $844 $42 5%
Russia 1998 $271 $24 9%#p#分页标题#e#
Korea 1997 $527 $57 11%
Thailand 1997 $151 $17 12%
Indonesia 1997 $238 $21 9%
Mexico 1995 $421 $48 11%
*Progressive Policy Institute, September 24, 2008, and own estimations.
(through exports) have been criteria in allocating ODA debt relief and pure grants.
If politicians and international bureaucrats realise that default risks become very
high, they prefer to grant debt relief in order to conceal their imprudent past lending
and to ‘sell’ the renunciation of funds as an innovative poverty reduction
measure, especially if lobbying by non-governmental organisations (NGOs) in
favour of debt relief increases their chances of obtaining positive public credit for
the delivered debt relief. According to this reasoning, politicians in donor countries
do not like to admit policy errors. Politically rational governments in creditor
countries would find arguments for further debt relief measures. Thus, debt relief
is driven by path dependence. Debt relief then is a politically cheap, but economically
expensive form of publicly visible development policy.
In our study, we analysed the determinants of debt relief in more than 100
developing countries between the mid-1990s and 2004. On the one hand, our
findings confirm the political rationale outlined above but are – on the other hand
– somehow encouraging, as creditor governments indeed seem to learn. The most
striking result for the 1990s is the strong path dependence of debt relief. At the
beginning of the 21st century, this pattern has changed. Path dependence, though
still visible to some extent, is much weaker in the period 2000–2004. In this period,
the institutional quality became more relevant, in particular the change in
institutional quality. The provision of debt relief in recent years seems to follow
some prudential rules and to be conditioned on relatively decent policies rather
than only the level of indebtedness and the amount of previous debt forgiveness.
The results also suggest that recent debt relief has been provided in favour of
poor countries that have shown improvements in their governance quality, of
course not neglecting the level of indebtedness and the amount of debt relief
granted in the 1990s (see table 2).
Table 2 Determinants of debt relief 1995–2004
Determinant Period 1995–1999 Period 2000–2004
Past debt relief Positive and highly significant Positive and weakly significant
Poverty Positive and significant Positive and highly significant
Institutions No correlation Positive and significant
Change in institutions n.a. Positive and significant
Controls No significant correlation No significant correlation
These results suggest that the discussion of institutions in development, which has
its roots in academic circles and has been transferred into the international development#p#分页标题#e#
organisations, has not only produced political statements but also some
policy measures. Along these lines, a debt relief for emerging economies in the current
situation may also be based on economic rather than on political rationality.
The history of debt relief is characterised by political failure and short-term thinking.
Consequently, so far debt relief did not deliver promising results. Neither the
economic performance nor the governance quality has increased. Analysing the
The political economy of debt relief 47
determinants of debt relief programs in the 1990s, we derive a standard result of
international political economy. Governments of creditor countries have granted
debt relief rather because of political than of economic reasoning. In particular, we
can confirm a path dependence with respect to debt relief granted.
However, the determinants of debt relief for highly indebted poor countries
have changed slightly, which indicates learning processes in creditor countries.
Thus, recent debt relief programs since 2000 seem to be positively influenced by
economic and institutional development as well as the results of the latest
research on the role of institutions for growth and development. This may indeed
be the result of a successful learning process of donor countries’ governments and
a slight change in the allocation pattern of debt relief along with the introduction
of some sensible criteria during the last decade. Analysing debt forgiveness within
the framework of the Enhanced HIPC initiative, one can find a relation between
debt relief and enhanced institutional quality. This is a very promising sign for the
As a consequence of the dramatic financial crisis the world has changed. The
global financial system will never be the same. Traditional instruments, certain
financial products and regulations will disappear. A new order is requested,
though yet to be developed. The determined reaction of the IMF and national governments
has undoubtedly helped securing the savings of many people and has
been necessary to prevent a collapse of the banking sector and whole economies.
However, the question remains if bailing out broke countries and banks will stabilise
the financial markets and fiscal policies in the future or rather set further
incentives for irresponsible lending, unsound policies and business practices.
Much depends on the application of the rule to tie debt relief to good governance
for helping the emerging countries.
48 The First Global Financial Crisis of the 21st Century Part II
10 November 2008
The Indian variant of the credit crunch is different. This column outlines potential
means of expanding India’s credit supply. Simply cutting interest rates will not
How can India be facing credit crunch if credit continues to grow at a torrid 30%?#p#分页标题#e#
Yet, it is undeniable that call rates have risen sharply to double-digit levels. What
is going on? And how should monetary policy respond?
First, distinguish the Indian phenomenon from what we have seen in Western
credit markets. In the latter, the crisis was primarily about a lack of confidence in
the financial system and the evaporation of trust between agents because of uncertainty
about exposure to mortgage-related assets. In short, the problem was a
diminished supply of credit. Even the inability of firms to raise capital in the commercial
paper market similarly reflected an unwillingness of banks and the public
to supply finance to firms that were believed to be exposed to toxic assets.
The Indian variant is somewhat different. The private sector’s funding from foreign
sources and from the non-bank public (through the issuance of bonds and
raising equity) has dried up because of combination of capital outflows and
declining share prices. In 2007/08, for example, 40% of funds available to Indian
industry were raised through external commercial borrowings and new equity
issues. Funding for Indian companies that have borrowed abroad has also dried up
because of trouble in foreign credit markets, forcing these companies to turn to
the domestic banking system for credit. And firms’ own funding has declined as
profits have headed south.
This reduced supply of non-bank and foreign funding has led the private sector to
turn to banks to make up this shortfall: that is, there has been a sharp increase in the
demand for domestic bank credit. Of course, with banks lending to finance the losses
of oil companies, there has been an additional squeeze (crowding out) of credit to
the private sector as a result of pre-emption of bank credit by the government.
So, the answer is yes, there is a credit crunch despite torrid credit growth
because the demand for credit has gone up. Price (the call interest rate), not quantity,
is the right signal.
The policy question then is – how can this additional credit be provided to the
private sector? Or to put it in accounting terms – how can the aggregate size of the
balance sheet of the banking system as a whole be increased?
India’s credit crunch conundrum
Arvind Subramanian
Peterson Institute for International Economics and
Johns Hopkins University
Five sources of credit
Simple macroeconomic accounting suggests that additional supply of credit can
come from five sources: government, the Reserve Bank of India, firms’ own profits,
the non-bank public, and abroad.
If the government could reduce its deficit, more of the existing credit could
be made available for the private sector. With oil prices declining, this channel
should, unless the government increases its deficit for other reasons, start#p#分页标题#e#
kicking in.
The Reserve Bank of India (RBI) could also facilitate greater credit supply by
reducing the cash reserve ratio, allowing banks to reduce their balances at the RBI
and to make them available to the private sector. The RBI has been using this policy
tool vigorously and perhaps will, and should, continue doing so. Of course,
there is a natural floor to the cash reserve ratio stemming from prudential considerations.
Cutting the statutory liquidity ratio is more complicated. It makes
additional resources available to the private sector only if the non-bank public is
willing to hold government paper in its portfolio. If the result of cutting statutory
liquidity ratios leads to a re-allocation of these bonds within the financial sector,
there are no extra resources from the banking system as a whole.
Can the non-bank public augment the supply of credit? Only if it is willing to
hold more bank deposits, which the banks would lend to the private sector. But
this would require making bank deposits more attractive and hence an increase in
interest rates. Indeed, some banks have been attempting to raise deposit rates to
attract customers.
How can the rest of the world augment credit? Increases in remittances and in
NRI deposits into the Indian banking system could help achieve this. But again
this would require making the holding of deposits more attractive, entailing raising
interest rates and avoiding the risk of depreciation.
The interest rate dilemma
Here then is the dilemma for interest rate policy. Reducing interest rates can help
address the current credit crunch in a number of ways. First, by reducing the cost
of bank’s funding and raising their spreads, it would increase bank profitability.
Second, it could also help corporate profitability which has two positive effects: by
increasing the own source of funding (profits) it reduces firms’ demand for bank
credit and by improving the asset quality of banks it frees up resources to expand
credit. Finally, lower rates helping corporate profitability could attract foreign
capital into the equity market. This would again, for the reasons discussed above,
alleviate the credit crunch by increasing non-bank funding of firms and hence
reducing their demand for bank credit.
On the other hand, lowering rates would reduce remittances and NRI inflows,
which are known to be interest-sensitive. It could also lead the public to take
money out of the banking system to put in other assets or hold it as cash. Some
money could also find its way abroad through direct and indirect (for example,
trade) channels. All of these would reduce the supply of credit, aggravating the
credit crunch.
50 The First Global Financial Crisis of the 21st Century Part II
The policy implications are then clear for alleviating the ongoing credit#p#分页标题#e#
squeeze. Unambiguous ways of helping would be to reduce government claims on
credit and reducing the cash reserve ratio so that implicitly the central bank
finances credit creation. On the other hand, cutting interest rates does not have
an unambiguously positive effect. Policy makers should take note of that.
Whoever said that conducting monetary policy would be easy?
Editors’ note: This first appeared in the Indian newspaper Business Standard.
India’s credit crunch conundrum 51

1 November 2008
Financially integrated India has been hit by the financial contagion. This column
explains what Indian policymakers need to do in order to restore confidence in
the financial system and avoid the risks of easing monetary policies. The time has
come for the Reserve Bank of India to use its foreign exchange reserves to inject
liquidity into the financial system.
‘Brand India’ is being buffeted by the global financial crisis. India has been more
financially integrated than was generally supposed, and hence more affected by
financial contagion than expected. The stakes are high because policy hesitancy
or missteps could turn mild contagion into virulent disease.
One lesson that countries are learning is that during a crisis of confidence, policy-
makers have to get ahead of the curve in order to reassure markets.
Governments have discovered the hard way that responses that are reactive, piecemeal,
and uncoordinated risk undermining rather than adding to confidence. A
formidable policy arsenal needs to be deployed to have any chance of restoring
stability. In western financial markets confidence is returning, slowly, only after a
series of ambitious actions, boldly initiated by the UK and then followed by
Europe and the US, as many economists advocated.
Between last week’s actions to shore up the financial system and Monday’s cut
in interest rates, Indian policymakers can legitimately claim to have risen to the
challenge. But will these actions be enough? What more will be necessary?
Broadly, more will need to be done on the financial sector side in order to do
less on the monetary policy side. Put differently, if confidence in the financial system
is not restored, the easing, even substantial easing, of monetary policies that
we have recently seen may not have enough traction, and may even entail risks.
First and foremost, the plight of individual financial institutions should be
addressed. A benchmark should be that no Indian bank should have credit default
swap (CDS) spreads exceeding 300 or so basis points. It is likely that perilously elevated
CDS spreads reflect problems with foreign funding. So, high on the action
list would be to provide foreign currency resources from the Reserve Bank of
India’s reserves. The RBI’s liquidity injections operations that have so far been in#p#分页标题#e#
rupees need to be expanded to foreign currency.
Preserving financial sector
confidence, not monetary easing,
is key
Arvind Subramanian
Peterson Institute for International Economics and
Johns Hopkins University
One way to do this would be to hold foreign currency auctions for all domestic
financial institutions to meet either their own needs or those of their corporate
clients that face foreign currency funding pressures. The Fed and ECB responded
to dollar shortages in Europe through extensive swap operations that made available
enormous lines of dollar credit in European markets. The RBI foreign currency
auctions should be held quickly and flexibly so that liquidity can virtually be provided
on tap. The RBI’s foreign exchange reserves have been accumulated for rainy
days, and these are not just rainy but stormy days, justifying their liberal use
If these measures prove inadequate, the government may need to step in to
guarantee the foreign-currency debt of domestic financial institutions. This may
need to be complemented with government re-capitalisation, especially if private
banks are unable to raise capital from private sources within a very short period of
time. India just cannot afford to have financial institutions that are flashing
amber or red in these times.
Moving beyond individual institutions, and given the crisis of confidence, it
may be worth requiring all banks to raise their capital adequacy ratio (CAR) to
about 15–18%, within a short period. If meeting this higher CAR requires additional
government capital injection, that should be seriously considered. Ways
could be found for this capital to be returned to the government once the crisis
subsides. If all banks were seen to be meeting this high standard, it could have a
significant impact in reassuring markets. The rationale for the higher ratio, apart
from the confidence boosting impact, is the more substantive one that banks’
non-performing assets are bound to rise as the economy weakens. An apparently
cushion-providing 15% CAR today could very easily become an 8% CAR within a
short space of time.
Next, it might be worth imposing additional transparency requirements on all
the major banks to reassure investors and the public. Uncertainty in this environment
leads to markets believing the worst. All banks should therefore be required
to immediately clarify and publish key variables of concern, including foreign
currency exposure, especially on the liability side, the extent and sources of
wholesale funding, and exposure to derivatives and other such instruments. A
strong transparency effort, under the RBI’s supervision, could have an important
reassuring function.
Finally, what about exchange rate and monetary policies? On the former, the#p#分页标题#e#
RBI should refrain from foreign exchange intervention, which at the moment
sends contradictory signals because it sucks out liquidity at the very time that the
RBI is pumping enormous amounts of liquidity back into the economy. Far better
to use the RBI’s foreign exchange reserves to meet the foreign funding requirements
of domestic financial institutions rather than to defend some level for the
On monetary policy, the RBI has been doing the juggling act of easing interest
rates and injecting rupee liquidity, on the one hand, while trying to encourage
capital inflows and discourage outflows through a variety of measures such as raising
interest rates on foreign currency deposits. Make no mistake that there is an
inherent tension, even plain contradiction, between these actions, which the RBI
has been able to avoid because residents, unlike foreign investors, are not fleeing
rupee assets. The risk of aggressive easing is that it might trigger the move away
54 The First Global Financial Crisis of the 21st Century Part II
from rupee holdings, at a time when confidence in the rupee is so shaky, when
current and prospective depreciation would offset the favourable effects on inflation
from declines in commodity prices, and when credit is still growing at a
whopping 30%. It is worth noting that while the repo rate has been cut to 8%, the
call rate — which reflects market conditions — is at 6%, below CPI inflation,
resulting in negative real interest rates.
A loss of confidence in the rupee is an outcome devoutly to be avoided. At this
juncture, restoring confidence in individual financial institutions and the financial
system is key to achieving that objective and to avoid unreasonably burdening monetary
‘Brand India’ has come to connote not just rapid growth but a reasonable ability
of policymakers to respond to challenges. Of course, this response will be
assessed by outcomes. But critical to this assessment will be whether processes for
arriving at outcomes are effective, and specifically, whether all concerned institutions
play their rightful roles and maintain their credibility. ‘Brand India’ must
pass all these tests.
Editors’ note: This first appeared in the Indian newspaper Business Standard.
Preserving financial sector confidence, not monetary easing, is key 55

27 October 2008
The current financial crisis will probably lead to an unnecessarily deep recession.
This column suggests that European central banks, misguided by outdated econometric
models, should have cut rates faster and deeper in a coordinated fashion.
They should now scrap these models and agree on a large, coordinated cut of
2 percentage points.
When future economic historians look back to trace the triggers for the October#p#分页标题#e#
2008 financial panic and the unnecessarily severe recession of 2009, they will likely
put their fingers on two.
• The failure to keep Lehman Bros functioning as a going concern.
• The failure of the ECB and the Bank of England to use their interest rate
setting firepower to organise a substantial globally co-ordinated interest
rate cut (the 8 October 2008 cut was too timid).
Economics ministries, not central banks, demonstrated
A convincing argument for independent central banks adopting an inflation targeting
framework is that, where central banks are forward looking and responsive,
they should be able to avoid deflationary slumps. The markets then should expect
the central banks to assess clearly the global economic situation and the downside
risks, and take decisive action. Instead, it was the European finance ministries, via
the bank refinancing packages announced between October 8th and 14th, that
demonstrated their far greater understanding of the risks involved. They acted in
a timely and potentially effective internationally co-ordinated manner. It was less
effective because the central banks failed to follow up their initial too small interest
rate cut. They were persuaded into a co-ordinated half point interest rate cut
on October 8th. The central banks then sat on their hands, despite a daily barrage
of deflationary news.
The folly of the central banks
of Europe
John N Muellbauer
Oxford University and CEPR
Emerging markets and the deflationary firestorm
By October 16th, the impact on emerging markets of the deflationary firestorm,
in consequence of the collapse in global growth and in commodity prices, had
become all too apparent. History shows that the resulting combination of financial
and currency crises leaves long-lasting damage in lost output, bankruptcies
and bad debts that handicap future recoveries. There is little chance of a significant
commodity price recovery from recent levels in the next six months. The reason
is that instead of stabilising the global economy, emerging market demand,
such as China’s, is falling, and thus amplifying the shock. As I pointed out at the
Bank of England’s Monetary Policy Roundtable (Sept 30th), a straightforward
piece of economics underlies this idea. While consumer spending is closely linked
with the level of income, investment is more driven by growth. It is the huge share
of investment in national output in emerging economies that makes them, and
their commodity demands, highly sensitive to the global slowdown.
The dual effect of the depreciation of emerging markets’ currencies and the
massive falls in commodity prices will induce the largest negative shock to the
price level in developed economies since WWII. Moreover, collapsing export#p#分页标题#e#
demand and rapidly rising unemployment will add domestic deflationary pressure.
The deflation will in part be offset by the improvement in the terms of trade
for the developed countries, and eventually also by fiscal measures undertaken to
boost demand. However, with the rise in food and energy prices accounting for
approximately 80% of the rise in inflation in 2007–2008 in most European countries,
the coming collapse of inflation in 2009 should have been obvious to every
central banker.
What could have been?
As late as October 21st, the central banks of Europe still had an opportunity for
credible and confidence boosting action on interest rates. A short-term rise in
global stock markets gave a window for action which would not have been seen
as a ‘too little, too late’ fire-fighting reaction to market panic. An accompanying
statement could have noted the dramatic shift in the inflation outlook. It could
have acknowledged that, in effect, monetary policy had involuntarily tightened
with falling inflation expectations raising real interest rates. Policy had already
been tightened through raised market interest rates paid by households and firms,
due to widened spreads under the credit crunch.
Would a co-ordinated 1% cut, accompanied by the promise of decisive and
timely further action in the light of rapidly evolving news, have worked to halt
the panic? Sceptics, perhaps including some in the central banks, were doubtful,
but quite wrong.
The most obvious impact of a cut would have been to raise the profit outlook of
private sector banks in every country. This would have boosted the flow of investors’
funds to the sector and raised banks’ share prices, thereby enhancing their ability to
lend and replenishing trust of depositors and in the interbank market. The result
would have greatly amplified the benefits of the earlier refinancing operation of the
ministries of finance, and lowered money market and credit spreads.
58 The First Global Financial Crisis of the 21st Century Part II
Some of the cut in policy rates would have lowered borrowing rates faced by
hard-pressed households and firms, though more gradually for some types of debt.
Where floating rate debt dominates (e.g. the UK), cash flow effects on consumer
spending are large. In research (with Janine Aron and Anthony Murphy) summarised
in my Jackson Hole paper of 2007, this effect was estimated for UK
consumption. With credit now so restricted and debt levels so high, the size of the
impact on spending of a cut in borrowing rates is larger than ever. Thus, had the
policy rate fallen, the UK might well have experienced a less severe recession than
Germany, which is far more exposed to the slump in exports of capital goods.
Currency crises in emerging markets
Another benefit would have been to ameliorate currency crises in emerging markets#p#分页标题#e#
and smaller countries such as Denmark. Their exchange rates depend in part
on interest rate spreads with the major currencies. A co-ordinated global interest
rate cut would have widened spreads without these countries having to raise rates
to support their currencies in the face of severe recessions. Moreover, as late as
October 21st, many other central banks would have felt able to join a co-ordinated
cut without exposing their currencies.
More generally, the reduction in policy rates, and the prospect of more to follow,
would have reduced returns on safe assets, such as government bonds, and
induced investors at the margin to rebalance towards riskier assets, such as equity
and corporate debt. The rise in such asset prices would eventually have helped to
restore collateral values, slowing the spiral of rising bankruptcies.
Following the panic beginning on October 22nd, the task of restoring
confidence is far harder. With asset prices so much lower, the bad loan position of
the banking system looks worse, and with it, the potential burden on tax payers.
The damage for the UK looks particularly severe, with its debt and housing
market vulnerability – reflected in the sudden decline in Sterling and in Treasury
gilt prices.
Conclusion: Scrap the models and agree on a big, coordinated
rate cut
Why Europe’s key central banks made this potentially catastrophic error is a long
story. One reason, however, rests in their econometric models, based on fashionable
but outdated economic theory.
It is deeply ironic that central bankers who rightly have made much of the
moral hazard of bailing out private bankers, have adopted central bank models
excluding channels for real world moral hazard and credit crunches. These models
are overdue for the scrap heap. Central banks making policy without functioning
models are like aeroplanes flying without radar, and the consequences are
now obvious.
They now have a last chance to undo the damage of last week. They need to
put aside short-term currency wobbles, focus on the big picture and surprise the
markets with a much larger cut, probably of 2 percentage points. If international
The folly of the central banks of Europe 59
co-ordination is now harder to achieve, then leadership by the ECB and the Bank
of England will have to suffice.
John Muellbauer ‘Housing, credit and consumer expenditure.’ in Housing
Finance, and Monetary Policy: a Symposium sponsored by the Federal Reserve
Bank of Kansas City, Jackson Hole, Wyoming, August 30-September 1, 2007,
Federal Reserve Bank of Kansas City, 2007, p. 267–334.
60 The First Global Financial Crisis of the 21st Century Part II
30 September 2008
Europe’s largest banks are highly leveraged and thus vulnerable, as Fortis showed.#p#分页标题#e#
But some of these banks are both too large to fail and too big to be rescued by a
single government. The EU should: (1) urgently pass legislation to cover banks
with significant cross-border presence and empower the ECB to provide direct support,
and (2) create an EU-level rescue fund managed by an existing institution
like the European Investment Bank.
Europe’s universal banks were supposed to be immune to the fallout from the subprime
We now discover that any financial institution – universal bank or not – is vulnerable
if its leverage is high enough – as is the case for Europe’s largest banks. As
we pointed out 10 days ago, Europe’s banks are too big to fail but also too big to
be rescued by any single government. The unfolding of Fortis illustrates vividly
the weaknesses and hurdles of raising adequate defenses against a fully-fledged
banking crisis in the euro-area. This is an area where urgent EU action is needed.
In the case of Fortis, no European solution was possible. The ECB can only provide
liquidity against collateral to keep the money market functioning. It has no
powers to resolve a solvency crisis. In the absence of a European Treasury, such
operations can only be done by national authorities. But national authorities tend
to think nationally and are naturally reluctant to pay for the rescue of banks
abroad. In the case of Fortis it was relatively easy to cut the bank into three pieces,
but this would be more difficult with other large EU banking groups.
Foreign affiliates and banking crises
A key difficulty is that large European banks typically have subsidiaries – separate
legal entities – with separate balance sheets in every country where they operate.
However, asset and liability management is centralized. Cash and liquidity
reserves are also managed centrally and these assets may be ordered back to the
mother-company at times of stress. In such cases, subsidiaries receive paper which
can become worthless if the bank becomes insolvent.
Given this, burden sharing among national treasuries is controversial in cases
of bank failure. Disputes can delay timely decisions. Issues surrounding the equal
Crisis management tools for the
Daniel Gros and Stefano Micossi
Centre for European Policy Studies; Assonime
treatment of creditors and depositors in the different countries can add layers of
In the case of Fortis, the three governments – Belgian, Dutch and
Luxembourgish – choose to inject capital into the subsidiaries on their territory,
thus effectively creating 3 separte, state-owned banks. This is no doubt a harbinger
of the Balkan-isation of the EU banking system that might spread like a forest
fire unless decisive action is taken immediately.#p#分页标题#e#
EU policy makers need to take two steps quickly:
• First, a new EU ‘Statute of Union’ for chartered banks should be established
for banks in the EU/euro-area with ‘significant’ operations in
more than one member state. This could be done by Regulation adopted
by the Council of Ministers.
These banks would be subject to fully consolidated capital requirements and
supervision. In exchange, they would have direct access to ECB liquidity support
– support they could count on even in case of a severe, bank-specific crisis. By the
same legislative act, a new supervisory authority should be created in Frankfurt –
preferably at the ECB – but in any case it should be legally obliged to cooperate
fully with the ECB in all its activities.
• Second, an EU-level contingency fund for rescue operations should be
created at the European investment bank (EIB).
The EIB already is a public agency and issues publicly guaranteed bond to finance
its operations. Its Board of Governors is made up of the ministers of finance of all
EU members and they hold the purse strings. Given that this infrastructure is
already in place, the rescue fund could be operative within weeks. Policy makers
only need to give the EIB the power to take equity stakes in financial institutions
under clearly defined circumstances. When these circumstances materialize, however,
the EIB should have full power to act without further government interference,
issuing (guaranteed) bonds as required to finance the operation.
One could even go a step further. The EIB and/or ECB could be allowed to act
preventively to stop contagion, or at least make it less likely. They could do this
by forcing highly leveraged EU banks with significant cross border operations to
recapitalize themselves or accept public funds. For instance, a capital injection of
⇔280 billion would be sufficient to reduce the leverage ratio of the 10 largest euro
area banks from its current value of 33 to below 20. This would underpin confidence
and thus reduce the risk of massive liquidity withdrawals by depositors.
Such an investment could be unwound once distressed conditions in financial
markets started to ease.
Of course, support by the EIB must come with strings attached to preserve the
value of the public investment and to make sure those who mismanaged pay the
consequences. Thus, the price paid for the (preferred equity) public sector stake
should fully protect the value of the investment, and management should be
changed. Enhanced controls and supervisory procedures should be envisaged during
the period of EIB support.
62 The First Global Financial Crisis of the 21st Century Part II
We are living in extraordinary times. The uncertainty created by the US Congress’s#p#分页标题#e#
rejection of the Paulson Plan will render the market environment even more forbidding
for European banks. Policy makers in Europe cannot continue to muddle
through. They need to rise to the occasion. The implementation of these simple
proposals would put them ahead of events in the unfolding crisis.
Being behind the curve is extremely costly – a fact that US taxpayers have discovered
in a spectacular and exceedingly expensive manner over the past two
Editors’ note: This is an updated version of a column that appeared today in the
Financial Times newspaper, 30 September 2008.
Crisis management tools for the euro-area 63

20 October 2008
The current crisis has exposed the poor organisation of financial supervisory
responsibilities, as central banks, EU ministers, and treasury authorities fought to
respond appropriately. This column argues for the reorganisation of the European
financial regulatory apparatus using a ‘four peaks’ approach that horizontally
divides responsibilities according to objectives.
World leaders, after a false start, have made decisions that at least give us a chance
of getting past this crisis. Now is the time to start thinking about how to reduce
the risk of finding ourselves in the same situation in the future.
Many troubled intermediaries violated no rule or regulation. It is certainly right
to replace greedy managers. The same decision should be taken for those responsible
for designing the wrong rules for bank capital, rating agencies, and accounting
standards. The same approach should be taken for supervision: those who did not
abide by the rules must be severely punished, along with those who were not able
to supervise.
Who is in charge?
The crisis calls into question the efficacy of both the ‘horizontal’ allocation of
competencies among different authorities (fragmentation in the US or the single
regulator in many EU countries) and the ‘vertical’ distribution of competencies,
where only national entities appear to be in charge of supervision (in the US there
is a mix of federal and state competencies on banks while only states supervise
insurance; in Europe, lacking a political and fiscal union, the agencies are basically
all at the member state level). The central banks’ role swings from monetary
policy to lender of last resort to policy-maker, as we have observed over the last
year and more so in the past few weeks.
In the beginning, UK central bankers panicked in the face of a textbook bank
run. Then, all authorities hysterically moved to restrict short selling. Late night
meeting of EU ministers to bail out transnational banks, frantic decisions across
Europe to raise deposit insurance coverage beyond credible levels, and guarantees
for all interbank loans followed. Looking at the ways such policies have been used#p#分页标题#e#
A proposal on financial regulation
in Europe for the next European
Carmine Di Noia
Assonime and LUISS-Guido Carli University
for recent bailouts has raised doubts about their efficacy. All the traditional instruments
have been exploited (sometimes in a creative way or mixed together): direct
government intervention, central bank intervention, deposit insurance, and other
guarantees. All kinds of intermediaries are involved: commercial and investment
banks, investment and hedge funds, investment firms, and insurance firms. The
traditional three-way division of the financial system into banks, capital markets,
and insurance has been finally defeated by the events.
The huge need for fresh capital (through direct injection of capital or loans, the
purchase of toxic assets, new rules on deposit insurance, etc.) remind us of a simple
concept: bailouts must ultimately be the responsibility of the government,
only possibly assisted by the authority and the central bank (which are independent
agencies). On the contrary, bail out decisions are often taken by central
banks, as lenders of last resort, or competent authorities (sometimes central
banks), who should have been, on the contrary, supervising the entity so that it
did not go bankrupt. Furthermore, no lender of last resort has the access to the
money needed for direct intervention in extreme cases: the net result of the Fed’s
intervention in the AIG case is its loss of independence from the US Treasury.
Central banks and competent authorities already have too many conflicts of
interest in carrying out different objectives (macroeconomic stability, prudential
supervision, investor protection or competition). They are worse if those objectives
are those of the policy maker (national interest, bailing-out of a big intermediary).
Furthermore, national and international coordination among authorities is
slow and cumbersome, with hundreds of bilateral and multilateral memoranda
of understanding or colleges of supervisors on financial conglomerates. The Level
3 Committees (Cebs, Cesr and Ceiops), in spite of excellent but limited permanent
staff, depend wholly on their constituent authorities and have rigidly tripartite competence
(banks, securities and insurance) according to an obsolescent framework.
In spite of progress in recent years, the system is still unable to effectively
respond to the challenges of a largely integrated market. This has two regrettable
consequences. It offers inadequate protection for investors and citizens (taxpayers)
and it creates an extra regulatory burden entailing a loss of competitiveness for
financial industry.
It is too early for one (or more) central regulator (s) and supervisor (s) at the
European level. Lacking a political union, still too many different rules exist (commercial#p#分页标题#e#
codes, company laws, failure procedures, corporate governance) and policy-
makers and taxpayers remain national. But is certainly too late to keep only
national authorities.
Reorganising financial supervision into four peaks
Something can be done. A feasible solution, already suggested some years ago1
and identified as the optimal long-term regulatory structure by the Paulson
report2, is the four-peak model (see Figure 1). Regulation and supervision should
66 The First Global Financial Crisis of the 21st Century Part II
1 Di Noia e Di Giorgio (1999), Should Banking Supervision and Monetary Policy Tasks be Given to Different
Agencies, International Finance; Di Giorgio e Di Noia (2001), Financial Regulation and Supervision in the Euro
Area: A Four-Peak Proposal.
2 Department of Treasury (2008), Blueprint for a modernized financial regulatory structure.
be arranged horizontally by objective – separate agencies should be in charge of
macroeconomic stability, microeconomic stability, investor protection and competition
for all intermediaries including insurers. Each of these objectives should
also have a federal structure, with a structure similar to the one established for the
European System of Central Banks (ESCB).
The ESCB should have responsibility for macrostability issues and lending of last
resort throughout the EU – not just the Euro area, so to avoid awkward meetings
with UK fellows.
Then a European System of Prudential Supervisors should be established, using
possibly the expertise of the ECB, national central banks, Cebs and Ceiops. The
system should denote a central entity in charge of the prudential regulation of all
intermediaries and of the coordination of the national authorities, possibly
designed by objective in each country. The national prudential supervision
authorities should be in charge of all supervision but not regulation.
The third peak should be a European System for Investor Protection. The structure
should be similar as above. A central entity, exploiting Cesr expertise, should
be in charge of all regulation of conduct-of-business rules of all intermediaries,
including insurance and pension funds, transparency of all financial products
(from banking deposit to insurance contracts), and issuers and markets. Some
supervision should be exercised in case of multinational intermediaries or issuers.
National authorities should focus only on supervision.
The fourth peak, that of competition, already exists with a central entity (DG
Competition) supervising relevant operations while national authorities supervise
smaller operations.
A proposal on financial regulation in Europe for the next European Council 67
Figure 1 The proposal: a New European System of Financial Regulation
European System of
Central Banks
European System For#p#分页标题#e#
European System for
Invest or Protection
European System of
National Central
Supervisory Authority
Coordination Committee
Coordination Committee
Investor Protection
Antitrust Authority
European Prudential
Regulation Authority
European Investor
Protection Authority
European Antitrust
European Level
Domestic Level
Apart from this vertical form of coordination, cooperation would be also desirable
horizontally, at both the European and national levels. This coordination,
and resolution of eventual controversies could be provided by special
Commissions for the Supervision of the Financial System established at the EU
Council Level (with the Commission, too) and at national treasuries.
How to implement it? Many difficulties are obvious. Treaty changes are complicated
(but why not explore the route of intergovernmental agreements?).
Commission or EU regulation must be carefully analysed, as well as the possibility
offered to the Council by Article 352 (ex Article 308 TEC) of the Treaty.3 The
opposition of existing central bank and national supervisors to some centralisation
and redesign of competencies at national level is enormous.
The existing crisis offers the (hopefully last!) occasion to act in order to increase
the efficacy of financial supervision, simplifying the complex architecture of
existing authorities. In the US, Secretary Henry Paulson did not dare to put a single
word of his Blueprint in the TARP. And in Europe? The ‘financial crisis’ cell4
created by the European Council two days ago is not sufficient; let’s do something
68 The First Global Financial Crisis of the 21st Century Part II
3 If action by the Union should prove necessary, within the framework of the policies defined in the Treaties, to
attain one of the objectives set out in the Treaties, and the Treaties have not provided the necessary powers, the
Council, acting unanimously on a proposal from the Commission and after obtaining the consent of the
European Parliament, shall adopt the appropriate measures.
4 See http://www.consilium.europa.eu/ueDocs/cms_Data/docs/pressData/en/ec/103441.pdf
17 October 2008
EU leaders have agreed on a bail-out plan but much is still unknown about its
details. How will governments act as equity shareholders? Who will deal with
cross-border banks? This column discusses the need for a Euro-area bank supervisory
authority, as financial integration has outpaced regulatory integration.
At last, European countries appear to have realised that the solvency problem at
the heart of the current crisis goes well beyond their national borders and requires
cooperation. After a week of collapsing stock markets and rising fear of widespread#p#分页标题#e#
bank defaults, the leaders of the 15 euro-zone countries have reached an agreement
on a plan that follows the broad outline of the British bail-out plan – governments
will buy equity stakes in banks and will guarantee new borrowing to
unblock the interbank market. Together with the announcement that the ECB will
create an unsecured lending facility to purchase commercial paper by banks, this
plan has finally managed to instil some confidence into the markets, as witnessed
by the immediate jump of stock prices.
Devil in the details
Of course, while the broad lines of these interventions are clear, much is still
unknown about their detailed design and implementation – and this is a case
where the devil is in the details. How will each government determine the equity
stakes to be bought in distressed banks? Clearly, governments should not bail out
all banks irrespective of their degree of solvency. The same issue arises for the provision
of loan guarantees and the purchase of commercial paper from banks.
Presumably equity injections and loan guarantees should be implemented in close
cooperation with the relevant banks’ main supervisors, as already argued by Javier
But other ‘details’ are no less important for the long-term outcome of the bailout.
What will ensure that these equity injections and the implied partial or total
nationalisations of European banks will not take us back to the era of widespread
The European response to the crisis:
Not quite there yet
Marco Pagano
University of Naples Federico II and CEPR
1 See Javier Suarez, ‘The Need for an Emergency Bank Debt Insurance Mechanism,’ CEPR Policy Insight No. 19,
March 2008.
state control over banks? In the UK, Germany, France and Italy (as well as in the
US), governments are pledging that they will take equity stakes in the form of preferred
shares and that they regard this as a temporary investment, to be eventually
sold back to the market once the crisis is over. But are such pledges common to
all of the Euro-area governments? And in the countries where governments made
them, what guarantees that they will be upheld, and over which time horizon?
Governments as passive investors
A related question is whether governments will behave as passive investors or
wield some control over the key decisions of the banks that they bail out.
Historical experience from past crises shows that governments tend to take an
active role in controlling the institutions that they bailed out. This applies, for
instance, to the Reconstruction Finance Corporation created by President Herbert
Hoover in 1932 and to the Institute for Industrial Reconstruction (IRI) created in
Italy during the Great Depression. It also applies to the more recent experience of#p#分页标题#e#
Sweden’s financial crisis in the early 1990s, when the government bailed out the
country’s banks, replaced their executives, and forced mergers among them to
strengthen the survivors. But if governments are going to have such sweeping control
rights, it would be important to indicate clearly how they will use them. For
instance, will they be entrusted to bank surveillance authorities or will they rather
stay directly with the governments?
Put bluntly, what will prevent reverting to a regime where politicians extract
huge rents from the control of banks or mismanage them, as used to happen in
much of Continental Europe before the privatisations of the 1980s and 1990s?
Clearly, this question is closely tied to the credibility of government’s exit as a
shareholder. If we go back to a regime where politicians can extract control rents
from banks, governments will find it hard to surrender such control once the crisis
is over, as witnessed, for instance, by the fact that IRI kept controlling stakes in
the largest Italian banks for over half a century after the Great Depression.
The answers to these questions will shape the structure and working of
European financial markets for a long time.
Bailing out big, cross-border banks: Create a supra-national
There is also the all-important issue that unfortunately European leaders have
completely disregarded so far – how to deal with the bail out of large banks with
extensive cross-border activities and subsidiaries. European governments have
decided to implement the bailout plan at the national level rather than create a
common authority to attack the problem at a supra-national level. This is probably
an efficient solution for most Euro-area distressed banks, which are small or
medium institutions with little or no cross-border operations. But it is totally inadequate
for those few large banks with extensive cross-border operations and
subsidiaries, whose solvency is crucial for the systemic stability of the European
credit market. If any of these banks were to experience solvency problems, we
70 The First Global Financial Crisis of the 21st Century Part II
would need a fast and commonly agreed procedure to determine how the
governments of the various countries involved should intervene and share the
burden of the bail-out.
The best way to face this formidable challenge would probably be to create a
supra-national authority to coordinate the bailout. Of course, designing the rules
to determine when such an authority should bail out a cross-border bank and how
the implied costs are to be shared across EU member states is no easy task. One
can think of alternative sharing rules. For instance, the burden to be paid by each
government might be set on the basis of the balance sheets, the share of riskweighted#p#分页标题#e#
assets, or the share of regulatory capital of the various subsidiaries. The
design of these rules will have important implications for the incentives of the
managers of these banks and, most importantly, for European taxpayers. But, for
all their technical difficulty and political sensitivity, these issues can no longer be
dodged. If one or more of euro area’s largest cross-border banks turned out to be
insolvent, this limitation of Europe’s policy response would become tragically
Set up an embryonic Euro-area bank supervisory authority
Taking up this challenge would be a golden opportunity to create the embryo of
a future Euro-area bank supervisory authority, capable of monitoring the risks
being taken by the few large European banks with large cross-border operations,
while leaving the many purely national banks of the Euro area under the surveillance
of the corresponding national supervisors – an idea that has already been
repeatedly proposed by Tommaso Padoa-Schioppa.2 Hopefully the crisis will
induce governments to recognise that, in its current incompleteness, European
monetary and financial integration is in a potentially unstable situation. We have
created a single, integrated financial market where the operations of the main
players naturally transcend national boundaries. Yet, we have so far failed to complement
this construction with its natural counterpart – a supra-national surveillance
authority for Europe’s supra-national banks. This half-way stop is a very dangerous
one. Precisely because the current situation poses substantial risks for the
European banking system, it can also become a unique opportunity to secure
European financial integration on much firmer grounds than it currently is.
The European response to the crisis: Not quite there yet 71
2 See Tommaso Padoa-Schioppa, ‘Europe Needs a Single Financial Rulebook,’ Financial Times, 11 December
2007, p. 13.

20 November 2008
Finance, the market and globalisation are at risk of being jointly demonised by the
crisis. This column argues that the these three elements are neither good nor bad;
they are just opportunities for individuals, for societies and for economies that
must be understood and regulated.
A critical rethinking of finance has been prompted by the present crisis. It is also
implicating the very notion of the market economy and the globalised form that
it has taken in recent years. Finance, the market and globalisation are at risk of
being jointly demonised, including by normally moderate observers of economic
affairs. Recollecting a few basic arguments in favour of the trio may not be useless
at this juncture.
Finance: instrumentum diaboli?
At its core, finance is first and foremost a mechanism for shifting purchasing#p#分页标题#e#
power over time.
Lending is an ancient human activity. Embedded in it is the suspicion of
immoral conduct on the part of the lender, seen as the one who, for personal profit,
either encourages the borrower’s spendthrift ways or exploits the borrower’s
genuine needs. Which is why in some human communities, at certain times in the
past but also today (for example in the Islamic world), charging interest on money
loaned was/is forbidden by either law or religion.
The very concept of money was probably devised at the dawn of humanity
along with that of credit, and perhaps even at its service, as a means of transferring
spending power over time by detaching it from any specific physical good.
Money flanked and possibly surpassed credit as a source of negative symbols in the
popular imagination.
Yet money and credit are part of what has enabled human beings to free themselves
from the barbarism of immanence, from the savagery of a life ruled by the
consumption for survival, which is spent in an instant. They teach man to think
about the unfolding of time and they do so by appealing to the most powerful of
all psychological levers, that of desire and need. Learning how to project a desire
into the future or to predict a need is a fundamental step in evolution. It pushes
Finance, market, globalisation:
a plot against mankind?
Salvatore Rossi
Bank of Italy
people to design a method for satisfying future desires or needs, and that method
is saving. If everyone’s savings is lent to someone else, both the personal (if the
loan is interest-bearing) and the social utility are augmented, because two ends are
simultaneously met: that of investors who have in mind their future consumption
(needs-desires) and that of those who instead require additional immediate
purchasing power, motivated by the mere urge to consume, but possibly – and
this is the most socially interesting case – by the desire to increase their own
productive capacity, and therefore by a plan that is equally far-sighted and futureoriented.
In a monetary economy, finance – consisting of markets and intermediaries
whose job is to assure the optimal allocation of resources and risks – is what makes
the saving-credit-investment gears turn. It is one of humanity’s great intellectual
achievements. Yet it does not enjoy the universal admiration accorded to such
other intellectual watersheds as the wheel or the number zero. The problem is that
everybody can use the wheel and the number zero profitably, easily and naturally,
while by definition finance creates a conflict of interest between two major,
and equally deserving, categories: lenders and borrowers. The first group will want
to see high interest rates and broad guarantees, be they real collateral or based on#p#分页标题#e#
reputation. The second group will want low interest rates and the possibility of
providing the minimum possible guarantees.
The unalterable fact that the objectives of these two groups are, at least in part,
conflicting leads to tensions being inevitably offloaded onto professional intermediaries.
They always run the risk of being seen as parasites who are happy to sit
back and let others toil – the people who produce tangible goods and save up to
ensure that they can retire in peace – before fleecing them mercilessly. It must be
acknowledged that the victims of this prejudice often do practically nothing to
dispel it; indeed, at times their conduct seems designed to lend it credence.
Evident examples of this are to be found in the current global financial crisis.
Yet, the pivotal role of finance in our lives has never been apparent as in the
present turbulent days.
Market: did it fail?
In this crisis, who has failed, State or Market? I argue that it is more a State failure,
but by virtue of a paradox. One firmly established conclusion of centuries of economic
science is that the market must be ‘regulated’ or it is no market. If the government
practices absolute laissez-faire, the free competitive market cannot last; it
is strangled by the monopolistic spirit of operators. This is a law of nature, a sort
of economic entropy. The pure competitive market is the optimal regime from the
standpoint of ‘buyers,’ i.e. the community as a whole, but the worst possible for
the ‘sellers,’ a powerful minority constantly trying hard to oppose it. Such a market
is a limiting condition that the public authorities may seek to approximate
only by virtue of unflagging effort. Clear, comprehensive, specific rules are essential;
and farsighted, attentive regulators and supervisors who cannot be captured
by the ‘sellers’ are indispensable. They must obviously be efficient: the burden of
the regulatory apparatus that inevitably weighs on private agents ought to be nondistorting,
light and non-bureaucratic. But we cannot do without it.
74 The First Global Financial Crisis of the 21st Century Part II
This forms the essence of what to my mind is the most advanced contribution
of liberalism to economic thought. Nobody should confuse the great principles of
liberty with the arbitrariness of complete laissez-faire. Eighty years ago, an Italian
champion of liberalism in politics and a neatly pro-free-market economist, Luigi
Einaudi, wrote:
The maxim of economic liberalism (is) taking on a third – I would call it a religious
– meaning. In this interpretation, ‘economic liberals’ are those who accept the
maxim of laissez-faire, laissez-passer almost as if it were a universal principle. (…)
The whole subsequent history of the doctrine demonstrates that economic science#p#分页标题#e#
(…) has nothing to do with the religious conception of economic liberalism.1
The ‘religious’ notion that Einaudi stigmatised so scathingly was resuscitated in
the second half of last century, as the consequence of a debate on the foundations
of public economy. The standard theory of regulation as fundamental to the
public interest came under increasing criticism in the 60s, and gave way to an
alternative view, according to which markets themselves, or at the most civil
courts, can remedy virtually all market failures, whereby government is necessarily
incompetent, possibly corrupt, and ‘captured’ by the very interests it is supposed
to regulate, so it can only make things worse.2
The schools of thought backing this view are unquestionably among the high
points of twentieth-century economics.3 Unfortunately, in the last twenty years,
especially in Britain and America, that view has been used to forge a properly religious
dogma, as Einaudi understood it, and the policies today under indictment
were born of that religion. The global financial crisis of these past two years turns
the empirical evidence overwhelmingly against it. The fundamental problem
underlying the crisis has been one of rules and their effective application. The laissez-
faire fundamentalists may be seen paradoxically as State interventionists, in
that they wanted the government, allying with vested interests, to purposely
deprive the competitive market of the air it breathes, namely rules and supervision.
If this view is correct, by a twist of language we can call it a State failure: a
failure by inaction, not excessive action, due to the refusal to see, to counter or to
correct an evident series of market failures.
Globalisation: the accomplice?
In the frenzied hunt for a scapegoat during this delicate conjuncture, there has
been no lack of anathemas proclaimed against globalisation. In past years detractors
and enthusiasts of globalisation have squared off for some time, but the
former are rapidly gaining ground since the outbreak of the financial crisis.
Finance, market, globalisation: a plot against mankind? 75
1 L. Einaudi (1931), ‘Dei diversi significati del concetto di liberismo economico e dei suoi rapporti con quello del
liberalismo’ in B. Croce and L. Einaudi, Liberismo e liberalismo (Ricciardi: Milan and Naples, 1988). English
translation in Luigi Einaudi, Selected Economic Essays (Palgrave Macmillan: Basingstoke and New York, 2006),
pp. 75–76.
2 This critique is ordinarily associated with the Chicago School of Law and Economics and with such economists
as Ronald Coase, George Stigler and Michael Posner.
3 However, the critique has in turn been criticized both in theory and empirically. On the empirical side, in particular,
it has been noted the strident contrast between the doctrine’s precepts and the reality of a world at once far#p#分页标题#e#
wealthier and far more extensively regulated than a hundred years back. See A. Shleifer (2005), ‘Understanding
Regulation,’ European Financial Management, 11, 4, pp. 439–451.
The complaints have tended to be mixed up: the Chinese are waging unfair
competition against me, the price of petrol has doubled, I find a toxic asset in my
securities portfolio that I didn’t even know I had, my banks is making trouble
about giving me more credit since it is unable to procure liquidity in a global market
paralysed by mutual distrust. All this, most people have been thinking, should
have something to do with globalisation.
The problems are serious and concrete, but the target is too generic to be useful.
Globalisation involves various aspects: production, trade, finance, migrations,
the diffusion of ideas and knowledge. These aspects all have one characteristic in
common: the heightened mobility made possible by the ICT revolution.
Technology, then, is the prime mover, even if the trade and financial liberalisation
policies adopted in many countries in the 1990s assisted the process.
In effect, globalisation and innovative finance are two sides of the same coin
minted by technological innovation. Because of that deep nature, they are neither
good nor bad, they just represent an opportunity for individuals, for societies, for
economies; they must be understood and governed, and cannot be stopped,
except at the cost of accepting backwardness and marginality.
Disclaimer: The opinions here expressed are only the author’s and do not
involve, in particular, the Bank of Italy. An extended version, in Italian, of this
note is forthcoming in: Il Mulino, 6, 2008.
76 The First Global Financial Crisis of the 21st Century Part II
12 October 2008
Europe’s new crisis plan will hopefully stop the panic. This column explores the
remaining issues – the sharing the burden of transnational bank losses and restarting
the inter-bank lending market. It suggests a technical change to the guarantees
that would produce a better result.
The title of the press release from the emergency Euro area summit is already muddled
– ‘A concerted European action plan of the euro area countries’. The outcome
of this extraordinary summit was neither an action plan, nor was its contents really
specific to the euro area countries.
The limited results of two emergency summits in Europe show how much more
difficult it is to manage a banking crisis in an area in which there is no fiscal solidarity
and even limited regulatory convergence. One cannot just translate the
lessons from past crises, almost all of which were at the national level, to formulate
a European response to the current financial turmoil.
One general lesson from past crises is that it is imperative to avoid a generalised#p#分页标题#e#
bank run. Hence it was certainly useful for the euro area summit to state the obvious.
European governments will not let any systemically important bank fail. This
is not news, but its restatement should still contribute to reduce the sense of panic
prevailing in financial markets.
The real issue in Europe had always been the question of burden sharing – i.e.
who pays for the losses at a trans-national bank. The case of Fortis does not
constitute a good precedent, as this issue was not really settled. Moreover, the different
pieces of Fortis had not yet been tightly integrated, so it was still relatively
easy to cut the bank into three parts operating (now independently) in the three
Benelux countries. This is one way in which the current situation is different from
national banking crisis.
While stopping the panic was the immediate priority, the real question is
whether Europe can now avoid a credit crunch, i.e. a sharp slow down in bank
lending. A credit crunch would lead to a large loss of output, but this seems
unavoidable as banks will now feel that they first have to rebuild their capital and
their liquidity before they can extend new credit.
This issue is particularly acute for the inter-bank market, and its urgency is by
now understood by all policy-makers. The inter-bank market has become dysfunctional
almost everywhere. This market is important because it channels funds
Can Europe take care of its own
financial crisis?
Daniel Gros
Centre for European Policy Studies
from banks that collect more deposits than they can usefully lend out to banks
that have more credit-worthy customers than deposits. If this distribution mechanism
does not work, banks with few deposits must cut lending (making the
second problem much worse).
How to revive the inter-bank market?
How to revive the inter-bank market? The crisis has now become so acute that
banks refuse to lend short even if they have the funding. Eurozone banks prefer
to deposit surplus funds at the ECB’s low yielding deposit facility rather than to
lend to other banks. The ECB has de facto become the clearing house for the
collateralised inter-bank market in the euro area. This part of Europe is working.
However, the normal, unsecured, inter-bank market remains frozen.
Breaking the negative feedback: The need for European
This issue needs to be tackled, but no country can achieve it on its own since the
bulk of the inter-bank market is spans national borders. This is another difference
between national banking crises and the current situation in the euro area. What
is needed is a coordinated approach, as proposed by the UK – but at the euro area
level. The ‘action plan’ of the euro area countries emphasises this point, but it
seems to be headed in the wrong direction.#p#分页标题#e#
Experience has shown that under present circumstances any additional funds
pumped into banks will be hoarded rather being lent onward in the inter-bank
market. The reason is quite simple: banks refuse to lend to other banks even if
their counterpart appears to be safe because in a world in which other banks do
not lend even to safe banks, even safe banks can become illiquid very quickly. This
negative feedback loop must be broken.
Even with the vague government guarantee now extended by most governments
to all systemically important institutions, banks will still remain reluctant
to lend to each other even if all banks in Europe might now be ‘government-sponsored
entities’ as Fannie Mae and Freddie Mac used to be called in the US. Most
inter-bank lending in Europe is cross-border and a guarantee by a foreign
government is never perceived as good as a guarantee by the own government.
This is yet another difference between a national bank crisis and the problems
of the euro area.
Moreover, even if the blanket guarantee for banks in Europe were perceived as
rock-solid, the key point remains that banks all over the world now place an
extremely high premium on liquidity. This implies that banks are likely to hoard
the additional liquidity they can obtain through the debt they can issue with a
government guarantee. The experience of Japan has shown that even pumping
enormous amounts of liquidity in the banking system may not be sufficient to get
credit flowing again.
A different approach would have been much better. Each government should
guarantee its own banks reimbursement of inter-bank loans, including cross-bor-
78 The First Global Financial Crisis of the 21st Century Part II
der loans, if they are to a bank from another country that participates in this
scheme. Thus this guarantee scheme would apply to the asset side of banks’
balance sheets. This is an important difference from the current thinking to guarantee
the liabilities of banks. Guaranteeing their liabilities makes funding easier,
but as argued above, is no guarantee that credit actually increases.
The guarantee for inter-bank lending proposed here would presumably be valid
for a limited time and governments could charge appropriate fees (as would also
be the case in the guarantee of banks’ liabilities contained in the euro area
approach). But given current levels of the cost of protection against counterparty
default in the banking system, this fee could be substantial enough to provide a
comfortable insurance premium for the protection of tax payers without choking
off the market.
The objection of (national) finance ministers will of course be that this exposes
them to a risk that originates potentially in another jurisdiction. In reality this
risk will be quite limited because the euro area leaders also decided to shore up#p#分页标题#e#
their large banks and prevent bank failures.
Moreover, losses from housing related activities seem relatively minor in Europe
(except Spain and Ireland). This implies that the key issue in Europe is not how to
make up massive losses, but how to resolve a coordination problem which has led
to the disappearance of the vital inter-bank market.
Missed opportunity
Euro area countries had the chance to agree on a specific action for the euro interbank
market. They got one important technical detail wrong. In principle, this
should be easy to correct. But in reality this will be very difficult, as all national
leaders now have to implement the common approach at home. Once one or two
countries have started implementation, it will be extremely difficult to change
tack as these countries will naturally not take it kindly if they have to go back to
their national parliaments. Once a general principle has been set, it becomes
extremely difficult to change. In a national context the direction of action can be
changed much more quickly to adapt to quickly changing circumstances. Witness
the UK (or Germany) where a national administration performed a complete
U-turn in a very short time.
One should thus be cautious in applying the lessons from previous crises to the
European context. Certain issues are specific to Europe and certain solutions,
which might be desirable, are not politically feasible in an area that adopted a
common currency hoping that the absence of fiscal solidarity would not be tested
by the markets.
Can Europe take care of its own financial crisis? 79

6 October 2008
The liabilities of the biggest US bank equal half the US tax revenues; the ratios in
Europe are bigger. Deutsche Bank’s liabilities are one and a half times Germany’s
annual tax revenue; Barclays’ are twice Britain’s. This crisis will either leave
European financial integration in tatters or quicken the development of European
fiscal capacity. European integration is a historical process that routinely stumbles
upon crises that threaten to destroy it, only to find that it has been deepened by
the crisis.
One of the interesting and perhaps sad lessons of last weekend’s mini-summit of
European leaders in Paris is that Europe’s predicament has been made worse by
allowing financial integration to run ahead of fiscal integration.
Financial integration got ahead of Europe’s governance capacity
The logic at the time was that financial integration would reinforce the single market
and facilitate economic integration. The consequence is that Europe now has
financial institutions that are large relative to individual member states. European
financial institutions funded the acquisition of cross-border assets through the
money markets (since regulators make it expensive to acquire deposits). Now the#p#分页标题#e#
money markets have frozen and these institutions are too large for taxpayers in
their home country to rescue.
Europe’s national leaders don’t have the tax base for a US-style
Individual European states could not agree to a US-style bail out over the weekend
because they do not have the tax bases to do so. The liabilities of Bank of America,
the largest US bank by balance sheet, are approximately half of the annual tax revenues
of the United States. That is a big ratio, but it is dwarfed by the ratio of liabilities
to home tax revenues of Deutsche Bank at one-and-a-half times, and of
Barclays at two times.
The financial crisis may hasten
European integration but slow
global banking
Avinash Persaud
Intelligence Capital
The currency markets have followed the scent of this fiscal issue ever since the
US began considering Treasury Secretary Paulson’s Plan. The Euro lost 5% in a little
over a week against the US dollar. But the problem may not be as bad as the
currency markets think. Big government can make big mistakes. Far from enviable,
the US approach may prove to be expensive folly. It is far from clear that
Paulson’s Plan will trigger private investment into banks, and if there is none, US
Treasury purchases of troubled assets above market prices is an expensive way to
inject new capital into the banks. I suspect Europe will eventually stumble towards
solutions to the credit crunch that are better for being constrained by Europe’s
national budgets, but can nevertheless operate effectively at the European level.
Better than Paulson’s Plan: Capital injections and debt-equity swaps
One idea that is emerging from the weekend discussions is for European governments
to offer an injection of equity capital into institutions that seek assistance.
I would add that as a condition of doing so, they should negotiate a partial debtfor-
equity swap of the bank’s creditors.
Getting sufficient capital is the problem that banks have today – we have
moved on from the liquidity problem of the last eighteen months – and injecting
capital is far less expensive than buying assets. The US is taking advantage of its
tax base more than it should. Using the promise of an equity injection as a lever
to negotiate a restructuring of bank debt will also help European taxpayers share
this lower burden of bank rescues with bondholders. Recall that bondholders were
paid to take the risk of bank failures.
Addressing government control issues with European-level
Many thorny issues arise when governments start taking equity stakes in local banks.
This is one of the reasons why the US authorities decided to be indirect and buy bank
assets instead. But Europe has the potential to do this one step removed from national#p#分页标题#e#
governments in a way that the US may not have been able. European governments
can increase the capital subscription of the Luxembourg-based European Investment
Bank to fund capital injections into banks. The weekend meeting already sanctioned
a ⇔30bn EIB fund to help small businesses hit by the credit crunch. While the
process could not be de-politicised, the EIB or a new cousin can act more independently
of national governments and more consistently across them.
Limits to global finance: The tax base
But the most interesting lesson of this phase of the crisis is that there is a greater
limit to the globalisation of finance than we thought. The constraint is in a different
direction than previously imagined – the taxpayers’ guarantee.
This will cause a reappraisal of a few global banking brands. It also casts a new
light on the viability of offshore financial centres. In Europe’s case, it either leaves
82 The First Global Financial Crisis of the 21st Century Part II
financial integration plans in tatters, or it quickens the development of a
European fiscal capacity. For good or for ill, I would bet on the latter. The history
of European integration has been that the process routinely stumbles upon crises
that threaten to destroy it, only to find that it has been deepened by the crisis. The
euro’s arrival probably required the near collapse of the European Monetary
System in 1992–1995.
The financial crisis may hasten European integration but slow global banking 83

30 October 2008
The euro is plunging and EU banks are coming under renewed pressure. There is
a strong demand for ‘European’ bonds as well as a need for massive government
capital infusions to prevent the crisis from getting worse in the banking sector and
the European periphery. This is why the EU should set up a massive European
Financial Stability Fund.
The plunging euro
Why is the euro plunging against the dollar and the yen? Why are European banks
coming under renewed pressure? Should the emerging financial and foreign
exchange crisis of countries gravitating around the euro lead to new EU policy
The euro is plunging against the dollar because investors, in their scramble for
safety and liquidity, are flocking to US and, also to some extent, Japanese government
bonds which are considered safer and more liquid than other governmentbacked
paper available in the market – including public debt instruments issued
by European governments. In other words, the constellation of separate markets
for sovereign debt paper of unequal quality issued by European governments
cannot compete with the US market for the huge global financial flows in search
of a safe harbour. Until the EU develops a unified market for bonds denominated
in euro and backed jointly by EU member states – or, better, by euro-area member#p#分页标题#e#
states – its claim for the status of reserve currency for the euro will not be met. As
a result, capital is not coming to Europe, where it is badly needed to shore up its
shaken financial system; moreover, the US will continue to dictate the agenda in
international monetary affairs, even now, after the colossal damage inflicted on
the world by their misguided macro and regulatory policies. To add insult to
injury the US government is now paying 2–3 percentage points less on its short
term debt than even the most virtuous EU member states.
European banks under pressure
Second, why are European banks coming under renewed pressure, and how is
this related to mounting pressures in countries gravitating around the euro?
Worsening economic prospects are only part of the explanation. The deteriorating
foreign exchange and financial conditions of satellite countries in the euro area –
A call for a European Financial
Stability Fund
Daniel Gros and Stefano Micossi
Centre for European Policy Studies; Assonime
from the Baltic region to Eastern Europe, Turkey and Ukraine, not to mention the
imploded Icelandic financial system – is also weighing heavily on EU banks’ financial
solidity since they provide the backbone of the banking and financial system
in those countries, and therefore are now much exposed to the consequences of
mounting capital flights and currency attacks in those countries. European banks
hold over $1,500 billion of cross-border claims on emerging European economies
(out of a total of $1,620 billion). When all European banks run for the exit, they
are increasing their own losses – thus fuelling the need for further recapitalisation.
There is no escape: the EU will have to take responsibility for the stabilisation
of financial conditions in these euro-satellites and will need substantial resources
to be able to do it – for emergency balance of payment assistance as well as direct
provision of good government paper in exchange for flawed private claims, precisely
as the US did with their Brady Bonds in the 1980s to resolve the Latin
American debt crisis. The existing funds for Macro Financial Assistance that could
be mobilised are much too small to have a substantial impact.
European banks are also coming under renewed pressure because the national
rescue programmes put in place following the meeting of the Heads of State and
Government of the euro area on October 12th are starting to look insufficient.
One reason is their prevalent case-by-case approach, which has kept banks away
from their governments’ helping hand for fear of political interference in the
choice of management or credit policies. This applies in particular to Italy and
Germany, where the largest private banks have so far declined to apply for government#p#分页标题#e#
capital infusions and guarantees because they fear heavy handed intervention
by their national finance ministries. Another reason is that country-based
rescue plans fail to provide convincing guarantees to depositors and investors in
large cross-border banks where it is far from clear who will take responsibility for
losses generated in an EU country other than that of legal residence. The near run
on the branches of ING in Spain illustrates how deep this mistrust runs.
The way ahead
The way ahead has already been shown by the US and UK authorities with their
de facto compulsory recapitalisation of all main banks – which was followed by a
similar approach in France. The case-by-case approach must be abandoned and an
ambitious capital target must be set for all EU main banks as was recently advocated
by Wyplosz. Again, there is no need to tap national budgets in order to do
so. EU government-backed bonds can provide adequate resources by making it
possible to tap the gigantic global capital flows in search of safety; the euro and
the credibility of the European financial markets would greatly benefit from these
capital inflows.
The overall message from financial markets is that investors everywhere have
developed a strong preference for public debt. In the US and Japan, public debt
carries no risk because if needed the government could always force the (national)
central bank to print the money needed to meet its obligations. But this is not
the case in Europe since no European government can force the ECB to print
money. For international investors there is thus no euro area government bond in
which they could invest to diversify their risk away from the dollar.
86 The First Global Financial Crisis of the 21st Century Part II
We thus have at the same time strong demand for ‘European’ bonds and a need
for massive government capital infusions to prevent the crisis from getting worse
in the banking sector and the European periphery. This is why the EU should set
up a massive European Financial Stability Fund (EFSF). The fund will probably
have to be at least on the scale of the US Troubled Assets Relief Programme (TARP),
say ⇔500–700 billion. It would issue bonds on the international market with the
explicit guarantee of member states. As the rationale for the EFSF is crisis management,
its operations should be wound down after a pre-determined period (5
years?). For global investors EFSF bonds would be practically riskless having the
backing of all member states.
Setting up a European Financial Stability Fund
Setting up a fund with a common guarantee does not imply that stronger member
countries would have to pay for the mistakes of the others since at the end of its
operations losses could be distributed across member countries according to where#p#分页标题#e#
they arose. But in all likelihood the Fund would not lose, but rather would make
money, because its funding costs would be much lower than that of member states
and because its existence would stabilise European financial markets. Germany,
which so far has opposed this idea, might be the biggest beneficiary because German
banks are likely to be its biggest customer, Germany’s automobile industry would
gain most from a stabilisation of the European banking sector and Germany’s
exporters would gain most from a stabilisation of the European periphery.
This Fund could be set up quickly at the European Investment Bank, which
already exists as a solid institution with the necessary expertise. (Technically the
EIB is an agency of EU governments whose board of governors includes the ministers
of finance of member countries). A fund run be a European institution
would lead to a different political economy dynamic since national finance ministers
will have an interest to see it wound down once financial markets operate
again normally. By contrast, it will be much more difficult to end national support
schemes since no finance minister will want to be the first one to withdraw support
for his or her national champions.
The resources available to the EFSF would be used mainly for bank recapitalisation,
especially for those banks which rather ‘gamble for resurrection’ than accept
the presence of heavy handed interference of national governments. Moreover,
the EFSF could also beef up the funding of existing EU instruments for balance of
payments assistance to the European neighbourhood. But a key consideration in
setting up such an emergency fund should not be the problems that are already
known. Given the unpredictable nature of this crisis, a key consideration should
be for the EU to prepare for the ‘unknown unknowns’ that are certain to arrive
sooner rather than later.
President Sarkozy has recently called for the creation of an economic government
for the euro area. Under normal circumstances one would have replied that
the economic governance of the euro area was assured by the independence of the
ECB and the Stability Pact. This is clearly no longer sufficient when Europe is facing
the worst economic and financial crisis since World War II. The speed and
depth of the crisis have clearly overwhelmed the usual decision making mecha-
A call for a European Financial Stability Fund 87
nisms. Europe needs action on a scale that can only be decided at the highest
political level.
88 The First Global Financial Crisis of the 21st Century Part II
29 September 2008
When the storm passes, bank regulation will top the global policy agenda. This
column presents new evidence that a bank’s private governance structure influences
its reaction to bank regulation. Since governance structures differ systematically#p#分页标题#e#
across countries, one-size-fits-all regulation may be ineffective. Bank regulations
must be custom-designed and adapted as financial governance systems
Banks matter.1 When banks efficiently mobilise and allocate funds, they lower the
cost of capital to firms and accelerate capital accumulation. When banks allocate
credit to entrepreneurs with the best ideas (rather than to those with the most
accumulated wealth or strongest political connections) productivity growth is
boosted and more people can pursue their economic dreams. And, when banks
manage risk prudently, the likelihood of systemic crises is reduced.
Of course, banks are double-edged. Banks that collect deposits with one hand
and lend to friends and political cronies with the other stymie innovation and
growth, while enriching the elite. And banks that gamble, protected on the downside
by a generous government safety net, too frequently have sparked devastating
crises that have exacted enormous human costs in virtually every country.
In turn, bank regulations and governance matter. If official regulations and private
governance mechanisms foster well-functioning banks, the probability of
costly crises is reduced and economic growth is accelerated along with the expansion
of economic opportunities.
Unfortunately, regulations and governance systems too often fail to promote
sound banking as exemplified by the turmoil embroiling financial markets today.
Bank regulation and private governance: A critical, little
understood nexus
In fact, little is known about how private governance mechanisms interact with
national regulations to shape bank risk taking. Rather, researchers and policymak-
Governance of banks
Luc Laeven and Ross Levine
IMF and CEPR; Brown University
1 Disclaimer: While one of the authors of this column is a staff member of the International Monetary Fund, the
views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or
its management.
ers have focused on using official regulations to induce sound banking, while
largely ignoring how owners, managers, and debt holders interact to influence
bank risk.
Bank owners, debt holders, and managers frequently disagree about risk.2 As in
any corporation, diversified owners of banks (owners who do not have a large fraction
of their personal wealth invested in the bank) have a greater incentive to
increase risk than uninsured debt holders. Stock holders disproportionately enjoy
the fruits of high-risk, potentially high-return investments, while debt holders
want the bank to take as little risk as possible, while earning enough to pay them
back. On risk, non-shareholder managers (managers who do not have a substantial
equity stake in the bank) frequently align themselves with debt holders against#p#分页标题#e#
diversified owners. Non-shareholder managers generally prefer to take less risk
than owners because their jobs are linked to the survival of the bank. Of course,
to the extent that the manager has a large equity stake in the bank or holds stock
options, this would enhance his or her risk-taking incentives through enticing
potentially large rewards for high-return investments. In practice, however, bank
managers often do not hold much bank stock, placing them at odds with diversified
bank owners in their views on risk taking.
Thus, the comparative power of owners, managers, and debt holders within
bank’s governance structure matters. Banks with an ownership structure that
empowers diversified owners will tend to take more risk than banks in which owners
have less influence.
New evidence
In a recent paper (Laeven and Levine, 2008), we test how national regulations
interact with a bank’s private governance structure to determine its risk-taking
behaviour. It is crucial to examine regulations and governance simultaneously.
If regulations boost the risk-taking incentives of bank owners but not those of
managers and debt holders, then the actual change in bank risk depends on the
comparative power of owners within the bank’s governance structure. Thus, the
same regulation will yield different effects depending on the governance structure
of each bank. Similarly, changes in policies toward bank ownership, such as allowing
private equity groups to invest in banks or changing limits on ownership concentration,
could have differential effects depending on bank regulations.
Examining national regulations or bank governance in isolation will almost
certainly yield misleading results since regulations and governance structures differ
across countries. To address this, we first collected new information on the
ownership and management structure of banks and merged this with data
on bank regulations around the world. The new database covers detailed data on
banks across 48 countries and traces the ownership of banks to identify the ultimate
owners of bank capital and the degree of ownership concentration.
90 The First Global Financial Crisis of the 21st Century Part II
2 See influential theories by Galai and Masulis (1976) and Jensen and Meckling (1976), and recent empirical work
on nonfinancial firms by John, Litov, and Yeung (2008).
Most big banks have very concentrated ownership
It turns out that banks around the world are generally not widely held, despite
government restrictions on the concentration of bank ownership, though there is
enormous cross-country variation.
• About 75% of major banks have single owners that hold more than
10% of the voting rights.
• 20 out of 48 countries do not have a single widely held bank (among
their largest banks).#p#分页标题#e#
• Of those banks in our sample with a controlling owner, more than half
are families.
Most governments restrict the concentration of bank ownership and the ability of
outsiders to purchase substantial stakes in banks without regulatory approval, generally
to limit concentrations of power in the economy. But regulatory restrictions
on the concentration of bank ownership are often ineffective or not well enforced.
Families employ various schemes, such as pyramidal structures, to build up control
in banks.
Key results
We find that banks with more powerful owners (as measured by the size of their
shareholdings) tend to take greater risks.
This supports arguments predicting that equity holders have stronger incentives
to increase risk than non-shareholding managers and debt holders and that
large owners with substantial cash flows have the power and incentives to induce
the bank’s managers to increase risk taking.
Furthermore, the impact of bank regulations on bank risk depends critically on
each bank’s ownership structure such that the relationship between regulation
and bank risk can actually change sign depending on ownership structure.
• For example, our results suggest that deposit insurance is only associated
with an increase in risk when the bank has a large equity holder with
sufficient power to act on the additional risk-taking incentives created
by deposit insurance.
• The data also suggest that owners seek to compensate for the loss in
value of owning a bank from capital regulations by increasing bank risk.
• Stricter capital regulations are associated with greater risk when the
bank has a sufficiently powerful owner, but stricter capital regulations
have the opposite effect in widely held banks.
Ignoring bank governance leads to incomplete and sometimes erroneous conclusions
about the impact of bank regulations on bank risk taking.
Governance of banks 91
Policy implications
These findings have important policy implications. They question the current
approach to bank supervision and regulation that relies on internationally established
capital regulations and supervisory practices. Instead, we find that:
(1) private governance mechanisms exert a powerful influence over bank risking,
(2) the same official regulation has different effects on bank risk taking depending
on the bank’s governance structure.
Since governance structures differ systematically across countries, bank regulations
must be custom-designed and adapted as financial governance systems
Regulations should be geared toward creating sound incentives for owners,
managers, and debt holders, not toward harmonising national regulations across
economies with very different governance structures.
Galai, D. and R. Masulis, 1976, ‘The Option Pricing Model and the Risk Factor of
Stock,’ Journal of Financial Economics, 3, 53–81.
Jensen, M. and W. Meckling. 1976. ‘Theory of the Firm: Managerial Behavior,
Agency Costs, and Ownership Structure,’ Journal of Financial Economics 3,
John, K., L. Litov, and B. Yeung, 2008, ‘Corporate Governance and Managerial Risk
Taking: Theory and Evidence,’ Journal of Finance, forthcoming.
Laeven, Luc, and Ross Levine, 2008, ‘Bank Governance, Regulation, and Risk-
Taking,’ Journal of Financial Economics, forthcoming. Available at:
92 The First Global Financial Crisis of the 21st Century Part II
3 December 2008
Globalisation seemingly erodes governments’ ability to redistribute wealth.
This column presents new evidence of the tradeoff between integration and
redistribution, showing that financial development has filled in where government
has receded. The current crisis may pose political challenges to both financial
development and economic integration.
The current global financial crisis highlights the vexed issues of what role national
governments should and do play in an internationally integrated economic
system. In Dani Rodrik’s (1998) classic analysis of data from the 1960s to the early
1990s, openness to international trade was found to be associated with a larger
share of government in GDP. Government policies meant to shelter citizens from
risk may indeed be more important in countries where international market access
fosters opportunities to trade but also exposes workers to more frequent and
intense shocks. More recent and precise data on social expenditure in 18 OECD
countries confirm Rodrik’s observation. In Figure 1, the fraction of GDP spent on
such policies is larger in OECD countries that import and export more, perhaps
because they are small and near to each other or because they choose to deregulate
international trade.
Another mechanism is relevant, however. Redistribution may be more useful in
more open economies but national governments are less powerful if economic
integration allows private agents to seek more lenient taxes and more generous
subsidies across countries’ borders. Competition among systems (Sinn, 2003) may
reduce the viability of collectively enforced national policies, making income
redistribution negatively associated with international openness. It is not difficult to
find such a relationship in the data. In Figure 2, we plot deviations from countries’
means of social expenditure and openness, which capture reasons for countries to
be permanently more or less open, or more or less inclined to social expenditure.
The relationship is negative. This suggests that as technological progress and#p#分页标题#e#
multilateral trade liberalisation have made borders less of a barrier to economic
activity, the scope of redistribution policies has become smaller.
As an increasingly globalised economic system increases the risk households
face and makes it harder for governments to enforce redistribution policies, something
has to pick up the slack. Our CEPR Discussion Paper 7048 finds that,
controlling for country and time effects, the negative association between open-
Finance, redistribution,
Giuseppe ‘ and Anna Lo Prete
University of Turin and CEPR; University of Turin
94 The First Global Financial Crisis of the 21st Century Part II
Figure 1 Public social expenditure and trade openness
3 3.2 3.4 3.6 3.8 4 4.2 4.4 4.6 4.8 5
Log (Imports+Exports)/GDP, average in previous 5 year period
Log Public Social Expenditure/GDP,
5 year averages
Figure 2 Public social expenditure and trade openness, deviation from means
–0.2 –0.1 0 0.1 0.2 0.3
Log (Imports+Exports)/GDP, 5 year average, deviations from country means
Log Public Social Expenditure/GDP, 5 year
average, deviations from country means
ness and redistribution illustrated in Figure 2 is more pronounced when and where
financial markets are better developed. As globalisation progressed, financial development
substituted for government policies. In theory, this makes a lot of sense.
Financial markets must indeed be more important if international competition
makes it difficult to implement social protection schemes while introducing new
sources of income risk. In a more risky world, absent heavily redistributive national
welfare states, credit and insurance volumes have to increase.
Globalisation increases aggregate incomes but erodes redistribution, and it
could decrease welfare if it were not accompanied by better insurance against new
and larger risks. In our empirical work, following Jappelli and Pagano (1994), we
proxy the accessibility and efficiency of household financial markets by loan-tovalue
ratios – the percentage of a house purchase price that may be financed by
mortgages. Available indicators are significantly and sensibly related to openness
and social policy developments. Over time, loan-to-value ratios increased from
about 75% on average in the 1980s to about 90% in the 2000s. They differed
sharply across countries in the 1980s, when loan-to-value ratios already exceeded
80% in the UK and the US but were only slightly above 50% in Italy and Greece.
By the late 1990s, the loan-to-value ratios in all our OECD countries exceeded#p#分页标题#e#
70%, and by the early 2000s they ranged up to 115% in countries such as the
From the perspective of this column, a high loan-to-value ratio is a good thing.
Borrowing allows households within countries to buffer the ups and downs of
international competition without having to rely on collective redistribution and
makes it possible to reap the fruits of globalisation in terms of overall competitiveness.
For individual households, it is beneficial to be able to borrow a lot and
go bankrupt upon negative income shocks. But there can be too much of a good
If individual repayment risk is not properly packaged and diversified, financial
market development can be a source of aggregate instability. Financial markets are
indeed in trouble and, if our perspective on past developments is correct, their
fragility does not bode well for globalisation. The breakdown of private financial
markets excites calls for stronger redistribution. If redistribution is national (as it
has to be as long as politics are national), it will only be sustainable if national borders
become less permeable to economic activity.
Researchers will be looking carefully at signs of such reversals. Not only financial
market development, but also trade and social policies will change as a consequence
of the current economic turmoil. The character of these developments
may foster confidence in the structural character of the empirical relationships we
detect in our paper, which could so far be spuriously driven by trending factors
other than those we focus on.
And policymakers should also be keenly aware of these mechanisms. The path
that led to the Great Depression was paved by protectionism and an increasing
role of government. Rescuing financial institutions fosters confidence, but using
the rising power of governments in the current financial storm to bail out manufacturers
distorts competition and reduces confidence in further economic
growth. To steer clear of the Great Depression path in a world where redistribution
is no longer very effective and financial markets are key to the sustainability of
international integration, we must develop an internationally coordinated finan-
Finance, redistribution, globalization 95
cial regulation framework and avoid retracing backwards decades of international
integration and financial development.
Bertola, Giuseppe, and Anna Lo Prete (2008), ‘Openness, Financial Markets, and
Policies: Cross-Country and Dynamic Patterns’, CEPR Discussion Paper 7048.
Jappelli, Tullio and Marco Pagano (1994), ‘Savings, Growth, and Liquidity
Constraints’, Quarterly Journal of Economics, 109(1), 83–109.
Rodrik, Dani (1998), ‘Why Do More Open Economies Have Bigger Governments?,’
Journal of Political Economy, 106(5), 997–1032.#p#分页标题#e#
Sinn, Hans-Werner (2003), The New Systems Competition, Oxford: Blackwell
96 The First Global Financial Crisis of the 21st Century Part II
12 June 2008
To pay for its current account deficit and capital exports, the US needs $2 trillion
of additional foreign investment in 2008. Recent research shows that the quality
and depth of US capital markets are key to attracting such investment, but the subprime
crisis has raised doubts. A judicious regulatory reaction to the subprime crisis
will thus be critical to the value of the dollar. If the US imposes a massive
increase in poorly thought-out regulation, the dollar could quickly return to its
downward spiral.
The US government is so concerned about the US dollar that on June 3 it broke
from standard operating procedure and had the chairman of the Federal Reserve
Board speak about the dollar (a role previously reserved for the US Treasury
Secretary and occasionally the President). The dollar immediately strengthened
and some analysts predicted that the dollar’s relentless depreciation since its peak
in February of 2002 was finally over. Some even predicted a dollar appreciation
over the next year (at least versus the Euro and other flexible currencies). On June
6, however, the dollar took another dive and fears resurfaced that the dollar’s
depreciation had further to go. Secretary Paulson responded on June 9 by stating
in a CNBC interview that he ‘would never take intervention off the table’ to support
the dollar.
What will it take?
In order for the dollar to stabilize, the US will need to attract enough capital at
existing prices to not only finance its current account deficit, but also to balance
capital outflows by US citizens (which increased by over 100% from 2005 to $1.21
trillion in 2007). Figure 1 shows the countries with the largest holdings of US portfolio
liabilities (equities and debt) as of June 30, 2007.
What Next for the Dollar?
The Role of Foreigners
Kristin Forbes
Sloan School of Management, MIT
98 The First Global Financial Crisis of the 21st Century Part II
Will foreigners continue to add to their holdings of US assets? This is the greatest
vulnerability to not only the dollar, but also the existing system of large global
imbalances. Rough estimates suggest that despite the reduction in the US current
account deficit, the US will require an additional $1.8 to $2.7 trillion of foreign
investment in just 2008.1 This is in addition to the (roughly) $16 trillion that
foreigners already hold.2 Will foreigners invest these massive sums of money at
current exchange rates? What will be the effect of increased regulation in US markets
and perceived hostility in some sectors to foreign investment?
How have foreigner done on their US investments?#p#分页标题#e#
These questions are particularly pressing given the disappointing returns that foreigners
have recently earned in the US. Evidence shows that investors tend to
‘chase returns’—i.e., increase investment in assets and countries that have recently
had higher returns and vice versa.3 But from 2002 through 2006—before the
1 Assuming that the U.S. current account deficit in 2008 is $627 billion (IMF forecast) and gross U.S. capital outflows
are between $1.2 trillion (equal to gross outflows in 2007) and $2.0 trillion (assuming growth in capital
outflows from 2007 to 2008 equals the average annual growth rate from 2005 through 2007). Capital flow statistics
from Bureau of Economic Analysis.
2 According to the Bureau of Economic Analysis, foreigners held $16 trillion in U.S. liabilities at year-end 2006
and data for 2007 is not yet available.
3 For evidence on return chasing, see Henning Bohn and Linda Tesar (1996), ‘U.S. Equity Investment in Foreign
Markets: Portfolio Rebalancing or Return Chasing?’ American Economic Review: Papers & Proceedings 86:
77–81. Also see Erik Sirri and Peter Tufano (1998), ‘Costly Search and Mutual Fund Flows,’ Journal of Finance
Figure 1 Foreign holdings of US portfolio liabilities (30 June 2007)
Notes: Based on US govt. data ‘Report on Foreign Portfolio Holdings of US Securities’. Includes official and nonofficial
sector holdings.
*Bahrain, Iran, Iraq, Kuwait, Oman, Saudi Arabia and United Arab Emirates.
Cayman Islands
Middle East Oil
Billions of US$
Total Debt (short- & long-term)
What Next for the Dollar? The Role of Foreigners 99
4 For more details on return calculations, see Kristin J. Forbes (2008), ‘Why do Foreigners Invest in the United
States?’ NBER Working Paper #13908.
5 For evidence that these return differentials between foreign investment in the United States and U.S. investment
abroad did not exist in bonds, and probably in equities, over longer periods of time, see Stephanie Curcuru,
Tomas Dvorak, and Francis Warnock (2008), ‘The Stability of Large External Imbalances: The Role of Returns
Differentials,’ Quarterly Journal of Economics, forthcoming.
recent turmoil in US financial markets—foreigners earned an average annual
return of only 4.3% on their US investments, while US investors earned a much
more impressive 11.2% abroad.4
This lower rate of return for foreigners investing in the US persists even after
removing official sector investment (as much as possible given data limitations)#p#分页标题#e#
and focusing only on the private sector.5 As shown in Figure 2, this pattern even
persists for investment within specific assets classes—equities, foreign direct
investment, and, to a lesser extent, bonds. For example, foreigners earned an average
annual return of only 7.6% on their US equity holdings from 2002 through
2006, while US investors earned 17.4% on their foreign equities. These patterns
also persist (although to a lesser extent) after removing the effect of the dollar’s
depreciation and making rough adjustments for risk.
Figure 2 Returns on private sector investment positions, 2002–6
U.S. investments abroad
Equities Bonds
Foreign investments in U.S.
Average Annual Returns
Other Potential Reasons to Invest in the US
Are there reasons why foreigners would invest in the US even if they expect these
lower returns to continue? Without a doubt. Foreigners may be attracted to:
• the highly liquid US financial markets—especially investors in countries
with small and less developed financial markets.6
• the strong corporate governance and accounting standards in the US.
(Granted, recent problems with SIV’s and other structured products
shows that these standards have room for improvement, but they are
still perceived to be better than in many other countries.)
• the US as part of a standard portfolio diversification strategy, especially
if returns in the investor’s country are less correlated with US returns.
• US investments due to close linkages to the US through trade, ‘familiarity’
(such as sharing a common language or colonial history) and low
information costs.
• the US due to the benefits of holding assets in the global reserve currency.
While all of these reasons could hypothetically motivate foreigners to hold US
assets, which are actually important in practice?
The evidence
A recent analysis, ‘Why do Foreigners Invest in the United States?’, tests which factors
drove foreign investment in US stocks and bonds between 2000 and 2006.7 It
finds that the most important factor was the perceived advantages from the developed,
liquid and efficient US financial markets. Even after controlling for a series
of factors (including income levels), countries with less developed financial markets
invested significantly more in the US relative to other countries and what
optimal portfolio theory would suggest.
Although the benefit from the more developed and liquid financial markets in
the US is not the only factor supporting US capital inflows, the empirical estimates
suggest it can be important. For example, the estimates from the previous analysis#p#分页标题#e#
suggest that if Italy improved its equity markets to a level comparable to France,
then Italy would reduce its holdings of US equities by $3.7 billion. Taking a more
extreme example, if China developed its bond markets to a level comparable to
South Korea, it would reduce its holdings of US bonds by about $200 billion (compared
to total holdings of $695 billion of US bonds at the end of 2006). Although
this is only a fraction of total US Treasury, agency and corporate bonds outstanding,
it is ‘real money’.
100 The First Global Financial Crisis of the 21st Century Part II
6 For excellent theoretical models of this relationship, see the following three papers. (a) Ricardo Caballero,
Emmanuel Farhi and Pierre-Olivier Gourinchas (2008), ‘An Equilibrium Model of ‘Global Imbalances’ and Low
Interest Rates,’ American Economic Review 98(1): 358–93. (b) Jiandong Ju and Shang-Jin Wei (2006), ‘A Solution
to Two Paradoxes of International Capital Flows,’ NBER Working Paper #12668. (c) Enrique Mendoza, Vincenzo
Quadrini and José-Víctor Ríos-Rull (2006), ‘Financial Integration, Financial Deepness and Global Imbalances,’
NBER Working Paper #12909.
7 Kristin J. Forbes (2008), ‘Why do Foreigners Invest in the United States?’ NBER Working Paper #13908.
Implications for the Future of the Dollar
The role of differences in financial market development in supporting US capital
inflows has several important implications. First, countries around the world will
hopefully continue the progress they have made in developing and strengthening
their own financial markets. This will gradually reduce this important incentive
for countries to invest in the US. Any such adjustments and the corresponding
effect on the dollar, however, would likely occur very slowly, since developing
financial markets (especially in low-income countries) is a prolonged process.
Second, and potentially more worrisome, is the implication for recent events in
the US. Recent market volatility, problems with US rating agencies and a lack of
transparency in off-balance sheet structured products have raised concerns that US
financial markets may not be the ‘gold standard’ that they were previously
believed. Recent discussion by the US Congress about rewriting mortgage agreements
sets a worrisome precedent of government intervention in private contracts.
Hostility to foreign investment has emerged in a few high-profile cases. This
series of events has undoubtedly already reduced foreign willingness to hold US
assets and accelerated the depreciation of the dollar over the past few months.
The US needs to improve its regulatory mechanisms in order to avoid a repeat of
past excesses. But at the same time, the US government will hopefully not overreact#p#分页标题#e#
and rush to pass a massive increase in poorly thought-out regulation. Any such
response could seriously undermine the existing advantages of US markets and
reduce foreigners’ willingness to invest the massive sums of money required by
the US to support its current account deficit and capital outflows by US investors.
The dollar could quickly return to its downward spiral. This need not occur if critical
decisions on openness to foreign investment and financial market regulation
are driven by cooler minds instead of election-year politicking. It is critically
important that policymakers augment—instead of undermine—the long-term efficiency,
resiliency and openness of US financial markets. If foreigners lose interest
in investing in the US, additional reassuring words by Chairman Bernanke and
Secretary Paulson, and even coordinated intervention in currency markets, could
not support the dollar.
What Next for the Dollar? The Role of Foreigners 101

17 November 2008
Why are investors rushing to purchase US government securities when the US is
the epicentre of the financial crisis? This column attributes the paradox to key
emerging market economies’ exchange practices, which require reserves most
often invested in US government securities. America’s exorbitant privilege comes
with a cost and a responsibility that US policy makers should bear in mind as they
handle the crisis.
A familiar script has played as the global financial crisis has spread, picking up
speed and intensity. The drama has three acts that have been written out in the
historical record for as long as there have been open financial markets.
• Act One: Unbounded Enthusiasm. Some markets find favour with global
investors.1 Credit becomes readily available, asset prices percolate,
and many categories of spending are buoyed.
• Act Two: Day of Reckoning. Recognition that some of that enthusiasm
was overdone spreads among investors. New credit flows cease, collateral
is sought, asset prices crash, and prominent private-sector icons
• Act Three: Restoration. Here governments pick up the pieces, typically
passing on the cost to future generations by issuing a vast volume of
debt. The cost can be punishing because investors pull away from the
governments of emerging market economies as forcefully as they do
from private creditors.2
American exceptionalism
But there has been one prominent exception to this classic tale. With fitting irony,
the US, which is the epicentre of the crisis, has avoided Act Three. The US enjoyed
a capital inflow bonanza that funded yawning current account deficits, and asset
Is the US too big to fail?
Carmen M Reinhart and Vincent Reinhart
University of Maryland; American Enterprise Institute
1 In Reinhart and Reinhart (2008a and b), we refer to this act as a ‘capital flow bonanza.’
2 Such funding strains have frequently been sufficient to compel governments to default. This is why we find in
Reinhart and Reinhart (2008a) that episodes of capital flow bonanzas help to predict sovereign defaults.
prices spiralled upward only to crash. While the crash has constricted credit and
is redrawing the financial landscape, the US has not been punished by investors
in typical Act-Three fashion.
If this had happened to any other government in the world whose national
financial institutions were in as deep disarray as those of the US, investors would
have run for the hills – cutting off the offending nation from global capital markets.
But for the US, just the opposite has happened.
Rather than facing prohibitive costs of raising funds, US Treasury Bills have seen
yields fall in absolute terms and markedly in relative terms to the yields on private
instruments. This has been called a ‘flight to safety.’ But why do global investors
rush into a burning building at the first sign of smoke?
The answer lies in part with the exchange market practices of key emerging
market economies.
Since the last global market panic, the Asian Financial Crisis of 1998, many governments
have stockpiled dollars in their attempts to prevent their exchange rates
from appreciating. At the same time, the long upsurge in commodity prices has
swollen the coffers of many resource-rich nations. As a result, and as shown in the
latest forecast in the World Economic Outlook of the International Monetary
Fund, international reserves of emerging market economies are expected to have
increased $3.25 trillion in the last three years. According to the Fund’s survey of
the currency composition of those holdings, the bulk is in dollars (see Figure 1).
104 The First Global Financial Crisis of the 21st Century Part II
1995 1997 1999 2001 2003 2005 2007
All countries Industrial Developing
Figure 1 Dollar assets in allocated foreign exchange reserves
Source: IMF, Currency Composition of Official Foreign Exchange Reserves
share of total, percent
Is the US too big to fail? 105
The dollar portion of these reserves is most often invested in US government
securities, which offers excellent market liquidity, and US government debt is also
considered as safe as anything (following a precedent laid down by the first
Secretary of the Treasury, Alexander Hamilton).3 All this explains the dollar’s popularity
with foreign investors who might otherwise be expected to shun the US.
As the Figure 2 indicates, foreign official entities now own almost one-quarter of
outstanding government securities (the upper panel). These holdings of securities#p#分页标题#e#
constitute about 10% of non-US nominal GDP (the lower panel).
Figure 2 Foreign ownership of U.S. government securities
Source: IMF, World Economic Outlook, Federal Reserve Flow of Funds Accounts
3 The history of US debt is not unblemished. Reinhart and Rogoff (2008) report that the US never defaulted on its
sovereign external debt but that the abrogation of the gold clause in 1934 constituted a domestic default.
share of total, percent
total foreign
as share of world GDP (ex. U.S.), percent
Our currency, your problem
Herein lies the special status of US government securities. For a few of the world’s
key decision makers, it is not in their economic interest to stop, or even slow, the
purchase of Treasury Bills. As Keynes once said: ‘If you owe your bank a hundred
pounds, you have a problem. But if you owe a million, the bank has a problem.’
Potential capital losses on existing stocks keep foreign investors locked into US
government securities.
Figure 2 also shows a precedent for recent financial market strains. The last time
foreign official purchases bulked so large in the US government’s financing was
from 1968 to 1973, when the Bretton Woods system of managed exchange rates
broke down.4 At that time, keeping the system going required increasing support
from abroad, primarily from Europe. This time around, the source of that support
has shifted to Asian-Pacific economies and Middle East exporters. In both cases,
the message from the US seems best summarised in the words of then-Treasury-
Secretary John Connolly, who famously advised, ‘the dollar is our currency, but
your problem.’
As the tone of those words suggests, another lesson from the earlier experience
is that foreign resentment with a US-dominated arrangement grows over time.
That America could be a source of financial instability and a haven of sovereign
financial security seems to some, to quote Valerie Giscard d’Estaing, to be an ‘exorbitant
privilege.’ In this episode, Treasury yields have fallen and the foreign
exchange value of the dollar has appreciated recently. Moreover, many European
financial firms have had funding difficulties associated with a lack of access to dollar#p#分页标题#e#
liquidity. This has made it necessary for European officials, caps in hands, to
seek swap arrangements with the Federal Reserve to acquire dollars to re-lend to
their national champions.
Recent enthusiasm in Europe for fundamental reform of the international monetary
system finds its roots, in part, in this resentment. They do not want our dollar
to be their problem, and they want to erode some of that privilege. Put it those
terms, however, it seems clear that this will mostly be a one-way conversation. US
officials must recognise that their nation’s funding advantage rests on the unrivalled,
for now, position of US government securities in global financial markets.
Thus, they will listen and agree to work-streams for groups to report back in the
future. But whether it is this Administration or the next, advantages to the US,
unfair as that may seem as viewed from abroad, will seem worth preserving.
An exorbitant privilege that comes with a cost and a responsibility
These advantages come with a cost and a responsibility. Open access to markets
probably allowed US officials to drift in their response to the financial crisis. They
initially mistook a solvency problem for a liquidity one. When action was
ultimately forthcoming, Treasury officials failed to articulate a clear sense of prin-
106 The First Global Financial Crisis of the 21st Century Part II
4 Dooley, Folkerts-Landau, and Garber (2004) have dubbed this latest period Bretton Woods II, in part exactly
because of the role of foreign official purchases in facilitating US current account deficits. They pose plausible
reasons why it might be in the self-interest of foreign officials to do so. Another possibility, as discussed earlier, is
that existing portfolio holdings are so large that officials are in a self-fulfilling trap.
ciples and priorities for intervention. This ad hoc improvisation has probably
stretched out and intensified the crisis. In a crisis in an emerging market economy,
the sudden stop of credit to the government forces painful adjustment to be
done quickly.5 These adjustments may have been painful, but a quick response
tends to reduce the overall bail-out cost.
As for responsibility, officials must recognise that investors have granted the US
its reserve-currency status for reasons. Size matters, but other reasons include a
respect for the rule of law and for contract enforcement and the predictability and
transparency of the policy process.
When US officials move to the next stage of the crisis – the search for legislative
protections to prevent a recurrence – it will be important to preserve these
attractive aspects of US markets.
Michael P. Dooley , David Folkerts-Landau, Peter Garber, ‘The revived Bretton
Woods system,’ International Journal of Finance & Economics Volume 9 Issue#p#分页标题#e#
4, 2004, pp. 307 – 313.
Reinhart, Carmen and Vincent Reinhart ‘Capital Flow Bonanzas: Past and Present,’
in Jeffrey Frankel and Francesco Giavazzi (eds.) NBER International Seminar in
Macroeconomics 2008, (Chicago: Chicago University Press for NBER, forthcoming
Reinhart, Carmen and Vincent Reinhart, ‘From capital flow bonanza to financial
crash,’ VoxEU (2008b).
Reinhart, Carmen and Kenneth Rogoff, ‘The Forgotten History of Domestic Debt,’
NBER Working Paper 13946, April 2008.
Is the US too big to fail? 107
5 In this regard, the current US situation is more akin to that in Japan in the 1990s, when policymakers delayed
addressing the fundamental problem of non-performing loans and favoured half-measures for some time. The
Japanese government could tap a large pool of domestic saving to fund its equivocations so that the opinion of
global creditors was not relevant. The lesson is market discipline does not apply either if a nation is too big to
fail or saves too much to care.

7 October 2008
Global crises used to remind us why we have the IMF. If the Fund doesn’t come
up with some new ideas for how to handle this one, it may remind us why it has
become increasingly unimportant. The IMF could reassert its relevance by aiding
middle-income countries caught up in the crisis with new ideas on how to link
emergency lending with policy adjustment.
As the financial crisis has unfolded, the International Monetary Fund has been
noticeable mainly for its absence. This will now change – at least temporarily – as
its Governors assemble for their annual meeting and the kleg lights are turned on.
The question is whether those Governors and the management to whom they
entrust the Fund’s operation can restore its relevance for more than a weekend.
If not now …
If this is not a set of circumstances that call for the Fund, it is hard to know what
is. While recent problems affecting institutions like Fortis and Dexia have been
adequately handled by a handful of governments, containing a run on a much
larger British, German, or Swiss bank will require wider international cooperation.
The managing director, Dominique Strauss-Kahn, should urge governments to get
their ducks in a row. He should urge them to move together when raising deposit
insurance limits and extending other guarantees in order to avoid draining funds
from one another’s financial systems. He should call for coordinating interest rate
cuts and fiscal stimulus to prevent the world from sliding into depression. For consciousness-
raising purposes if nothing else, the Fund should be issuing an urgent
call to action, not maintaining radio silence.
Multilateral Consultation on the crisis: Too little, too late
No doubt Mr. Strauss-Kahn will also call for an IMF-directed Multilateral#p#分页标题#e#
Consultation bringing together the US, European Union, and others to discuss the
credit crisis. But cross-Channel and Transatlantic crisis management will not be
arranged through a Multilateral Consultation or more generally through the IMF.
Can the IMF save the world?
Barry Eichengreen
University of California, Berkeley and CEPR
Central bankers are already in continuous communication. The relevant regulators
meet under the aegis of the Basel Committee of Banking Supervisors.
European finance ministers meet as the Ecofin Council, and if they need to reach
Mr. Paulson they know his number. They do not need a Multilateral Consultation
to bring them together.
And having Mr. Strauss-Kahn and his deputies orchestrating their meeting is
unlikely to produce a different outcome. Reflecting diplomatic niceties, the IMF’s
first Multilateral Consultation on global imbalances stretched over the better part
of a year. This does not exactly match the timing of a financial panic. Any
Multilateral Consultation focusing on immediate management of the crisis will
quickly become irrelevant.
Focus on regulatory reform: Better ideas needed
Better would be to focus the next Multilateral Consultation on regulatory reform
and preventing the next crisis. Here, however, the IMF must first demonstrate that
it is a better orchestrator of these discussions than the Bank for International
Settlements (BIS) or the Financial Stability Forum. Establishing this means offering
better ideas. And so far the novel ideas for regulatory reform – capital insurance,
countercyclical capital requirements, forcing over-the-counter trading into an
organised exchange – have come from other quarters.
To advertise the 2007 decision strengthening its surveillance of currencies, the
Fund will also want to say something about exchange rates. Under current circumstances,
however, the less said the better. Notwithstanding the lemming-like rush of
investors into US treasury bills, the dollar will have to fall over the medium term as
capital flows into the United States diminish, reflecting the reluctance of foreigners
to accumulate more toxic assets. Dollar depreciation may make life difficult for other
exporting countries, but it is unavoidable and should not be resisted. It is not clear
that there is anything constructive for the Fund to say about this.
Aiding middle-income countries
Where the Fund should have a role is in aiding middle-income countries caught
up in the crisis. Countries with large current account deficits and relying on foreign
capital to finance them will find their position unsustainable as growth
slows, undermining their ability to export, and as foreign investors, cash-strapped
and in a state of high anxiety, hesitate to commit.
In present circumstances, anyone with a large current account deficit depending#p#分页标题#e#
on foreign capital inflows is at risk. This includes, of course, the United States,
although America is not a client of the Fund, since it can effectively print international
reserves (the dollar remaining the dominant reserve currency). But in
many smaller countries with even larger current account deficits relative to the
size of their economies, corporate borrowing, home mortgages, and even auto
loans are denominated in foreign currency. For them, flooding the markets with
liquidity and letting the currency depreciate, as the US does, is no solution.
Indeed, it will only make matters worse.
110 The First Global Financial Crisis of the 21st Century Part II
Helping countries in this pickle has long been the IMF’s bread and butter. But
even here it is not clear that the crisis will allow the Fund to reassert its relevance.
Eastern Europe crisis countries may be bailed out by the EU and the ECB, while
their East Asian counterparts may receive swaps and credits through the Chiang
Mai Initiative. Once again the Fund may end up being sidelined unless it demonstrates
that it has a better idea, in this case about how to link emergency lending
with policy adjustment.
http://www.ukthesis.org/dissertation_writing/It is sometimes said that the crisis is a reminder of why we have the IMF. If the
Fund doesn’t come up with some new ideas for how to handle it, the crisis may
only remind us why we can forget it.
Editors’ note: This column first appeared on http://www.eurointelligence.com/.
Can the IMF save the world? 111


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