With Spain’s bailout failing to provide much comfort to financial market investors, the European debt crisis continues to rumble on, fully five years after issues in wholesale funding markets first began to register. So far, the crisis has challenged many assumptions that economists held about the way the world works, almost always to the detriment of the ordinary people who have lost jobs or even homes as a consequence. Here is my take on some of the key lessons we have learnt so far.
1.) Inflation targeting is not a panacea
Back in 2007, BoE Governor Mervyn King said that the risks to financial stability seemed to be low, and that central bank independence had convinced the world that the UK economy would be stable. It turns out that inflation targeting, while useful, is not the be-all and end-all the Governor thought it was.
2.) Policymakers need to be creative
When the crisis hit, central bankers were the swift-response teams (even though many of them moved far too slowly). But cutting interest rates to near-zero was not enough to revive their economies, so we ended up seeing probably the biggest expansion of central bank balance sheets in history. Who had heard of quantitative easing, outside of Japan, six years ago?
3.) Banks are a lot riskier than we thought
During the boom years before the crisis hit, banks were apparently making bucket-loads of money. They were deemed a good investment, and a favourite of shareholders. Now we know that those profits were often illusory. And the fundamental risk associated with the basic banking model – borrowing short term to lend long term – is far higher than we all thought.
4.) Ordinary businesses are safer than we might have thought
While governments and banks have slipped precariously close to the cliff, and in some cases off it, the performance of non-bank businesses in Europe and the US has been striking. Despite the biggest banking crisis on record, and the deepest downturn since at least the 1930s, ordinary businesses have done alright. Larger firms with access to capital markets have been able to fund themselves; and though smaller firms have been hit by banks tightening credit conditions, even there company failure rates have been more subdued than we might have expected.
5.) House prices can fall…
One of the root causes of the whole US sub-prime mortgage bubble, for some, was an implicit assumption that US house prices would always keep on rising … Oops!
6.) … but don’t necessarily have to collapse
At the same time, some forecasts of house price collapses have been wildly wide of the mark. Several notable firms forecast 40% peak-to-trough falls in UK (nominal) house prices when the crisis broke. To date, they are down 12% or so since their peak, and have been going broadly sideways since mid-2009. And this despite transaction volumes being about 50-60% of their pre-crisis levels. Clearly not all housing markets are the same.
7.) A trade surplus is just another imbalance
The reason that peripheral euro area economies are mired in recession is the need for them to go through internal devaluation in order to regain competitiveness against Germany, so they can stop running deficits. But their trade deficits are Germany’s surplus with its euro partners. These surpluses are great if you can get them, but an imbalance all the same.
8.) ‘Solidarity’ does not translate well into German
Should German investors take partial losses on their investments in Greek or Spanish banks? No, instead the German government should lend its counterparts money, so that German investors get paid back in full. The end result is that instead of the Spanish private sector owing the German private sector money, the Spanish government owes the German government instead. Oh dear.
9.) European governments can go bust
All too obvious now, in the aftermath of the Greek bailouts and restructuring. But a surprisingly amount of guidance and even regulation was implicitly or explicitly based on government debt as a ‘safe’ asset. Hopefully, no longer.
10.) Economics has an awful lot to answer for