In 1849 Jean-Baptiste Alphonse Karr in his journal ‘Les Guêpes’ coined one of the most famous aphorisms of all time: Plus ça change, plus c’est la même chose.
Ever since signature of the Treaty of Maastricht on European Union in 1992, the EU has been an embodiment of this modus operandi. Swinging from one extreme to another: from active attempts at reforms to active, and indeed passive, pursuit of the status quo, Europe has been living from one crisis to the next. And every iteration of the existential threat leads to ever-deepening integration or harmonisation of European institutions.
Despite failure after failure, this process is touted as necessary for creating a functional response to the crises of the past and preventing the crises in the future. The fact that Karr’s dictum subsisted despite every wave of apparent reform swayed nobody.
Thus, applying advanced Brian Cowen, we are where we are, which is precisely where we were. Two recent events illustrate this perfectly: Greece and the current debate about future financial crises.
This May, Europe marked the sixth anniversary of the Greek crisis and the start of the sovereign debt crisis in the euro area. Both were and remain stuck on the famous page from ‘Les Guêpes’.
The real sovereign debt crisis in Europe traces back to the Italian, Greek, Spanish, Portuguese, Belgian, and Irish economic development paths of the 1990s and 2000s – characteristically marked by rampant inflation of property bubbles, the explosion of banking credit and profligate public spending on permanent state programmes backed by temporary tax revenues. Public debt rose, as did private debt. Not only in Greece, but Europe-wide.
At the start of the 1990s, there was only one country (from the group that today forms the euro area) with a public-debt-to-GDP ratio in excess of 100 percent, and only two countries with a public-debt-to-GDP ratio in excess of 90 percent. By 2011 the number of euro area members with debt-to-GDP ratio exceeding their annual output was five. Last year, there were six and eight with debt to GDP ratio in excess of 90 percent. History teaches us a simple, but painful, lesson: no country that ended 1990-1995 with a debt-to-GDP ratio above 90 percent was able to shake off that burden.
Greek debt is spectacular, by all measures. It reached above 90 percent of GDP in 1993, dipped below that for only one year (1999) – thanks to Goldman Sachs’ financial engineering – and hit 109 percent of GDP in 2008. Since then it has risen to 178.4 percent of GDP (end of 2015), and the path from 2016 on is now looking more North than South.
With numbers like these, one is tempted to repeat the EU’s mantra that Greece is unique and hence cannot be treated as a symptom of a general malaise. But take just one fact: between 1995 and 2005, total gross Government debt across the euro area grew by 21 percent every five years. In 2005- 2010 the rate of growth of debt accelerated to 37.7 percent – quite understandably, due to the crisis and the banks bailouts. Then came the Age of Austerity and 2010-2015 Government debt across the euro area rose 21 percent once again. “Plus ça change…”.
You couldn’t make this up. In 1995, today’s euro area member states had combined gross government debt of €3.95 trillion; by the end of 2017, based on the IMF’s latest projections, it is likely to be just under €10 trillion. In the entire history of the common currency area, there has been not a single year in which total gross government debt declined in absolute terms.
So back to Greece. May’s shenanigans in the Eurogroup and other European institutions tell us that we are nowhere near having learned the lessons of the recent crises, let alone the separate lessons of their causes. With the flaring of debate about the sustainability of the Greek debt only 9 months since the ‘final package’ or Bailout 3.0 was sealed on Greek debt funding in August 2015, one thing was clear: the EU has little concern for the actual situation in Greece.
In the mind of European leaders the crisis has abated, if not completely gone away. The result of the Eurogroup ‘solution’ was predictable, reached without any drama: Greece got the loans it was promised so it can pay down loans that are maturing. The flicker of excitement about the prospect of an exit from the IMF programme and debt relief was fast extinguished: the EU promised yet again to examine Greek debt sustainability some time in the future and the IMF flip-flopped on its tail, before joining the gang of ‘helpers’. Everyone went promptly to sleep as the acute crisis was averted if only at a cost of shoving ever more risks under the European rug. “Plus ça change…”.
But the problem is that the real lesson from the 2008-present crisis should be exactly the opposite of complacency. Sovereign-debt crises, like financial ones, are not being prevented by the EU’s ongoing ‘reforms’ and the deployment of old ‘solutions’ – integration and harmonisation. Worse, the disease might be getting stronger thanks to European ‘medicine’.
In a recent working paper, a group of ECB researchers quantified the “significant spillover effects from sovereign to corporate credit risk in Europe” in the wake of the announcement of the first Greek bailout on April 11, 2010. Based on their estimates, every ten percent rise in sovereign credit risk lifted corporate credit risk by 1.1 percent on average after the bailout. In other words, contagion is a strong risk. Worse, “these effects are more pronounced in countries that belong to the Eurozone and that are more financially distressed. Bank dependence, public ownership and the sovereign ceiling are channels that enhance the sovereign- to-corporate risk-transfer”.
So we should worry about the potential for a Greek-style crisis to reconflagrate in the future. Greece is just a canary in the euro-area mine, as I warned in these pages and in my 2015 paper on the future of the euro area prepared for a group of MEP.
Europe’s response to these warnings has been predictable in Karr’s way: to attempt addressing the threat of contagion through the financial system, the EU came up with two – harmonisation – exercises. These are the Capital Markets Union and the European Banking Union. Both aim to raise, not lower, credit creation in the euro area. Bank dependency will rise, not fall. And with it, the contagion channel will widen.
All that is needed is a spark of a shock to the black powder of half-baked policy responses and another crisis will ignite. The sparks are flying around. As summed up by data from the Policy Uncertainty Index, the policy environment in Europe is more volatile than it was before the global financial crisis, and is on a rising trend once again.
The Financial Times’ Martin Wolf and Forbes’ Frances Coppola both warned in recent weeks that the state of the global (and European) financial sector is not only far from health, but is rife with risks of another major meltdown.
As Wolf put it, writing in the footsteps of Mervyn King, former governor of the Bank of England, “alchemy lies at the heart of the financial system; …a medieval idea, but one we have not as yet discarded”. The banks are designed to game the system of regulation and supervision, exploiting subsidies afforded by the monetary policy and protectionism of regulatory authorities, while increasing the risk loading on their lending books.
The problem, as both King and Wolf note, is that there are at least three possible solutions to this vicious spiral of regulatory risk-amplification: force banks to hold more equity, force banks to hold more reserves, or drastically revamp the system of banks’ collateral to allow more accurate risk weighting to be applied to banks’ assets and reserves.
To put it simply, none of these alternatives is pursued by the European regulators today. Instead, Europe is creating a banking system built on yet another debt-driven bubble, this time even more complex (ever heard of CoCos? Those pretty ugly convertible securities the banks have been issuing to provide bailable cushions in case of a solvency crisis) and more risk-loaded than the one that collapsed in 2008-2009.
Worse, with feeble attempts to shore up riskweighting schemes for assets, EU regulators are sleep-walking into future problems. In simple terms, low-risk assets under normal markets conditions can become high-risk assets in a crisis. In which case, to prevent systemic contagion, monetary authorities can either guarantee these assets ex ante the crisis, or face a systemic crisis no matter what risk weightings are applied in accounting terms. Put differently: you bail the system out before you need to bail the system out. “Plus ça change…”.
Speaking at Trinity Business School, this May, Frances Coppola noted that in the wake of the financial crisis, euro-area banking systems became more concentrated, with drastically fewer, and ever-bigger, banks controlling the financial flows. This has meant that “we put our faith in centralised institutions…transferred increasing amounts of responsibility to regulators… substituting public-sector safe assets for the private sector assets that failed us”.
These actions might have protected us from a repeat of the same banking crisis that we witnessed in 2008, but they have not changed “the core beliefs that generate crisis.…Belief that there can be returns without risk, and gains without losses: that safety is cost-free; that following the herd is wise, and being contrarian is dangerous…. These are the beliefs that lead to crisis. These are still our beliefs”.
The simple truths we should have learned from the crisis are three-fold. Firstly, no system can ever foresee all possible risk scenarios that could result in a systemic collapse. Secondly, concentration within any risk-prone system is a prescription for increasing fragility of that system. And thirdly, only a diversified, horizontally distributed system of risk analysis, inclusive of uncomfortable contrarians, can spot and trace the evolution of complex risks.
European political leaders, monetary policy authorities, debt agencies leads, financial regulators and banking supervisors learned none of this.
As Coppola puts it: “We cannot see where the next crisis will come from. But of one thing I am sure. It will not be like the last crisis: but in our inadequate response to the last crisis, and our failure to recognise the source of all crises in our own irrational beliefs, we are already sowing the seeds of the next”.
“Plus ça change, plus c’est la même chose”…
By Constantin Gurdgiev