Europe's imbalanced response to the financial crisis

Since last year, politicians and regulators across the G20 have been hard at work trying to place the international financial system on a more stable long-term footing. Many critics believe they are not doing enough. A common criticism is that there was only a brief window of opportunity to rein in the powerful financial sector, but that the recent return to mega-bonuses shows that this window has already closed. Policymakers, on this view, have squandered the opportunity to proceed with a much-needed regulatory clampdown. Widespread as this view is becoming, it does not really stand up to scrutiny.

Consider first the volume of regulatory reforms which is emerging from the G20, the EU and individual countries. Proposals have been brought forward to subject banks to higher capital requirements; to make regulatory rules less pro-cyclical; to tighten liquidity requirements; to influence the way employees in finance are remunerated; to regulate credit rating agencies and alternative investment vehicles (hedge funds, private equity firms and the like); to strengthen the supervision of cross-border entities; and to ensure that the authorities pay closer attention to the build-up of risks across the financial system as a whole.

By any standards, this amounts to an extensive reform agenda. It does not obviously speak of a timorous regulatory response. If anything, regulation currently seems to be doing all the heavy lifting. A more plausible criticism is that some reforms are being driven by populism (or, more charitably, a crude understanding of the causes of the crisis); that not enough attention is being paid to the combined impact of the reforms being proposed; and that the macroeconomic causes of the crisis are barely being tackled. The result is that regulatory costs could increase without delivering commensurate gains in financial stability.

Take capital requirements. Most people agree that banks were under-capitalised in the run-up to the crisis. So banks will now have to hold more capital than they have done in the past. Just how much more is harder to say. But it could conceivably end up being too much. Regulators are counting on higher capital charges to tackle all sorts of regulatory issues, from irresponsible bonuses to banks that are ‘too big to fail’. Less attention is being paid to the cumulative impact of all these increases. Yet an over-capitalised banking sector could be as damaging to economic growth as an under-capitalised one was to financial stability.

In any case, it is illusory to expect regulatory changes alone to deliver greater stability. Consider Spain, where regulators wisely forced banks to make provisions during good times to cover losses in the bad. The ‘counter-cyclical’ nature of the Spanish regulatory regime has rightly won many plaudits. Some variant of the Spanish system should be adopted at EU level. However, it is important to be clear about what this system did and did not achieve. It left Spanish banks with larger capital buffers than banks elsewhere in the EU. But it did not prevent Spain from experiencing an ultimately destructive property price bubble.

Spain’s experience shows that while regulation matters, macroeconomic factors do too. Inappropriately low interest rates or large capital inflows can overwhelm regulatory regimes, however well-designed. So it is odd that the contribution of economic policy to financial stability should have occupied a far smaller place in political discussions than, say, the regulation of hedge funds or bankers’ bonuses. The subject of global imbalances, for example, was barely discussed by the G20 until its summit in Pittsburgh in September 2009 – and then only after overcoming stiff political resistance from countries like China and Germany.

The Chinese and German reluctance to discuss global imbalances runs deep. Both enjoy large balance of payments surpluses; each remains attached to its export-oriented growth model; and both are reluctant to concede that these may have played a role in the crisis. For them, the crisis was the result of regulatory failures and financial excess, particularly in the Anglo-American world. The Chinese and the Germans are right to criticise British and American recklessness. But they have had difficulty recognising that such profligacy was partly fuelled by the international capital flows which their very own surpluses were generating.

What of the lessons for monetary policy? The financial crisis has dealt a major blow to two assumptions which were prevalent in the years preceding it. One is that if monetary policy delivers steady growth and low inflation, financial stability will inevitably follow. The other is that it is economically less costly for central banks to ‘clean up’ after asset price bubbles have burst than it is for them to try and prevent bubbles from inflating in the first place. These issues have been discussed – but in academic settings such as the annual symposium hosted by the Federal Reserve Bank of Kansas, not political ones like the G20.

The oft-repeated claim that policy-makers in the G20 and the EU are doing too little on the regulatory front is misplaced. In their determination to be seen to be doing something, politicians and regulators may even end up doing too much. If there is a flaw in the response to date, it is that all the focus is falling on regulation – while the macroeconomic factors that contributed to the crisis are being treated as side-issues. In the run-up to the G20’s Pittsburgh summit, Germany’s chancellor, Angela Merkel, dismissed global imbalances as an ‘ersatz’ problem. The central issue, she implied, was tackling bankers’ bonuses.

What are the risks of such an approach? Consider the implications for Spain. Like the UK, its economy is over-indebted and needs to rebalance. Since Spain belongs to the euro, however, it cannot rely on a weaker exchange rate to do so. To rebalance without experiencing too much pain, external demand must grow more strongly. If surplus countries like Germany are unwilling (or unable) to boost demand, Spain will suffer a deeper and longer recession – worsening losses among its already weakened regional banks (cajas). Another reason to think that financial stability cannot be divorced from economic policy.