Category: Global economy

Categories
Global economy

Crises and mutations : a progress towards new opportunities?

Nouvelle revue de Géopolitique

Economic crises are often the subject of analyses framed within more or less short-term contexts. Here I want to set out a long-term vision of the crises, not without first bringing to mind this thought from Antonio Gramsci: “a crisis is what comes between the old and the new”.

Taking a more “regulationist” approach, you could say that each severe crisis of capitalism is a time of fundamental change affecting a collection of elements which constitute and organise society and the economy. These are moments of major transition where it can be observed in hindsight that they have given rise to new systems of regulation and new models for organisations, society and the economy. They generally bring into play new industries driving the economy, new ways of organising work, new kinds of consumption, often new ways of combining private and public, as well as new centres of the global economy. In my understanding, we are currently in that phase of major change and deep crisis which, as this renewal gradually emerges, could be accompanied by a long phase of growth and significant gains in productivity, as has occurred each time in history.

An economy in transition 

I am listing four main transitions today.

The first transition, globalisation and the emergence of new countries, has occurred in two phases.

The first phase, especially at the end of the nineties and throughout the years after 2000, sees emerging countries concentrate their efforts on the determinants of their success, their export industries, taking particular advantage of their low labour costs.

These industries benefit from the demand by already developed countries, causing global overproduction, as there is no parallel destruction of production capacity to the same extent in the developed countries. Accordingly this global overproduction and low-cost competition produces a slowdown, even a stagnation, of purchasing power for people in the developed countries.

This phenomenon leads to an increase in debt, allowing the over-production crisis not to be felt so severely. The increasing indebtedness of actors from the developed countries allows a development in demand at a global level during this period, masking the consequences which should have arisen from the stagnation of purchasing power associated with a large excess of global production capacity.

This increase in debt involving all economic actors, primarily those in the private sector, degenerates into crises of over-indebtedness. These lead to severe economic and financial crises, which relentlessly worsen the public debt situation. This stronger and stronger growth in the developed world’s debt corresponds to an increase in balance of payments imbalances, with current deficits in the North and matching surpluses in the South.

The second phase of globalisation is where emerging countries become increasingly mature. A middle class gradually appears, then its purchasing power grows and little by little, systems of social protection and retirement benefits appear. It is probable that an internal growth will develop, gradually rebalancing previous imbalances, in an unplanned fashion.

The second transition is a consequence of the first: the debt reduction phase. Historically, debt reduction phases, within contexts of quite serious debt crises, begin abruptly but are completed over long periods of between five and ten years. These are resolved with levers of different types, operating alternatively or in conjunction, such as credit depreciation and zero or very slow growth with a slow reduction in the rate of indebtedness achieved by growth in savings and the reduction or limiting of consumption, investment and public spending. They are accompanied by risks of deflation. We are currently in this phase for the euro zone taken as a whole. Another outcome of debt crises can be an increase in inflation when circumstances permit, as inflation does not occur as a matter of course.

The third transition is that of demographic change. It is very well known, but an ageing population remains a key phenomenon in many emerging and developed countries, with the exception of Africa. It raises fundamental questions about the cost of social systems, social security and pensions, which have further repercussions on the debt question. Up to now in France we have partially dealt with these questions by increases in debt within these systems.

The fourth transition rests on the transition in energy, the major issue of this century. The scheduled end of energy from fossil fuels, with these resources gradually being exhausted, ought to have the end result of increasing raw material prices, leading to a worldwide deceleration in growth. This redoubled struggle for energy sources has caused a change in the balance of power between countries which possess natural resources and those which do not, leading in the end, technical progress permitting, to the slow, uneven, uncertain appearance of substitute forms of energy which could lessen the constraints on growth to a greater or lesser extent.

Prospects for industrial renewal

Having talked about these major transitions, we need to turn to what the drivers of renewal could be, without claiming to be exhaustive or even any claims as to their success; the drivers that would allow us to emerge gradually from this crisis, allowing new systems of regulation to appear which would permit a return to a long phase of growth.

Each great phase of capitalism in fact has seen the appearance of new driver industries bringing fundamental changes to the economic environment, ways of producing and consuming, the merchandise itself,  ways of working and spending leisure time… This was notably how we moved from the steam engine that made railways possible, to the internal combustion engine that made cars possible, and then to the electric motor which made household electrical appliances possible. Three potential drivers of future development warrant further attention:

The first one, the digital one, which is already substantially developed but whose impact in my opinion is still in its early stages. Whether we are dealing with changes in modes of consumption or work, changes in business models between produces and distributors, distributors and consumers or producers and consumers, with the appearance of new productivity gains as a key factor, it seems to me that we are still very far from finished with development of this kind.

The digital revolution gives increased power to consumers. Consumers in fact have the capacity to become significantly more demanding because they are better informed about the quality of goods and services as well as their price, thanks to data gathered on the internet. This revolution also allows them to increase comfort by considerably improving the practical benefits they can expect as a result.

These days we no longer queue for cinema or train tickets because of the internet; similarly our consumer transactions involve less and less movement because we can purchase directly from our computers and arrange delivery. “Business models” have been substantially changed as a result. If distributors can build the loyalty of their customers and operate pro-actively with them by intelligent use of the data they hold, they can gain power over producers by positioning themselves so as to propose solutions better adapted than previously to each “consumer-individual”, building the solution together with the customer who has become a “consumer-actor”. In this new relationship, distributors take power over producers, making them compete to find the best combination of goods and services most appropriate to each customer. And where the distributor does not develop sufficient legitimacy, the producer can appeal directly to the consumer and squeeze out the distributor.

Radical changes like this in relationships between producers, distributors and consumers will no doubt allow every cycle to be reworked. In this way there will be a drastic selection process between the three groups of players, allowing the most efficient to emerge and enabling the greatest gains in productivity.

The second driver of renewal is biotechnology. Developments in this field can particularly stem from the desire to combat the ageing of the population where it turns out to be possible to satisfy that demand. These biotechnologies are being perfected on a daily basis and will in the future enable repair of the body and a more effective fight to prevent disease. Finally, biotechnology machines will be developed in the near future which will allow different parts of the body to be replaced, broadening the whole scope of merchandise yet further at the same time.

Finally, energy, a key sector bringing together renewable energy, energy storage technology (a really fundamental problem) and energy saving, will be an essential key to future growth due to the development of these industries and because they will loosen the constraints caused by the gradual exhaustion of energy from fossil fuel sources.

A transformation in consumer and working practices

In parallel and consistent with these new industrial drivers we are seeing the emergence of different modes of consumption. These are the result of digitalisation, of a variety of new technologies, with network effects attached, of stagnating purchasing power and a change in mindset (including people’s awareness of the increasing scarcity of natural resources.) Changes are occurring in essential spending, where the emphasis is changing from the ownership of the object toward its use. For example, buying a telephone these days is no longer a simple matter of purchasing a device; we are acquiring the ability to access a catalogue of applications and phone and internet services.

We now have access to cloud computing and, as a result, ownership of computers with very high memory capacities will drop. We are buying fewer books, CDs and films and renting more and more. In the same way, self-service hire of a car for one single journey in town will develop. And we are still speaking of heating and air conditioning, but in the future we will pay for a service that regulates the temperature of each room in our home, when we choose, rather than buying the energy that makes this possible. Such practices will grow over time. In turn, these new modes of consumption will lead to radical changes in company “business models” and in the organisation of the economy as well as new opportunities for growth.

Alongside new modes of consumption, new modes of working and possibly new norms for salary payment are also appearing. This is only in its infancy, but we can already see the development of teleworking or working via a network, thanks to new technology. Work outside the office and without fixed hours is beginning to become more widespread, leading to discussion of changes in methods of payment.

Positive outcomes depend on greater agility

As in any time of profound crisis and change, we face changes which are uncertain, painful and challenging. At those times we see geographical areas or strata of population becoming winners or losers. We must hope that a country like ours knows how to make the choice, because it really is a choice, to pursue structural policies which will facilitate a constructive way out of the crisis. We need to promote the flexibility to transform ourselves, playing to our strengths and our know-how, cutting down the factors that inhibit the necessary adaptation, and reduce the areas of inefficiency. We have the means to do this, as long as we provide the right framework of legislation, regulation and incentives to encourage implementation.

Download Crises and mutations:a progress towards new opportunities ? (PDF)

Read in french : Crises et mutations, vers de nouvelles opportunités ?

Extract from an address by the author during the Aix-en-Provence Economic Forums in July 2013.

Categories
Global economy

Crisis and changes : new opportunities ?

Economic crises are often the subject of analyses framed within more or less short-term contexts. Here I want to set out a long-term vision of the crises, not without first bringing to mind this thought from Antonio Gramsci: “a crisis is what comes between the old and the new”.

Taking a more “regulationist” approach, you could say that each severe crisis of capitalism is a time of fundamental change affecting a collection of elements which constitute and organise society and the economy. These are moments of major transition where it can be observed in hindsight that they have given rise to new systems of regulation and new models for organisations, society and the economy. They generally bring into play new industries driving the economy, new ways of organising work, new kinds of consumption, often new ways of combining private and public, as well as new centres of the global economy. In my understanding, we are currently in that phase of major change and deep crisis which, as this renewal gradually emerges, could be accompanied by a long phase of growth and significant gains in productivity, as has occurred each time in history.

I am listing four main transitions today.

  • The first transition: globalisation and the emergence of new countries, broken down into two phases. The first phase, especially at the end of the nineties and throughout the years after 2000, sees emerging countries concentrate their efforts on the determinants of their success, their export industries, taking particular advantage of their labour costs. These industries benefit from the demand by already developed countries, causing global overproduction, as there is no parallel destruction of production capacity to the same extent in the developed countries.
    Accordingly this global overproduction and low-cost competition produces a slowdown, even a stagnation, of purchasing power for people in the developed countries. This phenomenon leads to an increase in debt, allowing the over-production crisis not to be felt so severely.
    The increasing indebtedness of actors from the developed countries in fact allows a development in demand at a global level during this period, masking the consequences which should have arisen from the stagnation of purchasing power associated with a large excess of global production capacity. This increase in debt involving all economic actors, primarily those in the private sector, degenerates into crises of over-indebtedness. These in turn lead to severe economic and financial crises, which in turn relentlessly worsen the public debt situation. This stronger and stronger growth in the developed world’s debt corresponds to an increase in balance of payments imbalances, with current deficits in the North and matching surpluses in the South.
    The second phase of globalisation is where emerging countries become increasingly mature. A middle class gradually appears, then its purchasing power grows and little by little, systems of social protection and retirement benefits appear. It is probable that an internal growth will develop, gradually rebalancing previous imbalances, in an unplanned fashion. 
  • The second transition follows the first and results from it: the debt reduction phase. Historically, debt reduction phases, within contexts of quite serious debt crises, begin abruptly but are completed over long periods of between five and ten years. These are resolved with levers of different types, operating alternatively or in conjunction, such as credit depreciation and zero or very slow growth with a slow reduction in the rate of indebtedness achieved by growth in savings and the reduction or limiting of consumption, investment and public spending. They are accompanied by risks of deflation. We are currently in this phase for the euro zone taken as a whole. Another outcome of debt crises can be an increase in inflation when circumstances permit, as inflation does not occur as a matter of course.
  • The third transition is that of demographic change. It is very well known, but an ageing population remains a key phenomenon in many emerging and developed countries, with the exception of Africa. It raises fundamental questions about the cost of social systems, social security and pensions, which have further repercussions on the debt question. Up to now in France we have partially dealt with these questions by increases in debt within these systems.
  • The fourth transition rests on the transition in energy, the major issue of this century. The scheduled end of energy from fossil fuels, with these resources gradually being exhausted, ought to have the end result of increasing raw material prices, leading to a worldwide deceleration in growth. This redoubled struggle for energy sources has caused a change in the balance of power between countries which possess natural resources and those which do not, leading in the end, technical progress permitting, to the slow, uneven, uncertain appearance of substitute forms of energy which could lessen the constraints on growth to a greater or lesser extent.

Having talked about these major transitions, we need to turn to what the drivers of renewal could be, without claiming to be exhaustive or even any claims as to their success; the drivers that would allow us to emerge gradually from this crisis, allowing new systems of regulation to appear which would permit a return to a long phase of growth.

Each great phase of capitalism in fact has seen the appearance of new driver industries bringing fundamental changes to the economic environment, ways of producing and consuming, the merchandise itself,  ways of working and spending leisure time… This was notably how we moved from the steam engine that made railways possible, to the internal combustion engine that made cars possible, and then to the electric motor which made household electrical appliances possible.

I shall deal essentially here with three potential drivers of the future:

  • Digital, which is already substantially developed, it is true, but whose impact in my opinion is still in its early stages. Whether we are dealing with changes in modes of consumption or work, changes in business models: producer-distributor, distributor-consumer or producer-consumer; with the appearance of new productivity gains as a key factor, it seems to me that we are still very far from finished with development of this kind. The digital revolution gives increased power to consumers. Consumers in fact have the capacity to become significantly more demanding because they are better informed about the quality of goods and services as well as their price, thanks to data gathered on the internet.
    So it is much easier for them to collect information and compare quality and price. On the other hand, this revolution allows them to achieve a very significant increase in comfort by considerably improving the practical benefits they can expect as a result. These days we no longer queue for cinema or train tickets because of the internet; similarly our consumer transactions involve less and less movement because we can purchase directly on the net and arrange delivery.
    “Business models” have been substantially changed as a result. If distributors can build the loyalty of their customers and operate pro-actively with them by intelligent use of the data they hold, they can gain power over producers by positioning themselves so as to propose solutions better adapted than previously to each “consumer-individual”, building the solution together with the customer who has become a “consumer-actor”. In this new relationship, distributors take power over producers as never before, making them compete to find the best combination of goods and services most appropriate to each customer.
    Conversely, if the distributor does not develop sufficient legitimacy, the producer can appeal directly to the consumer and squeeze out the distributor.
    Radical changes like this in relationships between producers, distributors and consumers will no doubt allow every cycle to be reworked. In this way there will be a drastic selection process between the three groups of players, allowing the most efficient to emerge and enabling the greatest gains in productivity.
  • Developments in biotechnology particularly can stem from the desire to combat the ageing of the population where it turns out to be possible to satisfy that demand. These biotechnologies are being perfected on a daily basis and will in the future enable repair of the body and a more effective fight to prevent disease. Finally, biotechnology machines will be developed in the near future which will allow different parts of the body to be replaced, broadening the whole scope of merchandise yet further at the same time.
  • Energy, a key sector bringing together renewable energy, energy storage technology (a really fundamental problem) and energy saving, will undoubtedly be an essential key to future growth by the very fact of the development of these industries but also by the fact that they will ease the constraints caused by the gradual exhaustion of energy from fossil fuel sources.

In parallel and consistent with these new industrial drivers we are seeing the emergence of different modes of consumption. These are the result of digitalisation, of a variety of new technologies, with network effects attached, of stagnating purchasing power and a change in mindset, including people’s awareness of the increasing scarcity of natural resources. Changes are occurring in essential spending, where the emphasis is changing from the ownership of the object toward its use. Buying a telephone these days, for example, is no longer a simple matter of purchasing a device; in reality we are acquiring a means of access to a catalogue of applications and phone and internet services.

Now, as everyone knows, we have access to cloud computing and, as a result, ownership of computers with very high memory capacities will drop. We are buying less books, CDs and films and renting more of them. In the same way, self-service hire of a car for one single journey in town will develop more and more. And we will still speak of heating and air conditioning, but certainly in the future we will pay for a service that regulates the temperature of each room in our home, when we choose, rather than pay for buying the energy that makes this possible. There is no doubt that practices like this will only grow with time. In turn, these new modes of consumption will lead to radical changes in company “business models” and in the organisation of the economy as well as new opportunities for growth.

Alongside new modes of consumption, new modes of working and possibly new norms for salary payment are also appearing. This is only in its infancy, but we can already see the development of teleworking or working via a network, thanks to new technology. Work outside the office and without fixed hours is beginning to become more widespread, leading to discussion of changes in methods of payment.

As in any time of profound crisis and change, we face changes which are uncertain, painful and challenging. At those times we see geographical areas or strata of population becoming winners or losers. We must hope that a country like ours knows how to make the choice, because it really is a choice, to pursue structural policies which will facilitate a constructive way out of the crisis. We need to promote the flexibility to transform ourselves, playing to our strengths and our know-how, cutting down the factors that inhibit the necessary adaptation, and reduce the areas of inefficiency. We have the means to do this, as long as we provide the right framework of legislation, regulation and incentives to encourage implementation. 

Download “Crisis and change : new opportunities ?” (PDF)

Categories
Euro zone Finance Global economy

The future of the euro zone

Some background to begin with. The European Monetary System (EMS) was put in place to create a fixed but adjustable peg for the various currencies within the zone. From 1979 on, it served to prevent sudden and disruptive fluctuations in the exchange rates of the currencies of the countries within the European Monetary System. However, while proving very useful, it remained a source of instability: external events could cause unsought asymmetrical shocks between the European countries concerned. For example, the weakening of the dollar against other currencies prompted market operators to seek refuge in the deutsche mark. This strengthened the German currency against the dollar but also against the French franc and other EMS currencies. However, the economic trends in Germany and in France or the other countries did not necessitate this movement in their exchange rates.

Moreover, since each country in the zone kept its own currency, the current account balance had to be monitored country by country. Any country needing stronger economic growth – due to faster population growth for example – was regularly hampered by an external constraint: an economic growth gap between two countries automatically resulted in a deterioration of the current account balance of the country with the strongest growth. The unavoidable effect of this phenomenon was a constraint of alignment on the slowest growth rates among the larger countries within the European Monetary System.

The single currency, created to substitute EMS, was structurally a part of this reflection. On the one hand, a single currency would allow the dollar to weaken with the same impact on all the countries in the euro zone. On the other hand, it could be thought that the creation of the single currency would generate greater leeway for economic policy: the current account balance would be considered at the level of the euro zone as a whole and not at the individual levels of each country. This would supposedly enable a country to stimulate its economy, if necessary, without immediately running into the external constraint, as long as there was no deterioration in the current account balance of the euro zone as a whole. Lastly, a single currency among the countries in question, without any possibility of devaluation or revaluation, would provide economic agents with a more stable forecasting basis for foreign investments and trade, imports and exports, without having to bear the costs linked to currency exchange. The example put forward was the United States, where an individual state can stimulate its economy without encountering any immediate obstacle linked to its current account balance.

Federalism versus convergence

There were two tacit schools of thought when the euro zone was created. Both perceived clearly that a monetary zone could not work properly on its own.

The first school of thought held that, to become efficient and develop a satisfactory system of auto-regulation, the euro zone needed to be gradually rounded out with a greater degree of federalism. On its own, the creation of a single currency was not enough to ensure the regulation needed in the event of difficulties. If a country within the zone experienced an isolated recession, it had to adjust without being able to benefit from any weakening or devaluation of its currency. In the absence of any type of federal regulation, the only possibility left to the country was to reduce labour costs and public spending in order to become more competitive, by provoking a sort of internal devaluation that was inevitably painful at social level and costly in terms of economic growth during the first years of adjustment.

Two conditions for avoiding overly costly downward adjustments were, in theory, clearly identified. Firstly, mobility of the labour force within the euro zone, enabling people who had lost their jobs in one country to find work in another country within the zone. Secondly, budgetary solidarity between the countries with a single currency, so as to organise budgetary transfers from the strongest growth countries to those in difficulty, thereby lightening the internal adjustment needed. This situation is exactly that of the United States, thanks to a shared language and a long tradition of mobility, and a federal budget that is large enough to allow such transfers.

Europe did not have this history of mobility nor the unified legal and social framework that would foster it. But, by continuing to build the union, Europe could achieve a greater degree of federalism that would enable budgetary transfers, on the strict condition of federal supervision of each country’s budget as no solidarity mechanism could be developed without ensuring that the policies implemented at national level were serious. This was the line of the first school of thought whose hopes were based on continuing European construction, based up to then on economic aspects, before going on to make the necessary progress at political level.

The other school of thought, which prevailed when people did not dare or want to express federalist aims, was to limit admittance to the European monetary zone to very similar countries that could be expected to continue being similar, which, quite justifiably in this context, led to the creation of convergence criteria. If the member countries of a monetary zone are on the same economic trend and converge in terms of inflation, budget deficit to GDP and public debt to GDP, and stay that way once they are part of the zone, adjustments between member countries are no longer necessary. There is therefore no need to look for greater federalism.

Shared mistakes In the light of the events of the past few years, both schools of thought were mistaken.

The first, since the increased federalism expected to follow creation of the zone as a matter of course has not occurred and it has proved difficult to conjure international solidarity out of nothing.

The second, since, either for political reasons or because some countries deliberately hid certain aspects of their economies, the countries admitted to the zone were not all chosen based on their strong structural and economic similarities. Mistaken, moreover, because monetary union does not automatically mean convergence will be preserved, even if it existed when the zone was created. On the contrary, it gradually induces structural differences linked to industrial polarisation in some regions corresponding to deindustrialisation of other regions within the zone. A single monetary policy, adapted to the average of the euro zone countries and not to each country’s specific economic conditions, combined with the absence of foreign exchange risk, leads in fact to diverging national economic specialisations, which can result in structural current account deficits in some countries due to insufficient industrialisation.

The financial markets were also mistaken. They kept the interest rates for the public debt of the different euro zone countries at very similar levels, even though significant differences were gradually emerging in both public debt ratios and current account deficits.

These policy and market mistakes resulted in a major crisis specific to the euro zone, caused, not by bad results and ratios at consolidated level, but by increasingly major differences between countries within the zone, without any mechanism for regulating such phenomena having been put in place, or even provided for.

How can the vicious circles be broken? Resolving the zone’s intrinsic problems has so far proved extremely difficult, painful and confused.

Two vicious circles have emerged that have accelerated the crisis. The first is that formed by the economic growth rate, the interest rate on public debt and the public deficits of the countries in difficulty. To restore its public finances and competitiveness, a country must drastically reduce public spending and increase taxes while reducing labour costs – even when several countries within the same zone are doing so at the same time. The impact on economic conditions is in this case very negative. The fiscal multiplier in such circumstances – with very weak growth – has been calculated, including by the IMF, to be greater than 1. A given reduction in public spending in Europe generates an even greater contraction in economic activity. The resulting slowdown in growth worsens the public deficit, which worries the markets and pushes up interest rates on public debt. This in turn has negative repercussions on the public deficit.

The second vicious circle consists of the feedback loop between the banks and public debt of a same country. European banks hold, as safe investments, bonds issued by their governments, and by the governments of other euro zone countries given the strong financial integration within the monetary union. Fears concerning the solvency of these countries therefore also trigger doubts about these banks which, if these doubts degenerate into a systemic crisis, can only be saved by their governments, thereby immediately exacerbating the fears relating to the public debt.

With a series of tentative initiatives, the euro zone has tried to feel its way out of this severe crisis and break these circles. Once again, two main tendencies arising from the two schools of thought described above have emerged, even though there has been some cross-over and even convergence between them.

The first argues that finding a way out of the crisis depends on Europe’s capacity to move towards greater federalism, a capacity strengthened by the crisis. The second argues that each of the countries in difficulty should itself restore its competitiveness by making sufficient efforts in terms of costs and deficits. Once again, these two tendencies, which are not totally mutually exclusive, have converged toward the European compromises we have already seen.

Thus, after hesitating for rather too long, Europe’s political deciders and the European Central Bank decided to create a European intervention fund, thereby pooling part of the debt of the countries in difficulty, and to create the European banking union. European banking union is an essential component of a monetary zone because banking supervision at the European level is necessary. There is sometimes a suspicion that some national regulators overprotect their country’s banks or do not wish to see the problems and turn a blind eye. A European level of banking supervision is all the more valid in that our banks are also multinationals in Europe, so as to ensure the same quality and efficiency in terms of banking supervision. But the key argument in favour of European supervision is that there can be no solidarity without shared supervision. For this reason the recent agreement is conditional upon putting in place the other essential elements of banking union.

The solidarity aspect worries healthy banks because they are afraid they will suffer from the situation of the weaker banks. The constitution of a European deposit guarantee scheme, at several different levels if necessary, would provide the basis for European interbank solidarity. One possibility would be to have, in addition to the national deposit guarantee funds, a deposit guarantee that would be triggered, at certain times, after the national guarantees had been exhausted, directly at European level, based on the solidarity of the European banks of other countries. This interbank solidarity mechanism would be supported by a solidarity mechanism between the euro zone states. A European crisis resolution mechanism, with in particular a European resolution fund, is expected to be put in place. Such a fund would mean that bank recapitalisation would not necessarily rely solely on the State concerned, which would therefore break the second vicious circle described above.

The ECB has announced that it now has the possibility of purchasing unlimited amounts of the public debt of countries in difficulty if their interest rates exceed a level considered normal, enabling a gradual return to better solvency, providing they implement a structural policy that allows this.

These fundamental decisions – resolution fund, banking union and the ECB’s unlimited, but conditional, intervention policy – have restored confidence and broken these vicious circles, temporarily at least. The issue now being debated in economic circles is whether the efforts made by each country – together with the measures referred to above – can restore the euro zone’s structural situation and save it as it is, by ensuring the lasting convergence of the member states.

The alternatives to austerity

The intense efforts being made by the southern European countries have a huge social cost in terms of living standards and employment. On average, the public debt/GDP ratio of these countries has not improved – it has even worsened in some cases – given the multiplication effect of more than 1 of these budgetary measures. In the case of Greece, the cancellation of a large part of the Greek debt held by the private sector does not appear to have been enough to turn the country around given the considerable social and economic cost of the austerity measures implemented. Italy has decided to implement major structural reforms but is struggling to regain competitiveness and seems to be exhausting itself in uncertain political battles, as can be seen from the recent elections. The improvement in the current account balances of these distressed countries, with the exception of Spain, comes more often than not from a slump in imports due to recession rather than any increase in exports achieved through increased competitiveness. However, Spain is beginning to see some results in the turnaround in its current account balance and the rise in exports.

The question is whether the painful search for competitiveness though austerity in each of the countries concerned, without adjusting exchange rates, can be successful. The lasting recession it provokes undermines potential growth. Even supposing it is successful in the long term, can the turnaround in public finances and exports be achieved before the social cost triggers a political and social crisis that compromises the European equation and the efforts made?

Assuming competitiveness is restored before any crisis breaks, the question is: should the euro zone regulate itself solely by a downward adjustment in living standards in order to bring some countries, through considerable internal efforts, into convergence with more acceptable public deficit and public debt levels and a better balance of payments? If the industrial basis is weak, balance can only be achieved through sluggish growth that does not boost imports, leading inevitably to a lasting slowdown in the euro zone. Or should regulation of this monetary zone by achieved through a mixture of the structural reforms needed to improve public finances and a European policy of supporting potential growth, by truly coordinating economic policies – stimulation here, dampening there – and transfers between the countries so that the least industrialised countries are not permanently obliged to make downward adjustments through austerity?

Such a mixture could help bring about these structural changes without excessive brutality and without triggering a severe recession, thereby making these reforms more acceptable. The structural reforms successfully achieved by Canada and Sweden in the 1990s were greatly facilitated by accommodating economic conditions which made the temporary social cost of these reforms acceptable. This mixture would naturally include better supervision of budgetary policies in particular, because there can be no solidarity without control, in order to avoid moral hazards.

The last question is: can the euro zone develop a greater degree of federalism – supervision, coordinated economic policy and budgetary transfers – that would ensure greater solidarity among its members, without however accepting laxity or “free riders”? This would enable the essential structural reforms to be carried out in a number of countries in an organised and better planned manner over a longer period, and therefore less painfully and with less risk. And to acknowledge and accept the natural diversity of the countries within the zone, including the industrial differences arising from the very existence of the single currency.

This would favour a higher average rate of growth by authorising some countries to have current account deficits while others have surpluses. Or will the euro zone be incapable of carrying out this political change and find itself condemned to requiring, too quickly and for too long, the least industrialised countries to implement austerity policies that bring long-term average growth down to low levels for the whole zone, with all the accompanying political risks. And possibly a risk for the future of the Euro itself.

Download The Future of the euro zone (PDF)

Read in french: L’avenir de la zone euro

First published in french in Nouvelle Revue de Géopolitique, n° 9, Avril-Mai-Juin 2013

Categories
Global economy

New crisis, new growth

La Tribune – August 2009
The world according to Each day this summer we interrogate a key current affaires witness on the aftermath of the crisis. For banker Olivier Klein, the economic crisis is an indication of a world transformation which should see China playing a major role alongside the United States, and our daily lives changing due to nanotechnology.
“New crisis, new growth” interview with Olivier Klein Professor of economics at HEC, bank CEO
A graduate of ENSAE and HEC, Olivier Klein has had senior responsibility in key areas (risk management, mergers and acquisitions, capital investment) in the banking world (BFCE, Natexis, Caisse d’Epargne). Renowned for his teaching talents, for over twenty years this Russophone has simultaneously held down a career as an associate professor at HEC.

It is said that the economic crisis will make our world different and that “things will never be the same again”. Do you share this view?

“The crisis consists precisely in the fact that the old is dying and the new cannot be born”, wrote Antonio Gramsci at the start of the twentieth century. Every fundamental capitalist crisis is in effect a time of deep transformation where a new mode of regulation painfully emerges, different from the previous one which has become less effective. Post facto, we can discern its consistency in making new dynamic industries appear, pushing growth; new more productive work organizations; and new consumer trends. However, a new centre of the world-economy usually appears which channels and dominates the rest of the capitalist world. This global transformation will prevent the degeneration of the system and give it back its vitality and efficiency. The first transformation, which we know about in our globalised world, is the emergence of at least one new power which each day gains ground not only in terms of economic weight, but also political, diplomatic and tomorrow probably monetary too: China. Contrary to different past forms, it is possible that we will see a multi-polar world, inevitably more unstable but undoubtedly more balanced with the coexistence of American and Chinese forces. Europe will only take its place in the game if it offers the means to organize itself as well as power, in other words being more unified.

What are the new driving forces of economic growth?

New leading industries will be linked, it seems, to future challenges. Telecommunications industries, developed at the beginning of the 1990s, are still bringing new sources of productivity gains. However two major sectors are at the heart of the current technological and industrial revolutions. In particular, biotechnology will allow better repair of our bodies, and enlarge the domain of merchandise ; the perpetual enlargement of merchandise being the driving force of capitalism. We will soon be able to better fight diseases, but also buy biotechnological machines to replace a particular defective part of our body, also slowing the effects of old age. However, we are now aware from this point forward that we live in a world of limited resources. Furthermore, as Obama correctly points out, new growth will also be based on industries able to save energy and all technologies which can produce and store renewable energy. Both bio and green technologies will rely on the development of nanotechnologies.

Should we really believe in green growth?

“Green” innovations will be essential in supporting growth as well as in creating new industries, but also because they release the constraints linked to the finite nature of natural resources which impact economic growth. In effect, as soon as there is a slight economic upturn, prices of raw materials (including oil) and higher interest rates stunt any possible return to growth.

And how will employment be affected?

New modes of communication will help to bring changes to work organizations. Working from home, working away from the office and flexible working are quickly developing and will shape work relations and modify salary norms. Also, consumer norms are experiencing significant changes, with the emergence of new anovoidable consumer products (e.g. mobile phones) different to those ten fifteen years ago.

Will capitalism continue to be our economic model?

A new type of regulation of capitalism is probably in the process of emerging. Its outline is still blurred, and it is appearing, as to be expected, with resistance, hesitations and failures which punctuate the serious crisis of transformation which we are aware of today. As always, new technologies as for new ways of living which emerge can be based on fairness, humanism (the struggle against the effects of old age, the protection of out planet, etc.) and democracy, and so can be promising for progress and a better world. However, we also know that a bad direction would be possible: a support to terrorism or totalitarianism. The world seems to be at a crossroads which will affect the future of human societies.
“Never waste a crisis. It can be turned to joyful transformation.” Positive words on the future from Rahm Emanuel, a close aid of Obama.
Interview by Philipe Mabille

Categories
Economical and financial crisis Global economy

What reforms are needed to keep under control financial instability?

Today, two obvious facts clash. In the first instance, financial markets are not self-regulating. In global and deregulated finance, they lead unavoidably to crises which are violent to a greater or lesser degree and which intensify, or even spark cycles in the real economy, as much in their euphoric stages as in periods of depression. The second fact is the essential character of these same markets which allow for the reallocation of risks (interest or exchange rates, for example) and which allow, in tandem with the banks, the adaptation of the needs and capacities of global finance. Today the banks alone cannot assure the sum total of financing the economy.

That is why one conclusion is abundantly clear : the need for adequate rules and reforms of a diverse nature enabling us to limit the intrinsic instability of finance, as we cannot make it disappear. We must take care, with the subsequent return to a new period of euphoria, to ensure that these reforms have begun before we rush to forget the recurring lessons that each financial crisis shows us.
The reasons for the inherent instability of finance are increasingly well analysed. They reside in the underlying nature of a financial or property asset, for which the price is not determined by its production cost, following the example of a reproducible good or service. In fact its value corresponds to the estimation of a promise of future revenues that the asset in question will bring. And yet, this forecast is very uncertain in as much as the future is hard to predict in a decentralised and monetary economy. In fact, the evolution in household savings levels as the multiple interactions of private competition and complementary economic agents renders their respective successes or failures very difficult to foresee, and even more so to quantify.

Here economists talk about a situation of radical or fundamental incertitude, but the forecast is equally uncertain because the exact risk to the issuer of the asset in question (for example shares or bonds) is not known to its holder. In effect they possess accurate information on neither the issuer’s current situation nor what their future actions will be, therefore ultimately deeply altering their risk profile. This information asymmetry and fundamental incertitude leads to a profound difficulty in knowing the equilibrium prices, that is to say the “normal” prices, of the financial assets for all circumstances in all likelihood, so facilitating mimetic behaviours in them and creating bubbles. Add to this the capacity to forget the effects of previous crises during euphoric periods and you have economic agents increasing their debt levels, thus pushing the leveraging effect to such a level that it threatens their financial situations, and during periods of depression they seek desperately to reduce this debt, thus considerably worsening the economic reversal. In other words, this phenomenon increases further when borrowers no longer gauge the solvability of lenders by the yardstick of their likely future returns, but by the expected evolution in the asset prices (for example shares or property) which are so financed or which act as a guarantee.

In addition, exogenously there are rules on the remuneration of the involved parties and accounting and prudential standards which can end up adding to the instability and procyclicity of finance.
All reform projects must therefore aim to combat the endogeneous as much as the exogeneous causes of financial instability. To tackle the exogenous causes is without question the least arduous task.

Tackling the exogenous causes.

First proposal

The IFRS (International Financial Reporting Standards) accounting standards have given priority to the assessment of assets in terms of their fair value, essentially based on the market price. This decision is based on the hypothesis that at any given moment the market price is the best indication of the “real” value of a given asset. And yet, today’s major credit crisis has shown, as if proof was needed, that while the market is fading under pressure from sellers, in the absence of buyers, prices are falling beyond all fundamental reality. In the same way and symmetrically, while we are in the middle of a speculative bubble the market price is totally dissociated from all equilibrium value. It is therefore necessary, as was the case in 2008, to be able to reasonably estimate value in an asset assessment, when the market does not allow it. Without this, the accounts depreciation leads to additional sales strung together one after the other in a self-maintaining flow towards low prices, and symmetrically in the event of a rise. In the event of market failure it is then necessary to use other methods than fair value to evaluate an asset. Avoiding returning to the method of accounting through historical value, which can be misleading in the case of assets held in trading, it may be useful to move to mark to model, provided there is external control of said methods, or the simple updating of reasonably expected future cash flows.

Furthermore, in contrast with the effect of the IFRS standards, in order to reduce the procyclicity of credit it is first highly desirable to encourage the banks’ supply. If they can accountably fund in advance as yet unproven future risks to their credit, they are less obliged to reduce their credit production during the occurrence of a major economic downturn. The impact of their accrued losses due to the increase of the cost of credit risk to their shareholders’ equity is in fact then compensated for, at least partially, by their provision write offs. Finally, it we should to re-examine the virtues of the old accounting framework of the banks on one point: that which would allow for the accumulation and discretionary provision write offs for general bank risks.

Second proposal

In the same way, the Basel 2 prudential standards are themselves procyclical. The bank shareholders’ equity required by Basel 2 is proportional to their credit liabilities in particular, themselves weighted by their associated risk. At the same time the positions in the financial markets are also considered according to their own risks (the value at risk method).

With evaluation models for these risks being essentially based on the data from a few previous years and hardly taking into account extreme risks, as much to credit as to market, a euphoric economic period leads little by little to more credits and speculative positions for the same amount of equity capital, and so further heightening the euphoria. While a period of depression forces banks to slow their credit rhythm or reduce their market positions for a given amount of equity capital, thus reinforcing the depression itself. It is also essential to modify the risk evaluation methods and the length of past time that they take into account, or moreover to apply stress scenarios to the models, enabling them to take into account more extreme cases (decomposition of risk factors and application of independent shocks).

In the end, with identical models following the example set by Spain, the solution is probably to adapt the ratio of required equity capital itself, according to the economic phase in progress, enabling it to be raised during a boom period in the cycle and lowered when there is a reversal permitting it to play a contra-cyclic role. In theory the second pillar of Basel 2 allows monetary authorities to proceed in this way but in practice, in the absence of clearer and better shared rules, it does not function in a satisfactory and coordinated way.

Third proposal

The question of the way in which the rating agencies work is also at the heart of the issue. Their procyclical nature is also obvious here. Furthermore, the CDO (collateralised debt obligation) rating is not the same as the corporate. The evaluation models for ranges of securitisation have failed, and not just because they did not integrate liquidity risk. In addition the fact that these models used data collected over too short a time period, they took little or no notice of the non-linear effects linked to the threshold effects, themselves due to the successive bringing into play of risk in different ranges of securitisation. Moreover, they have not appreciated the correlations in the flaws of the different components of the supports of securitisation.

In short, it is crucial to enforce that the marking agencies be obliged to show or make shown due diligence in the underlying securitisation, which is not the case at present (for example the cheating on sub-prime credit documents stems from this).

On another level we should add that these agencies are paid by the issuers who need their rating, which could lead us to doubt their impartiality. However, because its users are spread out and of very unequal size, it is impossible to conceive a viable system based on a payment from these users, so the choice is either to nationalize these agencies, claiming that they provide a service for the common good, or more likely we put them under a supervisory organisation which checks the quality of the methods used and the results after the event, so respecting proper ethics.

Likewise, as this has been done with external auditors, it would be prudent to establish their civil responsibility in case of an error in their rating process in counting on the jurisprudential control to further assure that their method of payment does not influence their decisions. In the end, in the same sense it seems absolutely necessary to separate their rating and advice functions (advice in terms of preparing for a rating).

Fourth proposal

The question of trader compensations is also decisive even if we cannot in any way make them the principal cause of the current chaos. Bonuses, paid annually, represent extraordinary amounts on an individual scale and are in principle based on the achieved earnings thanks to their trading positions. This compensation system is totally asymmetric because it does not erase the previous bonuses in the case of a final loss.

Thus, it is a strong incentive to take significant risks. At the very least it would be essential to only calculate and transfer the bonuses once the positions are finally released. But above all, because more and less favorable phases in the market follow one another over time, even disastrous phases as is the case now, we might say that the main part of the bonus may only be paid at the end of three or five year cycles for example, thus encouraging more long-term behaviour in traders. Without doubt it would be equally wise to limit these same bonuses to a multiple of their fixed salaries, not only as a question of social equality but also and above all to avoid unreasonable professional behaviour induced by abnormal sums.

Lastly we can remark that these compensation systems could be examined by supervisory bodies when looking at prudential solvency ratios. In effect it is likely that only banking self-regulation cannot manage to settle down the necessary new system of compensations once inter-bank competition is once again strong in this area.

Facing up to the endogenous causes.

To face up to the endogenous causes of financial instability is, less comfortable. A certain number of trails must therefore be followed.

Fifth proposal

Let us begin with the easiest path to apply to this end; monetary policy. As many central banks tell us, in the first place it is extremely difficult if not impossible to use interest rates as a weapon to slow or stop the emergence of euphoric phases in asset markets, because it is also the level of intervention of central banks that enables them to influence the rate of economic growth. And yet, slowing growth by an increase in rates is not often desirable even if it would be useful to prevent a euphoric state developing in the markets.

Secondly, the central banks cannot determine fundamental values with certainty and so cannot be sure to spot the beginnings of a speculative bubble. On the other hand there is no doubt that the monetary authorities could manipulate prudential solvency ratios better than they do presently, depending on the phase in progress. In effect, more often than not speculative bubbles on the stock market, as property bubble, come with a development of credit which is too fast in terms of the levels of debt and of leverage. If the debt was not able to increase in an abnormal fashion, than with a tighter control on bank solvency ratios, the bubbles would have less oxygen with which to develop. Following the same objective, the setting of an obligatory rate of reserves can be seen as the perfect companion.

However, the risk remains for the central banks to act at the wrong time.

Sixth proposal

As we have seen, these bubbles stem from the actor’s ability to develop a strong mimicry – rational in individual examples, but which lead to a collective irrationality – in the absence of reliable bearings as far as their fundamental values.

The central banks then try to speak out regularly, when it is necessary, in order to clarify to the market that prices seem to them to be some way off normal levels corresponding to a fair appreciation of the fundamentals. However, in general these warnings have little effect. Thus, Alan Greenspan spoke about an irrational exuberance in the stock market in 1996. This has did not avoid the creation and bursting of one of the strongest bubbles in 2000.

It may be possible to imagine an independent watchdog, a scientific panel of renowned experts, perhaps linked to the FMI or the Bank of International Settlements (BIS), that is capable of producing public reports on a quarterly basis for example, and which measures speculative tensions in the different asset markets.

Economists at the BIS have updated the fairly reliable predictive indicators of coming financial and banking crises. Essentially they are based on the measurement of the gap between the instantaneous evolution of property prices and stock prices and their long term tendency, along with the level of credits on the GDP and their long-term benchmark level. It is feasible to hope that if such relationships were regularly made and public, with suitable effect, little by little they could influence the creation of agent expectations on the markets. They could also enable a reduction in the capacity for markets’ disaster myopia. This largely shared cognitive bias fits with the progressive desensitisation that everyone has to the risk they are running, which grows little by little as the memory of the most recent of these rare yet violent events (in this case the financial crisis) fades with time, so encouraging behaviours which will ease the advent of the next disaster.

Seventh proposal

hort termism is inherent in finance since it is rational for fund managers or bank management to adopt or to have adopted a very short-term view in the management of their positions, taking into account the uncertainty concerning the fundamental value of assets. When we do not know what the “true” price is, we don’t bet for long on a convergence of market price towards an uncertain estimation of the fundamental value.

Thus, it is difficult to reduce this short-term view.

Some options, then. Aside from sovereign funds which are not restricted by the short term, it would be possible to aim certain funds towards the long term, for example pension funds, because their outflows can be predicted far in advance. Their accounting should be adapted in order to avoid needing an accounting of short term market fluctuations. In the same way, the rules for the outflows of funds could be revised according to their nature so that, for example, asset funds don’t have a daily liquidity thus lengthening the view of investors and managers.

Limiting this short termism could also be done by publishing fund values and their benchmarking at a reduced frequency so as not to enhance the mimicry of their managers.

Furthermore, in order to encourage individual investors to buy certain funds, for example, an attractive taxation should be implemented. In effect it is more sensible to impose low or nil tax rates, not to wrapped products or funds such as PEA’s in France, but to the direct or indirect holding of funds which are long-term in nature. In fact, even within a PEA it is perfectly possible to buy or sell funds listed daily and benchmarked monthly. Whether held within a PEA or not, these funds are led rationally to adopt very short term views and very mimetic behaviours in order to be sold as soon as they no longer have a high profitability, which could be offered by other funds. A beneficial taxation reserved for long term funds could therefore be a useful tool in limiting the inherent short termism in financial markets.

Eighth proposal

To tighten supervision is a necessity agreed upon by everyone. It comes through the supervision of up to now loosely or uncontrolled bodies, notably with hedge funds and securitisation vehicles. In effect they behave like banks but have an uncontrolled leverage and risks which are not scrutinised by supervisors. Evidently the same goes for investment banks in the US which for the most part have been helped by the Fed, although they were not supervised by the Fed itself. Added to that, supervision in the US is very broken up. And so for example, organisations which distributed sub-prime credits were not supervised by the Fed.

Besides, it could certainly be useful to envisage a pooling or at least an active cooperation on the part of bank and insurance supervisors. In effect, the circulation of credit risks between insurers and the banks is intense, for example due to the CDS market (credit default swaps).

In addition, a single supervisor, or at the very least federal, would be of great benefit in the euro zone, or even the European Union. With the supervisory bodies being national and the phenomena of financial crisis being worldwide since the advent of financial globalisation, a more forceful coordination in these bodies has become necessary.

More generally speaking, the regulators must pay extreme attention to the capacity of economic agents to raise leverages to unacceptable levels during euphoric phases, sometimes by circumventing the rules or using their shortages (distribution of sub-prime credit in the US, securitisation allowing the banks a strong leveraging effect despite Basel 2…).

Ninth proposal

A lot of ink has been spilled over securitisation and CDS market. They are certainly the specific and aggravating factors of the current financial crisis. They are, however, necessary since they enable banks to grant more credits than if they didn’t exist. Banks would not be able to finance the global economy solely through their equity capital. It merely remains that they be rethought so that they are at the same time more efficient and more “moral”. First and foremost, the supports of securitisation, such as the CDS, must be standardised. Their current heterogeneity added considerably to the mix-up of markets and their lack of liquidity. For CDS’s, it is furthermore essential to put them into organised markets, with guardianship of the market and clearing house, in order to guarantee a good end to contracts thanks to calls for a daily margin and deposits, which almost allows the elimination of risk of compensation.

For securitisation it is necessary to lessen the moral hazard which comes with them, since a bank which securitises its debts no longer bears the risk of credit it has granted, nor the obligation to monitor the borrower for the duration of the credit. All things which nevertheless normally define the role of banks in the credit process, from selection for the allocation of credit up to its’ reimbursement. To obstruct the possibility for banks not taking an interest in the reimbursement of credit – so as not to play the role of bank – as was seen at a preposterous level with the sub-prime market in the US, an obligation should be imposed on them to keep their risk liability at around, for example, 10% of securitised credits, by clearly indicating in their prospectus the exact risk held by the bank and enforcing a precise reporting next to the subscribers.

Finally, it is unreasonable to have allowed securitised bank debts hold by structures (conduits) bearing credit which are often long term, with a very short term refinancing. These conduits are in a sense the ersatz of uncontrolled banks, de facto allowing them to increase their leverage without the same regulatory control. And yet these same banks should give guarantees for the refinancing of their conduits, callable in cases of liquidity problems, so obliging them to retake previously securitised risks. In addition, in that case the disappearance of market refinancing with which the conduits were faced reveals a deep uncertainty as to the quality of the so securitised debts.

Tenth proposal

Upstream and more fundamentally, major financial instability is often facilitated by global macroeconomic and macro financial imbalances. This is certainly the case with the current financial crisis which has unfolded in the context of very high American current external deficits. These deficits are financed with no limits through official Chinese reserves, themselves due to imposing current account surplus, and are made possible by a long undervalued Chinese currency. It is from here that the discussion on a new Bretton Woods agreement stems, in particular regulating the value of currencies between themselves in a more harmonious fashion. It is unfortunately unlikely that such an attempt will succeed since the national interests in question cannot agree with one another. However it is not useless to look for possible arrangements, even temporary, which could eventually establish the resolution methods for such a divergence of interest in a more coordinated way.

To reduce financial instability is not easy, but, as we have seen, serious and pragmatic paths are open to us. The ideas presented here are certainly not exhaustive. But it is necessary to study them and, if needs be, to accomplish them as quickly as possible. Financial stability is a collective good which contributes to growth and the well-being of all. A demonstration from the absurd is in the process of being given.

Essay written in January 2009.

Categories
Economical and financial crisis Finance Global economy

The Current Financial Crisis : something old, something new

A New event or history repeating itself?

Financial crises happen time and again, each time exhibiting a fundamental similarity in their origins and the way in which they unfold, but also in their own specific characteristics. All financial crises take at least one of three canonical forms which history has regularly taught us since the 19th century, at least. Often they take on and combine each of the three forms successively or simultaneously. Let us analyse them, with particular reference to the works of Michel Aglietta and the economists at the Bank of International Settlements.

The first and oldest of these forms is the speculation crisis. Why do property assets (shares, real estate…) become the subject of speculative bubbles? Because their price, in contrast to goods, industrial services or repeatable trade, does not depend on their production cost. That is why their price can be some way off their manufacturing costs. The price of a financial asset depends fundamentally on the confidence we place in it based on the future returns it can bring as forecast by its issuer. But the determination of price also depends on what everyone anticipates regarding the confidence placed in this promise by others. Everyone reasons in this way.

If the information is not fairly shared (between lender and borrower, the shareholder and the management, or between the market actors themselves), coupled with the fact that the future is difficult to predict, these information asymmetries and the fundamental uncertainty favours mimicry in the parties. So it is in fact very difficult to know the fundamental value of the asset in consideration, and so also to bet on it. In this case, the direction of the market is decided by the others because it is the pure product of expression of the majority opinion which then becomes clear. So the parties understandably imitate each other, hoping to try and anticipate and go with market trends in a totally self-referring manner. Thus these bubbles can burst suddenly, with the reversal of the majority opinion, in an even stronger movement than that which characterised the previous phase.

The second form, the credit crisis, stems from the fact that over a prolonged growth period all parties (banks and borrowers) progressively forget about the possibility of crisis occurring and end up expecting unbounded growth (an effect of “disaster myopia”) . In this euphoric state, lenders dangerously lose their sensitivity to risk and the level of leverage (debts on the level of wealth or of household revenue or of net assets for businesses) and end up increasing excessively.

Besides, this phenomenon is considerably amplified where lenders no longer gauge the solvency of the borrowers against the yardstick of their likely future revenues, but against the yardstick of the expected value of the financed assets (notably shares or property) or which serve as collateral. In the end, and more often than not, during this phase they accept margins that do not cover the cost of risk of forthcoming credit, as is the competitive nature of the game.

The financial situation for the economic agents proves very vulnerable during the next economic reversal. Also, while the crisis is happening, the lenders (banks and markets) carefully reconsider the level of risk they are running, and by a symmetrical effect of the precedent, they sharply reverse their practice of credit grants, as much in terms of volume as margin, until they provoke a “credit crunch” which will itself reinforce the economic crisis that it has created.

The third canonical form of crisis; the liquidity crisis. During a certain dramatic sequence of financial crisis events, a contagious wariness appears as we are witnessing with today’s financial and banking crisis. For certain banks this defiance induces a fatal rush in their clients to withdraw their deposits. It can also lead to a rarefaction, even a disappearance of willingness with the banks to lend to each other for fear of a chain of banking bankruptcies. But this illiquidity in the market of inter-banking finance – without the last resort intervention of the central Banks in the role of lenders – produces these bankruptcies which are so dreaded. Apart from this, other forms of illiquidity can be produced.

Certain financial markets which yesterday were fluid can suddenly become illiquid; so much so that the concept of market liquidity is still highly self-referential, as André Orléan has analysed. A market is only liquid if all the parties involved believe it to be. If suspicion arises as to its liquidity, as was recently the case with the ABS market for example, all parties will find themselves selling to get out of the market, at the same time provoking its illiquidity in an endogenous fashion.

These three types of crisis are often interlaced and mutually lead to an extremely critical situation. As an example, credit can quickly grow excessively by virtue of the unusually high growth in the price of property assets which act as guarantees to these funds. And the prices of these assets shoot up themselves since easier credits allow for additional purchases.

Here we end up faced with a self-maintaining and potentially long-lasting phenomenon in markets which do not stabilise themselves at normal levels. Likewise the liquidity crisis is generated, for example, by a sudden fear over the value of bank debts and the financial assets which the financial organisations possess. In the search for liquid assets the banks will finance the economy less and try to sell their assets, which in turn worsens the speculative crisis as with the credit crunch.

The major crisis which began in 2007 is a combination of these three forms. Firstly a speculative property bubble, notably in the US, the UK and Spain. Next, a credit crisis due to a dangerous rise in the levels of household debt in these same countries, and to a very high leveraging from the investment banks, businesses in leverage buyout and hedge funds in particular. Finally a liquidity crisis in the securities products and inter-bank refinancing markets.

Each crisis reinforces the other two in a self-maintaining process.
The idiosyncratic element of the current crisis lies in the rapid development in securitisation of bank debts in recent years.
Securitisation comes from the credit organisation report of bank debts for individuals, businesses and local authorities. These debts are often grouped in a heterogeneous manner into supports with a high leveraging effect themselves, revenue supports to other banks, to insurers and to displacement funds, in other words ultimately for everyone.

Securitisation has therefore enabled significant growth in the financing of the global economy since it allows the banks to make much more funding than if they’d kept them in their balance sheet. But this technique, which is not controlled, has also incited the banks who use it most (particularly in the US) to considerably lower their selection standards and their monitoring of borrowers, and to agree to lend to increasingly insolvent borrowers because they then run no more risk after securitisation. So, for example it’s in this way that sub-prime credit liabilities multiply, significantly increasing the credit crisis which has come about following the bursting of the property bubble.

Non-regulated securitisation has then considerably aggravated the credit crisis, but also the liquidity crisis. In effect the difficulty in tracking these funds and the mixture of good and bad credits in the same supports, like the opaqueness and complexity (CDO…) of securities products, have in turn worsened the extent of the crisis itself. With everyone losing all confidence in the quality and even in their understanding of this kind of investment, their liquidity has in fact found itself suddenly dried up. In fear of the assets then being held in the banks’ balance sheet, and so those of the insurers, at the same time this has led in particular to an inter-bank liquidity crisis of a gravity that we thought had been consigned to the past. For public authorities the difficulty in resolving the problems which have arisen has increased.

Finally, the credit-rating agencies, armed with unappreciated mathematical models based on restrictive hypotheses and the exclusive analysis of past series, have accorded a quality grading (grade AAA) to sections of the supports in question. And yet this seal of approval has revealed itself little by little, as the crisis unfolds, to be of very poor quality. These grades, which moreover do not account for the risk of liquidity, have led many investors including bankers to reassure themselves of getting off lightly, and in the end wrongly, on the quality of their financial assets, without asking themselves overly about the reasons for which an AAA investment quotation could be so well compensated.

The entanglement of these three canonical forms of financial crisis, other specific elements and the current crisis explain the extreme seriousness of today’s situation, with its procession of banks in distress, the panic of investors, the “credit crunch” in process, and finally the powerful economic crisis. Only the strong actions of the authorities, at the precise moment when everyone doubts each other, has recently been able to begin to calm the inter-bank market a little and to avoid a total collapse of the financial system.
All that remains is to watch for, and try to counter, the economic consequences of the most serious financial and banking crisis since the ‘30’s. And to hope that the resultant risk of credit to businesses and households does not revive the banking crisis in a vicious circle which would once again exacerbate the coming recession.