Hugo Dixon

The credit crisis burst into the open five years ago. The euro crisis has been rumbling for over two years. The term “crisis” isn’t just on everybody’s lips in finance. Wherever one turns – politics, business, medicine, ecology, psychology, in fact virtually every field of human activity – people talk about crises. But what are they, how do they develop and what can people do to change their course?

The first thing to say is that a crisis is not just a bad situation. When the word is used that way, it is devalued. The etymology is from the ancient Greek: krisis, or judgment. The Greek Orthodox Church uses the term when it talks about the Final Judgment – when sinners go to hell but the virtuous end up in heaven. The Chinese have a similar concept: the characters for crisis represent danger and opportunity.

A crisis is a point when people have to make rapid choices under extreme pressure, normally after something unhealthy has been exposed in a system. To use two other Greek words, one path can lead to chaos; another to catharsis or purification.

A crisis is certainly a test of character. It can be scary. Think of wars; environmental disasters that destroy civilisations of the sort charted in Jared Diamond’s book Collapse; mass unemployment; or individual depression that triggers suicide.

But the outcome can also be beneficial. This applies whether one is managing the aftermath of Lehman Brothers’ bankruptcy, the current euro crisis, the blow-up of an oil rig in the Gulf of Mexico or an individual’s mid-life crisis. Much depends on how the protagonists act.

Students of crises are fond of dividing them into phases. For example, Charles Kindleberger’s Manias, Panics, and Crashes identifies five phases of a financial crisis: an exogenous, normally positive, shock to the system; a bubble when people exaggerate the benefits of that shock; distress when some financiers realise that the game cannot last; the crash; and finally a depression.

While there is much to commend in Kindleberger’s system, it is too rigid to account for all crises in all fields. It also downplays the possibility that decision-makers can change the course of a crisis. A more flexible scheme that leaves space for human agency to affect how events turn out has two just phases: the bubble and the crash.

The bubble is typically characterised by mania and denial. Things are going well – or, at least, appear to be. Feedback loops end up magnifying confidence. In corporations or politics, bosses surround themselves with lackeys who tell them how brilliant they are. In finance, leverage plays a big part.

This is not healthy. Manic individuals don’t know their limitations and end up taking excessive risks – whether on a personal level or in managing an organisation or an entire economy. As the ancient Greeks said, hubris comes before nemesis.

But before that, there is denial. People do not wish to recognise that there is a fundamental sickness in a system, especially when they are doing so well. For example, back in 2007 at the World Economic Forum in Davos, the greed was palpable. Market participants had such a strong interest in keeping the game going that they turned a blind eye to the unsustainable buildup of leverage.

The ethical imperative in this phase is to burst the bubble before it gets too big. That, in turn, means both being able to spot a bubble and having the courage to stop the party before it gets out of hand. Neither is easy. It’s hard to recognise a sickness given that there is usually some ideology which explains away the mania as a new normal. The few naysayers can be ridiculed by those who benefit from the continuation of the status quo.

What’s more, politicians, business leaders and investors rarely have long-term horizons. So even if they have an inkling that things aren’t sustainable, they may still have an incentive to prolong the bubble.

The crash, by contrast, is characterised by panic and scapegoating. People fear that the system could collapse. Negative feedback loops are in operation: the loss of confidence breeds further losses in confidence. This is apparent on an individual level as much as a macro one.

Events move extremely fast and decisions have to be taken rapidly. Witness the succession of weekend crisis meetings after Lehman went bust – or the endless euro crisis summits. The key challenge is to take effective decisions that avoid vicious spirals while not embracing short-term fixes that fail to address the fundamental issues. With the euro crisis:, for example, it is important to improve competitiveness with structural reforms not just rely on liquidity injections from the European Central Bank.

In this phase, there is no denial that there is a problem. But there is often no agreement over what has gone wrong. Protagonists are reluctant to accept their share of responsibility but, instead, seek to blame others. Such scapegoating, though, prevents people from reforming a system fundamentally so that similar crises don’t recur.

Crises will always be a feature of life. The best that humanity can do is to make sure it doesn’t repeat the same ones. And the main way to evolve – both during a bubble and after a crash – is to strive to be honest about what is sick in a system. That way, crises won’t go to waste.

What should be the long-term vision for the euro zone? The standard answer is fully-fledged fiscal, banking and political union. Many euro zone politicians advocate it. So do those on the outside such as David Cameron, Britain’s prime minister, who last week called on the zone to “make up or break up”.

The crisis has demonstrated that the current system doesn’t work. But a headlong dive into a United States of Europe would be bad politics and bad economics. An alternative, more attractive vision is to maintain the maximum degree of national sovereignty consistent with a single currency. This is possible provided there are liquidity backstops for solvent governments and banks; debt restructuring for insolvent ones; and flexibility for all.

Enthusiasts say greater union won’t just prevent future crises – it will help solve the current one. The key proposals are for governments to guarantee each other’s bonds through so-called euro zone bonds and to be prepared to bail out each other’s banks. In return for the mutual support, each government and all the banks would submit to strong centralised discipline.

But the European people are not remotely ready for such steps. Anti-euro sentiment is on the rise, to judge by strong poll showings by the likes of France’s Marine Le Pen and Italy’s Beppe Grillo. Germany’s insistence last December on a fiscal discipline treaty has stoked that sentiment.

An attempt by the region’s elite to force the pace of integration with even more ambitious plans could easily backfire with voters, particularly in northern Europe. They would fear being required to fund permanent bail outs for feckless southerners. Premature integration might not even help with the current crisis if it backfired with investors. They might start to question the creditworthiness of a Germany if it had to shoulder the entire region’s debts.

In contrast, the principle of “subsidiarity” – the Maastricht treaty’s specification that decisions should be taken at the lowest possible level of government that is competent to handle them – is good politics and good economics. Of course, even advocates of political union such as Wolfgang Schaeuble, Germany’s finance minister, subscribe to this principle. The issue is to define the minimum conditions needed for the sustainability of the single currency. There are probably three.

The first is that insolvent entities – whether they are governments or banks – should have their debts restructured. One of the main reasons states and lenders were allowed to leverage themselves so much in the boom was because there was a widespread view that they couldn’t go bust. The complacency sowed the seeds of the crisis.

Meanwhile, a key mistake in managing the crisis was the failure to restructure Greece’s debts as soon as they became unbearable. If that had been done, private-sector creditors would have taken the hit. Instead, they were largely bailed out – with the result that 74 percent of Athens’ outstanding 274 billion euros in debt is now held by governments and the International Monetary Fund, according to UBS. This means taxpayers will be on the hook when the big fat Greek default occurs.

Of course, if Greek debt had been restructured earlier, banks in the rest of the euro zone would have had big holes in their balance sheets. Some would have needed bailouts from their governments. But that would have been better than the current debilitating long drawn out sovereign-cum-banking crises.

What’s more, in the future, insolvent banks shouldn’t be bailed out either. Their creditors should be required to take losses before taxpayers have to stump up cash. The failure to do so explains why the government of Ireland, previously financially solid, become infected by its lenders’ folly.
The second minimum condition for monetary union to flourish follows the first: there should be liquidity backstops for banks and governments that are solvent.

With banks, the natural liquidity backstop is the European Central Bank. The quid pro quo is that lenders have to be properly capitalised. Time and again throughout the crisis, euro zone governments have ducked this issue. Only this month, France and Germany conspired to dilute the Basel 3 global capital rules as they apply to Europe, while Spain imposed another half-hearted restructuring on its banks. If the euro zone’s leaders want a successful single currency, this nonsense has to stop.

For governments, the natural liquidity backstop is the European Stability Mechanism, the zone’s soon-to-be-created bailout fund. To do its job properly, it will need extra funds – as it isn’t be big enough to help both Spain and Italy. One option could be to allow it to borrow from the ECB.

Again, the quid pro quo would be solvency. Insolvent government would only get access if they restructured their debts. And illiquid but insolvent ones would need credible long-term plans to cut their debts. Italy, with debt over 120 percent of GDP but huge private wealth and state assets, might one day find itself in the latter category. In return for liquidity, it might have to agree a multi-year programme to privatise real estate and to tax wealth.

The final minimum condition for a successful monetary union is much more flexibility, particularly in labour markets. This is the key to restoring competitiveness in southern Europe and enabling the zone to respond to future shocks.

If the euro zone can do these three things – restructure insolvent institutions’ debts, provide liquidity to solvent ones and improve flexibility everywhere – nations will be able to keep both the euro and much of their sovereignty. That’s a preferable vision to either a euro super-state or the chaos of disintegration.

It has become fashionable to talk about the need for a euro zone “growth compact” as weariness mounts over a diet of nothing but austerity. France’s new president Francois Hollande has popularised the idea. Even Mario Draghi has backed it. That gives the concept credibility as the European Central Bank president was one of the main supporters of the austerity-heavy “fiscal compact”, which requires governments to balance their budgets rapidly. Olli Rehn, the European Commission’s top economic official, has joined the bandwagon too: at the weekend, he advocated a pact to boost investment, while hinting that there may be scope to ease up a bit on the austerity.

But all this chit-chat won’t lead to much unless politicians are prepared take unpleasant decisions on reforming labour, welfare and banking – measures which would boost growth in the long run. That has to be the quid pro quo for loosening the current fiscal squeeze or further easing monetary policy – measures that would help in the shorter term. 

Without such a grand bargain, any growth compact is likely to amount to little more than extra funds for investment. Rehn mentioned the main ideas at the weekend: using EU budget funds to guarantee lending to smaller firms; encouraging countries with fiscal surpluses to increase public investment; and boosting the capital of the European Investment Bank. While these measures are worthy, they are not of the scale needed to change the course of one of the biggest economic crises in recent history. 

The main guts of a growth compact ought to be somewhat looser fiscal and monetary policy married to deep structural reform. 

Look first at fiscal policy. It is great that policymakers such as Rehn seem to understand the dangers of an austerity spiral – where excessive budget squeezes crush the economy which in turn makes it harder to balance budgets and so requires further austerity. He says Europe’s fiscal rules are “not stupid”. 

 But even if Germany, Europe’s paymaster, can be persuaded to go along with a laxer interpretation of the rules, there is a limit to what will pass muster with the bond markets. While investors aren’t enamoured with growth-crushing austerity, they won’t finance profligacy either. Credible long-term plans to rein in deficits and restore competitiveness are needed. With those in place bond investors would be happy if the European Commission allowed governments another year or so to balance budgets. 

 The need for substantial change is not limited to countries already in crisis. In France, industry is increasingly uncompetitive and the government spends 57 percent of GDP. Tackling that ought to be the government’s priority, though it got little mention during the election campaign. Even Germany would benefit from reforming its weak services industries. Meanwhile, across Europe there needs to be a determined drive to deepen the region’s single market. 

 To gain the full benefits of monetary policy, there also needs to be a quid pro quo with the politicians. It’s important not to misinterpret Draghi’s new fondness for the word “growth”. The ECB is still keen on fiscal rectitude and is not signalling looser monetary policy. When Draghi talks about a growth compact, what he has in mind is structural reform – something that will not bear fruit for some time. Indeed, Draghi talks about the need for a 10-year vision. 

 While the central bank has engaged in exceptional measures to prevent the system collapsing – buying government bonds and spraying cheap money at the banking system – it has done so with a heavy heart. It rightly fears that such monetary rescues reduce the pressure on both governments and banks to reform themselves. Germany’s Bundesbank is even calling for the ECB to prepare to exit from these exceptional measures. While it won’t get its way – Draghi has made clear he thinks it’s too early to do this – talk of an exit is already making the money markets and the banks nervous. And that is undermining some of the benefits of the current loose policy. 

 For the ECB to be happy to pursue further monetary laxity, it will need to be convinced that governments are going to use the time they are being given wisely. A priority is to recapitalise zombie banks. So long as lenders have weak balance sheets, they will find it hard to fund themselves in the markets and will therefore lack the confidence to finance growth. 

 The key short-term imperatives are in Spain and Greece. But weak balance sheets are not confined to these two countries. Other governments have shown themselves unwilling to impose higher capital requirements on their lenders. Last week, for example, both Germany and France argued for changes in the way the new Basel 3 capital rules are applied to Europe so that their banks won’t need to raise so much capital. If politicians could bring themselves to grasp the nettle on banking, lenders would find it easier to fund themselves in the markets and the ECB would be less grudging about providing emergency assistance if it was still needed. 

 The ideal growth compact would match reform of banks, labour and welfare with less short-term austerity and accommodative monetary policy – and throw in some extra money for investment. Given the difficult political choices required, such a deal won’t be easy to pull off. But the tectonic plates are shifting across Europe. Now is the time to push for it.

Can the euro omelette be unscrambled without provoking the mother of all financial collapses? With the crisis heating up again as Spanish 10-year bond yields hit 6 percent last week, the question has renewed urgency. The conventional wisdom is that such unscrambling is impossible. The economic, political and legal complications of bringing back national currencies are so immense that the euro zone’s 17 nations are effectively locked in a prison with no exit.

A 250,000 pound prize offered by Simon Wolfson, a UK businessman, has aimed to turn this conventional wisdom on its head. In offering what is the second-largest economics prize after the Nobel, Wolfson hoped to stimulate creative juices. In one case, he has – although even it is no silver bullet.

Of the myriad problems with returning to the drachma, peseta and lira, the most intractable is how to prevent it triggering bank runs and ultimately financial chaos. Depositors would flee if they thought their euros were set to be converted into a national currency certain to suffer dramatic and immediate devaluation. This has already been happening to some extent in Greece. If the Greeks knew for sure that their old currency was coming back, the current fast walk would turn into a stampede. Even worse, the damage wouldn’t be confined to Greece.

Depositors in other peripheral countries would pull savings from their banks. Bond markets in these other countries would also seize up. Why would anybody want to lend money to Rome or Madrid in euros if they thought they were going to be paid back in devalued liras or pesetas?

The solution proposed by most Wolfson Prize finalists is secrecy. Plans for a country’s exit from the euro should be kept under wraps and then sprung on the unsuspecting world on a Friday evening. But this is impractical. How could 17 governments keep secret something that will involve lots of wrangling? Would a democratic country really be able to foist such a momentous decision on its people without a parliamentary debate? Even if secrecy was possible, it wouldn’t stop contagion to other countries.

Catherine Dobbs, a private investor who used to develop algorithms for an investment firm in the City of London, has come up with an ingenious solution. At the point of break-up, every euro – wherever it is located – is replaced by a basket of two (or more) new currencies. This is a radical shift in thinking. Until now, most people had envisaged all economic activity in the exiting country being redenominated in its new local currency while all the other countries kept the euro.

Dobbs illustrates her idea using the unscrambling the egg metaphor. The euro zone is broken up into two sub-zones: the yolk and the white. For some bizarre reason, she equates the yolk with the periphery (Greece, Spain etc) and the white with the core (Germany, the Netherlands etc). But I’m going to flip it round as it’s more intuitive to think of the yolk as the core. The idea is that every euro is swapped for a fixed ratio of yolk currency and white currency, roughly in proportion to the relative size of the two sub-zone’s economies. Say for every euro, people got 70 percent of a yolk and 30 percent of a white.

Once this has happened, the yolk and white are free to float – with the yolk presumably appreciating and the white currency depreciating. New contracts are denominated in yolk or white. But existing euro contracts have to be honoured by delivering the fixed proportion of yolks and whites in the basket.

The one exception to this – which Dobbs hints at but doesn’t spell out – would be employment contracts: they would need to be redenominated into their new local currency. This would effectively allow wages in the periphery to fall, which is vital if competitiveness is to be restored.

The beauty of the scheme is that there’s no incentive for citizens in the periphery to grab their savings in the run-up to such a switchover and pop them into a core bank. Their euros will be worth the same wherever they are located. As a result, the detailed planning for the break-up can be done in public rather than in secret.

Neat as Dobbs’ idea may be, the politics of it are problematic. While savers in peripheral countries would like receiving a mixture of yolk and white for their euros, those in core countries could hate it. They would feel that a chunk of their savings was being forcibly swapped into the weak white currency even though, in theory, the value of the basket should still be one euro. Workers in the periphery who would be paid only in the depreciating white currency wouldn’t be happy either. While their wages would effectively be slashed, their debts, rents and other costs wouldn’t be. Many would face hardship and bankruptcy.

Perhaps that is just too bad. Somehow wages have got to come down in the periphery and devaluation would be a faster way of getting there than the current grinding austerity, which isn’t pleasant either. The snag is that such vested interests mean it’s most unlikely that heads of government could discuss the yolk/white scheme one day and back it. Rather, there would be lots of debate over what the right plan was. And before any decision had been reached, there would have been a massive capital flight. Sadly, the euro egg looks pretty well scrambled.

Beware the “F” word. The European Central Bank and, to a lesser extent, the zone’s political leaders have bought the time needed to resolve the euro crisis. But there are signs of fatigue. A renewed sense of danger may be needed to spur politicians to address underlying problems. It would be far better if they got ahead of the curve.

The big time-buying exercise was the ECB’s injection of 1 trillion euros of super-cheap three-year money into the region’s banks. A smaller breathing space was won last week when governments agreed to expand the ceiling on the region’s bailout funds from 500 to 700 billion euros.

These moves have taken the heat out of the crisis – both by easing fears that banks could go bust and by making it easier for troubled governments, especially Italy’s and Spain’s, to fund themselves. Data from the ECB last week shows how much of the easy money has been recycled from banks into government bonds. In February, Italian lenders increased their purchases of euro zone government bonds by a record 23 billion euros. Spanish banks, meanwhile, increased their purchases by 15.7 billion euros following a record 23 billion euro spending spree in January.

The risk is that, as the short-term funding pressure comes off, governments’ determination to push through unpopular reforms will flag. If that happens, the time that has been bought will be wasted – and, when crisis rears its ugly head again, the authorities won’t have the tools to fight it.

Early signs of such fatigue are emerging. One is the tendency of politicians – most recently, Italian Prime Minister Mario Monti – to say that the worst of the crisis is over. They may wish to take credit for their crisis-fighting skills or relax. But it is too early to declare victory.

Italy is a case in point. Monti should have pushed through crucial reforms to the labour market earlier, while his popularity was high and the electorate was afraid that Italy would be engulfed by the crisis. He did not. And although he has now come up with a good package, his honeymoon period as the unassailable technocratic prime minister is nearing its end. His popularity fell to 44 percent from 62 percent in early March, according to a poll published last week by ISPO. Two-thirds of Italians oppose his labour reforms.

It’s a similar story in Spain. Mariano Rajoy, the incoming prime minister, should have cracked on earlier with a budget to bring the government’s finances into balance. To be fair, his administration did publish plans last Friday to curb its deficit – though it won’t be possible to judge how credible these are until Madrid explains how the health and education spending of Spain’s free-wheeling regional governments is to be reined in. Meanwhile, Rajoy’s honeymoon is also over. Last week, he failed to win the regional election in Andalucia and faced his first general strike.

Both Monti and Rajoy are still in strong positions. Although Italy’s political parties could theoretically kick Monti out, they are even less popular than him. Meanwhile, the Spanish prime minister has a sound majority in parliament. But as each month passes, it will get harder to push through reforms. Both men must hold their nerve and implement their full programmes while they can, without compromise.

Further afield, the appetite for austerity is also flagging – sometimes in unexpected places. The Dutch government, one of the high priests of fiscal rectitude, is finding it difficult to cut its own deficit. The ruling coalition may even collapse under the strain.

There is also increasing unhappiness about the fiscal discipline treaty Germany rammed through in December. Francois Hollande, the French socialist who is the front-runner to be France’s next president, wants to add a growth component to it. So do Germany’s social democrats, whose support is needed to ratify the treaty even though they are in opposition.

A fudge will probably be found that adds a protocol to the treaty which emphasises the importance of growth as well as discipline. Indeed, that would be no bad thing: too much austerity can be self-defeating as severe budget squeezes can crush an economy and make it even harder to raise taxes and cut deficits.

However, governments can’t ease up on short-term austerity and do nothing. What is needed is a vigorous programme of long-term structural reforms such as freeing up labour markets and introducing more competition into services industries. This could ultimately boost GDP by about 15 percent in large euro countries such as France, Italy and Spain, according to the Organisation for Economic Cooperation and Development. Even Germany, whose services markets are sclerotic, could benefit by about 13 percent of GDP.

Such a programme would make the euro zone’s economies fit enough to stand on their own feet when the anaesthetic of cheap money fades. But do governments have the will to make these changes given that the cheap money is lulling them and their people into believing the worst of the crisis is over?

A prod from the markets may be what is required. There are indications that this is beginning to happen. Spanish 10-year bond yields briefly reached 5.5 percent last week. The art, though, will be in the calibration. If markets move too little the politicians will be complacent. If there is too much, the euro zone will slip back into full-blown crisis.

To: Barack Obama
From: Humboldt Pye, Chairman of First Reform Bank

Dear Mr. President:

I’m writing an open letter to you and other G20 leaders on behalf of the chairmen of the world’s leading banks to say sorry.

We do not think banks are to blame for every ill the world currently faces, as the Occupy Wall Street protests and their kin in other countries suggest. A balanced audit would attribute responsibility to policymakers too: you and your predecessors set the rules of the game that we so craftily exploited. Even the public had a hand in the current mess: excess spending in some countries and inadequate taxpaying in others allowed people to consume too much.

But we are not in a position to lecture the rest of society. During the bubble years, we focused first on our own pay packages and then on profits for our shareholders. Insofar as we thought about the wider interest, we comforted ourselves with the belief that financial markets were efficient and free markets were the best way of generating wealth. So, as we pursued our self-interest, the world must by definition get better.

There were many flaws in this intellectual edifice. But contrary to popular belief, the weakness was not so much the failure of the market as the failure to apply the market. Central banks, especially the U.S. Federal Reserve, were always cutting interest rates at the first sign of trouble. The belief that Nanny was always there to rescue the markets lulled us into taking excessive risks. Second, the notion that governments would always bail out banks meant our bondholders didn’t bother to rein us in. Finally, our compensation practices amounted to “heads I win, tails you lose” bets. If our gambles paid off, we went laughing all the way to the bank. If they didn’t, the tab was ultimately left with taxpayers.

Our apology, though, can’t stop here. How we behaved after the bubble burst was arguably even worse. If it wasn’t for the extraordinary government and central bank assistance we’ve received (and still enjoy), most of us would have gone bankrupt. Despite this, we have kept paying our staff mega packages.

Our greed has enraged the people. Countries have imposed special taxes on the industry and pretty much everywhere the regulatory noose has tightened. We are not so naive to think we can swim against this tide, but we have sought to delay and dilute the most significant changes to capital and liquidity rules, which really hit our bottom line.

We have tried especially hard to wriggle out of anything that smacks of nationalization. Those of us who haven’t avoided this fate have had tough controls imposed on bonuses and dividends. The rest of us have therefore preferred to do anything to escape the state’s embrace, such shrinking our balance sheets rapidly, which allows us to boost capital “ratios” without issuing extra equity. Given the binge of the bubble years, deleveraging is appropriate. But rushing the process is probably tightening credit conditions and worsening the economic difficulties.

During this whole process, we’ve communicated terribly. Not that even a great orator like you, Mr. President, would have found this easy. The public assumes that everything we say is self-serving. But a leadership vacuum compounded this problem. Most of us were too cowardly to speak up. The few who did got pilloried – like Goldman Sachs’ Lloyd Blankfein when he made a bad taste joke about how he was doing “God’s work”.

That pretty much left JPMorgan’s Jamie Dimon to fill the void. For a while, he did a valiant job of speaking up for the industry in a down-to-earth manner. But too many flattering profiles about how he was a latter-day John Pierpoint Morgan saving the financial system may have gone to his head. His verbal assault on the Bank of Canada governor, Mark Carney, at the International Monetary Fund meeting in September shocked even other bankers.

We would now like to press the reset button in our relationship with society. At the heart of this will be the regulatory regime you are developing – in particular, measures to make sure that no bank in the future is too big to fail. Our pledge is that we will cooperate as you institute these changes, rather than fight them every step of the way.

We will also try harder to explain what we do. If we can’t show how what we do helps society, we should stop doing it.

We do not, of course, expect the public to believe our protestations of better behavior. So our senior executives are foregoing bonuses for at least two years. We are also going to squeeze cash compensation for other staff. We hope the public will in time appreciate that this leopard can change its spots.

Yours sincerely,

Humboldt Pye