Journal of Financial Economics

REF 103 The crisis exit policies

This article provides some empirical evidence on the recent global financial crisis in comparison with previous crises. First, this comparison is done through an assessment of the international contagion effects between several countries’ stock markets during previous episodes of financial turmoil. Secondly, we analyze the real impact of crises, in comparing the losses in GDP during the main financial crises in advanced countries. The results show that the recent global financial crisis stands out relatively to the other crises by the magnitude of the international contagion effects and also the strength of its impact on the real economy in the advanced countries.

A review of the past financial crises suggests that the 2008-2009 crisis could lead to a durable loss of activity. In the main scenario, the French economy might suffer a permanent loss of 7 points of GDP compared to the pre-crisis trend. The weakness of productivity is one of the mechanisms that could account for this permanent loss. This loss of productivity is related to the unexpectedly good performance of the French labour market during the crisis, regarding the loss of activity. The crisis has also accelerated the old tendency of debt increase the French economy has been facing for 30 years. At this point, the debt level becomes problematic.

The 2007-2208 financial crisis led to the return of active economic policies in order to avoid a general collapse of the world economy. But facing the fears of financial markets due to an excessive public debt and to a revival of inflation, the governments have soon entered a fiscal consolidation process. Today with an ailing economic activity, they seem to be powerless. The temptation is great of restoring conventional macroeconomic policies whose foundations lie on the main stream of macroeconomic theory whose weakness has appeared in broad daylight.

Following the financial crisis, governments of industrialized countries have undertaken major programs to stimulate demand and to recapitalize banks. As a result, levels of public debt rose sharply, and they will probably continue to do so in the near future in the OECD countries. However, there is no consensus on the effects of public debt on the economy. This article examines the theoretical contributions to this debate. First, we question the possible existence of a desirable public debt target, and then we focus on two major risks associated with long-term indebtedness: its impact on growth and the stability of the policy mix.

For euro zone countries, exiting the crisis implies exiting the sovereign debt crisis. That means acting on different control levers both at the EU level and at the countries’ level. Using strong and efficient mechanisms, the EU must establish financial solidarity and has to reform the euro zone governance. As what regards France in particular, restricting institutional mechanisms must be put into force so that this country will have to follow its Parlement’s decisions on public finance in a way consistent with the country commitments towards the euro zone.

This article examines the exit strategy, which in the ECB’s terminology is to be understood as the unwinding of the various non-standard measures decided independently of the interest rate policy stance. We study the different possible scenarios depending on whether the continuation of non-standard measures or the crisis exit coincide with the extension of an accommodative interest rate policy or a change in its stance. We show that the action of the ECB since the end of 2009 corresponds to a succession of two of these scenarios, first with the unwinding of the so-called “enhanced credit support policy” followed by a monetary policy status quo. However, the emergence of the sovereign debt crisis in the euro area forced the ECB to change tactics, with the implementation of the Securities market programme (SMP) followed, a little later, by the raising of key rates. The current situation remains tense with, on the one hand, banking systems that are still very dependent on the Eurosystem for their refinancing and, on the other, governments that are faced with difficult fiscal positions. This situation illustrates the difficult trade-off between the risk of a premature exit and that of exiting exceptional measures too late, against the backdrop of a financial crisis that has now lasted since the summer of 2007.

This article intends to give a short presentation and assessment of the new rules of banking regulation initiated by Basel III. We first describe the motivations and key breakthroughs of the reform. Then we try to estimate, from a theoretical and empirical point of view, the costs and benefits of this new framework. Lastly we focus on three complementary questions which have to be dealt with to give Basel III its full efficiency.

The 2007-08 global financial crisis highlights that the preservation of financial stability requires going beyond the micro-prudential regulation by promoting a macro-prudential policy. This latter has to cope with the different dimensions of the global financial risks, especially the procyclicality of the financial system and the problems related to interconnectedness and “too big to fail” financial institutions. This paper reviews the different tools which could be dedicated to the strengthening of the resilience of the global financial system both in its time and cross-sectional dimension.

Over the last twenty years, income inequality has been stretching upwards all around the world. This movement has been particularly significant at the top of the income scale. The article examines the links between the changes in the income distribution and the outburst of the recent financial crisis. It relates the increasing debt of the poor to the stagnation of their income as well as the income of the middle class. But it does not conclude that a change of trend of inequality is a necessary precondition for a recovery. A new path can result only from simultaneous national policies aiming at similar objectives. They could deal with reductions in rents, return to full employment, an increase in education and skills and a new tax policy.

Is it really a good idea to consider that reduction of global imbalances is a priority, as proposed by the participants at the G20 Finance in Washington on 13 and 14 April 2011, adopting a set of indicative guidelines to address major and persistently large imbalances? To answer, several questions must be addressed. What was the role of global imbalances in the rise of financial fragility before the crisis? What are the theoretical foundations of such a limiting external surpluses and deficits? Is it an intrinsic objective of economic policy, or rather an intermediate target in the way to more coordination in economic policies and exchange-rate dynamics? And above all, is it appropriate in times of crisis?

The nature of the present exchange rate regimes explains the global imbalances lying at the heart of the financial crisis. Most of the countries that have accumulated foreign exchange reserves since 1990 have a fixed exchange rate system. The currency of the main debtor – the US – is floating and the European countries bearing a deficit have a fixed exchange rate system with their main commercial partners along with a floating one with the others. Such conditions had to lead to a financial crisis and pave the way for a currency war. Nevertheless, a better exit of the crisis is possible if the present rebalancing of the international trade and the continuation of the emerging countries growth lead to an appreciation of their real exchange rates.

In the emerging countries, growth is strong and inflation accelerates with fast-growing labour costs; the aim of economic policies is therefore the slowdown inflation with restrictive monetary policies. In the OECD countries, growth is disappointing and inflation only results from higher import prices; fiscal policy cannot remain expansionary, hence the persistence of monetary stimulus. The strong implied appreciation of the currencies of emerging countries is not a favourable development for OECD countries, which is not the common view: it is leading to higher import prices and not to a stimulation of production, which is little substitutable to the one in emerging countries; however, it benefits emerging countries because of its effect on inflation.

The G20 has played a key role in the international coordination of economic policies during the first phases of the crisis. On one hand, the magnitude of the crisis has aligned the preferences of the main economies and on the other hand, the international community has quickly found a relevant forum of cooperation: the G20 whose way of functioning by consensus, inclusion of the main emerging economies and the highest level of representation made it suited to the stakes.

For crisis exit as in normal times, the background of international cooperation is less favorable, as the structural differences inside the G20 generate automatically a misalignment of preferences. In addition, as a legacy of the crisis, the room of maneuver of budgetary policies is also very different.

However, this embryo of international coordination generated by the crisis could survive as (1) there is a demand by the markets and also the people, (2) the holistic approach of the G20, combining macroeconomic coordination, strengthening of the international monetary system and financial regulation reform can facilitate global compromises and (3) the formalization of the coordination within the G20 (“Framework for growth”).

The 2008 financial crisis, the ensuing economic crisis, and the euro zone sovereign debt crisis make reform of economic governance in the euro zone a necessity. When the euro was created, it was decided to not fully coordinate economic policies – instead the decision was made to set up a system of safeguards against national behavior that would be detrimental to the zone’s stability. This system showed its limitations and, faced with an emergency, the zone’s nations have reformed the framework of the monetary union’s economic policy.

It is indisputable that euro zone governments have made progress in their economic governance. The rules have been strengthened and especially the acceptance on a national level of European constraints should lead to countries better following the rules. Nevertheless, the conscious choice of largely decentralizing economic policy raises problems, in particular less transparency on a European level and making it more difficult to evaluate risk. Moreover, the refusal to allow the central bank distinguish between sovereign debts detracts from the robustness of its independence. Reinforcing the European system requires delegating the evaluation of its national actions to a common, independent European body. Making these evaluations public would strengthen the market’s disciplinary power, which is naturally regulatory.

The appearance of sovereign funds in the French economy – though still small – must be considered as a positive fact. The main concern should be the risk of a lack of their interest in the investment opportunities of the French economy rather than that of a massive inflow of funds.

The big French companies own major assets to attract them and have them associated to their growth. On the whole, the attractiveness strategy to implement must rely first on the main economic agents but also on a sound politico economic diplomacy targeting these funds. Another important point is trying to have a French influence in these funds’ management teams.

A financial restructuring of the sovereign debts of some European countries would be a sound financial and economic solution to the persistent crisis. Despite the differences between 1980’s Mexico and the present EU, the results of the Brady plan implemented in 1990 highlight that technical solutions are available. Nevertheless, such an implementation requires that the European policy makers make a clear choice for increased federalism.