The 2008 Global Financial Crisis in Retrospect

Marcus Miller argues that the growth of cross-border banking posed threats to financial stability that were ignored by central banks focusing on targeting domestic inflation. He discusses the role of pecuniary externalities, information failures, and the risk of insolvency in the subsequent ‘bank run’. It is argued that the financial system before 2008 was flawed by two Fallacies of Composition: first the belief that systemic stability could be guaranteed by regulations that made safer the portfolios of individual banks; second was a business model that reckoned holding securitized assets ensured liquidity whenever necessary. The author concludes that, while Iceland took exemplary action in bringing reckless bankers to justice, the failure to do this in the United States and the UK has had serious political consequences, such as the election victory of Donald J. Trump in the US elections in November 2016 and, possibly, the majority vote a few months earlier in favour of the UK leaving the European Union.

Michael Dooley makes a case for capital controls. He describes how the growth of international capital flows has increased the incentives by banks to choose high-risk strategies by opening the door to an almost infinite supply of leverage. He argues that the main problem with international investors when it comes to financial stability is that there are so many of them. It follows that limiting domestic financial institutions access to foreign investors can be an effective component of prudential regulation. In particular, he makes the case for required reserves on foreign deposits at domestic financial institutions.

Peter Garber traces the crisis to three failed public sector projects launched in the late 1990s. These were a scheme to redistribute wealth by lending to uncreditworthy borrowers for real estate purchases in the US; China’s export-driven growth strategy; and the launch of the euro in 1999. The rapid increase in China’s exports to the US created a capital flow into the US and within the Eurozone, Germany exported goods to the southern periphery and German banks lent money to banks, businesses, and governments in the south. The effect of these flows was to drive global real interest rates to very low levels and this led to the expansion of the SPVs and SIVs, effectively ways of raising short rates for those who demanded it.

Robert McCauley maps the capital flows that preceded the 2008 crisis and argues that it was European banks that fuelled the U.S. housing boom. Large official inflows into U.S. Treasury and agency notes should have reinforced a U.S. mortgage market dominated by fixed-rate mortgages. Instead, one observed a big shift to mortgages priced with floating (“adjustable”) interest rates and to riskier, leveraged mortgages that agencies could not guarantee. This banking glut accounts for the parallel real estate booms and busts in Spain and Ireland. McCauley shows that the Irish and Spanish banking systems experienced capital inflows that were huge in relation to the inflows into the United States in the same years.

Brad Setser finds that, first, sectoral imbalance in the United States shifted from the government sector to the household sector from 2004 to 2007; second, the available supply of Treasuries failed to grow in line with the enormous increase in central bank reserves, which incentivized more complex forms of financial engineering; third, after 2006, central bank flows fail to cleanly register in the U.S. data; fourth, the growth in private flows into the United States that coincided with record official reserve growth reflected the increasingly complex chains of financial intermediation needed to fund the U.S. deficit; and fifth and finally, some of the “missing” central bank flows—the gap between the growth in dollar reserves implied by the IMF’s data and the visible inflow into Treasuries and Agencies—likely was lent to European banks, both directly and indirectly, through the cross-currency swap market.

Jeffrey Shafer discusses the prelude to the 2008 financial crisis during the Great Moderation in the United States. Lax monetary policy, fiscal stimulus, a current account deficit and innovations in financial markets set the stage for the crisis. The capital flowing into the United States fuelled a house price boom that came to a halt in 2006. Several factors contributed to the boom and bust. Long-standing government policy provided support for housing and homeownership; government sponsored Fannie and Freddie aggressively expanded; refinancing to withdraw equity became common; innovations in the retail mortgage-backed securities market enabled mortgages to be packaged with tranches that were rated as equivalent to US Treasuries for which there was strong foreign demand; the risks introduced by packaging and distribution of RMBS was not well understood; underwriting standards deteriorated markedly; and, finally, the losses from bad credit decisions were multiplied by the collapse of vulnerable sources of liquidity in non-banks and off balance sheet entities.

Robert Aliber discusses the reasons for bank failures and financial crises. He makes three main points. First, US macroeconomic stability would be increased if the US Congress established a government agency to provide capital to individual banks after a systemic crisis causes large loan losses. Second, the crisis of 2008 is explained by a surge in the export earnings and the trade surpluses of China and the oil-exporting countries, and of the increase in their demand for foreign securities on the prices of real estate and stocks in the United States and other countries that had capital inflows. The higher asset prices then caused increased consumption and current account deficits. Third, there is a criticism of Dodd-Frank. The premise of Dodd Frank is that the crisis resulted from the decisions by banks to increase their purchases of risky securities rather than from a surge in the supply of credit from an increase in the capital account surpluses. Dodd Frank does nothing to dampen cyclical increases in investor demand for US dollar securities

Edwin Truman discusses the incidence of banking crises and concludes that there is no reason to expect an end to financial crises in the future. Moreover, he argues that financial reforms in recent years may have had the effect of increasing the severity of those crises that will occur by preventing the occurrence of smaller crises. Second, he finds that capital controls can be of use but not as a rule for all countries in all circumstances. Although a sudden stop of capital flows often precede crises they are not the underlying cause. Instead, there is greed on the part of borrowers and lenders that turns into fear when a disturbance occurs. Thus capital flow management controls, although often desirable, are not a panacea. Moreover, the authorities may find it difficult to distinguish between good and bad types of banking flows and over time capital controls will be evaded and become distortionary. Finally, Truman explores the possibility of major countries taking into account the effect of their policies on others but is not hopeful that central banks can deviate much from the local mandates.

Hamid Raza and Gylfi Zoega address the issue whether the causes of financial crises in Iceland can be found locally, within Iceland, or in world capital markets. They explore the role of capital inflows in generating a stock market boom in Iceland as well as a real exchange rate appreciation. Using a VAR methodology, the authors find that the inflow of capital caused a booming stock market as well as an appreciation of the currency. Moreover, a positive shock to the stock market caused a subsequent capital inflow and appreciation. The results confirm the hypothesis that capital flows and credit generation created the stock market bubble and the overvalued exchange rate that contributed to the pre-crisis economic boom. A sudden stop of these flows made the stock market collapse and the exchange rate lose half its value.

Gauti Eggertsson, Sigridur Benediktsdottir and Eggert Thorarinsson describe the economic development that preceded the financial crisis in Iceland and draw some lessons for other countries. Of particular interest is the extent of lending to related parties in the years preceding the crash. Lessons include the importance of transparent firm ownership to facilitate supervision of insider lending and large exposures; strict rules against lending against own banks shares, and also against lending with collateral in other financial institutions shares; realising that implicit government guarantees are much weaker for cross border deposits and liabilities and that once banks are allowed to operate in different currencies or across borders, they can become victims of self-fulfilling runs simply because they do not have access to a lender of last resort; and more attention needs to be paid to capital flows, and policy tools need to be developed to respond to them.

Fridrik M. Baldursson explores the effects of the economic policies prescribed by the IMF in response to the Iceland crisis. He finds that the capital controls were effective in that a gap emerged between the onshore and the offshore exchange rates; domestic interest rates did not follow foreign interest rate, and the statistical properties of exchange rate movements changed when controls were imposed and no longer indicated the presence of a carry trade. However, Baldursson argues that interest rates were kept too high, higher than in Malaysia following the 1997 crisis. Hence the capital controls did not constitute a departure from more orthodox policies prescribed by the Fund during previous crises.

Gudrun Johnsen studies the relationship between the compensation systems used by the Icelandic banks and the decisions made by the management that, among other factors, led to the disaster. Evidence was found of misreporting of key performance indicators. Banks’ leadership teams in all three banks engaged in a large scale market manipulation as staff option awards were used as a vehicle to falsify equity through inappropriate hedging of options via off-balance sheet SPVs, in addition to excessive lending to staff and favoured customers to purchase banks’ stocks with insufficient collateral backing. This behaviour helped meet bonus targets, derail financial supervisors and the investing public, while bringing and keeping incentive pay, in the form of stock and options, in the money. Loan portfolios in the failed banks were marked by excessive risk taking and funds were tunnelled to related parties.

Jon Danielsson discusses the use of capital ratios and macroprudential regulation and describes the limitations of each policy: How banks can inflate capital ratios, how capital requirements fail to reduce the risk of aggregate shocks and how Basel III regulations burden smaller banks relative to larger banks. Moreover, Danielsson discusses the pros and cons of putting macroprudential regulations in the hands of a central bank, the possibility that this policy may turn out to be procyclical and the dangers faced to the credibility of a central bank that attempts to assess the economic risk of political decisions.

Tinna Laufey Asgeirsdottir reviews the literature on the relationship between business cycles and health outcomes and then describes the results of studies on the effect of the 2008 crisis on heart health and consumption habits in Iceland. Asgeirsdottir shows how the economic collapse in October 2008 lead to an increase in the number of heart attacks, which she attributes to the severity of the collapse and the shock that it may have caused in the population. In contrast, the collapse of the currency made the imports of alcohol, tobacco, and sweets more expensive, hence reducing their consumption with positive effects on the health of the nation.

Thorvaldur Gylfason discusses the economic, political, and judicial aftermath of Iceland’s financial collapse in 2008. It considers lessons learnt, or not learnt, with emphasis on unsettled issues concerning the distribution of incomes and wealth, banking, and politics. The study makes three main points. First, the measurement of income flows and living standards needs to be adjusted in two respects. Second, since the crisis, Ireland has made a significantly stronger recovery than Iceland in terms of per capita income. Third, Iceland’s economic recovery from the crisis is marred by a visible deterioration of various components of the country’s social capital.

Asgeir Jonsson surmises the lessons from Iceland’s monetary history since sovereignty in 1918, during which time experiments have been made with various arrangements. His main conclusions are that it is not the choice of an exchange rate regime itself that is most important, but to follow the ground rules required by each framework. There is nothing to indicate that inflation targeting cannot work successfully in Iceland, as it has in other Nordic countries, if a reasonable societal consensus can be reached on the ground rules. The balance of payments has played a key role for economic stability in Iceland, and independent monetary policy is not truly an option unless it is possible to manage the capital account, directly or indirectly, irrespective of the exchange rate regime in place. This has traditionally been accomplished with capital controls, but at a great social cost. The appropriate application of macroprudential tools should offer a new ray of hope for the second century of monetary policy in Iceland.

Fredrik Andersson and Lars Jonung describe Iceland’s economy and list the possible currency regimes. They ask which is the best monetary policy regime for Iceland and conclude that a flexible exchange rate with an inflation target can be ruled out because such a system has served as a shock amplifier. They find that Iceland can only maintain a domestic inflation target over the long run through capital controls. But the authors consider such controls to be very costly and likely to increase corruption. Instead of a floating regime, they find that a fixed exchange rate regime is the preferred choice. But as a microstate, Iceland is not able to create sufficient credibility for such a regime, which leaves a monetary union as a solution. But since full euroization is not an option for Iceland because it is not a full member of the European Union, nor will be a member in the foreseeable future, the preferred monetary union alternative is, in their view, a currency board, accompanied by a wide-ranging reform package to foster fiscal stability, wage and price flexibility, and financial stability.

The current inflation-targeting regime did not manage to stabilise inflation at the official target in the first decade since its establishment in 2001, nor was it able to contain the large macroeconomic and financial imbalances that were building up from the middle of the decade, culminating in the catastrophic financial crisis in the autumn of 2008. The crisis triggered a major revision of the monetary policy framework and its governance and decision-making structure. These changes are described by Thórarinn G. Pétursson, the chief economist of the Central Bank of Iceland. His findings suggest that these reforms have increased the transparency and credibility of monetary policy in Iceland with improved inflation performance and greater overall nominal and real stability compared to before.

Sebastian Edwards finds that monetary policy in Iceland has been run in an effective way since approximately 2012 and contributed in a significant way to the recovery of the Icelandic economy. He then addresses two new instruments of monetary policy: currency intervention and capital controls. He reviews the evidence for the efficacy of these instruments in other countries and suggests that the central bank make the policy framework clearer, possibly following the lead of the Reserve Bank of New Zealand, and that capital controls should be gradually lifted.

The quip from books on military history is that the generals plan to fight the next war as if it were going to be similar to the last war. The counterpart statement for those who develop regulatory initiatives to forestall banking crises is that they still do not understand that the cause of the debacles in the United States, Great Britain, Iceland, Ireland, and Spain in the autumn of 2008 and why Greece and Portugal had sovereign debt crises fifteen months later.