From crisis to recovery: the tools for the job

It is said that a day is a long time in politics – in financial markets, it can seem like an eternity. Certainly, the global financial system has witnessed quite a few of those days in recent months. And what started off euphemistically – and optimistically – being referred to as a “credit crunch” soon developed into a full-scale financial crisis which is now slowly spreading its tentacles into the wider, or so-called ‘real’, economy.

Although trouble had been brewing for some time, and certain economists had been warning of difficulties ahead for the last few years, the generally accepted starting point of the current woes was the US bank liquidity crisis which began in the summer of 2007 due to a large number of defaults on so-called sub-prime mortgages – a once-obscure term that has now become a household name. Pretty soon, this credit crunch in the United States was beginning to cause concern around the world.

Some large European banks were exposed to the sub-prime crisis in the United States, putting a squeeze on liquidity in Europe, too. As a number of financial institutions on both sides of the Atlantic began to falter – the first sign of trouble being the nationalisation of the Northern Rock bank in the UK in February 2008 – this led to jitters on stock markets around the world. Given how closely intertwined and integrated global financial markets have become, when America sneezed, the whole world eventually caught a cold. “The EU is an important part of the global system and so we were bound to suffer sooner or later,” explains Sean Berrigan, head of the Financial Sector Analysis Unit at DG ECFIN.

Summer of uncertainty

By the summer of 2008, things were beginning to look much more precarious. On the verge of collapse, America’s two main mortgage guarantors, the colourfully named Fannie Mae and Freddie Mac, were placed under government conservatorship in September. The following week came the spectacular and shocking bankruptcy of Lehman Brothers, one of the USA’s biggest investment banks. “Lehman Brothers completed the uncertainty because it had previously been viewed as a bank that was too big to fail,” notes Berrigan. “This really shook market confidence badly.” In the immediate aftermath, stock exchanges around the world took a battering.

By the end of September, the contagion had reached Europe, with the British mortgage lender Bradford & Bingley, the Benelux banking group Fortis, and Glitnir, Iceland’s third largest lender, the first to drift into dire straits. Again, stock markets in Europe and the United States fell dramatically, with the Dow Jones suffering its steepest drop in history on 29 September, following the rejection of a bail-out plan by the House of Representatives. Ever since, markets have been fluctuating wildly.

Rising to the extraordinary challenge

With potential meltdown looming and the United States in deadlock over how to proceed, individual Member States and the EU rapidly and decisively roused into action, setting the pace and tone for the global response, which focused on injecting capital and confidence back into the markets. “From the outset, Europe has taken decisive action to manage this crisis,” remarked Economic and Monetary Affairs Commissioner Joaquín Almunia, speaking at the 2nd Brussels International Economic Forum on 11 November 2008. “Governments, the Commission and the European Central Bank (ECB) have been working closely together to contain the turmoil, protect savings and maintain a flow for credit for businesses and households.”

The first step involved boosting the liquidity of financial markets. Ever since the sub-prime crisis broke out, the ECB had been injecting a stream of capital into the markets – including tens of billions of euros in money-market auctions – and adjusting interest rates to calm investors and optimise conditions. With several European banks teetering on the edge, efforts were stepped up.

At the end of September, several rescue plans were launched to save a number of leading financial institutions through partial nationalisation and other measures. Belgium, the Netherlands and Luxembourg saved Fortis bank with an €11.2 billion investment; Iceland nationalised Glitnir, and France, Belgium and Luxembourg pumped €9 billion into Dexia bank. In early October, the British government announced that it would make GBP25 billion (€30 billion) in preference share capital available to a number of banks and financial institutions, while the Icelandic government took control of Landsbanki.

Unprecedented coordination

Pretty soon, the word ‘billion’ was starting to lose its lustre and ‘trillion’ was entering the general lexicon at an alarming rate. But the disheartening speed of the emerging crisis was somewhat matched by the heartening level of the coordinated response to stave it off – here, the Commission, including DG ECFIN, played an important behind-the-scenes role. “The Commission has helped to monitor the situation, design responses and mediate between Member States,” notes Berrigan.

In early October, in an audacious bid to avert a possible fear-induced banking collapse through the mass migration of depositors, EU leaders agreed to guarantee deposits of up to €50 000, while several Member States went a step further, pushing the figure up to €100 000. On 2 December the ECOFIN Council decided to apply this guarantee from 1 July 2008, subject to approval by the European Parliament.

On 16 October, all 27 Member States agreed an ambitious rescue package, worth up to €1 trillion, to shore up the beleaguered banking sector. “The October agreement… was an unprecedented act of coordination, allowing us to synchronise national responses within a common European framework,” emphasised Joaquín Almunia.

Turning crisis into recovery

By the end of October, the Commission had hammered out a framework for recovery entitled ‘From financial crisis to recovery’. “The EU should build on this success [in dealing with the financial crisis so far] and decide to tackle the next stages of the crisis in a united, coordinated manner, turning these challenges into opportunities; adding selected short-term measures to the Lisbon Strategy for growth and jobs,” the Communication urged.

The proposal set out a three-pronged approach: redesigning the EU’s financial market architecture, dealing with the fall-out from the financial crisis on the real economy, and putting the EU at the forefront of the global response to the financial crisis. Regarding the financial crisis, it recommends the rapid and consistent implementation of national bank-rescue plans and decisive measures to limit the spread of the crisis between Member States. An example of this ‘containment’ policy was the €6.5 billion the EU pledged in financial assistance to troubled Hungary.

The document also calls for the restructuring of the European banking sector in order to avoid similar crises in the future. It points out that Member States, in collaboration with the Commission, need to redefine the European financial sector’s regulatory and supervisory model, particularly for the large cross-border financial institutions. Currently, oversight bodies are national and this has severe limitations when dealing with crossborder organisations.

Kick-starting a stalling economy

The woes in financial markets have gradually spread to infect the broader economy, reflected in, among other things, steeply rising financing costs and tightening lending conditions (see chart). “The financial crisis has now leaked into the real economy,” observes Sean Berrigan. DG ECFIN’s autumn economic forecast, which was released on 3 November 2008, revised earlier expectations downwards.

Source: Commission services

It projected 1.4% (1.2% for the euro area) economic growth for the EU in 2008, half what it was in 2007. This is set to drop even more sharply in 2009 to 0.2% (0.1% for the euro area), before recovering gradually to 1.1% in 2010 (0.9% for the euro area). As a result, employment is set to increase only marginally in 2009-2010, after the 6 million new jobs created in 2007-2008. Meanwhile, unemployment is expected to rise by about 1%, having reached its lowest level in a decade. “We are in danger of the weakening economic outlook feeding back into financial markets, thereby triggering a vicious cycle. The EU wants to prevent this through targeted measures,” says Berrigan.

In its framework for recovery, the Commission outlined an action plan for jump-starting the faltering EU economy. It recommended that Member States raise their investment in research, innovation and education; promote more ‘flexicurity’ (job flexibility with social security provisions) as a means of protecting people rather than specific jobs; free up businesses, especially SMEs, to build markets at home and internationally; and enhance European competitiveness by continuing to green the economy.

However, the document warned against an abandonment of budgetary constraints. “The Stability and Growth Pact provides the right policy framework, balancing short-term stabilisation needs and long-term structural reform requirements, notably supporting the adjustment process,” the Communication elaborates. “Implementation of the Pact should ensure that any deterioration of public finances is accompanied by structural reform measures adequate to the situation.”

Smart investment in the future

On 26 November 2008, the Commission fleshed out these priorities in a comprehensive €200-billion economic recovery plan which complements the financial markets. Representing 1.5% of the Union’s combined GDP, the plan will mostly be funded (€170 billion) and run at the national level, with EU coordination and supervisory support. “Exceptional times call for exceptional measures. The jobs and well-being of our citizens are at stake,” Commission President José Manuel Barroso said at the launch. Acknowledging that the coordinated fiscal expansion would likely lead some Member States to breach the 3% of GDP Maastricht deficit threshold, the Commission stressed that the Stability and Growth Pact would be applied to ensure that the correction of excessive deficits takes place in line with the recovery of the economy. As Commissioner Almunia put it at the press conference, “The Stability and Growth Pact stays. It’s certainly not put in parentheses, as I’ve read somewhere. If a deficit is above 3% we will start the excessive deficit procedure, unless it exceeds the reference value by a few decimals only, is caused by exceptional circumstances and is temporary”.

In order to ensure that Member States can customise their plans to suit their needs and learn from one another, the Commission has assembled an EU ‘toolbox’ which national governments can utilise. Tools in the box include greater support for the unemployed and the poorest households; the funding of large infrastructure projects such as energy networks and broadband internet; temporary VAT cuts across the whole economy, similar to those decided by the UK; and the reduction of taxes on labour. EU leaders approved the package at their summit in Brussels on 11 and 12 December 2008.

To have the maximum sustainable impact, the recovery plan needs not only to spark a recovery but also to help achieve the EU’s longer-term socio-economic and environmental goals – this is what the Commission’s proposal refers to as ‘smart investment’. “If Europe acts decisively to implement this recovery plan, we can get back on a path of sustainable growth and pay back short-term government borrowing,” President Barroso explained. “If we do not act now, we risk a vicious recessionary cycle of falling purchasing power and tax revenues, rising unemployment and ever wider budget deficits.”

New dawn for the global economy

Another remarkable aspect of the current crisis is the extent to which the major economies of the world, both developed and emerging, have coordinated their responses and approaches. In addition to the close transatlantic collaboration, which might be expected given the alignment of the US and EU economies, there has also been close coordination between the so-called G20, a group of the world’s top 20 economies. At its meeting in mid-November in Washington, the assembled leaders even agreed to work to resume the stalled Doha Round of world trade negotiations. The G20 is next due to assemble in London in April 2009 to review progress and further coordinate their actions.

Despite the gloom and doom that currently prevails, the turmoil can be constructively channelled to reform the global financial and trading systems so as to make them more efficient, equitable, sustainable and suitable for the times. Both Britain’s Gordon Brown and France’s Nicolas Sarkozy have called for a ‘new Bretton Woods’, evoking the need for an overhaul as radical as that undertaken following World War II.

“We must grasp this opportunity to drive forward a restructuring of global governance – including the Bretton Woods institutions – so that they reflect the geopolitical realities of the 21st century,” said Commissioner Almunia at the International Economic Forum. From the Commission’s point of view, global financial institutions – such as the International Monetary Fund (IMF), the World Bank and the Financial Stability Forum – should be made more equitable and Europe needs to consider consolidating its position within them.