AFTER THE AFTER THE SUBPRIME SUBPRIME

MORTGAGE CRISIS: MORTGAGE CRISIS: WHAT STRATEGY WHAT STRATEGY

FOR EUROPE?FOR EUROPE? Robert BOYER

PSE (Paris-Jourdan Sciences Économiques)

Babbot Room, The Octagon, Amherst College, March 26, 2008

INTRODUCTIONINTRODUCTION• Entering a new and quite uncertain Entering a new and quite uncertain

epoch:epoch:

What will be the consequences for the What will be the consequences for the US of the sub-prime mortgage crisis?US of the sub-prime mortgage crisis?

How interdependent is the world with How interdependent is the world with respect to the American economy?respect to the American economy?

Is a finance-led growth regime a Is a finance-led growth regime a fatality?fatality?

How should new regulations How should new regulations restore the structural stability of restore the structural stability of such a regime?such a regime?

Will Europe be drastically affected Will Europe be drastically affected by the sub-prime mortgage crisis?by the sub-prime mortgage crisis?

What alternative strategies for the What alternative strategies for the European Union?European Union?

• The strategy of this presentationThe strategy of this presentation

An institutional analysis of the origins of An institutional analysis of the origins of financializationfinancialization

A simple macro model of finance-led growthA simple macro model of finance-led growth

An interpretation of the origins of financial An interpretation of the origins of financial crisescrises

Diversity and legacy of European Diversity and legacy of European institutional configurations: an alternative institutional configurations: an alternative to financializationto financialization

SYNOPSIS OF SYNOPSIS OF PRESENTATIONPRESENTATION

I.I. The pressures towards a The pressures towards a finance-led regime.finance-led regime.

II.II. The homeland of The homeland of financialization is the US…but financialization is the US…but potential macro-economic potential macro-economic instability.instability.

III.III.From the Internet bubble to From the Internet bubble to the sub-prime mortgage crisis.the sub-prime mortgage crisis.

IV.IV. How Europe will be How Europe will be affected?affected?

V.V. The European Union: the The European Union: the search for alternative search for alternative models.models.

VI.VI. ConclusionsConclusions

I. THE PRESSURES I. THE PRESSURES TOWARDS A FINANCE-TOWARDS A FINANCE-

LED REGIMELED REGIMEBack to social historyBack to social historyThe 60s: a The 60s: a de facto de facto compromise compromise

between managers and wage earnersbetween managers and wage earnersConsumers

Patient financial market

Managers Permissive international regime

Wage-earners

Strong links Weak links Direction of influence

The 80s: An international The 80s: An international competition led regime weakens the competition led regime weakens the bargaining power of wage earnersbargaining power of wage earners

Consumers

Gain from trade Managers More

international competition

Discipline

Erosion of past compromise

Wage-earners

Strong links Weak links Direction of influence

The 90s: The The 90s: The ex postex post alliance of investors and managers alliance of investors and managers

Consumers

Transparency

Managers Large and powerful financial markets

Share holder value More risk Financialisation of

income and pensions Wage-earners

Strong links Weak links Direction of influence

The 2000s: The emerging tensions within the The 2000s: The emerging tensions within the finance industry and the rise of the lawyerfinance industry and the rise of the lawyer

State,

as the last resort

THE LAWYER

Institutional Investors

Managers Auditors

Rating Agencies Financial Analysts

Fund Mangers

Pension funds

Flow of information Financial flow Intermediation of conflicts and related income

Financialization is part of a long term Financialization is part of a long term structural transformation of contemporary structural transformation of contemporary capitalism, after the crisis of Fordismcapitalism, after the crisis of Fordism

International opening

Regained power of managers

Demand addressed to managers =

shareholder value

Surge of CEO compensation

Erosion of wage-earners bargaining

power

Acceptance of pension funds

Inflow on the stock market

Financial bubble

Crisis of the Fordist growth

regime

Conservative backlash

Financial deregulation

Multiple innovation in

finance

II.II.THE HOMELAND OF THE HOMELAND OF FINANCE LED GROWTH: FINANCE LED GROWTH:

THE US… THE US…

An accumulation regime at odds with An accumulation regime at odds with Fordism: the centrality of the stock Fordism: the centrality of the stock marketmarket

+ Dividends

and Pension funds

+ High stock market price

+ Easy access to

credit

+

Profit

+

Consumption Production

+

+

Employment Diffusion of

Financial norms - Careful management

of investment

+

Globalised Financial

regime

Shareholder value as a new form of competition

and governance mode

Highly reactive wage labour

nexus

The multiple channels of financializationThe multiple channels of financialization

+ Monetary policy,

Financial market stabiliser

+

Limitation of

public borrowing

-

Public

expenditure

+

Stock Market

prices

G F

Credibility of Government ac-

tions

E Tax system favour-able to the most mobile factors

+

+

+

Industrial specialisa-tions, Financial con-

centration

Raising the required rate

of return

- Productive investment

+ Profit

A

+ + -

FINANCIAL SYSTEM

Management of firms for sharehold-

ers

B Labour con-tract flexibil-

ity

+ Productive capacity

Effective de-mand

Employment, wages

- +

+

+ “Patrimonial” Eq-uity based Household

behaviour

C

Wealth effect on Sav-

ings/Consumption Allocation

+ Current con-sumption

+

+

Privatisation of elements

of social security

D Pensions via stock market

Purchase of housing and

durable goods

+

+

+

+ Secured bor-rowing

A simple A simple macroeconomic macroeconomic

modelmodel

Various Various regimesregimes

A finance-led regime is A finance-led regime is possible if: possible if:

– The financial wealth / income ratio The financial wealth / income ratio is highis high

– The investment is profit ledThe investment is profit led

This regime is structurally stable if:This regime is structurally stable if:

Wage formation is not too much Wage formation is not too much competitivecompetitiveThe rate of return required by The rate of return required by shareholders is not too highshareholders is not too high

The Central Bank has to react The Central Bank has to react quickly to financial bubblesquickly to financial bubbles

Testing the model for some OECD Testing the model for some OECD countriescountries

The US: the only finance-led The US: the only finance-led regimeregime

……..BUT A POTENTIAL ..BUT A POTENTIAL MACROECONOMIC MACROECONOMIC

INSTABILITYINSTABILITY

The development of financial market The development of financial market first extends the likelihood of a first extends the likelihood of a finance-led regime…finance-led regime…

But up to some threshold, the But up to some threshold, the economy enter into a zone of economy enter into a zone of structural instability.structural instability.

III.III. FROM THE FROM THE INTERNET BUBBLE TO INTERNET BUBBLE TO

THE SUB-PRIME THE SUB-PRIME MORTGAGE CRISIS.MORTGAGE CRISIS.

• This regime is generating This regime is generating speculative bubblesspeculative bubbles that burst out… that burst out…

• ……But are cured by an But are cured by an activeactive monetary policy… monetary policy…

• ……And the positive impact of And the positive impact of financial innovationsfinancial innovations……

• ……For instance the For instance the securitisationsecuritisation first prevents the fragility of banks first prevents the fragility of banks A strong paradox: an unstable accumulation regime rescued by the deepening of financial innovations

• ……But But private innovationsprivate innovations, such as , such as subprimesubprime loans, exploit this opportunity to shift the risk… loans, exploit this opportunity to shift the risk…

• ……The boom of this market reaches its limits, the reversal of The boom of this market reaches its limits, the reversal of confidence confidence challenges challenges macroeconomic stabilitymacroeconomic stability……

• ……And again the And again the Central BankCentral Bank is the rescuer of last resort in order to preserve the is the rescuer of last resort in order to preserve the viability of the financial viability of the financial systemsystem

Figure 1 – A typical sequencing of

financial crises

Private innovatio

n

Success /

High profit

Rapid adoption

Entry in the zone

of financial fragility

Lender as a last resort

No public intervention: collapse

of the innovation

Regulation by the

government

Viability of the regulated

innovation New

cycle

Figure 2 – A first example: energy derivatives

and the ENRON collapse

Energy derivatives

Unprecedented profit

Creative accounti

ng

Bankruptcy

New rules of accountability for CEO and CFO

Prevention from any

public control by lobbying

But not any reform of

accountability principles

A structural weakness

Potential for new crisis

Figure 3 – A second example: rise and collapse of Northern Rock

Financing by bonds of mortgage

loans

High profit / Rapid

capture of market shares

No reaction

of Financial Service Agency

More bonds issued

Banking run

Initially, Bank of England did not bail out

Worsening of the crisis

Systemic crisis

Conflict between Bank of England,

Treasury, FSA

Search for self

regulation

A failed innovation

Nationalization of

Northern Rock

Figure 4 – A third example: the sub-prime mortgage

Sub-prime mortgage

New and growing market

Absence of public regulatio

n

Securitization shift the risk

Reversal of the

housing

market

Melting down of the sub-prime

market

Limited FED

intervention

Diffusion of Non

Performing Assets (NPA)

A creepin

g banking

crisis

Searching for new

regulations

Recapitalization by

sovereign funds

Mergers among banks

Unlimited access to

liquidity from FEDA systemic

financial crisis

IV.IV.HOW EUROPE WILL HOW EUROPE WILL BE AFFECTED?BE AFFECTED?

The financial led regime is not observed in The financial led regime is not observed in EuropeEurope

COUNTRIESPARAMETERS

United States

Great Britain

Canada Japan Germany France

1.Average propensity to consume (1996)

0.95 0.926 0.956 0.869 0.884 0.908

2. Wealth in shares/ disposable income (1997) %

145 75 95 30 25 20

3. Extent of capital gains /disposable income (%)

35.5 15 11 - 7 7 5

4. Proportion of shares and bonds in households’ financial assets

28.4 52.4 n.a. 25.3 21.3 14.5

1.Monetary market rate 5.34 7.38 5.20 0.32 3.5 3.46

1.Return on bonds 6.51 5.59 7.30 1.06 3.97 4.23

1.Reference profitability 12%-16% 12%-16% 12 - 16% 5% 6% -7% 9%

Actually, in other OECD countries Actually, in other OECD countries alternative alliancesalternative alliances may exist and may exist and govern govern different different accumulation regimesaccumulation regimes

Managerial

expertise

THE

AMERICAN FIRM

Governance under

shareholder value

The firm as a bundle of

competences

THE JAPANESE

FIRM

Financial

capital Firm specific

competences

ESOP

Employee ownership/

co-management

THE GERMAN FIRM

The different channels of the The different channels of the diffusion of American financial diffusion of American financial crisiscrisis

Many European financial institutions Many European financial institutions have non performing sub-prime loans have non performing sub-prime loans or derivatives: how important are they?or derivatives: how important are they?

The impact of the American recession The impact of the American recession upon world trade…possibly upon world trade…possibly compensated by Asian dynamism.compensated by Asian dynamism.

The negative impact of the appreciation The negative impact of the appreciation of the euro upon growth and of the euro upon growth and employment in Europe.employment in Europe.

A long lasting revaluation of A long lasting revaluation of financial risk, as a source of credit financial risk, as a source of credit crunch.crunch.

The imperfection of the European The imperfection of the European policy mix (a single monetary policy policy mix (a single monetary policy but contrasted national budgetary but contrasted national budgetary policies): a clear limitation to the policies): a clear limitation to the reactivity of the EuropeanUnion.reactivity of the EuropeanUnion.

V. THE EUROPEAN UNION: V. THE EUROPEAN UNION: THE SEARCH FOR THE SEARCH FOR

ALTERNATIVE MODELSALTERNATIVE MODELS A change of epoch: from the primacy of the wage labor nexus to the

omnipresence of a financial logic

The European treaties codify this swing in the hierarchy of the economic institutions

Figure 1 – The hierarchy of the European procedures: the primacy of the monetary

regime

Any growth strategy has to take into account the shift in the conception of economic policy

Source : Freely inspired of EC/DGE "Reinforcement of mechanisms for economic policy

coordination", July 28, 1999.

A survey of alternative A survey of alternative strategiesstrategies

S1 – Promote a better policy mix in order to rejuvenate S1 – Promote a better policy mix in order to rejuvenate growthgrowth

S2 - Convert Information and Communication Technologies S2 - Convert Information and Communication Technologies (ICT) into a knowledge based economy (KBE)(ICT) into a knowledge based economy (KBE)

S3 - Gender equality and the response to ageing as sources S3 - Gender equality and the response to ageing as sources of a welfare / services driven growthof a welfare / services driven growth

S4 - S4 - A recurring temptation of some member states riding A recurring temptation of some member states riding the financial globalisation the financial globalisation

Figure 2 – First strategy: A pragmatic coordination of monetary and fiscal

policies in order to promote growth and creation of jobs.

Table 2 – Institutional conditions of this first strategy

Figure 3 – Second strategy: convert Information and Communication Technologies (ICT) into a knowledge based economy (KBE)

Table 3 – Institutional conditions of this first strategy

Figure 4 – A third strategy: gender equality and the response to ageing as sources of a

welfare / services driven growth

Figure 5 – Strategy four : Riding the financial globalisation, as a recurring temptation of

some member states

Table 2- What growth regime for the early 21st century?

CONCLUSIONCONCLUSION

C1 -C1 - The US is the first economy The US is the first economy to experience the to experience the benefits and benefits and the risksthe risks of a finance-led of a finance-led regime.regime.

C2 -C2 - The recurrence of powerful The recurrence of powerful financial innovationsfinancial innovations is at the is at the origin of most financial crises origin of most financial crises in the US, but their in the US, but their macroeconomic consequences macroeconomic consequences differ drastically.differ drastically.

C3 -C3 - The collapse of the The collapse of the sub-sub-prime prime mortgage is the last mortgage is the last one and the one and the most severemost severe since since WWII. It sheds a crude light WWII. It sheds a crude light upon the danger of a bold upon the danger of a bold financial liberalizationfinancial liberalization

C4 -C4 - This is an incentive to This is an incentive to reassess the role of reassess the role of financial financial re-regulationre-regulation, in order to try , in order to try to reduce the instability to reduce the instability potentially associated to potentially associated to intense financial innovations.intense financial innovations.

C5 –C5 – With the possible exception With the possible exception of UK, of UK, no European economyno European economy is following the American is following the American trajectory. This reduces the trajectory. This reduces the risk of an equivalent melting risk of an equivalent melting down, but down, but many channelsmany channels will will diffuse the American diffuse the American recession to the rest of the recession to the rest of the world.world.

C6 -C6 - A priori, financialization A priori, financialization may well be may well be detrimental detrimental to to most non US economies. most non US economies. Consequently they should Consequently they should resist to further financial resist to further financial liberalization.liberalization.

C7 –C7 – The mission of European The mission of European Union should be to contribute Union should be to contribute to the to the discipliningdisciplining of the of the international finance and the international finance and the promotion of promotion of welfare welfare enhancingenhancing growth strategies. growth strategies.

MANY THANKS FOR YOUR MANY THANKS FOR YOUR ATTENTIONATTENTION

Robert BOYERCNRS (PSE- Paris Jourdan Sciences Economiques),

EHESS, CEPREMAP48, Boulevard Jourdan 75014 PARIS

+ 33 (0)0 43 13 62 56

boyer@pse.ens.frSite WEB :

http://www.jourdan.ens.fr/~boyer/