Lessons to learn from the Financial Crisis (Eastern European edition)

Happy New Year! We should congratulate ourselves for surviving the first recession and financial crisis in the history of capitalist Romania. Barely and shaken up, but we’re here, now. In the sumptuous halls of the National Bank of Romania (NBR) building, Oxygen Events recently organized a debate on the topic “What we learned after 5 years of Financial Crisis”. What are the lessons the Financial Crisis(*) taught us and what could have been prevented or avoided based on the experience gained from previous recessions?

During the 2007-2009 Financial Crisis, the U.S. benefited from the experience gained in the Great Depression of 1929-1930. Historically speaking, the monetary policy applied by the U.S. Central Bank (U.S. Federal Reserve or “Fed”) during the Great Depression was not an appropriate one. At the time, the Fed reduced the lending and money supply precisely when they were most needed. The Americans learned a lot from that experience and this was evident in the recent Financial Crisis when monetary policy favored liquidity couples with reduced interest rates. In academic terms this liquidity infusion is called “quantitative easing” but in layman terms you can think of it as “loads of new money at the disposal of those who could use it for economic activities and to create jobs”.

Unlike the U.S. during the Great Economic Depression of 1929-30, Europe was not confronted with such a dramatic situation and did not learn that fiscal austerity measures would not help it overcome the recession “unruffled”. What Europe remembers from that period is the hyperinflation in Germany that contributed to the installation of fascism, which perhaps explains why the IMF recommended massive decrease of public expenditure and the reduction of budget deficits. Moreover, the situation of several more affected Euro countries – Greece, Ireland, Italy, Spain, where budget deficit reduction policies were legitimately required, put additional pressure on the European fiscal and monetary authorities and delayed political decisions. It was only towards the end of the Financial Crisis that the European Central Bank applied incentive monetary policies at the level of the Euro Zone by significantly decreasing the refinancing interest rate and by injecting additional liquidity on the monetary market.

Romania, being faced for the first time with a financial crisis in an open economy, adopted a combination of austerity fiscal policies (drastic reduction of public expenditure and increase of taxes – VAT from 19% to 24%) coupled with restrictive monetary policies (a liquidity deficit on the interbank market of over 10% in 2008-09 and an increase of interest rates). Unfortunately, these measures are the least fortunate options from the possible ones applied across the U.S. and the Euro Zone. As a result, the exchange rate was maintained for a relatively short period of time, followed by an inevitable depreciation, the GDP decreased by almost 10% and we lost one million jobs. The austerity measures have indeed met their purpose, but with such a high price. The budget deficit was substantially reduced from 9% to a current 2-3%, as well as the current account deficit, from almost 14% to less than 2%, at present. At the same time, however, lending in the economy was reduced and consumption dropped.

From the NBR conference I identified 5 lessons that our successors can (and hopefully will) learn:

(1) The economic theory, as taught in school, fails to prevent crises. Macroeconomics, as a discipline, was introduced after the 1929-30 Depression in order to explain and prevent recessions. In time, a number of financial models were developed, laying the foundations of economic research which post-Financial Crisis are being questioned. Economy is a complex adaptive system, in which the network structures involving individuals play a significant role. Silviu Cerna in his paper “The Financial Crisis and Economic Theory” (Academica Journal, July-Aug 2013) proposes that it’s unrealistic to model macroeconomic phenomena strictly based on individuals’ behavior such that the entire economy behaves “rationally” or “irrationally” as if it were a single individual. Philippe Herlin, in his paper “Repenser l’ economie” questions even the premises and analysis instruments of the financial models.

(2) The monetary policy of the World’s Central Banks is converging. In general, the aim of all Central Banks is price stability (inflation control) and financial stability (of the banking system). Unlike Europe, the U.S. also considers employment as an objective. In the recent crisis years we notice that, despite the austerity measures adopted in the Euro countries, the European Central Bank lined up its approach to the recession with that of the Fed, by adopting similar monetary policies, namely decreasing the interest rates and increasing market liquidity. Even the Central Banks in the non-Euro zone adopted lately the same objectives, as did the NBR but only in the past year. Also, financial stability is almost impossible to attain in absence of cooperation between the central banks of various European countries. In order to consolidate and centralize the supervisory measures, the European Union established the Banking Union for the Euro countries and for some non-Euro countries. Romania opted for the Union;

(3) It was proved once more that we need distinctly anti-cyclical monetary and fiscal policies. The impressive growth experienced by Romania in 2004-2008 was supported by public and private consumption, in the context of the possibility to adhere to the European Union and the liberalization of the current account of the balance of external payments. The growth was also stimulated by the flexible fiscal and monetary policies, such as the significant reduction of taxes, the appreciation of the national currency which led to the stimulation of the consumption goods import. Unlimited access to foreign currency loans and financing of real estate projects with extremely flexible lending regulations, led to the unsustainable increase of lending and in the 2004-2008 period no mitigation measures were taken.

Moreover, in the context of a politically-favorable period, income tax was reduced to the global rate of 16%.  Taxes should not be reduced in boom periods! It is a pro-cyclical measure, not an anti-cyclical one! As the Financial Crisis onset, the NBR introduced restrictions to foreign currency loans. The effects of this measure on Romania were the massive capital outflow and the limitation of external financing, corroborated with lower capital inflow (in the form of foreign direct investments and money sent in from abroad by Romanian workers). The Romanian authorities changed the flexible monetary and fiscal policies active during the boom years, to more restrictive ones during the recession period, again, pro-cyclical! During the Financial Crisis NBR adopted the same measures with which the U.S. Fed failed in the 1930s Great Depression.   The lesson is that policies must be anti-cyclical, therefore restrictive during the period of unsustainable growth, and flexible, incentive-oriented, in a recession period. So, all together now: “we increase interest rates during a boom, we decrease interest rates during a recession”.

(4) Economic growth and development policies through private external savings don’t work in Romania (yet?). This refers to how I and many others bought homes using a mortgage loan from a bank, a loan made with money from the savings of the farmers in Denmark, Norway, etc. The access to such foreign currency loans led to an excessive increase of consumption and value of real estate properties. It’s one thing when the value of my apartment increases from EUR 100,000 to EUR 200,000 because Romania has become a strong technology and manufacturing center and attracts capital and know-how that increase income, competition and prices. And it’s a completely different matter when the value increases only because we can all borrow money easily and we can pay more for an apartment. I’m not saying that Romania has not grown at all in terms of added value in the economy, but a significant part of consumption was on credit. The authorities have lost sight of the internal factors that support a sustainable growth: continuing the reforms and structural adjustment, increasing productivity, stimulating internal savings and investments, the development of small and medium-sized enterprises. A detailed report of the World Bank (A Country Economic Memorandum, May 28, 2013, Report No. 74635-RO) shows how the financial crisis in 2008 “revealed fundamental weaknesses in the Romanian economy and policies” and makes several recommendations to make the most of our country’s competitive advantages, particularly in key sectors such as energy, infrastructure and agriculture.

(5) The role of commercial banks and lending policies have barely changed. A few commercial or investment banks made restructurings, on account of being too big, too complex and too volatile and endangering financial stability (too big to fail). In the U.S. the solution was the merger or absorption of investment banks by commercial banks (see Merrill Lynch taken over by Bank of America) thus the big ones became even bigger! The pre-crisis legislation regarding the separation of the investment banks from the commercial ones (Glass Steagall Act) was not reinstated, and the practice and the attitude of the banks towards their customers t seem to have changed much. In Europe, a few states (U.K., Netherlands) proceeded to the restructuring or takeover of several commercial banks, but other than that, almost nothing has happened even in the countries that were most severely affected by the recession! The changes in the field of banking – are rather pro-cyclical, introducing additional restrictions and limitations in a market where bank assets are naturally diminishing. In Romania, where some banks have been affected by the contagion (particularly from parent banks) but also by the high proportion of non-performing loans (20%), they reduced their portfolios and became more prudent, but they are in good condition in terms of capital and solvency. Except for a few small greedy banks, the banking system is sound and continues to grant loans at a much slower pace. Additional supervisory measures discourage foreign currency lending and have tightened the general lending conditions.

Plus ça change, plus c’est la même chose!

(*) In Romania, the most spectacular economic downfall was in 2009 (-6.6%) and 2010 (-1.1%), then we had a slight increase in the following years, culminating with the best year, 2013 (3.5%). It seems we are not completely beyond the recession if we listen to the entrepreneurs (it’s like it never ends!), although the politicians declare loud and clear that “in Europe the crisis is over” (F. Holland). In an outburst of optimism, we have growth forecasts of over 3% in 2014-2015 worldwide, as well as in Europe. In what concerns us, Romania might achieve growth rates as high as 3.5-4.5% in the following years.