Updated: Mar 7, 2019
The EU should engage in meaningful financial regulation, including a tax on financial transactions and measures to deleverage the banking system and to separate speculative investment from retail banking activities.
Clément Fontan and Joakim Sandberg argue that as a reaction to the financial crisis in the years 2007 to 2009, EU authorities created billions of euros “out of thin air” to recapitalise the large banks that were on the verge of collapse due to very risky financial behaviour. This led to increased levels of public debt and, in turn, to reduced public spending on welfare, health care, and public security. Despite this experience, regulators so far have failed to implement the measures necessary to prevent another financial crisis in the future.
It is often said that “money rules the world”. The proverbial wisdom usually refers to the power money holds over individuals, providing both incentives and restrictions that determine our choices. The saying, however, is also an accurate description of the power money holds over society at large. Contemporary economies and societies are dependent on a well-functioning financial system, including the operations of banks and stock markets. Without it, the flow of vital goods and services would simply stop. This dependency gives ample power to the institutions that control the flow of money, which is why the saying can also be read as a warning about possible abuse of power. In the following, we argue that European leaders should heed this warning and change course. The European Union has gone too far in supporting its powerful financial system to the detriment of the ordinary citizen’s interest in a stable and just economy. More precisely, European policymakers must learn the lessons from the recent global financial crisis and European debt crisis. Both call for stricter regulations of the banking and financial system. The upcoming parliamentary election is an opportunity for citizens to demand that the EU ought to protect its people before its banks.
Financial deregulation and its effects
There has been a global trend since at least the late 1970s, among policymakers primarily in the US and the UK, towards “liberating” and deregulating the banking and financial system. This has involved a softer stance on, for example, the separation of speculative investment from retail banking activities, the level of debt that banks can take on, and the possibility to invest in very risky assets, such as junk bonds and leveraged financial derivatives. The European Union has not been immune to this zeitgeist. In pursuit of its project of “ever closer union”, the EU has put much emphasis on harmonising European capital markets – and, crucially, not in the direction of harmonising strong regulation, but rather through liberalisation and deregulation.
The declared aim of the Economic and Monetary Union (EMU) and, subsequently, the adoption of the euro as a single currency was to liberalise capital movements in order to promote economic growth. Since the early 2000s, a primary goal of the European Central Bank (ECB) has also been to encourage “financial integration”, which means that large European banks should spread their investments in stocks and bonds more broadly across the EU. The idea underlying the promotion of financial integration was that the increased capital flows from “core” eurozone banks to “peripheral” countries would foster the convergence of European economies. However, as we know, EMU financial integration did not lead to economic convergence. Rather, uncontrolled capital flows from the core to the periphery led to an excessive expansion of the banking sector in core eurozone countries as well as growing public and private debt, inflationary pressures and, ultimately, loss of competitiveness in the peripheral countries.
The 2008 global financial crisis and the subsequent so-called European debt crisis from 2010 onwards should have been a wake-up call for policymakers pursuing the economic policy agenda outlined above. First, the financial crisis demonstrated with great clarity how an underregulated financial system in which banks have little incentive to care about the societal effects of their activities can wreak havoc on national economies and societies. When the extremely risky loans and investments of several banks started to fail, the whole European banking system was brought to a halt. The flow of money between the over-connected banks virtually froze. The resulting “credit crunch” for the real economy brought it, too, to the verge of collapse. The underlying reason was the extreme levels of leverage: Banks had much too little capital underlying bloated balance sheets full of extremely risky “toxic” positions. In this situation, voices were raised for letting the banks – including their owners and managers – go under as a punishment for their recklessness. However, this was not an option for European policymakers since it would have caused tens of millions of citizens to lose their life savings, plus tens of millions to lose their jobs. The whole system of payments, managed by private banks, could have stopped to function. The ordinary flow of goods and services in the economy would have come to a virtual standstill.
Second, while the recapitalisation of banks prevented a global financial meltdown, the fall of market prices still triggered a severe economic downturn and a sharp rise in unemployment. This, in turn, together with the costs of recapitalisation, greatly increased government debt. When peripheral countries, such as Greece, Ireland, and Portugal, thus saw their public deficits explode and could no longer make payments on the loans they had taken from banks in core eurozone countries, such as Germany and France, the banking crisis morphed into a sovereign debt crisis. This latter problem was exacerbated by the ECB’s politics of financial integration and “tough conditionality”, even as European leaders had not been able to agree on some mechanism to funnel stabilising funds from wealthier member states to member states in need.
Lamentably, the apparent failure of underregulated markets to remain stable and allocate resources in any politically desirable way did not sway EU policymakers to change the economic paradigm of liberalisation underlying European integration. Quite to the contrary, the EU’s response to the crisis came to focus on protecting the banks and their shareholders, once again, rather than the population at large. From 2010 onwards, the ECB has created hundreds of billions of euros out of thin air in their program of “quantitative easing”, which basically means direct purchases of financial assets in order to boost prices and stabilise the financial system. The idea behind the program was to buy financial regulators time to reform the banks’ business models and prescribe higher capital buffers. However, the emergency measures came without conditions for the banks, and it is clear that they did not amount to the required real policy change.
Furthermore, the EU opposed a restructuring of Greece’s debt in 2010 against the advice of the International Monetary Fund (IMF). The main reason seems to have been to protect the mostly French and German banks that had recklessly lent Greece more money than it could be expected to repay. Greece was ultimately forced to implement harsh austerity measures – that is, to reduce public spending on welfare, healthcare, and public security – to balance its budget and regain the trust of creditors. Since these measures came into effect, the suicide rate in Greece has doubled. Following cuts in health spending, the number of hospitals in the country has been halved and new cases of HIV infections rose by 40 percent between January and June 2011. Data like this sheds light on what the abstract economic consequences of austerity measures really mean: For the weakest citizens, they mean increased suffering and premature death.
An adequate policy response One could argue – as EU leaders do – that the cost of letting big banks fail would have been so high that bailouts and spending cuts are a necessary price to pay. There is some merit to this argument since smooth financial flows are vitally important to any modern society. However, there is a “moral hazard” problem inherent in saving failing banks from the consequences of their reckless practices. As long as banks are deemed “too big to fail”, what is to stop them from going back to extreme risk-taking and thereby causing yet another financial crisis? Any rescue measures for failing banks must therefore be conditional on imposing regulation to actually change their business model towards less risky operations. The financial crisis was the moment to do just that. Regrettably, European leaders seem to have missed it.
It is also important to see how the benefits and burdens of the chosen policy measures have been distributed unequally in society. Both the bailouts themselves and the subsequent austerity measures only exacerbated the dire situation for many ordinary EU citizens. Not only did they lose their jobs due to the crisis, but they also lost their unemployment benefits due to the spending cuts. At the same time, the bailouts protected the wealth of the much smaller class of individuals who own significant portfolios of stocks and bonds. What is more, the ECB’s programme of “quantitative easing” only bloated the prices of those assets and made the rich even richer.
Our argument here is that EU leaders must shift focus and protect the majority rather than the banks and the financial elite. In practice, this requires first and foremost a re-regulation of the banking and financial system. One important suggestion is to separate speculative investment banking from less risky retail banking, licensing banks to do either the one or the other. This would lead smaller investment banks to no longer be regarded as “too big to fail”. Another suggestion is to deleverage the banking system, that is, to limit the sum of loans that banks can grant relative to their reserves. A third suggestion is to tax every financial transaction, including trades in so called derivatives (i.e. complex bets on the performance of currencies, stocks, or bonds). Such speculative bets, with little or no connection to any financing needs of the real economy, make up the vast majority of all financial transactions and greatly increase the risk of speculative bubbles.
The EU also needs much deeper integration in terms of social policy to balance the adverse effects of financial integration on the poorer member states described above. In particular, there needs to be a standing mechanism to funnel stabilising funds from wealthier countries to peripheral nations in order to ensure a minimal level of social welfare within the EU (compare the proposal of Philippe Van Parijs in this volume).
Some of these measures were, in fact, on the agenda of EU leaders just after the global financial crisis. For example, there was much talk about implementing a financial transaction tax, which many hailed as a landmark step forward in terms of curbing dangerous speculative activities (compare the proposal of Gabriel Wollner in this volume). All such initiatives, however, were eventually stopped or shelved at various points in the political process.
Looking towards the future Ten years after the global financial crisis of 2008, the European economy has bounced back from the recession – even though some countries, most notably Greece and Italy, are still plagued by the inadequate answers given to their economic problems. The lessons of the crisis therefore tend to be ignored, and policymakers fall back on the flawed thinking of the past. The EU’s current plan to increase growth through building a so-called capital market union, for example, is in fact yet another round of liberalisation and deregulation of the European financial system. We view this project as extremely problematic since it amounts to once again encouraging the very risky financial speculation that led to the previous financial crisis.
EU policymakers should, quite to the contrary, prioritise the ordinary citizen’s interest in a stable and just economy. The EU, therefore, should protect its people before its banks. This requires at least two things: restrictive financial regulation and deeper social policy integration. There are ample political forces within the EU that understand the great dangers inherent in a runaway financial system. Thus, our plea is that EU citizens support such political forces that favour tighter regulation for the financial industry and pan-European fiscal solidarity in the upcoming parliamentary election.
Clément Fontan, born in Strasbourg, France. Professor in the Faculty of Economic, Social and Political Sciences and Communication at the UC Louvain, Belgium.
Joakim Sandberg, born in West Sweden. Senior Lecturer at the University of Gothenburg.
Further reading Fontan, Clément, François Claveau and Peter Dietsch. Do Central Banks Serve the People? Cambridge (UK): Polity Press, 2018.
Streeck, Wolfgang, and Armin Schäfer. Politics in the Age of Austerity. Cambridge (UK): Polity Press, 2013.
Stuckler, David, and Sanjay Basu. The Body Economic: Why Austerity Kills. New York: Basic Books, 2013.