Scapegoating the US lets others off too easily

Scapegoating the US lets others off too easily

Scapegoating the US lets others off too easily

Written by Simon Tilford, 02 October 2008

by Simon Tilford

Huge amounts have been said about the consequences of the credit crunch for the US and UK economies. They undoubtedly face major adjustments, and several years of very weak economic growth. There has also been trenchant criticism of spendthrift ‘Anglo-Saxons’ living beyond their means, derailing the global economy in the process. The US is a convenient scapegoat for politicians confronted with economic uncertainty, but it needs to be remembered that a number of European and East Asian economies benefited enormously from the credit boom. Indeed, it could not have happened without excess savings generated by the likes of China, Germany and Japan.

The credit booms in the US and UK, as well as in other countries such Spain and Australia, were not simply the result of poor commercial practices and policies in those countries. They were also the by-product of imbalances in the global economy. The US is regularly pilloried for running a large external (current account) deficit, for playing fast and loose with its currency, and hence for destabilising the global economy. This is misleading. The US did not cause the current problems all on its own. Those governments that believe a rising current account surplus is a symbol of national economic virility and competitiveness played a major role too. Indeed, their surpluses are the underlying cause of instability.

If some countries routinely run huge current account surpluses, others must run huge deficits. German and East Asian surpluses have to be invested somewhere and they got invested in housing and other assets in the US, UK and elsewhere. Criticism of the US Federal Reserve for pursuing an excessively weak monetary policy, and hence inflating asset prices is fine as far as it goes. But low interest rates were needed to encourage enough borrowing to soak up the excess liquidity produced by rising current accounts surpluses. Those condemning the US need to ask themselves where the global economy would have been without the demand generated by the US and other big deficit countries. China would certainly have grown much less rapidly and Germany and Japan would probably still be mired in economic stagnation.

Many in Germany, Japan and China argue that their dependence on the US is declining because the US accounts for a falling share of their respective current account surpluses. What they fail to notice is that the US has still been absorbing much of the liquidity that China, Japan and Germany have generated by running external surpluses with other economies. Furthermore, US demand has stimulated trade between other countries (for example, Chinese purchases of Japanese components or German machinery).

With credit conditions now tight and employment growth very weak, there will be a progressive narrowing of the US current account deficit (along with those of the UK, Spain etc). The governments that regularly criticise the US for the destabilising impact of its imbalances might not like the implications of this process. This unwinding poses a big problem for export-dependent economies. It exposes their domestic imbalances, which are just as much of a ‘problem’ as those of the US. An external surplus suggests that there are inadequate investment opportunities in an economy.

In a European context, it is imperative that the German government takes steps to rebalance the German economy. Domestic savings need to fall and investment needs to rise. Much is made of the competitive ‘gains’ the Germans have made in recent years and how this stands their country in good stead. Improved price competitiveness could help German firms to gain market share in the downturn, but collapsing export orders demonstrate that it will provide only so much support. Steep falls in investment in machinery and equipment and in purchases of cars in most of the country’s key export markets will hit the Germany economy hard next year.

The German finance minister, Peer Steinbruck, needs to spend more time thinking about how to address the country’s exceptionally weak domestic demand. Tax cuts would be a good first step. The German government needs to get over its obsession with fiscal probity. In the long-term, of course, fiscal discipline is a necessity, but at present it risks aggravating an already serious situation. China and Japan faces different challenges, but the underlying problem is one of excessive dependence on exports.

Unfortunately, there is little sign of any rethinking of economic strategy in these three economies. If anything, the problems experienced by the US have confirmed the belief that a competitive economy is one with a big external surplus and rising international reserves. This is bad news for everyone. Unless China, Germany and Japan make a net contribution to global demand, the world really could face a slump. Instead of gloating about the US’s comeuppance they should be considering what will drive their own and others’ economic growth.

Simon Tilford is chief economist at the Centre for European Reform.


Added on 08 Oct 2008 at 18:57 by Anonymous

Hi Simon,

Thank you for this interesting take on the situation. As a non-economist and lay person, I need help understanding something which you touched upon.

I believe you are speaking on a macroeconomic level with regard to trade and the "excess savings" of China, Japan, and Germany.

Can you tie it to a micro level--on individuals'/households' responsibility in this debacle? Various media talk about the massive savings rate of Japan, and I always thought they were referring to individuals who save by putting away yen in the bank (thereby providing banks with greater liquidity) instead of spending it on gadgets, travel, or what have you that Americans are always blamed for (and rightfully so).

Is there culpability on the part of Americans for their poor personal saving habits? If the US govt had continued with its deficits and international debt, but American citizens had saved a lot in the bank, would the picture today look much different?

In other words, does the average Joe who doesn't have a mortgage but spends more than he earns, using credit cards, etc. play a role in all of this? Or is he one of these "innocent" Americans the Congressmen have been railing on about as of late?


Financial regulation: Is the Channel narrowing?

Financial regulation: Is the Channel narrowing?

Financial regulation: Is the Channel narrowing?

Written by Philip Whyte, 27 February 2009

by Philip Whyte

On February 25th, a Commission-appointed taskforce headed by Jacques de Larosière published its much-awaited report on financial supervision in the EU. By coincidence, a parallel (but less widely reported) event took place the same day on the other side of the Channel: Lord Turner, the chairman of the UK’s Financial Services Authority (FSA), gave evidence to a parliamentary committee. What light does Lord Turner’s evidence shed on the UK’s likely reception of the Larosière report?

London’s status as a financial centre has long played an important role in Britain’s complex relationship with the EU. Although the UK has been a strong supporter of the single market, it has been suspicious of any moves that might undermine London’s position as Europe’s pre-eminent financial centre. London’s status has partly rested on the UK’s ‘light touch’ regulatory regime. And many in the UK have long worried that the survival of that regime is threatened by the encroachment of EU rules – particularly as countries such as France and Germany, which aspire to ‘repatriate’ business to Paris and Frankfurt, have never had the City of London’s best interests at heart. This explains why the City, the most cosmopolitan economic cluster anywhere in the EU, is relatively Eurosceptic. And it partly explains successive British governments’ reticence to EU integration.

However, the financial crisis is transforming some longstanding British assumptions. It is not that the crisis has reduced domestic Euro-scepticism. Domestic opposition to joining the single currency remains as strong as ever. But the crisis has called into question the merits of ‘light touch’ regulation. Popular feeling against financiers is running high. A backlash is in full swing. Bankers have fallen even lower in the public’s esteem than politicians, journalists and estate agents. Given the epic scale of the profits which have been privatised and the losses which have been socialised, the opprobrium financiers are attracting is understandable. All the main political parties are going along with the public mood. But it would be wrong to dismiss the recent furore as politicians pandering to the mob. For the change in British assumptions seems to run deeper: it is intellectual, as well as political.

Take Lord Turner’s evidence to the Treasury select committee. What did he say? In essence, he said that the era of light touch regulation was over. He promised a ‘revolution’ in financial regulation that would include tougher capital rules for banks, and capital and liquidity rules for previously large, unregulated institutions such as hedge funds. Asked about the way in which the FSA had supervised a bank which had to be bailed out in 2008 with taxpayers’ money, he said that it “was a competent execution of a philosophy of regulation that was, in retrospect, mistaken”. Lord Turner is no populist, so his testimony represents one of the strongest repudiations of the philosophy of light touch regulation to date. It would be wrong to conclude that the British have converted to the French and German view of financial markets. But the intellectual distance across the Channel has narrowed.

What of the British view on pan-European regulatory structures? The government has opposed periodic calls for the establishment of a pan-European regulator. And there is no reason to believe that the financial crisis has made it anymore keen on the idea. It will continue to oppose any blueprint that smacks of supranationalism. The question is: does the Larosière report propose institutional structures that the UK could accept? It is not yet clear. The Larosière group is not recommending that a single regulator be established. It has recognised that this would be unrealistic, given the absence of political appetite in the UK and some other member-states. So it has proposed building two separate structures: one dealing with traditional micro-prudential supervision (the oversight of individual institutions) and another with macro-prudential issues (risks to the financial system as a whole).

Micro-prudential supervision would build on existing institutional arrangements by establishing a European System of Financial Supervisors. The day-to-day supervision of institutions would be left to national regulators, and international colleges of regulators would continue to oversee cross-border banks. But there would be greater central coordination. The so-called Level 3 committees, which currently try to coordinate national regulatory approaches across the EU, would be given more powers and turned into new authorities for the banking, insurance and securities industries. Macro-prudential supervision would be carried out by a European Systemic Risk Council. This new body would be chaired by the European Central Bank (ECB), but composed of national central banks and regulators. It would collate and analyse information relating to system risk and financial stability.

Could the British government sign up to the institutional architecture proposed by the Larosière report? Although the report does not recommend the establishment of a single, pan-European regulator the British government may still find it difficult to cede new powers to EU bodies. The governing Labour Party is domestically weakened and, with only a year before the next general election, is trailing the opposition Conservative Party by a huge margin in opinion polls. The political context is important because Labour will not want to expose itself to accusations from Eurosceptic Conservatives that it has “given powers away to Brusssels”. The Channel may have narrowed, therefore. But it is far from clear that it has done so sufficiently to allow the Larosière report to be implemented. This is a shame, because there may be no other way to reconcile political constraints with the needs of the moment.

Philip Whyte is a senior research fellow at the Centre for European Reform.

The real G20 agenda

The real G20 agenda

The real G20 agenda

Written by Katinka Barysch, 13 March 2009

by Katinka Barysch

Finance ministers from the G20 countries are meeting in London this weekend to prepare for the global economic summit at the start of April. Expectations are high. But what will the summit be about? Judging by recent comments from European leaders, the agenda will include clamping down on tax havens, regulating hedge funds and cutting bankers’ bonuses. Most commentators agree that these questions are not the most pressing for restoring financial stability and economic growth. Martin Broughton, president of the UK employers’ federation CBI, rightly dismissed them as “red herring issues”.

World leaders must focus two things: how best to work together to prevent an even deeper global recession; and how to avoid future crises of such magnitude.

The first issue is as pressing as it is divisive. While the US administration is pushing for more fiscal spending, the Europeans are reluctant, and most emerging powers are keeping quiet. Many countries are loath to commit to more budget spending before they know whether and how their existing emergency packages are working. The second part of the agenda is longer term and fiendishly complicated. No-one should expect an unwieldy group of 25 or so (G20 has become a misnomer) heads of state to discuss the minutiae of capital adequacy ratios or cross-border supervision. The G20 is a process, not an event, and this summit is a political exercise, not a technical one.

What the April meeting is really about is maintaining faith in multilateral solutions at a time when the temptation for go-it-alone and beggar-thy-neighbour policies is growing. If leaning on Liechtenstein or forcing disclosure onto hedge funds helps this cause then so be it. But in terms of confidence building two issues appear paramount: the role of the International Monetary Fund and governments’ commitment to avoid protectionism.

Since September 2008, the IMF has lent over $50 billion to countries ranging from Pakistan to Ukraine. It urgently needs more cash. The US and EU governments are supporting a doubling of the Fund’s resources to $500 billion. They appear less willing, however, to redress their own over-representation in international financial institutions. This would be a precondition for emerging powers such as China to contribute significantly to an increase in IMF resources, and – perhaps more importantly – accept its legitimacy at the heart of the global financial system.

The IMF needs enhanced legitimacy to fulfil other functions that will be equally essential for future financial stability. First, the world needs better surveillance of national macro-economic and exchange rate policies to address the kind of global imbalances that have contributed to the current crisis. The IMF already has such mechanisms in place but they need to be strengthened. Second, the Fund needs to expand its new, $100 billion short-term, conditionality-light lending facility for emerging markets that are well run. It could also encourage such countries to pool their foreign exchange reserves to make them available for emergency lending.

Without easily available emergency finance, emerging markets will conclude that the best insurance against future pain is to accumulate more reserves. They will do this by keeping their currencies down and running big external surpluses. This kind of policy, as practiced by China, has already caused lots of friction. In an environment where global trade is shrinking, it would fuel a nasty protectionist backlash in the West. That is why the G20 summit needs to produce a firm commitment to increasing the IMF’s role and resources while setting in train a thorough reform of its governance structures.

There are already some signs that protectionism is rising. World Bank economists have counted 47 new trade restrictions since late 2008. More than a third have been put in place by the G20 countries that pledged to avoid such measures at their November 2008 summit. But the real risk is not a return to a 1930s-style tariff war but what Richard Baldwin and Simon Evenett (in a recent CEPR paper) call “murky protectionism”: industrial subsidies, requests that banks lend to only local companies, or the use of environmental arguments to discriminate against foreign goods and services. Examples abound, such as the ‘buy American’ provisions in the US stimulus programme or Nicolas Sarkozy’s idea that French car companies should make cars only in France. Encouragingly, in these instances international outrage ensued and the governments in question backtracked. The risks, however, remain high.

Therefore, G20 leaders need to broaden the ‘no protectionism’ pledge from last November to cover non-tariff measures. And they need to task international organisations such as the OECD and the WTO with alerting the world to national measures that could be harmful for that country’s trading partners.

Katinka Barysch is deputy director of the Centre for European Reform.


Added on 30 Mar 2009 at 16:26 by Andrew Gibbons

Maybe it's time to establish or designate an independent referee organisation to assess the economic impact (i.e. the effective rate of protection) of any new trade policy measure by any country.

Not a new idea, but a non-partisan verdict on the implications of trade measures would bring objectivity and transparency to the debate -- and act as a disincentive for covert protectionism.

Added on 13 Mar 2009 at 21:54 by Aydin Sezer

Thanks Katinka,

We should admit that developed countries apply non-tariff measures, especially by using environmental arguments to discriminate against goods from developing countries. This is not a new policy in international trade.

How to reform the European Central Bank

How to reform the European Central Bank

How to reform the European Central Bank

Written by Jean-Paul Fitoussi, Jérôme Creel, 11 October 2002

The real G20 agenda: From technics to politics

The real G20 agenda: From technics to politics

The real G20 agenda: From technics to politics

16 March 2009
From Open democracy

External Author(s)
Katinka Barysch

Le G20 a manqué une chance de réformer la finance

Le G20 a manqué une chance de réformer la finance

Le G20 a manqué une chance de réformer la finance

24 April 2010
From La Tribune

External Author(s)
Katinka Barysch

Issue 47 - 2006

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Issue 47 April/May, 2006

A new European approach to China

External author(s): Mark Leonard

How to build a better EU foreign policy

By Charles Grant. External author(s): Mark Leonard
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The Europeans at the London summit

The Europeans at the London summit

The Europeans at the London summit

Written by Katinka Barysch, 01 April 2009

by Katinka Barysch

Christine Lagarde, the French finance minister, threatens to walk out of the London G20 summit unless France gets its way on tougher financial regulation. The toppled Czech Prime Minister, Mirek Topolanek, who happens to hold the EU presidency, describes the US fiscal stimulus as “the road to hell”. Not one EU leader deems it necessary to support Gordon Brown publicly when he tries to drum up support for a more concerted international effort to revive the global economy. The Dutch and the Spaniards are turning the G20 itself into a misnomer by insisting on their own place at the table, and raising the number of the already over-represented Europeans (The fact that there will be six European governments represented, plus the Czech presidency, plus the European Commission, not counting the European heads of the World Trade Organisation and the International Monetary Fund, attracts deserved ridicule from other countries).

So is the G20 just another opportunity for the Europeans to show how weak, divided and status-conscious they are?

In fact, the Europeans have not done as badly in the run-up to the summit as some media reports (and occasional outbursts by stressed prime ministers) suggest.

EU leaders managed to thrash out a reasonably coherent position at their spring summit on 20th -21st March. The meeting’s final communiqué has a special section on the agreed line for the London summit. The words in this section are vague but represent a workable compromise which could allow the Europeans to speak with one voice at the G20.

G20 finance ministers had already reached a kind of truce on the issue of more fiscal stimuli at their meeting on March 14th. Not surprisingly, EU leaders, at their spring summit a week later, also rejected calls for an immediate increase in budgetary spending. So why some commentators are still speculating whether the G20 may come up with a new, co-ordinated package is a bit of a mystery. There needs to be a firm pledge from all G20 countries to assess critically the fiscal efforts they have made so far, and then to revisit the issue of a co-ordinated stimulus at their next summit, probably later this year.

At the March 20th–21st summit, EU leaders called only for swift implementation of those packages already announced. This, and the fact that the communiqué also calls on the EU countries to prepare for “an orderly reversal of macro-economic stimuli” and to “ensure consistency with longer term objectives such as sustainable public finances” represents a victory for Berlin and other capitals worried about inflationary pressures and the stability of the euro.

The Europeans supported global efforts to make more money available for the poorer and more vulnerable countries around the world. They started at home, by doubling the size of the EU’s own emergency fund for Central and Eastern Europe to €50 billion. The Europeans also agreed to raise an additional €75 billion as their contribution to a significant increase in the IMF’s war chest, to at least $500 billion. Since Japan had already pledged $100 billion, the onus is now on the US and China to chip in.

China, of course, will be cautious about committing money to an unreformed IMF. Here the EU’s position is lame. The communiqué only calls for a “reform of the IMF so that it reflects more adequately relative economic weights in the world economy”. The Europeans should have made it clearer that they are prepared to decrease their own voting shares and representation on the IMF’s management board. But diplomats say that the strongest opposition to thorough IMF reforms currently comes from the US – reluctant to give up its de facto ability to veto IMF decisions – rather than Europe.

On financial market regulation, the EU’s position is quite far advanced, much more so than the American one. The EU summit communiqué list all the measures that the EU wants to take – on regulating credit agencies, hedge funds, credit default swaps and so forth – and attaches deadlines to each. There has been a great deal of convergence within Europe, chiefly between Germany, France and others that want to see tighter rules and supervision of financial markets, and the UK, which has abandoned its belief in ‘light touch’ regulation. There are a lot of similarities between the recommendations of the recent reports from Jacques de Larosiere, which the EU wants to use as a basis for its legislative programme, and Adair Turner, head of the UK’s Financial Services Authority. Both, for example, call for more co-ordination between the supervision of individual banks and the monitoring of the stability of the financial system as a whole. The emerging US position as presented by US Treasury Secretary Timothy Geithner on March 26th also calls for more centralised supervision of US financial services, as well as a reform of capital adequacy and accountancy rules (in line with EU demands). Geithner for the first time acknowledged that hedge funds and other hitherto lightly regulated but systemically important finance vehicles need at least some supervision.

Of course the devil is in the detail and the London summit cannot and will not agree on more than the broad principles of further regulation and supervision. The debate about a new supervisory system in the US is only just beginning. It will be long and politicised. The EU’s deadlines for new legislation run from May until the end of 2009. Since the European Parliament will be re-elected in June and the European Commission will step down in October (although it could be extended to the end of the year), comprehensive new rules are unlikely before 2010.

The EU has looked weak and divided in the run-up to the G20 summit. Its reluctance to make more commitments to increase fiscal stimuli is rightly open to criticism. But the Europeans have actually managed to agree a reasonably coherent position and in many respects, their positions are as, or more, polished than the US ones.

Katinka Barysch is deputy director of the Centre for European Reform.

The G20 summit – a distraction?

The G20 summit – a distraction?

Written by Simon Tilford, 03 April 2009

By Simon Tilford

The good news first. The summit delivered more than expected. The trebling of the funds available to the IMF goes well beyond anything expected and is very welcome. From a European perspective it increases the likelihood of further crises in central and Eastern Europe being handled through the IMF, rather than the EU having to get involved in the politically fraught business of setting conditionality. A renewed commitment to resist protectionism, together with an additional $250 billion for trade finance and $250 billion in special drawing rights are positive moves, as is the agreement to use the proceeds from IMF gold sales to help the poorest countries.

The agreements to extend financial regulation to all systemically important financial institutions and to establish a Financial Stability Board (FSB) to replace the existing Financial Stability Forum (FSF) also represent progress. The FSB will include FSF members along with G20 countries that are not FSF members, Spain and the European Commission. It will be in charge of identifying systemic risks and will collaborate with the IMF to provide an early warning system for future crises. The FSB will also implement FSF principles on bankers' pay and insure appropriate capital adequacy ratios. The deal represents a necessary democratisation of the international financial system.

Now the bad news. The agreement does little to address the immediate challenges facing the global economy – dealing with toxic debt and the contraction of aggregate demand. In this respect, the summit and the grandiose statements accompanying it were probably a distraction. There is little in the agreement that will help "restore confidence, growth and jobs" or "repair the financial system and restore lending", as claimed by the summit communiqué. Over time, the agreement might help to “strengthen financial regulation and rebuild trust” and could help to ‘prevent future crises’. But it is unlikely to help "overcome this crisis."

The absence of additional national measures to stimulate demand comes as no surprise, but it is no less disappointing. Perhaps the most important moment at the summit was when President Obama reminded the world that it can no longer expect the US to provide a disproportionate share of the growth in global demand. While condemning the US for its profligacy and talking about the advent of a fairer, more multilateral world, many countries seem to be relying on the US continuing to perform the role of 'consumer of last report'. This is either hypocritical or parochial or both.

Across much of Europe, the summit agreement is being portrayed as victory over the 'Anglo-Saxons'. This is rather puzzling. The agreement will not lessen the economic crisis facing Europe. Listening to French and German criticism of US proposals for a co-ordinated stimulus, anyone would be forgiven for thinking that the US would have had most to gain from such a package. In fact, the countries that stand to lose most from the collapse in global trade and the prospect of several years of exceptionally weak growth in global demand are the countries running big trade surpluses. The Japanese understand this and the need for stimulus; the German government does not. Europe as a whole will pay the price.

Similarly, the G20 agreement will do very little to address the problem of frozen credit markets. The Europeans are right to stress that strengthened regulatory oversight will be needed in order to put the financial sector on a more stable long-term footing. Indeed, everyone recognises this. But the more immediate problem is dealing with toxic debt. Agreeing to tighten regulation once the recession is over will not persuade financial institutions to lend now. The agreement to "provide significant and comprehensive support to our banking systems to provide liquidity, recapitalise financial institutions, and access address decisively the problem of impaired assets" means little. Too many European governments remain in denial over the extent of the problem, and will not take the necessary action to remove toxic debt from their banking systems.

The deal will not prevent the economic slump in Europe from deepening. This will lead to the further weakening of public finances that many European governments are anxious to prevent. Moreover, even the strengthening of multilateral control over the global financial system might have unintended consequences for some European countries. One systemic risk the FSB is almost certain to flag up is the persistence of huge, structural current account deficits, and the destabilising impact these have on the global financial system. A more regulated global financial system will involve more obligations for the big surplus countries, such as Germany.

Simon Tilford is chief economist at the Centre for European Reform


Added on 03 Apr 2009 at 18:35 by french derek

Simon, You are being too ungrateful. This is probably the first ever time that so many countries, from such diverse economic backgrounds, have reached such momentous agreements in so short a time. And you complain about what they didn't include.

Germany/France were right to stand up for their united view, that capitalism has a European face. More than that, "Europe" is not a country, nor the EU a nation state. Each European country's problems are different and each has already taken measures of redress. It's too early to say whether they will work or not. Simply throwing more money around now is not the answer.

As you say, the fact that the IMF, rather than the EU is given the rescue task is more important than who funds that (conditions included). The key, common decisions have been taken (different from the 1930's). Time now for each country to see how things progress - then call upon the iMF if needed. To me, that represents a "common" approach.

Anglo-Saxons and hedge funds: Culprits or scapegoats?

Anglo-Saxons and hedge funds: Culprits or scapegoats?

Written by Philip Whyte, 07 August 2009

by Philip Whyte

Disasters often provoke unseemly bouts of finger-pointing. This has certainly been true of the global financial crisis. In the Anglo-Saxon world, libertarians have blamed it on governments, and governments on ‘bankers’. But in continental Europe, many blame Anglo-Saxons for their supposed reluctance to regulate financial markets. The crisis, they believe, would never have happened if the British and the Americans had regulated and supervised their financial sectors like the French and the Germans. On this view, the UK needs to change, notably by clamping down on hedge funds. Does this narrative stack up? Or have some Europeans just turned Anglo-Saxons and hedge funds into their scapegoats of choice?

Tirades against Anglo-Saxons long predated the crisis, but they have gathered in intensity since it began. In the run-up to the G20 summit in April, Luxembourg’s prime minister, Jean-Claude Juncker, stated that this crisis “started in the US. The Anglo-Saxon world has always refused to add the dose of regulation which financial markets needed.” At the end of the same summit, the French President, Nicolas Sarkozy, announced the death of “unregulated Anglo-Saxon finance”. And in July, Germany’s chancellor, Angela Merkel, told a political meeting in Nuremberg that “with us, dear friends, Wall Street or the City of London won’t dictate again how money should be made, only to let others pick up the bill.”

In any analysis of the causes of the crisis, the UK and the US clearly deserve a share of the blame. They tolerated unsustainable domestic credit booms which wreaked havoc on themselves and the rest of the world. But they were hardly the only countries to experience credit-fuelled housing booms. Denmark, France, Ireland and Spain did too. Nor were they the only countries which allowed ‘shadow banking’ entities to proliferate and banks’ exposures to complex financial instruments to grow. It was a funding crisis at two ‘special investment vehicles’ (SIVs) that brought the regulated German bank, IKB, to its knees. And German banks built massive exposures to collateralised debt obligations (CDOs).

What of hedge funds? Listen to French and German leaders, and you would think that hedge funds were central to the financial crisis. France and Germany have leaned on the European Commission to propose a directive that would regulate hedge funds; they have criticised the Commission’s resulting legislative proposal as too weak; and they have accused the British of dragging their heels. France and Germany are not entirely wrong: the example of Long Term Capital Management in 1998 shows that some hedge funds can pose a threat to financial stability. Even so, it is hard to avoid the conclusion that France and Germany have used the crisis as an opportunity to advance one of their hobby horses.

Both the EU’s de Larosière report and the UK’s Turner review agree that hedge funds did not cause the global financial crisis. They did not drive the growth in sub-prime lending. They did not cause house prices to fall. And they did not force regulated banks (such as Germany’s Hypo Real Estate) to hold CDOs on their balance sheets. So it is quite wrong to imply, as some French and German politicians do, that the crisis would not have occurred if hedge funds had been more tightly regulated. It is also wrong to suggest that the British are reluctant to regulate hedge funds. The British government has accepted the Turner review’s recommendation that “regulation should focus on economic substance, not legal form”.

The Turner and de Larosière reports point to a broad, technocratic cross-Channel consensus on the causes of the financial crisis and the lessons to be learned. Does it matter if this is not reflected in political rhetoric? Yes, for two reasons. First, political obsessions can often drag policy in undesirable directions. (Remember that when Germany chaired the G7 in the months leading up to the crisis in 2007, it was so fixated with regulating hedge funds that it was blind to what turned out to be the central problem: the excessive leverage and effective under-capitalisation of the regulated banking sector). Second, rhetoric can poison negotiations unnecessarily, making agreement more difficult to reach.

Populist broadsides against Anglo-Saxons and hedge funds are unlikely to help the prospect of pan-European regulatory reform. If French and German politicians are not careful, the scenario which they paint of a recalcitrant Britain at odds with the rest of Europe could become a self-fulfilling prophesy. It is no secret that sections of Britain’s media and political class are primed to detect sinister motives in anything emanating from Europe. More often than not, such fears are just paranoid fantasy. But for once, the British may be forgiven if they conclude that France and Germany are exploiting the crisis to promote some of their longstanding objectives and to weaken London’s position as a financial centre.

Philip Whyte is a senior research fellow at the Centre for European Reform.


Added on 20 Aug 2009 at 11:47 by Vincent

I have much sympathy with the idea of light regulation and in particular for hedge funds. However, when Christophe Miller's writes that the FSA already monitors big hedge funds, does that mean that the main critic of the proposed EU regulation is that it covers also small hedge funds? In that case, are we sure that the collective collapse of several "small" hedge funds having followed a similar risky strategy would not trigger the kind of panic the collapse of LTCM did generate 11 years ago?
Given the current economic disaster can we blame those who try not to fight only the last war but also to anticipate the possible next failure of the financial system?

Added on 07 Aug 2009 at 12:41 by Christopher Miller

Good article. But what the French, Germans and PES conveniently fail to see is that the UK's regulation on hedge funds is already excellent, with all managers registered, and systemically important managers have a dedicated team overseeing them.

We have long known that hedge funds can but don't usually pose a systemic risk, which is why the FSA monitors the big ones.

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