Fiscal Policy in Financialized Times:
Investor Loyalty, Financialization and the Varieties of Capitalism
Daniela Gabor (Bristol Business School) and Cornel Ban (Boston University)
10742 words
Abstract: This paper argues that scholarship on the varieties of capitalism could provide
a more complete understanding of fiscal policy convergence in the Eurozone after 2010 if
it better examined the interdependencies between banks and sovereigns. According to
recent research, the interaction between coordinated and liberal capitalisms, and their
distinctive macroeconomic policy preferences, generates global imbalances and
instability. Rebalancing can only occur if the incentives governing national polities
change dramatically. In Europe’s case, sudden stops in capital inflows from coordinated
capitalisms triggered an asymmetric response, forcing deficit (liberal and mixed)
economies to address such imbalances. As wage-setting institutions could not restore real
exchange rate competitiveness a la Germany, governments were compelled to adopt the
conservative macroeconomics of the coordinated economies in an institutional setting ill
adapted to such policies. In contrast, our account highlights the constraints that financial
actors in sovereign bond markets place on the conduct of fiscal policy. Drawing on recent
contributions in the literature on financialization, we introduce the concept of the
‘collateral motive’ – investors’ demand for government bonds to meet their funding
needs – and show how this becomes a pivotal mechanism for fiscal consolidation as the
singular response to the ongoing Eurozone crisis. Without analyzing the process through
which the collateral motive ignited a run on peripheral sovereign bond markets, which in
turn and compelled states to stabilize these markets through austerity, a complete
account of the ongoing Eurozone crisis cannot be provided.
Introduction
Since the collapse of the Lehman Brothers, an unusual degree of policy convergence has
prevailed in the European Union. The widespread adoption of expansionary
macroeconomic regimes was swiftly followed by a swing into fiscal austerity after May
2010. Whereas austerity can be interpreted as a natural phasing out of exceptional crisis
measures aptly dubbed by Pontusson and Raess (2012) as “liberal Keynesianism,” it is
remarkable that countries embraced fiscal conservatism before their economies returned
to the growth potential (IMF, 2011) and despite their initial commitment to ‘timely,
temporary and targeted’ fiscal activism (European Commission, 2009; see also IMF
2009).1 Can this convergence be attributed simply to the imperative of reassuring (bond)
markets through austerity at a time when the European sovereign debt crisis was picking
up speed? And how can one reconcile this outcome with the scholarship on varieties of
capitalism (VoC), that suggests distinctive institutional complementarities lead to
different macroeconomic policy responses to economic shocks (Hall and Soskice 2001;
Hall and Gingerich 2009; Hancke et al 2009; Thelen 2009; 2012; Martin and Swank
2012)2?
To address these questions we first explore how recent VoC research can explain
convergence on fiscal austerity. We then offer a complimentary framework that
disaggregates the incentives facing financial actors in sovereign bond markets. In doing
so we highlight distinct financial mechanisms for convergence in macroeconomic
trajectories. Specifically, we examine the recent varieties literature that asks what
happens when the two types of capitalism, and the macroeconomic regimes they support,
interact in a world of free capital flows (Carlin 2012; Iversen and Soskice 2012; Soskice
and Iversen 2010). This new Varieties literature argues that institutional
complementarities in coordinated economies support an export-led growth model that
discourages risky financial practices and a consumption-led, credit-financed growth
model based on high-risk finance in liberal economies. Coordinated economies export
their surplus savings to liberal economies, feeding growing imbalances that national
polities cannot curtail. Rebalancing can only occur when sudden stops in capital inflows
force governments to puncture these institutional equilibriums. This asymmetric
rebalancing revolves around wage restraint and conservative macroeconomic policies. If
wage-setting institutions cannot generate policies to restore real exchange rate
competitiveness as large wage-setters in Germany successfully did after reunification
(Carlin, 2012), and with constraints on autonomous monetary or exchange rate policies,
fiscal policy shifts to a conservative stance3.
1
Exceptions from the rule is Estonia’s self-imposed austerity in 2009. The other East European member
states adopted austerity as part of IMF assistance (Latvia, Hungary, Romania) and those that did not fall
under IMF policy jurisdiction (the Czech Republic, Poland, Slovakia and Slovenia) undertook
expansionary policies in 2009.
2
Schneider and Paunescu (2012) provided an empirical test of the stability of the models of capitalism
posited by this literature and found that comparative advantages develop as predicted in the VoC approach,
but the types of capitalism in question are more diverse and dynamic than the VoC approach suggests.
3
We do not aim to explain the distinctive preferences for fiscal consolidation in Berlin Consensus style
(expenditure cuts and increases in VAT) as opposed to fiscal consolidation along more redistributive lines,
via tax hikes at the top (Bach and Wagner 2012) or fiscal repression (Reinhart and Li 2012). Future
research will clarify why this alternative consolidation path was not pursued.
This is a compelling account of the mechanisms that generate instability within
advanced capitalist economies and of today’s policy responses. Yet it similarly resists a
systematic re-examination of internationalized finance beyond the attention paid to how
distinctive coordination mechanisms allow risky financial technologies. Instead we show
that the shift to market-based finance and the resulting interdependencies between banks
and sovereigns left the bond markets of European sovereigns increasingly vulnerable to
sudden stops in the capital flows that deficit countries depended upon. Without explicit
central bank support, sudden stops pressure governments to adopt fiscal consolidations.
We develop this argument by extending Ian Hardie’s (2011) framework for analyzing the
financialization of government bonds markets in emerging countries. We introduce an
additional concept of investor loyalty in sovereign bond markets, which we term the
collateral motive – investor demand for government bonds to meet funding needs - and
we link it to changing banking models (Cetorelli and Goldberg 2012; Engelen et al, 2011;
Hardie and Howarth 2011; Poszar et al 2010; Bruno and Shin 2012; Mehrling 2012;
Singh and Stella, 2012). In sum, demand for sovereign bonds to use as collateral for the
funding of the financial sector deepens government bond markets while eroding
investors’ loyalty. This transformation of government bond markets into collateral
markets contributes to new, and pathological, institutional interdependencies between
governments and their banking sectors. Sovereign risk affects banks’ funding conditions
such that banks’ loyalty towards foreign or own governments is closely tied to the
collateral qualities of that debt. Sudden stops in collateral (sovereign bond) markets
forces governments to adopt fiscal austerity unless central banks commit to reverse that
sudden stop. Absent a central bank willing to do so, as countries in the Euro have found
out, and austerity appears as the only way forward.
The paper develops the argument as follows. We first examine the pre-crisis view
of comparative macroeconomic adjustments, opposing the accommodative regimes in
liberal economies to the conservative regimes characteristic to coordinated economies.
Next, we review the post-2008 reconceptualization of the Varieties literature that re-casts
coordinated economies as export-economies and traces the crisis to strategic interactions
in distinct political economies rather than to the shifting nature of finance per se (Iversen
and Soskice 2012, Soskice and Iversen 2010, Carlin 2012). After noting the explanatory
limits of this approach, we introduce the collateral motive into Hardie’s framework and
use this to explain how observed fiscal policy choices in Europe while usefully
augmenting the Varieties approach.
Varieties of Capitalism and Fiscal Policy
For the past decade, the interest in macroeconomic policy of the VoC scholarship
focused on two related questions: how institutional complementarities constrain or enable
discretionary macroeconomic policies in response to economic shocks and how
macroeconomic policy preferences affect economic outcomes. The first question has a
straightforward answer: the institutional makeup of coordinated regimes articulates a
strong preference for conservative macroeconomics while the opposite is true for the
liberal model (Iversen 2007, Carlin and Soskice, 2009). In coordinated economies, skill
intensive production regimes necessitate a large welfare state to keep in place the
conditions for the continuous acquisition of those skills4. Fiscal policy thus relies on inbuilt automatic stabilizers in response to shocks. In contrast, the discretionary component
is constrained by strong and generally centralized labor unions embedded in coordinated
wage bargaining institutions and governments operating in negotiation-based, consensus
polities (Soskice 2007, Carlin and Soskice 2009). 5 This combination generates
conservative macroeconomic policies because policy-makers expect wage setters to
respond to discretionary policies with demands for wage increases, leading to a wageinflation spiral. By contrast, deregulated labor markets characteristic to liberal market
economies (LMEs) allow for discretionary counter-cyclical measures because wage
setting is too fragmented to produce significant aggregate effects. Furthermore, LME’s
majoritarian political systems and weakly aggregated interest groups cannot effectively
prevent discretionary policies (Soskice 2007: 94-95; Carlin and Soskice 2009; Amable
and Azizi 2009). Varieties scholars used these insights to test the link between
macroeconomic policy preferences and economic outcomes. While earlier research
stressed domestic economic outcomes6, current contributions argue that the differences
observed in aggregate management regimes matters in a more fundamental way.
Yet macroeconomic preferences have cross-national consequences (Iversen and
Soskice 2012, Carlin 2012, Soskice and Iversen 2010) and can explain the pre-crisis
build-up in global imbalances (see Obstfeld and Rogoff, 2010). The global imbalances
hypothesis, the increasingly dominant account of the global financial crisis, suggests that
imbalanced trade regimes and cross-border financial flows generate financial instability
unless policy makers take corrective and coordinated action in the form of high interest
rates in deficit countries and domestic demand stimulus in export-led economies. The
economic relationships between US and China provide the context to this ‘imbalanced
macro’ hypothesis. The combination of permissive monetary policy in the US and
mercantilist exchange rate policies in China fed imbalances as Chinese surplus savings
found their way into the credit and housing bubbles in the US (Catte et al, 2011; Rajan
2010). Translated to a European context, these imbalances took the form of current
account surpluses in northern European countries, channeled by their banking sectors into
housing and credit bubbles in ‘Southern’ economies7 (Stockhammer 2012, de Grauwe
2012). European macroeconomic choices mirrored the imbalanced macro regimes
sustained by the US and China. The European governance framework aggravated the
problem, since a common monetary policy narrowed the mechanisms of adjustment to
either real wages or fiscal policy, none readily deployed to either stimulate domestic
demand in Northern countries or increase competitiveness in the ‘periphery’ (Schnabl
and Freitag 2012). But having attributed responsibility to imbalanced macro regimes, this
4
For a critique of the conflation of welfare generosity and coordination see Thelen (2012).
See Thelen’s (2012) critique of these dictohomous variables and the call to pay attention to the coalitional
foundations of varieties of capitalism.
6
For example, Carlin and Soskice (2009) argued that Germany’s poor performance throughout the 1990s
can be attributed to its pro-cyclical stance in response to the shocks experienced in the 1970s and 1980s.
Even if Germany preserved its export competitiveness, the contraction in private and government
consumption offset higher export revenues and translated into lower GDP growth.
7
For instance, in 2007, Germany had a 3.8% of GDP current account surplus, Netherlands 5.6% and
Austria 1.7%, whereas Greece ran a 8.5% of GDP deficit, close to Portugal’s 8.9% and Spain’s 5.8%,
figures indicative of the broader trend throughout the 2000s.
5
literature cannot explain why policy-makers failed to address imbalances in the first
place. The post-crisis revised Varieties literature attempts to provide that answer.
Why the Crisis Happened: Global Imbalances Meets the New Varieties Literature
Committed to a causal story that rests on complementary institutions, the new
literature makes three main revisions. First, it reframes coordinated economies as export
economies (Soskice and Iversen 2010a), second it introduces the real exchange rate as a
determinant of comparative competitiveness (Carlin 2012; Carlin and Soskice 2009;
Soskice and Iversen 2010a; 2010b) and, finally, it examines these processes against the
background of the free flow of financial capital across borders. Based on these revisions,
this scholarship can provide valuable insights into the mechanisms that generate
instability in advanced capitalist economies despite criticism to the contrary (Heyes et al
2012:222). It further stands on its head the convergence thesis claiming that the
unprecedented power of finance “flattened” the space for policy diversity towards the
liberal form of capitalism (Streeck 2009; 2010; 2012; Glyn 2007). The revised account,
applied to the particular nature of the European crisis, becomes an account of
macroeconomic policy convergence towards the coordinated model.
The new literature highlights the interactions between the two types of capitalism
as follows. In export-led economies, overvalued exchange rates reduce export
competiveness, triggering unemployment in the export sector. For this reason, unions in
export sectors tailor their wage demands to exchange rate dynamics. The interaction
between the skills regime and conservative macroeconomics is crucial. Since higher wage
demands will prompt conservative central banks to raise interest rates and appreciate the
real exchange rate, unions prefer wage restraint to contain real exchange rate
appreciation, preserve employment and the long-term investment in high skills. From this
perspective, the literature can now offer a different treatment of the economies that fall in
between the two ‘pure’ categories (Schmidt 2009). Since mixed economies like Spain or
Italy have lower capacity for strategic coordination in labor relations (Hall and Gingerich,
2004), their wage-setting institutions, similar to the liberal economies, will not be
oriented to real exchange rates (Carlin, 2012). In other words, mixed economies behave
closer the liberal economies that do not have the institutional constellations to accumulate
external surpluses from export activity. Additionally, highly-skilled workers in
coordinated economies tend to save more due to uncertainties about the future of the
welfare state (Carlin and Soskice, 2009), generating substantial private savings8. That in
turn puts breaks on consumption-led import demand. Consequently, export-led
economies accumulate saving surpluses.
The system of training and high-skills formation determines what happens to
savings surpluses in a world of highly deregulated capital flows. Export-oriented
economies avoid risky financial innovation because the high skilled workers are reluctant
to enter high-risk careers. Moreover, consensus polities generate a cautious attitude to
financial regulation that prevents financial institutions to develop complex (and risky)
products in the national political economy. In contrast, liberal economies with system of
training focused on the accumulation of general skills encourages the highly skilled to
move into risky financial activities. The political system trusts the benefits of financial
8
For example, the debt of German households contracted by 11% between 2000-2008, whereas it increased
by 35% in Ireland, 22% in Spain and 18% in Greece (Stockhammer 2012).
innovation and can even come to see the financial sector as the key driver of economic
growth and external competitiveness, as the experience of the United Kingdom preLehman testifies (Moran 2006). As a result, finance in export-led economies remains
‘patient’ at home, but looks for profitable placements abroad and finds them in liberal
economies.
The example of the Dutch banks or German Landesbanken illustrates well this
point. These invested into new financial instruments developed by the US shadowbanking sector (Bruno and Shin, 2012). Closer to home, banking sectors in export-driven
European countries intermediated large capital flows into southern Europe and Austrian
banks into Eastern Europe. For example, Germany intra-EMU balance of payments was
on average in equilibrium before 2008, as large current account surpluses (exports to
other EMU countries) were offset by private (banking) sector capital outflows into the
same countries (Mayer 2011). Capital exports from coordinated economies thus finance
large current account deficits in mixed or liberal economies, whose propensity to adopt
discretionary macroeconomic policies supports a growth model based on overvalued
exchange rates, credit-financed consumption and housing booms, a model familiar to
emerging countries confronted with large capital inflows (Gabor 2012). It is the
interaction between the two types of capitalism, and the distinctive macroeconomic and
risk-taking preferences they sustain, that generates the imbalances underpinning the
European crisis.
How come these political economies failed to recognize the importance of
rebalancing before 2008? The new VoC research highlights the incentives governing
domestic politics across different types of capitalism. Export economies had no incentive
to adopt expansionary macroeconomic policies that would reduce external surpluses
because these would involve a loss of competitiveness resisted by politically powerful
export sectors. This explanation is often invoked to explain why German trade unions
support the German’s government insistence on conservative macroeconomic solutions to
resolve the European debt crisis (Carlin 2012, Stockhammner 2012). In turn, policy
makers in liberal economies did not recognize re-balancing as a policy priority because
the available tools - cuts to spending and domestic demand – were politically difficult to
deliver in institutional contexts that, as we saw, traditionally support accommodative
macroeconomic regimes. The narrow mandate for price stability further allowed
inflation-targeting central banks to reject responsibility for external imbalances and
financial instability (Blanchard and Cotarelli, 2010). In contrast to coordinated
economies, the private sector in either liberal or mixed economies could not
autonomously generate corrections of exchange rate misalignments because,
paradoxically, it lacked the necessary large wage-setting institutions (Carlin 2012) that
delivered wage suppression in Germany. Thus the mechanisms underpinning political
and institutional stability cemented policy divergence, feeding imbalances rather than
containing them.
Sudden Stops and Fiscal Policy Convergence
This revised VoC account offers a very clear story of change. Rebalancing can
only occur if the incentives governing domestic political coalitions that sustain
imbalanced macro regimes drastically change (Iversen and Soskice 2012; Soskice and
Iversen, 2010a), echoing the early emphasis on change in response to exogenous shocks
in the global economy (Blyth, 2003). In the current (European) crisis, such exogenous
transformation in incentives may occur in response to sudden stops in cross-border
capital flows. Indeed, it is now widely agreed that financial globalization has rendered
capital flows as the main conduit for the transmission of global shocks (IMF 2010;
Cetorelli and Goldberg 2012). In the context of the European crisis, the Greek fiscal
scandal in late 2009 provided the trigger for a reversal of capital flows returning in
successive waves to surplus saving, export-led economies (Germany and other Nordic
countries) from high deficit ‘peripheries’ such as Spain, Portugal, Italy, Greece (Merlen
and Pissani-Ferri 2012)9. For example, the German balance of payment position shifted
from (near) equilibrium before 2008 to a significant surplus: of the EUR 200 bn
registered in 2009-2010, a quarter represented net capital inflows as private financial
actors reduced their exposure to Southern European countries (Mayer 2012). The revised
VoC framework can provide insights into fiscal convergence whenever sudden stops
occur.
Typically, policymakers do not respond to exogenous constraints in easily
predictable ways (Widmaier, Blyth and Seabrooke 2007: 748). However, sudden stops
confront deficit countries with the immediate necessity to adjust macroeconomic policies
to bridge funding shortfalls. This is why sudden stops matter analytically. In this crisis,
the archetypal liberal model, the US, resembles coordinated economies because distress
in international financial markets translated into an increase rather than a reversal, in
capital inflows 10 . In turn, export-led countries would only consider policies to curtail
external surpluses in an exceptional case: a coordinated expansion across all export-led
economies. Otherwise, individual adjustments may translate into lost export markets that
would turn that export-driven country into a deficit country exposed to global financial
volatility. Yet international coordination is difficult to achieve. Even the institutional
context of the Eurozone, which should in principle engender mechanisms for such
symmetric adjustments via coordinated expansions in the surplus countries, provides little
encouragement. Although the European Commission (belatedly) enshrined the
importance of symmetric adjustments in its recently introduced Macroeconomic
Imbalance Procedure (2011), so far it has failed to persuade Nordic countries to adopt
internal revaluations even though these may provide a faster resolution to the European
crisis (de Grauwe, 2012). The rebalancing is asymmetric because it is only deficit
economies that recognize external rebalancing as a policy priority if confronted with a
sudden stop.
The asymmetric rebalancing vindicates the implied preference for the coordinated
model in the varieties scholarship (Blyth 2003). Having been forced to repeatedly explain
how coordinated economies can preserve their distinctive features under the pressures of
liberalization (Thelen 2011), scholars can now argue that strategic interactions in
coordinated models are better suited to mitigate vulnerability to the inherent volatilities of
global finance (see Carlin 2012). Critically, the wage-setting institutions of the private
9
Merler and Pissani-Ferri (2012) identify three ‘waves’ of sudden stops in the Eurozone crisis: the postLehman deleveraging affecting primarily Greece and Ireland during Oct. 2008-January 2009; the May 2010
Greek bailout that generated contagion to all GIIPS countries, and the end of 2011 renewed pressures on
Italy and Spain.
10
In the well-documented history of financial crisis, the US is atypical: whereas financial capital usually
abandons the countries at the center of the crisis, the collapse of Lehman triggered a search for safeheavens that translated into large capital inflows into the US financial markets.
sector autonomously generate exchange rate realignments that protect coordinated
models from the problems associated with overvalued exchange rates.
In a similar vein, the revised account implies that absent such autonomous
adjustments through the private sector, for example in liberal economies where wage
bargaining is decentralized, the only viable alternative is to adjust macroeconomic policy
to restore external competitiveness. Sudden stops require immediate policy responses;
otherwise countries face a balance of payment crisis. Without access to international
financial markets, deficit countries can no longer fund current account deficits (or budget
deficits if the sudden stop affects government bond markets) and have to request, as
Ireland or Portugal did, international official support. Governments in deficit economies
are more likely to puncture the institutional equilibrium underpinning the traditional
fiscal policy stance because they have to curtail current account deficits.
Bringing Finance Back In
Although the revised account involves a new treatment of finance, it remains illequipped to explain the relevance of international finance for macroeconomic policy
responses. Insofar as finance mattered in the early literature, it did so through the firm
lens. The original framework classified finance according to its relationship to productive
firms, proposing a well-known distinction between bank-based and market-based
systems. The first involves trust-based relations between firms and banks while the
second arms-length relations between firms and stock markets (Allen and Gale, 2000;
Berglo 1990; Zysman, 1983). Even contributions critical of VoC relied on this framing
when interrogating how the relationship between finance and firms survives the changes
in financial intermediation brought by financial innovation or regulatory pressures (Deeg,
1999; Krahnen and Schmidt, 2004; Dixon, 2012). The debate, then, typically focused on
metrics that confirmed or challenged the relative importance of banks or stock markets in
distinctive mechanisms of coordination (Engelen et al, 2011). It often suggested
convergence towards market-based relationships, as in Vitols (2005) account of the large
German banks that increasingly cut their close ties to industrial companies.
The ‘imbalanced macro’ account brings to attention risky financial practices. It
recognizes that banks in coordinated economies may have become more than ‘patient’
lenders. Yet because it defines propensity to risky financial innovation through the nexus
of skills-formation/regulatory attitudes, it continues to assume that where it matters – that
is, in the domestic economic realm – banks remain patient. German or Dutch banks may
have bought structured products, but they did it in high-risk financial centers such as
London or New York, not in Frankfurt (Iversen and Soskice 2010a). The methodological
nationalism characteristic to the VoC approach thus preserves intact the key assumption
that firms coordinate access to finance through the predicted mechanisms. It also implies
that post-crisis regulatory efforts would contain this cross-varieties funding of risky
innovations and somehow return finance to behaving according to the predictions of
varieties of capitalism.
Most importantly, however the details of financial intermediation are relevant for
national economic performance but not for discretionary fiscal policies. The high-risk
framing cannot identify new mechanisms of coordination that would render financial
institutions relevant to fiscal policies in the same way that wage-setting institutions or
coalition politics matter (Carlin and Soskice 2009). The strategic interaction between
financial innovation and the distinctive skill regimes favor high-risk activities in liberal
economies and conservative financial practices in export-led economies.
The failure to connect finance to fiscal policy can be traced to the continued
reliance on the traditional banking model in which lending is assumed to be funded
mainly from deposit activities (Engelen et el, 2011). Banks with funding gaps (loans in
excess of deposits) can borrow on the interbank market from banks with excess reserves.
It is true that the central bank may have to supply reserves if banks cannot find enough
reserves on the interbank markets – otherwise the market interest rate would move away
from its policy rate, particularly during moments of crisis (Allen and Gale, 2000). But
when it does this the central bank of New Keynesian models sets policy interest rates
according to price forecasts that depend on expenditure plans and wage-setting
institutions (Carlin and Soskice, 2009). In contrast, the institutional details of financial
markets themselves is assumed as irrelevant for price movements, and therefore for the
conduct of central banking (Blanchard et al, 2010). Moreover, during crises the supply of
lender-of-last resort liquidity is assumed to have no macroeconomic consequences
beyond mitigating tensions in the interbank market. The Fed or the Bank of England’s
outright asset purchases (unconventional monetary policies) are then just a continuation
of the traditional accommodative stance in liberal economies, while the ECB’s reluctance
to intervene in sovereign bond markets reflect the conservative views of (German) central
bankers in coordinated economies (Gabor 2012). Fiscal policy formulation, in this view,
remains a process shaped exclusively by domestic non-financial actors, a view
paradoxically silent on one key constraint for governments during crisis: the sovereign
bond market (Mosley 2000).
While Taking the Bond Market Seriously
The idea that sovereign bond markets constrain governments is not new. In fact,
this is how the European crisis is reported daily, drawing on the academic literature that
highlights the importance of bond markets. Indeed Mosley (2000) persuasively showed
that international financial markets can ‘react dramatically’ to government policies, but
only do so in response to volatility in inflation or budget deficits. Confronted with such
dramatic reactions, governments may have to please markets even if these are suspected
of speculative intentions (Corsetti et al 2010; 2012). Yet this is a self-defeating strategy
when markets anticipate fiscal tightening to have negative growth consequences, further
affecting government revenue and public debt sustainability. As a result, markets become
‘schizophrenic’, increasingly unable to distinguish between fundamentals and uncertainty
in the pricing of sovereign risk (de Grauwe and Ji 2012). Doubts about the government’s
ability to service its debts become self-fulfilling (Gros, 2012).
In these accounts, the ‘market’ is a black box to which governments feed austerity
plans and out come conflicting signals. But this black box that cannot explain why
Spanish banks continued to buy Spanish government bonds or why French banks stopped
doing so in early 2012, nor can it incorporate analytically the pervasive concerns with the
interdependence between sovereigns and their banking systems, so often voiced in the
European crisis (Buiter and Rahbari, 2012; Lane 2011, Achraya et al 2011, BIS 2011,
ECB 2011). We found that Ian Hardie’s (2011) research on the financialization of
sovereign bond markets in emerging countries can help us unpack this black box because
it explicitly considers the links between distinctive types of market participants, structural
features of the market and governments’ ability to undertake discretionary fiscal policies.
How Financialization and Investor Dis-Loyalty lead to Austerity
The core of Hardie’s argument is that bond markets that attract short-term
investors make it hard for governments to adopt discretionary policies in recessions.
Hardie defines financialization as ‘the ability to trade risk’, a process that affects both the
market structure and market actors. The financialization of market structure is
functionally equivalent to its liquidity: liquid markets increase the ability to trade risk
because they allow frequent selling and buying with minimum price changes. It is such
markets that attract impatient investors guided by short-term strategies. The increasing
presence of financialized investors increases market liquidity, further financializing the
market structure. In contrast, loyal investors that buy government bonds to hold to
maturity have little incentive to trade and thus reduce market liquidity. As Hardie put it
“more (less) financialized investors are likely to increase (decrease) the financialization
of market structure and more financialized markets attract more financialized investors.”
Critically, financialization puts constraints on the state. Impatient investors
undermine government debt sustainability because they tend to exit sovereign bonds
markets rapidly when confronted with uncertain conditions. Conversely, loyal investors
act as a stabilizing factor in times of crisis, preserving governments’ ability to borrow.
Although Hardie (2011) does not use the term explicitly, the distinction between loyal
and ‘impatient’ investors offers insights into the anatomy of sudden stops in sovereign
bond markets. This contributes to a growing literature that attributes sudden stops to
resident capital flight (Rothenberg and Warnock 2011), to non-resident withdrawal from
high-yielding markets (Gabor 2012), or when foreign investors leave while domestic
investors return to the country affected by sudden stops (Broner et al 2011). If patient
finance is what states need in hard times, the important question then becomes what
makes investors loyal during a crisis.
Hardie’s comparison of domestic banks in Brazil, Lebanon and Turkey suggests
that loyalty has several dimensions. The first is relative exposure. If banks hold
significant portfolios of government debt relative to their overall balance sheet or the
market size, they will face difficulties in exiting in a crisis. Regulatory caps on daily sale
volumes or abrupt price changes, if banks try to sell large volumes, will cement banks’
patience even when a sudden stop is anticipated. Some banks may not even have the
option of exiting because their sovereign holdings are too high to liquidate. In contrast to
the ‘home bias’ 11 literature that questions the benefits of banks’ preference for home
sovereign debt (see Fidora et al 2006), the financialization lens suggests that the higher
the relative exposure, the more loyal the bank and the lower the possibility that a sudden
stop materializes.
Second, investors will be more loyal if they do not have placement alternatives
readily available. In many less developed financial markets, domestic banks have access
to a narrow range of alternatives, often with lower returns that government bonds.
Therefore, even if banks can meet exit costs, they will remain loyal to preserve long-term
11
The term illustrates the contradiction between the theoretical proposition that in efficient markets, as the
markets of high income countries were routinely assumed to be, investors should have no preference for a
particular issuer and the instances where bank sovereign portfolios were dominated by their own sovereign.
sources of profit. Finally, a further important characteristic is the ability to avoid mark-tomarket valuation. Banks will buy during periods of market distress if they can hold
sovereign bonds in the banking book rather than the trading book, because the latter
values bonds at market price, exposing banks to market volatility. Conversely, holding
bonds in the banking book discourages banks from selling since the sale would be
accounted at market price, usually lower in a crisis (bar exceptional circumstances when
a possible default is expected). Banks are unlikely to lend government bonds to impatient
traders for shorting because the banking book valuation reduces the appeal of market
volatility. In short, governments face significant challenges for funding deficits in
financialized markets where investors have low relative exposure, readily available
alternative investments and are subject to mark-to-market accounting practices.
Hardie warns that his insights did not directly apply to high-income countries
because of their ‘safe-heaven status’. Even impatient investors prefer the liquidity of such
government bonds during crisis, a widespread view in the literature (Dow 2012), at least
until the European sovereign debt crisis. Safety becomes the over-riding motive for
holding bonds, and trumps the determinants of loyalty discussed above.12 Given this, we
return to the causal mechanisms of policy diversity underpinning varieties of capitalism
arguing that the ‘flight to safety’ account can be displaced if it includes an additional
dimension of investor loyalty arising from the changing funding models of banking in
high-income countries. We term this the collateral motive: investor demand government
bonds to meet their funding needs.
The collateral motive and the financialization of government bond markets
The framework we propose ties the collateral motive to fiscal policy choices in
Europe in three steps. First, we explain how the changing nature of banking in highincome European countries during the decade prior to the crisis transformed sovereign
bond markets into collateral markets. Then, we show how in these conditions collateral
management cultivated investor disloyalty, generating, a coordination problem involving
governments and their banking systems. We conclude by showing that in the particular
conditions of the European monetary union, this coordination problem could only be
resolved by frontloading fiscal consolidation.
The literature on banking widely agrees that banking models in advanced political
economies have changed. Rather than simply gathering domestic savings to lend out to
domestic companies, banking has become an increasingly transnational, market-based
activity (Engelen et al, 2011). Transnational banks move liquidity through internal capital
markets (Cetorelli and Goldberg 2012) and rely on diverse strategies of funding (BIS
2011, ECB 2011, Bruno and Shin 2012). These trends can be confirmed empirically by
comparing the sources of funding for large banking systems (see Figure 1). Indeed, most
European banking systems, whether from ‘bank-based’ or ‘market-based’ capitalisms,
met less than half of their funding requirements from their traditional source, customer
deposits, with France and Italy least reliant on deposit activity. Instead banks have turned
to market funding, from the issue of debt securities13 or direct borrowing on wholesale
12
From this perspective then, actors in sovereign bond markets do not obstruct, or can even support,
discretionary fiscal policy decisions in high-income countries, of whichever capitalist variety.
13
Including residential-backed mortgage securities, commercial mortgage-based securities, covered bonds
and collateralized debt obligations.
money markets, either domestic or cross-border (Hardie and Howarth 2010, ECB 2011).
Transnational banking also affects smaller banks without access to international markets.
Transnational banks can easily channel foreign liquidity into domestic money markets
and ease funding conditions for smaller banks even when the central bank attempts to
tighten the monetary policy stance (Bruno and Shin 2012, de Haas and van Lelyveld
2012). In sum, savings behavior in a particular economy no longer constrains lending
activity, as assumed in both the traditional and revised varieties of capitalism accounts
when banks rely on cross-border wholesale funding markets.
Figure 1 Share of customer deposit in total funding, selected European banking
systems, June 2010
80
60
40
20
0
Source: BIS statistics
Private repo markets have quickly become the largest global source of wholesale funding
(ECB 2011, Gorton and Metrick 2009). These are over-the-counter markets where the
repo lender exchanges cash for assets (collateral), and commits to re-sell that collateral to
the borrower at a later date (a day, a month or more). According to ICMA, global repo
markets grew, on average, at almost 20% between 2001 and 2007, driven by similarly
rapid expansions in both US and European segments14. European regulators encouraged
the rapid growth of this over-the-counter market, commending it as a demonstrable
benefit of financial innovation that improved the distribution of liquidity and risk
management (Giovanni Group 1999). Regulators supported these claims by pointing to
the mechanism of a repo transaction. Since the lender becomes the legal owner of the
14
By 2007, the US repo market reached an estimated US 10 trillion or 70% of US GDP and the European
repo market to EUR 6 trn before Lehman (Hordhal and King, 2008).
underlying collateral, collateral becomes a tool for risk management. In the event of the
cash borrower’s default, the lender can recover her loan by selling the collateral.
The most common collateral in repo transactions is a ‘safe asset’ that typically
satisfies two conditions (Hordahl and King 2008). First, it trades in highly liquidity
markets. Higher liquidity implies less price volatility, which maintains the value of
collateral close to that of the cash loan. Second, it is of high quality. Lower-quality assets
require a higher haircut, which is the difference between the value of the cash loan and
the value of collateral posted, to protect the lender against the risk that the collateral
issuer defaults. Prior to the crisis, the sovereign bonds of highly developed political
economies best satisfied these conditions (Bates, Khale and Stulz, 2008; Gorton and
Metrick 2011).
The pre-crisis growth in repo markets triggered similar growth in markets for
eligible collateral. When issuers of high quality sovereign debt did not satisfy the
growing demand for eligible collateral, responses varied depending on specific
institutional and regulatory contexts. One avenue involved collateral mining 15 (Pozsar
and Singh 2011) that ‘unearthed’ sovereign debt instruments from ‘buy to hold’
portfolios of patient investors (such as pension funds) and introduced them in collateral
portfolios. Similarly, collateral managers used the same sovereign debt instrument in
various repo transactions if legal provisions allowed re-hypothecation (Singh and Stella
2012). Furthermore, ‘safe assets’ theories argue that the production of structured
securities at the core of the US financial crisis was underpinned by a collateral motive16.
Shadow banks produced structured securities to address the shortage of the typical safe
assets, US sovereign debt, prior to 2008 (Pozsar 2011, IMF 2011). Put differently,
shadow banks increased leverage by generating structured securities, that could be used
as collateral in repo markets (Gorton and Metrick 2009).
In the European markets, collateral demand triggered distinctive solutions to a
similar problem. The rapid growth in European repo markets accompanying transnational
banking could not be supported by the conservative fiscal stance of the primary ‘safe
sovereign’, Germany (Bolton and Jeanne, 2011). Basically, Germany didn’t generate
enough debt relative to the demand for it. To solve this problem the European
Commission proposed to address the shortage by regulatory reforms (The Giovanni
Group 1999). It introduced legislation to ease the legal constraints to the cross-border use
of collateral and ensure equal treatment of Eurozone sovereign debt in repo transactions17
(Hordhal and King, 2008). In other words, the Commission decreed that all Euro
denominated sovereign bonds should be treated the same in repo transactions. The
intention was to transform the bond markets of ‘non-core’ sovereigns into collateral
15
Collateral mining ‘involves both exploration (looking for deposits of collateral) and extraction (the
“unearthing” of passive securities so they can be re-used as collateral for various purposes in the shadow
banking system)’.
16
This includes asset backed securities, asset backed securities, RMBS, CMBS, CDOs, CLOs)
17
In the US or UK, the sovereign collateral in funding-driven repos includes a homogeneous basket of
sovereign debt instruments (so that the maturity of instruments does not matter). In contrast, the European
sovereign rates are compiled on a basket of sovereign bonds issued by any of the euro area countries
(Hoerdahl and King, 2008)
markets, and thus harness the forces of financial innovation to the European project of
financial integration18.
At first, financial markets confirmed the Commission’s expectations. Sovereign
bond markets across Europe quickly became important sources of collateral. According
to BIS (2011), up to 90% of outstanding sovereign debt for Ireland, Italy, Greece,
Portugal and Spain circulated as collateral in private European repo transactions before
Lehman’s collapse. The sovereign bond markets of these countries together provided
around 25% of sovereign European collateral, a share comparable to that of the ‘safe’
sovereign, Germany (ICMA 2008). That European banks could raise repo funding on
identical terms with German, Greek or Italian sovereign collateral (Hordahl and King
2008) testified to the success of the financial integration project. European banks
produced eligible repo collateral not by shadow innovation, as in the US, but by helping
non-core European sovereigns migrate into the safe-asset collateral category. In other
words, investors did not enter sovereign bond markets because of an ‘accidental’ yet
collective mispricing of credit risk, as is the standard account of pre-crisis sovereign yield
convergence (De Santis and Gerard 2006). Instead, the collateral motive became an
important driver of demand for European government bonds because European banks
could access repo market funding by using collateral other than that issued by their own
governments.
Indeed banks increasingly posted other Euroarea government bonds as collateral
to raise funding from other Euroarea financial institutions. The share of own government
collateral declined from 63% in 2001 to 31% in 2008, as other Euroarea institutions
became the main counterparties (see Table 1). The collateral motive improved the
liquidity of sovereign bond markets and advanced financial integration, exactly as the
European Commission intended. It did so however at the price of building up
pathological institutional complimentarities that would only become apparent in the
crisis.
Table 1 Distribution of collateral and counterparty in repo transactions, Euroarea, 2005-2010
Collateral
Counterparty
National
Euroarea
National
Euroarea
2001
63
27
43
36
2005
39
57
29
51
2007
36
60
38
42
2008
31
65
31
48
2009
36
59
32
44
2010
31
64
37
44
source: compiled from Euro Money Market Survey
18
For the Commission, the new regulation was more than a pragmatic response to a policy problem. The
Commission trusted the promises of financial innovation in repo markets: increased liquidity, improved
risk management and better pricing tools (Giovanni Group 1999; Engelen 2011). This expectation was
grafted onto the European integration project itself. Financial innovation would achieve financial
integration of both wholesale money markets and sovereign bond markets. It was the “ever wider” union,
financial market style.
The Collateral Motive and Investor Loyalty
Demand for collateral also changed investors’ loyalty vis-à-vis their sovereigns.
Consider the example of commercial banks, traditionally the largest holder of
government debt. As Table 1 confirms, banks demanded Euro area collateral to diversify
collateral portfolios, sharpening the internationalization of sovereign debt markets
(Bolton and Jeanne, 2011). But diversified collateral portfolios conversely reduce banks’
relative exposure - to use Hardie’s phrase - to both home and foreign sovereign in terms
of market size. In the Eurozone foreign banks held higher shares of government debt than
domestic banks in all but three Eurozone countries (Germany, Greece and Spain) by 2010
(see Table 2). Even in those three countries, non-bank investors (hedge funds, pension
funds and other institutional investors) held close to or more than half of outstanding
government debt. Where national regulatory provisions allowed, some buy-to-hold
institutional investors chose to lend their securities to collateral ‘miners’, increasing the
availability of alternative instruments.
Table 2 Participants in sovereign bond markets (holdings as % of overall volume)
Austria
Belgium
France
Germany
Netherlands
Greece
Ireland
Italy
Spain
UK
Domestic
banks
6%
9%
8%
34%
10%
19%
7%
9%
41%
6%
Foreign
banks
18%
16%
8%
13%
16%
16%
32%
12%
12%
3%
Non-bank
holders
76%
75%
84%
53%
74%
65%
61%
79%
47%
91%
Source: EBA Stress Tests, 2010
Taken together this diverse investor base and the availability of alternative sources of
collateral reduced the costs of exit for banks faced with sovereign risk: loyalty became
both expensive and counterproductive. Indeed, Angeloni and Wolf (2012) show that
European banks reduced exposure to the five ‘southern’ Eurozone countries in the first
nine months of 2011 as the European sovereign debt crisis intensified. French banks
reduced their holdings by almost 22%, and German banks by 15%, mostly by
withdrawing from the Italian sovereign bond market, the second largest source of
collateral in Eurozone 19 according to ICMA (2011) statistics. The French banks’
19
For Italy, European Banking Authority data for 2010 show that the banks of the other European countries
reduced their overall net exposure by €57 billion (of which €40 billion by German banks alone). BIS data
(not completely homogeneous with the EBA data) indicate that this exposure diminished further in the first
withdrawal is worth noting because the French banking system is highly marketdependent, funding around 23% from interbank market sources for which it requires high
quality collateral (BIS 2011 and Figure 1 above). As sovereign bond markets become
collateral markets, the costs of exit in terms of relative exposure and alternative
instruments become smaller, reducing the loyalty of market participants.
The collateral motive decreased loyalty in still more fundamental ways through
valuation practices, Hardie’s third dimension of investor (im)patience. At first sight,
accounting practices in Europe should support investor loyalty. European banks hold only
a small percentage of sovereign debt instruments on trading books that mark to market,
according to Financial Times less than five percent. But in practice, banks are exposed to
collateral market volatility even when they hold bonds in the banking book because of the
nature of collateral management. In traditional banking, deposit insurance protects the
cash lender (the saver) from risks that the counterparty, the bank, may default. Collateral
similarly enables the cash lender in repo transactions to mitigate counterparty risk
(Gorton and Metrick 2009). But collateral does not eliminate all risk for the lender, in the
way that deposit insurance does. Instead, it changes the lender’s exposure from the
counterparty to the market where that collateral trades. To paraphrase Hordahl and King
(2008, p. 40) the main risk in a repo transaction is collateral market risk. If the
counterparty defaults, the lender will fully recover her cash if she can sell that collateral
at its posted value, that is if the market remains liquid and if the collateral has not fallen
in value. For this reason, collateral managers typically worry about the liquidity of
collateral markets, be it those of structured securities or sovereign debt markets, and
mitigate these worries by mark-to-market valuations.
By definition then, collateral management is necessarily short-term and impatient
regardless of whether it is either overnight, as in the US repo markets, or if it involves
daily re-valuation for longer maturities, as in Europe. In the latter case, even if the repo
has a three-month maturity, collateral managers still use mark-to-market practices to
calculate the value of collateral portfolios on a daily basis, and trigger margin calls if
prices are falling20. The possibility of margin calls requires borrowers to either maintain
(expensive) reserve collateral or have ready access to high-quality collateral. Thus, markto-market practices in collateral management erode investor loyalty, just as Hardie (2011)
described in the case of international investors in emerging countries’ bond markets.
Collateral managers must respond immediately to changes in either perceptions of
collateral liquidity or overall confidence in valuations. The case of collateral markets
supplied by governments (rather than shadow banks) stands apart because of the
particular impact that crisis, financial or economic, has on government deficits. A crisis
increases the fiscal burden either directly through the costs of bank rescue programs (and
these were high across Europe, see Engelen et al 2011) or if it triggers automatic
stabilizers (higher welfare payments and lower tax revenue). Thus government deficits
can increase even in the absence of discretionary stimulus measures. The higher supply of
government bonds will push prices down (and yields up) unless private actors or the
central bank increase demand. In a crisis, collateral managers have every incentive to
half of 2011.
20
For example, a Spanish bank that posted Spanish sovereign collateral for a three-months repo initiated in
March 2010 would have had to post additional collateral to compensate for the fall in the price of Spanish
collateral triggered by contagion from the Greek crisis.
abandon collateral markets that they perceive to be risky because a fall in the price of that
asset may result in margin calls. Reduced demand reduces market liquidity, increases
price volatility and margin calls further affecting demand - a vicious cycle that can
precipitate a run on a collateral market. In other words, shifting perceptions of sovereign
risk or confidence in valuations may trigger sudden stops in collateral markets.
Collateral Damage in the Euro Crisis
The valuation of complex debt instruments often involves creative practices that
retain credibility while investors remain confident (Mackenzie, 2010). But financial crisis
typically erode confidence in valuations of risk and return (Dow 2012). For instance,
Lehman’s collapse saw rising uncertainty about the value of structured securities. What
ensued, Gorton and Metrick (2009) showed, was a sudden stop in the repo segment using
structured products as collateral. In conditions of market uncertainty that reduces the
value of collateral, collateral managers abandon higher-risk collateral markets or, if under
serious funding pressures, may even resort to fire sales that further add to price volatility.
By the end of October 2008, the only institution that still accepted structured securities as
collateral was the US Federal Reserve, under its extraordinary liquidity injections
(Bernanke, 2009).
This was a lesson that European policy makers appeared to have learnt from the
US debacle. Similar to the US, private repo actors began questioning the ‘safe-asset’ tag
attached, in this case, to sovereigns with well-documented domestic vulnerabilities
(housing boom, high reliance on external funding). Concerns about sovereign risk saw an
increasing shift in collateral demand for German safe assets and away from ‘higher-risk’
sovereigns such as Ireland or Greece. Repo transactions collateralized by Irish and Greek
bonds fell in volume, as spreads to German debt widened (BIS 2011). For all purposes,
new concerns with sovereign risks and its impact on collateral liquidity appeared to ignite
a run on the collateral markets supplied by ‘periphery’ sovereigns. However, systemic
European crisis measures, including the extraordinary liquidity support from the ECB,
supported private investor demand for higher-yielding sovereign bonds throughout 2009
(Caceres et al 2010). Spreads between different European sovereign yields narrowed and
repo volumes using Greek and Irish collateral returned to pre-Lehman volumes (BIS,
2011). Coordinated policy action contained the potential run in the periphery collateral
markets.
However, country-specific factors and contagion from other sovereigns (Caceres
et al 2010) became important once the ECB refused to ease tensions in the Greek
government bond market (Featherstone 2011) and instead remained committed to
withdrawing its extraordinary liquidity support for European banks (ECB 2010). In May
2010, the ECB signalled that it would not stabilize collateral markets if that collateral was
supplied by sovereigns, fearing the political backslash from Northern countries (Gabor
2012). This started successive waves of runs on European collateral markets. Indeed, the
BIS (2011) reported that the share of repo transactions collateralized by Greek and Irish
sovereign bonds halved between December 2009 and June 2010. Later that year, the Irish
case offered the clearest example of a run on a sovereign collateral market that eventually
forced the Irish government to ask for a bailout.
The Irish run featured a key market player named LCH Clearnet. This clearing
house, Europe’s biggest, acts an intermediary in repo transactions, and thus assumes the
collateral risk that a cash lender would face in a bilateral transaction. For this reason,
although repo transactions in Europe are mostly bilateral, strains in a particular collateral
market (Irish sovereign bonds) will see lenders increasingly preferring to move repo
activity through the clearing house21. The LCH Clearnet uses a rigid rule: if the yield on a
sovereign bond increases by more than 450 basis points above a basket of AAA rated
assets, it will trigger margin calls. When the Irish yield went above that threshold in
November 2010, LCH raised margin requirements for banks that wanted to use Irish
collateral to 15%. Because Irish banks were not members of LCH, this mainly affected
non-Irish banks (that incidentally held far higher holdings than the Irish banks). These
reduced demand for Irish government bonds, pushing yields further up, triggering a new
margin call (FT Alphaville)22. By November 21st, LCH had tripled the haircuts on Irish
debt to 45%. The run on the collateral market (worsened by short-selling) stopped only
once the Irish government asked for an international bailout. Similar developments
underpinned the Portugese bailout, and the withdrawal of German and French banks from
the Italian government bond market discussed earlier. Collateral managers cannot remain
loyal if loyalty threatens their access to repo funding and banks’ loyalty towards foreign
governments is depended upon the collateral qualities of their debt.
The Limits of Loyalty
The behaviour of domestic banks confronted with a run in the collateral market of
their own sovereign is a powerful example of why the collateral motive matters. It is
worth remembering that in Hardie’s framework, loyal domestic banks are crucial to
preserving fiscal policy autonomy during crisis. From this perspective, except for Ireland,
the GIIPS sovereign bond markets should have benefited from the high ‘home bias’ of
their domestic banks compared to Nordic countries. For example, both Spanish and
Italian banking sectors held over 75% of sovereign debt in home sovereign instruments in
March 2010, before the sovereign debt crisis exploded (see Figure 3). At first, the
benefits of loyal banks became apparent throughout 2009. The ‘home bias’ strengthened
as banks used the long-term ECB liquidity to buy higher-yielding debt of their own
governments, just as Hardie’s framework would have predicted.
But once funding conditions tightened, loyalty can became costly in collateral
terms. The repo lenders may attempt to pre-empt a ‘double exposure’ by refusing to lend
to a periphery bank seeking to borrow again periphery collateral. The ECB (2011) termed
this the ‘coordinated risks’ on the repo market between counterparty (bank) and collateral
(sovereign debt), and in the words of a collateral manager: “an Irish bank pledging Italian
debt as collateral is less desirable from a credit perspective than an Irish bank pledging
AAA-rated security with no correlation to the European debt crisis. Where firms are
declining PIIGS debt, collateral pledgers are sometimes faced with having to offer higher
quality collateral” (SLT 2011: 12). The ‘coordinated risks’ that affected Spanish (and
Italian) banks throughout 2011 prompted these to curtail credit to the domestic economy
(thus worsening the recession) to offset the loss of access to market funding23. It also
triggered changes in their collateral strategy: to avoid such coordinated risks, both Italian
21
Indeed, the Spanish government welcomed the admission of Spanish banks to the LCH Clearnet platform
in May 2010 because it would ease their access to repo funding collateralized with Spanish bonds.
22
http://ftalphaville.ft.com/blog/2010/11/03/393051/when-irish-margins-are-biting/
23
http://www.ft.com/cms/s/0/1b6855b8-c404-11e0-b302-00144feabdc0.html#axzz24wgcv2mx
and Spanish banks reduced exposure to their sovereigns from December 2010 to
September 2011, the first by around 7% and the second by almost 30% (Angeloni and
Wolff 2012). Banks that manage significant portfolios of sovereign collateral as part of
their market-funding strategies inevitably lose loyalty, in Hardie’s sense, towards their
home sovereign.
Figure 2 Share of domestic government debt in total government debt portfolios, selected European
banking sectors, June 2010
100
90
80
70
60
50
40
30
20
10
0
When sovereign bond markets become collateral markets, new institutional
complementarities emerge in advanced political economies, so-called sovereign-bank
nexus or ‘loops’ (Acharaya et al 2010; BIS 2011). Governments have to absorb the costs
of bank restructuring or bank failure because bank runs would destroy the banking
system. But if higher spending increases sovereign risk (Merler and Pissani Ferri, 2012),
it can disrupt the collateral function of sovereign debt, with adverse effects on banks’
funding conditions (BIS 2011), particularly where those banks are ‘loyal’ banks. The
ingredients for a sudden stop in the sovereign collateral market are therefore always
present because this interdependence between banks and sovereign creates a problem of
coordination: who will assume responsibility for preventing a run on the sovereign
collateral market? Private domestic banks cannot resolve this problem because of the
impatient nature of collateral management discussed above. Central banks may be better
candidates because theoretically there are no constraints to their ability to stabilize bond
markets. As shown by the case of the Fed or the Bank of England, central banks can
always create more base money to purchase government bonds (de Grauwe, 2012).
Indeed, it is hardly a coincidence that the two liberal economies that preserved ‘safe
asset’ status for their government bonds had central banks willing to engage in repeated
rounds of quantitative easing, that is outright purchases of government bonds.
Absent the political and ideological conditions for such interventions,
governments remain the only institution to stabilize their debt market. Expansionary
fiscal policies that generate growth could be one option, yet the familiar time lags
involved in fiscal expansions imply that in the first place, higher expenditures will
increase funding needs in a finacialized market guided by short-term considerations.
Higher expenditures stand to worsen the crisis. The only remaining option is to reduce
the supply of government debt. And it is this path that all threatened Eurozone economies
chose, irrespective of the varieties of capitalism they belonged to.
Conclusions
The global financial crisis has made the varieties of capitalism literature more attentive to
macroeconomic policy preferences. While the original version of Varieties could not
explain the convergence to the fiscal policy preferences of the coordinated model, recent
revisions highlighting how external imbalances interact with existing institutions are
better equipped to do this. However, even the extended framework continues to neglect
the causal importance of finance for he rush to austerity in the Eurozone. To address this
gap, we examined the financialization of sovereign bond markets as a critical factor in the
European austerity drive and as a progressive augmentation of the Varieties approach.
The VoC framework suggests that institutional constellations dictate
macroeconomic preferences. Coordinated economies typically chose conservative fiscal
responses to crisis, whereas fiscal expansion is the standard fiscal policy line in
recession-stricken liberal regimes. These preferences, together with distinctive regulatory
attitudes towards risky financial activities, constitute the key mechanism that generates
instability in developed capitalist economies. From this perspective, austerity becomes
the response to asymmetric pressures on liberal and mixed regimes. Governments there
have to redress their external imbalances once the flow of capital from coordinated (or
export) economies came to a sudden stop. Specifically, the institutional
complementarities of export economies support the buildup of surplus savings,
discourage risky financial practices and prevent consumption-led, credit-financed growth
based on high-risk finance. But before the crisis struck, these economies also exported
their surplus savings to liberal and mixed “peripheries”, bankrolling imbalances that
polities there had no incentive to reduce. The main consequence of the crisis was that the
sudden stop in these capital flows forced “periphery” governments to resist their penchant
for expansionary policies and instead combine wage restraint with conservative
macroeconomic policies to bridge funding gaps. Yet because liberal and mixed regimes
could not restore their external competitiveness through coordinated wage setting
institutions and monetary policy autonomy, fiscal policy consolidation remained the only
available macroeconomic policy choice.
This is a compelling account. The pressure to rebalance was indeed pivotal, but
missing from this explanation is the story of why the sudden stops occurred and why
governments respond with austerity. While for new Varieties literature a sudden stop still
remains a black-boxed exogenous shock, our account shows that the workings of he black
box can be gauged from the shifting perceptions of banks’ collateral managers about
sovereign risk and their incentives to be loyal or not. We clarify why these actors came to
matter in the first place by showing that the pre-crisis shift to transnational market-based
funding of European banks’ locked banks and sovereigns together in an embrace that led
governments towards austerity rather than any other instrument of rebalancing. Our key
finding is that sudden shocks may force deficit economies to rebalance, as VoC argues,
but if the government’s bonds had remained on the books of loyal investors, the
governments’ ability to borrow would perhaps have been preserved and austerity could
have been avoided.
Investors’ disloyalty to their sovereign bond placements is an important
determinant of austerity as policy. What makes investors disloyal are their low exposure,
the availability of alternative investment opportunities, the buildup of diversified
collateral portfolios and a market dominated by mark-to-market valuation techniques .
Although these insights were developed with emerging markets in mind, we found that
investors in the sovereign bonds of the Eurozone’s liberal and mixed “peripheries”
behaved with the same impatience as investors in highly financialized bond markets for
emerging economies. Before the crisis, European banks relied increasingly on crossborder market funding. The demand for sovereign bonds boomed, spurred on by the
European Commission’s policy of making all the sovereign debt for periphery countries
equally eligible as collateral in private European repo transactions. This provided more
collateral at the cost of eroding banks’ loyalty to their native government bonds, as the
diverse investor base and the availability of alternative sources of collateral reduced the
costs of exit for banks faced with sovereign risk. In sum, the Euro plus the repo turned
ostensibly European lending into international lending in a common currency with
disastrous results when the sudden stop occurred. Sovereign bond downgrades trigger
margin calls, prompting managers to "disloyally" head for the exits. This is precisely
what happened in 2010, when downgrades of “periphery” bonds rendered them ineligible
or expensive to post as collateral due to higher haircuts. As a result, collateral managers
in banks had no choice but reduce exposure to lower-value bonds, even if they were their
own government’s. Thus, banks’ loyalty towards governments became closely tied to the
collateral qualities of debt.
The situation in the Eurozone was further complicated by the fact that in early
2010 European Central Bank did not steadfastly commit to repair the damaged collateral
function of “peripheral” sovereign bonds, as it did in 2009. Just as downgrades chipped
away at the collateral value of these bonds, making investors increasingly disloyal, the
ECB withdrew extraordinary liquidity interventions. In these conditions, the governments
of liberal and mixed governments had to address the disruption of collateral markets for
fear that bank runs would wreck their countries’ banking systems and take the national
economies down with them. Since the attempt to absorb these costs through expansionary
fiscal policy could only make the problem worse given these constraints, leading to
further downgrades, the onus fell upon European governments and the societies they
governed to pay the price of stabilizing collateral markets. The collateral damage of
collateralization is austerity.
Theoretically, our argument is a refinement of the new Varieties account of policy
after the crisis. To fully explain this outcome the incentives of collateral managers must
be married to the Varieties literature’s insights on how the institutional makeup of liberal
and mixed regimes transforms them into deficit economies, while forcing a rebalancing
when they face sudden stops in capital flows. In turn, rather than relegate sudden stops to
exogenous shocks as does the new Varieties literature, our approach clarifies the
mechanisms of the shock and explains why austerity was perceived to be the only
instrument of rebalancing left in the Eurozone’s liberal and mixed regimes. As such, the
main lesson of the paper is that it was not just the interactions between the different
institutional complementarities of varieties of capitalism that explain pan-European
austerity, but also transformations in the way European banks used the bonds of
European sovereigns in their cross-border funding strategies.
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