international analysis and commentary

The link between jobs and finance in Europe

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The job crisis in Europe is one of the major consequences of the economic crisis that started in the financial sector five years ago. It has not been taken seriously enough by the European Commission and the European governments who, since the Greek crisis exploded, have (on the contrary) privileged austerity measures, convinced that these were necessary to re-establish confidence in the sovereign bond market.

Proof is in the rise in unemployment in the euro area which went from 7.6% in 2007 to 11.4% in 2012. Among youth aged 15 to 24 unemployment reached 24% in 2013. The OECD estimate of discouraged workers (those who give up on trying to find employment because they think it is impossible to find a job) in the EU-21 was more than one million people in 2012, almost double compared to the years prior to the crisis. In 2007, involuntary part-time workers (part-time workers who would like to work full time but are unable to find full-time employment) represented 15.7% of all part-timers, in 2012 that number went up to 19.3% (OECD).

Part of the explanation behind the transfer of the crisis from the financial sector to the real economy – and thus to employment – is the so-called “credit crunch”, or the massive reduction in credit and liquidity available from the banking system. In Europe, more than in other regions, bank credit is the main source of funding for the private sector. This can partly explain the size of the banking sector in Europe, which is very large compared to other contexts: European bank assets represent 349% of EU GDP, while in the US they represent only 78%. In Europe concentration is also higher: the top ten banks hold almost one third of the total assets of the sector, that is 122% of GDP, while this proportion is 44% in the US (2010 data from Liikanen Expert Group).

Following an analysis conducted by the High-level Expert Group on reforming the structure of the EU banking sector chaired by Erkki Liikanen, a Finnish politician and the Governor of the Bank of Finland, that was presented to the European Commission in early October, we know that prior to the crisis European banks engaged in excessive risk taking that was not matched with sufficient capital protection. They had large mortgage backed security positions (among which a large portion were subprime) and excessively relied on short-run funding. Moreover, they were strongly exposed on interbank lending (e.g. small banks were often creditors of large groups, for amounts that exceeded their own capital), in a context where exposure rules on interbank loans were (and still are) missing. From October 2008 through the end of 2010, European governments spent 1.6 trillion euros to support the banking sector, to which we must add the implicit subsidy to those banks that were considered “too big to fail” and that were backed by state guarantees on bank debt holders.

But, then, why isn’t Europe recovering from the credit crunch? First, because of a misplaced fear of inflation when it came to intervene in the sovereign debt crisis. Even though there is no reason for a risk of booming inflation (in September 2013 it was a little higher than 1%), this fear slowed down the process of making the ECB a lender of last resort by purchasing bonds of Member States. This decision was finally taken in September 2012 and had an important effect of reducing interest rates on the government bond market. As the economist Paul De Grauwe has argued, this highlights the fact that high interest rates were a consequence of sheer panic and did not reflect “economic fundamentals” of the Southern European countries: after the intervention by the Central Bank, interest rates declined, while debt/GDP continued rising as a consequence of austerity measures.

A major problem with the ECB’s role is that in order to intervene, the bank requires tighter budgetary cuts that will deepen the recession. Recession and lack of demand explain, then, why the private sector does not invest even though interest rates are lowering: investments are mainly constrained by the prospect of low sales and by the decline in orders from downstream firms and from the public administration. Some economists (such as Nouriel Roubini) claim moreover that the ECB should start using the unconventional instruments of monetary policy that its equivalents in other countries use (FED, Bank of England, Bank of Japan) and engage in quantitative easing, that allows to increase the monetary base, when decreasing short-term interest rates does not prove effective.

Looking closer at the banking system, we see nevertheless that the increase in monetary base by the ECB doesn’t translate into more loans by the banks. For example, a very recent study conducted by the Italian organization of small and medium firms (Unimpresa) argues that, in Italy, between May 2012 and May 2013, loans decreased by 58 billion euros.  

There are two sets of reasons for this: the first is the financial institutions’ willingness to accumulate liquidity for fear of another downturn, at the expense of credit provision to other sectors of the economy. Raising capital is also the direction indicated by the European regulatory system on banks, but risks to be pro-cyclical if not counterbalanced by incentives to use collected capital to finance the economy.

The second set of reasons relies on the small and decreasing importance of customer loans in the overall assets of banks. This applies in particular to loans to households and non-financial corporations: in March 2012, these amounted to 28% of the aggregate balance sheets (report of the “Liikanen Expert Group”). There has been a shift from deposit taking, lending, securities underwriting, and trust services towards market-making activities, brokerage services, and personal account trading; the proportion of interbank lending in total lending increased over time and intermediation chains lengthened.

This raises a matter of regulation. In the Liikanen report, it is stated that: “Given the severity of the crisis, one may have expected a rapid restructuring of the banking sector (…). However, the restructuring of the EU banking sector on aggregate has been relatively limited to date” (p. 25). Even though the lesson of the financial crisis was that such a strong deregulation of the financial sector was detrimental to the whole economy, we are still lacking a reform of the banking sector. One of the major recommendations of the cited report is to require legal separation of particularly risky financial activities (such as proprietary trading of securities and derivatives) from deposit-taking banks within each banking group.

A positive step in this direction was the vote by the European Parliament in September 2013 on the “Single Supervisory Mechanism”, which is the first step towards a European Banking Union: the hope is that a banking union would monitor the European banks, the level of risk and the guarantees on deposits. This project is not without opponents, namely the German government (at least before the elections). What is needed now is a common bank resolution mechanism and a single rulebook that everyone can follow. The path toward a stronger regulatory framework for European banks has to be continued, with more attention focused on the needs of the real economy and employment.