Macro-financial crises: Impeding the rush for the exit
Patrick Honohan 30 October 2020
When the Minsky moment (Minksy 1975) occurs with the denouement of a macro-financial crisis, the smart money rushes for the exit, especially if the banking sector is implicated in the crisis. Those who exit hope to escape loss, but their efforts often impose heavier losses on others. What can the authorities do?
Despite the extensive historical record, there is no universally acknowledged playbook; no consensus on the value of currency depreciation, creditor bail-in and administrative controls on capital movements as ways of dealing with the incipient outflows.
Governments generally hesitate before adopting these measures because of the adverse side-effects on different interest groups, and because the longer-term consequences seem unclear. Will currency depreciation result, unleashing lasting high and volatile inflation? Will bail-in of the creditors of failed banks undermine future access of the sovereign and of private firms to the financial markets? Can capital controls be anything more than a stop gap, buying time for more far-reaching action?
These are questions that are likely to become relevant again as the pandemic recession has its knock-on effects on the solvency of firms, households and their bankers. Lebanon is likely only the first in a new wave of countries facing such pressures.
Three European cases during 2008-13, each of them a fall-out of the Global Financial Crisis, illustrate sharply different approaches to crisis-driven outflows. All three countries faced over-extended fiscal positions and deep insolvencies in their over-dimensioned banking systems once the pre-crisis boom had ended.
- The exchange rate of the Icelandic krona collapsed, capital controls were introduced and overseas creditors of the banks were bailed-in.1
- There was, of course, no currency depreciation in Cyprus, but depositors in failed Cypriot banks suffered bail-in and there were administrative controls on bank deposits and international transfers.2
- Ireland employed none of these tools.
Although each of these three countries suffered a deep recession, each also saw a strong post-crisis economic recovery and each has seen a rebound in its international credit rating. It is clear that the policy choices that were made were partly determined by pre-existing country conditions and partly by considerations of international spillover that guided the terms on which official assistance was provided.
In 2008, Iceland had no practical alternative to currency depreciation, and the capital controls – instigated, to the surprise of many, by the IMF – moderated only somewhat the decline which occurred (Honohan 2020). Bail-in of bank creditors was also pre-ordained by the scale of the Icelandic banking system and its losses. Iceland largely managed to insulate its domestic banking and payments system from haircut and disruption, thereby avoiding the hostage scenario which has impeded the use of bail-in in other banking systems. Interestingly, by trapping onshore assets of the foreign creditors of the failed banks, the capital controls enabled the government to lever a large ‘stability contribution’ before the controls were eventually lifted.
Ireland’s banking losses were much smaller than those of Iceland in proportion to the economy, so its initial 2008 guarantee of substantially all bank liabilities, though unnecessarily comprehensive, was more affordable (Honohan 2019). This was a home-grown policy but, when Ireland thought to haircut some newly unguaranteed liabilities two years later, that was vetoed by the Troika lenders, who feared spillover effects in the euro area bank bond market. Currency depreciation was also ruled out in Ireland by virtue of its use of the euro; on the other hand, access to Eurosystem liquidity meant that capital controls were not needed or considered in Ireland.
The currency question strongly influenced the distributional pattern of the recovery in Ireland and Iceland. Currency depreciation moderated Iceland’s employment decline and speeded the macroeconomic recovery, whereas in Ireland job losses were proportionately much larger and the recovery slower – though automatic social welfare stabilisers acted to limit the increase in income inequality that would otherwise have occurred. This is shown in Figure 2, which illustrates how real wages continued to rise in Ireland to 2009 and declined only gradually thereafter, whereas they fell precipitously in Iceland after 2007 when the exchange rate collapsed. Employment fell only half as much in Iceland as in Ireland.
Inflation in Iceland did surge for a while after the collapse of the exchange rate, with a couple of years of double-digit price rises. But annual inflation averaged only about 2% after 2013, so, despite Iceland’s chequered historical record with high inflation, the 2008 event did not create a lasting inflationary environment. Being in the euro meant that Ireland’s inflation was even lower – indeed, close to zero on average since 2008, so well below target.
Cyprus, like Ireland, was in the euro area when its crisis crystallised in early 2013, but official thinking in Europe on bail-in and capital controls had changed. Besides, banking stability had largely been restored elsewhere in Europe by then. (A perception that many non-resident depositors might be from Russia may also have been a factor in European officials’ willingness to tolerate bail-in.) The bail-in of depositors in the two main banks of Cyprus was quite severe. One of them was liquidated, and uninsured depositors lost about 95%; in the other, about one-half of uninsured deposits were converted to equity, effectively recapitalising this bank without an injection of government funds (Honohan 2020).