Fiscal Policy in Financialized Times: Investor Loyalty, Financialization and the Varieties of Capitalism

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28 Οκτ 2013 (πριν από 3 χρόνια και 7 μήνες)

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Fiscal
P
olicy in
Financialized T
imes:

Investor Loyalty,
Financialization
and

the V
arieties of
C
apitalism


Daniela Gabor


(Bristol Business School) and
Cornel Ban

(
Boston

University
)

10742 words


Abstract:
T
his 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, s
udden

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 German
y
, 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 market
s 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
.
W
ithout analyzing the process through
which
the collateral

motive ignited a
run on peripheral
sovereign bond

markets
, which in
turn

and
compelled

states to stabiliz
e

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 Europea
n
Union. T
he 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 Pontusso
n and Raess (2012) as “liberal Keynesianism
,


it i
s
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 Sosk
ice 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
. I
n doing
so
we
highlight
distinct financial

mechanisms for convergence in macroeconomic
trajectories. Specifically, we
examine the
recent

varieties literature th
at 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 i
nstit
utional
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
.
C
oordinated 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 punc
ture
these
institutional equi
libriums. 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 aft
er reunification
(Carlin, 2012), and with constraints on autonomous monetary or exchange rate policies,
fiscal policy shifts to a conservative stance
3
.




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 pr
edicted 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
capitali
st 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 countr
ies.
We introduce an
additional
concept

of investor loyalty in sovereign bond markets,
which we
term the
collateral motive


investor demand
for
governm
ent 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 201
2
;
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

erod
ing

investors’ loyalty.

Th
is

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’ fun
ding conditions
s
uch

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 ba
nks comm
it

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. W
e 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 explanato
ry
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
macroecon
omic 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 mo
del
(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 skills
4
. Fiscal policy thus relies on in
-
bu
ilt 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, c
onsensus
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
wage
-
inflation

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 effect
s
.
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 betw
een
macroeconomic policy preferences and economic outcomes. While earlier research
stressed domestic economic outcomes
6
,

current contributions argue that the differences
observed in aggregate management regimes matters in a more fundame
ntal way.

Yet m
acroe
conomic 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
).
T
he 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
a
ction

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 th
e context to
this ‘imbalanced
macro’

hypothesis.

T
he combination of permissive mon
etary 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, the
se imbalances
took

the form of
current
account surpluses

in northern European countries, channeled by the
ir

banking
sectors into
housing and credit bubbles in ‘S
outh
ern’

economies
7

(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

eith
er

stimulate domestic
demand in
Northern countries or increase

competitiveness in the ‘periphery’
(Schnabl
and Freitag 2012
).

But hav
ing attributed responsibility to
imbalanced macro regim
e
s
, this




4

For a critique of the conflation of welfare generosity and coordination see Thelen (2012).

5

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 competitiv
eness, 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.

literature cannot explain
why

policy
-
mak
ers failed to
address

imbalance
s

in the first
place
.
The post
-
crisis revised Varieties literature

attempts to

provide that answer.


Why the
C
risis
H
appened
:
G
lobal
I
mbalances

Meets the New

Varieties Literature


Committed to a causal story that rests on complementary institutions, the new
literature
makes

three main revisions. First, it reframe
s

coordinated economies as export
economies (Soskice and Iversen 2010a), second it introduce
s

the real exchange rate as a
determinant of comparative competitiveness (Carlin 2012; Carlin and Soskice 2009;
Soskice and Iversen 2010a; 2010b) and, finally, it examine
s

these processes against the
background of the free flow of financial capital across borders. Based on these revisi
on
s,
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
).
T
he 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, o
vervalued 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 h
igher wage
demands will prompt co
nservative central banks to raise interest rates and ap
preciate the
real exchange rate,

u
nions prefer wage restraint to contain real exchange rate
appreciation
, preserve
employment and the long
-
term investment in high skills.
From this
perspective, the lit
erature 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 Gingeri
ch,
200
4), 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 savings
8
.
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
. E
xport
-
oriented
economies avoid risk
y financial innovation because the
high skilled workers are reluctant
to enter

high
-
risk careers. Moreover, consensus
polities

generate

a cautious attitu
de 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 accumula
tion of general skills encourag
e
s 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 t
he United Kingdom pre
-
Lehman testifies

(Moran 2006)
.
As a result, finance in export
-
led economies remains
‘patient’ at home, but looks for profitable placements abroad and
find
s

them in liberal
economies.

The example of the

Dutch banks or
German L
andesban
ken
illustrates well this
point
. These
invested
into
new financial instruments developed by the US shadow
-
banking sector

(
Bruno and Shin
, 201
2
).

Closer to home, banking sectors in export
-
driven
European countries intermediated large capital flows into sout
hern 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 201
1
).
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 mo
del 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 t
he
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 competiti
veness

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
finan
cial 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, i
t lacked

the necessary
large
wage
-
s
etting in
stitutions (Carlin 2012
) that
deliver
ed

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


Th
is

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 (
Ivers
en 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
S
pain, 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 c
apital inflows
as private financial
actors reduced their exposure to Southern European countries (Mayer 2012).


The revised
VoC framework
can provide

insight
s

into fiscal convergence whenever sudden stops
occur.

Typically,
policymakers do not respond to ex
ogenous constraints in easily
predictable ways (Widmaier, Bly
th 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
. I
n this crisis,
the archetypal liberal model, the US,
resemble
s

coordinated economies
because distress
in international financial markets translated into an
increase

rather than a reversal, in
capital inflows
10
.
In turn
,
export
-
led coun
tries 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 co
untry 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 (Blyt
h 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
glob
al finance

(see Carlin 201
2
)
.

Critically, t
he
wage
-
setting
institutions of the private



9
Merler and Pissani
-
Ferri (2012) identify three ‘waves’ of sudden stops in the Eurozone crisis: the post
-
Lehman deleveraging affecting primarily Greece and Ireland during Oct. 2008
-
January 2009; the May 201
0
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 his tory of financial cris is, the US is atypical: whereas financial capital us ually
abandons the countries at

the center of the cris is, the collaps e of Lehman triggered a s earch for s afe
-
heavens that trans lated 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 compe
titiveness
.

S
udden stops

require immediate
policy
responses;

otherwise
countries face

a balance of payment crisis
. W
ithout
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.
G
overnments
in
deficit

economies
are more likely
to puncture the institutional equilibrium
underpinnin
g the
traditional
fiscal
policy stance
because

they have to curtail

current account deficits
.


Bringing
F
inance
Back In


Although

the revised account
involves

a new treatment of finance
, it remains ill
-
equipped

to explain the relevance of international finance for macroeconomic policy
responses
.
Insofar as finance
mattered in the early literature
, it d
id

so through the firm
lens.
The original
framework

classified finance according to its relationship to product
ive
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

rel
ied

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). T
he debate
,

then
,

typically focused

on
metrics that confirm
ed

or challenge
d

the relative impor
tance of banks or stock markets

in
distinctive mechanisms of

coordination

(Engelen et al, 2011)
. It often suggest
ed

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
recogn
izes that banks in coordinated economies may have become mor
e than ‘patient’
lenders. Yet

because it defines propensity to risky financial innovation through the nexus
of skills
-
formation/regulatory attitud
es, 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 2010
a
).
The m
ethodological
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
-
var
ieties funding of risky
innovations and

somehow return finance to behaving according to the predictions of
varieties of capitalism.

Most importantly, however

th
e details of financial intermediation
are relevant
for
national economic performance but not for

discretionary fiscal policies
. The
high
-
risk

framing cannot identify new mechanism
s

of coordination that would render financial
institutions relevant to fiscal policies in the same way that wage
-
setting institutions or
coalition politics matter (Carlin an
d 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 interban
k 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 dur
ing 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 liqui
dity 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 accommoda
tive 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
t
hat
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, g
overnments may have to please markets even
if these are

sus
pect
ed

of speculative intentions
(Corsetti et al 2010; 2012)
.

Yet t
his 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 an
d uncertainty
in the pricing of sovereign risk (de Grauwe and Ji 2012)
.

D
oubts about the government’s
ability to service its deb
ts
become self
-
fulfilling

(
Gros, 2012)
.


I
n 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
doin
g 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 20
11, 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 part
icipants, 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.
T
he financialization of market struct
ure is
functiona
lly equivalent to its liquidity:

l
iquid 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 strategie
s. 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 contribute
s 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 coun
try affected by sudden stops (Broner et al 2011)
.
If patient
finance is what states need in hard times, t
he 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

financia
lization lens suggests that
the higher
the
relative exposure,
the more loyal the bank

and t
he 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 alternat
ives, 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 m
arkets, 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
-
to
-
market 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 govern
ment 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 expos
ure
, 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’.
E
ven impatient investors prefer th
e liquidity of such
government bonds during crisis
, a widespread view
in the literature (Dow 20
12
), 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, w
e
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 cha
nging
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 mot
ive 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 high
-
income European countries during the decade prior to the crisis
transformed

sovereign
bond markets into collateral m
arkets. 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 strategi
es of funding (BIS
2011, ECB 2011,
Bruno and Shin

201
2
). These trends can be confirmed empirically by
comparing the
sources of funding for
large banking system
s

(see Figure 1).

Indeed, most
European
banking systems
, whether from ‘bank
-
based’ or ‘market
-
bas
ed’ 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 securities
13

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 res idential
-
backed mortgage s ecurities, commerc
ial mortgage
-
bas ed s ecurities, 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 liqui
d
ity 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

market
s
.



Figure
1

Share of customer deposit in total
funding, selected European banking
systems, June 2010


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 al
most 20% between 2001 and 2007, driven by similarly
rapid expansions in both US and European segments
14
.
European r
egulators
encouraged
the rapid growth of this over
-
the
-
counter market, commending it as a demonstrable
benefit of financial innovation that
im
proved 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).

0
20
40
60
80
underlying collateral, c
ollateral bec
omes
a tool for risk management. In the event of the
cash
borrower
’s

default, the lender can recover her loan by selling the collateral.

T
he 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, whic
h

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 sat
isfied 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 context
s
.
One avenue involved
collateral mining
15

(Pozsar
and Singh 2011) that ‘unearthed’ sovereign debt instruments from ‘buy to hold’
portfolios of patien
t 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).
Furt
hermore,
‘safe assets’ theories argue that
the production of structured
securities at the core of the US financial crisis was underpinned by a collateral motive
16
.
Shadow banks produced
structured securities to
address

the shortage of the typical safe
asset
s, US sovereign debt, prior to 2008 (Pozsar 2011, IMF 2011).
Put differently,

shadow
banks
increase
d

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.

T
he 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 a
nd Jeanne, 2011).
Basically, Germany didn’t generate
enough debt relative to the demand for it. To solve this problem t
he European
Commission proposed to address
the shortage

by regulatory reforms (
The
Giovanni
Group 1999).
It

introduced legislation
to ea
se

the legal constraints to the cross
-
border use
of collateral and ensure equal treatment of Eurozone sovereign debt in repo transactions
17

(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

Colla
teral mining ‘i
nvolves 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 as s et backed s ecurities, as s et backed s ecurities, RMBS, CMBS, CDOs, CLOs )

17

In the US or UK, the s overeign collateral in funding
-
driven repos includes a homogeneous bas ket of
s overeign debt ins truments (s o that the maturity of ins truments do
es not matter). In contras t, the European
s overeign rates are compiled on a bas ket of s overeign bonds is s ued 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 integration
18
.

At first, finan
cial markets confirmed
the Commission’s
expectations.

S
overeign
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 circu
lated 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 (IC
MA 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 collat
eral 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, t
h
e 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
. T
he share of own government
col
lateral

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
Europea
n 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


200
1

2005

2007

2008

2009

2010

Collateral

National

63

39

36

31

36

31

Euroarea

27

57

60

65

59

64

Counterparty

National

43

29

38

31

32

37

Euroarea

36

51

42

48

44

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 pr
oject 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

D
emand
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 demand
ed Euro

area collateral

to diversify
collateral portfolios
,

sharpening the internationalization of sovereign debt ma
rkets

(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 instituti
onal 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 alt
ernative instruments.




Table
2

Participants in sovereign bond markets (holdings as % of overall volume)


Domestic
banks

Foreign
banks

Non
-
bank
holders

Austria

6%

18%

76%

Belgium

9%

16%

75%

France

8%

8%

84%

Germany

34%

13%

53%

Netherlands

10%

16%

74%

Greece

19%

16%

65%

Ireland

7%

32%

61%

Italy

9%

12%

79%

Spain

41%

12%

47%

UK

6%

3%

91%

Source: EBA Stress Tests, 2010



T
aken together this

diverse investor base and
the availability of
alternative sources of
collateral reduce
d

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 2
011 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 ba
nks 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 market
-
dependent, funding around 23% from interbank market sources for which it requires high
quality collateral (BIS 2011 and Figure 1 abov
e). 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.

T
he collateral motive

decrease
d

loyalty in
still
more fundamen
tal 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 bo
oks 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 ba
nking, 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
default
s
, 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
.

B
y 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 falling
20
. The possibility of margin calls requires
borrowers to either maintain
(expensive) reserve collateral or have ready access to high
-
quality collateral.

Thus
, mark
-
to
-
market practices

in collateral management

erode investor loyalty
, just as Hardie (2011)
described in the case of international invest
ors in emerging countries’ bond markets.

C
ollateral 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 Enge
len 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 do
wn (and yields up) unless private actors or the
central bank increase demand.

In a crisis, c
ollateral managers have every incentive to





half of
2011.

20

For example, a Spanis h bank that pos ted Spanis h s overeign collateral for a three
-
months repo initiated in
March 2010 would have had to pos t additional collateral to compens ate for the fall in the price of Spanis h
collateral triggered by contagion f
rom the Greek cris is.

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 i
n valuations
may trigger sudden stops in collateral markets
.


Collateral Damage in

the Euro Crisis


The valuation of complex deb
t 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 u
ncertainty about the value of structured securities. What
ensued, Gorton and Metrick (2009) showed, was a sudden stop i
n the repo segment using
structured

products
as collateral.
I
n 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 less
on 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, hig
h reliance on external funding).

C
oncerns 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 f
ell 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,
c
ountry
-
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
201
0
).
In May
2010, the ECB signal
led

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 offe
red 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 r
epo 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 house
21
.
The
LCH Clearnet
uses a rigid rule: if the yield on a
sovereign bond increases by more than 450 basis points abo
ve

a basket of AAA rated
ass
ets, it will trigger margin calls.
When the Irish yield went above that threshold i
n
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
-
I
rish 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 21
st
, 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
.

C
ollateral 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
th
eir

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 i
n 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
.

F
or 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 app
arent 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
tighten
ed
,
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 co
unterparty (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 t
o the European debt crisis. Where firms are
declining PI
I
GS 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 prom
pted these to curtail credit to the domestic economy
(thus worsening the recession) to offset the loss of access to market funding
23
. It also
triggered changes in their collateral strategy: t
o avoid such coordinated risks, b
oth 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
-
iris h
-
marg ins
-
are
-
biting/

23

http://www.ft.com/cms/s/0/1b6855b8
-
c404
-
11e0
-
b302
-
00144feabdc0.html#a xzz24wgcv2mx

and Spanish banks re
duced 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 strateg
ies inevitably lose loyalty, in Hardie’s sense, towards the
ir
home sovereign
.


Figure
2

Share of domestic government debt in total government debt portfolios, selected European
banking sectors, June 2010



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
)
.
G
overnments have to absorb the costs
of bank
restructuring or

bank

failure

because
bank runs would destroy the banking
system.
But if h
igher
spending

increases sovereign risk

(Merler and Pissani Ferri, 2012)
,
it can disrupt the collateral
function of sovereign debt
,
with

adverse effects on banks’
fun
ding conditions

(BIS 2011)
, particularly where those banks are ‘loyal’ banks.

The
ingredients for a sudden stop in the sovereign collateral market are
therefore
al
ways

present

because

this

interdependence between banks and sovereign creates a
problem of
co
ordination:
who
will

assume responsibility for
preventing a run on the sovereign
collateral

market
?

Private domestic ba
nks cannot resolve this problem because of the
impatient nature of collateral management discussed above. Central banks may be better
can
didates
because theoretically

there are no constraints to the
ir
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)
.
I
ndeed, i
t 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 repeate
d
rounds of quantitative easing, that is

outright purchases of government bonds.

0
10
20
30
40
50
60
70
80
90
100

Absent the political and ideological conditions for such interventions,
governments remain the only institution to stabiliz
e their debt market. Expansionary
fiscal policies that generate growth could be one option, yet the familiar time lags
involved in fi
scal expansions imply that in the first place, higher expenditures will
increase funding needs in a finacialized market guided by short
-
term considerations.
H
igher expenditures stand to worsen the crisis. The
only remaining

option is
to
reduce
the supply o
f government debt. And it is this path that all
threatened
Eurozone economies
chose, irrespective of the varieties of capitalism they belonged to.



Conclusions


T
he 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
inte
ract 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
examine
d

the financialization of so
vereign 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. C
oordinated economies
ty
pically chose conservative fiscal
responses to crisis, whereas

fiscal expansion
is

the standard fiscal policy line in
recession
-
stricken liberal regimes.
T
hese 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 fina
ncial 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
macroecon
omic 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 li
terature

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.
W
e 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 th
an
any

other instrument of rebalancing.
Our key
finding is that s
udden 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 perh
aps have been preserved and austerity could
have been avoided.


I
nvestors’ 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 alternati
ve 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 bon
ds of the Eurozone’s liberal and mixed “peripheries”
behaved with the same impatience as investors in highly financialized bond markets for
emerging economies.
B
efore the crisis, European banks relied increasingly on cross
-
border 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

erod
ing

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 governmen
t’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 dama
ged 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 con
ditions, 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 t
hese 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 mark
ets.

The collateral damage of
collateralization is austerity.

Theoreti
cally, o
ur 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 V
arieties 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
exog
enous shock
s
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, t
he
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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