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 PolicyFor 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 in-built 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 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 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 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.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 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.

Why the Crisis Happened: Global Imbalances Meets the New Varieties LiteratureCommitted 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 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 pre-

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).

Lehman 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 shadow-banking 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 inflows10. 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 sector autonomously generate exchange rate realignments that protect coordinated models from the problems associated with overvalued exchange rates.

9Merler 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 2010 Greek bailout that generated contagion to all GIIPS countries, and the end of 2011 renewed pressures on Italy and Spain. 10In 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 safe-heavens that translated into large capital inflows into the US financial markets.

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 InAlthough 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 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 SeriouslyThe 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 AusterityThe 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 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

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.

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 marketsThe 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 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 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 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.

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

France UK

Italy

Netherla

nds

Austria

Germany

Spain US

Japan0

20

40

60

80

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 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

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).

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 mining15 (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 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

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)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.

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

2001 2005 2007 2008 2009 2010Collateral National 63 39 36 31 36 31

Euroarea 27 57 60 65 59 64Counterparty National 43 29 38 31 32 37

Euroarea 36 51 42 48 44 44source: compiled from Euro Money Market Survey

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)

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

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 Eurozone19 according to ICMA (2011) statistics. The French banks’ 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 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 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 half of 2011.

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, mark-to-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 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 CrisisThe 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

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.

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

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.

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 LoyaltyThe 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 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.

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

Figure 2 Share of domestic government debt in total government debt portfolios, selected European banking sectors, June 2010

Netherla

nds

Belgium

Denm

ark

France

Sweden

Austria

Ireland

Germany

Portugal

Italy

Spain

Greece

0

10

20

30

40

50

60

70

80

90

100

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 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 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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