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Unregulated Capital Markets

The „Deregulation of capital markets“ is an essential driving force of the current crisis. This means a gradual reduction of legal ruling of global financial markets, but especially in the USA and Europa. This development has significantly increased the scope of action of financial actors like banks, investment fonds, hedge fonds, insurances, etc. and triggered fundamental changes in the way our economic system works.

Fatal Evolution

While real economic projects and business ideas constituted the focus of business activity until the early 1980s, fiscal motives and considerations dominated afterwards. Investing in companies that produce and sell goods and services was reduced in favor of financial products which promised yield by exploiting price changes of internationally traded assets (stocks, bonds, commodities, derivatives, etc.). Said progress of change is interrelated with the deregulation of capital markets in a decisive manner. The basic function of the financial sector is the conversion of short-term deposits into long-term loans in order to fund ventures. Financial regulation was charged with the task of binding finance to thus function. Upon removal and non-actualization of legal rules the financial sector gained new freedoms, which promoted a casino mentality and caused neglect of its original purpose: the long-term funding of businesses (Boyer 2000, van Treeck 2009, Schulmeister 2010).

This deregulation can be experienced in many areas and contexts. Deregulations are, for example, relaxations of regulations for banking operations (especially in the USA where the Glass-Steagall-Act was disestablished which kept commercial banks and investment banks apart and thus drew a line between banking and casino), global evasion of safeguarding provisions in the context of bank lending (due to special financial innovations), the abolition of capital control, the enablement of unrestricted international capital movements, and the liberalization of the international currency system through the abolition of fixed exchange rates in the early 1970s. All these relaxations created advantages for assets and capital - such as the greater possibility to transfer assets to tax havens (area of the so-called offshore economy) (Hein und van Treeck 2008).

New Requirements

Alongside this new perspective, prevalent business and national economic views changed as well: Although there used to be the notion that wages and productivity should rise alike in order to enable employees to buy the goods produced by them, nowadays it has become most important to maximize profits in order to be attractive to foreign investors - the economy started orientating itself by the stockholders’ interests. The positive feedback of mass production, mass income and mass consumption (Busch und Land 2009) was hence interrupted and priorities inverted: Welfare state policies or fair wages rather seemed hindering in the pursuit of internationally flexible investment, while further obstacles for financial operations were removed and flexibilization of working conditions were regarded suitable tools. Contrary to real economic investments which potentially create value and thus increase our wealth, investments in the financial system are zero-sum situations which do not lead to increased wealth but merely redistribute existing wealth among the players - all by just betting against each other on future market trends.

Massive Growth

Abolishing protective mechanisms in bank lending led to a systematic multiplication of risks borne by the financial sector. Parallel the volume of the financial sector also rose massively. This is indicated by the enormous sums of money transacted on the capital markets which have quadrupled within the past 20 years (Stockhammer 2008; please find more information under speculation).

The crisis may have convinced politicians of the necessity of more financial regulation but due to a lack of international coordination and political influence of finance, a fundamental realignment of the financial system and its relevant branches is yet to be conducted.


Boyer, R. (2000): Is a finance-led growth regime a viable alternative to fordism – a preliminary analysis. Economy and Society, 29(1). pp. 111-145.

Busch, U. und Land, R. (2012): Teilhabekapitalismus, Fordistische Wirtschaftsentwicklung und Umbruch in Deutschland 1950 bis 2009. In: Forschungsverbund Sozioökonomische Berichterstattung (Eds.): Berichterstattung zur sozioökonomischen Entwicklung in Deutschland. Teilhabe im Umbruch. Zweiter Bericht, Chapter 4, Wiesbaden. pp. 111-151.

Hein, E. und van Treeck, T. (2008): Finanzmarktorientierung. Ein Investitions- und Wachstumshemmnis?, IMK-Report 2008(26)), Duesseldorf.

Schulmeister, S. (2010): Mitten in der großen Krise: Ein New Deal für Europa, Wien.

Stockhammer, E. (2008): Some Stylized Facts on the Finance-dominated Accumulation Regime, Competition & Change, Vol. 12. pp. 189-207.

van Treeck, T. (2009): The political economy debate of ‘financialization’ – a macroeconomic perspective. Review of International Political Economy, 16(5). pp. 907-944.

Free Capital Markets

International capital mobility means that money can be transferred to beyond the borders of one country to another without limitations. This implies that capital can always be invested where low tax rates or high yields are to be expected. Capital mobility was promoted especially due to the elimination of capital control. These were, in fact, implemented in order to limit capital mobility, which would prevent destabilizing effects on the economy from occurring. Said barriers were mostly abolished in Europe between the late 1970s and early 1990s (Vernengo und Perez-Caldentey 2012). Nowadays, freedom of movement of capital is one of the four fundamental freedoms of the European Union.

Global Competition

Globalization of the financial system has brought about competition between financial centers and hence an incentive to make ideal use of different regulations. Central to these activities are investments in financial products that can be easily and quickly relocated, whereas immobile property such as condos, houses or firms cannot be moved from point A to point B (Schulmeister 2009).

An important consequence of liberalization of capital movements is a simplification of speculative operations and a corresponding tendency to invest money rather in financial products than in real economy. Another crucial consequence is the emergence of offshore economy which enables wealthy individuals or companies to evade taxes by transferring their capital to so-called tax havens.


Schulmeister, S. (2009): Eine generelle Finanztransaktionssteuer: Konzept, Begründung, Auswirkungen, WIFO Working Papers, 2009(352), Vienna.

Vernengo, M. und Pérez-Caldentey, E. (2012): The euro imbalances and financial deregulation, Real world economics review Nr 59. pp. 83-104.

Financial Innovations

Over the course of the deregulation of capital markets there was an increase in the scope of action for the financial sector. At the same time the liberalization of capital movements caused an immense influx of capital which was further intensified by institutional factors such as private pension plans. In order to make ideal use of these new possibilities, fresh and often non-transparent financial products and speculative strategies were developed. This was mainly due to ostensible risk mitigation - the new products were regarded profit-yielding and almost risk-free and sold to clients with this argumentation. However, in fact it was just a way to cover up the risk and to increase speculation intensity.. But on the financial market the understanding was widely spread, that risks could be shared and insured (CDSs) and thus secure profits could be generated. But through this behavior an even bigger systemic risk was created which finally disappointed all optimistic expectations concerning the handling of risks with CDS and similar instruments.

Higher Risk

In professional jargon one speaks of „overconfidence“ (Malmendier et al. 2011) which leads to an „illusion of control“(Friedman & Friedman 2009) , reduces risk perception and creates a tendency towards rent-seeking, higher risk and intensified speculation. This lowered sensitivity for risky credit business eventually led to the granting of so-called “NINJA” loans, standing for "No Income, No Jobm No Asset", thus mirroring the socio-economic situation of the debtors. Hence, said loans could be regarded bad loans from the start (Stockhammer 2008).

Central to this development is the changing role of the banks. Moving away from their usual business of accumulating money, giving it as loans and earning money through fees and interest, to casual lending and the reselling and insuring of already granted loans. For that purpose separate fonds and companies - so-called "conduit banks" - were founded in order to evade current banking laws.

Boom of the Derivatives

Essential instruments in speculation are financial futures transactions in the broader sense. These traded products are called „derivatives“. Their value depends on the future development of certain benchmarks (e.g. commodities, bonds, stocks, currencies or interest rates) or the rendering of certain services to fixed prices in the future. There is a booming market for such derivatives leading to an unforeseen scale. In 2007 alone quoted derivatives, traded on stock markets, amounted to 40 times the global economic output (Schulmeister 2012).

Volumes traded in financial markets (Schulmeister 2012)

Hereafter, three financial innovations central to the crisis are presented and their respective effects are outlined. These are credit default swaps (CDS), collateralized debt organizations (CDOs) and computer-based speculation algorithms. While the first two are derivatives, the latter is basically a new category of speculative strategies.


Friedman, H. und Friedman, L. (2009): The Global Financial Crisis of 2008: What Went Wrong?, Working paper, New York.

Malmendier, U., Tate, G. und Yan, J. (2011): Overconfidence and Early-life Experiences: The Effect of Managerial Traits on Corporate Financial Policies, Journal of Finance, Vol.66(5). pp. 1687–1733.

Schulmeister, S. (2012): Präsentation am Transformationskongress, Berlin, June 8, 2012.

Stockhammer, E. (2008): Finanzkrise: Chronologie, Ursachen und wirtschaftspolitische Reaktionen. Kasinokapitalismus mit staatlichen Fremdheilungskräften, Grundrisse Nr. 28. pp. 13-22.

CDS and CDOs

Credit Default Swaps

A CDS (Credit Default Swap) enables buyers to bet against the repayment of a loan. As it is customary for insurances a premium has to be paid. In return, one receives compensation if the debtor defaults on the debt. This compensation, however, is paid no matter if the defaulting of debtor causes any loss for the investor himself. The development of credit default swaps has perverted the idea of insurance, the hedge against a risk, into an instrument of speculation, allowing to bet on a stakeholder’s bankruptcy and to profit from loan defaults without having to bear the associated risks. This can be compared to a fire insurance that can also be taken out on the neighbor’s house in order to cash in on the insurance sum in case of a fire (Rajan 2010).

Not only have credit default swaps intensified speculation but also promoted higher risk tolerance in finance since risky investments were routinely covered by CDSs. Risky lending was thus easily justified. This is also the main reason why at the first high point of the crisis the world’s largest insurance company AIG (American Insurance Group) was almost brought to its knees.

Collateralized Debt Obligations

CDOs (Collateralized Debt Obligations) are large block securities that assets (in the case of the financial crisis 2007/2008 it was mainly mortgage-backed bonds) of varying quality are accumulated in. The basic principle is bundling high-risk investments with such that are regarded safe (stocks, bonds, mortgage loans, etc.) so that the resulting blocks can be resold to other stakeholders. The aspired goal of such processes is the distribution of risk. However, the bundling also covers up the degree of credit-worthiness of debtors, which often renders the actual value of the block obscure. This can be reasoned by the fact, that the credits where often re-bundled before they were sold to the next financial player. In some cases, CDOs were re-bundled up to forty times (Sinn 2012). Analyzing these blocks is a complex task and often causes their depreciation. Therefor analysis is rare and the blocks remain in the record with their purchase value intact. This, in turn, causes systematic veiling of high-risk and bad loans that are listed in the bank’s accounting and are constantly misvalued. This valuation was backed by rating agencies, which understood the re-bundling and the distribution of risks as a way to diversify risk. Because of this on average the newly structured products (CDOs) had better ratings than the referring pool of mortgage-backed bonds. This pattern of re-bundling and an improving rating was also related to as alchemy in research (Benmelech & Dlugosz, 2009).

These instruments promote risk-taking in two ways: On the one hand the non-transparency of CDOs determines systematic underestimations of already taken risks and on the other hand CDOs allow (like CDSs) divesting oneself of certain risks by reselling them in blocks (risky credits leave the own balance sheet) (Vorbach und Wixforth 2011).


Benmelech, E. & Dlugosz, J. (2009): The alchemy of CDO credit ratings. Journal of monetary economics. Amsterdam : Elsevier, Vol. 56(5). pp. 617-634.

Rajan, R. (2010): Fault Lines. How Hidden Fractures Still Threaten the World Economy, Princeton University Press.

Sinn, H.-W. (2012): Finanzmärkte der Zukunft – Lehren aus der Finanzmarktkrise, in: Spitzley, K. (Eds.): Hochleistungsnetzwerk Deutschland – Wertschöpfung und Wohlstand für die Zukunft, Hamburg. pp.229-250.

Vorbach, J. und Wixforth, S, (2011): Deregulierter Finanzmarkt – Mitverursacher der Krise in Europa, Paper for the Momentum Congress, Hallstatt.

Speculation Strategies

Computer-based algorithms

Taking a look at the practices of the capital markets shows that human action is increasingly being replaced by automatized and computerized routines. Programmed patterns are used to relocate invested money on the capital markets while obeying predefined strategies. Such models were first used in the late 1970s (Ferraro et al. 2005) and were declared one of the main reasons to have caused the American stock market crash in 1987. Nowadays there are a plethora of computer-based speculation strategies - some are built from statistical projections of past data or try to follow price trends, while some rest upon concepts of economic theories, and others simply rely on pace by attempting to exploit minimal differences in price by issuing several millions of orders per second (so-called “hyper frequency speculation”) (Schulmeister 2009).

What goes for all these models is that stakeholders are given an idea of control which mainly depends on the level of sophistication of the algorithm that is used. This causes the illusion of control because the mathematical models may be entirely incomprehensible for the majority of the people but they convey a feeling of insurance (Friedman und Friedman 2009), which further encourages risk-taking. Also, utilizing such models is often linked to the systematization of a “herd behavior” on the capital markets. Hence, if many market players use so-called “trend-following patterns” that project past trends into the future (thereby reinforcing them), bubbling is no extraordinary phenomenon but systemically inherent in the market subjects’ behavior respectively the applied formulas (de Long et al. 1990, Orrell 2012).


De Long, J. B., Shleifer, A., Summers, L. H. und Waldmann, R. J. (1990): Positive Feedback Investment Strategies and Destabilizing Rational Speculation. Journal of Finance, 45(2). pp. 379–395.

Ferraro, F., Pfeffer, J. und Sutton, R. I. (2005): Economics Language and Assumptions: How Theories can become Self-Fulfilling. The Academy of Management Review, 30(1). pp. 8–24. .

Friedman, H. und Friedman, L. (2009): The Global Financial Crisis of 2008: What Went Wrong?, Working paper, New York. Dl.: http://ssrn.com/abstract=1356193

Orrell, D. (2012): Economyths - how the science of comlex systems transforms economic thought. London: Icon.

Schulmeister, S. (2009): Der "Aufbau" der großen Krise durch "business as usual" auf Finanzmärkten, Presentation at the annual meeting of the Keynes-Association, 16 & 17, 2009, Vienna.

Offshore Economy and Tax Havens

Offshore economy means a legal vacuum that imposes hardly any legal regulations or tax liabilities of capitals or assets. Most importantly, asset bases are kept as intransparent as possible with the intention to evade taxes or to elude certain regulations (such as alimony payments). Hence, the final destinations of this money are called tax and regulatory havens (Rixen 2009).

A Downward Race

Indicators of such regulatory havens are the non-disclosure of ownership structures, possibilities to circumvent regulatory capital requirements and reserve ratios as well as a lock of access by authorities. In an evaluation for the “Financial Secrecy Index”, published by independent Tax Justice Network, Switzerland is in the lead before the Cayman Islands and Luxembourg. Austria is among the “leading”, on 17th place. Between these countries an actual race has begun; concerning the question who can deregulate best in order to attract investors. An example of this issue is the debate on bank secrecy which eventually is another method of covering up assets and laundering money, earning Austria the reputation of a tax haven. After all, offshore economies are of great practical significance especially for fortune from criminal activities as they deliver a maximum of non-transparency to its assets (Schmidt 2012). Estimations assume that solely for Germany the assets which are hidden from taxation in tax havens lay between 150-300 billion Euros – this money is neither taxed in the country of its origin nor is it consumed there (Unger 2013).

Big Business in Back Rooms

Regulatory havens have close ties to the system of conduit banks, encompassing technically all finance companies that give loans or credit guarantees without being bound by banking regulations. Parts of them were founded by common banks as separate institutions (fonds, trading companies, etc.) in order to sell new financial products in the best possible way. The advantage of this lies in the fact that these conduit banks are not bound by banking regulations and can operate without minimum reserves. Furthermore, most conduit banks are located in regulatory havens and are therefore not taken into consideration as part of their parent company in the latter’s control although there is a very close connection concerning the risks taken (Ötsch, 2012). The ramifications of this vast development were, in fact, that liabilities of conduit banks were higher than those of the regular banking in 1995 and that it more than doubled between 2002 and 2010 to 46 trillion Euros, which is represented by the annual reports of Financial Stability Board and Tax Justice Network (Henry 2012). The sums stated are based upon estimates since capital movements are just partly open to scrutiny. However, it is certain that the number of unknown cases of funds circulating in the conduit bank system is significantly higher.

The sheer size of the conduit bank system brings about a series of economic implications which are relevant to the emergence of the crisis. The extralegal space of offshore economies promotes financial innovations and reinforces the probability of bubbling for encompassed giant volumes of capital. Eventually, all this capital was pooled and brought to capital markets free of tax, which, in combination with other factors (such as heightened Sintensity of speculation or computerized speculation), lead to a systematic overheating of the capital markets.


Financial Stability Board (2011): Shadow Banking: Strengthening Oversight and Regulation, Recommendations of the Financial Stability Board.

Henry, J. S. (2012): The Price of Offshore Revisited, Tax Justice Network.

Ötsch, S. (2012): Die Normalität der Ausnahme: Finanzoasen als Parallelökonomie von Eliten und die ausbleibende Regulierung, Momentum Quarterly 2012(2)), pp. 27-44.

Rixen, T. (2009): Paradiese in der Krise. Transparenz und neue Regeln für Steuer- und Regulierungsoasen. In: Heinrich Böll Stiftung (Eds.): Band 4 der Reihe Wirtschaft und Soziales, Berlin.

Schmidt, M. (2012): Regulierungsoasen und Schattenbanken, WISO 35(2), Linz. pp. 103-118.

Unger, B. (2013): Wir sollten in Europa anfangen. Interview, Böckler Impuls 2013(3), Duesseldorf.

Unequal Distribution

Over the past 30 years, that gap between the rich and the poor has widened. The distribution of wealth becomes even more unequal - there are few who own more and more and many who simply get by, but not more.

Few Own More and More

This polarization is also a main cause in the genesis of the financial and economic crisis. The wage share in average has declined by10 per cent within the past 30 years, and this in almost all industrialized countries. Simultaneously, the amount of capital and capital gains has risen by this proportion. This development has led to a concentration of wealth in the hands of a small segment of the population. Hence, in Austria the wealthiest 10 per cent hold more than 60 per cent of the entirety of all assets (Csoka 2011). A similar picture can be drawn for the whole Euro-area. Here, the wealthiest 20 % of the population own 67.7 % of the net wealth, whereas the poorest 60 % only possess 12 % of the total net wealth (ECB 2013).

Distribution of assets in Austria based on data from the financial assets survey by OeNB 2004 and the real estate survey by OeNB 2008

The development of gross profit share and wage share shows that there has been a process of redistribution from the bottom to the top for the past 30 years. The acquired national income is every more thinly spread among those people whose performance laid the foundation for economic growth.

The Wide Base is Being Lost

A sinking wage share not only causes unequal distribution of assets but also affects consumption, because it is the earners of low and middle incomes, who have to spend the greater part of their income on covering costs, save only little money and hence run into debt if incomes stagnate. The additional consumption of luxury goods by the wealthy cannot compensate for the losses on the majority’s side. Instead the wealthy citizens rather use huge parts of their assets for speculation. This is how unequal distribution of assets and incomes affects domestic demand if private households do not accept further indebtedness themselves (Marterbauer 2011).

Wage share and gross profit share in Austria based on data by EU Commission, Ameco-DB, AK-Wien, (Schlager 2012).

Who Earns More?

But there is also an increasing inequality between those who earn an income from labor. The top one per cent of income earners in the USA receives 20 per cent of all incomes (Atkinson et al. 2009). In the 1970s this value was below 10 per cent. The same development can be observed in Europe - the share of top income earners keeps growing while incomes of middle and low classes fall or –in the better cases merely stagnate (Altzinger et al. 2011, 2012, Atkinson 2007).

Another reason for the unequal distribution is the tax policy. High incomes, capital and assets have been rendered tax-free in the past decades in several steps. The deregulation of capital markets as well as international capital mobility and tax havens promoted a global tax competition. As a results of this development, a great part of tax revenues stems from income and consumption while income from assets, financial operations and other kinds of unproductive income contribute less to the community (Eder 2012).


Altzinger, W., Berka, C., Humer, S. und Moser, M. (2011): Die langfristige Entwicklung der Einkommenskonzentration in Österreich, 1957-2008 – Teil I. Wirtschaft und Gesellschaft, 37(4). pp. 513-530.

Altzinger, W., Berka, C., Humer, S. und Moser, M. (2012): Die langfristige Entwicklung der Einkommenskonzentration in Österreich, 1957-2008 - Teil II. Wirtschaft und Gesellschaft, 38(1). pp. 77-102.

Atkinson, A. (2007): The distribution of earnings in OECD countries. International Labour Review, 146(1). pp. 41-60.

Atkinson, A., Piketty, T. und Saez, E. (2009): Top incomes in the long run of history. Journal of Economic Literature, 49(1). pp. 3–71. .

Csoka, B. (2011): Verteilung der privaten Vermögen in Österreich. WISO, 34(4). pp. 77-94.

ECB (2013): The Eurosystem Household Finance and Consumption Survey: Results From the First Wave. Statistics Paper Series, Nr. 2, April 2013.

Eder, M. (2012): Vermögensbezogene Steuern: Sozial gerechte Steuerreform oder Klassenkampf und Enteignung? WISO 35(2). pp. 81-102.

Marterbauer, M. (2011): Zahlen bitte! Die Kosten der Krise tragen wir alle, Vienna.

Schlager, C. (2012): Wer oder Was ist schuld an unseren Schulden und wer zahlt?, Präsentation Tagung Wege aus der Krise, May 11, 2012 Vienna.

Speculation and Rent-Seeking

As large fortunes are concentrated with a minority of the population, they are urging to invest said fortunes since the basic needs of the wealthy are mostly satisfied. For the everyday consumption of goods and services, only a small part of the income is needed. The greater part is used for capital increase - a tendency which is further reinforced by free capital markets and new financial products.

The economy’s orientation of investments is thus subject to a shift from real economic products to speculative financial operations (Boyer 2000). The chance of realizing higher yields without real investments pushes both business focus and innovational strength towards finance, which has the result that important and necessary investments in the real economy are no longer undertaken and subsequently weaken real economy (Schulmeister 2010).

Boom of Derivatives

The rejection of the real economic production to a financialization of the economy is expressed by the growth of international capital movement. The trading of derivatives alone has multiply exceeded the global GDP within the past decades. At the moment, the value of the derivatives traded amount to roughly 40 times of the global GDP (Schulmeister 2012a).

Trade volume of stocks in relation to the global GDP (Schulmeister 2012b).

One major procedure associated with derivatives is “rent-seeking”. This term describes the process of ascertaining economic income without any performance to deliver in order to achieve it. These types of business operations seek to redistribute present wealth. Originally, this term was associated with rent and lease both of which do not rely on a task being performed. Now this term is applied to a multitude of other economic phenomena (Stiglitz 2012).


Boyer, R. (2000): Is a finance-led growth regime a viable alternative to fordism – a preliminary analysis. Economy and Society, 29(1). pp .111-145.

Schulmeister, S. (2010): Mitten in der großen Krise – ein „New Deal“ für Europa. Picus-Verlag, Vienna.

Schulmeister, S. (2012a): Vorsorgende oder vor-sorgende Wirtschaft. In: Egner, H. und Schmid, M. (Hrsg.): Wissenschaft in einer vorsorgenden Gesellschaft, Munich.

Schulmeister, S. (2012b): Präsentation am Transformationskongress, June 8, 2012, Berlin.

Stiglitz, J. (2012): The price of inequality- How today´s divided society endangers our future. New York: Norton.

Growing Private Debt

The polarization of the income distribution systematically reduces the ability to build up savings for the greater part of the population. Middle or lower income households spend most of their income on the coverage of their fixed living expenses. The consumption of health care, educational services or housing must be financed with loans because savings can no longer cover the costs (Hein und Truger 2010).

Private savings and credit financing of household incomes in the USA in per cent of available income. (IMK 2009).

Living a Life on Credit

The diagram shows the development of debt and savings in US- households. From the 1960s to mid-1980s, the saving rate continually grew from about 8 to 10 per cent) and from this time it has rapidly declined onwards to roughly 2 per cent of incomes. Borrowing developed mirror-inverted, as there was a trend-reversal in the mid-1980s and the accumulation of debt began to increase from 40 per cent and peaked with 130 per cent in 2008 (Marterbauer 2011). The diagram explains how a lack of income is compensated with increasing debt. Households try to uphold the same level of consumption and living standard by taking out loans. This results in an over-indebtedness of private households and heightens the risk of bad loans which cannot be repaid anymore. Such a development is rather likely in the event of bubbling prices on real estate markets (like in the USA or Spain). Such a bubble significantly increases both the debtors’ and the loaners’ willingness to accept risks since continuous accretion of the respective properties is expected.


Hein, E. und Truger, A. (2010): Krise des finanzdominierten Kapitalismus – Plädoyer für einen keynesianischen New Deal für Europa und die Weltwirtschaft. In: Wirtschaft und Gesellschaft, 36(4). pp .481-517.

IMK (2009): Von der Finanzkrise zur Weltwirtschaftskrise (III), IMK-Report Nr.41, Duesseldorf.

Marterbauer, Markus (2011): Zahlen bitte! Die Kosten der Krise tragen wir alle, Vienna.

Stagnating Demand

For the greater part of the population, labor is the only option to earn an income and hence it is the decisive factor for the amount of money that is available for consumption. Domestic demand for goods and services is - for the most part - determined by the available income of the population. If wages as a share of the total income fall, private households can either choose to reduce their consumption or to increase debt. Falling wage shares are noticeable in all western industrial countries, hence the amount of private consumption - not taking debt into account - is in decline. Excepted from this development are those countries which experienced domestic demand built primarily on credit (USA, Great Britain, Ireland and Spain) (Bofinger 2006).

LShare of wages in entire income in per cent (own research, data corpus: Ameco 2013).

Sinking domestic consumption generally results in low demand for goods and services, which - in turn - results in a surplus production and cutbacks of capacities in companies leading to dismissals and fewer investments. Higher unemployment rates further dampen private consumption, causing sinking revenue and increasing expenses for national budgets.

Exports as a Way Out?

One way to escape this negative spiral is selling the produced goods and services abroad, meaning to aspire an export-oriented economy and to accept trade imbalances. In this way a lack of domestic demand is compensated by higher foreign demand. However, the problem is merely shifted to the importing countries, because domestic products there are driven out of the market and jobs are lost. If a lack of domestic demand is compensated by exports, it is only unemployment that is shifted abroad (Stockhammer 2011).


Ameco (Annual macro-economic database) (2013): Adjusted wage share as percentage of GDP at current factor cost, called on June 04, 2013. .

Bofinger, P. (2006): Wir sind besser als wir glauben. Wohlstand für alle, Hamburg.

Stockhammer, E. (2011): Von der Verteilungs- zur Wirtschaftskrise: Die Rolle der zunehmenden Polarisierung als strukturelle Ursache der Finanz- und Wirtschaftskrise, Studie für die Arbeiterkammer Wien.

Bad Loans

The granting of credits is usually determined by the borrower’s solvency. If the risk of payment default is high, interest rates are high as well, and/or other values such as real estates are required as collateral. The assessment of these collaterals is based upon their market value and it is up to the individual bank and its risk-evaluation to decide whether market values and potential proceeds match. Loans are declared „bad“ when repayment is no longer possible and collateralization is insufficient to cover the whole sum or is not in place at all (Altvater 2010).

Misplaced confidence

There were developments ahead of the crisis that systematically circumvented realistic assessment of risks in bank lending. On the one hand, financial innovations succeeded in insuring and bundling loans, and thereby concealing the true risks. On the other hand, assessment of future developments was constantly positive. These risky assumptions caused bank lending to be primarily oriented towards soaring prices. Hence, credit checks were not conducted any longer (Schulmeister 2009). This sort of bank lending (“NINJA loans”) plus the new financial products promoted bubbling on the real estate markets in the USA and Spain. (Marcuse 2008 or Friedman & Friedman 2009). This misguided faith was not only fuelled in the direct lending, but also in the usage of financial innovations as CDOs or CDSs. Financial actors were stuck in the belief, that these new products would be able to completely distribute the risk and by this reduce the risks. Eventually the resulting buildup of this enormous over-indebtedness and the final burst of the bubble made necessary the biggest bank bailout of all times.


Altvater, E. (2010): Der große Krach. Oder die Jahrhundertkrise von Wirtschaft und Finanzen von Politik und Natur. Muenster.

Friedman, H. und Friedman, L. (2009): The Global Financial Crisis of 2008: What Went Wrong?, Working paper, New York.

Marcuse, P. (2008): Ein anderer Blick auf die Subprime Krise. ProKla: Zeitschrift für kritische Sozialwissenschaft, 38(4). pp. 561-568.

Schulmeister, S. (2009): Der "Aufbau" der großen Krise durch "business as usual" auf Finanzmärkten, Vortrag auf der Jahrestagung der Keynes-Gesellschaft, February 16-17, 2009, Vienna

Fewer Investment in Real Economy

A flourishing economy needs solvent consumers and investment-happy entrepreneurs alike. Especially in Central Europe wages have stagnated for the past few years and thus purchasing power has declined. Resorting to private debts in order to compensate income losses would be helpful only for a limited time. This can only work if wages rise in the foreseeable future so that the additional interest burden can be paid for. Only then domestic demand can be permanently stabilized even in the case of decreasing wages (Flassbeck 2010).

Real and financial wealth of capital companies in Germany (Schulmeister 2012).

Companies as Financial Jugglers

Fewer purchases affect the entrepreneurs’ willingness to invest. Competitors to real economic activity, speculation and new financial products became ever more attractive investment opportunities because they promised high yield and are more flexible than real investments in factory buildings or machines. Hence, on the entrepreneurial side a shift took place, from real production to financial investments and speculation. Since 1990 there has been a continuous, noticeable decline of real economic activity. Yet, at the same time financial participation and capital have considerably increased (Cetkovic und Stockhammer 2010).

If, in situations like this, the state cuts public investment such as education, infrastructure and health (as is demanded by IMF, ECB and EU commissions for Southern European countries), the consequences are the same and purchasing power as well as demand are reduced while facing rising unemployment rates. This is what additionally reinforces the negative spiral, and higher unemployment leads to further loss of revenue and an increase in expenditure within national budgets (Krugman 2012).


Cetkovic, P. und Stockhammer, E. (2010): Finanzialisierung und Investitionsverhalten von Industrie-Aktiengesellschaften in Österreich. Wirtschaft und Gesellschaft, 36(4). pp. 453-479

Flassbeck, H. (2010): Die Marktwirtschaft des 21. Jahrhunderts, Frankfurt/Main.

Krugman, P. (2012): Vergesst die Krise. Warum wir jetzt Geld ausgeben müssen, Frankfurt/Main.

Schulmeister, S. (2012): Die 2010er-Jahre – ein Jahrzehnt der Depression?, Präsentation bei der Tagung von Kautsky-Kreis und Kocheler Kreis, June 29, 2012, Berlin.

Financial Distress of Nations

Through stagnating domestic demand and few investments in real economy fiscal revenue decreases since less taxes and social insurance contributions are paid, which goes for payroll tax, corporate income tax and consumption tax. Reduced willingness to invest means fewer jobs and subsequently higher welfare spending, especially for unemployment or short-time work (Reiner 2011or Marterbauer 2012). Loss of revenue alone makes up for 50 per cent of crisis-related expenses in the G 20 states and hence a huge part of increased national deficits.

Reasons for the increase of national debt in G20 from 2008-2015, totaling 39 per cent of GDP, IMF. (Schlager 2012).

Unequal Distribution and its Repercussions

These heavy ramifications on the national budget are also an immediate result of unequal distribution of wealth, which, if even, would bring along higher domestic demand. If the most wealthy one per cent of US-American earners, who earns about 20 per cent of the collective income, earned only 15 per cent instead and the savings be redistributed to low and medium incomes, domestic demand would directly climb by one per cent. Lower propensity to save at lower income causes more consumption and thus a boost in real economy. This means that overall demand would rise by about two per cent and thereby lower unemployment (Stiglitz 2012). Both effects make a positive impact on the national budget as tax yield will rise while welfare spending and transfers diminish (Crotty 2012).

As we see, an economic downturn sets in motion a series of self-intensifying effects and puts additional pressure on nations and their respective budgets. Owing to economic stimulus packages and bank bailouts national debt has increased and thus higher annual interest payments are required. Yet, at the same time, credit-worthiness of these states has been lowered, which is why interest expenses for new national debt have been on the rise, which, again, hinders the condolidation of the budget (Bieling, 2011).


Crotty, J. (2012): The great austerity war: what caused the US deficit crisis and who should pay to fix it? Cambridge Journal of Economics, 36. pp. 79–104.

Marterbauer, M. (2012): Keynesianische Budgetpolitik unter neuen Rahmenbedingungen. Offensive Antworten auf Finanzkrise und Staatsschuldenkrise, Kurswechsel, 1/2012. pp. 11-22.

Reiner, S. (2011): Gutes Leben und gute Arbeit weggespart. ProKla, Zeitschrift für kritische Sozialwissenschaft, 41(2). pp. 213-230.

Schlager, C. (2012): Wer oder Was ist schuld an unseren Schulden und wer zahlt?, Präsentation Tagung Wege aus der Krise, May 11, 2012, Vienna.

Stiglitz, J. (2012): The price of inequality. How todays divided society endangers our future. New York: Norton.

Bubbles on Capital Markets

Increased activity on the capital markets fuels the search for new forms of investment and ever higher yields. New financial products and large sums of capital ready to be invested are quite conducive to this development.

However, it is usually the same pattern that benefits the occurring of bubbles. As so called “herd behavior” comes into being when many investors follow the same strategy. Soaring stock prices traditionally attract new buyers, causing further price rises and positive expectations, which in turn attracts more buyers. This is how markets “overheat”, which means that traded goods or stocks are assessed significantly better than they actually are. Upon reaching a certain level, sales are conducted and the stock price plummets - the bubble has burst (Kindleberger 1978, Shiller 2006). One-sided systematization and technologization of the financial economy’s behavioral patterns does not counteract this trend but has extensively automatized the application of similar strategies instead (Orrell 2012).

From Spiral to Bubble

The real estate bubbles in America and Spain experienced similar developments. Standards for the accommodation of loans were continually lowered, expecting that house prices would rise further. Large parts of the population were able to take out loans which, under normal circumstances, they could never pay back. The only surety was the ever increasing price of houses. These risks were hidden and made invisible through new financial products (CDS, CDOs), promising lower risk to the investors by pooling. Demand for real estate sharply rose owing to easier bankability, which is why house prices increased further. This launched a spiral: Taken out credits seemed to be financeable even more easily and other loans were taken out under more favorable conditions in respect of rising real estate prices. This brought about an utter overvaluation of real estate and caused the bubble. It burst when the financial system became aware of that more and more estate owners were no longer able to pay their installments, and forced sales revealed that the mortgages could not be converted into money, how it had been expected when the credit had been given (Marterbauer 2011).

Price developments on the American real estate market (Standard & Poor´s: American Real Estate Price Index. 8/2010; Shiller 2006, Standard & Poors 2010).

The resulting losses of individual banks transferred very fast on other credit institutions and in such a way on the whole banking system. Those cascade effects emerge through the interdependent refinancing among banks. Because of this banks are tightly coupled to each other and big uncertainty arises around the question, to which extent they could be hit by other troubled banks (Caballero & Simsek 2011). The burst of the bubble creates cash shortages and thus forces individual banks to liquidate short-term loans. Through this, the pressure on other banks to sell assets also increased. This chain reaction mainly concentrated on certain asset classes like CDOs and lead to dramatic price falls (Fire Sales) and to additional losses in banks’ balance sheets.

The bubble was fatal since, unlike earlier bubbles, it did not only concern a limited number of companies and investors but millions of people who suddenly had to face insolvency and being left with nothing, given the subsequent economic slump which causes them to be unemployed and homeless (Stieglitz 2008). Many non-refundable, bad loans eventually necessitated enormous public bank bailouts.


Caballero, R. & Simsek, A. (2011): Fire Sales in a Model of Complexity. Working Paper, National Bureau of Economic Research, March 14, 2011, pp. 1-41.

Kindleberger, C.P. (1978): Manias, Panics and Crashes. London: Macmillan.

Marterbauer, M. (2011): Zahlen bitte! Die Kosten der Krise tragen wir alle. Vienna.

Orrell, D. (2012): Economyths - how the science of comlex systems transforms economic thought. London: Icon.

Shiller, R.J. (2006): Irrational Exuberance. Crown Business.

Stiglitz, J. (2012): The price of inequality- How today´s divided society endangers our future. New York: Norton.

Standard & Poor´s (2010): Case-Shiller Home Price Index, Amerikanischer Immobilienpreisindex.

Bank Bailout

Due to the burst of the real estate bubble and the economic slump, the banks were facing immense refinancing difficulties. Many of the allegedly safe financial products (CDS, CDOs) became uncollectible. Therefor values had to be depreciated significantly, causing huge losses especially with the special-purpose entities that had transacted these businesses. Because of their tight bond with the commercial banks the risk was transferred to the latter (Liebert et al. 2012). The second aspect lies with the banks’ risk assessment for many loans were granted without proper securities and not secured by sufficient equity. Upon the outbreak of the crisis many loans could not be paid back anymore, which led to according losses on the banks’ side. The decreasing liquidity in the market and a lack of liquid equity shook the confidence in the financial sector. Thus, countries had to provide much money so that the financial system would not collapse and the banks would remain capable of acting (Schulmeister 2009).

Extent of all aid payment for the financial sector in per cent of the entire EU -27 GDP: 4506,47 billion Euros (own research, data corpus: EU Commission 2012).

The reason for the necessity to bailout big banks is the so called systemic relevance of banks. Banks are said to be system-relevant if both their national and international interlocking with the corporate sector are this intensive that a failure of those banks would have inestimably severe consequences for the whole economy. This systemic relevance is supported by the fact that the heavily increasing leverage of companies has made bank lending even more important for the economy (Busch 2012).

Who Bears The Costs?

For whole Europe the support for financial institutions amounted to 5.2 per cent of the GDP what equally raised the debt-to-GDP ratio. This means that debts increased by 670 billion Euros solely due to the bailout and ongoing support of weak banks (Standard, 22 April 2013). The bank rescue required higher borrowing as well as higher interest expenditures in the current budget and thus increased the pressure on the countries. One instrument of bailing out the banks was the implementation of Bad Banks by the national governments or the banks themselves. Bad Banks serve the purpose of storing distressed assets and thus enable the banks to clear up the banks’ balance sheets. Solely the Bad Bank of the failed German Hypo Real Estate assets are assumed to be worth 125 billion Euros. For whole Europe it is estimated that assets of 1 trillion Euros is stored in Bad Banks (Hesse 2013). It remains unclear, which losses will arise out of these Bad Banks and the restabilization of banks in the future. The hidden risks for the tax payers related to the banking sector are key-arguments of rating agencies in the grading of the credit worthiness of European countries and has led to the downgrading of many countries with a big banking sector.


Busch, U. (2012): Zur Rolle der „Finanzindustrie“ in Wirtschaft und Gesellschaft, Sitzungsberichte der Leibniz-Sozietät der Wissenschaften zu Berlin, 2012(113), pp. 47-66.

Hesse, M. (2013): Auf der Kippe. Der SPIEGEL, 2013(17), April 22, 2013, p. 74.

Liebert, N., Ötsch, R. und Troost, A. (2012): Der graue Markt der Schattenbanken. Blätter für deutsche und internationale Politik, 2012(6), pp. 83-90.

Schulmeister, S. (2009): Der "Aufbau" der großen Krise durch "business as usual" auf Finanzmärkten, Lecture at the annual meeting of the Keynes-Society, February 16-17, 2009, Vienna.

Oswald, G. (2013): Bankenrettung kosteten EU-Staaten 670 Milliarden. Der STANDARD, April 22, 2013.

National Debt Crisis

Nowadays, the financial crisis is talked about mostly as “national debt crisis” because in comparison to their economic performance (GDP) the debts of nations have noticeably increased. Referring to this it is important to have a closer look at the reasons of this increase. The combination of decreasing government revenue and increasing expenses in order to support conjuncture and to establish bank rescues, are the most important factors for the states’ financial hardships (Flassbeck 2012). The development of national debt since the beginning of the crisis is illustrated in the following graph.

Debt quotas in comparison (own research, data corpus: Eurostat 2013).

Compared to economic performance, national debt was in decline within the entire euro zone until the outbreak of the crisis. It was not until the crisis and the consequential tax losses and bailout packages that European national budgets ran into a massive increase of debt. There were attempts to counteract the macroeconomic downward spiral by impulses on economic-political grounds. The additional debt, in combination with negative economic data, caused especially Southern European countries to lose credit rating, which affected the interest rate necessary for refinancing national budgets.

If the recession in Southern Europe continues, their national budgets will be further weakened by ongoing tax losses and welfare spending. If in a situation like this financial scope is further limited (as requested by the fiscal pact), no sufficiently big demand impulse can be applied. Through this the downward dynamic is further accelerated and the affected nations’ financial struggles become even more severe (Stiglitz 2012).


Eurostat Government Statistics (2012): Quarterly public debt level, called on June 6, 2013.

Flassbeck, H. (2012): Zehn Mythen der Krise, Berlin.

Stiglitz, J. (2012): The price of inequality - How todays divided society endangers our future. New York: Norton.

International Disparity

Nowadays it is undisputed that the global disparities are one major source of the current financial and economic crisis. However, the sources of these disparities are still a matter of discussion both politically and academically. On the one hand, the world observes the emergence of countries which had permanent deficits with regard to their trade and current account balance, and on the other hand, there are countries that relied on an export-oriented growth model while facing stagnating domestic demand.

The figure shows the current account balance of the United States and Germany from 1980 to 2007 in percent of GDP and from 1992 to 2007 for China. During that period, the current account balance of the United States has been negative and strongly declining between 1990 and 2007, reaching a deficit of 6 percent of GDP in 2006. Germany and China, however, experienced a remarkable increase of their current account balance. After the reunification in Germany, the balance of the current account was moderately negative until 2000. The labor market reforms together with a stagnating domestic demand, which ultimately led to an export-led growth model, caused the current account balance to improve significantly. Germany was seen as the Exportweltmeister (world champion of exports). The case of China is somewhat similar to Germany. The current account balance rose dramatically, especially after 2000. Similar to Germany, China relied on a very pronounced export-led growth model with a very low domestic demand and a large share of net exports as a share of GDP (7 percent in 2007).

Current account balance for the United States, Germany and China, 1980-2007. Source: Belabed et al.(2013)

Of course, the current account balance does not only include the balance of trade but also net transfers between countries, which means that the financing of deficits is included in the graph below. The financing of trade deficits, especially in the United States, was made possible through financialization (the increased importance of financial markets, see Hein 2013) and the underregulation of financial markets.

The economic disparities between the nations rely on various types of growth models. The United States, for instance, have built their economic growth model on a credit-financed consumption-driven approach where weak aggregate demand was counteracted by the increased availability of credit for the part of the population who did not see their incomes grow in line with inflation and productivity. Other countries, mainly developing countries but also countries like Germany, have relied on a export-led growth model which was temporarily successful to overcome insufficient domestic demand, but proved to be unsustainable in the longer-term. Any policies designed to reduce global disparities have to take into account the three fundamental causes of the crisis: (i) an unequal distribution of income and wealth, (ii) underregulation of financial markets and (iii) international disparities with the underlying flawed set-up of modern growth regimes.


Belabed, C.; Theobald, T. & van Treeck, T. (2013): Income Distribution And Current Account Imbalances, IMK Working Paper 126

Hein, E. (2013): The Macroeconomics of Finance-dominated Capitalism – And its Crisis, Edward Elgar Publishing

Trade Imbalances in the European Union

There is growing concern among policy makers and economists alike evolving around global trade imbalances, especially between Germany and China (two major surplus countries) on the one hand and the United States (major deficit country) on the other. What actually accounts for the trade imbalances is an ongoing matter of discussion. One theory, the theory of global savings gluts, asserts that current account deficits of the U.S. were principally caused by surplus savings of countries like China by reducing interest rates in the United States prior to the crisis and fuelling the domestic credit and consumption boom. Another, more recent, line of reasoning argues that income inequality has – at least partially – caused current account imbalances between major countries.

Inequality, trade and current account imbalances

Recent studies prominently argued that rising income inequality accounts for most of the global imbalances observed prior to the current financial and economic crisis. More precisely, countries with large increases in income inequality, either functional or personal, experienced large current account deficits, respectively, or surpluses depending on the country-specific institutional environment. Financial deregulation, for instance, enabled households to borrow from domestic and foreign lenders to finance consumption. The result was a deterioration of national savings-investment and trade balances as in the U.S. In Germany and China however, households were either not able or willing to borrow which, in the context of growing inequality, weakened domestic aggregate demand and led to an export-oriented growth model ultimately resulting in the large current account surpluses prior to the crisis (see Kumhof et al. 2012, Kapeller and Schütz 2012, Belabed et al. 2013 and Behringer and van Treeck 2013).

In the U.S. (and also in the U.K. and Canada) we observe a sharp rise of top income shares leaving the remainder of the population with stagnating or even falling shares of national income (Piketty and Saez 2006). At the same time, the share of wages in national income declined only marginally (from 65% to 62%) in the U.S. between 1980 and 2007. Taking into account that households’ consumption depends not only on their own wealth or income, but also on consumption of their social reference group (Duesenberry 1949) defined as the households one step up in the income distribution, these households face enormous pressure to finance additional consumption through a decline in savings or an increase of debt. The latter was readily available because of the specific institutional environment in the U.S., namely financial market deregulation. Summing up, the U.S. current account deficit can, at least partly, be explained by a decline of household’s financial balance which, in turn, was caused by the enormous income gains of the very affluent parts of society, given the institutional environment in the U.S.

Figure 1: Financial balances, personal distribution of income, USA 1980-2007; Belabed et al.(2013).

In Germany, however, top income shares were essentially flat (e.g. the share going to the top 10% increased from 32% to 37%) whereas labor’s share of income declined significantly from 64% to 55%, so the functional distribution of income worsened. Not very surprisingly, this caused insufficient domestic aggregate demand which was countered by relying on an export-led growth model that was successful because wages in Germany remained depressed, leading to a significant improvement of the corporate financial balance. Highly firm-specific skills of the labor force in Germany imposed a relatively high risk of longer-term unemployment on workers in Germany which, in turn, was the reason for the relatively high saving rates of households. Both improved the current account balance in Germany and contributed to global imbalances that seem to be at the root of the current crisis (Horn et al. 2009). The german corporate sector has become rather reluctant to distribute its increasing profits as dividends to households which is the reason why top income shares have been essentially flat (see Figure 2).

Figure 2: Financial balances, functional distribution of income, Germany 1980-2007; Belabed et al.(2013).

China is a special case because it experienced both, a rise in personal and functional income inequality, and experienced dramatic increases in the current account balance reaching 10% of GDP in 2007. However, due to financial repression, households in China were not able to borrow to finance additional consumption expenditures so aggregate consumption did not remain flat but decreased. In addition, China’s institutional environment can be characterized as one in which corporate and government sectors are favored over households. This means that high current account surpluses in China are not caused by household thriftiness but rather by low wages and household income which leads to weak aggregate consumption. Indeed, consumption’s share of GDP has never surpassed 50 percent and decreased significantly since the early 2000s. Aggregate demand was fuelled by a spectacular investment boom and an export-led growth model, in particular since 2000. Summarizing, the effect of the trends of the functional income distribution (decline in household disposable income and wage share) dominated the effects of rising personal income inequality ultimately contributing to the large current account surpluses (see Figure 3).

Figure 3: Financial balances, functional distribution of income, China 1992-2007; Belabed et al.(2013).

Ultimately, trade deficits have to be financed somehow. For instance, the U.S. financed their deficit by selling government securities to surplus countries, e.g. China, which enabled the U.S. to sustain a normally unsustainable situation for quite a long time. Since the early 1980s the current account balance of the U.S. was never positive except for one year, in 1991, and declined afterwards for almost two decades until the crisis broke out in 2007. At the same time, interest rates have been historically low so that borrowing costs decreased significantly during the expansionary phase of the business cycle after 2000-1 in the U.S.


Behringer, J. and T. van Treeck (2013): Income Distribution and Current Account – A sectoral perspective, IMK Working Paper 125

Belabed, C.; Theobald, T. & van Treeck, T. (2013): Income Distribution and Current Account Imbalances, IMK Working Paper 126

Duesenberry (1949): Income, Saving, and the Theory of Conumer Behavior, Harvard University Press

Horn, G.; Joebges, H. & Zwiener, R. (2009): Von der Finanzkrise zur Weltwirtschaftskrise (II) - Globale Ungleichgewichte: Ursache der Krise und Auswegstrategien für Deutschland, IMK-Report 40

Kapeller, J. and Schütz, B. (2012): Conspicuous consumption, inequality and debt: The nature of consumption-driven profit-led regimes, Working paper 1213, JKU Linz.

Kumhof, M.; Ranciere, R.; Lebarz, C.; Richter, A. W. & Throckmorton, N. A. (2012): Income Inequality and Current Account Imbalances, IMF Working Paper 12/8

Piketty, T. & Saez, E. (2006): The Evolution of Top Incomes: A Historical and International Perspective., American Economic Review 96(2), pp. 200 - 205

Further Readings

Frank, R. H.; Levine, A. S. & Dijk, O. (2010): Expenditure Cascades, Social Science Research Network

Rajan, R. G. (2010): Fault Lines: How Hidden Fractures Still Threaten The World Economy, Princeton University Press

Reich, R. B. (2010): Aftershock - The Next Economy and America's Future, Vintage Books

van Treeck, T. & Sturn, S. (2012): Income Inequality As A Cause Of The Great Recession? A Survey Of Current Debates, Conditions of Work and Employment Series 39, ILO

Growing public debt

The public opinion on national debt is mostly a problematic one: Nations whose debt level is high are allegedly prone to speculative attacks and must pay higher interest rates. Furthermore, it is argued, high ratios of public debt to GDP were assumed to hamper economic growth (Reinhart and Rogoff 2010), which was often used to justify harsh austerity measures in Europe and elsewhere. However, this line of reasoning has come under heavy attack (Herndon et al. 2013). As a matter of fact, things are not as simple as standard economic theory (and high-level public officials) would want the world to believe. First, public debt may rise as a consequence of low growth and, moreover, debt-GDP ratios are somewhat misleading as they may rise despite decreasing levels of public debt if GDP declines even faster.

Figure 1 shows household and government debt as a share of GDP for Spain in the pre-crisis period. Government debt as a share of GDP peaked around 65 percent in the mid-1990s and, contrary to most other countries, public debt was falling continuously and significantly in the years after the introduction of the Euro until a record low level of 30 percent in 2007. Clearly, Spain did not face a “public debt crisis” but a huge credit bubble in the private sector. Therefore, any remedies aiming at bringing down public debt aim at the wrong part of the patient. The main reason for the surge in public debt is, contrary to public opinion, not the increase in fiscal stimulus, but lower tax receipts due to weak profits and high unemployment (Economist 2013). These observations can also be extended to other countries, e.g. Greece, Ireland, United Kingdom or Germany (Economist 2013a, Figure 2). The perfect ingredient for a major recession is a simultaneous attempt of deleveraging of all economic sectors (public, private and foreign sector).

Figure 1: Household and government debt as a share of GDP, Spain, 1995-2012; Source: Federal Reserve Bank of St. Louis, FRED

Figure 2 presents the same data for the United States and, again, it is not public debt that increased and caused the current financial and economic crisis. After the presidency of Bill Clinton, government debt had fallen to 60 percent of GDP, which is a relatively normal level from a European perspective. Certainly, since the crisis struck, public debt as a share of GDP increased, but as a consequence of the crisis and not its cause. In 2007 the debt-GDP ratio for the government was around 110 percent and the increase (50 points) is almost entirely due to the financial crisis that started in 2007 in the housing market and the subsequent recession after the collapse of Lehman Brothers in 2008. Household debt, however, soared just before the crisis emerged in 2007. Financial instability, therefore, did not stem from the public sector’s excess demand for credit but from the household sector’s excessive borrowing to finance consumption and investment expenditures (housing) in the decades preceding the financial crisis (see, for instance, Reich 2010, Rajan 2010).

Figure 2: Household and government debt as a share of GDP, United States, 1980-2012; Source: Federal Reserve Financial Accounts and Flow of Funds

Furthermore, it is wrong to assume that high public debt levels are always and everywhere the cause of speculative attacks. Countries like Japan pay relatively low interest rates despite a very high debt-to-GDP ratio of more than 200 per cent. The main reason for this is the fact that such countries primarily have debt with their own population and speculative interest pressure merely results from internationally traded foreign debt.


Herndon, T.; Ash, M. & Pollin, R. (2013): Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff, PERI Working Paper 322, University of Massachusetts at Amherst

Rajan, R. G. (2010): Fault Lines: How Hidden Fractures Still Threaten The World Economy, Princeton University Press

Reich, R. B. (2010): Aftershock - The Next Economy and America's Future, Vintage Books

Reinhart, C. M. & Rogoff, K. S. (2010): Growth in a Time of Debt, American Economic Review 100(2), pp. 573-78

The Economist (2013): Stimulus vs. Austerity - Sovereign doubts

The Economist (2013a): The Dangers Of Debt - Lending Weight

Interest Rate and Financing of Nations

Burdensome interest rates were regarded as one of the main outcomes of the current financial and economic crisis. Before the crisis, long-term interest rates that countries had to pay on their long-term securities have been relatively stable. For instance, Greece had to pay the same interest on its sovereign debt as Germany or other countries (see Figure 1). Average long-term rates in these countries ranged between 4.3 percent (Germany) and 4.8 percent (United States and Greece).

Figure 1: 10yr nominal government bond yields for selected countries, monthly data, 01/1999-10/2013; Source: Federal Reserve Bank of St. Louis, FRED

Since 2008 long-term interest rates have increased dramatically in various countries (see Figure 1). In Greece, for instance, interest rates on long-term government bonds reached an all-time high in early 2012, reflecting the risk of the breakdown of the euro area starting with Greece (“Grexit”). The same trends, although to a lesser extent, can be observed for other euro area countries, for instance Portugal, Spain, Ireland and Italy. Germany, among others, remains the “safe haven” within the euro area, with interest falling below 2 percent since the outburst of the crisis in the euro area. In the U.S., interest rates have fallen as well since 2008, which is remarkable given that the U.S. have been at the center of the current crisis.

The most cited term for these trends in interest rates and the financing of nations are usually the “sovereign debt crisis” or “public debt crisis”. However convincing this story may sound at a first glance, public debt in some countries was quite low before the crisis, and remained around levels comparable to Germany and Austria, so there must be more to the story of abnormally high interest rates in some countries. In Spain for instance, public debt was actually decreasing before the crisis to a level of around 30 percent before 2008. Private sector debt was rapidly increasing, fuelled by a construction and consumption boom that lasted for almost the entire first decade of the new millennium (2000-2008). Indeed, the threshold of private debt, laid out in the macroeconomic imbalance procedure (160% of GDP) was already surpassed in 2004 (European Commission 2012).

Monetary Policy in the wake of the crisis

How has monetary policy reacted? It is a widely shared point of view that the relatively aggressive monetary stimulus and, to a lesser extent, the fiscal stimulus prevented the U.S. from a scenario which the euro area experiences right now – low or no growth on the one hand and a relatively strong reluctance to act by the monetary and fiscal authorities. The Federal Reserve, led by Great-Depression scholar Ben Bernanke, has cut interest rates aggressively to almost zero (see Figure 2) and introduced various unorthodox policy measures, e.g. quantitative easing through buying securities from the Treasury Department. Of course, there are risks to these policies. One line of argument against quantitative easing and loose monetary policy is that it creates bubbles in asset markets (e.g. housing or stock prices). However, recent reports stated that unemployment in the U.S. is falling, new jobs are created and growth seems to pick up.

The euro area, however, is only slowly recovering from the euro crisis. This is due to various factors; the most important ones seem to be the following: Firstly, the ECB was reluctant to lower interest rates appropriately (see figure 2), mainly caused by ultra-orthodox monetary authorities within the euro area (esp. Germany’s Bundesbank). Secondly, the ECB has long been opposed to unorthodox monetary policies or is simply not allowed to finance governments directly. The last important factor seems to be the ongoing bias of authorities towards structural reforms at the expense of growth-oriented fiscal and monetary policy. Greece, for instance, experienced a decline of GDP of around 20 percent since 2008. However, since the transition from Jean-Claude Trichet to Mario Draghi, the ECB seems to have a more expansionary stance on its monetary policies. In mid-2012 Mario Draghi announced that the ECB will do “whatever it takes” to defend the euro and introduced two long-term refinancing operations (see here…). Since then, the pressure on countries to obtain credit from supranational lenders (IMF, EU and ECB – the so called “Troika”) declined. Ireland, for instance, was able to return to capital markets in mid-December 2013, although the economic situation remains fragile. In the United Kingdom, the official bank rate has been cut to 0.5 percent in 2009 and has remained there since. In addition, the central bank has initiated an asset purchase program in March 2009 to “give a further monetary stimulus to the economy”.

Summing up, countries which have reacted swift and bold have been more successful in terms of growth, employment and unemployment. It remains a question for the future whether austerity-prone decision makers will take this into account when designing the next “stimulus” packages.

Figure 2: Main policy rates of ECB and FED, monthly data, 01/1999-11/2013; Source: Eurostat and Federal Reserve Bank of St. Louis, FRED

All the factors mentioned above influenced the deterioration of long-term interest rates, which rendered the possibilities of countries to (re)finance themselves through capital markets impossible. Those countries which did not mainly rely on structural reforms but on growth-promoting monetary and fiscal policy saw their economies grow more quickly and, even in the presence of high public-debt to GDP ratios, were able to finance themselves through capital markets (e.g. United States). Growth prospects for the year 2014 for the U.S. and the euro area are 2.5 and 0.7 percent respectively (Horn et al. 2013). Recessions are not the right time for structural reform experiments. This could have been learned from the New Deal eighty years ago where policy interventions followed the principle of relief, recovery and reform in a chronological manner.


European Commission (2012): Macroeconomic Imbalances – Spain, Occasional Paper Series no. 103 (dl. 10.12.2013)

Horn, Gustav et al. (2013): Krise überwunden? - Prognose der wirtschaftlichen Entwicklung 2013/2014, IMK Report 86, October 2013.

Rating Agencies

Rating agencies are institutions that equip nations and other institutions such as banks with a trust index (a rating) which indicates the probability of debt being repaid. If the assumed risk is higher, the rating is worse, which often leads to higher interest for loans (Bösch 2011).

Justified Influence?

This guidance function gives rating agencies great pull (Prager 2012). For, if the rating is adjusted downwards, many investors will consider relocating their money. Thus, a small adjustment of the rating can cause quite a dynamic and go far beyond the objective. This way, entire nations fall victim to a downward trend that can lead to bankruptcy, if no evidence can be supplied that there is safe liability for loans or that the economy grows in rates sufficient to pay the debt. In the tense situation of this crisis, rating agencies are suddenly a focal point of interest to the media and the public - and even one arbitrary or incorrect adjustment of a rating may have serious consequences. This powerful position makes the rating agencies heavy players in the crisis, since - from a functional perspective - one might even call them fire accelerants (Gärtner und Griesbach 2012).


Bösch, V. (2011): Ratings in der Krise, Materialien zu Wirtschaft und Gesellschaft Nr. 110, Vienna.

Gärnter, M. und Griesbach, B. (2012): Rating agencies, self-fulfilling prophecy and multiple equilibria? An empirical model of the European sovereign debt crisis 2009-2011, Discussion Paper no. 2012-15, St. Gallen.

Prager, C. (2012): Ratingagenturen. Funktionsweisen eines neuen politischen Herrschaftsinstrument, Vienna.