​Bailouts lead to weaker economies

Government bailouts of banks may have made Europe's fragile economic stability worse rather than better, according to new large-scale research. 

In addition, a widespread expectation of government support makes banks more vulnerable to collapse. 

The research, led by Dr Renatas Kizys, an economist at the University of Portsmouth, is the first to suggest large-scale rescues of banks does not stabilise the banking sector or a country’s economy but instead appears to have the opposite effect. 

The study is published in the Journal of International Financial Markets, Institutions and Money: http://www.sciencedirect.com/science/article/pii/S104244311500102X

Dr Kizys said: “The results go against conventional wisdom but we have found clear evidence of a strong two-way loop between banks facing a crisis and governments stepping in to help them resulting in a higher cost to the public sector.

“The findings go much further than previous work in explaining the complex and volatile relationships within countries when things go wrong.”

The research team, including Dr Nikos Paltalidis, Durham University, and Dr Konstantinos Vergos, University of Portsmouth, examined data from the financial sector from March 2005 to June 2013. They studied more than 2,000 daily observations of various metrics, including the stock markets index for 12 Eurozone countries, the volatility index, which measures uncertainty in the stock markets and credit default swaps, indicating the level of credit risk.

The results provide a stark picture of how the Eurozone went from a period of low to high credit risk following the collapse of the Lehmann Brothers bank in 2008, triggered by the 2007 sub-prime mortgage crisis in the US.

The resulting global recession included, the researchers say, the worst deterioration in public finances in the world’s major advanced economies in a peacetime period.

The research found that in addition to bailouts exacerbating any weaknesses in Europe’s finances, the more governments interfered, the faster the ‘feedback loop’ of deterioration. The end result of the ‘feedback loop’ was always a bigger bill for the public sector.

Dr Kizys said: “The results indicate the greater the bailouts given by Eurozone governments to their banks, the faster those economies deteriorated, exposing them and the public to greater sovereign risk.”