Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

What would happen if an oligarch failed in his responsibilities was demonstrated in June 2009 when Putin descended on Pikalevo, a small town south of St. Petersburg dominated by the metallurgical empire of Oleg Deripaska. Deripaska, who had once been listed as the richest man in Russia, with a fortune estimated at $28 billion, had seen it reduced to $3.5 billion. But that was no excuse for not paying wages.20 Indignant workers were blockading the Moscow highway, causing a 250-mile traffic jam. In front of the TV cameras Putin upbraided Deripaska. Tossing him a pen, the premier demanded that the oligarch sign the paychecks there and then. It was economic management by personal intimidation of the telegenic tub-thumping variety.

Even before the crisis, the expert advisers that Medvedev cultivated in his personal entourage had been calling for a new course.22 In the wake of the crisis their message was even louder. What had made Russia so vulnerable in 2008 was its lopsided integration into the world economy: on the one hand, its excessive reliance on oil and gas; on the other hand, the corrupt culture of capital flight, in which Russian oligarchs sluiced money in and out of the country through the off-shore banking system.

What Russia needed was economic transformation, and for that it needed not less but more interaction with the world economy, and above all with its technological leaders. And this had wider implications. After the shocking confrontation with the West in August 2008, Moscow needed to change course. With the crushing of Georgia, the Kremlin had made its point. In the future, Medvedev asserted, the success or failure of Russian foreign policy should be judged by a single criterion: “whether it contributes to improving living standards in our country.”

And if Russia was hard hit by the 2008 crisis, the impact on Eastern Europe was even worse. The shock to the most highly leveraged transition states of the former Communist bloc was staggering. If we compare the forecasts for 2010 made in October 2007 with the expected outturn two years later, we see how radically the crisis changed the outlook for the worst-hit countries in the region.

One year into the crisis, in October 2009, the IMF’s forecast for Latvia’s GDP in 2010 was 39 percent lower than it had been in October 2007. Over the same two-year period, Estonia’s and Lithuania’s GDP expectations were revised downward by a whopping one-third.

Individually, the East European states are not big economies. But taken together they formed a substantial unit comparable in economic heft to France or the state of California. They were the pride of Europe’s transformation process, and the battleground in the new confrontation with Russia that had taken shape between 2007 and 2008.

The situation was made even worse, however, by the source of the capital that fueled their growth: the overleveraged banks of Western Europe. In total, the West European banks and their local branches had $1.3 trillion at stake in emerging Europe, $1.08 trillion excluding Russia.

29 In Bulgaria, Romania, Hungary and Lithuania, foreign loans made up more than half of all credit. As the forint plunged, in a matter of weeks Hungarian families saw their mortgage and car loan bills surge by 20 percent.

With the Fed having used swap lines to stabilize a core group of economies in which American interests were undeniable, one might have expected the ECB to extend similar support to the East European neighbors of the eurozone. Certainly this was the expectation of the Fed.

whereas the Fed had effectively licensed the ECB to issue dollars, the ECB had no intention of extending equivalent privileges to Poland or Romania. With Sweden and Denmark the ECB established publicly announced swap lines. Their banks would supply liquidity to Eastern Europe. Meanwhile, the central banks of Poland and Hungary were fobbed off with repo arrangements that treated them no better than stressed commercial banks in need of extra liquidity.

Even the limited facilities offered by the ECB were extracted only thanks to urgent pressure from the Austrian and French central banks, which had particular reason to worry about the losses their banks might suffer on their East European portfolios.33 Austria’s banks were in particular difficulty because they had made loans in Swiss francs, funding them with borrowing in Switzerland, where interest rates were low. Now the Swiss franc was soaring and funding was scarce.

Membership in the EU and NATO was supposed to have promoted Eastern Europe from their inferior status in the global pecking order. Ex-members of the Warsaw Pact and former Soviet republics had eagerly refashioned themselves as exponents of Donald Rumsfeld’s new Europe. They now found their prospects for growth shattered and their governments thrown back to where their post-Communist careers had begun, as lesser sovereigns, and more or less resentful supplicants for international financial assistance.

At 20 percent of Hungarian precrisis GDP, it was a very substantial commitment and an unusually generous multiple of Hungary’s IMF capital quota.36 The IMF considered the program to be unusually lenient. Unsurprisingly, the Hungarians did not see it in such favorable terms.

In 2010 the right-wing Fidesz party would reap the benefits with a crushing electoral victory, setting Hungary on the path to a self-declared illiberal democracy.

Additionally, at the urging of Washington, a new, minimally invasive flexible credit facility, offering a total of more than $80 billion in ready cash, was made available to Mexico, Poland and Colombia. Mexico thus had the singular distinction of receiving both a swap line and an IMF credit facility.

Thanks to the IMF and EU intervention, an immediate meltdown was avoided on the East European periphery of Europe in the fall of 2008.39 But the situation remained extremely precarious.

Evoking a different chapter in Europe’s history, the Viennese press was warning of a “monetary Stalingrad” that threatened Austria’s and Italy’s banks.

the alarmist talk in Central Europe was also a reflection of the fact that Western Europe wasn’t listening.

Germany shot down Austrian and Hungarian initiatives for a common support fund.42 “Not our problem,” Peer Steinbrück announced.

In early 2009 there were calls, ironic in light of later events, for Poland and other East European EU members to be put on a fast track to eurozone membership, thus bringing them under the protective umbrella of the ECB.44 A confidential IMF staff report backed the proposal arguing that “[f]or countries in the EU, euro-isation offers the largest benefits in terms of resolving the foreign currency debt overhang [accumulation], removing uncertainty and restoring confidence.

Circumventing Brussels, the Austrian government announced what became known as the Vienna Initiative. This multilateral scheme committed the World Bank, the European Bank for Reconstruction and Development and the European Investment Bank to a program of 24.5 billion euros in new lending and capital injections.

As it turned out, the most important battleground for East European stabilization was a long way from Vienna. As the twenty-first century began, Latvia, Lithuania and Estonia had seemed like the lucky ones. Unlike other former Soviet republics, such as Ukraine, Georgia or Belarus, they had successfully transitioned to full membership in both the EU and NATO. Furthermore, unlike Hungary or Poland, the Baltics were eager to join the euro as soon as possible.

Latvia faced the unwinding of its huge deficits in the context of a comprehensive global crisis that had forced its regional competitors in Poland, Hungary and Romania to devalue. If the Baltics did not follow suit, how were they to keep up? How would they cope without foreign funding? How could they regain export competitiveness and shrink imports if they could not adjust their currencies against the euro? Without devaluation the only way to right the trade balance was by rebalancing domestic demand, cutting wages, raising taxes and slashing government spending.

The cost of servicing their debts in euros would simply have become prohibitive. Though they were not yet members of the eurozone, in early 2009 the Baltics faced a predicament that was a grim precursor of things to come.

for two of Sweden’s most important banks, Swedbank and Nordea, the entanglement with the Baltics was existential.51 If their loans were written off, the capital of both banks would be completely wiped out.

One Central European minister of finance, who preferred to remain anonymous, predicted that the chain reaction across Central and Eastern Europe would take down at least half a dozen European banks. Latvia would play the role of a Lehman, or, even more ominously, that of the infamous Austrian Kreditanstalt in the financial crisis of 1931, the failure of which had precipitated Weimar Germany’s final slide toward disaster.

the European Commission dug in its heels. Latvia was en route to eurozone membership. It must stay the course. If it needed to rebalance its current account it must do so through deflation and austerity. The results for Latvia were drastic. By the summer of 2009 house prices had plunged by 50 percent. Civil servants, including one-third of the country’s teachers, were fired and public salaries were slashed by 35 percent. Unemployment surged from 5 to 20 percent.53 Remarkably, Latvia clung on, as did its neighbors.

The financial austerity course imposed a huge pressure on the new democracies of the Baltics.55 In Latvia popular discontent with the new austerity line and accusations of corruption against the political class led to two referenda calling for protection of pensions and a public right to dissolve the parliament by plebiscite.

In February a conservative coalition government took office under the high-profile member of the European Parliament Valdis Dombrovskis. His government’s objective was to stay the course of austere conformity. “We are facing national bankruptcy. It’s going to be tough,”56 Dombrovskis told the nation. What, after all, was the alternative? The legacy of the Soviet period hung over Latvia.

Faced with the double crisis of 2008 the reaction of Eastern Europe was not uniform. The Baltics stayed the course. Hungarian nationalism rebelled. But nowhere was the double shock more jarring than in Ukraine.

In the spring of 2008 the decision by Ukrainian president Viktor Yushchenko to apply for NATO membership—eagerly applauded by the Bush administration, Poland and the other East Europeans—split Ukrainian politics. Whereas President Yushchenko threw in his lot with the West, Prime Minister Yulia Tymoshenko favored the policy of balance between Russia and the West that Kiev had pursued since independence and that had made her personal fortune as a kingpin in the gas trade.

Since the 2004 revolution, Ukraine’s economic growth had come to rely on foreign borrowing. By early 2008, foreign funds made up 45 percent of all corporate financing and 65 percent of household loans in Ukraine.

The onset of the crisis stopped the credit flow. And it hit Ukraine’s exports hard. As one of the legacies of the Soviet era, steel accounted for 42 percent of Ukraine’s foreign currency earnings. No sector was worse hit by the crash in global investment spending than steel. Prices plunged and industrial output by January 2009 was falling at an annualized rate of 34 percent.59 As Ukraine’s economy slid into recession, millions were left without pay, if they were not actually thrown out of work.

In October 2008 Ukraine had no option but to follow Hungary to the IMF. Kiev signed up to a $16.4 billion loan package.

It asked for Ukraine to fully fund its budget, to set a realistic exchange rate and to ensure that its financial system was stable. But even this was more than Kiev could manage. The exchange rate was allowed to devalue from the overvalued rate of 5 hryvnia to the dollar to 7.7, though unofficially it traded as low as 10 to the dollar.

The upshot was paradoxical. On the one hand, the impasse in Ukraine’s post–cold war development was more evident than ever. What hope there was of economic development lay in further integration with the West even at the expense of painful structural adjustment. On the other hand, by the autumn of 2009 the most popular politician in Ukraine was Viktor Yanukovych, the representative of the Russian-oriented “party of the regions” with its base in eastern Ukraine, the thuggish dinosaur of the transition era whose rigged election victory in 2004 had triggered the Orange Revolution.

The one point of relief for Ukraine in 2009 was that geopolitical tension between East and West seemed to be subsiding.

Womp womp

the fragility of the situation was painfully exposed in January 2009 when a dispute between Russia and Ukraine over unpaid bills and gas prices left Ukraine without heat in the depth of winter and interrupted flow through the pipelines running west to Europe.62 The dispute was resolved only with EU mediation and a price increase for Gazprom that would become an albatross around the neck of Prime Minister Tymoshenko.

Russia had made good on Putin’s announcement at Munich that the unipolar moment was passing. And the Americans knew it was true. But when they thought of multipolarity, they did not think first and foremost of Putin’s ramshackle regime. They thought of China. And so, in fact, did Russia’s own best analysts.

Toward the end of 2008 the Atlantic magazine garnered an interview with a fast-talking manager of China’s sovereign wealth fund.4 The result was a startling insight into a topsy-turvy world. Over recent months, Gao Xiqing remarked, the world had watched as America, “after months and months of struggling with your own ideology, with your own pride, your self-righteousness,” had finally applied “one of the great gifts of Americans, which is that you’re pragmatic.” The Fed and the Treasury had intervened on a massive scale to stabilize the financial economy, so now, Gao quipped, when the Chinese looked to the United States, what they saw was not capitalist democracy, but “socialism with American characteristics.”

Woof. Pride goeth before a fall

It hadn’t been only ideology and vanity that stood in the way of a solution in September and October 2008. Interests had been at stake. Convening the “executive committee of the bourgeoisie” was never going to be a simple task. But, then, Gao was not a party theorist. He was an alumnus of Duke Law School and sported a CV including time spent working for Richard Nixon’s Wall Street law firm.

As Barack Obama’s stunning election victory demonstrated, many Americans agreed with Gao.

Eeeeehhhhhh no

Chinese purchases of Treasurys, meanwhile, increased. China’s total holding of US securities continued to rise from $922 billion in June 2007 to $1,464 billion two years later.6 Nor was this surprising. Panic and crisis, turned US Treasurys into the most desirable asset in the world. Everyone wanted safety. Treasury prices were rising, yields easing, so too was the dollar. If China had wanted to diversify out of its dollar assets, this was the moment to do it. There was insatiable global demand for safe dollar assets. But what the crisis revealed was that China’s options were limited.

Given the scale of Chinese export success and its accumulation of foreign assets, Western observers are apt to believe that China’s growth must be “export dependent.” But this is an optical illusion that reflects our recalcitrant Western-centric view. Exports are important to China, and its insertion into the world economy has transformed global trade. But even before the crisis China’s domestic economy was large and it was growing extraordinarily rapidly, far more rapidly than China’s markets abroad.

A large part of the value in China’s world-beating exports was accounted for by imported raw materials and subcomponents.

no more than one third of China’s growth from 1990 was driven by exports, with two thirds coming from domestic demand.

In China, far and away the main driver of growth was its enormous wave of domestic investment. As China’s cities expanded and its infrastructure modernized at a staggering rate, the physical reconstruction of the country sucked the entire Chinese economy up with it.

In the spring of 2008, as the rest of the world slid toward recession, Beijing’s main worry was that China’s economy was expanding too fast. Growth in consumption was roaring along at more than 20 percent per annum. The People’s Bank of China raised interest rates and government fiscal policy was tightened to choke off the boom. Meanwhile, China’s government machine was reorganized to concentrate responsibility for more balanced national growth in centralized superministries.

Whereas in July 2008 Chinese exports were growing by 25 percent, imports by 30 percent and FDI by 65 percent per annum, six months later China’s exports were falling by 18 percent, imports by more than 40 percent and FDI by 30 percent. It was an astonishing switchback. Even if net exports normally accounted for only a third of China’s growth, the impact was severe.

As the winter of 2008–2009 approached, 30 percent of China’s gigantic annual surge of college graduates—5.6 million per annum—were unable to find work. The reserve army of tens of millions of rural migrants fared even worse.