Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

To reverse the balance of risk, when Beijing pegged its exchange rate it chose one that was not too high, but too low. This was what Japan and Germany had done in the 1950s and 1960s.27 It was a recipe for export-led growth, but it created tensions of its own.

Undervaluing the currency made imports more expensive than they needed to be, which lowered the Chinese standard of living. When it ran a trade surplus with the United States and bought American government bonds, poor China was exporting capital to rich America, funding American consumers to buy the products of its huge new factories.

With China’s trade surplus with the United States surging from $83 billion in 2000 to $227 billion in 2009, to hold the value of the yuan down the Chinese central bank had to continually buy dollars and sell its own currency. To do so it printed yuan. In the normal course of things this would have unleashed domestic inflation, wiping out any competitive advantage and triggering social unrest. So, to “sterilize” the effects of its own intervention, the People’s Bank of China req...

With so many currencies fixed against the dollar, without the possibility of adjusting export competitiveness by means of devaluation or appreciation, it was no surprise that the world economy polarized into export surplus and import deficit countries.

For those on the surplus side of the “global imbalances,” so-called sovereign wealth funds (SWF) became huge repositories of capital. According to estimates by the Peterson Institute for International Economics in Washington, DC, by 2007 emerging market sovereign wealth funds held at least $2 trillion in assets, in addition to the trillions in reserves held by their central banks.

China’s State Administration of Foreign Exchange looked for safe and predictable returns. Its safe assets of choice were long-dated US government debt and securities guaranteed by the US government.

The imbalances were worrying, but, at least as far the surplus countries were concerned, they promised that the first shock in the case of an unwinding would be borne by the other side. It was the United States, the world’s great deficit economy, that would see its currency devalue and its interest rates surge as foreign investors abandoned American assets. It was this scenario that caused Orszag, Rubin and Senator Obama such concern. Nor were they alone.

Economists Nouriel Roubini and Brad Setser warned that if investors were to lose confidence, the United States could face a very sudden depreciation of the dollar and a massive hike in interest rates.31 It might well turn out to be the worst recession experienced since World War II.32 And America would not only be depressed. It would be humbled at the hands of the rising power of Asia.

For Larry Summers, who had moved from the Treasury to an ill-fated stint as president of Harvard, it reawakened memories of cold war–era mutually assured destruction. At the heart of the world economy, he told Washington audiences, was a “balance of financial terror.”

To ease these imbalances, the obvious solution, as the Hamilton Project demanded, was fiscal restraint. Reduce the federal deficit, squeeze domestic demand, reduce the import of Chinese goods and Chinese money. But the Bush administration didn’t seem to care.

In November 2002 O’Neill tried to warn Vice President Dick Cheney that the surging “budget deficits . . . posed a threat to the economy.” Only for Cheney to cut him off with the following remark: “You know . . . Reagan proved deficits don’t matter.”

If Cheney’s version of Republicanism prevailed, it undermined the basis for turn taking in America’s two-party system. How could the Democrats conduct responsible “national” economic policy if the Republicans viewed the economy as a resource to be milked for the benefit of its privileged constituency?

The question was pressing because following the momentous November 2006 midterms, control of the House and the Senate changed hands. In a turn of events that can only be described as fateful, it would be the Democrats who held power in Congress during the greatest crisis of American capitalism since the 1930s. But that was in the future. In 2006 the question was whether the Democrats, as the new power on Capitol Hill, should once again take responsibility for cutting the deficit.

Given this dilemma, the disaster scenarios invoked by Orszag and Rubin take on a different meaning. They were as much about controlling the agenda within the Democratic Party as about winning over Republicans. If all that was at stake in the struggle over the deficit was a percentage point of economic growth here or there, why should the Democrats not put their own partisan priorities first?

The irony, however, was that as the Fed’s reputation and authority grew, its key tool of policy seemed to be losing its effectiveness. The short-term interest rate set by the Fed no longer seemed to be setting the pace for the rest of the economy.

Following the dot-com crash Greenspan had cut rates to 3.5 percent. After the 9/11 attacks there were further cuts, reaching 1 percent in the summer of 2003. Then, from 2004 on, the Fed started raising rates. Faced with America’s trade deficit and its rapid domestic boom, this was the standard prescription. It should increase private saving and restrict investment.

Most strikingly, as the Fed hiked short-term rates, rates in long-term bond markets failed to respond. There were too many buyers of long-term bonds, driving prices up and yields down.

By fixing their currencies against the dollar, many of America’s trading partners prevented not only a downward movement of the dollar, which might have restored America’s competitiveness. They also prevented an appreciation of the American currency, which would normally have followed on an interest rate increase.

Under de facto fixed exchange rates, an increase in the interest rates would not reduce the supply of credit. It had the opposite effect of making investment in the United States more attractive, drawing in a greater flow of foreign funds.

The Fed found itself boxed in between China’s determination to peg its currency and the refusal of Congress t...

The availability of foreign funding negated Fed efforts to raise interest rates.

As capital surged in, this pushed down US interest rates, stoking the domestic economic upswing and sucking in imports, above all from China. But barring a change of heart on the part of Congress or a general liberalization of exchange rates, there was little the Fed could do.

The lesson of the 1930s was that the Fed must act promptly not just to prevent the money supply expanding excessively but also to prevent bank failures from causing it to implode.

As an economist steeped in the disastrous history of the 1920s and 1930s gold-exchange standard, Bernanke knew all too well the perils of a lopsided fixed exchange rate system. He was profoundly critical of China’s currency policy.

In July 2005, to relieve pressure on the US economy, China began to allow a slow currency appreciation. In due course this would bring about a 23 percent revaluation. But it was painfully slow.

China could not be expected to take advice from the IMF until it had representation on the IMF’s board that was commensurate with its size. Furthermore, Beijing would expect IMF monitoring to apply to the United States as well.

Paul Krugman sketched the logic of what he described as a “Wile E. Coyote moment,” in which foreign investors would suddenly realize that there was nothing holding the dollar up other than their own purchasing of it.

The best and brightest in American economic policy were not wrong to worry about the Sino-American imbalance. If it had blown up, it would have been a disaster. Ten years on, the scenario still hangs over the world economy.

No one was under any illusion that it was simply a market relationship, a matter of business as usual. When Paulson was worried about a Chinese dollar sell-off, he knew whom in Beijing to call. Larry Summers’s cold war analogy proved more apt than he realized. The balance of financial terror held.56 But in the meantime, what became increasingly clear was that the US policy-making elite had been focused, as Bradford DeLong would put it, on the “wrong crisis.”

What they did not put in question was the basic functioning of America’s economy, its banks and financial markets. America’s problems were its people, its society, its politics, not its economy as such.

Since the early 2000s the American economy had been buoyed not only by huge fiscal deficits but by a sustained surge in house prices. Now, in some of the most challenged neighborhoods in the country, tens of thousands of families who had recently taken out home loans were failing to make payments.

For tens of millions of Americans this crisis hit them where it hurt most, at home. But compared with the grand sweep of global economic imbalances and the Sino-American relationship, the mechanics of American mortgage finance cannot but appear a parochial concern.

real estate may be mundane, and McMansions may be nondescript, but they account for a huge share of total marketable wealth worldwide. By one estimate, the share of American real estate in global wealth is as much as 20 percent.

In 2007 American consumers bought c. 16 percent of global output, and nothing made them feel better than surging real estate prices. As America’s home prices almost doubled in the ten years leading to 2006, this raised household wealth by $6.5 trillion, delivering a giant boost not just to the United States but to the world economy.

to explain how this could trigger a financial crisis, with bank failures spreading panic and a credit crunch across the world, there is one crucial thing to add: Real estate is not only the largest single form of wealth, it is also the most important form of collateral for borrowing.

Between the 1990s and the outbreak of the crisis in 2007, American housing finance was turned into a dynamic and destabilizing force by a fourfold transformation—the securitization of mortgages, their incorporation into expansive and high-risk strategies of banking growth, the mobilization of new funding sources and internationalization.

On October 6, 1979, after an unscheduled meeting of the Federal Reserve’s key interest-rate-setting committee, the Federal Open Market Committee (FOMC), Paul Volcker, the Fed chair, announced that the Fed would henceforth attempt to tightly regulate bank reserves and that interest rates could be expected to rise.6 It was the Fed’s response to a wave of inflation that was threatening domestic instability, America’s global standing and the status of the dollar.

with prices accelerating toward annual increases of 14 percent in 1979, Volcker and the Fed decided that it was time to apply the brakes. It was the moment the power of the modern Fed was born. The interest rate was its weapon.

The result was to send a shuddering shock through both the American and the global economies. The dollar surged, as did unemployment. Inflation collapsed from 14.8 percent in March 1980 to 3 percent by 1983. In Britain this was the crisis with which the Thatcher government began. In Germany it would contribute to Schmidt’s unseating and his replacement by the conservative government of Helmut Kohl.8 France’s Socialist government under President François Mitterrand would be forced into line in 1983.

It was an end not just to inflation but to a large part of the manufacturing base in the Western economies, and with it the bargaining power of the trade unions. No longer would they be able to drive up wages in line with prices. And there was another part of America’s postwar political economy that did not survive the disinflationary shock of the 1980s: the peculiar system of housing finance that had emerged from the New Deal era.

Since the 1930s, America’s housing finance had been based on commercial banks and local savings banks, so-called savings and loans, making long-term fixed interest loans. By the late 1960s thirty-year fixed interest loans had become normal, with as little as 5 percent in down payment.10 The funding was provided by depository institutions, which offered government-insured savings accounts with capped interest rates. This was the basis on which home ownership had expanded to almost 66 percent of households by the 1970s.

For home owners on fixed interest, long-term mortgages, the inflation of the post–Bretton Woods era was a windfall. The real value of their loans was eaten up while their interest rates remained fixed. For the banks that lent to them it was a disaster.

Wow eat shit Boomers

To borrow from money markets or issue bonds, they now faced the withering interest rates set by the Fed. Meanwhile, their portfolios of fixed interest mortgages were devalued as rates on new loans soared.11 By the early 1980s the vast majority of the almost four thousand savings-and-loan banks still in operation were insolvent.

By the late 1980s the macroeconomic picture was stabilizing. Inflation was down and interest rates were falling. Whereas most bond investors did well in the new era, anyone who held mortgage loans had to reckon with another risk.

for the lender it means that the US mortgage contract is highly one-sided. During a period of rising rates their fixed-rate loans will devalue. During a loosening of monetary policy, when rates fall, the borrowers refinance. Lending for thirty-year terms at fixed rates is a viable business proposition only under the kinds of conditions of stability that prevailed under Bretton Woods between 1945 and 1971. In a new age of flexible monetary arrangements it was dangerously one-sided, especially if the risks were concentrated in small mortgage lenders with limited means of funding themselves.

The basic anchor of America’s mortgage system in the aftermath of the savings-and-loans debacle was the so-called government-sponsored enterprise (GSE).14 The mother ship of the GSEs was Fannie Mae, founded in 1938 to create a secondary market for lenders who were willing to issue the new type of government-insured Federal Housing Authority mortgages promoted by the New Deal.

Fannie Mae did not issue mortgages. It bought them mainly from commercial banks across the United States that specialized in issuing FHA-insured mortgages.

Fannie Mae was able to fund its purchases of these standardized mortgages cheaply because its credit rating was that of a government agency that could not fail. So-called agency debt was equivalent to that of the Treasury.

To get them off at a time of fiscal stress during the Vietnam War, in 1968 Fannie Mae was privatized. The branch still devoted to making loans to public employees and veterans was split off as Ginnie Mae. “New Fannie Mae” was licensed to buy any mortgages, government guaranteed or not, that conformed to certain quality standards—so-called conforming loans.

Despite this government guarantee, with their large portfolios of fixed interest loans, the GSEs were hit hard by the Volcker shock of the early 1980s. Fannie Mae came close to failure. But it survived, and as the housing market recovered in the 1990s, the GSEs flourished. Thanks to their residual tie to the federal government, the GSEs continued to enjoy a substantial discount in funding costs.