Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

European financial adventurism came in all shapes and sizes. And it was not confined to the City of London–Wall Street axis. From the 1980s Dublin set out to establish itself as a low-tax, low-regulation jurisdiction, attracting bankers from Europe and North America.

By the time of the crisis, Depfa’s total assets as reported by credit-rating agency Moody’s had swollen to $218 billion, one-third the size of Lehman.35 This astonishing expansion was not from Depfa’s own resources. It had precious few to begin with. Depfa grew like other market-driven modern banks. It borrowed to lend. And it made handsome profits doing so.

the competitive race for profit and market share among the banks in turn unleashed a regulatory race to the bottom. In 1984 Fed chair Paul Volcker proposed new rules to set minimum standards for bank capital, hoping thereby to prevent undercutting of relatively robust banks by less well-capitalized competitors, notably from Japan.

The more capital a bank has, the more it is able to absorb losses. However, the larger a bank’s book of loans relative to its capital, the higher the rate of return it will be able to offer investors.

Capital ratios were, therefore, one of the neuralgic points of bank governance. After years of deadlock, in September 1986 the Fed and the Bank of England reached a deal, which in July 1988 finally brought the Basel Committee to agreement on what was known as the Capital Accord, or Basel I. Henceforth, the minimum level of capital that a large international bank should aim to hold against normal business loans was set at 8 percent.

If the 8 percent rule had been imposed as a simple percentage, the effect would have been to encourage banks to make the most high-risk investments available in a frantic attempt to milk every cent of profit from every dollar of capital. It would have incentivized risk taking. So the Basel Committee provided for a basic system of risk weights, requiring no capital to be held against the low-risk, short-term debt of governments that were members of the OECD, the exclusive club of rich countries.

Furthermore, the lax provisions of Basel I enabled banks to hold substantial parts of their portfolio off balance sheet in special purpose vehicles (SPV) financed by ABCP.

Their national regulators interpreted Basel I in such a way as to allow them to hold hundreds of billions of dollars of securities and fund them with short-term commercial paper, without needing to commit much of their capital. Not only was their capital stretched thin but the maturity mismatch was terrifying.

Whereas Basel I had been a conventional regulation aiming to impose standards on the industry from the outside, the chief ambition of Basel II was to align risk regulation with “best business practice” as defined by the bankers themselves.

Though Basel II notionally maintained the 8 percent capital requirement, once the big banks applied their proprietary risk-weighting models, they found that they could sustain larger balance sheets than ever before.

Rather than tightening those regulations as a way of moderating the real estate boom, Basel II cut the capital weight of mortgage assets to 35 percent, which made it far more attractive to hold high-yielding mortgage-backed assets.

Rather than imposing intrusive inspections and external audits, Basel II placed heavy emphasis on self-regulation, disclosure and transparency.

The regulators were utterly subservient to the logic of the businesses they were supposed to be regulating. The draft text of what would become the Basel II regulations was prepared for the Basel Committee by the Institute of International Finance, the chief lobby group of the global banking industry.

Nor was the Basel framework well designed to drive standards upward. Both Basel I and Basel II enshrined the principle of “home country rules.” This required signatories to the system to accept the regulations of all other parties as adequate.

banks from lax areas of supervision were free to operate according to their domestic norms in lucrative American and European markets.

The Fed further amplified the effect by declaring in January 2001 that the US banking operations of foreign financial holding companies that were considered adequately capitalized in their home countries would not need to meet separate capital adequacy rules in the United States.

Tellingly, it was the FDIC, the American deposit insurance agency that oversaw medium and small American banks, that raised objections. The FDIC’s chair, Sheila Bair, an outspoken midwestern Republican appointee, was incredulous that big banks were effectively being given license to “set their own capital requirements.”48 It would give them a huge competitive advantage over their smaller competitors. The FDIC estimated that the introduction of Basel II would permit big banks to reduce their capital by 22 percent.

According to the calculations of the Bank for International Settlements (BIS), Deutsche Bank, UBS and Barclays, three of the most aggressive European players in global financial markets, all boasted leverage in excess of 40:1, compared with an average of 20:1 for their main American competitors. In 2007, even before the crisis struck with full force, leverage at Deutsche and UBS touched 50:1.

Of course at every stage in the construction of global capital markets, think tanks, economists and lawyers contributed ideas and argumentation to justify the next move.

Technological change gave banks massive new information-processing capacity. The complex financial instruments they produced exuded an energizing charisma.53 The clannish society of the bankers created a social force field of common assumptions and an overweaning superiority complex. They were the masters of the universe. They could not fail. But the basic driver of expansion and change was the competitive search for profit, played out in the force field of financial engineering, transnational capital movement and competitive deregulation between Wall Street, the City of London and Basel.

It was not that the key players were completely oblivious to risk. But they believed in their capacity to manage it and were totally comm...

Would Europe’s central banks have the dollar reserves necessary to backstop the European financial system? It was an old-fashioned question, seemingly out of season in a world of limitless global liquidity.56 But when the question was put by analysts from the BIS, the answer was sobering. In the balance sheets of the European banks at the end of 2007 there was a mismatch between dollar assets (lending) and dollar liabilities (funding by way of deposits, bonds or short-term money market borrowing) of $1.1–1.3 trillion.57

Against the backdrop of a sanguine view about financial markets, their “hoarding” of dollars was widely seen as a sign of insecurity, an aftereffect of the trauma of the 1997 crisis.58 It is telling that no one troubled to ask the question of what the adequate level of reserves would be for a European country with a gigantic globalized banking system.

When asked later how he justified such minimal reserve holdings prior to the crisis, one of the most outspoken central bankers of the period paused for a minute, smiled at a point well taken and then said quite simply: “Given our long history of relations with the Fed, we didn’t expect to have any difficulty getting hold of dollars.”

If Europe preferred not to highlight its role in the “American” financial crisis of 2008, covering its tracks was made easier by the fact that from 2010 Europe was consumed by its own “authentically” European crisis.

Once Nixon abandoned the gold peg in August 1971, Europe faced a problem. Fluctuating exchange rates would disrupt the tightly integrated trading networks that had brought Europe together. On the other hand, efforts to create a zone of exchange-rate stability by pegging the European currencies against one another reopened the basic question of power.

The stresses might have been manageable if capital movement had been constrained, limiting speculative attacks. But by the early 1980s the freewheeling habits of the eurodollar business had become the global norm.

Huge surges of hot money between currencies put extreme pressure on the more financially fragile states and conferred an intolerable degree of influence on Germany’s conservative central bank.

By 1983 even France’s Socialist administration under François Mitterrand was forced to give in. After a series of messy devaluations between 1981 and 1983, Paris abandoned its effort at social democracy in one country and adopted instead a hard-currency policy of “franc fort.”

The pressures generated by unrestricted capital movements across Europe’s fixed exchanges in turn provided a powerful argument for those who favored ever closer European integration.2 How else were the weaker members of the European Monetary System to regain even a modicum of control over the conduct of monetary policy?

Given the national interests at stake those would most likely have gone nowhere had it not been for the sudden end to the cold war. The fall of the Berlin Wall in 1989 and German chancellor Helmut Kohl’s irresistible push for national reunification threatened to make Germany even more dominant. A currency union and irrevocable economic unification seemed to both Kohl and Mitterrand the best way of securing a much larger Germany in a peaceful and stable continent.

Despite this benign atmosphere, there were two problems that preoccupied experts both inside and outside the eurozone. The first was whether preexisting imbalances in intra-European trade would narrow or expand over time.

Second, there was the risk of asymmetric external shocks.6 A bust in tourism would hurt Greece far more than Germany. A collapse in Chinese import demand would damage Germany in a way that it would not hurt Ireland.

Along with labor mobility, it was this backbone of social security, disability and unemployment benefits that held the gigantic diversity of the US economy from Alabama to California together. Worryingly, there was plenty of self-congratulation in Brussels in the early 2000s but little urgency about building the overarching mechanism of fiscal redistribution and burden sharing that would be necessary to see the eurozone through a recession, let alone a major financial crisis.

The collective effort of the 1990s to stabilize Italy’s finances shaped a generation of Italian technocrats and politicians who would go on to play a key role in European politics, among them Mario Monti, economist, EU commissioner and future prime minister of Italy, and Mario Draghi, the future head of the ECB.

In 2003 France and Germany both exceeded the agreed limit of a 3 percent budget deficit, but Brussels shrank from imposing sanctions on such heavyweights.

Agenda 2010 would come to define a new bipartisan self-understanding of Germany’s political class.13 Having accomplished the enormous task of reunification, Germany had overcome its internal difficulties and “reformed” its way back to economic health. It is a narrative that is superficially compelling and it would have significant implications for how Berlin approached the crisis of the eurozone, but it does not withstand close scrutiny.

German companies do not win export orders by shaving the wages of unskilled workers. A far more important source of competitive advantage came from outsourcing production to Eastern Europe and Southern Europe.

The blue-collar electorate and the left wing of the SPD never forgave Schroeder for Hartz IV.15 The left wing split from the SPD to unify with the former Communists of the East. The result was a new party known as Die Linke, which gathered almost 10 percent of the electorate. Together, Die Linke, the SPD and the Greens were a powerful political force. Red-Red-Green was capable of winning a majority. But the bitter divisions between them over Agenda 2010 made a broad-based center-left coalition difficult to imagine.

In the 2005 election that brought her to power, Merkel ran on a strong promarket platform. It was unpopular and she subsequently softened her stance. But there is little doubt that the 2005 agenda expressed the chancellor’s basic personal vision. It can be summarized in three numbers: 7, 25 and 50. As Merkel is fond of pointing out, Europe has 7 percent of the world’s population and 25 percent of global GDP. But it is responsible for 50 percent of global social spending.17

Fiscal consolidation, like Hartz IV, commanded a consensus across the center ground of German politics. The finance ministry was claimed by Peer Steinbrück, an acolyte of the legendary SPD chancellor of the 1970s and 1980s, Helmut Schmidt.

It was not for nothing that “postdemocracy” became one of the buzzwords of German political discussion in the early 2000s.

Beyond these high-minded considerations, German fiscal strategy was also driven by more basic calculations of electoral advantage. Over the two decades since unification, West Germany had poured more than a trillion euros into reconstruction and regional subsidies for the East.

Capping deficits was a not-so-covert promise to the rich southern states to rebalance priorities away from the needy and indebted eastern and northern members of the Bund.

Well before the Greek crisis broke, the most prosperous regions of West Germany had made clear their refusal to take responsibility for other people’s debts, German or otherwise. The argument that the debts “shouldered by the West” to pay for spending “in the East” had generated huge orders for West German business—in effect exports within Germany from West to East—cut no ice.

there are striking similarities between the debates in Germany and those in Rubinite circles in the United States. On both sides of the Atlantic, globalization, competitiveness and fiscal sustainability were key issues. Nor should this be surprising. The rise of China and the funding problems of the modern welfare state were common challenges.

if there was a common agenda, there were common blind spots too. For all the focus in the eurozone on the need to make labor responsive to the demands of global competition, for all the calls for common fiscal discipline, there was an almost total lack of recognition of the destabilizing forces unleashed by global finance.

Unlike the Fed, which had a dual mandate for price stability and maximum employment, the ECB had price stability as its only target. All this made the ECB the most remote of all the modern central banks.

Nor would it be fair to say that anti-inflation politics were the ECB’s only ambition. It also wanted to promote Europe as a financial center and the euro as a reserve currency, and that meant actively developing European debt markets. Specifically, it meant importing to Europe the American model of a repo market for government debt.

Rather than the ECB, it was Europe’s banks that bought their governments’ debt. But they did so with the understanding that if they needed cash in a hurry, the bonds could be exchanged with the ECB on a repurchase basis.