Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

If it had wished to maximize pressure on Europe’s government to preserve fiscal discipline, the ECB could have adopted a discriminatory system of nationally specific repo haircuts, imposing tougher conditions on less credible peripheral eurozone borrowers.

But instead of discriminating, the ECB took the view that a single currency implied a single rate. It would repo the bonds of all European sovereigns on the same terms.

The result was a self-reflexive loop in which the ECB relied on markets to exercise discipline over public borrowers while the markets came to assume that the ECB’s “one bond” policy implied an implicit European guarantee for even the weakest borrowers.

despite the unprecedentedly low interest rates, there was, in fact, no public debt boom after 2001. Certain countries borrowed more than others. But overall, the Maastricht rules limiting deficits exercised an effective restraint, especially when one considers the inducement to borrow provided by the convergence of yields.

no major public borrower was grossly abusing the situation. Indeed, as economic growth moved into a higher gear, the ratio of public debt to GDP across the eurozone fell by 7 percent.31

Portugal had the most rapidly rising public debt ratio and its budgeting was undeniably lax. But when it joined the euro, its debt was at a low level. Unfortunately, Lisbon made the mistake of entering at an uncompetitive exchange rate.

Greece was the other reprobate. In the 1990s, to qualify for eurozone membership, Greece, like Italy, had eked out primary surpluses (on the budget excluding debt service). Even with interest costs running at 11.5 percent of GDP, this had held the deficit in check. After the formation of the eurozone, Greek borrowing costs and debt service charges fell by more than half. It could have been the opportunity for a substantial fiscal consolidation. Instead, Athens let its tax revenue decline.

What made Greece’s situation dangerous, however, was not the pace of borrowing after 2001 but the debts built up in the 1980s and 1990s, when modern Greek democracy had been established on the back of a huge surge in government spending and expensive borrowing.

Though the degree of Greece’s problems was not fully appreciated, it was a known problem case and it was small fry.

Germany’s government ran up debt, but combined it with consumer and investment spending so repressed that it produced an ever-larger current account surplus. From the point of view of the eurozone’s macroeconomic balance, it would have been better if Germany had broken the fiscal rules more comprehensively.

The backdrop to the eurozone crisis was, indeed, a gigantic surge in debt, but it was in the private, not the public, sector.

Giving Europe the scale necessary to cope with the wild fluctuations of global capital unleashed in the early 1970s was always the chief raison d’être of the European Monetary Union. But the global credit expansion of the early 2000s put anything hitherto experienced in the shade, and Europe’s banks were at the leading edge of the boom.

Cross-border lending within the eurozone exploded, rising even more rapidly than cross-border finance globally.36 Europe’s bankers used the same array of modern banking techniques in the eurozone that they were putting to such profitable use in London and New York.

from the early 2000s, American-style securitization took off in Europe as well. In 2007 more than $500 billion in loans were securitized in Europe. In 2008 the total reached $750 billion in European asset-backed security issuance with UK and Spanish banks particularly active.

if we focus on intra-European flows, it is clear that Germany, despite its export prowess, did not dominate the European financial system. Germany was the largest net lender. Its status was like that of China in relation to the US economy. But financial flows within Europe no more mapped onto trade than they did in the world economy.

France and the Benelux were particularly important because they served as channels through which funds flowed into the eurozone from the outside. American and other lenders from the rest of the world clearly preferred to do business with well-known French, Dutch and Belgian counterparties, who then channeled the funds to the European periphery.

The flow of funds around Europe, as around the global economy, was driven not by trade flows but by the business logic of bankers, who sought out the cheapest funding and the best returns.

Between 2001 and 2006, Greece, Finland, Sweden, Belgium, Denmark, the UK, France, Ireland and Spain all experienced real estate booms more severe than those that energized the United States.

It was these credit-fueled booms that drove the trade and fiscal imbalances of the eurozone, rather than the other way around. The huge influx of credit from all over the world to a hot spot like Spain inflated economic activity there. This generated healthy tax revenues for Madrid, which proudly boasted a fiscal surplus. It also generated export orders for Germany. Foreign demand gave a boost to the languishing German economy, raising incomes and profits.

German households and businesses did not want to spend their income increment in Germany, on either consumption or investment. The German government borrowed, but not enough to soak up the difference. Through interbank markets, surplus liquidity in the north helped to fund business ventures around Europe. Some of that, not surprisingly, went to Spain. At the end of the day the accounts balanced. Germany’s savings appear as the counterpart to Spain’s trade deficit.

It wasn’t Germany’s excess savings, or its exports, that produced the boom in Spain. It was the lopsided credit-fueled boom that produced the demand imbalances, the trade flows and the savings imbalances.

Had Germany’s domestic economy been in more robust shape, Germany’s demand for imports would have been larger, and the trade imbalances within the eurozone might have been smaller. A somewhat larger fraction of the Spanish economy might have been directed toward producing goods for export to Germany rather than supplying the domestic boom.

In modern finance, credit is not a fixed sum constrained by the “fundamentals” of the “real economy.” It is an elastic quantity, which in an asset price boom can easily become self-expanding on a transnational scale.

Where does Greece, the country that would become the epicenter of the eurozone crisis, fit in this picture? It is present, but vanishingly small. Of the annual flux in cross-border funding within the eurozone between 2004 and 2006, which on average came to c. 1.8 trillion euros, Greece accounted for 33 billion euros. That is less than 2 percent, proportional to Greece’s weight in eurozone GDP.

Greece too experienced a property boom on a par with the United States. The red flag in Greece was not the annual inflow of capital after 2001 but the fact that the new borrowing was being added to huge stocks of debt already accumulated in prior decades.

It would later be said that the ECB should have done more to dampen the boom in Ireland and Spain. And it is clearly true that this was made more difficult by the fact that it set one interest rate for the entire eurozone. In effect, by setting low rates, the ECB prioritized the need to stimulate the German economy over restraining the boom in the periphery.

it is wishful thinking to imagine that the ECB could have curbed the boom with a rate hike. If the EU’s business statistics are to be believed, investment in Spanish tourism and real estate offered rates of return of 30 percent or more. Little wonder that investment crowded in.39 In a world of globalized finance, the ECB could no more limit the flow of funds to such a hot spot than the Fed could choke off the capital inflow to the United States.

In the case of Spain, the larger, internationalized banks were, in fact, held on a tight leash. Foreign investors expected high governance standards. And they came through the crisis well.41 But the same cannot be said for the local mortgage lenders, the cajas that made up 50 percent of the credit market.

One of the side effects of a bubble is that it makes balance sheets look good. Tough governance reform seems unnecessary and punitive.

Among Ireland’s tiny political elite a similar spirit of ebullience prevailed. Coddled by EU investment and incestuously connected with bankers and developers, politicians boasted of the global attractions of Dublin’s International Financial Services Center.

Though a member of the eurozone and benefiting enormously from Brussels subsidy payments, the Irish liked to regard themselves as an “outpost of American (or Anglo-American) free-market values on the far edge of a continent where various brands of social democracy were still the political norm.”

There are many risks involved in forming a currency union and it would no doubt have made sense for Europe to have added a fiscal constitution. But Europe’s chief problem was not the lack of a fiscal fire code. Its problem was the lack of a financial fire department.

Coping with highly integrated financial capitalism requires a state that is disciplined, has the capacity to act and has the will to do so. Coping with a banking crisis on the scale that was brewing in Europe required a very capable state indeed.

it was in Europe that bank finance had grown most disproportionately.47 Europe’s banks had always been large. Unlike the United States, where equity and bond markets were the main sources of business finance, Europe’s economies had long relied heavily on bank lending. But spreading out across the EU and feeding off the transatlantic financial circuit, the European banks had grown to gargantuan size. In 2007 the three largest banks in the world by assets were all European—RBS, Deutsche Bank and BNP.

Combined, their balance sheets came to 17 percent of global GDP. The balance sheet of each of them came close to matching the GDP of its home country—Britain, Germany and France—the three largest economies in the EU.

By this standard every member of the eurozone was at least three times more “overbanked” than the United States.

This was the true deficit of the eurozone. It was a monetary union that unified financial markets but provided none of the institutions of governance required for a banking union.

The state of denial was common. The difference was that when the unthinkable happened, the United States had a structure of federal government within which to improvise a response. The misfortune of the EU was that when the crisis struck, it not only lacked such structures. The crisis came at a moment when the EU’s efforts to build a more robust constitutional framework had run up against basic political limits.

Up to the early 2000s, the EU operated against a backdrop of what political scientists called a “permissive consensus.”51 Europe’s population accepted the gradual push for ever closer union without enthusiasm but also without protest.

Contrary to prevailing myth, the EU is by no means a gigantic bureaucracy. The EU employs fewer people than most medium-sized cities. But it was a sprawling, incoherent constitutional structure lacking in democratic accountability.

The constitution was a pleasing portmanteau of all the nostrums of good governance of the early 2000s. The European Trade Union movement gave its approval. Tony Blair and Britain’s New Labour government were enthusiastic. In Washington, DC, the Hamilton Project would probably have been pleased to put its name to it. But on May 29, 2005, the constitution was rejected by popular referenda in France and then, in June, in the Netherlands. Left-wing hostility to the promarket character of the EU and nationalist hostility to Brussels united to deliver solid majorities against it.

Given the reality of increasingly close economic and financial integration and the extension of the EU to Eastern Europe, the project of reorganizing Europe could not simply be abandoned. A substitute had to be found.

Merkel’s relationship to Europe was quite different from that of her mentor Helmut Kohl.55 Given her upbringing in cold war East Germany, her early fascination with the outside world was directed first to Russia and then to Britain and the United States. This was of a piece with her embrace of globalism and its causes of the 1990s, including environmental politics and climate change.

There was no grand hegemonic project in early-twenty-first-century Berlin. What they had in common was their belief that it is not just Germany’s right but its proper historical role to act as a self-confident veto player in European affairs.

If it was a blind spot, it was not a repressed desire for domination but a tendency to underestimate the extent to which Germany’s success and international prominence were in fact interdependent with Europe.

The Lisbon Treaty enshrined intergovernmentalism and Europe’s voters had shown their willingness to exercise a veto over steps beyond that. How, given this disequilibrium, the EU would respond to an unforeseen crisis was anyone’s guess.

If one compares American and European policy discussion in the early 2000s, one sees that they shared many preoccupations. Policy experts on both continents were focused on fiscal discipline and international competitiveness, supply side incentives, efficient government spending, deficits, evidence-based welfare policy, education reform and flexible labor markets.

Sharing a deep faith in markets, neither realized the threat posed by the new, market-based model of banking. On both sides of the Atlantic they were oblivious to the risks accumulating in overleveraged banks, relying on vast quantities of wholesale funding.

If we are looking for one crucial difference it is surely this: From the morning of September 11, 2001, America was a superpower at war. Not only that, under the Bush administration, it was a regime pursuing a global war on terror.

In the early twenty-first century it amounted to nothing less than a civilization divide, a bifurcation within modernity, between the chastened postimperial world of Europe and the expansive, imperially aggressive Anglosphere.59