Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

In the aftermath of World War II, the Bretton Woods monetary system had sought to restrict speculative capital flows. This gave the US Treasury and the Fed controlling roles. The aim was to minimize currency instability and to manage the global shortage of dollars. But it meant that the US authorities had to operate the kinds of controls that we now associate with China. This was a fetter on private banking. From the 1950s, with connivance of the UK authorities, the City of London developed as a financial center that sidestepped those constraints.18 British, American, European and then Asian banks too began to use London as a center for unregulated deposit taking and lending in dollars. Among the first to avail themselves of these “eurodollar” accounts were Communist states that wanted to keep their export earnings safe from meddling by the US Treasury. They set a trend. By the 1960s eurodollar accounts in London offered the basic framework for a largely unregulated global financial market.

As a result, what we know today as American financial hegemony had a complex geography. It was no more reducible to Wall Street than the manufacture of iPhones can be reduced to Silicon Valley. Dollar hegemony was made through a network. It was by way of London that the dollar was made global.19

For many of the most fast-paced global transactions, it was London, not Wall Street, that was the location of choice. By 2007, 35 percent of the global turnover in foreign exchange, running at a staggering $1 trillion per day, was conducted between computer systems in the City of London.

As Howard Davies, the FSA’s first chair, put it in the libertarian language of the day: “The philosophy of the F.S.A. from when I set it up has been to say, ‘Consenting adults in private? That’s their problem.’”28 The sort of thing that you could do in London but not in New York is exemplified by “collateral rehypothecation.”

Lse!

As they had grown up in the nineteenth and twentieth centuries across the United States and Europe, modern banks had been regional and national in scope. They lived in close and often incestuous relations with national Treasuries, central banks and regulators. The reglobalization of banking unleashed from the 1950s raised basic questions of governance.

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. For the resilience of a bank in the face of losses on its loan book, capital is the crucial criterion. 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. That was the point of the elaborate legal structures designed to hold securitized assets off balance sheet, to minimize the capital invested and to maximize its leverage. Capital ratios were, therefore, one of the neuralgic points of bank governance.

Impt

Almost as soon as the standard was set, the argument over its definition, implementation and consequences began. 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.39 Mortgages and mortgage-backed securities were also favored with low-risk weights. But at the margin, the system continued to encourage risk taking.

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. Under Basel I mortgage assets had been rated as relatively safe and counted only 50 percent for purposes of calculating the necessary capital. 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.41 Precisely as the private label securitization boom was about to accelerate, the regulations lightened.

Arghhh

Partly, as a result, if we take leverage—the ratio of bank balance sheet to bank capital—as the basic indicator of banking risk, a considerable gap emerged between the United States and the Europeans ahead of the crisis. 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 50:1.50 Even allowing for differences in the ways in which Europeans and Americans account for bank balance sheets, the gap was significant.

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 committed to maximizing the rate of return. So every regulation and every restriction on leverage was subject to second-guessing and subversion by the overwhelming force of competition and the unfettered movement of capital that had been gathering steam since the 1960s.

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

Oops

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.5 The fear was that the lack of currency adjustment could lead to cumulative divergence as less competitive regions fell further and further behind. 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. American critics, in particular, warned that Europe’s labor markets did not have the flexibility or mobility of their American counterparts.7 And if people would not move, faced with a crisis, Europe would need a common system of benefits, taxes and spending to allow funds to flow from the more prosperous to the more hard-hit regions. 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.

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 This, as Merkel sees it, is not sustainable.

Fatefully for the future of the eurozone, the problem of fiscal control was cast by German politics already from the early 2000s as one of equity within a federal transfer union. 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.

And Trichet was perfectly suited to play this dual role. He was a deeply conservative former head of the Banque de France. The ECB’s independence was his highest value and he guarded it jealously. The ECB’s constitution provided plenty of safeguards. Its deliberations were shielded from public scrutiny by minimal transparency requirements. To prevent it from being put to work as a vehicle of fiscal policy, it was banned from monetizing newly issued government debt. 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.26 To call it apolitical would be a misnomer, because it, in fact, entrenched a conservative bias against inflation as the unquestionable doxa of Europe. 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. Being able to repo government securities made them much more attractive as assets.

Impt

The result was that Greece and Portugal could borrow on terms that were better than ever before in their history, and one might have expected this to produce a huge surge in new public borrowing. Reading some commentary on the eurozone crisis, one might imagine that this was indeed what happened.30 But, 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.

Wouldnt have guessed this

It may fly in the face of conservative assumptions about “democratic deficits” and the spendthrift habits of irresponsible politicians, but the formation of the eurozone without an ironclad fiscal constitution did not lead to a festival of unrestrained sovereign borrowing. The backdrop to the eurozone crisis was, indeed, a gigantic surge in debt, but it was in the private, not the public, sector. The eurozone played host to the same runaway, market-driven process of credit creation that European banks were contributing to so actively in the North Atlantic economy.

The upward spiral of asset prices and balance sheets that drove the US boom was even more pronounced in Europe. 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. In Ireland and Spain, the combination of credit growth and house price inflation was truly explosive. 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.

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.

How badly such a facility was needed becomes clear only when we put together the local and global activities of Europe’s banks, to get a full view of their spectacularly overinflated growth. America’s banks were very big and very important to global finance. But it was in Europe that bank finance had grown most disproportionately.

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.

Holy shit

To call for unified action to tame, discipline and make safe a particular sector of business activity was hardly out of keeping with Europe’s history. Indeed, the origin of European integration was the realization that Europe’s coal and steel industries were sources of conflict and instability. Out of that logic had emerged the European Coal and Steel Community as the first step toward the “European rescue of the nation-state.”49 Likewise, the Common Agricultural Policy had been devised in the 1960s to contain the spillover costs of national farm support policies. It was only in the 1980s that this sectoral vision of the EU went out of fashion, displaced by the deceptive simplicity of the single market. 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. If there was one urgent reason why Europe truly did need a fiscal constitution it was to provide the financial underpinning for a giant deposit insurance and bailout fund.

No one in the United States wanted to think about bank failures either, not in 1997 and not in 2007. Indeed, as his reaction to Rajan’s impolitic remarks at the Jackson Hole conference in August 2005 made only too clear, Summers was one of the “very serious people” enforcing that taboo. 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.

Yep

Jesus

In December 2001 the European Council charged a European Convention with drafting a constitutional document that would ensure efficiency, clearer lines of responsibility and prepare the way for Europe’s expansion. The convention consisted of a commission of bigwigs headed by that old warhorse of French Europeanism former president Giscard D’Estaing.52 The proposal enshrined a new balance between centralized decision making by majority vote and the irreducible role of the European nation-states. It subordinated all the various institutions and treaties that had made up the pillars of European integration into a single overarching European Union.

The unified Germany is what made her. Beyond that, Merkel’s world was larger than Europe. The crucial implication is that in European affairs the German chancellor did not look to Brussels for solutions. She was no federalist. Rather than seeing the future of Europe in the construction of common European institutions and machinery directed from Brussels, Merkel advocated intergovernmentalism. She looked for grand bargains between the European nation-states.

Unlike Merkel, Schäuble was a federalist, eager to move the hard core of Europe to a higher stage of integration. What they shared was not a desire to dominate Europe. 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. Germany’s terrible history forbids strategies of domination or even overly assertive leadership. But the success of the Federal Republic gives it the right to insist that European solutions meet its standards, and Berlin will apply those standards as it sees fit. It was a minimal, demanding and sometimes arbitrary and self-serving posture.

In 1990 French president François Mitterrand favored a conciliatory vision of embracing the former Soviet bloc in a common European security policy that would supersede NATO as well as the Warsaw pact.1 But neither Helmut Kohl nor George Bush wanted anything to do with that. The West had won. It would set the terms for Europe’s reunification.

By October 1998, with 40 percent of the population counted as living below the subsistence minimum, Moscow was reduced to appealing to the international community for assistance to pay for food imports. As inflation soared to an annualized rate of 84 percent, Russians lost confidence in their national currency. As the new millennium began, dollars made up 87 percent of the value of all currency in circulation in Russia. Outside the United States, Russia was the largest dollar economy in the world. International investors in Russia were required to pay their local taxes in American currency. Russia became the ultimate experiment in dollarization, a nuclear-armed, former superpower with a currency supplied from Washington.

The EU never developed its own hard-power capabilities. Not only was European military cooperation factious and frowned upon by Washington, but the European states all took the peace dividend. In light of Russia’s weakness, what reason was there not to run down their substantial cold war military establishments? It was this decision that laid the basis for the transatlantic divide on security policy in the 2000s. It also left the East Europeans all the more dependent on the Americans, whose military preponderance grew ever more massive as the new century progressed. At the same time, after the first round of financial assistance in the early 1990s, the United States played no more than a peripheral role in shaping the wider integration of Eastern Europe. On the ground it was the EU that set the pace in erasing the legacy of the Soviet experiment.

In the last funding period, 2007–2013, 175 billion euros were earmarked in structural funds for Eastern Europe, 67 billion euros for Poland alone.14 The Czechs received 26.7 billion euros, and 25.3 billion went to the Hungarians. Across the region, the EU’s money was sufficient to fund between 7 and 17 percent of gross fixed capital formation over a seven-year period. The sums that were poured into the new member states in Eastern Europe by Brussels were comparable in scale to the famous Marshall Plan launched in 1947 to rescue ruined postwar Western Europe.

The impact of this simultaneous financial, political and diplomatic incorporation was transformative. In the main cities of Eastern Europe the material standard of living converged rapidly with norms in the West. And it is hardly surprising that this should have made an impression on the less-favored ex-Soviet republics farther to the east. By the early 2000s, many of the former Soviet republics seemed locked in a time warp.

The result was that Eastern Europe reproduced on Europe’s doorstep the configuration of overoptimistic expansion that had led to the emerging market crises of the 1990s. Success stories of market reform and privatization, combined with freedom of capital movement and relative stability of exchange rates, led to a huge inward surge of capital. Capital inflow led to upward pressure on exchange rates. All the indicators looked good. But the entire constellation—the booming domestic economy, the appreciating exchange rate, the rising reserves—could all be traced back to a common factor: the huge inward surge of foreign capital. What if that surge reversed? What if there was a sudden stop?

Impt

If the 1990s had been terrible for Russia’s economy, the new millennium brought a period of recovery. Vladimir Putin, who was confirmed as president by a landslide election victory in May 2000, will forever claim credit for Russia’s restoration. In fact, the turnaround in Russia’s financial fortunes already had been initiated in 1999 by austere former Communist Yevgeny Primakov, Putin’s political mentor. The collapse in the external value of the ruble jolted Russia’s export industries into life and curbed imports. But the key driver of the recovery was the global boom in oil and other commodities, which began months after Putin took office in the latter half of 2000. From $9.57 per barrel in 1998, the spot price of Urals crude would soar by 2008 to $94 per barrel. It would have taken catastrophic mismanagement for the Russian economy and Russian public finances not to have flourished. The questions were who would benefit from the boom and how would it affect Russia’s relationship with the outside world.

Did the contradictory geopolitical consequences of global growth, strengthening both Russia and its former satellites, make conflict inevitable? Certainly not from an economic point of view. The growth of the Polish and Baltic economies and the development of Ukraine, Georgia and Russia did not preclude each other. European exports to Russia flourished and all of Europe relied heavily on Russian gas. The question was whether a shared and interconnected prosperity could be given a common political meaning. Would it be cast as a foundation for a stable and prosperous international order? Or would the uneven but dramatic growth serve as fuel for a new arms race? Would interdependence come to be seen not as productive and efficient but as a source of vulnerability and threat? In the dark years of the 1990s the former Communist economies had experienced a common emergency. Exhaustion and disorder were shared. The common boom, ironically, would prove far more explosive.

There is no reason to doubt that the economic potential of the new centres of global economic growth will inevitably be converted into political influence and will strengthen multipolarity.” Under such circumstances, for the West to imagine that a global order could be based on its own organizations—the EU and NATO—rather than the truly comprehensive authority of the UN was either self-deceiving or in profoundly bad faith. Nor could the West reasonably claim that NATO expansion into Eastern Europe had “any relation with the modernisation of the Alliance itself or with ensuring security in Europe,” unless it presumed Russian hostility. How, then, could Moscow not interpret such expansion as a “serious provocation”?

No formal process of membership application was initiated. But Merkel conceded that the summit should issue a statement endorsing the aspirations of Georgia and Ukraine and boldly declaring, “These countries will become members of NATO.”51 It was a fudge, and a disastrous one at that. It invited the Russians to ensure that Georgia and Ukraine were never in a fit state to take the next step toward NATO accession. It invited Georgia, Ukraine and their sponsors to force the pace. Ambiguity was a formula for escalation. And both sides responded accordingly.

Oops

But over the course of 2008, Russia did unload its portfolio of $100 billion of Fannie Mae and Freddie Mac bonds. As Reuters reported it, the decision was motivated primarily by domestic political concerns.

Interesting

Then, between 1998 and 2007, in a gigantic surge of growth, it quintupled its balance sheet. As house prices faltered, some of its more marginal loans were primed to go bad. It was no surprise that “the Rock” got into trouble. But the obviousness of this connection is deceptive. What triggered the collapse in 2007 were not the loans on its balance sheet but the mechanism of their funding. Northern Rock was the model of a modern highly leveraged bank: 80 percent of its funding was sourced not from deposits but wholesale, at the lowest rates global money markets would offer. The bank’s 2006 annual report gives an idea of this far-flung funding operation:

Bear and Lehman were badly run. Under intense competitive pressure they made high-risk bets on some of the worst parts of the mortgage securitization business. But they were not exceptional. Merrill Lynch too had huge real estate exposure, and it was funding $194 billion of its balance sheet on a short-term basis in the summer of 2008.20 In total, prior to the Lehman bankruptcy, $2.5 trillion in collateral was posted in the triparty segment of the repo market alone on a daily basis. This gigantic pile of claims and counterclaims could become destabilized in a matter of hours. Market analysts recognized the bimodal quality of this experience. It was a “massive game theory,” one commented.

Woof

In a dramatic burst of expansion from the 1990s onward, the Financial Products division of AIG had developed into a major player in the derivatives markets. In total in 2007 it had a book of $2.7 trillion in derivatives contracts.22 Of this total, credit default swaps accounted for $527 billion. Of these, $70 billion were on mortgage-backed securities, and of those, $55 billion had exposure to dangerous subprime. Given its inside knowledge of the property market, AIG had stopped writing new CDS already in 2005. But given the relatively small size of the portfolio and the AAA rating of the assets it had written CDS on, it had not thought it necessary to insulate itself against losses. It was a fatal mistake. Out of a total of 44,000 derivatives contracts on the books of AIGFP, there were, it turned out, a cluster of 125 CDS on mortgage-backed securities that were about to go bad in a spectacular way. Those 125 contracts would inflict book value losses on AIG of $11.5 billion, twice what the ill-fated AIGFP unit had earned between 1994 and 2006. This was a heavy blow, but given its enormous global business, AIG could absorb portfolio losses on this scale.

Jesus

As at Bear and Lehman, it was not the slow-moving crisis in real estate markets that threatened AIG. An avalanche of defaults and foreclosures would in due course grind its way through the system. But that would take years. The first credit default event on which AIG had to pay out did not occur until December 2008. The problem was the anticipatory reaction of financial markets and the fast-moving revaluation of securitized mortgages and the derivatives based on them. In the case of AIG, as it lost its top-tier credit rating, this triggered immediate margin calls from the counterparties to AIG’s insurance contracts. They wanted collateral to prove that AIG could meet its obligations if the mortgages did go bad. It was these collateral calls, running into tens of billions, that threatened to tip AIG over the edge.

Yep

A group within AIG specialized in pooling the high-quality Treasurys and other securities held by AIG’s insurance funds. It lent those assets to other investors in exchange for cash, a trade akin to a repo. AIG’s securities-lending business then looked to maximize returns by investing the cash it received from the securities loan in higher-yielding but more risky mortgage-backed securities. Perversely, the securities lending office of AIG began to take those risky bets in 2005 precisely at the moment that AIG’s own Financial Products division decided it was too risky to continue writing CDS on mortgage-backed securities. By the summer of 2007, AIG’s securities lending program had $45 billion invested in high-yield private label MBS. As the securitization business collapsed, those assets became virtually unsalable, leaving AIG scrambling to find funds with which to repay the securities borrowers who now wanted their cash back. In search of profit, a cash-rich insurance company sitting on a giant portfolio of high-quality securities had turned itself into a dangerously leveraged shadow bank with a serious maturity mismatch. And to make matters worse, it was dealing with some of the most heavy-hitting players in global finance.

Oops...

One of the plays that would see Goldman through the crisis was the big short position it had built, betting against mortgage-backed securities. A big piece of that bet was placed by buying CDS from AIG. Already by June 30, 2008, Goldman had called $7.5 billion in collateral. When AIG was downgraded on September 15, there was a new surge in margin calls. Of the total claim against AIG, which now topped $32 billion, Goldman Sachs and its partner Société Générale accounted for $19.8 billion.

As money market mutual funds, repo, ABCP and AIG’s credit default swaps all came into question, the shock waves spread far beyond the United States. Among the investments most favored by the money market funds were European bank debts. They were a key source of dollar funding for the European megabanks.32 With the mutual funds pulling back, how were the European banks to fund their large books of dollar assets? With interbank lending shutting down, the European banks resorted to a variety of roundabout mechanisms to obtain dollar funding. A measure of their desperation was the price that they were willing to pay to borrow in euro, sterling, yen, Swiss francs and Australian dollars, and then to swap those loans into dollars. Normally, since these were close to risk-free transactions, the premium was zero. As dollar funding shut down, it soared to 2–3 percent.

Given that there weren’t any deposits, no one needed to run. You just stopped transacting in money markets and pulled in your horns. The result of the collective flight to safety, not by households but by the largest actors in the global financial system, was a trillion-dollar disaster.

These were severe shocks, but for sheer scale the US crisis trumped them all. An early IMF estimate in the summer of 2009 put US household wealth losses at $11 trillion.38 By 2012 the US Treasury would raise that to $19.2 trillion.39 Independent estimates put the figure closer to $21–22 trillion—$7 trillion from real estate, $11 trillion in the stock market and $3.4–4 trillion in retirement savings.40 From their peak in 2006, by 2009 US house prices had fallen by a third. At the worst point in the crisis, 10 percent of home loans across the United States would be seriously in arrears and 4.5 percent of all mortgages crashed into foreclosure. More than 9 million families would lose their homes. Millions more suffered years of anxiety as they struggled to make payments on homes that were no longer worth the mortgages secured on them. At the worst point in the crisis more than a quarter of US homes had negative equity.

Every kind of expenditure that could be postponed was cut back. For America’s long-ailing motor vehicle industry it was the coup de grâce. Car and light vehicle sales plunged from an annual rate of 16 million units in 2007 to as few as 9 million per annum in 2009. By December 2008 it was clear that both Chrysler and General Motors would fail. In the early twenty-first century GM was no longer the national totem that it had once been. Its total worldwide employment in 2007 was 266,000, compared with a peak of 853,000 in 1979.

Wow

What made the collapse of 2008 so severe was its extraordinary global synchronization. Of the 104 countries for which the World Trade Organization collects data, every single one experienced a fall in both imports and exports between the second half of 2008 and the first half of 2009. Every country and every type of traded goods, without exception, experienced a decline.

Wow