Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

At the G20 in London, Merkel and Sarkozy had taken a public stance on the need for financial consolidation. In large measure this was political theater. Given the shock to Germany’s export sector, Merkel’s government could not ignore calls for a stimulus package. Unemployment was surging, and in the coming autumn the CDU and SPD had an election to fight. Early in 2009 Angela Merkel’s grand coalition brokered a deal. Finance Minister Steinbrück reluctantly agreed to a modest emergency package of extra spending and tax cuts.31 Automatic stabilizers would take care of the rest. But the question of fiscal consolidation that had preoccupied Merkel’s grand coalition since 2005 could no longer be dodged. The SPD and CDU agreed that even as they administered the stimulus, budget balance at both the national and regional levels of government would be enshrined in a constitutional amendment. This was not a resolution forced on Germany by panic in the bond markets or immediate financial necessity. German government bonds (Bunds) were for the eurozone what US Treasurys were for the dollar world, the safe asset of choice.32 Despite its gaping deficit in 2009, Germany had no difficulty selling debt. It was not markets but the cross-party consensus on fiscal consolidation that had emerged before the crisis that dictated a decisive and irrevocable turn toward austerity. It was a decision driven by a long-term vision of competitiveness and retrenchment, the lobbying of taxpayer and busines...

Blargh

Though the Obama stimulus crested in the second year of his presidency, this was offset in 2010 by cuts to other areas of federal spending and a crushing contraction in state and local spending. Though it suited no one to acknowledge the fact, between 2009 and 2010 Germany’s deficit was actually increasing more rapidly than that of the United States.44 Though the arguments were apparently more transparent, the politics of fiscal policy in the wake of the crisis were in their own way no less opaque than those that framed monetary policy.

Jerks

It was not Obama at his most articulate. But it was a clear statement of basic principles. The “core investment needs of the country” were a matter for “private capital.” Government stimulus spending, whether on infrastructure or on education, was incidental. What was crucial was getting the banks back on their feet. It was music to the ears of the man who would deliver the “tough love” that Obama promised—Tim Geithner, his Treasury secretary. For Geithner nationalization was never an option. In 2008 at the New York Fed he had seen the depth of the market panic. He had witnessed the ructions over Bear and Fannie Mae and Freddie Mac. He had been in the room on the afternoon of Monday, October 13, alongside Paulson, Bernanke and Bair when they forced the bankers to take TARP capital. That was enough. As far as Geithner was concerned, to have pushed for further nationalizations in 2009 would have been a “deeply transforming policy mistake.”

With Geithner at the helm, the Treasury’s response to the crisis was not to tackle “too big to fail” by breaking up the biggest banks. Nor was it to bring the interests of wider society to bear by way of politicized oversight. Instead, the Treasury’s solution was to increase the oversight and managerial capacities of the state’s regulatory agencies—the Treasury itself, the key regulators and the Fed. If capitalist finance was a given, then one would have to accept the necessity of dealing with gigantic banks and complex, fast-moving markets. One had to accept also that this system was crisis prone. Crises, indeed, were inevitable. All one could hope to do was to build a crisis-fighting capacity at the national and international levels that was adequate to cope. In 2008 the Fed and the Treasury had acted on a spectacular scale with effects well beyond the boundaries of the American national economy. At the London G20 the IMF had been given the firepower it needed. What the Treasury aimed to do in 2009 was to continue the consolidation at the national level. As it had done since October 2008, this would revolve around recapitalization. As they recovered from the shock the banks were champing at the bit to repay the TARP funds. To further force the pace the Fed and the Treasury cooperated to introduce a new regime of regulation and oversight known as stress testing. This would be followed by a major political effort to get legislation through Congress that would legitimize an...

In rejecting the Swedish option, President Obama had gestured to America’s “thousands of banks.” At the time the president spoke there were, in fact, 6,978 commercial banks operating in the United States. But those never mattered to Geithner or Bernanke. They were the province of the FDIC. What mattered for systemic stability were the nineteen major banks with assets in excess of $100 billion, c. $10 trillion in total. Subjecting those massively complex institutions to thorough scrutiny would have been a labor of Hercules. The stress tests were something more tactical and fast moving. In a crash effort, a scratch team of two hundred bank examiners, supervisors and analysts ran through the books.24 The disaster scenario they applied was far from apocalyptic. They assumed that GDP would fall by only 2–3 percent, unemployment would rise to 8.5 percent and house prices would fall by between 14 and 22 percent. That turned out to be optimistic. But even starting from those numbers and the default probabilities they implied was enough to generate sobering conclusions. On top of the losses of $350 billion already recognized by the spring of 2009, under the stress test scenario the banks might expect to suffer a further $600 billion in write-downs and charge-offs by the end of 2010. This, then, posed the truly critical question: How much capital would be required to make the banks safe and restore market confidence? This was a matter of judgment. The Treasury and the Fed weighed a ...

Oof

According to inside reports, the original estimates caused consternation in banking circles. Bank of America faced a call for $50 billion in extra capital. Citigroup was called on to raise $35 billion. Wells Fargo was so dismayed at the initial ask of $17 billion that it threatened a lawsuit. In the end they settled on a bargained compromise. By far the biggest burden was imposed on Bank of America, which was required to raise $33.9 billion to exit the emergency ward. Wells Fargo’s quota was set at $13.7 billion. As its senior financial officer commented: “In the end we agreed with the number. We didn’t necessarily like the number.”26 Ailing Citigroup had more reason to be satisfied. By allowing for future revenue streams, its capital requirement was massaged down to a modest $5.5 billion, a seventh of the original figure.27 It was barely more than the bank would pay out in bonuses that year. After weeks of haggling, on May 7, 2009, the public was informed that America’s big banks needed to raise a manageable total of $75 billion. The stress tests were a balancing act that began with an exercise in accounting precision and ended in a game of bargaining and confidence.28 Whether they were taken in or simply delighted to discover how helpful the Treasury and the Fed were being, the markets responded well. The spread between very safe AA corporate bonds and the price that banks paid to borrow on their Baa bond rating fell from 6 percent to 3 percent, reducing funding costs. T...

Hmm

This was the script that the administration liked. A light-touch government intervention had enabled private business to take the lead. Nationalization had been avoided. As President Obama had promised, “[P]rivate capital” would be “fulfilling the core—core investment needs of this country.” But what this celebratory narrative glossed over were the more ambiguous implications of the exercise. The stress tests subjected the accounts of the commanding heights of American finance to intrusive scrutiny not by the public and the markets but by select teams of government bank supervisors. By the same token, they placed a seal of official approval on profit-driven private business activity. They were the model of a new regime of comprehensive, anticipatory oversight but also of entanglement between the American state apparatus and the big banks. This might be obtrusive and expensive in bureaucratic terms. It was onerous for those banks subjected to it. But it also conferred privileges, specifically the implicit promise that a bank that passed the stress test was deemed safe by the Fed and the Treasury. If it came to a crisis, a bank that had passed the test could hardly be denied assistance. Among this group of tightly regulated and closely supported entities, there could be no sudden and unforeseen failures. With that risk removed, it was significantly cheaper for such banks to issue shares and borrow money. One study estimated that in the wake of the crisis the advantage in fun...

Impt

The result was a sprawling piece of legislation running to 849 pages.34 Rather than offering a single coherent thesis, the Wall Street Reform and Consumer Protection Act, commonly known as Dodd-Frank, embodied a compendium of crisis diagnoses. Was the crisis due to mass predation of poorly informed borrowers? In which case what was needed was Elizabeth Warren’s Bureau of Consumer Financial Protection (Title X). Was it opaque over-the-counter derivatives that had blown up the system? In which case the fix was transparent, market-based trading of derivatives (Title VII—Wall Street Transparency and Accountability). Was it the breakdown of responsibility in the extended chains of mortgage securitization that poisoned the well? In which case securitizers should be required to have skin in the game (Title IX—Investor Protections). Was the sheer size of banks at the root of all the problems? Were they simply too big to fail? In which case the answer was to restrict bailouts and to make the industry pay for them (Title II—Orderly Liquidation Authority) and to cap banks’ further growth (Title VI, sections 622 and 623). Had investment banks used client money to gamble? If so, the thing to do was to reinstate 1930s-style divisions between commercial and investment banking by way of the so-called Volcker rule banning “proprietary trading” (Title VI, Volcker rule). All of these theories about the crisis of 2007–2009 had major political resonance. All of them made their way into the mea...

Hmm not sure i agrdee

The Treasury had a clearer view of the mechanics of the crisis. It wanted more capital, less leverage, more liquidity. And it wanted centralized powers in the Treasury and the Fed to deal with the next disaster. It spelled out this vision in a blueprint, which it issued in the summer of 2009.35 This was in many ways quite different from what emerged as Dodd-Frank. But that was not by accident. Many of the omissions were strategic. As Geithner unabashedly remarked, “[W]e didn’t want Congress designing the new capital ratios or leverage restrictions or liquidity requirements. Whatever their flaws, regulators were much better equipped” to decide those technical issues. “History suggested that Capitol Hill would be too easily swayed by the clout of the financial industry and the politics of the moment; we didn’t think that was the place for the intricate work of calibrating the financial system’s shock absorbers.”36 In other words, what the Treasury and the Fed knew to be the main drivers of the crisis were kept off the legislative agenda.

Indeed, consumer protection and macroprudential regulation might very well be at odds. As Larry Summers remarked to the president, the “airline safety board shouldn’t be in charge of protecting the financial viability of the airlines.”42 That was fair but it begged a further observation. Whereas there are plenty of safety agencies, there are, in fact, no agencies responsible for ensuring the financial viability of airlines or any industry other than banks. Airlines are expected to take care of their own finances. But Geithner and Summers preferred to sidestep the ramifications of that thought.

Savage

the worst-hit areas, such as Florida, fully 12 percent of properties were given up by their owners or seized by banks for foreclosure. Foreclosure proceedings were operating at such a pace that they were given over to quasi-automated legal processes that turned out to be ruinously flawed. In a nightmarish administrative and legal tangle, ever more victims were sucked into the crisis.

Emotions ran so high in the spring of 2010 that it took a coalition of Treasury, centrist Democrats and business lobbyists to block a last-minute effort to ban any banks enjoying an FDIC guarantee from engaging in derivatives trading of any kind. For the biggest banks this would have been truly costly. The resulting compromise “pushed out” only 10 percent of the least dangerous derivatives. Similarly, a last-minute proposal to address “too big to fail” by putting a cap on the total size of bank balance sheets was blocked in the banking committee by Chris Dodd and other “moderate” allies. One vital late amendment that did make it into the final law was the Collins Amendment of May 2010.50 Drafted behind the scenes by the FDIC, it demanded that whatever capital standards the Fed and the regulators set for the biggest banks should at least match the level required of the smaller FDIC-regulated banks. Bair wanted to roll back the favoritism shown to the big banks under the Basel II regime. She also wanted to ensure that capital standards applied to holding companies as well as commercial banking subsidiaries. The Fed and the Treasury resisted. They insisted that setting capital requirements was their regulatory prerogative. The banks screamed that the demanding new capital standards would force them to cut credit by $1.5 trillion. It came down to a struggle in the House and Senate reconciliation process, in which Senator Susan Collins and Bair prevailed with the backing of Dodd.

Blargh watered down volcker rule

All told, Dodd-Frank called on regulators and agencies to formulate 398 new rules for the financial sector. Each one became the target for no-holds-barred lobbying by interested parties, who could now operate outside the limelight of congressional debate. By July 2013, three years on from the passage of the law, barely 155 of the 398 required rules had been finalized.51 The highly controversial Volcker rule was a case in point.52 How to draw internal divisions inside banks to insulate client money from proprietary trading was a hugely technical and contentious business. Even with the best will in the world it was nearly impossible to draw a line between the actions of a bank in making a market for a client and trading on its own behalf. What emerged was less a “bright” regulatory line than a Rorschach blot. It took until December 2013 for the five agencies involved to agree on a wording of the basic Volcker rule, 1,238 days after Dodd-Frank was passed.53 The result was a 71-page document with an explanatory addendum that ran to a modest 900 pages. Banks were not so much told what to do as they were invited to demonstrate that they were not in violation of the rule. What exactly would constitute proof of compliance was a matter for further negotiation.54 The best advice the lawyers could offer was that it was up to banks to decide the level of “regulatory risk tolerance” they were comfortable with. After passing the law in July 2010 and issuing the “final” formulation of th...

It wasn’t only the bankers to whom Dodd-Frank caused anxiety. Geithner was worried about how it would work in a crisis. He feared that the formalized process of resolution centered on the FDIC would hobble the crisis response. But that put a premium on crisis prevention, and that points to the truly significant change brought about by Dodd-Frank. It perpetuated and institutionalized the stress-testing regime begun in the spring of 2009, and as such it was one of the pioneers of a new type of governance known as macroprudential regulation.56 This required banks to be assessed not simply in terms of their business models but with regard to their impact on macroeconomic stability. Conversely, macroeconomic scenarios were evaluated in terms of their impact on the key banks. Henceforth, the risk of financial crisis was no longer a matter for ad hoc intervention in emerging market economies, as it had been in the 1990s. It was to be a permanent preoccupation of governments across the G20. The Financial Stability Council created by Dodd-Frank gave the Fed and the Treasury and the other regulators a standing platform from which to develop this new form of oversight and control. As the government regulators became ever more sophisticated in their understanding of modern finance, the banks built gigantic compliance teams to interact on a daily basis with the regulatory authorities. It was in the interaction between the two that the truly crucial work was done of defining the rules f...

Through the stress tests the Treasury had sidestepped calls for nationalization and the “resolution” of Citigroup. Instead, in the interests of financial stability and minimizing the drain on the TARP fund, the Treasury and the Fed were in effect making it a government objective to restore bank revenue to healthy levels. The logic was inescapable. If financial stability, along with inflation control and employment, was now a key objective of economic policy, then bank profits were one of the key intermediate variables. More profit meant more strength on bank balance sheets and more stability.

In the aftermath of the crisis, many reform-minded economists were calling for a huge step up in capital.63 Economists Anat Admati and Martin Hellwig spearheaded a call for banks to be required to hold capital up to 20–30 percent of their balance sheet, the kind of capital ratio that was typical of other businesses and hedge funds. This would have given them huge solidity. And it would have justified much lower rates of return. For the same reason, it was vigorously resisted by the global banks, which had no desire to be turned into boring providers of financial utilities. Leading

The rest of the US delegation did not go so far as Bair. The compromise that resulted was a substantial change but by no means radical. The new rules specified 7 percent as the basic minimum requirement for Tier 1 common equity in relation to risk-weighted assets for all banks. However, systemically important banks were required to hold higher amounts, depending on their size and impact on the world economy. Between November 2014 and January 2019, the twenty-nine selected institutions would be required to raise their capital in relation to risk-weighted assets to between 8 and 12.5 percent, depending on their degree of systemic importance.66 A further 3.5 percent could be added in the form, for instance, of convertible bonds that at moments of stress transformed from bonds to equity. Crucially, unlike under Basel II, leverage was measured two ways. The basic standard was set with regard to risk-weighted assets, which banks could calculate according to arcane in-house formulae. But as a cruder test of solidity, risk-weighted leverage would be checked against a simple ratio of total bank assets to loss-absorbing capital. This was not to fall below a 3 percent “leverage ratio” of equity to assets. This left Bair and her fellow campaigners indignant. In the United States, by way of the Collins Amendment and the standard set by the FDIC, the bar was raised higher. But if more was not done at Basel, it had less to do with the American delegation than with opposition from Europe.

TARP, followed by the stress tests, the Dodd-Frank regime and capital planning, put the American banking system on a forced road to recovery. It foreclosed more radical options. The banks remained too big to fail. Far from downsizing or breaking them up, by 2013, J.P. Morgan, Goldman Sachs, Bank of America, Citigroup, Wells Fargo and Morgan Stanley were 37 percent larger than they were in 2008.73 The resources of the state were put one-sidedly at the service of management and shareholders. But if the aim was to get America’s banks out of the emergency ward, it worked. As Geithner insisted, the ultimate test of his policy of stabilization was the financial health of the banks, and on that score the record was pretty unambiguous. Between 2009 and 2012 the eighteen largest US banks increased their common capital from $400 billion to $800 billion. They reduced their ratio of risky wholesale funding from $1.38 per dollar of FDIC-insured retail deposits to $0.64. At the same time, they raised the share of their assets in cash, Treasurys and highly liquid instruments from 14 to 23 percent.74 The elite closure and cooperation that the Treasury and the Fed had finally managed to orchestrate in October 2008 was doing its job.

By contrast, the lack of comprehensive recapitalization of Europe’s wounded banking system was an omission that marks one of the fundamental turning points in the crisis. With the help of low-interest loans from Trichet’s ECB, many banks resorted to the makeshift of pumping up their profits by buying higher-yielding government debt. But the failure to build new capital would leave the European banks in no position to absorb any further shocks. While the United States began to stabilize, in Europe the banking crisis of 2008 would merge a year later with a new crisis: a panic in the eurozone public debt market. The connecting thread between the crisis of subprime and the crisis of the eurozone was the fragility of Europe’s bank balance sheets. Back to back, the combination of the two crises would mark one of the most significant inflections in European economic history since 1945. It would shake Europe’s politics to its foundations. It would open a stark divide within the Atlantic economy between Europe and America, and it would pose a profound challenge to transatlantic relations.

Oops

In the summer of 2009, with the acute crisis in the banking sector having been cauterized, both the European and the American economies began to recover. But aftershocks continued. With the insulation provided by the Fed and the Treasury, in the United States these aftershocks no longer manifested as acute stress in the financial system, but in misery spread across millions of households struggling with unaffordable mortgage payments and houses that were no longer worth the debt secured on them. The wave of foreclosures of American homes did not reach high tide until early 2010. Debtors continued to default, in other words, but their disaster did not pose systemic risks. They were the powerless ones who received precious little support from the Obama administration or anyone else. The main props to the economy other than the open-handed liquidity provision of the Fed were the automatic stabilizers of the fiscal apparatus. They left a deep dent in public finances, not just in the United States but across the advanced economies. In 2010 this would trigger a global backlash demanding fiscal consolidation and a return to the agenda of fiscal sustainability that had been so widely touted before the crisis. Controlling the debt-to-GDP ratio would become a mantra. After the largesse of the 2008 bank bailouts came austerity, though not for the same people, of course. But money is fungible. Ultimately, health care, education and local government services were all entries in the sam...

the eurozone from 2010 was extraordinary. The denial, lack of initiative and coordination that had characterized Europe’s first response to the banking crisis in September and early October 2008 was a harbinger of things to come. In the first phase of the crisis in the autumn of 2008, the stresses could still be contained at the national level. In 2010 they spilled over into a general struggle for the future of Europe. Europe’s single currency almost came apart. Greece, Portugal, Ireland and Spain were driven into depressions the likes of which had not been seen since the 1930s. Italy became collateral damage. France’s sovereign credit was put in jeopardy. Prime ministers were ousted. Political parties collapsed. Nationalist passions were stirred to the boiling point. The Obama administration faced the prospect that Europe’s new crisis might spill back on the United States. In the spring of 2009 France and Germany had lectured the UK and the United States about financial stability. A year later they were reduced to calling on the IMF to help not just Greece but the eurozone as a whole. And it was not enough. Two years later the eurozone crisis was still menacing global financial stability.

Ouch

Viewed against the wider canvas of the global crisis stretching from Wall Street to Seoul, the troubles of Greece and Ireland were not unusual and we do not need to refer to idiosyncratic features of eurozone governance to explain them.1 Ireland was an overgrown offshore banking hub.

If Greece had been in Hungary’s situation in 2008, a member of the EU but outside the eurozone, it would in all likelihood have joined the East Europeans in the first round of IMF crisis programs.3 It was not that Greece was directly caught up in the transatlantic financial crisis. Its banks had regional interests at most. The crisis reached Greece by way of its export and tourism sectors. Then automatic fiscal stabilizers kicked in. Tax revenues slumped. None of this was unusual in 2008–2009. What set Greece apart was the precariousness of its fiscal position when the crisis struck. It bears repeating that Greece had not used eurozone membership to go on an outsized borrowing binge. The bulk of its debts were piled up in the 1980s and 1990s as its two main parties, PASOK (social democrat) and New Democracy (Christian democratic), lured voters with the promise of West European modernity and affluence.4 In 2006 Greece’s debt level relative to GDP was lower than it had been when it joined the eurozone in 2001. But it was not reduced by much and would have been worse but for fiddling. Athens’s failure was not to have used the exceptional period of rapid growth and low interest rates to substantially reduce its debt burden. Any sudden surge in the deficit, any upward hike in interest rates, was likely to topple it from just about managing to insolvency. That is precisely what happened in 2008. In response to the crisis, the conservative New Democracy government abandoned all f...

At a stroke the budget revisions for 2009 took Greece’s debt burden from 99 to 115 percent of GDP. Deficits running into the tens of billions adding continuously to the existing stock of debt, combined with surging interest rates, would soon make the problem impossible to contain. In 2010 alone Greece was due to make repayments totaling a massive 53 billion euros. That would have placed a strain on any borrower. But Greece’s problems were not due to illiquidity. It was insolvent. To actually stabilize its debts it would, according to one calculation, need to raise tax revenues by 14 percent of GDP and cut expenditure by the same amount. That was politically impossible. What Greece needed to do was to restructure, to agree with its creditors to reduce their claims. To do anything else, to add new loans to an already insupportable debt burden, would postpone the problem but at the price of increasing its scale.

Of course, restructuring was an unpopular option with the creditors. As recently as 2007 Greece’s bonds had traded at virtually the same yield as Germany’s. They were widely held. At the end of 2009, of Greece’s 293 billion euros in public debt outstanding, 206 billion were foreign owned, 90 billion were held by European banks and roughly the same amount by pension and insurance funds. For those claims to be written down would relieve the burden on Greece. But it would also tumble Greece out of the club of respectable European borrowers. At an earlier moment in its history PASOK might have turned a national bankruptcy into a liberating rupture.6 By 2009 it was no longer that kind of political party. Restructuring would involve Athens in humiliating negotiations with its creditors. It would most likely involve the IMF. Indeed, restructuring was not just unpopular, it was unspeakable. If you hoped somehow to postpone the inevitable and muddle through, the crucial thing was to preserve confidence. Even mentioning the possibility of restructuring was likely to precipitate a panic, shut off short-term funding and make immediate default inevitable. In due course, however, whatever tactic you adopted, the math was inexorable. Greece’s debts were too heavy and growing ever more so. Restructuring was inescapable. But rather than a clean cut, what transpired was a prolonged and agonizing rearguard action clouded by obfuscation and the endlessly repeated tactic of “extend and pretend.”

Oops

Confidence in funding markets had not recovered from the shocks they had suffered since 2007. A shock to confidence in the eurozone might lead to a general withdrawal of funding. What was at stake was not just Greece, but the far larger network of cross-border debt, in which France’s stake, like that of other rich country lenders, was truly enormous. Altogether, foreign bank lending to what became known as the eurozone periphery—Greece, Ireland, Portugal and Spain—topped $2.5 trillion. Of that total, France’s banks had c. $500 billion at stake and Germany’s banks had roughly the same. Most of that lending and borrowing was not to governments. Spain and Ireland had been swept up in the gigantic real estate inflation that was now painfully deflating. In Spain, in particular, there was reason to fear for the stability not of the government’s finances but of local mortgage lenders. Beyond the periphery, what was even more worrying was Italy’s public debt. Italy’s budgetary situation was far more tightly controlled than that of Greece’s. Indeed, prior to the crisis, it had been running primary surpluses (ahead of debt interest payments). But its debt level was worryingly high, and in May 2008 the Italian premiership had been taken by Silvio Berlusconi, who, despite his business credentials and his conservative coalition partners, was regarded as a dangerous opportunist. No one wanted the flames of panic to leap to Italy. Beyond Italy was Belgium and then France itself.

It was this three-tiered structure of debt that drove the politics of the eurozone crisis from the French point of view: the small bankrupt sovereign debtors—Greece and Portugal—at the bottom; then the victims of the real estate boom with big liabilities from the banking crisis—Ireland and later Spain; and finally the really big public debtors, led by Italy. As far as Paris was concerned, the long-term sustainability of Greece’s debt was less important than holding this giant pyramid in place.

Berlin’s refusal to stick to the bailout script was worrying for the French and shocking for the Greeks. But it should have been no surprise. Article 125 of the Maastricht Treaty banned mutual bailouts. The Lisbon Treaty that finally came into operation in December 2009, just as the Greek crisis exploded, had reinforced the primacy of nation-state responsibility. It also barred the route to the mutualization of debt, which might have allowed a European consortium to share the burden of backstopping some portion of Greece’s liabilities. In a crucial judgment on the Lisbon Treaty delivered on June 30, 2009, the German constitutional court had put a further obstacle in the way of any further moves toward EU integration.17 Karlsruhe insisted on a stiff test of democratic accountability before any further competences could be transferred to Brussels. What Berlin would agree to on February 11, 2010, was last resort, ultima ratio support for the euro as such. What that meant for a “bad apple” like Greece was unclear. Certainly, Greece should slash its deficits and engage in labor market reform to boost growth. But Germany was in no mood for a bailout. The vast majority of German politicians and public opinion appeared to be willing to let the markets have their way with both Greece and its creditors. If a debt write-down was necessary, so be it. If Athens was unable to pay, then there was support in Germany across the entire political spectrum for the debts to be restructured at ...

The search for a solution began in early 2010 in Schäuble’s finance ministry. Apparently without prior coordination with Angela Merkel’s chancellery, Schäuble proposed that the EU should establish a European Monetary Fund (EMF), able to conduct within the eurozone the kind of restructuring, stabilizing and disciplining role that the IMF played on the global stage.21 One version of the EMF idea, pushed among others by Deutsche Bank’s chief economist, Thomas Mayer, was for the fund to backstop debts up to a limit of 60 percent of a country’s GDP. Above that level debts would undergo restructuring, with bondholders taking a proportional and uniform haircut.22 It was a strikingly ambitious proposal that reflected Schäuble’s deeply held federalist European commitments. He was keen to use the crisis to push forward the agenda of European integration left unfinished at Maastricht in 1992. If Berlin had thrown its full weight behind the idea of an EMF and if its budget had been set to an appropriate size—what were needed were hundreds of billions of euros—the crisis might have taken another course.

The IMF had already put tens of billions of euros into Eastern Europe. The eurozone would take even more. In a new age of globalization, was a deep engagement in Europe the right direction for the IMF to be headed? And in dealing with European countries with powerful representation on the Fund’s own board, could the Fund’s economists be certain that their expertise would prevail? Specifically, would the Europeans take the IMF’s advice on the question of restructuring? Did they even understand the policy that the IMF was duty bound to pursue? Following its disastrous experience in Argentina’s financial crisis in 2001, the IMF had established new rules.25 The Fund would lend only to solvent borrowers, otherwise there must be restructuring. And if it was to lend, it would insist on lending early, before panic set in. Given the scale of speculative firepower that could be mobilized in leveraged financial markets, to lend once a run had started was likely to be both expensive and ineffectual. Given how far the Greek crisis had already progressed by the early months of 2010, it was hard to argue that it met either of these criteria.

Once before, sixty-three years earlier, a political crisis in Greece had triggered a transformation in US policy. On March 12, 1947, after the British had declared their inability to defeat the Communist insurgency in the Greek civil war, President Truman announced the doctrine of containment, one of the opening moves in the cold war. That summer, Truman’s secretary of state, General George Marshall, would back up containment with his legendary promise of economic aid for Europe. In 2010 there was no antagonist like the Soviet Union to force the Obama administration’s hand. What made Greece into America’s problem was not a global clash of ideologies, but the money coursing through the circulatory system of transatlantic finance. America’s mutual funds had hundreds of billions of dollars at stake in Europe’s banks, above all French banks. It was those same banks that were exposed in Greece. And the US branches of those same European banks were also major lenders to US households and firms. Any eurozone financial crisis would blow back on America.

committee of the EU, the ECB and the IMF would make up the soon to be infamous “troika,” dictating policy to Greece and the other “program countries.” What was ruled out was restructuring. On that Washington sided with the French and the ECB. Existing Greek debt would be paid off with new loans from the troika, whether or not the result was sustainable. The IMF would have to bend its operating procedures to the occasion. To satisfy Merkel’s insistence on the Lisbon rules, the “European” component would not consist of measures taken collectively via the central institutions in Brussels or jointly funded by the member states. That would require treaty change and might violate the line drawn by the German constitutional court. Instead, it would consist of individual national credits for Athens on a bilateral and voluntary basis coordinated through the Eurogroup, the powerful but informal meeting of the eurozone finance ministers. To avoid the appearance of a bailout—banned by Maastricht—the loans would not be on concessionary terms. Interest rates would be stiff and there would be a processing fee to compensate the lenders for their trouble. Finally, and most important, the support would not be provided preemptively to forestall a loss of market confidence. It would be offered only as an ultima ratio, if and when Greece lost access to the markets. It would be up to Greece, by means of austerity, to forestall that moment for as long as possible.

On March 30 the markets were rocked by news not from Greece but from Ireland. The bill for recapitalizing Ireland’s bankrupt banks was soaring. For Anglo Irish Bank alone, Dublin was now budgeting 34 billion euros, more than Ireland’s tax revenue in 2010. Soon Ireland’s deficit would be worse than that of Greece’s.38 In Ireland it was the banks pulling the sovereign down. In Greece the mechanism worked the other way around. Canny depositors in Greek banks were aware that their savings were invested in the government bonds that Athens was struggling to service. In the early months of 2010, 14 billion euros were withdrawn from Greek banks and shifted elsewhere in the eurozone. The first to move were the oligarchs moving huge sums by way of Cyprus, but they were soon followed by middle-class depositors pulling out a few thousand euros at a time.

Christ

But no deal emerged from Washington. The troika was only beginning to haggle with Athens over the terms of a rescue loan. Markets were left hanging. On April 28, 2010, the bottom fell out. The official chronicle of the German finance ministry is, as one might imagine, a sober document. This is how it describes events in Europe’s sovereign bond and interbank money markets that day: “The crisis becomes dramatically acute. Risk premiums for government bonds in some Eurozone member states such as Portugal, Ireland and Spain increase rapidly and reach levels equal to that which prevented Greece from accessing the financial markets in April. In an echo of the final dramatic phases of the financial crisis [of 2008], there is virtually no interbank lending between European banks. Within a very short period, there are overall signs of an acute pending systemic crisis.”43

Finally, in the first days of May, the deal was done. Greece agreed with the troika not only to slash its deficit but to aim for a surplus. It promised to deliver a turnaround in its budget balance of a staggering 18 percent of GDP.48 In 2010 alone the reduction of its deficit would be 7.5 percent of GDP. Every area of Greek public life would be touched, from ministerial contract cleaners to privatization of state assets. Everything was up for grabs. In exchange, Greece would receive a bailout far larger than previously conceived: 110 billion euros, of which 80 billion would come from the EU and 30 billion from the IMF, payable in quarterly installments over three years. The loans were at tough rates and it was clear that servicing them would create a repayment shock in 2013. But it was the best that the lending countries were willing to offer. Merkel promised an affirmative Bundestag vote for May 7. The question was whether the markets would give Europe that long.

What Could go wrong ?

It was profoundly disturbing that it was being undertaken to manage a crisis in Greece, a comparatively rich European country, at the behest of the EU. The Greeks were being lent vastly more than their quota, the capital contribution that normally limited a country’s IMF borrowing rights. The Fund was required to share control over the program with the other members of the troika, and its own experts were far from persuaded that Greece’s debts were sustainable. As they put it cagily: It was undeniable that “significant uncertainties around” the program made it “difficult to state categorically” that Greece would ever be able to pay back its debts. Normally this would be a red flag. Who, after all, would benefit from Greece taking on new loans from official lenders to pay off existing private debts it could not service? The outspoken Brazilian board member insisted that the program not be referred to as “a rescue of Greece, which will have to undergo a wrenching adjustment, but as a bailout of Greece’s private debt holders, mainly European financial institutions.”62 One could hardly ask for a clearer statement of the “bait and switch” substitution, by which a problem of excessive bank lending was turned into a crisis of public borrowing.63 But this substitution resulted less from a skillful ideological conjuring trick than from a lowest common denominator compromise between the main players in the Greek debt drama—Germany, France, the ECB, the IMF and the Obama administrati...

The IMF board approved the disproportionate and risky Greek bailout not because it made sense in its own terms, or was good for Greece, but because on the track record to date, Europe’s inability to contain the Greek crisis meant that there was “high risk of international systemic spillover effects.”66 Instead of restructuring Greek’s unsustainable debts, what would be restructured were its entire public sector and its creaky economy. Heroic assumptions about cost cutting and efficiency gains were the ways in which the IMF squared the Greek program with its conscience. Perhaps if it were shaken thoroughly enough, “sclerotic” and “clientelistic” Greece could be jolted onto a higher growth path that would make its debts sustainable after all. Austerity and “reform” were the only items on the agenda that the otherwise divided parties to the deal could agree on. Whether this was economically effective or politically sustainable and what it would mean for the democratic politics of Europe was another matter altogether.

Following their surprise bestseller This Time Is Different: Eight Centuries of Financial Folly, in January 2010 Reinhart and Rogoff launched a research paper with the title “Growth in a Time of Debt.”2 This purported to show that as public debts passed the threshold of 90 percent of GDP, economic growth slowed down sharply. It was a slippery slope that ended in a cliff. Excessive debt weighed on growth, which made the debt even less sustainable, further slowing growth. To avoid this fate, it was crucial to take action sooner rather than later. On closer inspection, Reinhart and Rogoff’s analysis turned out to be riddled with errors. Once their Excel spreadsheet was properly edited, there was no sharp discontinuity at the 90 percent mark and the case for emergency action was far weaker than they made out.3 But in early 2010 their arguments ruled the roost. In the Financial Times they opined: “[T]he sooner politicians reconcile themselves to accepting adjustment, the lower the risks of truly paralysing debt problems. . . . Although most governments still enjoy strong access to financial markets at very low interest rates, market discipline can come without warning.” Once bond markets realized the full measure of the “fiscal tsunami” unleashed by the banking crisis, their judgment would be merciless. “Countries that have not laid the groundwork for adjustment will regret it.”4 No one was safe. As

As commentators as knowledgeable as Ferguson, Reinhart and Rogoff must have been aware, the market discipline on display in the eurozone had not “come without warning.” The ECB and the German government were deliberately courting the bond vigilantes who swarmed over Greece. If they wanted to ease the pressure, all the ECB needed to do was what the Fed, the Bank of England or the Bank of Japan did as a matter of course—buy Greek bonds. But the ECB had no intention of doing that, not, at least, until the very last minute. The ECB meant to send a message: Austerity or else! They must have been delighted by the global reaction.

In what was dubbed an “emergency budget” in June 2010, Chancellor Osborne slashed spending and raised VAT. The aim was to calm markets by committing to close the deficit by 2015.14 The argument in 2010 was “necessity.” But, as Neil Irwin later commented: “Britain . . . was embarking on something that has rarely been attempted . . . cutting spending and raising taxes in a preemptive strike against the risk of a future debt crisis.”15 As Paul Krugman remarked from New York: “It’s one thing to be intimidated by bond market vigilantes. It’s another to be intimidated by the fear that bond market vigilantes might show up one of these days.”16 As the squeeze continued, other motives revealed themselves. Shrinking the state, it turned out, was an aim in itself. The ultimate goal, as David Cameron would put it in his speech to the Lord Mayor’s Banquet three years later, was “something more profound”: to make the state “leaner . . . not just now, but permanently.”

By 2015 Chancellor Osborne would claim to have slashed £98 billion in annual spending from the UK budget. From a maximum of 6.44 million public sector employees in September 2009, the UK public sector workforce would be reduced to 5.43 million in July 2016.18 One million jobs were cut, privatized or outsourced. It was a reduction larger than that imposed by the Thatcher or Major governments of the 1980s and 1990s. Translated to the US public sector payroll, it would be the equivalent of the elimination of 3.3 million positions. Because pension and health spending were ring-fenced, the pain was concentrated above all in local government. As the minister in charge roundly declared: “[L]ocal government is a massive part of public expenditure. It has lived for years on unsustainable growth, unsustainable public finance. . . . People blame the bankers, but I think big government is just as much to blame as the big banks.”19 Between 2010 and 2016 spending by local councils on everything from elderly day-care centers to bus services, public parks and library facilities fell by more than a third. Britain became a darker, dirtier, more dangerous and less civilized place. Hundreds of thousands of people who were barely coping on disability and unemployment benefits were tipped into true desperation.20 According to the OECD, only Greece, Ireland and Spain were put through worse contractions than those inflicted on the UK.21

Christ

After the worst economic crisis since the 1930s, at a time when, according to the OECD, 47 million people were unemployed across the rich world, and the total figure for underemployed and discouraged workers was closer to 80 million, the members of the G20 committed themselves to simultaneously halving their deficits over the next three years.43 It was the householder fallacy expanded to the global scale. It was a recipe for an agonizingly protracted and incomplete recovery.

Yep

For Germany even that was not enough. The lesson that Berlin drew from the Greek crisis was that the eurozone’s Stability and Growth Pact had failed. Germany, or rather the Red-Green coalition that had ruled Germany back in 2003, had to accept a measure of responsibility. Now, with Merkel and Schäuble at the helm, Berlin would take the lead in rededicating the eurozone to self-discipline. This was vital not only to restore economic health. It was essential for the politics of the eurozone. The Greek crisis had shown that Europe’s governments would have to work together. Federalists like Schäuble still insisted that the ultimate answer to the crisis would be “more Europe.” But for that to be acceptable to the taxpayers of Northern Europe, they had to be reassured that everyone was playing by the same rules. As the crisis in the eurozone gathered in intensity and Germany’s pivotal role became ever more pronounced, the rhetoric became more heated. Protesters waved placards showing Merkel’s face graffitied with a Hitler mustache. This was not only offensive and grotesquely unfair. It also represented a fundamental misunderstanding of Germany’s position. When it was accused of imperialism, the German political class could honestly reply that it did not harbor ambitions for continental domination. But Berlin did have a vision of economic and fiscal discipline, which had to be generally accepted before Germany would consent to any further steps toward integration.44 For reasons o...

Ugh

For Germany even that was not enough. The lesson that Berlin drew from the Greek crisis was that the eurozone’s Stability and Growth Pact had failed. Germany, or rather the Red-Green coalition that had ruled Germany back in 2003, had to accept a measure of responsibility. Now, with Merkel and Schäuble at the helm, Berlin would take the lead in rededicating the eurozone to self-discipline. This was vital not only to restore economic health. It was essential for the politics of the eurozone. The Greek crisis had shown that Europe’s governments would have to work together. Federalists like Schäuble still insisted that the ultimate answer to the crisis would be “more Europe.” But for that to be acceptable to the taxpayers of Northern Europe, they had to be reassured that everyone was playing by the same rules. As the crisis in the eurozone gathered in intensity and Germany’s pivotal role became ever more pronounced, the rhetoric became more heated. Protesters waved placards showing Merkel’s face graffitied with a Hitler mustache. This was not only offensive and grotesquely unfair. It also represented a fundamental misunderstanding of Germany’s position. When it was accused of imperialism, the German political class could honestly reply that it did not harbor ambitions for continental domination. But Berlin did have a vision of economic and fiscal discipline, which had to be generally accepted before Germany would consent to any further steps toward integration.44 For reasons o...

Good explanation

If there was any justification for the protracted torture of Greece, it was the fear that an immediate debt restructuring would unleash contagion to other sovereign debtors across the eurozone and destabilize Europe’s banks, thus causing a far wider crisis. So the immediate priority for European economic policy ought to have been to use the time bought by extend-and-pretend to strengthen the resilience of the eurozone financial system and the health of the banks. If one were to follow the American example, the obvious next step was to conduct a stress test to estimate likely losses, and then to carry out an energetic recapitalization with either public or private funds. Both in 2009 and 2010 the Europeans conducted stress tests of a sort. The 2010 exercise went further than that in 2009 in naming individual banks. But it too was a farce. The results published on July 23, 2010, proclaimed that of ninety-one leading European banks, only seven would see their primary Tier 1 capital reduced to dangerous levels by a sovereign bond crisis.49 In total the Committee of European Banking Supervisors estimated that Europe’s banks needed to raise no more than 3.5 billion euros in new capital. But, as was pointed out by skeptical analysts, this optimistic result depended on assuming that the vast majority of the sovereign debt held by banks, had zero risk of default, or was fully protected by the EU’s financial stability facility.50 According to the reckoning of the OECD, on less rosy ...

Blargh

The European institutions did not have the authority to intervene in national banking policy. The funds for recapitalization that had been created in 2008–2009 were spotty and facultative rather than mandatory in their application.51 National governments were too complacent and unwilling to disturb the comfortable status quo. Instead, Europe engaged in a double pretense. The troika went on pretending that Greek debt was sustainable, if only Athens adopted enough austerity. This was not true, as was becoming evident month by month: Greece was simply being driven into the ground. Meanwhile, the stress tests purported to show that Europe’s banks were robust, which they clearly were not. Indeed, their weakness ought to have been the best argument for refusing to risk Greek restructuring. This, however, was not an argument that the ECB could make out loud, for fear of triggering panic. Furthermore, it would have necessitated serious action on the recapitalization front, which both the banks and the national governments resisted. Caught in this double bind, the troika was reduced to pretending that all was well on every front. Meanwhile, in Greece unemployment rose from a low of 8 percent in the summer of 2008 to more than 12 percent in 2010. For young people it was already more than 30 percent. If the Greeks were the victims of extend-and-pretend, who were the beneficiaries? Billions of euros from the first tranche of the May 2010 program were disbursed to Athens, which in turn...

Infuriating

On September 30 the Irish government announced that, given its obligation to backstop the banks, in 2010 Ireland’s public borrowing requirement would surge from 14 percent to a jaw-dropping 32 percent of GDP. This would take Ireland’s public debt from a modest 25 percent of GDP in 2007 to 98.6 percent in 2010. The Irish government, once a paragon of austere public finance, was forced to withdraw from the bond market.56

Despite the exorbitant quality of the ECB’s demands, on November 21 Dublin had no option but to comply. The Irish Times responded with a remarkable editorial that captured the mood of national humiliation. It was emblazoned with a line from Yeats’s elegy to romantic Irish nationalism, “September 1913”—“Was it for this?” Was it for this, the paper asked, that Irish nationalists had fought their centuries-long struggle: “a bailout from the German chancellor with a few shillings of sympathy from the British chancellor on the side. There is the shame of it all. Having obtained our political independence from Britain to be the masters of our own affairs, we have now surrendered our sovereignty to the European Commission, the European Central Bank, and the International Monetary Fund.” But rather than lapsing into self-pity, the Irish Times went on: “The true ignominy of our current situation is not that our sovereignty has been taken away from us, it is that we ourselves have squandered it. Let us not seek to assuage our sense of shame in the comforting illusion that powerful nations in Europe are conspiring to become our masters. We are, after all, no great prize for any would-be overlord now. No rational European would willingly take on the task of cleaning up the mess we have made. It is the incompetence of the governments we ourselves elected that has so deeply compromised our capacity to make our own decisions.”68 For all its brilliance, not the least remarkable thing abou...

Setting aside the gross inequity of the troika’s demands, was it even plausible that Ireland posed risks of contagion comparable to Lehman? As Martin Sandbu of the Financial Times put it with rare force: “Lehman was a global bank.” Its business “was at the heart of the world’s financial plumbing.” Not rescuing it proved to be a disaster. The Irish banks, by contrast, were “a small racket in Europe’s financial periphery, busily and exuberantly losing . . . investors’ money in the time-honoured way of lending more for houses than they were worth.” Nothing “systemic” depended on their creditors being repaid in full.69 Of course there was some risk of spillovers. But if French and German banks suffered collateral damage, that was because they had participated so enthusiastically and profitably in the Irish boom. Given that responsibility was so widely spread, was it reasonable to impose the entire cost of containing the fallout on Ireland’s taxpayers alone? As Ajai Chopra of the IMF later remarked: “Yes, there would have been spillovers. But . . . the ECB could have stepped in. . . . That’s what a central bank is for, to deal with these sorts of spillovers.”70 But that was not the kind of central bank the ECB thought itself to be. On November 26 its representatives in Dublin made clear that if haircutting was involved, there would be no bailout. A day later the IMF team in Dublin received direct instructions from Washington to drop any further efforts to enroll the banks. The ...

Oh come on