Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

In their defense, legalists at the ECB would argue that the central bank’s mandate gave it only one objective, price stability. They could derive from that an obligation to maintain the functioning of Europe’s financial markets and Europe’s banks. And Trichet would thus justify his interference in Greek and Irish affairs and more to come. What the ECB did not have was a mandate to concern itself with the economic welfare of the eurozone or its member states in any broader sense. It was a willfully simplistic and conservative interpretation.73 It was ruinous for the eurozone. The crisis would begin to be overcome only when the ECB began to step beyond it. The Fed never took such a narrow view. It had a mandate both to preserve price stability and to maximize employment. This was a legacy bequeathed by the more broad-gauge economic policy debate of the 1970s. But it was anchored deep in the Fed’s organizational DNA by the memory of the Great Depression. The deflationary misery of the 1930s was the defining event in the Fed’s history. That was the history that Bernanke had pledged not to repeat.

How exactly quantitative easing works remains a subject of controversy.74 Large-scale purchasing of mainly short-term bonds drives up bond prices and thus reduces yields. Reduced short-term rates may help to lever down long-term rates and thus to stimulate investment. But that depends on there being businesses willing to invest, which cannot be taken for granted at a time of crisis. The most direct effect of QE comes via financial markets. As the central bank hoovers up bonds, it drives down yields, forcing asset managers to go in search of yields in other classes of assets. Switching out of bonds into stocks inflates the stock market, increasing the wealth of those with stock portfolios, tending to make them more willing to both invest and consume. This, to say the least, is an uncertain and indirect method of stimulating the economy. By boosting the wealth of already wealthy households, it is predestined to increase inequality. Low-income households have no way of participating in capital gains. QE was never anything other than an emergency expedient adopted by the Fed in light of the fiscal policy logjam in Congress. But the Fed itself was not insulated from the polarization of American politics.75 The FOMC vote on QE2 was split three ways. A vocal minority argued that the stimulus should have been much larger. The markets had already priced in a QE2 announcement at $75 billion. To have a substantial impact the Fed needed to deliver a surprise. Bernanke demurred. He did...

Significantly, they pointed out that “[t]he Fed’s purchase program has also met broad opposition from other central banks” across the world. This was no exaggeration. After eighteen months of wrangling at the G20 over fiscal policy, QE2 produced an open rift over monetary policy. This was predictable, but it was not necessary. The two agenda-setting innovations of October and November of 2010—the Merkozy PSI agenda of Deauville and Bernanke’s QE2—could have been complementary. As Chopra of the IMF had laid out, the ideal accompaniment for aggressive debt restructuring in Ireland would have been an ECB bond-purchasing program designed to insulate the other fragile members of the eurozone from the fallout. The push for PSI and bond market intervention were both responses to the inadequacy of the course embarked upon in Greece in May 2010. But in the eurozone the two never joined hands. Instead, rather than seeing QE as the necessary accompaniment to a more sustainable resolution of the eurozone debt crisis, Berlin’s conservatives led the international front against monetary experiments.

By the spring of 2011 austerity was biting deep into the social fabric of Europe. Spending cuts and tax increases were slashing demand and squeezing economic activity. Across the eurozone, 10 percent of the workforce were unemployed. But unemployment for those between the ages of fifteen and twenty-four was 20 percent. And on the troubled periphery, the numbers were numbing in scale. In Ireland general unemployment reached 15 percent and youth unemployment 30 percent, in Greece 14 percent and 37 percent, respectively. In Spain 20 percent of all adults and 44 percent of young people were unemployed by the summer of 2011. Half a generation had their launch out of education and into working life aborted. Nevertheless, the demand for further austerity was unrelenting. After Ireland and Greece had subordinated themselves to troika programs, on March 23, 2011, Portugal’s prime minster, José Sócrates, resigned after failing to gain support for budget cuts. A week later, on April 2, Spain’s social democratic prime minister, José Luis Rodríguez Zapatero, announced that he would not run for reelection and would prioritize stabilizing Spain’s finances. On April 7 Portugal became the third country to place itself under a troika program.9

23 Greek and Spanish politics would never be the same again. The crisis had leaped from the financial to the political sphere. But in the spring of 2011 the protests were held at arm’s length by the incumbent governments. What forced a change in policy was not protest, however passionate and imaginative, but the inescapable realization that extend-and-pretend, the “fix” cobbled together in 2010, simply did not work.

It was Trichet and his colleagues at the ECB who found the status quo unacceptable. As a result of months of bond buying, by the spring of 2011 they found themselves as proud owners of 15 percent of Greece’s junk-rated public debt.

As the eurozone crisis heated up again in April and July 2011, the ECB, in one of the most misguided decisions in the history of monetary policy, raised rates.28 In the ECB’s defense, it was true that inflation in Germany and other hotspots of the eurozone economy was picking up. The asymmetry between the relative prosperity of Northern Europe and the rest of Europe was all too real. But the ECB’s move was clearly intended as a political signal. The ECB was asserting its independence. It was putting Europe’s governments on notice. It would be up to them to take responsibility for the debt markets.29 Nor were interest rates the only way to send the message. Without fanfare, indeed, without public announcement of any kind, in mid-March the European Central Bank stopped purchases of eurozone sovereign bonds and introduced differentiated haircuts on repos for lower-rated bonds.

The yield spread between the safest and riskiest eurozone bonds surged. The Greek spread reached 1,200 points and this time the fear was different. In 2010 the markets had moved against individual countries, first Greece, then Ireland. Now a wall of money was moving against the eurozone as a whole. One key indicator was American money market funds, key contributors to the cash pools from which European banks sourced their funding, huge sources of liquidity managed by giant asset managers like BlackRock. Whereas in early 2011 they were still providing as much as $600 billion in funding to European banks, from the spring they drastically curtailed their exposure.31 Over the course of the year they would reduce their commitment to European banks by 45 percent. French banks were particularly hard-hit. Even giants like BNP were not exempt. On Wall Street large bets were now being placed not just on the default of the weakest borrowers—by the spring S&P was reckoning with a 50–70 percent haircut on Greek debt and a 1-in-3 chance of outright disorderly default—increasingly, investors were betting on the collapse of the euro itself.

Reasonble

But one thing was certain: The funds that anxious investors had already moved to safety in Germany were very unlikely to leave. What Germany was benefiting from was something akin to the exorbitant privilege enjoyed by the United States in the global economy. At times of stress, global money moved into dollars. In the eurozone, money moved to Germany.35 It was a privilege measured by the yield spread. As the yields on crisis-country bonds soared, those on Bunds eased. It was one of the factors that helped to feed Germany’s prosperity bubble. That a flow of funds into Germany should come to be seen as a burden was symptomatic of the feverish discourse of the crisis.

By May 2011 the effort to defend the indefensible, to uphold extend-and-pretend, had resulted in a complete breakdown of credible and coherent communication about the eurozone’s economic policy. Juncker was unusual only for feeling that he didn’t need to dress it up, which, as far as a tiny bourgeois tax haven like Luxembourg was concerned, might have been true. Projected onto a larger stage of the EU, the implications of Juncker’s “realism” were rather more disconcerting.

With Europe’s credibility draining away, what was needed was a “reset,” a clarifying intervention that would restore credibility and stop the crisis of confidence from widening. That is what Dominique Strauss-Kahn, as head of the IMF, seems to have had in mind when he scheduled meetings, first with Angela Merkel and then with the Eurogroup, for mid-May 2011. Strauss-Kahn “was going to push for a big firewall,” recalled one senior US official. “We were putting a considerable amount of expectation on the outcome of those meetings.”39 Inside the IMF, a new head of steam of opposition to extend-and-pretend was building. The Fund’s Ireland team had never been satisfied with the inequitable deal forced on Dublin by the ECB and the G7 in November 2010. Ireland’s problems, Ajai Chopra insisted, were not merely Irish in scope, “they are a shared European problem” that required joint European action.40 What was needed was to beef up the EFSF, giving it more resources and wider authority to intervene. Furthermore, as Ireland showed, Europe’s banks were too big to bail by any but the largest states. So Chopra insisted that if banks could not raise enough capital from private sources, there should be coordinated recapitalization across the

Whereas in 2007 eurozone bond investors had regarded Greek debt as equivalent to that offered by Germany, by September 2011 the CDS spreads on Italy and Spain were higher than those of Egypt in the throes of revolution.53 The three countries in the world judged most likely to default were all in the eurozone—Greece, Ireland and Portugal—well ahead of Belarus, Venezuela and Pakistan.54 The revolutionary mood seemed to have jumped the Mediterranean. The violent scenes in Athens fed fantasies of social disorder spreading across Europe. Supposedly serious financial analysts were talking of “hyperinflation, military coups and possible civil war.”55 But it wasn’t any longer a matter of individual predatory hedge funds, or one or two overexcited analysts talking the euro down; commercial banks and pension funds from across Europe and the United States were pulling tens of billions of euros out of Italy and the program countries.56 Once eurozone sovereigns lost their standing as issuers of safe assets, institutional investors had no option but to reallocate their portfolios. And that affected the European banks too. In the summer of 2011 wholesale funding was drying up.57

Some crazy stats

Greece would receive an additional 109 billion euros, meeting its financing needs through 2014 and enabling the IMF to continue as part of the troika. The interest it paid on its loans would be lowered to 3.5 percent. Maturities would be extended and, through a menu of PSI options, Greece’s creditors would make a contribution, though the precise amount remained to be determined. The ECB would be indemnified for any losses it suffered. If the Greek banks suffered irreparable damage they would be recapitalized out of troika funds.59 Most important, the governments stated emphatically that PSI applied only to Greece. It was the only insolvent eurozone sovereign. All others would honor their obligations without fail. To contain contagion the EFSF would be beefed up and at the behest of the ECB it would be empowered to enter the secondary market and to establish credit lines for nonprogram countries, such as Spain and Italy. The EFSF would no longer act only as an ultima ratio, as Merkel had insisted since March 2010, but as a preemptive agency, helping to stabilize markets to forestall any threat arising. These, finally, were the elements of a workable solution—buy-in by the Greeks, debt restructuring, further loans, cooperation with the ECB and backstopping by a newly empowered EFSF. There was even partial recognition of the need for bank recapitalization. The general structure was fine. But did the sums add up? And who was to pay?

The result of this compromise was that Greece would pay the reputational price for having restructured its debts, but it would gain precious little financial relief. It would be left carrying a debt burden of 143 percent of GDP, which was clearly unsustainable. As one Goldman Sachs analyst commented: “This tendency to ‘under-size’ otherwise good policy initiatives has been a recurrent feature of European policies.” A member of the UBS economics team was less polite: “This is fiddling around at the margins. . . . The debt needs to halve.” As to the new support facilities provided by the EFSF, Willem Buiter, chief economist at Citigroup, told Bloomberg Television, “The European Financial Stability Facility has gone from being a single-barreled gun to a Gatling gun, but with the same amount of ammo. . . . It needs to be increased in size urgently.”62 If Italy went critical, the EFSF would need not 200–400 billion but 1–2 trillion euros. Otherwise, only the ECB, with its bottomless supply of euros, could backstop the system.

Savage

If money was fleeing out of Europe, where was it to go? The answer since the onset of the financial crisis had been, paradoxically, the United States. As US subprime went bad, there had not been the panicked dollar sell-off that many had feared. Instead, investors shifted into US Treasurys, the very top of the global monetary pyramid. In 2008 the dollar surged and US interest rates fell. Successive waves of QE reversed that trend. The dollar slid against its major trading partners. This imposed losses on investors and made US bonds marginally less attractive. By the summer of 2011, however, something far more ominous was on the horizon.

With the eurozone wobbling, the American money market funds that were pulling out of European bank bonds continued to shift into US Treasurys. But appearances were deceptive. Investor demand for US government debt held up, but above all in lower-risk, short maturities. The average maturity of US Treasurys held by the MMFs declined from ninety-five days in January 2010 to only seventy days at the end of July 2011.71 Meanwhile, financial engineers began to contemplate the need for something no one had contemplated before—credit default swaps against US Treasurys.72

Prior to 2008 the market for US Treasury CDS had not existed. What would have been the point of insuring the risk-free asset class on which the entire global financial system rested? In the wildly improbable event of a US default, the general destabilization would be such that it was unclear whether any private financial entity would still be in a position to act as a reliable counterparty. Who would be left standing to pay out on insurance against the end of the world? Nevertheless, having first come into existence during the turmoil of 2008, when it seemed that Fannie Mae and Freddie Mac might fail, in the course of 2011 the niche market for CDS on US Treasurys sprang back into life. In the last days of July just over a thousand contracts were outstanding, with spreads running to 82 basis points. It was a fraction of what investors in Greek debt paid, but it was astonishing that the market existed at all.

Yess, and a silly one

On August 3 China’s Dagong ratings agency was the first to draw the obvious conclusion. It downgraded the United States from A+ to A. As Dagong remarked: “[A]t this crucial juncture, neither the Democratic Party nor Republican Party has shown any consideration for the general interest in order to argue for their own partisan interest; they had a hard time making the correct choice in a timely manner leaving the world in terror, which highlights the negative role of the US political system on an economic basis.”75 The US political system, the Chinese analysts concluded, “cannot resolve the fundamental influence of low economic growth, high deficit and increasingly higher debt to the debt service capability through increasing real wealth creation, with the declining national solvency irreversible. It is natural that QE3 monetary policy will be enabled for the next step, which will throw the world economy into an overall crisis; the status of [the] US dollar will be essentially shaken in this process.” This was the judgment of the G20 at Seoul turned into the language of credit rating. The year ended with a big sell-off of US government debt by Beijing. But there was no rout. The long buildup of Chinese claims on the US taxpayer had ended. But the portfolio stabilized at between $1.2 trillion and $1.3 trillion.

In their flailing generality, these statements are symptomatic of the depth of the crisis by the autumn of 2011. In the space of barely three weeks, the German chancellor managed to tell the press that politicians should be responsible to markets and to tell the pope that politicians should make policy for “the people” regardless of those markets. Was it a contradiction? Or was she implying some kind of synthesis? If so, was it a matter of finding the market-conforming mode of expression that would allow politicians to slyly exert their power or, more ominously, a matter of hammering democracy into such conformity that no market ever need fear the policy parliament might make? Did anyone in Berlin know? No surprise that Gregor Gysi, the sharp-tongued spokesman of Die Linke, should lash Merkel’s handling of the eurozone crisis as an engine of chaos and confusion.

The very least one can deduce is that the optimistic dogma under which democracy and markets were seen as natural and necessary complements—the mantra of the aftermath of the cold war—was dead.5 In its place the crisis had put a more realistic awareness of the potential tension between the two. But this generalization too has its risks, particularly when it is assumed that it is financial markets, not politics, that force the tension. Certainly in the course of the eurozone crisis that had not been the case. The pressure the more fragile members of the eurozone were under depended not on some inescapable clash of peoples and markets, or global capitalism and democracy.6 It was dictated, first and foremost, by the willingness, or not, of the ECB to buy bonds. In the markets many banks and traders were not just crying out for the EU to undertake a stabilization effort but betting billions that it ultimately would. What delayed the stabilization and escalated the conflict between democracy and markets to an extraordinary pitch was the struggle among Germany, France and the ECB over the future governance of the eurozone, a question in which politics and economics were inseparably intertwined. Ironically, the result, as in 2010, was to escalate the crisis to the point that European affairs could no longer be safely left to the Europeans.

European political obfuscations were obscuring the basic lesson of 2008: Questions of macroeconomic policy and systemic stability could not be hygienically separated from the workings of megabanks, now more politely known as systemically important financial institutions.

What Geithner proposed was standard American maximum-force firefighting doctrine. “The firewall you build has to be perceived as larger than the scale of the problem. You can’t succeed by shrinking the problem to fit your current level of financial commitments. . . . It’s more dangerous to escalate gradually and incrementally than with massive preemptive force.” According to the Treasury’s own estimates, the eurozone needed a fund of at least 1 trillion euros and preferably 1.5 trillion.25 Picking up an idea launched by Mark Carney of the Bank of Canada and Philipp Hildebrand of the Swiss Central Bank, Geithner argued that the European Financial Stability Fund should be leveraged to give it sufficient firepower to act as a firewall.26 The EFSF could borrow against the capital invested in it by Europe’s governments. It was a neat solution, but controversial in Europe, particularly in Germany, because as it increased the fund’s firepower, it also increased the liability for losses.

Meanwhile, from the other side of the Atlantic came news of trouble at the high-profile brokerage firm MF Global. American regulators had ordered MF Global to boost its net capital to cover against the multibillion-dollar position it had built in Irish, Spanish, Italian and Portuguese sovereign bonds. Inverting the legendary big short position that speculators had built against mortgage-backed securities in 2007, MF Global had taken a “big long” in eurozone sovereign debt. It was gambling that other investors were underrating the stability of the eurozone and the value of peripheral bonds. As institutional investors like pension and insurance funds and banks offloaded their eurozone securities, it was MF Global that bought them up. As had been true in the case of the big short, there was a race between market sentiment and the ability of the contrarian investor to stay liquid. In October 2011 time ran out on MF Global. The regulator’s call for more capital triggered inquiries into its balance sheets and revealed that to tide it over in the face of huge market pressure it had been dipping into client funds. By the end of October one of the most high-profile investors betting that the eurozone did indeed have a future collapsed.36 It was a bitter irony that it was precisely as MF Global filed for protection that the eurozone finally began to take steps toward a more decisive resolution of the crisis. On October 23 the European leaders held a gathering to sketch the outlines ...

Its's all timing

This time PSI would be the cornerstone of the entire deal. The haircut would be deep. Banks and their shareholders would have to recognize tens of billions of euros in losses. Rumor had it that the Germans were pushing for 60 percent. The creditors, negotiating from offices in the basement of the EU’s Justus Lipsius building, held out for less, and they were a powerful group. Despite the ongoing sell-off of peripheral bond assets, in 2011 all the major banks of France, Germany and Italy still held Greek bonds. So too did Greece’s own banks, major insurance funds and American hedge funds. To shift this weighty coalition of financial interests it took not only financial inducements but also a forceful personal intervention by Merkel and Sarkozy. At 4:04 a.m. on the morning of October 27, a deal on “voluntary bond exchange” at 50 percent was announced.38 The plan promised to reduce Greece’s debt below 120 percent of GDP. To tide it over Greece was to receive another 130 billion euros in funding, bringing the total in emergency loans it had received since 2010 to 240 billion euros, or more than 100 percent of Greek GDP. To contain the fallout from this momentous decision, all other euro area member states solemnly reaffirmed “their inflexible determination to honour fully their own individual sovereign signature.” The EFSF was to be boosted to close to 1.2 trillion euros by means of leverage or by using its resources not to make loans directly but as an insurance fund to cover...

This, at the time, appeared to be the dispiriting upshot of the Cannes conference: the removal of the Greek prime minister, deadlocked negotiations, no aid for Italy and a further faux pas by Berlusconi. Three years later it emerged that something far more dramatic had transpired. Lagarde’s Italian proposal was a sideshow. The real news was that Paris and Berlin were maneuvering to unseat the Italian prime minister. As Geithner put it in transcripts compiled for his memoirs: “The Europeans actually approach us softly, indirectly before the thing [Cannes meeting] saying: ‘we basically want you to join us in forcing Berlusconi out.’ They wanted us to basically say that we wouldn’t support IMF money or any further escalation for Italy, if they needed it, if Berlusconi was prime minister. It was cool, interesting.”44 Geithner could not hide his approval of the basic idea: “I really actually felt, I thought what Sarkozy and Merkel were doing was basically right which is: this wasn’t going to work. Germany, the German public were not going to support, like, a bigger financial firewall, more money for Europe, if Berlusconi was presiding over that country.” Unfortunately, a further page of Geithner’s candid observations was redacted. In his memoirs, Geithner says that he informed the president of this “surprising invitation” from Europe, but concluded, “[W]e couldn’t get involved in a scheme like that. ‘We can’t have [Berlusconi’s] blood on our hands,’” Geithner told the president.

In mid-November the governments of two eurozone members were taken over by men without democratic credentials whose main qualification was that they were undeniably market conforming.50 Critics pounced on the web of connections that tied key eurozone decision makers to Goldman Sachs and its bond market dealings in Europe.51 It was surely more than coincidence that Monti, Draghi and Otmar Issing, Merkel’s favorite economic adviser, had all worked for Goldman. But to describe this simply as a defeat of democracy at the hands of global markets would be misleading, to say the least. There have been many governments felled by market pressure. But Geithner was right. The driving force in the eurozone in the fall of 2011 was political, not economic. Berlusconi had to go because otherwise there would be no agreement from the “German public,” at least as represented by Merkel’s government, to a bigger European firewall. The gutting of Greek and Italian democracy in 2011 was the result of a toxic combination of massive financial integration with Berlin’s dogged insistence on intergovernmentalism. The lack of overarching structures with which to compensate for the asymmetric effects of the crisis enforced conformity to Berlin’s vision of financial probity, one state at a time. Around the chancellery in Berlin, in the wake of the changes in Greece and Italy they were not bemoaning the oppressive force of markets. Senior officials could be heard boasting: “We do regime change better th...

Impt

Merkel was not playacting. She knew how narrow her coalition’s majority was. If she had returned to Berlin with the Franco-American proposal, she might well have faced a major mutiny on the Right and the need for early elections. Given the opinion polls at the time, that was not an attractive option for Merkel. With support for her FDP coalition partners collapsing, a German election at the end of 2011 might well have yielded a majority for Red-Green.56 That was not the outcome to the eurozone crisis that Sarkozy wanted. Given the pressure that France was coming under, Paris was in no mood to take risks. The French and Americans backed off.

And to add further to German indignation, whereas Sarkozy and Merkel’s fiscal compact was to be instituted by solemn amendment of EU treaties, Van Rompuy proposed that his more far-reaching measures could be put through by so-called secondary legislation and limited agreement among the eurozone members. For Berlin it was clear. Brussels was up to its usual “tricks.”

At this critical juncture another force came into play to compound the impasse. Aside from Poland, the other major EU member not in the eurozone was the UK. London had watched the eurozone crisis unfold with a mixture of Schadenfreude and frustration.63 On every possible occasion Prime Minister Cameron lectured the eurozone members on the need for deeper integration, while at the same time exempting London from any commitments. For the good of Europe, Britain and the wider world economy, London demanded that the eurozone move toward full economic union. Meanwhile, for Cameron, struggling to contain an upsurge of Euroscepticism in the Tory party, Europe’s crisis was an opportunity to haggle. By exploiting the divisions within the eurozone, Cameron thought he could obtain explicit opt-outs for the City of London, especially from demands for a tax on financial transactions. But any such concessions were violently opposed by Sarkozy, and Merkel needed France far more than she needed the UK. When he realized that he was isolated, Cameron announced that he would not only veto a collective deal among the twenty-seven EU members.64 He would exercise his right to block any steps toward deeper integration by the eurozone members within the framework of the EU.

For Britain’s relationship to the EU it was a parting of the ways. It was clear that at least as far as Britain’s conservatives were concerned, a decision would soon be necessary on whether they could continue as cooperative members of the union. For the eurozone what emerged from the clashes of early December 2011 was the lowest common denominator of both options on offer. Germany got its fiscal compact, although it was cast not in the form of the treaty change that Merkel had wanted but in the minimal legal form of an intergovernmental agreement outside the framework of the Lisbon Treaty.65 The terms of the fiscal compact were draconian. In the future, Europe’s budgets were to be balanced or in surplus. By constitutional amendment or its equivalent, deficits were to be restricted to 0.5 percent of GDP. The European Court of Justice was to oversee the transposition of these rules at a national level. States that had a deficit in excess of 3 percent of GDP would be subject to automatic sanctions unless a qualified majority of states were opposed. Countries with debt levels in excess of 60 percent of GDP were required to embark on debt reduction. It was the German debt brake visi...

It was in early 2012 that top-secret planning began for the eventuality of a Grexit.4 Work on the so-called Plan Z would continue until August 2012, when it was finally stopped by Berlin. It was stopped because the upshot of the planning exercises was always the same. It would likely be ruinous for Greece, and the ramifications of Grexit for the rest of Europe were entirely unpredictable. They were unpredictable because Europe still had not built an adequate shield to protect the other fragile eurozone members from the fallout from a Greek bankruptcy. It was to reinforce and extend that inadequate safety net that the Europeans were applying to the G20 to support an expanded IMF facility. But the G20’s answer was clear. The rest of the world would regard Grexit as a failure not just of Greece, but also on the part of the larger European states that pretended to global standing as members of the G20. On February 19, 2012, Japan and China, in a rare show of unity, declared that they were willing to back the appeal for increased IMF funding, but only if the Europeans raised the cap on the ESM stability mechanism, to which the Bundestag was clinging.5 The Europeans must help themselves first.

But by the same token, Papademos, the central banker turned prime minister, lacked legitimacy. Elections were scheduled for April 2012 and he would surely lose. The main opposition party, New Democracy, had presided over the onset of the crisis and had consistently refused to support Papandreou’s government in the negotiations since 2010. So that placed any new agreement with Athens in question from the start. How were the Greeks to be nailed down? With typical forthrightness, German finance minister Wolfgang Schäuble suggested that perhaps it would be better for the Greeks not to hold elections.8 Suspending Greek democracy would allow the key measures to be put through before the voters were given a chance to have their say. But that suggestion provoked outrage in Athens. So, instead, what the troika managed to extract was a promise from the hitherto evasive leader of New Democracy, Antonis Samaras, that if he were to take office he would abide by any deal negotiated by his predecessors. Whatever happened in the elections, the fiscal program would have priority. On that basis Greece and its creditors engaged in the latest round of extend-and-pretend.

To describe the debt restructuring of 2012 in these terms—as no more than a continuation of the makeshift measures that had characterized the Greek debt crisis from the beginning—may seem unduly dismissive. The restructuring that was forced on the creditors of Greece between February and April of 2012 was the largest and most severe in history, larger in inflation-adjusted terms than the Russian revolutionary default or Germany’s default of the 1930s.9 By April 26, 2012, 199.2 billion euros in Greek government bonds were converted in exchange for 29.7 billion in short-term cash equivalent notes drawn on the EFSF and 62.4 billion in new long-term bonds at concessionary rates. All told, Greece’s private creditors had conceded a reduction of 107 billion euros. Allowing for the much later repayment of the new long-term bonds, the net present value of claims on Greece was cut by 65 percent. In December 2012 the claims of private creditors were further reduced by a buyback of the recently issued long-dated bonds.

Good summary

The problem was that the funds to sweeten the deal and induce the creditors to engage in the “voluntary” write-down did not come out of thin air. Nor did the money to pay for recapitalizing the Greek banks in the wake of the restructuring, or to pay for the December 2012 buyback. All this was funded by new borrowing from the troika. Furthermore, the 56 billion euros in Greek bonds held by the ECB were exempt from the 2012 restructuring. So the overall reduction in Greece’s debt burden was far less than advertised. As a result of the debt restructuring of 2012, Greece’s public debt was reduced from 350 billion to 285 billion euros, a 19 percent reduction. The really dramatic transformation was not in the quantity of debt but in who it was owed to: 80 percent was now owed to public creditors—the EFSF, the ECB or the IMF. In effect, Greece swapped a reduction of its obligations to private creditors of 161.6 billion euros for an increase in obligations to public creditors of 98.8 billion euros.

Impt

This meant that altogether, of the 226.7 billion euros in assistance loans received by Greece, only 11 percent went toward meeting the needs of the Greek government deficit and directly to the benefit of the Greek taxpayer.

Argh

If Greece’s debts had been unsustainable in 2009, in 2012, even allowing for the concessions granted by the official creditors, it clearly still was. In the interim, Greek society had been battered beyond recognition.

In 2008 Greek unemployment had been 8 percent. Four years later it was rising inexorably toward 25 percent. Half of young Greeks were without jobs. In a nation of ten million, a quarter of a million people were fed daily at church-run food banks and soup kitchens. Meanwhile, the Greek parliament had been reduced to a factory for decrees demanded by the troika. In the eighteen months following the May 2010 bailout, the Athens parliament had whipped through 248 laws, one every three days. By 2012 it wasn’t only the trade unionists and the Greek Left who were up in arms. Judges, military officials and civil servants were mounting resistance to the subordination of the Greek state. And there were other ways of expressing dissatisfaction and distrust. In the spring of 2012 the draining of funds from Greek banks accelerated at an alarming rate. As the election now scheduled for May 2012 approached, the euro system was discreetly sluicing billions in cash into Greece to preserve a veneer of normality. In total, 28.5 billion euros were quietly airlifted into Greece to disguise the size of the bank run.14

Good lord

And this appeal received support from an unexpected corner: the IMF. The emphasis on the paradox of thrift in the G20 briefing for Mexico City was the first sign of a major shift in Fund thinking on fiscal policy.20 In the summer of 2012 its staff revisited the forecasts they had made in the spring of 2010 as the eurozone crisis began and discovered that they had systematically underestimated the negative impact of budget cuts. Whereas they had started the crisis believing that the multiplier was on average around 0.5, they now concluded that from 2010 forward it had been in excess of 1.21 This meant that cutting government spending by 1 euro, as the austerity programs demanded, would reduce economic activity by more than 1 euro. So the share of the state in economic activity actually increased rather than decreased, as the programs presupposed. It was a staggering admission. Bad economics and faulty empirical assumptions had led the IMF to advocate a policy that destroyed the economic prospects for a generation of young people in Southern Europe.

Oopzises

And then, as if to compound the political upheavals of May, the last aftershock of the real estate crisis struck, in Spain. Along with Ireland, Spain had the distinction of experiencing one of the most extreme housing bubbles in the world. When that burst, the effect, as in Ireland, was devastating. The difference is that Spain is big—with a population of more than 45 million, compared with Ireland’s 4.5 million. Before the crisis, Spain’s economy was comparable in size to that of the state of Texas. So the bursting of the Spanish bubble was an event of macroscopic proportions. As the housing market collapsed, Spain’s unemployment rate shot up. Of the 6.6 million increase in unemployment in the eurozone between 2007 and 2012, 3.9 million was accounted for by Spain—60 percent of that grim total. As bad as Greece’s situation was, it was small by comparison and accounted for only 12 percent of the increase in eurozone unemployment. Most catastrophic of all was Spain’s youth unemployment rate, which by the summer of 2012 had surged to 55 percent.26 Even allowing for an extensive black economy, it was a deeply dismaying statistic.

tone toward the EU became more belligerent.28 New loss provisions called for from the Spanish banks were inadequate to calm the markets. By the spring of 2012 only huge injections of liquidity from the ECB were keeping Spain’s financial system afloat. But maintaining liquidity was not the same as restoring solvency. On May 9, 2012, Bankia declared that it was on the point of bankruptcy and urgently needed recapitalization. By May 25, with Bankia under new management, the figure had risen to 19 billion euros in new capital.29 With its economy already depressed, the last thing Spain needed was a new round of banking crises, and it would be even worse if a bank bailout spiraled, Irish style, into a bank-sovereign doom loop. Following the Bankia announcement, yields on Spanish public debt surged to 6 percent and then began to inch up toward 7 percent, above which Spain’s debt burden would begin to snowball as rising debt service costs further inflated the deficit. By May 2012 it was clear that Europe was once again sliding toward the edge. Bond market yields were rising around the periphery. It was a dire outlook. According to IMF figures, in the course of 2012 alone, Europe’s governments and banks needed to roll over and refinance debts amounting to an impressive 23 percent of GDP.30 They simply could not afford interest rates to surge out of control as a result of a panic in Spain.

As Draghi later confided to a friend: “I really got fed up! All those stories about the dissolution of the euro really suck.” The expression he used in Italian was apparently rather more colorful.48 So Draghi decided to change the script. The markets needed to understand the qualitative change that Europe was undergoing. The eurozone might have started life as an ill-shapen construction, but under the pressure of the crisis it was developing fast. Global markets needed to appreciate the fundamental changes that were reshaping Europe. Following the December 2011 fiscal pact, the summit of June 2012 was a turning point because for the first time since 2008 all the leaders had restated with a powerful voice that the “only way out of this present crisis is to have more Europe, not less Europe.”49 The forward motion of the EU’s integration machine was resumed. The point that Draghi wanted to drive home to global markets was political. “When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro,” he told the skeptical City of London crowd, “very often non-euro area member states or leaders underestimate the amount of political capital that is being invested in the euro.” These were not empty words because “actions have been made, are being made to make it irreversible.” And there was “another message” that Draghi wanted investors to hear: “Within our mandate, the ECB is ready to do whatever it takes to preserve t...

On September 13, 2012, the FOMC voted for QE3.62 It would be the biggest Fed expansion yet. Initially, the Fed committed to purchasing $40 billion per month in Fannie Mae and Freddie Mac agency bonds. What was different was that it undertook to do so until the Fed saw “substantial improvement in the outlook for the labour market.” Additionally, the FOMC announced that it would likely maintain the federal funds rate near zero as long as unemployment remained above 6.5 percent and the Fed’s inflation forecast did not exceed 2.5 percent. On December 12, 2012, the FOMC announced an increase in the amount of purchases from $40 billion to $85 billion per month. Because of its open-ended nature, QE3 would earn the popular nickname “QE Infinity.”

Wow

In his memoirs, Bernanke commented: “Like Mario Draghi, we were declaring we would do whatever it takes.”63 But this was far too kind to the Europeans. Draghi’s OMT as it emerged by September 2012 was a conditional confidence-building measure. It worked by calming markets and stopping the panic. But beyond that it provided no stimulus to the eurozone economy. In truth, the ECB’s possibilities were limited. QE for Europe with Germany’s conservatives on the warpath was unthinkable.64 As the eurozone economy stagnated and its banks deleveraged, the LTRO facilities were progressively paid back. Unlike the Fed, whose balance sheet Bernanke was actively expanding, the ECB’s balance sheet contracted back to where it had been in the crisis-ridden fall of 2011. Europe was sliding ever deeper into its second recession.

Important Contrast

Implicit in this rendition of what happened in the summer of 2012 is another narrative, at odds with Draghi’s intended meaning. “Whatever it takes” was, in fact, a form of surrender. The eurozone was finally giving in to what Anglophone economic commentators had been calling for all along. If only the ECB had moved to the Fed model earlier, as Obama had spelled out at Cannes, the worst of the eurozone crisis might have been avoided. What Draghi now promised was what Geithner, Bernanke and Obama had been preaching to the Europeans since 2010: “Do it our way.” Nor was it a coincidence that it was Draghi—an American-trained economist; a Goldman Sachs associate; a paid-up member of the global financial community; a “friend of Ben”; an internationalized, urbane Italian, not a provincial German—who delivered this conclusion to the agonizing story of the eurozone crisis. The Draghi formula—America’s formula—was self-fulfilling. He spoke the magic words. The markets stabilized. The eurozone was saved by its belated Americanization.

Looking back over the course of events since 2007, if one stopped the historical clock in the autumn of 2012, the story of the North Atlantic financial crisis could thus be twisted back into a familiar shape. Faced with a crisis of historic proportions, after its own fashion, the Obama administration had delivered a twenty-first-century demonstration of hegemonic leadership. It lacked the urgency and razzmatazz of the Marshall Plan era, but the upshot was decisive. Not only had America led the way through its own domestic stimulus and monetary policy programs. Through discreet diplomacy and the Fed’s massive liquidity programs, it had helped Europe across its worst crisis since the end of World War II. Americanization was the answer. Nor were the exponents of US economic policy shy about trumpeting their achievements. The Courage to Act would be the title of Bernanke’s memoir. The melodrama caused his more bashful European colleagues to wince. It was not the kind of language one associates with the recollections of an academic economist turned central banker. Other, more academic titles in the wake of the 2012 stabilization echoed the general mood of optimism. In the end, it had turned out to be a Status Quo Crisis.65 The System Worked.66 The global economy had survived and America had reasserted a new version of liberal hegemony. Europe resumed the forward march to a United States of Europe it had begun under American guidance in 1947. Among academic commentators, a cotta...

Impt

These were the parameters of the economic policy debate familiar since 2009 and long before. What they did not capture was the sense that a deeper and more serious problem was afflicting America’s economy and the society built on it. The hypothesis that Summers suggested to his audience at the IMF in November 2013 was disconcerting and unfamiliar; so jarring, in fact, that Summers, who is not given to either modesty or self-doubt, acknowledged, “[T]his may all be madness, and I may not have this right at all.” But in light of the data, the question had to be put: What if the inadequate recovery was not simply down to policy failure? What if there was a deeper problem, a chronic shortfall in the demand for investment relative to the supply of savings, resulting in a sustained condition of “secular stagnation”?

In an astonishing makeover of America’s recent economic history Summers proposed that for at least two decades American economic growth had been on weak foundations. To achieve no more than a “normal” rate of growth it had depended on “abnormal” financial bubbles. Looking back over recent decades, Summers asked in a subsequent speech, “[C]an we identify any sustained stretch during which the economy grew satisfactorily with conditions that were financially sustainable? Perhaps one can find some such period, but it is very much the minority, rather than the majority, of the historical experience.”11 It was a remarkable indictment of the policy consensus of which Summers himself had been a defining figure.12 It had dramatic implications for current policy. If America simply waited, the long-awaited rebound from the crisis of 2008 might never arrive. To address the chronic shortfall in investment, what Summers advocated was a new era of government activism. The United States would not match China, of course. Nor was that appropriate. But the conditions were right for a big burst of public investment. This would rebuild America’s infrastructure, and in so doing it would address the more fundamental questions posed by Detroit. Physical reconstruction would be a means to restore a sense of national coherence and national pride. As Summers remarked on another occasion: “Look at Kennedy airport. It is an embarrassment as an entry point to the leading city in the leading country in...

Impt

In October 2013 two French economists, one working in California, the other back in Paris, published the latest release of a long-running project on American inequality.14 Emmanuel Saez and Thomas Piketty were at this point not unknown. An earlier paper in which they mapped top incomes in the United States over the long run had yielded the “We are the 99 percent” slogan that the Occupy movement had used to such good effect.15 Nevertheless, the data they released in October 2013 were astonishing. From the latest round of tax releases they calculated that of the growth generated by the economic recovery since 2009, 95 percent had been monopolized by the top 1 percent. That tiny fraction of the population saw their incomes rebound from the trough of the recession by 31.4 percent.16 Meanwhile, 99 percent of Americans had experienced virtually no gain in income since the crisis. The data were subsequently revised to show a less extreme disproportion.17 But in 2013 the numbers were a sensation. The slow growth in GDP that worried Summers, in fact, hid two radically divergent realities. Whereas a tiny elite were doing extremely well, for average Americans the secular stagnation thesis that Summers advanced as a tentative academic hypothesis was simply the lived reality of the last forty years. Since America’s bicentennial in 1976, productivity growth, which drove overall economic growth, and the returns to labor in the form of household incomes had starkly diverged. The average A...