Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

After years of deadlock, in September 1986 the Fed and the Bank of England reached a deal, which in July 1988 finally brought the Basel Committee to agreement on what was known as the Capital Accord, or Basel I.

The obvious inadequacies of Basel I set in motion the search for a new framework that finally emerged in 2004 with the Basel II accord. But the transition from one regime to the other was telling. Whereas Basel I had been a conventional regulation aiming to impose standards on the industry from the outside, the chief ambition of Basel II was to align risk regulation with “best business practice” as defined by the bankers themselves.

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

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

The Fed further amplified the effect by declaring in January 2001 that the US banking operations of foreign financial holding companies that were considered adequately capitalized in their home countries would not need to meet separate capital adequacy rules in the United States.47 Despite the huge scale of their American operations, the European banks were not required to hold adequate capital actually in the United States.

Tellingly, it was the FDIC, the American deposit insurance agency that oversaw medium and small American banks, that raised objections. The FDIC’s chair, Sheila Bair, an outspoken midwestern Republican appointee, was incredulous that big banks were effectively being given license to “set their own capital requirements.”

To the American banks this did not seem fair. In response their industry lobby pushed hard to level the playing field. In February 2007 New York mayor Michael Bloomberg traveled to London, where he met with the chair of the UK’s FSA, and used the London platform to lobby for further deregulation in the United States. “The FSA is an example of the kind of streamlined and responsive regulatory framework Congress must implement if New York City is to remain the financial capital of the world,” the mayor intoned.

The clannish society of the bankers created a social force field of common assumptions and an overweaning superiority complex. They were the masters of the universe. They could not fail.

In the last instance, US banks could expect support from the bottomless resources of the Fed. But the question was particularly pressing for European banks operating a multicurrency balance sheet. In case of emergency, where would they get the dollars they needed? Who would be their lender of last resort?

Would Europe’s central banks have the dollar reserves necessary to backstop the European financial system? It was an old-fashioned question, seemingly out of season in a world of limitless global liquidity.

In the balance sheets of the European banks at the end of 2007 there was a mismatch between dollar assets (lending) and dollar liabilities (funding by way of deposits, bonds or short-term money market borrowing) of $1.1–1.3 trillion.57 The only central banks that held these kinds of sums were in China and Japan.

As it turns out, given the scale of the banking business in their jurisdictions, the level of foreign exchange reserves held by the Swiss and British central banks was astonishingly low—less than $50 billion each.

“Given our long history of relations with the Fed, we didn’t expect to have any difficulty getting hold of dollars.” In other words, there was a presumption that collaboration would be forthcoming and in an emergency the Fed would provide Europe, and London in particular, with the dollars it needed.

Both crisis narratives play to type: mercenary Americans, squabbling European nationalisms. But was it merely bad luck that the two crises followed so closely upon each other? Was it merely bad luck that the same banks were involved in both? If the buildup to the American crisis was less all-American than is generally credited, how “European” were the problems of the eurozone?

As far as the euro is concerned, the story again goes back to the early 1970s and the collapse of Bretton Woods. Between 1945 and 1971, the Europeans did not have to worry about intra-European currency issues. The dollar tied to the gold reserve in Fort Knox was the anchor of the global system. Once Nixon abandoned the gold peg in August 1971, Europe faced a problem. Fluctuating exchange rates would disrupt the tightly integrated trading networks that had brought Europe together.

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

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

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

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

Germany’s entry into the euro did not go well. The other members made sure to settle on competitive exchange rates against the Deutschmark. Germany’s exports took a hit. Its rule-busting budget deficits reflected its anemic growth.

To combat this scourge, between 2003 and 2005 the Schroeder government announced a national restructuring program titled Agenda 2010. Its main thrust was a multiphase program of labor market liberalization and benefit cuts, designed by a committee headed by VW’s head of human resources, Peter Hartz.

Hartz IV certainly drove millions of people more or less willingly off long-term unemployment benefits into a range of insecure jobs. This helped to hold down wages for unskilled workers, such as cashiers and cleaning workers. In the first ten years of the euro, despite soaring productivity, half of German households experienced no wage growth at all.

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

While its economic impact has been exaggerated, what Hartz IV did transform was German politics. The blue-collar electorate and the left wing of the SPD never forgave Schroeder for Hartz IV.

Merkel has come to be seen as the figurehead of Europe’s political center—oscillating between conservative stances on economic and financial policy and cultural modernization.

But there is little doubt that the 2005 agenda expressed the chancellor’s basic personal vision. It can be summarized in three numbers: 7, 25 and 50. As Merkel is fond of pointing out, Europe has 7 percent of the world’s population and 25 percent of global GDP. But it is responsible for 50 percent of global social spending.17 This, as Merkel sees it, is not sustainable.

The argument that the debts “shouldered by the West” to pay for spending “in the East” had generated huge orders for West German business—in effect exports within Germany from West to East—cut no ice. After 2010 the same argument would cut no ice at the European level either.

In Europe, as in the United States, it was politicians, workers and welfare recipients who were seen as the problem, not banks or financial markets.

Unlike the Fed, which had a dual mandate for price stability and maximum employment, the ECB had price stability as its only target.

France had actively promoted the market for its own debt by offering American-style repo facilities.27 The easier it was to trade French debt for instant liquidity, the more actively it would be purchased and the more accepting the market would be of France’s borrowing requirements.

Rather than the ECB, it was Europe’s banks that bought their governments’ debt. But they did so with the understanding that if they needed cash in a hurry, the bonds could be exchanged with the ECB on a repurchase basis. The terms of the repo and the size of the ECB haircut were the basic regulating variables in the unified financial system of the eurozone.

If it had wished to maximize pressure on Europe’s government to preserve fiscal discipline, the ECB could have adopted a discriminatory system of nationally specific repo haircuts, imposing tougher conditions on less credible peripheral eurozone borrowers. Haircuts in the bilateral repo market in the United States varied widely across different types of bonds.

In Europe in the late 1990s, Greece had had to offer far higher interest rates to attract lenders than had Germany. But instead of discriminating, the ECB took the view that a single currency implied a single rate. It would repo the bonds of all European sovereigns on the same terms.29 Unsurprisingly, this produced a dramatic convergence of yields as investors bid up the price of higher-yielding debts from countries like Greece, Italy, Portugal and Spain, which in the eyes of the ECB were now equivalent to Bunds, Germany’s rock-solid government bonds.

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

After the formation of the eurozone, Greek borrowing costs and debt service charges fell by more than half. It could have been the opportunity for a substantial fiscal consolidation. Instead, Athens let its tax revenue decline.

Though the degree of Greece’s problems was not fully appreciated, it was a known problem case and it was small fry. More politically significant in the early 2000s was the violation of the Growth and Stability Pact rules by France and Germany. This definitely eroded the authority of fiscal discipline.

In 2007 more than $500 billion in loans were securitized in Europe. In 2008 the total reached $750 billion in European asset-backed security issuance with UK and Spanish banks particularly active.

Once again, as in the case of America’s international finances, it is easy to deceive oneself about the direction of these intra-European flows.

We know where the loans went—Greece, Spain, Ireland. We know that Germany was the main “surplus” and “creditor” nation. So does that mean that Germany financed the credit boom? Certainly it had the largest trade surplus and was thus the largest net exporter of capital. But as far as overall financial flows within Europe are concerned, that simple mental map is as misleading as the exclusive focus on Sino-American financial relations is on a global scale.

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

American and other lenders from the rest of the world clearly preferred to do business with well-known French, Dutch and Belgian counterparties, who then channeled the funds to the European periphery. France was a major financial hub, not because it had a huge trade surplus but because it had large, ambitious banks that were willing to borrow to lend: 445 billion euros flowed out of France and 447 billion flowed in, leaving a net imbalance of merely 2 billion euros.

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

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

At the end of the day the accounts balanced. Germany’s savings appear as the counterpart to Spain’s trade deficit. But accounting identity is not the same as causal relationship. It wasn’t Germany’s excess savings, or its exports, that produced the boom in Spain. It was the lopsided credit-fueled boom that produced the demand imbalances, the trade flows and the savings imbalances. Europe’s banking system provided elastic intermediation.

Important

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

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

The failure of state building that mattered most was not fiscal union but the failure to build the capacity to handle a banking crisis.

But spreading out across the EU and feeding off the transatlantic financial circuit, the European banks had grown to gargantuan size. In 2007 the three largest banks in the world by assets were all European—RBS, Deutsche Bank and BNP.

Indeed, the origin of European integration was the realization that Europe’s coal and steel industries were sources of conflict and instability.

Likewise, the Common Agricultural Policy had been devised in the 1960s to contain the spillover costs of national farm support policies.