Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

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

It was a fateful coincidence that in the wake of the constitutional debacle of 2005, it was Germany that took the rotating presidency of the council of the EU. At this moment, early on in her career as chancellor, Merkel assumed responsibility for redrafting and driving through a replacement for the failed constitution. The result, after months of meticulous high-pressure preparation by Berlin, was the Lisbon Treaty of December 2007.

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

In August 2008, as the financial markets hurtled toward disaster, Russia went to war with Georgia, a Western-backed proxy.

But Russia’s economy was a shipwreck. In the words of George Soros, Russia was “a centrally planned economy with the centre knocked out.”2 In the so-called transitional recession, inflation soared and Russia’s real GDP fell by 40 percent between 1989 and 1995. On “Black Tuesday,” October 11, 1994, in one single session of frantic currency trading, the ruble lost more than a quarter of its value against the dollar. It was not until 1995 that Russia’s economy stabilized.

Outside the United States, Russia was the largest dollar economy in the world. International investors in Russia were required to pay their local taxes in American currency.

On average between 1989 and 1994, output fell by more than 30 percent. Inflation, unemployment and social inequality rocketed as real wages plunged and Communist-era welfare systems disintegrated. In the Baltic states, the hit to the wage level in the 1990s was staggering. Wages fell by 60 percent in Estonia and 70 percent in Lithuania. For many millions, emigration was the best option, illegal if need be.

Focusing only on the military dimension, NATO could move more quickly. Already in 1999 the Poles, Hungarians and Czechs were admitted as full members. The really big bang came in 2004. On April 1, 2004, Bulgaria, Estonia, Latvia, Lithuania, Slovakia, Slovenia and Romania joined NATO. A month later all but Bulgaria and Romania also joined the EU. The two stragglers were judged ready for EU membership in 2007.

Not only was European military cooperation factious and frowned upon by Washington, but the European states all took the peace dividend. In light of Russia’s weakness, what reason was there not to run down their substantial cold war military establishments?

Within a decade of the fall of communism, around half of all East European manufacturing capacity was in the hands of European multinationals.

Though the initial levels of spending were quite modest, after 2000 through the Cohesion Fund, the European Regional Development Fund and the EU’s agricultural subsidy schemes, tens of billions of euros flowed from West to East.

Across the region, the EU’s money was sufficient to fund between 7 and 17 percent of gross fixed capital formation over a seven-year period.

The takeover of Eastern Europe’s industrial base in the 1990s was just the beginning. By the end of 2008 Western-owned banks in the post-Soviet economies had extended $1.3 trillion in credits.

The “color revolutions” in Georgia and Ukraine in 2003 and 2004 were driven, above all, by the determination not to fall further behind and miss out on the dramatic changes going on farther west.

As far as the new accession states were concerned, the historical logic linking the EU to NATO and thus to the United States was undeniable. Western integration promised security and prosperity. But it also harbored risks, both financial and geopolitical.

The result was that Eastern Europe reproduced on Europe’s doorstep the configuration of overoptimistic expansion that had led to the emerging market crises of the 1990s. Success stories of market reform and privatization, combined with freedom of capital movement and relative stability of exchange rates, led to a huge inward surge of capital.

But the entire constellation—the booming domestic economy, the appreciating exchange rate, the rising reserves—could all be traced back to a common factor: the huge inward surge of foreign capital. What if that surge reversed? What if there was a sudden stop?

No one in Europe wanted to burst the bubble. Latvia was enjoying a recovery from the doldrums of the 1990s. In the fall of 2007 its foreign ministry moved into the newly renovated building it had last occupied in the 1930s, when Latvia first enjoyed its independence from czarist Russia.

Russia had watched as Latvia reclaimed its independence in May 1990. It had watched as Latvia conducted a referendum on EU membership in the autumn of 2003 that overrode the no vote of the ethnic Russian minority, and it had watched as Latvia, along with its Baltic neighbors, joined NATO in April 2004. Would Russia continue to watch as Latvia, and other countries like it, set about rolling back the Soviet-era boundaries of power even farther to the east?

Whereas in the 1990s large parts of Russia’s economy had been privatized, under Putin the energy sector was brought back under the control of the state, which in effect meant the oligarchic group around the president.

Tens of billions of dollars in oil and gas export earnings never returned to Russia. Russia’s oligarchs behaved like the masters of a 1970s petrostate, harboring their wealth in offshore havens like Cyprus, from where it cycled back to London and its convenient eurodollar accounts.

In the dark years of the 1990s the former Communist economies had experienced a common emergency. Exhaustion and disorder were shared. The common boom, ironically, would prove far more explosive.

When Germany and Russia signed the first Nord Stream pipeline deal in 2005, enormously increasing the flow of Gazprom’s gas to the West, it was denounced by Poland’s foreign minister as a second coming of the Hitler-Stalin Pact that had sealed Poland’s fate in 1939.

There is no reason to doubt that the economic potential of the new centres of global economic growth will inevitably be converted into political influence and will strengthen multipolarity.” Under such circumstances, for the West to imagine that a global order could be based on its own organizations—the EU and NATO—rather than the truly comprehensive authority of the UN was either self-deceiving or in profoundly bad faith. Nor could the West reasonably claim that NATO expansion into Eastern Europe had “any relation with the modernisation of the Alliance itself or with ensuring security in Europe,”

As one of Russia’s leading commentators, Dmitri Trenin, noted, Putin was driving home the reality of multipolarity: “Until recently, Russia saw itself as a Pluto in the Western solar system, very far from the center but still fundamentally part of it. Now it has left that orbit entirely: Russia’s leaders have given up on becoming part of the West and have started creating their own Moscow-centered system.” Russia was establishing itself as a “major outside player that is neither an eternal foe nor an automatic friend.”

At Munich in February 2007 the response of the Czech foreign minister, Karel Schwarzenberg, was immediate. “We must thank President Putin,” he remarked facetiously, “who has not only shown concern about the publicity for this conference, but has clearly and convincingly demonstrated why NATO had to enlarge.”

The urgency on the part of the smaller ex-Communist states was obvious. Their vulnerability in both security policy and economic terms was only too evident. But how would the big players in the European and transatlantic system—Washington, Berlin and Paris—respond? The question would explode embarrassingly into the open at the NATO summit hosted in Bucharest on April 2–4, 2008.

In February 2008 the West had rubbed salt in the wounds of Russian resentment by extending recognition to an independent Kosovo, overriding the claims of Serbia, which Russia regarded as its client.

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

As the financial markets in the United States convulsed in the summer of 2008, dark rumors circulated that Moscow was about to move from verbal attacks on dollar hegemony to concerted action. US Treasury Secretary Paulson had not named his sources, but in the run-up to the Olympics, his Chinese contacts informed him that they “had received a message from the Russians which was, ‘Hey let’s join together and sell Fannie and Freddie securities on the market.’”53 The fragility of America’s mortgage market was about to be turned into a geopolitical weapon.

But over the course of 2008, Russia did unload its portfolio of $100 billion of Fannie Mae and Freddie Mac bonds. As Reuters reported it, the decision was motivated primarily by domestic political concerns.54 “The holdings have met hostility from some Russian media and the public, who are wary of risky investments.” By the summer of 2008, one didn’t need to be a Russian nationalist to view American mortgage securities as a bad investment.

In early August 2008, with Russian encouragement, irregular forces in the rebel province of South Ossetia began shelling positions of the Georgian army.56 On August 7, apparently believing that they had Washington’s approval, the Georgian government took the bait. A sudden counterstrike by Georgia’s American-trained army would subdue Ossetia and Abkhazia, settle the outstanding territorial questions and clear the way for a successful NATO membership application. As the awe-inspiring opening ceremony of the Beijing Olympics exploded across Western TV screens, Georgia launched its army and air force into an invasion of South Ossetia.

was against this backdrop that President Sarkozy declared to the UN General Assembly: “Europe does not want war. It does not want a war of civilizations. It does not want a war of religion. It does not want a cold war. . . . The world is no longer a unipolar world with one super-Power, nor is it a bipolar world with the East and the West. It’s a multipolar world now.”60 He was, in effect, conceding the point Putin had made eighteen months earlier in Munich.

For the immediate future, the sheer shock of the financial crisis would tend to dampen geopolitical tensions. But the damage done by the escalation of 2007–2008 would prove to be long lasting.

Through securitization, risks were supposed to have been spread so that even severe losses would be absorbed across the broad base of the economy. That was the theory. By the late summer of 2007 it was evident that the reality was different.

On June 22, Bear Stearns was forced to bail out two funds that had made heavy losses on MBS.

But the really decisive break in market confidence came on the morning of August 9, 2007, when BNP Paribas, France’s most prominent bank, announced that it was freezing three of its funds.5 The explanation Paribas offered marked a decisive moment in the opening of the crisis: “The complete evaporation of liquidity in certain market segments of the U.S. securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating.”

The ECB did not at this point have data on the subprime exposure of Europe’s banks. But the stress in the interbank lending market was all too obvious. In response Jean-Claude Trichet and his colleagues opened the liquidity tap, offering funds at attractive rates in unlimited quantities. By the end of the day on August 9, Europe’s banks had taken 94.8 billion euros, and they took another 50 billion on August 10.

Quite how bad things were soon going to get was suggested three weeks later, when on September 14, Northern Rock, one of Britain’s largest mortgage lenders, failed. On TV screens, the Northern Rock panic looked like a classic bank run.

But off camera something even worse was happening. The trillion-dollar global funding market was shutting down.

Northern Rock had minimal exposure to US subprime. But that didn’t matter, because it sourced its funding from markets heavily used by banks that did.

Given Northern Rock’s extreme dependence on wholesale funding, it took only two working days after the markets dried up for the bank to notify the Financial Services Authority of an impending crisis.

Bear Stearns, the smallest of the US investment banks, reported the first loss in the firm’s history in the first quarter of 2007.13 As was common knowledge, it was heavily involved in mortgage securitization. That was enough to restrict its access to commercial paper markets. The bank’s ABCP issuance plunged from $21 billion at the end of 2006 to $4 billion a year later.

Unlike the implosion of ABCP, the “run on repo” was a surprise.14 Under British and American law, the holder of repo collateral is entitled to seize it ahead of any other claimant in the bankruptcy queue.

When news of a new round of mortgage failures hit the markets in March 2008 and hedge funds began emptying their prime brokerage accounts, quite suddenly the haircuts Bear Stearns faced in the bilateral repo market steepened and access to trilateral repo funding was shut off.

Then something even worse began to happen. The uncertainty spread from individual weak banks to the entire system. First in the spring of 2008 and then in June, the haircuts on bilateral repo took a severe step up across the board, for all asset classes, for all parties.

What pushed Lehman over the edge were collateral calls by anxious lenders. Given the falling value of its stock, J.P. Morgan demanded large postings of collateral to back up daytime triparty repo risks. By Tuesday, September 9, allowing for liens on its assets, Lehman’s liquidity pool was down to $22 billion. Two days later, on Thursday, September 11, Lehman was still posting $150 billion as collateral in the repo market.19 But then confidence broke. S&P, Fitch and Moody’s all downgraded Lehman.

One day the investment banks, dealers and those they borrowed from and lent securities to all functioned as a gigantic trillion-dollar machine based on confidence and widely acceptable collateral. The next day even a very large player in the system could be shut out.

Great graph

Perversely, the securities lending office of AIG began to take those risky bets in 2005 precisely at the moment that AIG’s own Financial Products division decided it was too risky to continue writing CDS on mortgage-backed securities.

search of profit, a cash-rich insurance company sitting on a giant portfolio of high-quality securities had turned itself into a dangerously leveraged shadow bank with a serious maturity mismatch.