Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

Compared with its massively export-dependent neighbors, Indonesia enjoyed a degree of insulation from the global shock. But it was also by far the largest state in the region and it was extremely difficult for its central government to deploy resources effectively across its sprawling island territories.

One of the main vehicles for their lending was 1Malaysia Development Berhad (1MDB), a fund designed to channel gulf petrodollars into Malaysian national development and to act as a counterpart for infrastructure development projects by China’s electricity grid, called State Grid. At the time of its launch, Najib’s program met with wide international acclaim.

All of Asia had to deal with the export shock. What set South Korea apart was the emergency in its financial sector.

One of the reasons why Fed officials advocated a swap line for South Korea was that they did not believe Seoul was willing to have recourse to the IMF any longer. Better to welcome South Korea discreetly to the top table rather than to risk a politicized clash that might upset fragile global markets.

There was no prior discussion or consultation. The rich countries decided to form a bigger club and asked twelve new members to join. It was global governance made simple.

It was far from a foregone conclusion, therefore, that this ad hoc intergovernmental forum should become the global platform through which the world’s leading economies responded to the financial crisis.

The G20 was a reflection of the new world created since the 1970s by globalized economic growth. The nations represented at the G20 might represent only 10 percent of UN member states and 60 percent of the world’s population, but they were responsible for 80 percent of trade and 85 percent of global GDP and their share was increasing.

Perhaps most important, there was strong language about the need to maintain open global trade. There would be no protectionist free-for-all, as in the 1930s.

As the G20 leaders assembled that afternoon in Buckingham Palace, it was a freak show of outsized personalities. When he was not grandstanding, Sarkozy was ostentatiously busy on his cell phone. Argentina’s Cristina Fernández de Kirchner reprised her anticapitalist posturing from Washington. Italy’s Silvio Berlusconi was noisily desperate to attract Obama’s attention. Otherwise, he was prone to nodding off. Merkel was unflappable and hard to budge. The Chinese dug in hard on their negotiating position. Several heads of government were unable to communicate fluently in English and most had little technical command of the material.

The real politics of the communiqué began in earnest with the section on financial reform. There would be a new global Financial Stability Board, which would devise improved regulations and discipline the ineffectual private credit-rating agencies. The G20 thus confirmed its role as the de facto lead body, setting the agenda for the Basel Committee, the IMF and other agencies of global governance.

This bought enough support for a truly headline-grabbing increase in IMF resources. The IMF would receive $250 billion in immediate new financing from members. There would be up to $500 billion in new Arrangements to Borrow, which provided the IMF with credits from member states on demand. And finally there would be an issue of $250 billion in SDRs to all the IMF members.46 This gave Brown the “plump, round headline figure of $1 trillion” that he so craved.

So it was Obama who swung into action, coaxing the two sides to accept a face-saving compromise under which the G20 would “take note” of a blacklist of tax havens issued by the Organisation for Economic Co-operation and Development (OECD), an organization descended from the Marshall Plan era to which China did not belong and which it could feel free to ignore.

It was a token of Brown’s success that Sarkozy was so keen to steal his limelight.

The London G20 was not mere theater. The incorporation of a key group of emerging markets into global economic policy was a genuine innovation. The ratification of the IMF deal was to prove particularly important. In the years to come it would prove to be a vital resource, ironically enough, for Europe.

By comparison, despite the size of the EU’s economy, Europe’s fiscal response to the crisis was derisory, barely more than 10 percent on the most generous measure.

The only Western fiscal stimulus that weighed seriously in the balance was that launched by the United States.

In London Sarkozy upbraided the Czech about his inappropriate tone. On the back foot Topolánek offered a rather less trite and more disarming explanation. Far from being inspired by the horrors of Stalinism, the phrase had popped into his head after an evening spent listening to the heavy metal classic Meat Loaf’s “Bat Out of Hell.”

The fact that the administration needed the Democrats to vote en bloc in favor of the stimulus gave leverage to so-called moderates—the Blue Dog Coalition and the New Democrat Coalition—free-market, antispending Democrats who were anxious to preserve their hard-won probusiness credentials.

The multiplier was positive and above 1. This implies that the effect of government spending on the economy was not just positive. More private economic activity was stimulated than the government originally contributed. So the impact of the government’s spending was to shrink the government’s share in overall economic activity.

While the banks and lenders were bailed out, 9.3 million American families lost their homes to foreclosure, surrendered their home to a lender or were forced to resort to a distress sale.16 The measures that the administration did develop to offer mortgage rescheduling were derisory in their impact.

Automatic stabilizers are the unsung heroes of modern fiscal policy.

Dominated by these nondiscretionary flows, modern state budgets have a powerful stabilizing effect on the economy. As economic activity declines and the economy calls for stimulus, tax revenue falls, entitlement spending increases and the government deficit automatically expands.

The actual general government deficit was 12.5 percent of GDP.22 More than half the support provided to aggregate demand was automatic or quasi-automatic. And this was typical of all advanced economies.

In the event, Summers and the other skeptics were proven right. There was no run against Treasurys. The bond vigilantes were a spook. America’s households were rebuilding their savings. Mutual funds were shifting out of risky mortgage bonds. Everyone wanted Treasurys. These were the kinds of systemic macroeconomic and financial mechanics that all too often escape fiscal hawks, who view the public budget like that of a private household.

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.

It was a choice that would change the politics not just of Germany but of the eurozone as a whole.

Germany’s federal government, for its part, agreed to bind itself by constitutional amendment to borrow no more than 0.35 percent of GDP under normal circumstances.35 There would be exceptions in case of cyclical shocks, but the cap was severe. It applied to investment as well as to current expenditure.

What began to prevail in Washington, DC, as in Europe from the late summer of 2009, were the fiscal politics of the precrisis period. The aim of fiscal “sustainability” returned to the fore.

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.

By 2009 confidence was still the problem. But now it was government deficits and the supposed threat of bond vigilantes that seized the headlines. Given actually prevailing conditions in bond markets at the time, the constraints this anxiety placed on fiscal policy were a triumph of precrisis centrist orthodoxy over the facts of the postcrisis situation.

Having excluded a full-scale fiscal response on grounds of protecting confidence, faute de mieux resurrecting the banks came to seem like the most promising path to recovery.

In the 2008 bonus season, after suffering tens of billions in losses, Wall Street paid out $18.4 billion to its top staff. That was two and a half times the amount that Congress approved for the president’s priority of modernizing America’s broadband infrastructure.

But the investment banks weren’t conventional public companies. They were partnerships run primarily for the benefit of their managerial elite and they expected to be paid, whatever happened.

But of all the bonus scandals, the one that really caught the public’s attention was AIG. It closed its fourth quarter of 2008 with a loss of $61.7 billion, the largest in US corporate history.

Perhaps the solution was to follow the Swedish example, to break up America’s megabanks, restructure, recapitalize and then return them to the market.

Larry Summers and Christina Romer, the leading economists in the administration, were compelled by the Swedish example, as was Paul Volcker.

March 15, 2008,

2009 surely?

And the pressure for action was only increased the following day, when the scandal erupted over bonuses paid to AIG’s senior staff. The president was furious. He wanted action. The nation’s top thirteen bank bosses were summoned to a meeting in the White House.14 At this moment there was a real fear on Wall Street that the Obama administration was about to go to war. Given how unpopular the banks were, it would have made good politics. But it didn’t happen.

When several of the CEOs offered the customary justifications for their exorbitant compensation—their businesses were large and risky; they were competing in an international talent pool—the president interrupted in exasperation: “Be careful how you make those statements, gentlemen. The public isn’t buying that. . . . My administration is the only thing between you and the pitchforks.”

Great quote

To the amazement of the hardened Wall Street deal makers, the only item on the table on March 27 was voluntary restraint on compensation.

The uncomfortable truth was that the Obamians lacked pitchforks of their own. Reviled by the Right and suspected by the Left of being in the pocket of Wall Street, as Geithner himself admitted, the administration would find itself in political “no-man’s land.”

As the acute crisis of 2008 passed into memory, a new relationship between the big banks and the authorities would be given permanent shape.

Purely for internal purposes, the New York Fed had for some time been in the habit of conducting crisis simulations with the main banks on Wall Street.22 In February 2009, in his first major speech as Treasury secretary, Geithner announced that these so-called stress tests would be turned into a comprehensive exercise of public policy.

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.

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.

In an extraordinary two-week period in December 2009, Citigroup, Bank of America and Wells Fargo raced one another to raise a total of $49 billion in common equity. Bank of America’s offering of $19.3 billion was the largest offering of common stock in US history.

The sooner they could repay the Treasury, the sooner they could escape the limits on compensation imposed on all TARP recipients, thus allowing them to retain and compete for talent. It was, as Bair ruefully remarked, “all about compensation.”

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 funding costs enjoyed by the larger banks relative to their smaller peers had more than doubled, from 0.29 to 0.78 percent. For the largest eighteen US banks, this implied an annual subsidy of at least $34 billion.

For the political fixer Emanuel, all that mattered was getting “points on the board.” The content of financial reform was someone else’s problem.

Many of them were sensible and worthwhile measures that redressed some of the grosser imbalances in the financial services industry. But in general they had little to do with the implosion of the wholesale-funded shadow banking system that actually brought down the house in 2008.