Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

As Geithner unabashedly remarked, “[W]e didn’t want Congress designing the new capital ratios or leverage restrictions or liquidity requirements. Whatever their flaws, regulators were much better equipped” to decide those technical issues.

In other words, what the Treasury and the Fed knew to be the main drivers of the crisis were kept off the legislative agenda.

To ensure collective responsibility, Bair and Frank insisted that oversight over the entire system should be exercised not by the Treasury and the Fed alone but by a Financial Stability Oversight Council chaired by the Treasury but gathering together all the key regulators. The idea of crisis management by committee appalled Geithner. But the council, in fact, was given many of the powers that he wanted. It would have the right to designate systematically important institutions. Those could be placed under a regime of heightened supervision and regulation including regular stress testing.

But the grief and distress caused by the crisis were forces to be reckoned with. They ran through American society in waves, and early 2010, as Dodd-Frank reached a critical point in its labored passage through Congress, was one such moment.

Foreclosure proceedings were operating at such a pace that they were given over to quasi-automated legal processes that turned out to be ruinously flawed. In a nightmarish administrative and legal tangle, ever more victims were sucked into the crisis.

Astonishingly, even Citigroup, which had a loss of $1.6 billion in 2009 and survived the year only due to government action, paid out $5 billion in bonuses. The bankers were happy to leave the past behind, but the American public was not.

While the legislation was in Congress the bank lobbyists—conscious of how high emotions were running—had held back. As they well understood, passing the act was only the first round. Once the law was on the statute books and the argument over implementation began behind closed doors, they swarmed all over the legislation.

All told, Dodd-Frank called on regulators and agencies to formulate 398 new rules for the financial sector. Each one became the target for no-holds-barred lobbying by interested parties, who could now operate outside the limelight of congressional debate.

took until December 2013 for the five agencies involved to agree on a wording of the basic Volcker rule, 1,238 days after Dodd-Frank was passed.53 The result was a 71-page document with an explanatory addendum that ran to a modest 900 pages.

The only thing that was clear was that it would generate enormous demand for compliance officers and corporate lawyers.

For the foreseeable future one of the main concerns of Fed and Treasury policy was to ensure that America’s top nineteen banks would earn a sufficiently ample portion of PPNR. The stakes were high. The banks that did not generate enough PPNR would not survive a stress test and would need to go to market or make calls on the TARP fund.

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

The G20 finance ministers had resolved during their critical meetings in October 2008 that no systemically important institutions would be allowed to fail. Now the question was how they would be regulated. The Americans had made a start. The wider frame would be set by the Basel Committee.

In addition, to constrain maturity mismatch, banks had to demonstrate that they had sufficient stable long-term funding to match their book of long-term loans.

According to the IIF’s in-house econometric models, a 2 percent increase in capital requirements for the G-SIFI would cut GDP in the United States, Japan and Europe by 3 percent and would reduce annual growth by as much as 0.6 percent. With the recovery struggling to achieve growth of 1 or 2 percent, that was an ominous forecast.64 It was a tendentious and hypothetical argument that the advocates of capital raising were forced to counter with their own even more elaborate econometrics.

Between November 2014 and January 2019, the twenty-nine selected institutions would be required to raise their capital in relation to risk-weighted assets to between 8 and 12.5 percent, depending on their degree of systemic importance.

This striking graph, which shows how aggressively America’s banks raised capital relative to their European peers, serves as a fitting conclusion to the first phase of the crisis. TARP, followed by the stress tests, the Dodd-Frank regime and capital planning, put the American banking system on a forced road to recovery. It foreclosed more radical options. The banks remained too big to fail.

By contrast, the lack of comprehensive recapitalization of Europe’s wounded banking system was an omission that marks one of the fundamental turning points in the crisis. With the help of low-interest loans from Trichet’s ECB, many banks resorted to the makeshift of pumping up their profits by buying higher-yielding government debt. But the failure to build new capital would leave the European banks in no position to absorb any further shocks. While the United States began to stabilize, in Europe the banking crisis of 2008 would merge a year later with a new crisis: a panic in the eurozone public debt market.

With the insulation provided by the Fed and the Treasury, in the United States these aftershocks no longer manifested as acute stress in the financial system, but in misery spread across millions of households struggling with unaffordable mortgage payments and houses that were no longer worth the debt secured on them.

After the largesse of the 2008 bank bailouts came austerity, though not for the same people, of course.

In the eurozone the switchback from the largesse of the banking crisis to the austerity that followed would take on a particularly dramatic form, because in three of its smaller member states the fiscal impact of the crisis was overwhelming.

It is not surprising, therefore, that the Greek and the Irish situations, followed by Portugal’s, should have caused political and financial stress and that this should have spread to both sides of the Atlantic. But what happened in the eurozone from 2010 was extraordinary.

Greece, Portugal, Ireland and Spain were driven into depressions the likes of which had not been seen since the 1930s. Italy became collateral damage. France’s sovereign credit was put in jeopardy. Prime ministers were ousted. Political parties collapsed. Nationalist passions were stirred to the boiling point.

The politicians in Dublin were driven by panic and their intimate ties to the local banking community, but Merkel’s veto on any collective European solution made Ireland’s situation untenable.

2006 Greece’s debt level relative to GDP was lower than it had been when it joined the eurozone in 2001. But it was not reduced by much and would have been worse but for fiddling.

A shock to confidence in the eurozone might lead to a general withdrawal of funding. What was at stake was not just Greece, but the far larger network of cross-border debt, in which France’s stake, like that of other rich country lenders, was truly enormous.

As far as Paris was concerned, the long-term sustainability of Greece’s debt was less important than holding this giant pyramid in place.

was a harsh and high-risk approach, whose appeal to the German public was consistent with the fact that they tended to blame “other people’s” banks and to underestimate the exposure of their own country’s financial institutions.

While engaging in extend-and-pretend and denying the need for restructuring, it was hard to generate momentum for any collective European effort at institution building.

Berlin had thrown its full weight behind the idea of an EMF and if its budget had been set to an appropriate size—what were needed were hundreds of billions of euros—the crisis might have taken another course. If Berlin had risen to the challenge it is hard to see how the rest of the eurozone governments could have resisted.

For Sarkozy it was unthinkable that the IMF should be involved at all: “Forget the IMF. The IMF is not for Europe. It’s for Africa—it’s for Burkina Faso!” he told the Greek government in early March.

All the ECB had to do to stop the destabilizing surge in Greek interest rates was to do what central banks do all over the world: buy sovereign bonds.

Rather than continuing the generous liquidity provision it had offered in 2009, the ECB allowed the LTRO scheme to expire.30 Then in April 2010 it began to discuss a new regime under which it would apply graduated repo haircuts to lower-rated sovereign bonds, limiting their attractiveness to banks.31 Trichet was engaged in the high-risk gamble of substituting pressure in the bond markets for the eurozone’s missing federal structures of fiscal and economic governance.

Once before, sixty-three years earlier, a political crisis in Greece had triggered a transformation in US policy. On March 12, 1947, after the British had declared their inability to defeat the Communist insurgency in the Greek civil war, President Truman announced the doctrine of containment, one of the opening moves in the cold war.

Restructuring could not be contemplated until the Europeans had found a way to stabilize bond markets and were ready to push through wholesale recapitalization of Europe’s banks.

For ordinary Greeks this meant pay cuts across the public sector. Contract workers were not renewed. The cap on dismissals from the private sector was lifted. The pension age was raised. VAT and other consumption taxes were hiked. An economy already under pressure was subjected to a further contractionary squeeze.

Finally, in the first days of May, the deal was done. Greece agreed with the troika not only to slash its deficit but to aim for a surplus. It promised to deliver a turnaround in its budget balance of a staggering 18 percent of GDP.48 In 2010 alone the reduction of its deficit would be 7.5 percent of GDP. Every area of Greek public life would be touched, from ministerial contract cleaners to privatization of state assets.

With the ECB refusing support, there was heavy trading in credit default swaps on Greek government debt. In a single day the Volatility Index (VIX), a measure of market uncertainty, surged by 31.7 percent. The euro plunged, losing 2.5 cents by early afternoon.52 What was going on between terminals on both sides of the Atlantic that afternoon would later become a matter of dispute in American courtrooms. But at 2:32 p.m. the market went into spasm.53 Half an hour later, by 3:05 p.m., the main American stock markets had given up 6 percent of their value, erasing $1 trillion from portfolios. As panicked traders fled to quality, demand for US Treasurys surged, driving yields down from 3.6 to 3.25 percent in a matter of minutes.

The next day, on May 7, 2010, the tone at the meeting of the European Council was apocalyptic. Commissioner Rehn and President Trichet delivered dire warnings. “It’s Europe. It’s global. It’s a situation that is deteriorating with extreme rapidity and intensity,”

The ECB was independent. It must be free to act as it saw fit. Friday, May 7, ended without agreement. But after events on Wall Street, it was clear that something big had to be done before trading resumed in Asia on Monday, May 10.

Was this a first step toward the mutualization of sovereign debts, and thus a radical step beyond Lisbon? Berlin was not going to concede anything of the sort.58 The entire deal hung in the balance until a Dutch participant with expertise in shadow banking suggested that the European Financial Stability Facility (EFSF) be incorporated as a private special purpose vehicle registered in the tax haven of Luxembourg. Eurozone governments would contribute capital on a country-by-country basis without assuming any overarching intergovernmental “European” commitment.

Over the days that followed, the markets calmed. Despite the opposition from Germany, the ECB’s promise to buy helped. There was less rush to sell if there was a purchaser of last resort. But to make this commitment manageable for the ECB, there was one further, unpublicized facet to the deal. Even if there was no immediate restructuring of Greek debt, the banks should not be permitted to offload their entire holdings of distressed debt. A concomitant of the ECB’s bond buying, insisted on with particular force by Merkel and Schäuble, was that all the eurozone finance ministries would pressure their leading banks to refrain from selling their holdings of Greek and other troubled bonds.

The outspoken Brazilian board member insisted that the program not be referred to as “a rescue of Greece, which will have to undergo a wrenching adjustment, but as a bailout of Greece’s private debt holders, mainly European financial institutions.”62 One could hardly ask for a clearer statement of the “bait and switch” substitution, by which a problem of excessive bank lending was turned into a crisis of public borrowing.

Instead of restructuring Greek’s unsustainable debts, what would be restructured were its entire public sector and its creaky economy. Heroic assumptions about cost cutting and efficiency gains were the ways in which the IMF squared the Greek program with its conscience.

“Well, my message, Glenn, is that PI[I]GS are us. . . . [W]e very quickly could find ourselves in a similar situation to Greece.”1 These were the words of historian Niall Ferguson, then at Harvard, on Glenn Beck’s Fox News TV show on February 11, 2010.

On closer inspection, Reinhart and Rogoff’s analysis turned out to be riddled with errors. Once their Excel spreadsheet was properly edited, there was no sharp discontinuity at the 90 percent mark and the case for emergency action was far weaker than they made out.

As commentators as knowledgeable as Ferguson, Reinhart and Rogoff must have been aware, the market discipline on display in the eurozone had not “come without warning.” The ECB and the German government were deliberately courting the bond vigilantes who swarmed over Greece. If they wanted to ease the pressure, all the ECB needed to do was what the Fed, the Bank of England or the Bank of Japan did as a matter of course—buy Greek bonds.

Using Greece as its exemplum, an alliance of convenience among right-wing fearmongers, conservative political entrepreneurs and centrist fiscal hawks shifted the political balance. Though unemployment remained high, though output was limping back, stimulus was abandoned. Earlier and more sharply than in any other recession in recent history, the fiscal screw was turned. On both sides of the Atlantic the result was to stunt the recovery.

The most remarkable instance of austerity contagion was the UK.

On February 14, 2010, twenty senior economists, including Ken Rogoff, wrote to the Sunday Times repeating Osborne’s charge that the Labour government was not doing enough to bring the budget under control.9 They were answered by a letter to the Financial Times from a much longer and no less distinguished list who opposed the call for fiscal retrenchment as premature and pointed out the irony that “[i]n urging a faster pace of deficit reduction to reassure the financial markets, the signatories of the Sunday Times letter implicitly accept as binding the views of the same financial markets whose mistakes precipitated the crisis in the first place!”