Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

The Fed found itself boxed in between China’s determination to peg its currency and the refusal of Congress to curb America’s budget deficit.

A decade after Thatcher’s Big Bang, with Britain’s native banking industry under intense competitive pressure, Tony Blair’s New Labour government set about further streamlining the City’s regulatory system.24 Nine specialist regulators were combined into a single agency, the Financial Services Authority (FSA). It set a new low bar for financial oversight. Tony Blair’s chancellor, Gordon Brown, boasted that the FSA offered “not only light but limited regulation.”25 The FSA was mandated to achieve its “goals in the most efficient and effective way.” “[N]ot damaging the competitive position of the United Kingdom” was its top priority.26 The FSA was required to apply cost benefit analysis to its own interventions and benchmark its operations against other countries.

The scale of this activity was enormous. According to the IMF team, trading in and out of London the main European and US banks achieved a collateral multiplication of 400 percent, amounting to roughly $4.5 trillion in additional funding, effectively out of thin air.

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.56 But when the question was put by analysts from the BIS, the answer was sobering. 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.

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 global recovery of the early 2000s.

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. The result was a self-reflexive loop in which the ECB relied on markets to exercise discipline over public borrowers while the markets came to assume that the ECB’s “one bond” policy implied an implicit European guarantee for even the weakest borrowers.

In the late 1990s, as European Monetary Union approached, Larry Summers had the temerity to ask an international gathering of financial experts: “Could the Europeans here explain to me what happens if a bank in Spain gets into serious trouble? What are the respective responsibilities of the Spanish supervision authorities, the Spanish central bank, the ECB, and Brussels?” The question silenced the meeting. After an embarrassed pause there followed a “chaotic argument among the Europeans, which ended without resolution but with only a sense that they didn’t want to air their linen in front of the rest of us.”

The collapse in the external value of the ruble jolted Russia’s export industries into life and curbed imports. But the key driver of the recovery was the global boom in oil and other commodities, which began months after Putin took office in the latter half of 2000.

Barclays resorted to a highly irregular deal with a gulf sovereign wealth fund to which it lent the funds to recapitalize itself, a transaction for which it was later to pay a substantial fine and for which its senior management would face criminal charges.

As a surprise treat for the finance ministers, President Bush made an impromptu appearance to add some easy charm to the discussions. Unfortunately, Bush’s remarks were not well calculated to reassure his guests. “You folks don’t need to worry,” he told them. “Hank’s got a handle on this. He’s going to freeze that liquidity.”90 Given that TARP was still in limbo and that freezing liquidity was the last thing anyone needed, it can hardly have been comforting.

As Barclays was to do in the UK, Deutsche preferred to rely on accounting tricks and investments from gulf state sovereign wealth funds to see it through the crisis. It too would later face legal action over its makeshift crisis management, but in the United States, not in Germany.

The Treasury faced the sheer impracticality of making markets for hundreds of billions of dollars’ worth of dubious assets at a time of market terror. Either it overpaid and sacrificed the taxpayer interest, or it drove a hard bargain and risked ruining the banks it was trying to help. Meanwhile, the British had tipped the discussion in favor of recapitalization. Rather than buying bad assets or guaranteeing more borrowing by the banks, government should inject share capital. Having obtained the funds from Congress for asset purchases, TARP would now be repurposed as a vehicle for injecting capital.

The October stabilization was not enough for Citigroup. In November it disclosed huge losses and announced fifty-two thousand layoffs. By Friday, November 21, 2008, Citi’s market valuation was $20.5 billion, down from $250 billion in 2006. As fear spread, the death knell sounded.

In the autumn of 2008 the stark truth could no longer be escaped. As Tim Geithner of the New York Fed told the FOMC, the Europeans “ran a banking system that was allowed to get very, very big relative to GDP with huge currency mismatches and with no plans to meet the liquidity needs of their banks in dollars in the event that we face a storm like this.”

Finally, in early 2009, the Fed began to move from emergency liquidity provision to what would subsequently become known as QE1—the buying up and holding on the Fed balance sheet of large quantities of mortgage-backed securities. For a central bank, buying securities was a conventional mechanism of monetary policy. But it would now be done on a far larger scale than ever before and with a wider array of assets. On top of the conventional purchase of Treasury securities, the Fed bought $1.85 trillion in GSE-backed mortgage-backed securities by July 2010. The busiest week of purchases was the third week of April 2009, and holdings (net of sales) peaked in June 2010 at $1.129 trillion. Crucially, what the Fed was doing was not just pumping liquidity into the system. It was also absorbing onto its balance sheet the maturity mismatch, which had done such damage in markets like ABCP. The Fed took the long-term asset in exchange for immediate liquidity.

It was this circulation of funds that allowed the Bank of England, the ECB and the Swiss National Bank to meet huge demands for dollars without running down their exchange reserves to even more critical levels. But for the swap facilities, between September 2008 and May 2009, monthly demand for dollars at the auctions organized by the ECB would have wiped out its reserves several times over.

The absence of a euro-dollar or a sterling-dollar currency crisis was one of the remarkable features of 2008. It was no accident. It was the swap lines that did the trick. What the Fed had done for money markets, the central banks now did for the global provision of dollar bank funding. They absorbed the currency mismatch of the European bank balance sheets directly onto their own accounts. Compensating public action ensured that private imbalances did not spill over into a general crisis.

When this support is added to the gigantic swap line facilities provided for the European central banks, the conclusion is inescapable. What the Fed was struggling to contain in 2008 were not two separate American and European crises but one gigantic storm in the dollar-based North Atlantic financial system.

The gigantic surge in stimulus spending also paid for what is perhaps the most spectacular infrastructure project of the last generation anywhere in the world, the construction of China’s high-speed rail network (HSR). In the first phase of Chinese growth, priority had been given to motorization and highway construction. Now rail came to the fore.

This huge additional growth boost was delivered through a variety of channels. But it was state directed from the top down and supplemental to China’s already enormous growth rate. When the entire complex is accounted for, this was an intervention comparable in scale to anything ever undertaken in the Mao era, or under Soviet communism. The Western capitalist economies had witnessed such huge mobilizations only in times of war. The rate of investment in the Chinese economy surged toward 50 percent of GDP, a level rarely, if ever, seen before. It was enough to offset even the worst shock to global trade.37 At 9.1 percent, China’s growth rate in 2009 was barely lower than it had been in 2008 and vastly higher than anywhere else in the world. And given the size to which the Chinese economy had expanded, this was decisive. In 2009, for the first time in the modern era, it was the movement of the Chinese economy that carried the entire world economy. Together with the huge liquidity stimulus delivered by the US Federal Reserve, China’s combined fiscal and financial stimulus was the main force counteracting the global crisis. Though they were not coordinated policies, they made real the vision of a G2: China and America leading the world.

Automatic stabilizers are the unsung heroes of modern fiscal policy. In the United States, no more than one third of federal government spending is discretionary. The rest is made up of mandatory expenditures required by existing “entitlements,” social programs such as unemployment and disability benefits, or retirement pensions.

Though Germany, France and Italy steered clear of the kind of stimulus package launched by the Obama administration, let alone that trumpeted by Beijing, their deficits were widening too. As the private sector deleveraged and cut its spending, they too saw huge nondiscretionary deficits. Indeed, it would have taken a heroic and truly perverse act of austerity to prevent these automatic stabilizers from coming into effect.

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. When the private sector is undergoing a shock episode of deleveraging, when the savings rate is surging as it was in 2009, what is needed to preserve the overall financial balance of the national economy is not for the state to cut its deficit too.

The antidebt consensus did not go entirely unopposed. Peter Bofinger, the maverick Keynesian member of the Wirtschaftsweisen, the official expert advisory committee on the German economy, was scathing in his criticism. If the German federal government was issuing no new bunds, where were German savers to invest the 120 billion euros that they sought to put aside every year? Because the German corporate sector was also generating a financial surplus, they could not on balance invest their funds in German businesses. Rather than funding investment at home, Germany’s savings would out of necessity flow into investments abroad.38 This was the financial counterpart to Germany’s chronic current account surplus, a symptom as much of repressed domestic consumption and investment as it was of export success.

The message was, ‘Why can’t you take action? You know you’ve got to do something.’ ”42 As the Financial Times put it, the failure of the eurozone to restore stability on its own terms meant that by April 2010, the “rescue” of the euro, “the ultimate expression of European integration, depended on outsiders in international institutions and the US administration.”

Between 2010 and 2016 spending by local councils on everything from elderly day-care centers to bus services, public parks and library facilities fell by more than a third. Britain became a darker, dirtier, more dangerous and less civilized place. Hundreds of thousands of people who were barely coping on disability and unemployment benefits were tipped into true desperation.20 According to the OECD, only Greece, Ireland and Spain were put through worse contractions than those inflicted on the UK.

For Berlin it was more important to achieve the 3 percent deficit rule specified by the eurozone’s Stability and Growth Pact than it was to honor its commitment to NATO to spend at least 2 percent of GDP on defense.

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.

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.”