9/26/2018
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The Real Cost of the 2008 Financial Crisis


Sunday September 16, 2018

The aftermath produced a lost decade for European economies and helped lead to the rise of anti-establishment political movements here and abroad.


The uplifting story of economic recovery overlooks the political consequences of financial collapse, both here and abroad. Illustration by Woody Harrington

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September 15th marks the tenth anniversary of the demise of the investment bank Lehman Brothers, which presaged the biggest financial crisis and deepest economic recession since the nineteen-thirties. After Lehman filed for bankruptcy, and great swaths of the markets froze, it looked as if many other major financial institutions would also collapse. On September 18, 2008, Hank Paulson, the Secretary of the Treasury, and Ben Bernanke, the chairman of the Federal Reserve, went to Capitol Hill and told congressional leaders that if they didn’t authorize a seven-hundred-billion-dollar bank bailout the financial system would implode. Some Republicans reluctantly set aside their reservations. The bailout bill passed. The panic on Wall Street abated. And then what?

The standard narrative is that the rescue operation succeeded in stabilizing the financial system. The U.S. economy rebounded, spurred by a fiscal stimulus that the Obama Administration pushed through Congress in February, 2009. When the stimulus started to run down, the Fed gave the economy another boost by buying vast quantities of bonds, a policy known as quantitative easing. Eventually, the big banks, prodded by the regulators and by Congress, reformed themselves to prevent a recurrence of what happened in 2008, notably by increasing the amount of capital they hold in reserve to deal with unexpected contingencies. This is the basic story that Paulson, Bernanke, and Tim Geithner, who was the Treasury Secretary during the Obama Administration, told in their respective memoirs. It was given an academic imprimatur by books like Daniel Drezner’s “The System Worked: How the World Stopped Another Great Depression,” which came out in 2014.

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This history is, on its own terms, perfectly accurate. In the early nineteen-thirties, when the authorities allowed thousands of banks to collapse, the unemployment rate soared to almost twenty-five per cent, and soup kitchens and shantytowns sprang up across the country. The aftermath of the 2008 crisis saw plenty of hardship—millions of Americans lost their homes to mortgage foreclosures, and by the summer of 2010 the jobless rate had risen to almost ten per cent—but nothing of comparable scale. Today, the unemployment rate has fallen all the way to 3.9 per cent.

There is much more to the story, though, than this uplifting Washington-based narrative. In “Crashed: How a Decade of Financial Crises Changed the World,” the Columbia economic historian Adam Tooze points out that we are still living with the consequences of 2008, including the political ones. Using taxpayers’ money to bail out greedy and incompetent bankers was intrinsically political. So was quantitative easing, a tactic that other central banks also adopted, following the Fed’s lead. It worked primarily by boosting the price of financial assets that were mostly owned by rich people.

As wages and incomes continued to languish, the rescue effort generated a populist backlash on both sides of the Atlantic. Austerity policies, especially in Europe, added another dark twist to the process of political polarization. As a result, Tooze writes, the “financial and economic crisis of 2007-2012 morphed between 2013 and 2017 into a comprehensive political and geopolitical crisis of the post–cold war order”—one that helped put Donald Trump in the White House and brought right-wing nationalist parties to positions of power in many parts of Europe. “Things could be worse, of course,” Tooze notes. “A ten-year anniversary of 1929 would have been published in 1939. We are not there, at least not yet. But this is undoubtedly a moment more uncomfortable and disconcerting than could have been imagined before the crisis began.”

In the years leading up to September, 2008, Tooze reminds us, many U.S. policymakers and pundits were focussed on the wrong global danger: the possibility that China, by reducing its huge holdings of U.S. Treasury bills, would crash the value of the dollar. Meanwhile, American authorities all but ignored the madness developing in the housing market, and on Wall Street, where bankers were slicing and dicing millions of garbage-quality housing loans and selling them on to investors in the form of mortgage-backed securities. By 2006, this was the case for seven out of every ten new mortgages.

Tooze does a competent job of guiding readers through the toxic alphabet soup of mortgage-based products that Wall Street cooked up: M.B.S.s, C.D.O.s, C.D.S.s, and so on. He looks askance at the transformation of commercial banks like Citigroup from long-term lenders into financial supermarkets—“service providers for a fee”—in the decades before 2008, and he rightly emphasizes the enabling role that successive Administrations played in this process, not least Bill Clinton’s.

But the great merit of Tooze’s tome—it runs to more than seven hundred pages—is its global perspective. Tooze maps the fallout as far afield as Russia, China, and Southeast Asia. He lays out the role played by European banks and cross-border flows of financial capital. And he provides a detailed account of the prolonged crisis in the eurozone, which, he maintains, “is not a separate and distinct event, but follows directly from the shock of 2008.”

The subprime fever originated in the United States, but soon spread to European behemoths like Deutsche Bank, HSBC, and Credit Suisse: by 2008, close to thirty per cent of all high-risk U.S. mortgage securities were held by foreign investors. Although the major international banks were domiciled and regulated in their individual countries, they were operating in a single, integrated capital market. So, when the crisis struck and many sources of short-term bank funding dried up, the European banks were left tottering. In some respects, they were in even worse shape than the American banks, because they needed to roll over their dollar-denominated mortgage assets, and Europe’s central banks and lenders of last resort—the European Central Bank, the Bank of England, and the Swiss National Bank—didn’t have enough dollars to tide them over.

Paulson and Bernanke didn’t predict any of this when they made the fateful decision, on September 14, 2008, to let Lehman fail. Paulson, in particular, was keen to escape the label of “Bailout King,” which he had been saddled with earlier in the year after orchestrating a rescue of Bear Stearns. An international banking disaster was avoided only because the Fed agreed to provide its European counterparts with virtually unlimited dollars through currency-swap arrangements, and to give troubled European banks access to various emergency lending and loan-guarantee facilities that it established in the United States. “The U.S. Federal Reserve engaged in a truly spectacular innovation,” Tooze writes. “It established itself as liquidity provider of last resort to the global banking system.”

But the Fed hid much of what it was doing from the American public, which was already choking on the U.S. bank bailout. It wasn’t until years later, as a result of the Dodd-Frank financial-reform act and a freedom-of-information lawsuit filed by Bloomberg News, that the details emerged. The sums involved were huge. According to Tooze’s tally, the Fed provided close to five trillion dollars in liquidity and loan guarantees to large non-American banks. It also provided roughly ten trillion dollars to foreign central banks through currency swaps. As with the seven-hundred-billion-dollar bailout for domestic banks, practically all this money was eventually repaid, with interest. But, had the full scope of what the Fed was doing emerged at the time, there would have been an uproar. Fortunately for the policymakers, there was no leak. An official at the New York Federal Reserve, which helped enact many of the covert lending programs, told Tooze that it was as if “a guardian angel was watching over us.”

Many of the politicians who came to be associated with the financial crisis and the bank bailouts weren’t so lucky. In 2009 and 2010, the center-left parties that occupied positions of power in the United States, Britain, and Germany all suffered electoral setbacks. In Berlin and London, new center-right governments committed themselves to slashing budgets and reducing deficits, which rose sharply as jobless rates went up and tax revenues went down. Keynesian economists warned that the recovery was too fragile to withstand austerity measures, but many conservative economists strongly supported them. Germany itself recovered even after it passed a balanced-budget amendment to its constitution and enacted the deepest spending cuts in the history of the Federal Republic. Yet the refusal of Europe’s largest and most powerful economy to act as a locomotive, and to help offset deflationary forces elsewhere, was to have some very negative consequences for the eurozone as a whole.

Tooze dwells at length on the European transition from stabilization to austerity, which coincided with the emergence of a sovereign-debt crisis in three peripheral members of the eurozone: Greece, Ireland, and Portugal. The “euro crisis” is often framed as a story of spendthrift governments run amok, but the real sources of the trouble were underlying faults in the euro system and the creation of too much credit by private-sector banks—the same phenomenon that led to the subprime-debt crisis in the United States.

In 1998, eleven Continental countries adopted the euro as their common currency, including the big three: France, Germany, and Italy. Greece followed suit the next year. (Seven more countries have since joined.) Under the euro system, individual countries gave up the freedom to set their own interest rates and adjust their own currencies. Instead, there would be a single interest rate, set by the European Central Bank, in Frankfurt, and a single exchange rate, set by the market. Member countries were also obliged to meet strict targets for their budget deficits.

Over time, many of the weaker European economies came to chafe at these restrictions. At first, though, the system seemed to be a miracle drug. Investors had traditionally treated countries like Greece, Ireland, and Portugal as risky bets, and demanded generous yields on the bonds those countries issued. After these countries adopted the euro, however, international investors loaded up on these bonds as if they were on a par with French and German bonds, even as yields fell. Tooze points out that, of the nearly three hundred billion euros’ worth of bonds that the Greek state had issued by the end of 2009, more than two hundred billion were foreign-owned.

In retrospect, the enthusiasm for this debt represented a credit bubble every bit as glaring as the American one that had seen Moody’s and the like conferring triple-A ratings on subprime dreck. Although Greek bonds were denominated in the same currency as German bonds, they were backed by the shaky Greek state. What made the situation even riskier was that Europe, unlike the United States, had no Fed to serve as a stabilizing force in the event of a crisis. The European Central Bank was prohibited from buying newly issued bonds directly from member governments, and for a long time it was reluctant to buy previously issued bonds on the secondary markets. It also lacked some of the lending and liquidity facilities that the Fed had set up in 2008 and 2009. Moreover, the eurozone had no centralized fiscal policy that could help member countries that ran into trouble. When serious problems emerged in Greece, Ireland, and Portugal, and the markets gyrated, the European political system was gripped by paralysis.

The quandary of how to deal with Greece was especially acute. By the middle of 2009, it had become evident that the small Mediterranean country wasn’t just suffering a liquidity crisis—it was insolvent. Its G.D.P. was plummeting, its budget deficit had risen to about thirteen per cent of the G.D.P., and the yields on its bonds had skyrocketed. “What Greece needed to do was to restructure, to agree with its creditors to reduce their claims,” Tooze writes. Yet many eurozone voters, notably those in Germany, were in no mood to do any favors for the Greeks—or the Irish and the Portuguese.

This reluctance is often attributed to a Teutonic belief that Southern Europeans, and Greeks in particular, are lazy and improvident. Tooze emphasizes another factor: after the 1990 reunification of Germany, the government in Berlin spent more than a trillion dollars rebuilding and subsidizing the East. By the time Angela Merkel, a former East German, took over as Chancellor, in 2005, the rich southern states, including Baden-Württemberg and Bavaria, were fed up. “Well before the Greek crisis broke,” Tooze writes, “the most prosperous regions of West Germany had made clear their refusal to take responsibility for other people’s debts.”

In May, 2010, the European Union, in concert with the International Monetary Fund, agreed to lend Greece a hundred and ten billion euros, which the country used to retire some of the debt that was owned by foreign banks and investors. Since the debt was retired at or near its face value, this amounted to a disguised bailout—not for Greece, which merely substituted one form of debt for another, but for the foreign banks that had bought Greek bonds. Although the banks, such as France’s BNP Paribas and Germany’s Commerzbank, got off lightly, the Greek people didn’t. In return for the new loans, the European Commission, the European Central Bank, and the I.M.F.—the “troika”—insisted on drastic cutbacks in government programs. In textbook Keynesian style, these retrenchments sent the Greek economy into an even deeper recession, further diminishing the country’s capacity to repay its debts.

The harsh treatment that Greece received set the template for the lending agreements that the troika then made with Ireland, Portugal, and Cyprus, all of which had banking crises of their own. Combined with Germany’s insistence on adherence to fiscal targets, and its refusal to adopt a stimulus, this policy produced a lost decade for the European economy, and contributed to the rise of anti-establishment political parties like Syriza, in Greece; Podemos, in Spain; and the Five Star Movement, in Italy. Nor did this draconian approach do anything to stabilize the euro system as a whole.

On the contrary, the markets became alarmed, in 2011 and 2012, about the creditworthiness of several larger European countries, especially Spain and Italy. The “spreads”—the difference between the yields on Spanish and Italian bonds versus those on German bonds—rose sharply, signalling distress. In Washington, Tim Geithner and other American officials, who had learned how quickly financial problems could spread from one region to another, looked on in dismay. Tooze recounts how, at the annual meeting of the I.M.F. in September, 2011, Geithner warned of “a cascading default, bank runs, and catastrophic risk” if the Europeans didn’t construct an adequate fire wall. Behind the scenes, Geithner enlisted President Obama to exert pressure on Merkel and other European leaders to mimic some of the steps that the United States had taken in 2008, encouraging them to create a proper bailout fund and turn the European Central Bank into an effective crisis fighter. The pressure didn’t work. As the market tremors increased, so did speculation that the eurozone might break up.

It was left to Mario Draghi, the president of the European Central Bank, to restore some calm. On July 26, 2012, Draghi, a worldly Italian economist who earned his Ph.D. at M.I.T. and subsequently worked at the World Bank, the Italian Treasury, and Goldman Sachs, gave a speech in London arguing that markets and foreign governments had underestimated the political capital invested in the European currency. “Within our mandate, the E.C.B. is ready to do whatever it takes to preserve the euro,” he promised. “And, believe me, it will be enough.”

Draghi provided no details about what the E.C.B. might do, and some observers were at first skeptical. “Ridiculous . . . totally impromptu,” Geithner wrote in his memoir, which Tooze cites extensively. But the speech proved to be a turning point. In September, 2012, Draghi announced that the E.C.B. was now prepared to buy bonds issued by individual eurozone countries, a move that finally created a Fed-style lender and buyer. (He’d convinced Merkel and her finance minister that there was no alternative.) At the same time, the members of the eurozone set up a permanent bailout fund, the European Stability Mechanism, with a lending capacity of five hundred billion euros. “The Draghi formula—America’s formula—was self-fulfilling,” Tooze writes. “The markets stabilized. The eurozone was saved by Americanization.” On either side of the Atlantic, the enduring question was: At what price?

Underpinned by explicit and implicit governmental guarantees, the Western financial system survived the great crisis, and in some ways it appears to be more robust than it was before 2008. A recent analysis from the Bank for International Settlements, a Basel-based institution that has been at the forefront of efforts to strengthen the lending system, noted that big banks are, on average, now holding twice as much capital as they did before the crisis, and have adopted various other reforms. Yet banks remain highly indebted and highly interconnected. Everyone knows that in a 2008-style panic they could still go down like dominoes, and that only large-scale public intervention would be able to save them. As a result, the general expectation is that, were another crisis to occur, governments (and taxpayers) would again step into the breach. The too-big-to-fail problem hasn’t gone away; it may even be more acute than before, because a wave of mergers during the last crisis left the banking industry more concentrated than ever.

And banks aren’t the only potential threat to financial stability. According to the Basel report, asset managers now control nearly a hundred and sixty trillion dollars, more than the worldwide holdings of the banking industry. During a market sell-off, the report warned, some of these firms could face pressures—such as a surge of investors eager to cash out—that would lead to a downward spiral.

Other analysts point to the dangers of lofty stock prices and rising indebtedness among non-financial corporations, many of which have been borrowing heavily to finance stock buybacks and other ventures. A recent McKinsey study showed that in the past ten years the amount of outstanding corporate debt has tripled across the world. In the United States, the study noted, almost two-thirds of non-financial debt is rated as junk or one notch above junk. Roughly three trillion dollars of this questionable credit is set to mature in the next five years. If the economy falters, or if interest rates rise sharply, many corporations may find themselves in the position of new mortgage holders a decade ago—unable to repay or roll over their debts.

More than four decades ago, the economist Hyman Minsky observed that periods of stability and investor optimism—such as the one we have enjoyed for the past few years—tend to amplify the dangers posed by a financial system based on easy credit. If the benefits of financial risk-taking were plentiful and widely shared, it might be worth society’s time to play the odds and bear the cost of the occasional blowup. But, these days, who believes that an unleashed financial sector is good for anybody but financiers?

In the United States and other countries, the long-term costs of the financial crisis and the great recession were enormous. The economic recovery that began, according to the National Bureau of Economic Research, in the summer of 2009 was weak and uneven. Growth in the G.D.P., wages, capital investment, and productivity continued to lag for most of the ensuing decade. In November, 2013, five years after the bank bailout, Larry Summers, President Obama’s top economic adviser during his first term, suggested that the U.S. economy had entered an age of “secular stagnation,” a term that was coined in the nineteen-thirties but had fallen out of favor with all but a small group of Marxist economists.

With the economy in the doldrums, the technocratic argument that it had been necessary to save Wall Street in order to save Main Street fell on deaf ears, and an alternative narrative gained widespread currency: the entire game had been “rigged.” It wasn’t just supporters of the Tea Party and Occupy Wall Street who said so. In the 2016 election, Donald Trump and Bernie Sanders both offered versions of this story. The Democratic Party establishment managed to overcome the Sanders insurrection, but Trump carried disaffected Republicans, and some disaffected Obama voters, too, through Election Day.

Resentment of Wall Street and Washington élites was only part of Trump’s platform—fanning racial fears and hostility toward immigrants was another key element—but it was one of his final, enduring messages. As Tooze points out, the last television ad that the Trump campaign aired featured head shots of Janet Yellen, the chair of the Federal Reserve at the time, and Lloyd Blankfein, the chief executive of Goldman Sachs, while Trump, in an alarmist voice-over, warned that “a global power structure” had made decisions that “robbed our working class, stripped our country of its wealth, and put that money into the pockets of a handful of large corporations and political entities.” A few days later, Trump won enough states to eke out his victory. “Overshadowed by memories of 2008, the 2016 election delivered a stark verdict,” Tooze writes.

Since then, Republicans in Congress have eliminated some of the financial regulations that were put in place after 2008. They have reduced capital requirements for all but the very biggest banks and sought to weaken the Volcker Rule, which bars any bank from speculating in the markets on its own account. Meanwhile, Trump has adopted a neo-isolationist stance on many issues, raising the question of how his Administration would react if another financial crisis threatened the global economy.

Toward the end of his book, Tooze returns to the fragile cross-party coalition that took shape in September, 2008, in order “to hold the United States together and provide the underpinnings for the global stabilization efforts of the Fed and the Treasury.” Could such a response be replicated today? With Trump in the White House and the Republican Party controlling Capitol Hill, Tooze writes, “it is an open question whether the American political system will support even basic institutions of globalization, let alone any adventurous crisis fighting at a national or global level.” Nobody can say for sure where the next financial crisis will come from. But Trump and the G.O.P. are busy hastening it along—even as they’re undermining the architecture needed to deal with it. ♦

This article appears in the print edition of the September 17, 2018, issue, with the headline “A World of Woes.”


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