by Neil Irwin
November 12—Berlusconi steps down, to be replaced by Mario Monti, a former European commissioner.
November 30—The Fed, ECB, and other leading central banks again announce swap lines to try to funnel dollars toward ailing European banks.
December 21—The ECB institutes a “long-term refinancing operation” (LTRO), which pumps €489 billion into European banks for a three-year term.
2012
February 29—The ECB holds a second LTRO, pumping an additional €529 billion into European banks.
May 6—Greek parliamentary elections lead to no decisive result, as extreme parties of the left and right see major gains.
July 26—In a speech in London, Draghi pledges that the ECB will do “whatever it takes to preserve the euro.”
September 6—The ECB announces a new program of Outright Monetary Transactions, a pledge to buy bonds in unlimited amounts to combat market bets against the survival of the eurozone.
September 13—The Fed announces a resumption of quantitative easing, pledging to continue buying bonds indefinitely unless the outlook for the job market in the United States improves or inflation becomes a threat.
October 23—Mervyn King delivers a speech saying that “printing money is not . . . simply manna from heaven.” He also says that “there are no shortcuts to the necessary adjustments in our economy,” as the Bank of England largely sits on its hands amid the new activism from the Fed and ECB.
December 12—The Fed announces it expects to keep low-interest-rate policies in place until either the U.S. unemployment rate falls to 6.5 percent or inflation is poised to exceed 2.5 percent.
Introduction: Opening the Spigot
On August 9, 2007, Jean-Claude Trichet awoke at his childhood home of Saint-Malo, on the coast of Brittany, ready for a day puttering about in his motorboat and enjoying the company of his grandchildren. It was time for his summer respite after a busy year as president of the European Central Bank. Mervyn King, the governor of the Bank of England, had also planned a leisurely Thursday: He would make his way from his flat in London’s Notting Hill neighborhood to the Kennington Oval, on the city’s south side, to watch the British national cricket team play India. Ben Bernanke, the chairman of the U.S. Federal Reserve, was alone among the three men who would guide the world through the convulsions of the half decade to come in having scheduled a regular workday. His security detail was to drive him from his Capitol Hill row house to the Treasury Department, where he had an early breakfast with Secretary Henry Paulson. Bernanke would eat oatmeal. For the three men, the day would not go quite as planned.
At about 7:30 a.m., Trichet’s phone rang. Francesco Papadia, the head of the ECB’s markets desk, was on the line from the central bank’s headquarters in Frankfurt. “We have a problem,” Papadia said.
Gigantic French bank BNP Paribas had announced that it was suspending withdrawals from three investment funds it managed. The funds were invested heavily in U.S. home-mortgage-backed securities that had become nearly impossible to value. Customers’ money would be locked up until the bank could figure out exactly how much the investments were worth. In itself, it was a tiny development: The three relatively obscure funds held only €1.6 billion in assets.
But the announcement confirmed the worst fears of bankers across Europe. They’d been worried for weeks about the losses they were facing on U.S. home loans. Supposedly ultrasecure mortgage bonds that had traded freely earlier in 2007 had by late July hardly been trading at all. As more and more people who’d taken out risky loans to buy a house in Tampa or Cleveland or Phoenix found themselves unable to pay them back, all the assumptions on which those loans had been made started to be called into question. Maybe all those AAA-rated securities weren’t really AAA after all. Had the banks poured vast sums into bonds that weren’t worth what they’d seemed to be? And if BNP Paribas couldn’t figure out how much its own funds were worth, how could any other bank know its real exposure to mortgage-backed securities?
It’s not for nothing that the word “credit” derives from the Latin creditus, “trusted.” Banks use highly rated securities as almost the equivalent of cash—whenever they need more dollars or euros, they hand the bonds over to another bank as collateral. It’s one of the basic ways they ensure they have exactly the amount of money they need to meet their obligations on any given day. But when it came to those mortgage-backed securities in early August 2007, that simple exchange suddenly became complicated. The problem wasn’t just that the securities were worth less than they’d been before—after all, banks can deal with losses. It’s that no one knew just how much less—and whether, if one bank had lent money to another down the street in exchange for mortgage-backed securities, it would ever get paid back.
Papadia and his staff spoke regularly with treasurers at twenty major European banks known as the money market contact group, and its members had been warning for days that, as one ECB official put it, an “infarction” was imminent. That Thursday morning, it hit: After the BNP Paribas announcement, with each bank out only for itself, the usual supply of cash was fast evaporating. “Trust was shaken today,” Deutsche Bank chief european economist Thomas Mayer told the New York Times. As one executive of a major global bank said later, “It was something none of us had experienced. It was as if your entire life you had turned the spigot and water came out. And now there was no water.”
It’s a more precise metaphor than it may seem, for liquidity is exactly what was disappearing in the banking system that day. No longer were euros, dollars, and pounds as easy to come by as water. History has taught again and again that when banks shut down and hoard their money, so too do the economies they serve. A banker who’s unwilling to lend to other bankers is likely also to be unwilling to lend to the businesses and households that need money to build a factory or buy a house. If unchecked, the banking crisis in Europe could inflict untold damage on the world economy. Suddenly, the European habit of taking a lengthy late summer vacation had become very inconvenient.
Gather the Executive Board, Trichet instructed Papadia. He needed to talk to the six officials from across Europe who share the collective authority to deploy the resources of the central bank—including the ability to create euros from thin air. ECB staff in Frankfurt began calling around to various villas and retreats in Spain, Italy, and Greece to arrange an emergency conference call. Trichet normally used the walled medieval port town of Saint-Malo as a retreat from the world, a place where he could enjoy the water and read poetry and philosophy. But now it would become the nerve center from which he would manage the first phase of the first great financial crisis of the twenty-first century.
By 10 a.m., the full Executive Board was on the line. Trichet was emphatic: “There is only one thing we can do, which is to give liquidity.” The ECB, he insisted, must flood the banking system with euros. He was proposing that the central bank fulfill its traditional role as “lender of last resort,” stepping in when private banks were pulling back, and using a novel means to do so. The ECB would abandon its usual practice of pumping some fixed amount of money into the banking system and instead make an unlimited number of euros available to the banks that needed them. The technical term for what Trichet and the Executive Board did at 12:30 p.m. central European time is to offer a “fixed-rate tender with full allotment.”
Translation: Come and get it, guys. We’ll give you as many euros as you need at 4 percent. Some forty-nine banks took €95 billion.
• • •
The Federal Reserve Bank of New York maintains a markets desk to monitor what’s going on across the world of finance, but during the early hours of the morning on the East Coast that Thursday, only a handful of young staffers were on duty to monitor overnight activity. It would take hours for the news to make its way to New York Fed president Timothy Geithner, who was on vacation on Cape Cod, and Bernanke, who was getting ready for his breakfast with Secretary Pauls
on.
At 6:49 a.m., Bernanke received an e-mail from Brian Madigan, head of the Fed’s monetary affairs division, explaining that “as you’ve probably seen, markets have sold off again overnight” and updating him on activity in the European bond and stock markets. But Madigan hadn’t yet received word of the ECB’s action. It was nearly half an hour later, as Bernanke’s black Cadillac sped along Independence Avenue, driven by an officer of the Federal Reserve’s own police force, before the chairman received the first word that the ECB had done something unusual. A 7:16, an e-mail arrived from David Skidmore, an official in the Fed’s press office: “Apparently Deutsche Bank had two money market funds fail and the ECB is making tender offers for dollar-denominated assets. Glenn Somerville of Reuters, who I’ve been talking to, is heading to the Treasury press room early.”
The details were wrong: It was BNP Paribas, not Deutsche Bank, three funds, not two, and the tender offers were denominated in euros, not dollars. But the gist was right: The ECB had intervened in markets in a way it never had before. And the most powerful man at the Fed was finding out about it through garbled rumors from a Reuters reporter. By the time he sat down for oatmeal with Paulson at 7:30, it was clear that something big had happened, even if no one seemed to be sure exactly what it was.
It wasn’t until 8:52 a.m. that Bernanke got a more accurate update, in the form of an e-mail from Kevin Warsh, a Fed governor who often acted as the chairman’s emissary to people in financial markets and at other central banks. “This action by the ECB sends two signals,” wrote Warsh, who had been working the phones all morning. “First, they are ready to provide liquidity to ensure the smooth operation of European money markets. Second, they are providing liquidity at their policy rate, and thus far not viewing a liquidity squeeze as a more fundamental reason to adjust its policy stance.” The Americans quickly understood that Trichet was trying to draw a bright line between what the ECB was doing for the financial system and what it was doing to address any underlying weakness in the European economy as a whole.
After breakfast, Bernanke went to his office at the white marble Eccles Building in Washington’s Foggy Bottom neighborhood. At 11 a.m., he met with a man named Lewis Ranieri, looking to pick his brain. In the 1980s, as a bond trader at investment bank Salomon Brothers, Ranieri had played a crucial role in developing the very concept of mortgage-backed securities. In other words, he’d more or less invented the markets that were now imploding. At 2 p.m., Bernanke met with Raymond Dalio and others from the world of finance. Dalio managed the world’s largest hedge fund, Bridgewater Associates, with $120 billion under its control. He’d developed a sophisticated model for understanding what was happening with credit extension in the economy, and Bernanke hoped to learn from Dalio’s analysis and perhaps incorporate it into the Fed’s own understanding of what was causing the financial and economic upheaval.
Later that afternoon, Bernanke’s inner circle of advisers, including both Warsh and Madigan, gathered on the leather couch and chairs in the chairman’s ornate workspace overlooking the National Mall. Geithner dialed in from Cape Cod, where he kept his cell phone to his ear as he paced in and out of his old family retreat. Fed vice chairman Don Kohn called in from his car en route to a wedding in New Hampshire. Market specialists were on speakerphone from New York, whose Federal Reserve branch had pumped $24 billion into the markets that morning as part of its routine efforts to keep short-term interest rates at the Fed’s official target. American banks weren’t having the same liquidity problems that their European counterparts were, so there was no apparent need for an intervention along the lines of what Trichet had done. It had been a brutal day in the U.S. markets, though, with the Dow Jones Industrial Average down 387 points, nearly 3 percent.
Bernanke was eager to signal to the world that the Fed was on the same page as the ECB, ready to stand behind the financial system as needed. Perhaps a statement saying as much was in order, he argued. Geithner, who often favored taking the most aggressive steps possible to bolster markets in crisis, wanted to begin discussing cutting interest rates to try to counteract the tightening of credit in the economy. But on that day at least, the group agreed that such an action was premature. A statement it would be.
Bernanke and his advisers talked about its language, and his communications aide, Michelle Smith, typed it up back at her office. She e-mailed him at 5:37 p.m. with a draft of what the Fed would tell the world the next morning at 8 a.m. It was a mere seventy-eight words, and stated that “in current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets,” and that “the Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets.”
Bernanke and the Fed, in other words, were ready to open the spigot as well.
• • •
At the Kennington Oval that Thursday, it was an up-and-down day for England that ended poorly for the home team. India scored 316 runs and lost four wickets on the first day of a five-day match. Mervyn King had left instructions with his staff that he not be disturbed except in an emergency, which created an interesting dilemma for the markets staff of the Bank of England, ensconced in its fortresslike headquarters on Threadneedle Street in the City of London. Was the ECB’s surprising injection of money into the banking system in fact an emergency?
When staffers finally decided that the answer was yes and called him, King was less worried about any action the Bank of England might take than whether the ECB was generating more panic by intervening instead of simply standing by. Just the day before, in a press conference, he’d described the tightening of the credit markets as “a welcome development, as a more realistic appraisal of risks is being seen.” He was privately dismissive of Trichet’s action, telling confidants that his old friend Jean-Claude had overreacted. The intervention, King argued, could prevent a necessary and overdue market correction. The banking system was simply counteracting years of excess, and Britain could easily weather whatever came next.
Among the leaders of the world’s great central banks, King would remain the deepest skeptic of the severity of the emerging crisis for more than a year to come. One of the most accomplished British economists of his generation, he believed in the purity of markets and was reluctant to intervene even when they seemed to be going haywire. The so-called King of Threadneedle Street was also supremely confident of his own views and analysis and quick to challenge anyone who disagreed—even when that someone was the most powerful central banker in continental Europe. A son of the working class in a country acutely sensitive to class divisions, King had used his extraordinary intellect and deep-seated competitive streak to claw his way into the nation’s ruling class. After joining the Bank of England as chief economist in the early 1990s, a time when the credibility of the institution was at a low point, he reshaped it in his image: rigorous in its analysis, theoretical in its approach, unsparing in its dismissiveness toward employees or departments that didn’t meet his high standards or share his predispositions.
In previous years, King had deemphasized regulating the banks, which he viewed as a messy, legalistic business compared to the elegant, intellectual work of shaping monetary policy. He even seemed to disdain bankers personally, and was privately contemptuous of their views. “Financial stability became a downplayed part of the institution,” said Kate Barker, a member of the Bank of England’s Monetary Policy Committee from 2001 to 2010. “[King predecessor] Eddie [George] was sorry to lose the financial-stability role, but I don’t think Mervyn was initially very interested in it.”
Indeed, on that chaotic Thursday, King left it to Deputy Governor Rachel Lomax to represent the bank in conference calls with his counterparts across the world. Later on, King would put himself as close to the front lines of the battle against panic as anyone. But on day one, his arrogance left him in the grandstands.
The leaders of the three major Weste
rn central banks were in different worlds—far apart physically, as was usually the case, but also disconnected in their analysis of the problem facing the world economy and what, if anything, they should do about it. To Trichet, the problem was a banking panic, a one-off moment of market uncertainty. To King, it was a necessary corrective to a long period of banking excess. To Bernanke, it was a more deeply intertwined set of risks to the banking system and the overall economy. He came to this view partly because the United States was ground zero for the housing downturn and bad mortgage lending that spurred Europe’s problems. But it was also a matter of Bernanke’s academic training. A leading scholar of the Great Depression, the chairman had theorized that the era was so troubled economically because of what he called the “financial accelerator”: Bank failures fueled economic weakness, which fueled even more bank failures, which in turn fueled further economic weakness. He was determined, if it became necessary, to use every tool at the Fed’s disposal to halt this vicious cycle.
It was sheer luck that the Federal Reserve had a chairman so well prepared for the moment. Bernanke’s academic training as a monetary economist, particularly as a scholar of the Depression, hadn’t come up in his interview with President George W. Bush in the summer of 2005, when the native of tiny Dillon, South Carolina, was being considered to replace legendary Fed chair Alan Greenspan. But that background would influence his every action from that August Thursday on. Bernanke seemed almost haunted by the fear that he would make the same mistakes central bankers did in the 1920s and ’30s, which left mass human misery in their wake.
Whatever their perceptions or prejudices, central bankers all have an awesome power: the ability to create and destroy money. Why is a piece of paper with Andrew Jackson’s face on it worth twenty dollars? Why can that piece of paper be exchanged for a hot meal or a couple of tickets to a movie? It’s only a slight exaggeration to answer, “Because Ben Bernanke says so.” The bill may have the U.S. treasury secretary’s signature on it, but at the top it reads, “Federal Reserve Note.” Central bankers uphold one end of a grand bargain that has evolved over the past 350 years. Democracies grant these secretive technocrats control over their nations’ economies; in exchange, they ask only for a stable currency and sustained prosperity (something that is easier said than achieved). Central bankers determine whether people can get jobs, whether their savings are secure, and, ultimately, whether their nation prospers or fails.