The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  Hundreds of negotiators and officials gathered in the Dutch town of Maastricht on February 7, 1992, to complete the treaty. As the Limburg Symphony Orchestra played Mozart, the finance and foreign ministers of Europe one by one signed the leather-bound books containing the 189-page agreement. It called for monetary unification of all the nations of the newly named European Union, with special exceptions for Britain and Denmark, both more eager than the rest to keep their options open. Besides a monetary union, it created a European Parliament, called for coordination on defense policy, and allowed the free movement of citizens across borders within the EU.

  Ruud Lubbers, the Dutch prime minister and thus the host of the gathering, celebrated the moment with a glass of champagne. “It’s done now,” Lubbers said. “There is nothing left but to drink a toast. Les jeux sont faits, rien ne va plus.”

  It’s a gambling reference, what a croupier at a roulette table says when betting has closed: The wheel has been spun; no more wagers. Now we can only wait to see the results.

  • • •

  After Maastricht, MIT economist Rudiger Dornbusch suggested, many British and even more American economists could be divided into three camps: “It can’t happen,” “It’s a bad idea,” and “It can’t last.”

  It takes more than a single currency to have a viable economic union, the Euroskeptics said. It also takes political union—joint policies on everything from bank regulation to taxes—and a population that’s comfortable moving around. More fundamentally, it requires that people in different parts of the currency area feel that they have common obligations to each other, that they are truly one nation. In an economy as large as Europe’s, there will inevitably come times when some parts have different economic situations—one place might experience a bust in the local housing market at the same time another is experiencing a boom in its local industries. When those two places are served by the same central bank, then one powerful tool to deal with a weakening economy isn’t there.

  The United States is a big country that has had its own challenges achieving a unified political system. But consider some of the ways “asymmetric shocks” are handled in a place where the Federal Reserve has to set a single monetary policy for a nation of 300 million people.

  When unemployment and poverty are high in one place, the U.S. government funnels money there from more prosperous places. And it’s not just in times of unique economic distress. Some states persistently receive more money from the government than they pay in taxes—particularly those with higher concentrations of people who receive food stamps or unemployment benefits. In 2005, Alabama paid, on average, $5,434 in taxes per resident to Washington. But Washington sent back to Alabama $9,263 per person. Much richer New Jersey paid $9,902 per person to the federal government but received only $6,740 in return. Yet American political unity is such that one never sees politicians or newspapers in New Jersey complaining about lazy Alabamans taking New Jerseyans’ money.

  The same applies with the United States’ banking system. The agencies that guarantee the nation’s banks—most prominently the Federal Deposit Insurance Corporation—are arms of the U.S. government, not of any given state. So if banks start to fail in one geographical area, the entire country stands behind them. The bailout of savings and loans nationwide cost U.S. taxpayers an estimated $123.8 billion between 1986 and 1995 and the private sector another $29.1 billion. Losses in Texas—where in the late 1980s savings and loans failed in massive numbers amid a real estate bust and falling oil prices—accounted for about 62 percent of that, according to one estimate. Imagine what would have happened if the federal government hadn’t been in place to rescue the state’s banks. The Texas government would have faced a dire choice: Either let the banks fail, in which case its citizens would lose their savings and the economy would collapse, or bail them out, in which case the state would have been thrown into a fiscal crisis. Texas’s total state tax collections in 1986 were only $10.2 billion. With only those funds available, it would have taken more than nine years for the state to pay for its bank bailout, even if it stopped paying for anything else—schools, roads, public safety. But again, when the rest of the country bailed out Texas banks in the late 1980s, there wasn’t much grumbling among residents of, say, Connecticut.

  And when the economy is terrible in one part of the United States, Americans are able to pick up and move to where conditions are better. In 2007, for example, 787,000 more Americans relocated from the Northeast to the South than the other way around. That reflects the brighter economic prospects in Sun Belt metropolises like Houston and Atlanta than in fading northern industrial centers like Buffalo and Providence. The Maastricht Treaty ensured that Europeans would have the legal right to relocate in a similar fashion. But moving within the United States is a different thing entirely from, say, emigrating from Portugal to Germany, as much as one might joke about how New Yorkers and Texans speak a different language.

  It all boils down to this: Economic unity isn’t just about having the same currency. It’s about having unified political institutions and, more broadly, a sense of cultural togetherness. Europe, argued the Brits and Americans, lacked this. It wasn’t, to use the technical term, an “optimal currency area.” Barry Eichengreen of the University of California at Berkeley showed how the economies of different parts of Europe have more variances in their growth patterns than those in different parts of the United States—implying the need for more integration of fiscal policy, not less. In a much-cited 1997 essay, Martin Feldstein of Harvard raised the idea that being yoked to the same currency would actually increase the likelihood of conflict between European nations. “In the beginning there would be important disagreements among the EMU member countries about the goals and methods of monetary policy,” wrote Feldstein in Foreign Affairs. “These would be exacerbated whenever the business cycle raised unemployment in a particular country or group of countries. These economic disagreements could contribute to a more general distrust among the European nations.” Summing up the conventional wisdom of the Euroskeptics was Paul Krugman, then of MIT, writing in Fortune:

  Here’s how the story has been told: a year or two or three after the introduction of the euro, a recession develops in part—but only part—of Europe. This creates a conflict of interest between countries with weak economies and populist governments—read Italy, or Spain, or anyway someone from Europe’s slovenly south—and those with strong economies and a steely-eyed commitment to disciplined economic policy—read Germany. The weak economies want low interest rates, and wouldn’t mind a bit of inflation; but Germany is dead set on maintaining price stability at all cost. Nor can Europe deal with “asymmetric shocks” the way the United States does, by transferring workers from depressed areas to prosperous ones. . . . The result is a ferocious political argument, and perhaps a financial crisis, as markets start to discount the bonds of weaker European governments.

  European economists were well aware of this sort of commentary. What the Americans didn’t understand, they said, was that the common currency was only part of the story. Europe might not be an optimal currency area yet. But the monetary union was one of the steps necessary to make it one; once the euro was in place, all the other forms of integration would follow. As for those European economists who had their own doubts—well, political leaders had a strategy for dealing with them. As Belgian economist Paul De Grauwe explained to the New York Times years later, “The European Commission did invite economists to present their views. It was a Darwinian process. I was invited, but when I expressed my doubts I wasn’t invited anymore. In the end only the enthusiasts were left.”

  With euro enthusiasts in charge, monetary union was on an irreversible course. There were things to negotiate, of course. The new central bank would, at German insistence, be located in Frankfurt rather than in Brussels, where most pan-European institutions are headquartered. It would have a single mandate, to maintain stable prices. (The Fed, by
contrast, is charged with maintaining both stable prices and maximum employment.) It would be strictly forbidden from using its ability to print money to fund governments; any hint of Weimar Republic–style monetizing of government debt was verboten.

  But as that crucial deadline of January 1, 1999, approached, there remained the question of who would run such an institution. And the battle over that answer was characterized by the sorts of nationalistic outbursts, hardball negotiations, and ugly compromises that would haunt the euro many years later. In 1997, the consensus had been that Wim Duisenberg, the head of the Dutch central bank, would become the first president of the European Central Bank. Duisenberg had the particular advantage of being viewed by Germany as sufficiently committed to hard money and monetary independence while also being regarded by the rest of Europe as being sufficiently non-German to be someone it could support. Germany had, after all, gotten most of what it wanted in the structure and location of the ECB. If the first president of the bank had been a German as well, it might as well be called the Neue Bundesbank.

  On November 3, 1997, French president Jacques Chirac made a phone call that threw Duisenberg’s candidacy into doubt. He had decided to nominate Jean-Claude Trichet, Chirac told the prime minister of Luxembourg. With Germany getting a central bank of its own design on its own soil, Chirac demanded that the French get the first presidency, for a single eight-year term. Trichet was hardly ideal from a domestic perspective; his German-style emphasis on low inflation had alienated French politicians on both the left and right. But Chirac was determined to put him forward, for a variety of reasons, ranging from the symbolic (his desire to have a Frenchman in charge) to the cynical (his desire to put his domestic political opponents in an uncomfortable position) to the seemingly irrelevant (his annoyance at liberal Dutch drug laws).

  At the start of May 1998, European leaders gathered in Brussels for a crucial final round of negotiations in advance of the launch of the common currency eight months later. Ironically, the man chairing the weekend discussion was one whose government had elected not to take on the euro at all. British prime minister Tony Blair was an enthusiast of forging closer connections with Europe, but his own chancellor of the exchequer, Gordon Brown, had repeatedly found reasons to forestall any commitment.

  The compromise that started to emerge seemed promising: Duisenberg would take the ECB presidency for some short length of time before handing it off to Trichet for a full eight-year term. Chirac suggested that Duisenberg retire on his sixty-fifth birthday, in June 2000. But the Dutch were angered at the idea of having their man forced out after a short period. So were the Germans, who saw it as an affront to the idea of central bank independence—after all, the whole purpose of giving the ECB president an eight-year nonrenewable term was so that politicians like Chirac couldn’t micromanage when a new leader takes over.

  “Who is this man who says we must waste all this time talking about a few weeks longer he stays in the job?” Chirac reportedly said at one tense point in the talks.

  “You say, ‘Who is this man?’ He is not someone who just turned up off the street, you know,” retorted Dutch prime minister Wim Kok.

  “Bof!” snorted Chirac, adding a moment later, “We have already accepted the bank would be in Frankfurt.”

  With the French threatening to veto Duisenberg, and the Dutch and Germans threatening to veto Trichet, Blair proposed a compromise: Duisenberg would make a personal and voluntary announcement that he would retire before his full term was out. (As it turned out, he stepped down and was replaced by Trichet in 2003.) The French would get their president within a reasonable time frame, and the Dutch and Germans would get at least the appearance of a central bank independent from politics. As he left the negotiations in Brussels that weekend, Helmut Kohl, among the great statesmen of the postwar period, looked bedraggled, and described the concluded talks as “the most difficult hours I have experienced in Europe.”

  • • •

  On January 1, 1999, the euro launched, first for electronic transactions, and three years later as a paper currency. Its value was fixed in stone that day: 1.95583 German deutschmarks, or 2.20371 Dutch guilders, or 1,936.27 Italian lira. To make it easier to refer to the new currency, the European Commission ordered up a new symbol, similar to those for the dollar or the pound. Designers settled on a sign that has origins as old as European civilization’s: €, an adaptation of the Greek letter epsilon.

  The new currency worked surprisingly well in its first several years, with no major economic downturns and low and steady inflation. But how many years of success had to pass before the “it can’t last”–ers seemed just as wrong as the “it can’t happen”–ers? Choosing a president had been contentious enough—what about fighting the aftereffects of a megacrisis?

  Les jeux sont faits, rien ne va plus.

  SEVEN

  Masaru Hayami, Tomato Ketchup, and the Agony of ZIRP

  Woodstock, Vermont, is a ridiculously charming New England town of three thousand people, and the Woodstock Inn a particularly quaint destination at its center. On two days in October 1999, however, the group that gathered there was interested in something other than antiques stores and fall foliage. Some of the world’s highest-profile economists and central bankers descended on Woodstock that month to discuss “Monetary Policy in a Low Inflation Environment,” a conference organized by the Federal Reserve Bank of Boston. Among them were a number of the top economic policymakers of Japan—and where they went, so did a surprisingly large contingent of the hypercompetitive Japanese press corps, buzzing around with television cameras and tape recorders.

  Most industrialized nations were booming in the late 1990s. But Japan was the big exception. The world’s second largest economy was experiencing the aftermath of a giant property bubble, mired in a cycle of zero growth and falling prices. In Woodstock, the message from American and British economists to the representatives of the Bank of Japan was: This is your fault. You can solve it. But to beat back deflation, you will need to be a lot bolder than you’ve been in the past. One of the speakers, Princeton professor Ben Bernanke, saw a particularly bewildering failure of policy.

  “Extreme policy mistakes were the primary cause of the Great Depression,” Bernanke said from the lectern at the Woodstock Inn. “And today in Japan one hears statements from policymakers that are eerily reminiscent of the 1930s. . . . There are strong reasons to believe that aggressive monetary expansion . . . could raise prices and stimulate recovery in Japan. But the downside of central bank independence is that, if for whatever reason the central bank seems determined not to take necessary policy measures, there is little that can be done, at least in the short run.”

  “Does the technical feasibility of preventing deflation imply that protracted deflation will never occur?” Bernanke asked, before giving his own answer. “No, because we cannot legislate against timidity or incompetence.”

  It is hard to overstate the extent to which, in the late 1980s, the economic juggernaut of Japan seemed to be taking over the world. Four decades removed from the end of World War II, the nation was growing faster than the United States or Europe. It was exporting the most advanced electronics and most reliable automobiles in the world. And it was buying land—lots and lots of land.

  The things that got people’s attention in the United States—and inspired some jingoistic outrage—were the high-profile acquisitions by Japanese investors on U.S. soil: Rockefeller Center in 1989, Pebble Beach golf course in 1990. But big deals abroad were nothing compared to what was happening in Japan’s domestic real estate market, where the prices of office and apartment buildings in Tokyo and the other major cities were being bid up to unfathomable levels. It was calculated that the garden around the Imperial Palace in Tokyo, all 1.3 square miles of it, was worth as much as the entire state of California. The market value of the land in Chiyoda, a Tokyo district with thirty-nine thousand residents in 1990, was eq
ual to that of all the land in Canada, home to twenty-eight million. Rents for residential space in Tokyo were four times higher than in New York City—and the price of residential land was a hundred times higher.

  The run-up in prices was a classic case of credit-fueled mania, facilitated by some financial engineering, or zaitech, as its Japanese variant came to be called. The savings of an increasingly prosperous nation, one running trade surpluses with the rest of the world, was channeled into Japanese banks. Those banks, in turn, lent to anyone who planned to buy land, which served as collateral. After all, land prices had always gone up in modern Japan. It seemed reasonable to believe they would continue to do so. Loan officers would even show up unannounced at companies with which they had no prior business relationship and offer them money for real estate purchases premised on future appreciation.

  People dreamed up theories of how the high land prices and extraordinary amount of bank lending made sense: Japan is an island, so its land is finite—yet its capacity for growth is apparently infinite. That analysis overlooked the fact that the appreciation was concentrated in six major cities, and that there remained huge undeveloped expanses of rural Japan that could accommodate further growth.

  The Bank of Japan played an important, if poorly understood, role in the economic boom. In the years just after World War II, the Japanese central bank was remarkably powerful, not merely managing the supply of yen in the economy, but also actively making decisions on what major industrial companies could and couldn’t invest in. Governor Hisato Ichimada, first appointed with the approval of U.S. occupiers in 1946, was so powerful that, a colleague once explained, “He was called Pope, because under him the central bank’s power was stronger than that of the government.” When Kawasaki asked for permission to build a steel plant, Ichimada answered, “Japan does not need any more steel,” adding that “I can show you how to grow [the wild herb] shepherd’s purse there.”