The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  The idea that one man’s debt is another’s savings is nothing new. Banks have been the intermediary in that exchange for centuries. But in the old days, a banker could look a borrower up and down, study his financial standing, and make the loan knowing that if the borrower didn’t repay, it was the banker’s problem. In this new era, the people with direct contact with borrowers were separated from the lenders by a chasm. The mortgage brokers who proliferated in storefronts all over the country were mere suppliers for the Wall Street bundlers. The brokers knew that some of these were terrible loans, but the big Wall Street firms had such a hunger for the fees they could earn by assembling packages and creating new securities to sell all over the world that they had little interest in knowing too much about what they were getting. The global investors buying the securities did so without necessarily understanding all the gory details of who the borrowers were and what their capacity to repay might be. The gold seal of an AAA rating was enough.

  The giant banks were the great intermediaries that made possible an apparent explosion of wealth. There were, by 2007, $202 trillion in financial assets on earth, 3.6 times the annual economic output of everyone on the planet; in 1990, the ratio was 2.6. That represents an extra $42 trillion in paper wealth over what would have existed had the ratio stayed constant. Global megabanks, hedge funds, insurance companies, and countless other financial firms were links in the chain that connected borrowers taking on ever larger amounts of debt with the global savings glut. And in Jackson Hole in 2005, almost no one seemed to understand just how weak that link was.

  But what did they understand? What did central bankers know about what was out of whack in the world economy? And when did they know it?

  On both sides of the Atlantic, central bankers had been fretting about the run-up in housing prices, even if they weren’t quite sure what to do about it. Without solid answers, they resorted to just trying to describe, with gentle euphemism, what was occurring in the property markets. There were “elements of buoyancy” in Spanish and Irish housing markets, as Jean-Claude Trichet put it in May 2007. Greenspan had conceded two years earlier not that a bubble was building, but that there was “froth”—a number of small bubbles in certain markets. “It’s pretty clear there is an unsustainable underlying pattern,” he told the Economic Club of New York. Three weeks before the 2005 Jackson Hole conference, Mervyn King was sufficiently worried about a British housing bubble that he tried to raise interest rates in order to slow down the housing market. Unusually for a central-bank governor, he was outvoted by Britain’s interest-rate-setting committee. The joke that went around London financial circles was that as a fan of the perpetually mediocre Aston Villa football club, King felt comfortable losing.

  The debate that went on behind closed doors at the Federal Reserve in 2005 reveals how challenging it was for the central bankers to convert their sense that something was wrong in housing into concrete policy. When the Fed’s Federal Open Market Committee met privately around the grand mahogany table overlooking Constitution Avenue in Washington to set interest rate policy for the United States, those concerns were sometimes aired—but rarely with a sense of urgency about finding policies that might alleviate them.

  “Hardly a day goes by without another anecdote-laden article in the press claiming that the U.S. is experiencing a housing bubble that will soon burst, with disastrous consequences for the economy,” said a dismissive Richard Peach, an economist at the Federal Reserve Bank of New York, in a confidential presentation to the FOMC on June 29, 2005. The rapid gains in the housing market, he said, “could be the result of solid fundamentals underlying the housing market”: low interest rates, strong productivity, peak earning of the baby boom generation, and rising incomes, particularly among the affluent.

  The same day, the committee heard a presentation on how a housing decline might affect the financial system. “Neither borrowers nor lenders appear particularly shaky,” economist Andreas Lehnert told Fed leaders as he gave an analysis of exposure to risky mortgage lending by U.S. banks and other institutions. “Perhaps it would be best simply to venture the judgment that the national mortgage system might bend, but will likely not break, in the face of a large drop in house prices.”

  Fed policymakers were attuned to the possibility that housing prices could decline, perhaps sharply. But they failed to understand just how deeply intertwined housing had become with the financial system, or how vulnerable the system was to a shock. “In the event of a sharp drop in housing prices, the odds of a spillover to financial institutions seem limited,” said Michael Moskow, the president of the Chicago Fed.

  In the hundreds of pages of transcripts from Fed policy meetings in 2005—not made public until years later—there are occasional glimpses of officials understanding the problems that were emerging. They almost seemed onto something when Mark Olson, a Fed governor, said he had heard that lending was being funded more by the private pools of mortgages being ginned up by Wall Street than by the more traditional mortgages backed by the government-sponsored Fannie Mae and Freddie Mac.

  “Not in the United States. I don’t know what country or planet,” said Lehnert.

  Olson cut him off.

  “The planet was Earth. The country was the United States,” he retorted. “And the person making the observation was talking about . . . what they see as a growing and undisciplined secondary market.”

  They quickly figured out that Olson was talking about the flow of new debt being issued, while Lehnert was thinking of the total amount outstanding. That miscommunication cleared up, the subject was immediately dropped.

  What the Fed lacked in this and other discussions about risks to the economy wasn’t technical expertise. It had that in spades. It wasn’t attention or discipline either. The discussions were exhaustive, involving a group of very smart people trying earnestly to come to the right answer. What the Fed lacked was creativity, the ability to see how housing and finance could interact with one another and cause greater damage than either could independently—particularly how the rapid increase in housing prices could threaten the financial system worldwide. In eight closed-door meetings over the course of that year—the transcripts take up nearly eleven hundred pages—there wasn’t a single mention of some of the developments in the financial system that could allow the popping of the housing bubble to turn into a global crisis: the excessive use of borrowed money by investment banks, for example, and the deep insinuation of mortgage-related securities of questionable safety into the machinery of modern finance.

  In the Fed’s 2005 meetings, the moment of most brutal clarity about the situation the U.S. economy faced wasn’t in any of the technical discussions of home price indices or the evolution of securitization markets. It was in a wry aside, made by Director of Research David Stockton. Stockton noted that a number of indicators suggested the housing boom could be ending. He continued:

  I offer one more piece of evidence that I think almost surely suggests that the end is near in this sector. While channel surfing the other night, to the annoyance of my otherwise very patient wife, I came across a new television series on the Discovery Channel entitled “Flip That House.” As far as I could tell, the gist of the show was that with some spackling, a few strategically placed azaleas, and access to a bank, you too could tap into the great real estate wealth machine. It was enough to put even the most ardent believer in market efficiency into existential crisis.

  In other words, the underlying causes of the global financial crisis were hiding in plain sight. Plenty of central bankers fretted about a global housing bubble. A smaller number worried about a global debt bubble—not just in mortgages, but also in consumer and corporate debt. A smaller number still saw a vast and rapid expansion of the financial sector as something that could threaten worldwide financial stability. And you had fundamental imbalances in the global economy that were at the root of it all—which central bankers were well aware of bu
t undecided about how to correct. They just didn’t see how all these pieces fit together.

  Ironically, part of the problem was the very success of central bankers. Investors had learned a lesson from the Great Moderation: that central bankers had mastered the economy. Inflation, in all the advanced nations and a growing number of emerging ones, had been conquered. Central banks could contain the impact of any adverse event that might come along, whether a financial crisis in fast-growing Asian economies or a popped stock market bubble in the United States, and prevent any widespread losses. In a seemingly riskless world, investors were willing to take all the more risk.

  Greenspan, who held more power over the financial future than any other individual on the planet, understood these interconnections, if not the degree to which the world economy was in peril. Lower risk premia—the compensation investors demand for taking on extra risk—that were “the apparent consequence of a long period of economic stability” had helped to push asset prices higher, he said from the lectern at Jackson Hole. The rising prices of stocks, bonds, and homes had led to much greater wealth and purchasing power, and the vast increase in the value of those assets was, Greenspan said, “in part the indirect result of investors accepting lower compensation for risk.”

  “History,” he noted, “has not dealt kindly with the aftermath of protracted periods of low-risk premiums.”

  • • •

  But one of the other economists at Jackson Hole that year was more prescient than even Greenspan—or, indeed, anyone else who speculated about what the world had to fear at that moment of economic triumphalism.

  In hindsight, many have pointed to a paper that International Monetary Fund chief economist Raghuram Rajan presented as a rare moment of clarity at the 2005 conference. Rajan indeed had an astute understanding of the ways in which the financial industry, with misguided compensation policies that encouraged risk-taking, was making the world a more dangerous place: Bankers were paid big bonuses for making money in the short run even if they were betting poorly in the long run. But he identified only one portion of what could go horribly wrong.

  It was Hyun Song Shin, then a professor at the London School of Economics, who in a response to Rajan’s paper most accurately portrayed the state of the global economy.

  “I’d like to tell you about the Millennium Bridge in London,” he began. In order to celebrate the advent of the year 2000, the British built a stunning new pedestrian bridge across the Thames. Its lateral-suspension design precluded the need for clunky-looking columns, making it a study in engineering elegance.

  “The bridge was opened by the queen on a sunny day in June,” Shin continued. “The press was there in force, and many thousands of people turned up to savor the occasion. However, within moments of the bridge’s opening, it began to shake violently.” The day it opened, the Millennium Bridge was closed. The engineers were initially mystified about what had gone wrong. Of course it would be a problem if a platoon of soldiers marched in lockstep across the bridge, creating sufficiently powerful vertical vibration to produce a swaying effect. The nearby Albert Bridge, built more than a century earlier, even features a sign directing marching soldiers to break step rather than stay together when crossing. But that’s not what happened at the Millennium Bridge. “What is the probability that a thousand people walking at random will end up walking exactly in step, and remain in lockstep thereafter?” Shin asked. “It is tempting to say, ‘Close to zero.’”

  But that’s exactly what happened. The bridge’s designers had failed to account for how people react to their environment. When the bridge moved slightly under the feet of those opening-day pedestrians, each individual naturally adjusted his or her stance for balance, just a little bit—but at the same time and in the same direction as every other individual. That created enough lateral force to turn a slight movement into a significant one. “In other words,” said Shin, “the wobble of the bridge feeds on itself. The wobble will continue and get stronger even though the initial shock—say, a small gust of wind—had long passed. . . . Stress testing on the computer that looks only at storms, earthquakes, and heavy loads on the bridge would regard the events on the opening day as a ‘perfect storm.’ But this is a perfect storm that is guaranteed to come every day.”

  In financial markets, as on the Millennium Bridge, each individual player—every bank and hedge fund and individual investor—reacts to what is happening around him or her in concert with other individuals. When the ground shifts under the world’s investors, they all shift their stance. And when they all shift their stance in the same direction at the same time, it just reinforces the initial movement. Suddenly, the whole system is wobbling violently.

  Ben Bernanke, Mervyn King, Jean-Claude Trichet, and the other men and women at Jackson Hole listened politely and then went to their coffee break. It would be two more years before the bridge started to wobble, and three more before it came falling down.

  Part II

  PANIC, 2007–2008

  NINE

  The Committee of Three

  Two years after Alan Greenspan’s grand send-off in Jackson Hole, the question for the conference was whether his successor could make the trip at all. Markets were in chaos in August 2007, and the symposium was to take place just three weeks after the European Central Bank’s surprising intervention during the BNP Paribas crisis. Ben Bernanke’s closest advisers debated whether they could jet off to the wilds of Wyoming with the markets so on edge. Cell phone coverage had arrived at the Jackson Lake Lodge only a few years earlier, and Internet connectivity was still iffy. If another wave of panic broke out, would they be able to gather the information they needed and act decisively?

  But if they canceled their usual appearances, markets could become even more jittery: If they can’t even go to Jackson Hole, this thing must be even worse than we thought. So Fed information-technology and -security staffers from Washington were dispatched to Jackson. Across the hall from Bernanke’s second-floor room at the lodge, away from the main event spaces, they set up a conference room with secure phone lines, Internet connections, and Bloomberg financial-data terminals so Fed officials—and their international counterparts, if it came to that—could do their jobs from a distance.

  Bernanke and his inner circle—New York Fed president Tim Geithner, Board of Governors vice chairman Donald Kohn and member Kevin Warsh, Fed monetary affairs director Brian Madigan—spent much of the two days of proceedings in their secure conference room on the second floor, plotting their response to the emerging panic.

  It was too bad: The topic of that year’s conference was housing finance, and some of the presentations were quite prescient. Robert Shiller of Yale, for example, warned that the long housing boom was soon likely to go bust, with severe economic consequences. “It does not appear possible to explain the boom in terms of fundamentals such as rents or construction costs,” he argued. “A psychological theory, that represents the boom as taking place because of a feedback mechanism or social epidemic that encourages a view of housing as an important investment opportunity, fits the evidence better.”

  Still, the discussion was overwhelmingly focused on the United States, with no real recognition of just how deeply all those bad U.S. home loans had become embedded in the world’s financial infrastructure, from European banks to giant insurer AIG. There was little sense that the problem went beyond subprime mortgage securities. The Millennium Bridge was wobbling, and everyone was uneasy—but not uneasy enough. And that was as true of the three leading Western central bankers as anyone.

  Jean-Claude Trichet and the ECB were injecting money into the European banking system, a practice they’d begun with no real warning to their counterparts in Washington and London. Bernanke and the Federal Reserve were acting as lender of last resort to banks too, as well as weighing whether to start trying to protect the overall economy by cutting interest rates. Mervyn King and the Bank of England wer
e standing by, content for the moment to let the banks suffer the consequences of years of risky lending.

  The three men didn’t know it yet, but they were in the early stages of what would become perhaps the world’s most important partnership—one in which their varied backgrounds, different personalities, and unique pathways to power would shape the course of all that was to come.

  • • •

  Jean-Claude Anne Marie Louis Trichet was a career bureaucrat with decades of crisis-fighting experience—and also a reader of poetry, philosophy, and literature who saw his profession as a central banker as being about something much bigger than economics. “I am convinced that economic and cultural affairs, that money and literature and poetry, are much more closely linked than many people believe,” he said in 2009. “Poems, like gold coins, are meant to last, to keep their integrity, sustained by their rhythm, rhymes, and metaphors. In that sense, they are like money—they are a ‘store of value’ over the long term. They are both aspiring to inalterability, whilst they are both destined to circulate from hand to hand and mind to mind.”

  To Trichet, the ECB was the most concrete symbol of European unity, an answer to the discord that had roiled his continent for hundreds—even thousands—of years. “Economic and monetary union is a magnificent undertaking that forms the basis of Europe’s prosperity and shared stability,” he said in the same speech, citing the words of Derrida, Dante, Proust, and Goethe as representing the philosophical underpinnings of a united European continent.