by Gordon Brown
Yet, whatever model is chosen, if reconstruction – delivering infrastructure and services – is at the expense of building local capacity, it can be the enemy of development, and the more we intervened in the domestic affairs of Afghanistan, the more we looked like an occupier and lacked the cultural understanding, local knowledge and even essential language skills needed. When we tried to encourage local initiatives free from dependence on outside aid, we found feeble local institutions, widespread corruption, and tribal loyalties more important than loyalty to the government.
Nation-building failed not just because it required almost limitless funds at a time when budgets were strained, nor because it was difficult to find the greater number of trained civilians and military experts we needed long-term on the ground: it failed because converting one of the world’s least developed and most ungovernable countries into a modern functioning society in one short decade was an unrealisable goal. And when it came to the crunch, even more basic aims had to take second place to our first duty: protecting our own troops.
Yet, during our time in Afghanistan, 6 million children who had been denied education – including 2 million girls – went to school, and we ensured that 80 per cent of the population had healthcare. All this was only possible because of the bravery and dedication of our troops – rightly regarded as the best armed forces in the world – and some of the most dedicated aid workers.
But these undoubted gains never gathered momentum and they now seem at risk. As I write, the Taliban controls half of Afghanistan and, according to claims from American military intelligence, it is now being armed by Russia. Although massively weakened by drone attacks, al-Qaeda still hides in the mountains. Two ISIS groups and the Haqqani network are now mounting regular bombings and attacks. Pakistan remains weak and at the epicentre of terrorism. The reflex response is as before – Washington sending in more troops. But if we did not succeed with 150,000 men and women under more favourable conditions than we now face, it is right to ask how much can be achieved today with a fraction of that number.
Nation-building did work in post-war Germany and Japan, in Cold War Greece and Turkey, in Korea and more recently in the Balkans. But it has failed again and again – in Vietnam, despite the presence at once stage of more than 500,000 US troops; in Iraq with 200,000 troops; and in Afghanistan. Nation-building will not succeed where there has never been a complete surrender of enemy forces or where a large proportion of the people are not on your side. Afghanistan suffered from levels of development not seen in Europe since the medieval era. Perhaps even more importantly, the Afghan state has never exercised effective control across a land mass in which a province such as Helmand hosts a kaleidoscopic population, subdivided into a multiplicity of tribes, mini-tribes and extended families, often with competing interests and loyalties, often at odds with each other. The overall campaign for Afghanistan could have been lost in Helmand, but never won there.
Now, with so many recent terrorist attacks in Britain, led by militants born here, it is harder to say we are fighting ‘over there’ to prevent violence ‘over here’. It will take time and perspective to gauge the ultimate impact of the Afghan war. Today many will ask the question first posed by General David Petraeus about Iraq in 2003: ‘Tell me how this ends.’
CHAPTER 15
THE BANKING COLLAPSE THAT SHOOK THE WORLD
‘No one should panic.’
With these words, the BBC’s business editor Robert Peston signed off his broadcast on the evening of Thursday 13 September 2007, having broken the news to the world of the Bank of England’s rescue plan for the Newcastle-based ailing bank Northern Rock.
The words might just as well have been spoken by the hapless Corporal Jones in Dad’s Army – for, like Jones’s famous catchphrase, they had the precise opposite of their intended effect. The public panicked.
The next morning, I was holding my normal meetings in 10 Downing Street when I was told I should turn on the television. All across the world, pictures were being broadcast of ordinary savers, now terrified they might lose everything, queuing outside branches of Northern Rock in Newcastle, Sheffield, Surrey and north London, in such large numbers that police officers were deployed for crowd control. Nothing like this had happened to a British bank since Overend Gurney & Company collapsed in 1866.
In fact, on the day that Peston delivered his scoop, the bank’s fortunes were looking better than they had in weeks. At the end of June 2007, Northern Rock had issued a profit warning in advance of poor results. Little public comment followed, but intensive and very private discussions were held during August and early September with the financial authorities about the state of the bank’s balance sheet. As the Treasury and Bank of England worked with Northern Rock on a rescue plan, the news leaked to the BBC and the rest is history. The next day Alistair Darling formally announced liquidity support. The Bank of England was clear in its judgement that Northern Rock was solvent. But none of these reassurances stopped the queues lengthening. I believed that the Bank of England needed to do far more to guarantee all Northern Rock deposits and, if necessary, those of other banks that could be imperilled by a run. That we did by Monday.
At first, I was determined to avoid nationalising Northern Rock. We did not want a bank on our hands. We knew that at some time it would have to be sold back to the private sector and we would be faced with a dilemma of whether to sell it back at a loss or to try to hold on to it to recoup our investment. We looked at all the options, including an auction to find a private buyer, but outside interest was conditional on the government assuming all the firm’s debts. Ten private companies expressed an interest in buying the bank at bargain-basement prices. In every case we were being asked to take on all the firm’s risks without receiving any of the benefits: in short, to nationalise the losses and privatise the gains.
When Northern Rock announced that all of those offers were below its stock exchange value, its share price dropped a further 20 per cent in November. By mid-February 2008 only two bidders remained: Virgin and the Northern Rock board. Alistair and I met to discuss both offers. Each bid would cost the government dearly: Virgin’s was conditional on three more years of liquidity support. I phoned a very unhappy Richard Branson to tell him his bid was far costlier to the taxpayer than state control. At 4 p.m. on 17 February, we announced that Northern Rock would be nationalised and managed at arm’s length as a commercial entity. When the Conservative–Liberal Democrat government later sold Branson the bank on what seemed to be similar terms to the ones he had been proposing in 2008, the British taxpayer was the loser. Our estimate had been that Virgin stood to make a quick £1.2 billion out of the deal.
It is true we were not prepared for what was happening – or for what was going to happen in the coming months. No one was. But we had not been passive. In 2006–7, Ed Balls, then Economic Secretary to the Treasury, had led the Treasury, the Bank of England and the FSA in a simulation exercise, a kind of ‘war game’ to model what might happen in the event of a bank failure. Would the fall of a bank or a building society spread contagion and raise systemic issues? If it did, at what point would we have to intervene? And what risk did Britain and indeed many other economies face from the increasingly global operations of financial conglomerates based beyond our shores?
I had approached Hank Paulson, the US Treasury Secretary, and he readily agreed to participate in a transatlantic simulation. Normally, the only such exercises that the UK conducts with the United States are military ones. As far as I know this was the first joint ‘war game’ focused on finance. Besides Hank, we brought together by video conference Ben Bernanke, chairman of the Federal Reserve, and the main regulatory bodies in the States, including the Securities and Exchange Commission and the New York Fed, as well as Callum McCarthy, chairman of the FSA, and Mervyn King, the governor of the Bank of England.
I suspect that most of the assembled group started out with the conventional view that the moral hazard of rescuing a bankrupt i
nstitution was so great that it was wiser to let it go under: if a bank thought it would be rescued, it could take undue risk. Yet after playing out various scenarios, everyone moved to accept, albeit reluctantly, that there were circumstances in which a rescue would be unavoidable.
Had it been known we were conducting such simulations, the markets might have panicked, so no private sector participants were in the room. In hindsight, we might have been better prepared for what was to come if we had simulated potential private sector responses, for the question that our simulation could not definitively answer was whether the private sector would be prepared to be part of the rescue.
More importantly, the exercise was not designed to explore what might happen in the case of a succession of failures around the world. Nor did it include enough detailed discussion of the increased entanglement of financial institutions with each other, the possible effect of a ‘shadow banking system’ hidden from view, and what might happen if we suddenly had to account for a mountain of debt that had never been included on the official balance sheet. But this was the scenario that lay ahead of us.
Capitalism needs credit to flourish. Of course, we knew of the historical tendency of markets to go too far, to generate unsustainable credit booms and so-called ‘overleveraging’. We also knew that at the peak of a cycle, when lending is at its greatest, the risk to the system is greatest too, and so extra capital is needed to maintain confidence and prevent collapse. But we could never obtain international agreement on the kind of global financial regulation I had championed since the Asian crisis: namely on transparency, capital requirements and cross-border supervision. The general feeling was that globalisation – sourcing capital from all over the world – had spread the risk and, by diversifying it across many institutions and through many instruments, had reduced the risk too.
In fact, as we were about to discover, these supposed safeguards would become the driving force for disastrous contagion. We were to find that banks everywhere were so entangled that, when one of them had too little capital to cover its positions, the whole market seized up; so when the crisis really hit, the system would be too highly leveraged to cope with the fallout from the collapse in American sub-prime investments. To keep the economy moving, governments would simply have to intervene.
Given Mervyn King’s participation in the war game, I was surprised when in mid-September 2007 he spoke out publicly on the moral hazard of intervening to save banks. By now, the banking failures were moving beyond Northern Rock. In October 2007, UBS and Citigroup each announced losses of over $3 billion from sub-prime related investments. At the end of the month, the CEO of Merrill Lynch had resigned after reporting an exposure to nearly $8 billion of bad debt. By December 2007 all of this was having a major impact on the banks’ willingness to lend to each other, and central banks were now coordinating billions in loans in order to get money flowing.
At Christmas 2007, while busy planning our new initiatives on the NHS and public sector reform, I also spoke regularly with Shriti Vadera, a former investment banker whom I now moved from her role as a minister in the Department for International Development to the Department for Business, Enterprise and Regulatory Reform. Shriti had been monitoring events. The freezing up of lending, she said, seemed to reflect a growing recognition that banks’ balance sheets were riddled with toxic assets.
The practices that had led to this would have appalled the ordinary depositor. The banks’ books no longer held the loans they had made to their customers, even though customers had been repaying them for the last fifteen or twenty years: instead the banks had parcelled up those loans, sold them on, and used them as collateral for further borrowing. By late 2007, although we did not know this at the time, 50 per cent of Britain’s outstanding mortgages had been sold off and were held in so-called ‘securitisation vehicles’. This meant they had been bundled together along with trillions of dollars’ worth of other new mortgages of variable quality from across the world, which had been given the most secure, reliable and, in many cases, thoroughly misleading of debt ratings – ‘Triple A’ – and then sold on and on and on in a speculative spiral that had become a rich source of income for many Wall Street and City firms.
In Northern Rock’s case, just 20 per cent of its loans were covered by retail deposits and mortgage payments. No other bank relied so much on short-term borrowing – often overnight lending – from the marketplace and at the same time paying low interest rates to fund long-term mortgages, so much so that their very survival depended on it. They had no plan B if the short-term financial markets dried up. Indeed, their strategy was so aggressive that it was but a short step from criminality: when they issued figures for mortgage debts in the months before the bank’s collapse, they had failed to disclose the arrears of hundreds of mortgages. The FSA later reported that the staff felt ‘under pressure’ to produce attractive figures. The true repossession figures were, in fact, 300 per cent higher than those reported. This was an offence – they were later fined – but the sanctions of the law should have been stronger, and should have led to prison sentences.
However, while Northern Rock was proven to be an outlier in the extent of its unorthodox financing, its practices were not unique: right across the system, particularly in the USA, even the most prestigious institutions were discovering the toxicity of their holdings. I now found to my horror a vast shadow banking system made up of banking affiliates that were not bound by the rules that applied to the banks themselves but which acted like banks – trading in dubious financial instruments and offering nearly twice as much credit as that intermediated by traditional banks.
The sheer size and pervasiveness of these instruments – free from regulation but also free of any government guarantees – formed the breeding ground for everything that subsequently went wrong. We now know that during 2008 an astonishing $50 trillion – more than the entire annual income of everyone in the world – was pledged across financial companies, all of it done without ever being properly declared. One company, AIG, had signed $1 trillion worth of insurance contracts without the resources to cover them. Even as the music stopped, extravagance and excessive risk-taking continued.
This shadow banking system had proliferated without politicians realising it, and with no one ever reporting the huge risks inherent in their practices. It was now so extensive and so far beyond the reach of the supervisory authorities that if it was not addressed, it was bound to be an ever-present threat to stability. But it was also clear to me that this gathering storm was not something Britain could deal with on its own. It was a global phenomenon flowing out of America and in all directions – indeed, I later discovered that half the US sub-prime debt was, by then, owned in Europe. As we returned in the New Year I drafted an article for the Financial Times under the title ‘Ways to Fix the World’s Financial System’. It was, I said, an underpricing of risk and a deficit of transparency that now had to be addressed by regulators and by firms themselves. That was the message I carried to the annual World Economic Forum in Davos, Switzerland, and was encouraged to do so by its energetic and path-breaking leader, Klaus Schwab.
For years Davos has been a celebration of globalisation. I had attended regularly since the 1990s. This time I warned that the sheer size of banks’ losses, unless addressed, could bring the threat of a global recession. New, more stringent, national and international rules for banking were urgently needed along with monetary and fiscal support to prevent a serious economic downturn.
At the end of January 2008, the US Fed revealed the scale of their concerns with two successive interest-rates cuts within a week. On 29 January, I brought European leaders Nicolas Sarkozy, Angela Merkel, Romano Prodi and José Manuel Barroso to discussions in London. We started off in the Cabinet Room and then, after an hour, moved to a small dining room on the first floor of Downing Street. In a relatively informal atmosphere we would be freer to say candidly where each of us stood.
None of us believed the banks when they
said they had cleaned up their balance sheets. Our starting point was that they had first to rid themselves of their impaired assets. I suggested that, to restore confidence, we then had to set a timeline and standards of transparency for a clean-up. We all agreed that we had to ratchet up pressure on the banks but there was a sense around the table that this was America’s problem and that the UK was caught up in it because, unlike mainland Europe, we were much more closely tied to Wall Street.
In the easy atmosphere of a small dinner party, everyone agreed that the current G8 – which included the advanced economies of Europe, America and Japan, as well as Russia, but which excluded major economies like China and India – could no longer be the sole vehicle for economic coordination. Suggestions ranged from a G8 plus five or six countries to an even wider group – a debate that was to continue right up until September.
On 6 February, I talked at length to President Bush about developing a joint plan to reduce the uncertainty gripping the markets. This led to a unanimous call from the G7 finance ministers in Tokyo for the prompt disclosure of banks’ losses. Over the next few weeks I had a videoconference with Chancellor Merkel and further meetings with President Sarkozy and Prime Minister Zapatero of Spain – and each conversation increased my certainty that we had to do more than just push for a declaration of losses. That was a first step towards restoring confidence, but it was certainly not enough. Slowly but surely I was coming to see that the assets of some of our biggest banks were so impaired that they did not have nearly enough capital to cover their liabilities.
The thunderclap that signalled massive underlying vulnerabilities across Wall Street was the demise of Bear Stearns in March 2008. A year earlier, it had been valued at $18 billion. Now JP Morgan Chase bought it for $240 million. When I met President Sarkozy at No. 10 on 27 March we issued a joint public statement calling for the first time for the immediate write-offs of toxic debts and the reform of the IMF so that, in concert with the Financial Stability Forum, we might at last have an authoritative early warning system.