by Adam Tooze
To the American banks this did not seem fair. In response their industry lobby pushed hard to level the playing field. In February 2007 New York mayor Michael Bloomberg traveled to London, where he met with the chair of the UK’s FSA, and used the London platform to lobby for further deregulation in the United States. “The FSA is an example of the kind of streamlined and responsive regulatory framework Congress must implement if New York City is to remain the financial capital of the world,” the mayor intoned. Bloomberg wasn’t the only one making the trip. That same month the Financial Times reported that Citigroup had “reshuffled its management in a move that gave greater influence to London-based executives, with five receiving global responsibility for their areas and the global head of commodities moving to London. Merrill Lynch, J.P. Morgan and Lehman Brothers also gave global management roles to executives based in the UK.”51 It was with these pressures in mind that Bloomberg and Senator Charles Schumer in May 2007 put their names to a McKinsey & Company report warning that New York’s position as the world’s leading financial center was under threat unless it fell into line with international standards. “The findings are clear: . . . our regulatory framework is a thicket of complicated rules, rather than a streamlined set of commonly understood principles, as is the case in the United Kingdom and elsewhere.”52
Of course at every stage in the construction of global capital markets, think tanks, economists and lawyers contributed ideas and argumentation to justify the next move. Technological change gave banks massive new information-processing capacity. The complex financial instruments they produced exuded an energizing charisma.53 The clannish society of the bankers created a social force field of common assumptions and an overweaning superiority complex. They were the masters of the universe. They could not fail. But the basic driver of expansion and change was the competitive search for profit, played out in the force field of financial engineering, transnational capital movement and competitive deregulation between Wall Street, the City of London and Basel. It was not that the key players were completely oblivious to risk. But they believed in their capacity to manage it and were totally committed to maximizing the rate of return. So every regulation and every restriction on leverage was subject to second-guessing and subversion by the overwhelming force of competition and the unfettered movement of capital that had been gathering steam since the 1960s.
What if the regulations failed? What if there was a comprehensive crisis of the transatlantic financial system? No one wanted to ask that question. In the rescue of the emerging markets in the 1990s it was Washington that had taken the lead. The US Treasury and the IMF acted in concert. Though they had faced determined criticism and foot-dragging from the Europeans, their resources were up to the task of bailing out Mexico or South Korea.54 Would that be the case if it were the transatlantic financial system that suffered a circulatory failure? The sums involved were enormous, denominated not in the billions or even hundreds of billions but in trillions. In the last instance, US banks could expect support from the bottomless resources of the Fed. But the question was particularly pressing for European banks operating a multicurrency balance sheet. In case of emergency, where would they get the dollars they needed? Who would be their lender of last resort?
The global Financial Stability Forum (FSF), a group set up in the wake of the 1990s financial crises, had been edging around the question since 2000. At the Bank of England, John Gieve was keen to run “table exercises” to game the scenario of a major international banking failure. But he met with little enthusiasm. Bank of England governor Mervyn King, a thoroughbred macroeconomist, was little interested in the technical issues of financial stability. “There was no real appetite on the US side to get into discussing particular examples. We were offering to put HSBC or Barclays on the table, with real balance sheets, and maybe in return, they would do Citi or Lehman. But that never got off the ground.”55 Would Europe’s central banks have the dollar reserves necessary to backstop the European financial system? It was an old-fashioned question, seemingly out of season in a world of limitless global liquidity.56 But when the question was put by analysts from the BIS, the answer was sobering. In the balance sheets of the European banks at the end of 2007 there was a mismatch between dollar assets (lending) and dollar liabilities (funding by way of deposits, bonds or short-term money market borrowing) of $1.1–1.3 trillion.57
The only central banks that held these kinds of sums were in China and Japan. Against the backdrop of a sanguine view about financial markets, their “hoarding” of dollars was widely seen as a sign of insecurity, an aftereffect of the trauma of the 1997 crisis.58 It is telling that no one troubled to ask the question of what the adequate level of reserves would be for a European country with a gigantic globalized banking system. As it turns out, given the scale of the banking business in their jurisdictions, the level of foreign exchange reserves held by the Swiss and British central banks was astonishingly low—less than $50 billion each. To backstop the sprawling banking system of the eurozone, the European Central Bank had little more than $200 billion on hand. What did this say about their assumptions about both financial risk and financial sovereignty? When asked later how he justified such minimal reserve holdings prior to the crisis, one of the most outspoken central bankers of the period paused for a minute, smiled at a point well taken and then said quite simply: “Given our long history of relations with the Fed, we didn’t expect to have any difficulty getting hold of dollars.” In other words, there was a presumption that collaboration would be forthcoming and in an emergency the Fed would provide Europe, and London in particular, with the dollars it needed. Given the scale of the offshore dollar business there could be no other answer. But for that same reason, it was also an astonishingly audacious assumption, an expectation so exorbitant that it was better left unspoken.
Chapter 4
EUROZONE
If Europe preferred not to highlight its role in the “American” financial crisis of 2008, covering its tracks was made easier by the fact that from 2010 Europe was consumed by its own “authentically” European crisis. The eurozone crisis followed directly on the footsteps of Wall Street and the US mortgage bust. But as conventionally understood, it is as if the Wall Street crisis and the eurozone disaster belong to different worlds. Whereas the US crisis involved overextended banks and mortgage borrowers impelled by greed and financial excess, the eurozone crisis would revolve around quintessentially European themes of public finance and national sovereignty. It would pit Greeks against Germans and reawaken memories of World War II. Both crisis narratives play to type: mercenary Americans, squabbling European nationalisms. But was it merely bad luck that the two crises followed so closely upon each other? Was it merely bad luck that the same banks were involved in both? If the buildup to the American crisis was less all-American than is generally credited, how “European” were the problems of the eurozone?
I
As the twenty-first century began, the Europeans could certainly be forgiven for being preoccupied with questions of politics and institution building. With the introduction of the euro as a single currency between 1999 and 2002 and the expansion of the EU to include much of Eastern Europe in 2004, they were embarked on truly dramatic experiments, which were driven as much by political and geopolitical considerations as by economics.1
As far as the euro is concerned, the story again goes back to the early 1970s and the collapse of Bretton Woods. Between 1945 and 1971, the Europeans did not have to worry about intra-European currency issues. The dollar tied to the gold reserve in Fort Knox was the anchor of the global system. Once Nixon abandoned the gold peg in August 1971, Europe faced a problem. Fluctuating exchange rates would disrupt the tightly integrated trading networks that had brought Europe together. On the other hand, efforts to create a zone of exchange-rate stability by pegging the European currencies against one another reopened the basic question of power. In a European Monetary System, whose currency woul
d replace the dollar as the anchor, as the “key currency”? The stresses might have been manageable if capital movement had been constrained, limiting speculative attacks. But by the early 1980s the freewheeling habits of the eurodollar business had become the global norm. Huge surges of hot money between currencies put extreme pressure on the more financially fragile states and conferred an intolerable degree of influence on Germany’s conservative central bank. From the early 1970s the Budesbank’s anti-inflationary stance and the resulting strength of the Deutschmark constrained not only Germany’s own government in Bonn but the governments of all of the rest of Europe too. By 1983 even France’s Socialist administration under François Mitterrand was forced to give in. After a series of messy devaluations between 1981 and 1983, Paris abandoned its effort at social democracy in one country and adopted instead a hard-currency policy of “franc fort.” Interest rates would be set at whatever level was necessary to hold the franc against the Deutschmark, even if that meant borrowers paying 18 percent or more. Far from seeking to restrict capital movement, European officials at international organizations like The OECD pushed for further liberalization. The pressures generated by unrestricted capital movements across Europe’s fixed exchanges in turn provided a powerful argument for those who favorerd ever closer European integration.2 How else were the weaker members of the European Monetary System to regain even a modicum of control over the conduct of monetary policy? By the late 1980s plans were afoot, driven above all by Jacques Delors, the president of the European Commission, and his supporters in the French Socialist Party, for another round of negotations over monetary integration. Given the national interests at stake those would most likely have gone nowhere had it not been for the sudden end to the cold war. The fall of the Berlin Wall in 1989 and German chancellor Helmut Kohl’s irresistible push for national reunification threatened to make Germany even more dominant. A currency union and irrevocable economic unification seemed to both Kohl and Mitterrand the best way of securing a much larger Germany in a peaceful and stable continent.3 As a price of surrendering the Deutschmark, the Germans exacted the promise that the new European Central Bank would continue the conservative heritage of the Bundesbank. But a joint central bank board would give a voice to all the other member states, and monetary union would end the ruinous cross-country pressure exercised by financial markets.
It was a spectacularly ambitious undertaking. The monetary union came into full effect in 2001. There was a single European central bank. There were fiscal rules limiting deficits and setting debt ceilings (known as the Stability and Growth Pact). But the euro was clearly unfinished.4 There was no unified economic policy. No unified regulatory structure for banking. Nor, however, was there much urgency in moving to further integration. In its early years, the new currency zone performed tolerably well. European growth accelerated. After an initial hike in prices following the adoption of the single currency, inflation remained moderate. Capital markets were calm.
Despite this benign atmosphere, there were two problems that preoccupied experts both inside and outside the eurozone. The first was whether preexisting imbalances in intra-European trade would narrow or expand over time.5 The fear was that the lack of currency adjustment could lead to cumulative divergence as less competitive regions fell further and further behind. Second, there was the risk of asymmetric external shocks.6 A bust in tourism would hurt Greece far more than Germany. A collapse in Chinese import demand would damage Germany in a way that it would not hurt Ireland. American critics, in particular, warned that Europe’s labor markets did not have the flexibility or mobility of their American counterparts.7 And if people would not move, faced with a crisis, Europe would need a common system of benefits, taxes and spending to allow funds to flow from the more prosperous to the more hard-hit regions. Along with labor mobility, it was this backbone of social security, disability and unemployment benefits that held the gigantic diversity of the US economy from Alabama to California together. Worryingly, there was plenty of self-congratulation in Brussels in the early 2000s but little urgency about building the overarching mechanism of fiscal redistribution and burden sharing that would be necessary to see the eurozone through a recession, let alone a major financial crisis.
Getting to the moment of unification had required huge efforts from many members of the eurozone. Italy, in particular, imposed severe belt tightening.8 The collective effort of the 1990s to stabilize Italy’s finances shaped a generation of Italian technocrats and politicians who would go on to play a key role in European politics, among them Mario Monti, economist, EU commissioner and future prime minister of Italy, and Mario Draghi, the future head of the ECB.9 It was another Italian economist, Romano Prodi, who as president of the commission oversaw the introduction of the new currency. But having mastered Italy’s acute financial political crisis of 1992–1993 and achieved euro membership, there was little energy left in Rome for further initiatives. The victory of Silvio Berlusconi’s Forza Italia in the 2001 elections was a sign of the times. Far from making progress toward further European integration, holding the line on the budget criteria set in the Maastricht Treaty was hard enough. In 2003 France and Germany both exceeded the agreed limit of a 3 percent budget deficit, but Brussels shrank from imposing sanctions on such heavyweights. To fiscal disciplinarians this raised the alarm. Would the EU’s central institutions ever have the political courage to impose themselves on larger members? For others the more pressing question was what was wrong with Germany.
Germany’s entry into the euro did not go well. The other members made sure to settle on competitive exchange rates against the Deutschmark. Germany’s exports took a hit. Its rule-busting budget deficits reflected its anemic growth. The world’s media labeled Germany the “sick man of Europe.”10 Germans themselves talked of a “blockierte Gesellschaft” (blocked society).11 The response from Gerhard Schroeder’s Red-Green coalition, which governed Germany from 1998 to 2005, was unexpectedly energetic. For years Germans had suffered from painfully high levels of long-term unemployment, exacerbated by the sudden deindustrialization of the former GDR. In 2005 joblessness would peak at 10.6 percent. To combat this scourge, between 2003 and 2005 the Schroeder government announced a national restructuring program titled Agenda 2010. Its main thrust was a multiphase program of labor market liberalization and benefit cuts, designed by a committee headed by VW’s head of human resources, Peter Hartz.12 The fourth and final phase of cuts, Hartz IV, became synonymous with a new German “reform” narrative. The unemployed were returned to work. Wage restraint restored German competitiveness. The reward came already in 2003 when Germany could boast of being the world export champion (Exportweltmeister).
Agenda 2010 would come to define a new bipartisan self-understanding of Germany’s political class.13 Having accomplished the enormous task of reunification, Germany had overcome its internal difficulties and “reformed” its way back to economic health. It is a narrative that is superficially compelling and it would have significant implications for how Berlin approached the crisis of the eurozone, but it does not withstand close scrutiny. Hartz IV certainly drove millions of people more or less willingly off long-term unemployment benefits into a range of insecure jobs. This helped to hold down wages for unskilled workers, such as cashiers and cleaning workers. In the first ten years of the euro, despite soaring productivity, half of German households experienced no wage growth at all. This shortened unemployment rolls. It also increased pretax inequality and lowered Germany’s wages relative to its European neighbors. But as to the competitiveness of German exporters, the significance of Hartz IV is far less obvious.14 German companies do not win export orders by shaving the wages of unskilled workers. A far more important source of competitive advantage came from outsourcing production to Eastern Europe and Southern Europe. Added to which there was the boost from the global recovery of the early 2000s.
While its economic impact has been exaggerated, what Hartz IV did transform was Ger
man politics. The blue-collar electorate and the left wing of the SPD never forgave Schroeder for Hartz IV.15 The left wing split from the SPD to unify with the former Communists of the East. The result was a new party known as Die Linke, which gathered almost 10 percent of the electorate. Together, Die Linke, the SPD and the Greens were a powerful political force. Red-Red-Green was capable of winning a majority. But the bitter divisions between them over Agenda 2010 made a broad-based center-left coalition difficult to imagine. The result was to hand the political initiative to their opponents. The decisive force in European politics for the next decade and beyond would be German Christian Democracy and its leader, Angela Merkel.