Crashed

by Adam Tooze

  Cross-Border Financial Flows Within the Eurozone and the World Economy: Annual Averages, 2004–2006 (in billions of euros)

  Note: Estimated gross flows (net asset acquisitions) of direct, portfolio and “other” investments (excluding financial derivatives).

  Source: A. Hobza and S. Zeugner, “The ‘Imbalanced Balance’ and Its Unravelling: Current Accounts and Bilateral Financial Flows in the Euro Area,” European Commission Economic Papers 520 (2014): table A.2.

  The flow of funds around Europe, as around the global economy, was driven not by trade flows but by the business logic of bankers, who sought out the cheapest funding and the best returns. The upward spiral of asset prices and balance sheets that drove the US boom was even more pronounced in Europe. Between 2001 and 2006, Greece, Finland, Sweden, Belgium, Denmark, the UK, France, Ireland and Spain all experienced real estate booms more severe than those that energized the United States. In Ireland and Spain, the combination of credit growth and house price inflation was truly explosive.

  It was these credit-fueled booms that drove the trade and fiscal imbalances of the eurozone, rather than the other way around. The huge influx of credit from all over the world to a hot spot like Spain inflated economic activity there. This generated healthy tax revenues for Madrid, which proudly boasted a fiscal surplus. It also generated export orders for Germany. Foreign demand gave a boost to the languishing German economy, raising incomes and profits.38 But German households and businesses did not want to spend their income increment in Germany, on either consumption or investment. The German government borrowed, but not enough to soak up the difference. Through interbank markets, surplus liquidity in the north helped to fund business ventures around Europe. Some of that, not surprisingly, went to Spain. At the end of the day the accounts balanced. Germany’s savings appear as the counterpart to Spain’s trade deficit. But accounting identity is not the same as causal relationship. It wasn’t Germany’s excess savings, or its exports, that produced the boom in Spain. It was the lopsided credit-fueled boom that produced the demand imbalances, the trade flows and the savings imbalances. Europe’s banking system provided elastic intermediation. Had Germany’s domestic economy been in more robust shape, Germany’s demand for imports would have been larger, and the trade imbalances within the eurozone might have been smaller. A somewhat larger fraction of the Spanish economy might have been directed toward producing goods for export to Germany rather than supplying the domestic boom. But there is no reason to think that a smaller flow of net savings from a more rapidly growing Germany would have done much to slow the credit-fueled upswing in Ireland or Spain. In modern finance, credit is not a fixed sum constrained by the “fundamentals” of the “real economy.” It is an elastic quantity, which in an asset price boom can easily become self-expanding on a transnational scale.

  Real House Prices and Growth Rate of Nominal Credit Relative to GDP

  Source: Prakash Kannan, Pau Rabanal and Alasdair M. Scott, “Macroeconomic Patterns and Monetary Policy in the Run-up to Asset Price Busts,” IMF Working Papers (November 2009), figure 2.

  Where does Greece, the country that would become the epicenter of the eurozone crisis, fit in this picture? It is present, but vanishingly small. Of the annual flux in cross-border funding within the eurozone between 2004 and 2006, which on average came to c. 1.8 trillion euros, Greece accounted for 33 billion euros. That is less than 2 percent, proportional to Greece’s weight in eurozone GDP. Of that flow of funds, a larger share than was the case in Ireland and Spain went to the Greek state. But Greece too experienced a property boom on a par with the United States. The red flag in Greece was not the annual inflow of capital after 2001 but the fact that the new borrowing was being added to huge stocks of debt already accumulated in prior decades. What would happen if the flow of funds was abruptly cut off was a worrying question, but given Greece’s tiny size, it was hardly headline grabbing.

  It would later be said that the ECB should have done more to dampen the boom in Ireland and Spain. And it is clearly true that this was made more difficult by the fact that it set one interest rate for the entire eurozone. In effect, by setting low rates, the ECB prioritized the need to stimulate the German economy over restraining the boom in the periphery. It was a reasonable decision. Germany’s economy is far bigger. Furthermore, given the rates of return that beckoned in the hot spots of the European economy, it is wishful thinking to imagine that the ECB could have curbed the boom with a rate hike. If the EU’s business statistics are to be believed, investment in Spanish tourism and real estate offered rates of return of 30 percent or more. Little wonder that investment crowded in.39 In a world of globalized finance, the ECB could no more limit the flow of funds to such a hot spot than the Fed could choke off the capital inflow to the United States. Ireland’s banks were a case in point. They sourced their funding wholesale in the City of London, outside the ECB’s immediate purview.40

  To have slowed the booms would have required not a mild tweak of ECB interest rates but a full-scale economic policy mobilization by the governments of the boom countries. This might have included tougher lending rules, throttling back growth in the banking system and even tighter fiscal policy. In the case of Spain, the larger, internationalized banks were, in fact, held on a tight leash. Foreign investors expected high governance standards. And they came through the crisis well.41 But the same cannot be said for the local mortgage lenders, the cajas that made up 50 percent of the credit market.42 They were tightly connected with local politics and deeply immersed in the real estate boom. Between 2002 and 2009 their business grew by a factor of 2.5, resulting in a combined balance sheet of 483 billion euro, or 40 percent of Spanish GDP.43 But efforts to restrict their lending were easily seen as a centralizing power grab by Madrid. And why should Spain’s politicians undertake such unpopular action? One of the side effects of a bubble is that it makes balance sheets look good. Tough governance reform seems unnecessary and punitive.44 Spaniards were enjoying their long overdue return to the spotlight. Firms like Telefónica, Ferrovial and Banco Santander were emerging as global players. Fashion giant Zara made its owner Amancio Ortega the richest billionaire in Europe. Prime Minister José Luis Rodríguez Zapatero was lobbying for Spain to be invited to join the top table in an expanded G8. With lean social services and booming tax revenues, Spain’s public budget was in far better shape than that of France or Germany. Why put the brakes on such a healthy-looking burst of private sector growth?

  Increase in Indebtedness in the Eurozone (% of GDP), 2000–2007

  Source: Calculated from Eurostat and OECD data (for the real home price index) from S. T. H. Storm and C. W. M. Naastepad, “Myths, Mix-ups and Mishandlings: What Caused the Eurozone Crisis?,” Annual Conference Institute for New Economic Thinking, “Liberté, Égalité, Fragilité,” Paris, France, April 2015, https://www.ineteconomics.org/uploads/papers/The-Eurozone-Crisis.pdf.

  Among Ireland’s tiny political elite a similar spirit of ebullience prevailed. Coddled by EU investment and incestuously connected with bankers and developers, politicians boasted of the global attractions of Dublin’s International Financial Services Center. Ireland’s tax system enabled foreign corporations to spirit hundreds of billions of dollars in profit past tax authorities in the United States and the rest of Europe. Though a member of the eurozone and benefiting enormously from Brussels subsidy payments, the Irish liked to regard themselves as an “outpost of American (or Anglo-American) free-market values on the far edge of a continent where various brands of social democracy were still the political norm.”45 In the American presidential election of 2008, the world was treated to the incongruous spectacle of Phil Gramm, chief champion of deregulation in Congress in the 1990s and economic adviser to Republican hopeful John McCain, touting Ireland as the beau ideal of a low-tax economy. Disgraced former prime minister Bertie Ahern toured the world selling audiences on the benefits
of “extreme economic globalisation, low personal and corporate taxes, ‘business-friendly’ government and light regulation.”

  IV

  There are many risks involved in forming a currency union and it would no doubt have made sense for Europe to have added a fiscal constitution. But Europe’s chief problem was not the lack of a fiscal fire code. Its problem was the lack of a financial fire department.46 The failure of state building that mattered most was not fiscal union but the failure to build the capacity to handle a banking crisis. Coping with highly integrated financial capitalism requires a state that is disciplined, has the capacity to act and has the will to do so. Coping with a banking crisis on the scale that was brewing in Europe required a very capable state indeed.

  How badly such a facility was needed becomes clear only when we put together the local and global activities of Europe’s banks, to get a full view of their spectacularly overinflated growth. America’s banks were very big and very important to global finance. But it was in Europe that bank finance had grown most disproportionately.47 Europe’s banks had always been large. Unlike the United States, where equity and bond markets were the main sources of business finance, Europe’s economies had long relied heavily on bank lending. But spreading out across the EU and feeding off the transatlantic financial circuit, the European banks had grown to gargantuan size. In 2007 the three largest banks in the world by assets were all European—RBS, Deutsche Bank and BNP. Combined, their balance sheets came to 17 percent of global GDP. The balance sheet of each of them came close to matching the GDP of its home country—Britain, Germany and France—the three largest economies in the EU.48 In tiny Ireland the situation was far more extreme. The liabilities of its banks added up to 700 percent of GDP. France and the Netherlands rivaled each other, with liabilities at 400 percent of GDP. The banks of Germany and Spain had liabilities amounting to 300 percent of GDP. By this standard every member of the eurozone was at least three times more “overbanked” than the United States. Furthermore, Europe’s banks were far more dependent on volatile “wholesale,” market-based funding than their US counterparts.

  Given the size of the balance sheets and the complexity of Europe’s banking businesses, it was foreseeable that only collective action would be sufficient to bail out a crisis that could spread across the eurozone. To call for unified action to tame, discipline and make safe a particular sector of business activity was hardly out of keeping with Europe’s history. Indeed, the origin of European integration was the realization that Europe’s coal and steel industries were sources of conflict and instability. Out of that logic had emerged the European Coal and Steel Community as the first step toward the “European rescue of the nation-state.”49 Likewise, the Common Agricultural Policy had been devised in the 1960s to contain the spillover costs of national farm support policies. It was only in the 1980s that this sectoral vision of the EU went out of fashion, displaced by the deceptive simplicity of the single market. This was the true deficit of the eurozone. It was a monetary union that unified financial markets but provided none of the institutions of governance required for a banking union. If there was one urgent reason why Europe truly did need a fiscal constitution it was to provide the financial underpinning for a giant deposit insurance and bailout fund.

  In the late 1990s, as European Monetary Union approached, Larry Summers had the temerity to ask an international gathering of financial experts: “Could the Europeans here explain to me what happens if a bank in Spain gets into serious trouble? What are the respective responsibilities of the Spanish supervision authorities, the Spanish central bank, the ECB, and Brussels?” The question silenced the meeting. After an embarrassed pause there followed a “chaotic argument among the Europeans, which ended without resolution but with only a sense that they didn’t want to air their linen in front of the rest of us.”50 Looking back on the incident, Summers attributed the chaos and embarrassed silence to the usual disunity of European politics. But in truth it was not that different from the United States. No one in the United States wanted to think about bank failures either, not in 1997 and not in 2007. Indeed, as his reaction to Rajan’s impolitic remarks at the Jackson Hole conference in August 2005 made only too clear, Summers was one of the “very serious people” enforcing that taboo. The state of denial was common. The difference was that when the unthinkable happened, the United States had a structure of federal government within which to improvise a response. The misfortune of the EU was that when the crisis struck, it not only lacked such structures. The crisis came at a moment when the EU’s efforts to build a more robust constitutional framework had run up against basic political limits.

  European Bank Liabilities as % of “Home” GDP, 2008

  Note: As of 2008.

  Source: https://qz.com/19386/europe-is-still-massively-overbanked-by-the-way/. Based on data from Barclays Research.

  Up to the early 2000s, the EU operated against a backdrop of what political scientists called a “permissive consensus.”51 Europe’s population accepted the gradual push for ever closer union without enthusiasm but also without protest. The EU is not an obtrusive presence. Contrary to prevailing myth, the EU is by no means a gigantic bureaucracy. The EU employs fewer people than most medium-sized cities. But it was a sprawling, incoherent constitutional structure lacking in democratic accountability. It was clearly unsatisfactory and would become even more so once the EU expanded in 2004 to include new East European members. In December 2001 the European Council charged a European Convention with drafting a constitutional document that would ensure efficiency, clearer lines of responsibility and prepare the way for Europe’s expansion. The convention consisted of a commission of bigwigs headed by that old warhorse of French Europeanism former president Giscard D’Estaing.52 The proposal enshrined a new balance between centralized decision making by majority vote and the irreducible role of the European nation-states. It subordinated all the various institutions and treaties that had made up the pillars of European integration into a single overarching European Union. Europe’s ambition was defined as being a “social market economy” that prioritized full employment, “social justice” and “solidarity between generations” as well as the fight against “social exclusion and discrimination,” while also promising to be “highly competitive.”53

  The constitution was a pleasing portmanteau of all the nostrums of good governance of the early 2000s. The European Trade Union movement gave its approval. Tony Blair and Britain’s New Labour government were enthusiastic. In Washington, DC, the Hamilton Project would probably have been pleased to put its name to it. But on May 29, 2005, the constitution was rejected by popular referenda in France and then, in June, in the Netherlands. Left-wing hostility to the promarket character of the EU and nationalist hostility to Brussels united to deliver solid majorities against it. It was a profound shock. The permissive consensus was dead. Whatever the rights and wrongs of the constitution, popular democracy had asserted itself and Europe’s elite were left in disarray.54 Given the reality of increasingly close economic and financial integration and the extension of the EU to Eastern Europe, the project of reorganizing Europe could not simply be abandoned. A substitute had to be found. If a true constitution was no longer a viable proposition, Europe would have to proceed by the tried-and-tested formula of intergovernmental treaty. This gave a key role to Germany, and from November 2005 this meant Chancellor Angela Merkel.

  Merkel’s relationship to Europe was quite different from that of her mentor Helmut Kohl.55 Given her upbringing in cold war East Germany, her early fascination with the outside world was directed first to Russia and then to Britain and the United States. This was of a piece with her embrace of globalism and its causes of the 1990s, including environmental politics and climate change. The unified Germany is what made her. Beyond that, Merkel’s world was larger than Europe. The crucial implication is that in European affairs the German chancellor did not look to Brussels for
solutions. She was no federalist. Rather than seeing the future of Europe in the construction of common European institutions and machinery directed from Brussels, Merkel advocated intergovernmentalism. She looked for grand bargains between the European nation-states. There are those who suspect that this is merely a disguise for a project of German domination.56 There were nationalists on the fringes of German politics of whom this might truly be said. But Merkel was not one of them, nor were other key figures in the CDU leadership, such as her interior minister, Wolfgang Schäuble, who would in 2009 replace Steinbrück as finance minister in Merkel’s second government. Unlike Merkel, Schäuble was a federalist, eager to move the hard core of Europe to a higher stage of integration. What they shared was not a desire to dominate Europe. There was no grand hegemonic project in early-twenty-first-century Berlin. What they had in common was their belief that it is not just Germany’s right but its proper historical role to act as a self-confident veto player in European affairs. Germany’s terrible history forbids strategies of domination or even overly assertive leadership. But the success of the Federal Republic gives it the right to insist that European solutions meet its standards, and Berlin will apply those standards as it sees fit. It was a minimal, demanding and sometimes arbitrary and self-serving posture. The position of “Madame Non” that Merkel only too readily assumes in European affairs was strongly backed by the domestic electorate. If it was a blind spot, it was not a repressed desire for domination but a tendency to underestimate the extent to which Germany’s success and international prominence were in fact interdependent with Europe. It also arrogated to Germany the right to set the pace. A veto costs time, and in an urgent crisis, whether in financial or foreign affairs, time lost can exact a heavy price. The more acute the crisis, the more decisive is the control over the clock exercised by the veto player. As Europe entered rough waters it was predictable that both the fear of “German domination” and calls for German leadership would intensify. So too would Berlin’s determination to control the pace of events.