Crashed

by Adam Tooze

  Western European Banks’ Claims on Central and Eastern Europe (in $ billions)

  Source: Danske Bank Research, “Euro Area: Exposure to the Crisis in Central and Eastern Europe,” February 24, 2009, table 1.

  The takeover of Eastern Europe’s industrial base in the 1990s was just the beginning. By the end of 2008 Western-owned banks in the post-Soviet economies had extended $1.3 trillion in credits. These huge figures were not only the result of “foreign loans” but amounted to the wholesale incorporation of the local banking system. Whereas in the eurozone French, Dutch, British and Belgian banks channeled funds into hot spots like Ireland and Spain, in the former Communist world it was Dutch banks like ING, Bavaria’s Bayerische Landesbank, the Austrian Raiffeisen Bank or Italy’s UniCredit that took the lead.

  Across Eastern Europe, financial integration went “all the way down.” To an extraordinary extent, foreign currency loans were used to finance mortgages, credit cards and car loans. In Hungary, the most extreme case, between 2003 and 2008, the entire 130 percent increase in household debt was made up of foreign currency credit. What could signify your arrival in the West more clearly and in a more personal way than the fact that your newly privatized home was financed in Swiss francs?

  The impact of this simultaneous financial, political and diplomatic incorporation was transformative. In the main cities of Eastern Europe the material standard of living converged rapidly with norms in the West. And it is hardly surprising that this should have made an impression on the less-favored ex-Soviet republics farther to the east. By the early 2000s, many of the former Soviet republics seemed locked in a time warp. As Gorbachev’s foreign minister, Eduard Shevardnadze had been a darling of the West. By the early 2000s his personal regime in Georgia was so riddled with corruption that it could not borrow even from the IMF. Ukraine had suffered almost as badly as Russia in the economic collapse of the 1990s and showed little sign of recovering. The contrast to its Polish neighbor was painful. The “color revolutions” in Georgia and Ukraine in 2003 and 2004 were driven, above all, by the determination not to fall further behind and miss out on the dramatic changes going on farther west.15 The title of the main Ukrainian protest group PORA translates as “It’s time.” Its symbol was a ticking clock.16 The post-Soviet laggards had no more time to lose. In Ukraine the revolutionaries of 2004 were careful to preserve a geopolitical balance, opting for neither Russia nor the West. In Georgia things were simpler. Having turfed Shevardnadze out, by 2006 the new Western-backed government in Georgia headed by Mikhail Saakashvili was glorying in its new status as “Top Reformer” accredited by the World Bank. Georgian soldiers were soon on their way to support the coalition in Iraq.17 Brussels might profess that “the EU does not do geopolitics,” and that slogan suited policy makers in old Europe, particularly Berlin. But to the bevy of new accession states that joined both NATO and the EU between 1999 and 2007 this made little sense. European integration and NATO were born together in the cold war. Their joint eastward expansion since 1989 was the result of the defeat of the Soviet Union. As far as the new accession states were concerned, the historical logic linking the EU to NATO and thus to the United States was undeniable. Western integration promised security and prosperity. But it also harbored risks, both financial and geopolitical.

  III

  In the financial integration of Eastern Europe as across the emerging market economies, the currency question was paramount. There was no uniformity of currency regime in the former Communist countries.18 In the Baltics, Latvia opted for a straight peg against the euro managed and defended by the central bank. Lithuania and Estonia opted for currency boards under which the entire domestic monetary system was tied to the stock of euros held by the board. The Poles and the Czechs opted for free floats. Hungary allowed the forint to move within bands. Bulgaria adopted a currency board and Romania a managed float, under which the central bank intervened periodically to guide the movement of the foreign exchange markets within adjustable bands.19 What they had in common were the optimistic expectation of convergence with the EU and, in due course, eurozone membership. And these hopes were not merely paper dreams. The preemptive adaptation of Eastern Europe economies to EU conditions changed their way of doing business, how markets operated and who owned what. No less significant was the adaptation of their policy-making institutions and their cadres. Thanks to active involvement by the Bank of England and the ECB, the Eastern European states were, by the early twenty-first century, equipped with Westernized central banks, staffed by professional economists.20 No one was more enthusiastic about the prospect of eurozone accession than the central bankers. Alignment with Brussels and Frankfurt not only raised their status. It also shielded them against unwanted domestic political pressure. Soon they would be joining the global elite of central bankers.

  The result was that Eastern Europe reproduced on Europe’s doorstep the configuration of overoptimistic expansion that had led to the emerging market crises of the 1990s. Success stories of market reform and privatization, combined with freedom of capital movement and relative stability of exchange rates, led to a huge inward surge of capital. Capital inflow led to upward pressure on exchange rates. All the indicators looked good. But the entire constellation—the booming domestic economy, the appreciating exchange rate, the rising reserves—could all be traced back to a common factor: the huge inward surge of foreign capital. What if that surge reversed? What if there was a sudden stop?

  Under top-secret conditions, the IMF ran a simulation exercise in February 2007 role-playing its response to a reversal in Hungary, which was among the most exposed East European economies. So anxious were they to preserve secrecy and avoid a panic that the IMF’s IT department created a separate SimulationMail e-mail system to avoid notes from the game leaking to the outside.21 Hungary’s own central bank duplicated the simulation. Its results, it breezily informed a conference at the ECB in the summer of 2007, were reassuring. If there was one note of caution, it was a reminder that 60 percent of Hungary’s banking sector was in the hands of Belgian, Austrian, Italian and German banks. In the event of a crisis, if Budapest was to cope, it would need the closest possible cooperation from its West European counterparts.22

  Hungary’s situation was grossly unbalanced, but the situation in the Baltic states was even more extreme. In early 2008 the IMF noted that Latvia’s economy was overheating so badly that its imports exceeded its exports by an amount equivalent to 20 percent of GDP.23 According to the IMF’s models, its currency was overvalued by between 17 and 37 percent. While China and the United States were in deadlock over their trade imbalances, the IMF’s staff thought it might be less contentious to single out Latvia as a country with an undeniably “fundamental imbalance.” That turned out to be a miscalculation. Any public pronouncement on irrational exuberance in the Baltic was blocked by the Europeans on the IMF board. They wanted to keep the Baltics on track for euro membership and did not want to risk an IMF warning unleashing a chain reaction of uncertainty across Eastern Europe. The Swedes in particular were deeply concerned. Their banks had lent so heavily to Latvia that a crisis could easily spill back across the Baltic. Over the winter of 2007–2008, the Scandinavian representative on the IMF board went so far as to block the dispatch of the IMF delegation to Riga to complete Latvia’s regular Article IV report.

  No one in Europe wanted to burst the bubble. Latvia was enjoying a recovery from the doldrums of the 1990s. In the fall of 2007 its foreign ministry moved into the newly renovated building it had last occupied in the 1930s, when Latvia first enjoyed its independence from czarist Russia.24 As one retrospective commentator noted, there were high hopes that “Latvia would be able to extend its foreign policy presence beyond the transatlantic space and facilitate the development of closer ties between post-Soviet states such as Ukraine, Georgia and Moldova and the EU and NATO. It was estimated that Latvia’s development cooperation budget would grow rapidly, that L
atvia would open new embassies in faraway places and that entering Africa in order to help poorer nations to develop was only a matter of time.”25 To say that this was a transformation in the fortunes of tiny Latvia would be an understatement. It was a vision both expansive and fragile. It depended on two crucial conditions—the continuation of Latvia’s feverish economic boom and the acquiescence of its hulking neighbor to the east. Russia had watched as Latvia reclaimed its independence in May 1990. It had watched as Latvia conducted a referendum on EU membership in the autumn of 2003 that overrode the no vote of the ethnic Russian minority, and it had watched as Latvia, along with its Baltic neighbors, joined NATO in April 2004. Would Russia continue to watch as Latvia, and other countries like it, set about rolling back the Soviet-era boundaries of power even farther to the east?

  IV

  If the 1990s had been terrible for Russia’s economy, the new millennium brought a period of recovery. Vladimir Putin, who was confirmed as president by a landslide election victory in May 2000, will forever claim credit for Russia’s restoration. In fact, the turnaround in Russia’s financial fortunes already had been initiated in 1999 by austere former Communist Yevgeny Primakov, Putin’s political mentor. The collapse in the external value of the ruble jolted Russia’s export industries into life and curbed imports. But the key driver of the recovery was the global boom in oil and other commodities, which began months after Putin took office in the latter half of 2000. From $9.57 per barrel in 1998, the spot price of Urals crude would soar by 2008 to $94 per barrel. It would have taken catastrophic mismanagement for the Russian economy and Russian public finances not to have flourished. The questions were who would benefit from the boom and how would it affect Russia’s relationship with the outside world.

  Whereas in the 1990s large parts of Russia’s economy had been privatized, under Putin the energy sector was brought back under the control of the state, which in effect meant the oligarchic group around the president. In the energy sector, the corporate giants Gazprom and Rosneft were the battering ram of state industry. In October 2003 respectable opinion in the West looked on aghast as Mikhail B. Khodorkovsky—who, in the 1990s, had installed himself as the billionaire owner of private oil giant Yukos in a particularly egregious privatization deal—was arrested and imprisoned on charges of tax evasion.26 A year later, Yukos’s main assets were snapped up in a fire sale by a shell company that turned out to be a front for state-owned Rosneft. Meanwhile, Gazprom consolidated its grip on the giant gas industry by buying up Sibneft from Roman Abramovich, who retired out of harm’s way to London to enjoy life at the top of the Premier League as owner of Chelsea FC. In 2006 threats of prosecution forced Anglo-Dutch oil major Shell to sell its valuable Sakhalin assets to Gazprom. In 2007 the TNK-BP joint venture was leveraged out of another promising gas field. Though Rosneft and Gazprom were never merged, together they gave the Russian state a powerful corporate underpinning. By one calculation the share of government-owned firms in oil production in Russia rose from 19 percent in 2004 to 50 percent in 2008.27

  With the force of a booming, state-controlled energy business behind them, Putin and his team built on the measures put in place in the 1990s to restore Russia’s finances. Of Russia’s state revenues, just under 50 percent were accounted for by taxes and revenues from oil and gas. The profits would have been even larger if growth in output of oil and gas had not slowed disappointingly after 2005. Nevertheless, as the profits of the oil and gas boom rolled in, household consumption by ordinary Russians surged back to precrisis levels, rising at a rate of 10 percent per annum. By 2007 the percentage of the population below the subsistence minimum had fallen to 14 percent. And this was no longer the feverish, dollarized speculation of old. Prices were stable and were no longer set in dollars. Taxes were paid in rubles. The Russian parliament passed a law imposing fines on public officials who lapsed into the bad old habits of using dollars as a unit of account.28 On one occasion even Putin found himself embarrassingly caught out. From 2003, the Russian Treasury, headed by the technocrat economist Alexei Kudrin, used oil and gas earnings to accumulate a gigantic strategic reserve of international assets. By early 2008 these had reached $550 billion. After China and Japan, Russia was now the third-largest holder of dollar reserves in the world. On Putin’s orders a special staff assembled a national reserve of food and vital raw materials.29 Russia would never again suffer the kind of humiliating crisis that it had lived through in 1998.

  Russia could thus seem the very model of a national economic powerhouse, with a huge trade surplus, surging foreign reserves and a strong state. But the paradox of Russia’s position was that its new prosperity was associated not with independence from the world economy but with entanglement with it.30 And this entanglement extended beyond the export of oil and gas. Money was even more liquid and the pipelines connecting the offshore banking system were ready laid. Tens of billions of dollars in oil and gas export earnings never returned to Russia. Russia’s oligarchs behaved like the masters of a 1970s petrostate, harboring their wealth in offshore havens like Cyprus, from where it cycled back to London and its convenient eurodollar accounts. From the early 2000s the pattern was further complicated by a large flow of funds back to Russia. In 2007 this peaked at an annual total of $180.7 billion, of which only $27.8 billion was foreign direct investment (FDI).31 The rest flowed through international banks such as Sberbank and VTB into the Russian financial system. To prevent a sharp appreciation, Russia’s central bank, like that of China’s, found itself having to sterilize the dollar inflow by buying it up with freshly minted rubles. Having driven dollars out of domestic circulation, Moscow was now assuming an unfamiliar position as a de facto creditor to the United States.

  With the global commodity boom fueling Russia’s resurgence at the same time as West European money flooded eastward into the territory of the former Warsaw Pact, it was as if the two great weather fronts of global capitalism were charging toward each other across Eurasia. Did the contradictory geopolitical consequences of global growth, strengthening both Russia and its former satellites, make conflict inevitable? Certainly not from an economic point of view. The growth of the Polish and Baltic economies and the development of Ukraine, Georgia and Russia did not preclude each other. European exports to Russia flourished and all of Europe relied heavily on Russian gas. The question was whether a shared and interconnected prosperity could be given a common political meaning. Would it be cast as a foundation for a stable and prosperous international order? Or would the uneven but dramatic growth serve as fuel for a new arms race? Would interdependence come to be seen not as productive and efficient but as a source of vulnerability and threat? In the dark years of the 1990s the former Communist economies had experienced a common emergency. Exhaustion and disorder were shared. The common boom, ironically, would prove far more explosive.

  Given his background, Putin had far less reason to look favorably to the West than had Boris Yeltsin. But early in his term as president even his critics acknowledge that Putin seemed to be looking to Washington for acceptance.32 After 9/11 Putin overrode the hostile impulses of many Russian nationalists and gave ostentatious backing to the American invasion of Afghanistan. But the rapprochement was one-sided. Under Bush, Washington never took Russia seriously as an ally and refused to treat Moscow’s brutal war in Chechnya as part of the common fight against terrorism and “Islamic extremism.” Rebuffed by Washington, the divisions over the Iraq War provided Russia with leverage. Playing Germans against Americans was a game Putin was familiar with from his old days as a KGB resident in Dresden. Nor was it only Germany and America that were at odds. Germany’s preference for détente with Russia was a source of alienation also between Berlin and the East Europeans. When Germany and Russia signed the first Nord Stream pipeline deal in 2005, enormously increasing the flow of Gazprom’s gas to the West, it was denounced by Poland’s foreign minister as a second coming of the Hitler-Stalin Pact that had sealed Poland’s fate in 1939. W
hen Moscow tweaked Ukraine’s gas prices over the winter of 2005–2006, it only confirmed the Poles’ worst fears. By early 2006 Warsaw and Washington were calling for a new division of NATO to confront Russia on its chosen terrain of energy security.33

  But it wasn’t just gas supplies that were in play. In April 2006 at the meeting of the IMF and the World Bank in Washington, with central bankers Mario Draghi, Ben Bernanke and Jean-Claude Trichet looking on, Putin’s finance minister, Alexei Kudrin, shook hands with the American Treasury secretary. Kudrin had come to announce the repayment of a large tranche of international debt still owed to the Paris Club of creditors from the bad old days of the 1990s. But he had also come to deliver a less friendly message. The dollar, Kudrin declared, was in danger of forfeiting its status as the “universal or absolute reserve currency.”34 It was simply too uncertain in value. “Whether it is the U.S. dollar exchange rate or the U.S. trade balance, it definitely causes concerns with regard to the dollar’s status as a reserve currency.” Eight years on from the humiliation of 1998, when Russia’s finance minister spoke, the markets listened. Kudrin’s words were enough to send the dollar down against the euro by almost half a cent.