Crashed

by Adam Tooze

  For macroeconomists this was a cause to celebrate the stabilizing properties of the modern tax and welfare state. For fiscal hawks it was a cause of deep concern. In the long run those debts would require higher taxes to service and repay them. This would pose major political challenges. And how would capital markets react? According to the script set out by conventional fiscal conservatism, one might have expected serious and immediate repercussions. Would the debt shock trigger the loss of confidence that Orszag and Rubin and so many others had warned about? How would savers be induced to hold trillions of dollars in government bonds? Would interest rates have to rise? Would this crowd out private investment? Would bondholders get jumpy? Would the bond vigilantes of the 1990s swing into the saddle, selling government bonds, driving Treasury prices down and yields up? In the spring of 2009, as the scale of the deficit became clear, business media reported that markets were up in arms. In light of “Washington’s astonishing bet on fiscal and monetary reflation,” the Wall Street Journal looked forward to a stern response from bond markets.23

  So serious were the rumblings and so painful were the memories of the Clinton era that in May 2009 Obama asked budget director Orszag to prepare a contingency plan.24 The budget director’s response was drastic. In the case of a bond market panic, the administration should severely hike taxes. The report was intended to be for the eyes of the president only. When Rahm Emanuel leaked it to Summers it provoked a towering fury. Summers threatened to resign and demanded that in the future he must have complete control of all economic policy input to the president. For all his rumpled, academic persona, Summers had a keen eye for power and could sense a new agenda of fiscal consolidation forming within the administration. This was a threat to his personal position. But it also violated his instincts as a “new Keynesian” economist. Summers might have censored Romer’s stimulus proposal, but he did not believe in the power of the “confidence fairies.”25 To be talking about budget cuts in the early summer of 2009, when the United States was about to hit the trough of the most severe recession since the early 1930s, was wildly premature. If confidence was the issue, the best way to restore it was to engineer a solid recovery.

  In the event, Summers and the other skeptics were proven right. There was no run against Treasurys. The bond vigilantes were a spook. America’s households were rebuilding their savings. Mutual funds were shifting out of risky mortgage bonds. Everyone wanted Treasurys. These were the kinds of systemic macroeconomic and financial mechanics that all too often escape fiscal hawks, who view the public budget like that of a private household. When the private sector is undergoing a shock episode of deleveraging, when the savings rate is surging as it was in 2009, what is needed to preserve the overall financial balance of the national economy is not for the state to cut its deficit too. Everyone cannot save at once without provoking a recession. As the proponents of “functional finance” have argued since the 1940s, the state must act as a borrower of last resort.26 In so doing it preserves aggregate demand and provides a flow of safe long-term bonds to financial markets. After the shock of 2008 the entire world was keener than ever to hold safe assets. A huge class of AAA-rated private label securities had shown itself to be far from safe, so the demand for Treasurys was huge. It wasn’t only Americans who wanted US government debt. As Treasury debt held by the public increased by $2.9 trillion between the summer of 2007 and the end of 2009, foreign buyers took more than half. Chinese holdings of Treasurys increased by $418 billion.

  Among those who were selling were some of the hardest-pressed banks. They needed to shrink their balance sheets. But that adjustment was cushioned by the central banks. In the first phase of what became known as QE1, on March 18, 2009, the Fed announced that it would purchase $750 billion in agency MBS and agency debt, as well as $300 billion in Treasury securities. The Bank of England made a similar announcement on March 9, committing to purchasing first £150 billion and then £200 billion of British government bonds, or gilts. So, far from swamping the markets with their debt, in 2009 yields on top-rated government bonds actually fell.

  In the eurozone things were more complicated. There too the automatic stabilizers kicked in and deficits ballooned. Debt issuance surged. But unlike in the UK or the United States, the ECB is barred from buying newly issued government securities. After Lehman, however, Trichet was in no mood to take risks. Though the ECB did not purchase newly issued government debt, what it did do was to repo sovereign euro bonds.27 As the eurozone deficits ballooned, the ECB operated what was known informally as the “grand bargain.”28 It supplied hundreds of billions of euros in cheap liquidity to Europe’s banks in the form of the so-called Long-Term Refinancing Operation initiated in May 2009.29 The banks then bought sovereign bonds. On average, the rate Europe’s banks paid to the ECB on the CTRO funding was only a third of the yield they earned on their bond holdings. All told, in the eurozone in 2009 the banks loaded up on 400 billion euros’ worth of sovereign debt.30 It was easy and apparently safe profit, and it was Europe’s most stressed banks, including Germany’s bankrupt Hypo Real Estate and Franco-Belgian Dexia, that were keenest to take advantage. Seeking to maximize their return, they put the ECB’s funds into the riskier peripheral bonds from Portugal and Greece that were offering a marginally higher yield. As in the UK and the United States, this helped to stabilize the government debt market, but there was a crucial difference. In the United States and the UK the central banks were pushing liquidity into the banking system. By contrast, in the eurozone, it was the balance sheets of the banks that absorbed the sovereign debt.

  III

  Fiscal stimulus was clearly necessary over the winter of 2008–2009. The automatic stabilizers were a welcome complement. Together they helped to revive the advanced economies in the worst crisis they had experienced since the 1930s. Thanks to general macroeconomic conditions and the intervention of the central banks, there was no run in the bond markets in either Europe or the United States. Nevertheless, already in the spring of 2009, anxieties about excessive deficits and the need for consolidation were to be heard on both sides of the Atlantic, and nowhere more so than in Germany.

  At the G20 in London, Merkel and Sarkozy had taken a public stance on the need for financial consolidation. In large measure this was political theater. Given the shock to Germany’s export sector, Merkel’s government could not ignore calls for a stimulus package. Unemployment was surging, and in the coming autumn the CDU and SPD had an election to fight. Early in 2009 Angela Merkel’s grand coalition brokered a deal. Finance Minister Steinbrück reluctantly agreed to a modest emergency package of extra spending and tax cuts.31 Automatic stabilizers would take care of the rest. But the question of fiscal consolidation that had preoccupied Merkel’s grand coalition since 2005 could no longer be dodged. The SPD and CDU agreed that even as they administered the stimulus, budget balance at both the national and regional levels of government would be enshrined in a constitutional amendment.

  This was not a resolution forced on Germany by panic in the bond markets or immediate financial necessity. German government bonds (Bunds) were for the eurozone what US Treasurys were for the dollar world, the safe asset of choice.32 Despite its gaping deficit in 2009, Germany had no difficulty selling debt. It was not markets but the cross-party consensus on fiscal consolidation that had emerged before the crisis that dictated a decisive and irrevocable turn toward austerity. It was a decision driven by a long-term vision of competitiveness and retrenchment, the lobbying of taxpayer and business advocates and the regional interests of the rich states of western Germany.33 It was a choice that would change the politics not just of Germany but of the eurozone as a whole.

  On Thursday, February 5, 2009, at a spartan Bundeswehr barracks in the precincts of Tegel Airport in the northern suburbs of Berlin, Chancellor Merkel personally brokered the deal.34 Under pressure from ultraconservative Bavaria, the fiefdom of the CSU, the Länder collectively committed themselves to a constitution
al amendment that would end all borrowing by 2020. Until 2019, the stragglers—Bremen, Saarland, Berlin, Sachsen-Anhalt and Schleswig-Holstein—would receive annual subsidies of 800 million euros. In exchange they would submit to the external review of their fiscal policy by a so-called Stability Council (Stabilitätsrat). Länder that refused to respond to the council’s advice would lose federal support. Germany’s federal government, for its part, agreed to bind itself by constitutional amendment to borrow no more than 0.35 percent of GDP under normal circumstances.35 There would be exceptions in case of cyclical shocks, but the cap was severe. It applied to investment as well as to current expenditure.

  No heed was given to the consequences that this draconian new rule would have for one of the largest bond markets in the world. Government bonds were seen only as a liability, not as a safe asset for savers. Austerity rhetoric ruled. Prime Minister Seehofer of Bavaria was jubilant. Chancellor Merkel declared a Weichenstellung (a change in the setting of the points). The debt brake was a demonstration that German federalism worked.36 On March 27, 2009, in the Bundestag, Steinbrück made a typically vigorous defense of the constitutional amendment. It was a matter not of macroeconomics but of democratic autonomy, of “fiscal room for maneuver.” Since the 1970s, despite notional debt limits, annual deficits had resulted in a budget in which 85 percent of federal spending was consumed by debt service and nondiscretionary spending. Fiscal politics were “petrified and devoid of life” (“versteinert und verkarstet”).37 Restraint on debt would give back to voters and parliament the freedom to choose their fiscal priorities. The antidebt consensus did not go entirely unopposed. Peter Bofinger, the maverick Keynesian member of the Wirtschaftsweisen, the official expert advisory committee on the German economy, was scathing in his criticism. If the German federal government was issuing no new bunds, where were German savers to invest the 120 billion euros that they sought to put aside every year? Because the German corporate sector was also generating a financial surplus, they could not on balance invest their funds in German businesses. Rather than funding investment at home, Germany’s savings would out of necessity flow into investments abroad.38 This was the financial counterpart to Germany’s chronic current account surplus, a symptom as much of repressed domestic consumption and investment as it was of export success. When it came to the Bundestag vote on May 29, 2009, the majority was wafer thin—68.6 percent as compared with the two-thirds required—but the amendment passed. It would take another two-thirds majority to undo it.

  It was a domestic matter first and foremost. But even before it had been carried in the Bundestag, the debt brake was being touted in Berlin as a major element in Germany’s foreign economic policy. The strong Deutschmark and the independent Bundesbank had made West Germany a model of conservative economic policy. The tough Hartz IV measures set a standard for “labor market reform” in Europe. Now the Schuldenbremse would become Germany’s latest instrument of conservative economic governance for export.39 For a politician of Merkel’s ilk, the problem of public debt, like the problem of inflation, was a problem affecting all advanced societies. It went back to the 1960s. It had built up over decades. Now was the time to make a stand. As Merkel headed to the G20 meeting in London she hailed Germany’s debt brake as a great achievement. As she told an audience at the German Chamber of Commerce: “We are going to have to try to transfer this to the whole world.”40

  IV

  At the London G20, the clash between Merkel, Brown and Obama had enacted familiar transatlantic stereotypes. The Germans were frugal and skeptical about Anglo-Saxon free-market finance. The Americans and the British were freewheeling advocates of whatever it took to keep the capitalist engine spinning. But this was a distortion on both sides. The Germans had plenty of fiscal problems of their own and bankrupt banks to match. Meanwhile, the Obamians were never the full-blooded high spenders that others painted them as. If Treasury Secretary Geithner urged the rest of the G20 to do more, it was in large part in the hope that America might do less. There were Democrats in Congress who wanted to make a major second effort and to push for another round of stimulus. But they got no help from the White House.41 Inside the administration, Christina Romer cut an increasingly lonely figure in her demand for a bigger fiscal effort. On occasion she would get the backing of Larry Summers. But when she became outspoken in favor of a second round of stimulus, as she did over the winter of 2009–2010, Romer was brutally silenced by Obama himself.42

  What began to prevail in Washington, DC, as in Europe from the late summer of 2009, were the fiscal politics of the precrisis period. The aim of fiscal “sustainability” returned to the fore. Geithner at the Treasury targeted a deficit of 3 percent by 2012, a huge tightening relative to the deficit of 10 percent of GDP in 2009. Even more aggressive was Orszag at the OMB, who ran in-house competitions for the best cost-saving ideas.43 All the Obama administration’s medium-term priorities tended to point toward streamlining government and trimming spending. The top political priority was health-care reform. Though this was tarred by Republicans as European-style socialism, given the bloated inefficiency of America’s publicly subsidized, profit-making health-industrial complex—which at 17 percent accounted for twice the share of GDP attributable to the financial services industry—the priority of the Affordable Care Act was to cut costs. Likewise, the thrust of Obama’s foreign policy was retrenchment. In 2009 the White House was persuaded to put more troops into Afghanistan, but only because it was simultaneously running down its Iraq commitment. America’s soldiers didn’t like it, but the age of major spending increases was over. Though the Obama stimulus crested in the second year of his presidency, this was offset in 2010 by cuts to other areas of federal spending and a crushing contraction in state and local spending. Though it suited no one to acknowledge the fact, between 2009 and 2010 Germany’s deficit was actually increasing more rapidly than that of the United States.44 Though the arguments were apparently more transparent, the politics of fiscal policy in the wake of the crisis were in their own way no less opaque than those that framed monetary policy.

  Chapter 13

  FIXING FINANCE

  “Confidence” is one of the most quicksilver concepts in economics. In 2007–2008 it had been the collapse in confidence in mortgage securitization, money markets and the banks that brought down the house and necessitated the bailouts. By 2009 confidence was still the problem. But now it was government deficits and the supposed threat of bond vigilantes that seized the headlines. Given actually prevailing conditions in bond markets at the time, the constraints this anxiety placed on fiscal policy were a triumph of precrisis centrist orthodoxy over the facts of the postcrisis situation. While the bond vigilantes never appeared, millons of jobless would pay the price for the failure to sustain fiscal stimulus. And the effects went beyond the labor market. The purpose of restraining fiscal policy was supposedly to maintain confidence and to create space for a private sector recovery. But where was that to come from? The real estate market was still collapsing. Households needed to pay down their debts and restore their overstretched finances. Uplift would have to come from business investment. For that there needed to be financial stability and easy credit, and from there the trail led back to the institutions that had actually been the source of the collapse of confidence in 2008, the banks and their dangerous balance sheets. Having excluded a full-scale fiscal response on grounds of protecting confidence, faute de mieux resurrecting the banks came to seem like the most promising path to recovery.

  Though the acute general panic of September 2008 had passed, the banks were still very fragile. As the full scale of the losses began to sink in—by May 2009 the IMF was estimating $1.5 trillion in write-downs around the world—default insurance premiums on bank debt surged to 300 basis points in the eurozone and 400 basis points in the United States.1 At those kinds of rates raising new bank funding was prohibitively expensive. And in the spring of 2009 Bank of America and Citigroup, two of America’s l
argest commercial banks, were still in danger.2 Bank of America was digesting the horrors of the Merrill Lynch balance sheet. At Citigroup the situation was even worse. Despite the double capital injection by the Treasury and the ring-fence around $300 billion of its most toxic assets, by May 2009 Citi’s shares were trading at 97 cents.3 The New York Fed was preparing plans for an all-out rescue effort that would involve guaranteeing all its debt and $500 billion in foreign deposits. Meanwhile, rather than recognizing the political trauma caused by the 2008 bailouts, the bankers in their self-satisfied insulation continued to help themselves to the lion’s share of whatever revenue they generated.

  In Britain, the most egregious case was RBS, a now majority state-owned bank that announced in February 2009 that it intended to honor £1 billion in bonus contracts.4 In the United States the figures were far larger. In the 2008 bonus season, after suffering tens of billions in losses, Wall Street paid out $18.4 billion to its top staff. That was two and a half times the amount that Congress approved for the president’s priority of modernizing America’s broadband infrastructure. Alternatively, if it had been retained by the banks, it would have made a substantial contribution toward their recapitalization.5 But the investment banks weren’t conventional public companies. They were partnerships run primarily for the benefit of their managerial elite and they expected to be paid, whatever happened. In the 2008 bonus season Merrill Lynch alone was responsible for $4–5 billion in payments. And it made sure to pay out earlier than normal in December 2008, just after the firm revealed a fourth quarter loss of $21.5 billion and days before it collapsed into the reluctant embrace of Bank of America.6 But of all the bonus scandals, the one that really caught the public’s attention was AIG. It closed its fourth quarter of 2008 with a loss of $61.7 billion, the largest in US corporate history. Nevertheless, on March 16, 2009, the company announced that its Financial Products division, which had been at the heart of the toxic spill, would be awarding $165 million in bonuses, a figure that might rise to as much as $450 million. Even President Obama expressed his “outrage” and demanded redress for America’s taxpayers.7 What was to be done?