Crashed

by Adam Tooze

  Dublin did not surrender without a fight. To find itself pushed into the financial emergency ward alongside Greece was a humiliating shock. So the ECB applied main force. On November 12 the ECB Governing Council threatened to withdraw support from the Irish banking system while leaking to the media that Ireland was about to apply for a bailout. On November 18 the Irish central bank chairman, Patrick Honohan, fresh from an ECB meeting in Frankfurt, contacted Irish broadcaster RTÉ to say that a national bailout was only days away.66 On November 19 Trichet spelled out to the Irish prime minister in a confidential letter the conditions under which the ECB would be willing to extend its assistance to the Irish banks.67 Dublin must immediately apply for aid and submit to the instructions of the troika. It must agree to an urgent program of further fiscal consolidation, structural reforms and financial sector reorganization. The banks must be fully recapitalized and the repayment of the ECB’s short-term financing for the Irish banking system must be fully guaranteed.

  Despite the exorbitant quality of the ECB’s demands, on November 21 Dublin had no option but to comply. The Irish Times responded with a remarkable editorial that captured the mood of national humiliation. It was emblazoned with a line from Yeats’s elegy to romantic Irish nationalism, “September 1913”—“Was it for this?” Was it for this, the paper asked, that Irish nationalists had fought their centuries-long struggle: “a bailout from the German chancellor with a few shillings of sympathy from the British chancellor on the side. There is the shame of it all. Having obtained our political independence from Britain to be the masters of our own affairs, we have now surrendered our sovereignty to the European Commission, the European Central Bank, and the International Monetary Fund.” But rather than lapsing into self-pity, the Irish Times went on: “The true ignominy of our current situation is not that our sovereignty has been taken away from us, it is that we ourselves have squandered it. Let us not seek to assuage our sense of shame in the comforting illusion that powerful nations in Europe are conspiring to become our masters. We are, after all, no great prize for any would-be overlord now. No rational European would willingly take on the task of cleaning up the mess we have made. It is the incompetence of the governments we ourselves elected that has so deeply compromised our capacity to make our own decisions.”68

  For all its brilliance, not the least remarkable thing about this editorial is where it put the blame. “The governments we ourselves elected” bore the historic guilt, not Ireland’s bankers, investors and their business partners across Europe and the wider world, not financial experts, economists and regulators. The loss of political sovereignty was no doubt painful. But who would really pay the price for “cleaning up the mess”? Would it be voters and taxpayers, or those who had profited from inflating the credit bubble? In the Greek case, at least, the debts were public. In Ireland taxpayers were being asked to pay for huge losses incurred by deeply irresponsible banks and their investors all over Europe. On December 7 Dublin announced a budget with a new round of 6 billion euros in cuts, half of what would have been saved if the bank bondholders had been haircut across the board. Instead taxes were raised on low-paid workers. Child-care allowances were cut and college fees were increased. Benefits for the unemployed, caregivers and the disabled were slashed.

  Setting aside the gross inequity of the troika’s demands, was it even plausible that Ireland posed risks of contagion comparable to Lehman? As Martin Sandbu of the Financial Times put it with rare force: “Lehman was a global bank.” Its business “was at the heart of the world’s financial plumbing.” Not rescuing it proved to be a disaster. The Irish banks, by contrast, were “a small racket in Europe’s financial periphery, busily and exuberantly losing . . . investors’ money in the time-honoured way of lending more for houses than they were worth.” Nothing “systemic” depended on their creditors being repaid in full.69 Of course there was some risk of spillovers. But if French and German banks suffered collateral damage, that was because they had participated so enthusiastically and profitably in the Irish boom. Given that responsibility was so widely spread, was it reasonable to impose the entire cost of containing the fallout on Ireland’s taxpayers alone? As Ajai Chopra of the IMF later remarked: “Yes, there would have been spillovers. But . . . the ECB could have stepped in. . . . That’s what a central bank is for, to deal with these sorts of spillovers.”70

  But that was not the kind of central bank the ECB thought itself to be. On November 26 its representatives in Dublin made clear that if haircutting was involved, there would be no bailout. A day later the IMF team in Dublin received direct instructions from Washington to drop any further efforts to enroll the banks. The finance ministers of the G7 had let Dominique Strauss-Kahn know that none of them welcomed talk of haircuts, and this was particularly true of the United States. As Tim Geithner later put it: “I was on the Cape [Cod] for Thanksgiving, and I remember doing a G7 call . . . in my little hotel room. . . . I said, ‘If you guys do that [haircuts], all you will do is accelerate the run from Europe. . . . [U]ntil you have the ability to in effect protect or guarantee the rest of Europe from the ensuing contagion, this is just [a] metaphor for our fall of ’08.’”71 With the IMF heretics silenced, the Irish were left with no alternative. Prime Minister Lenihan admitted resignedly: “I can’t go against the whole of the G7.” For Ireland to haircut unilaterally would be “politically, internationally, politically inconceivable.”72 On November 28 Ireland agreed to accept 85 billion euros in emergency loans: 63.5 billion euros from the troika; the rest came in the form of bilateral support from other EU members, notably the UK, whose own financial markets had contributed so much to the debacle.

  Band CDS Spreads

  Source: William A. Allen and Richhild Moessner, “The Liquidity Consequences of the Euro Area Sovereign Debt Crisis,” World Economics 14, no.1 (2013): 103–126, graph 2.3.

  Another deal was sewed up. Debts would be honored. The population of Ireland paid the price. A “Lehman moment” was avoided. But the result was not to restore confidence to the markets. The European financial crisis could not be contained by transferring the costs to taxpayers on a nation-by-nation basis. The resulting bailouts preserved the form of stability, but were not credible in their substance. In two surges, first in the spring and then in the fall of 2010, spreads on European bank credit default swaps—the price of insurance against default on bank bonds—surged above those charged to American banks. The first trigger was Greece, the second was Ireland. Europe’s financial crisis was simply too big and too interconnected to be handled on a national basis. The losses needed either to be pushed down to the investors all across Europe who had profited from the banks’ unsustainable business models or to be raised to the level of a coordinated European bailout. Extend-and-pretend on a national basis merely turned banking crises into fiscal crises, which widened uncertainty while deflecting attention from the real issue.

  IV

  In their defense, legalists at the ECB would argue that the central bank’s mandate gave it only one objective, price stability. They could derive from that an obligation to maintain the functioning of Europe’s financial markets and Europe’s banks. And Trichet would thus justify his interference in Greek and Irish affairs and more to come. What the ECB did not have was a mandate to concern itself with the economic welfare of the eurozone or its member states in any broader sense. It was a willfully simplistic and conservative interpretation.73 It was ruinous for the eurozone. The crisis would begin to be overcome only when the ECB began to step beyond it.

  The Fed never took such a narrow view. It had a mandate both to preserve price stability and to maximize employment. This was a legacy bequeathed by the more broad-gauge economic policy debate of the 1970s. But it was anchored deep in the Fed’s organizational DNA by the memory of the Great Depression. The deflationary misery of the 1930s was the defining event in the Fed’s history. That was the history that Bernanke had pledged not to repeat. In 2010
the United States had survived the worst of its crisis. But it was far from fully recovered. The housing market was still in shock. The percentage of outstanding mortgages in foreclosure proceedings was heading toward a grim record over the winter of 2010–2011 at 4.64 percent—more than 2 million homes. Since early in 2010 Bernanke had been sounding the alarm about an excessive tightening of fiscal policy. On the afternoon of November 3, the day after the dramatic midterm congressional elections, the Fed announced its response. After an intense internal debate, the Federal Open Market Committee resolved to begin purchasing securities at the rate of $75 billion per month for the next eight months. QE2 had arrived.

  How exactly quantitative easing works remains a subject of controversy.74 Large-scale purchasing of mainly short-term bonds drives up bond prices and thus reduces yields. Reduced short-term rates may help to lever down long-term rates and thus to stimulate investment. But that depends on there being businesses willing to invest, which cannot be taken for granted at a time of crisis. The most direct effect of QE comes via financial markets. As the central bank hoovers up bonds, it drives down yields, forcing asset managers to go in search of yields in other classes of assets. Switching out of bonds into stocks inflates the stock market, increasing the wealth of those with stock portfolios, tending to make them more willing to both invest and consume. This, to say the least, is an uncertain and indirect method of stimulating the economy. By boosting the wealth of already wealthy households, it is predestined to increase inequality. Low-income households have no way of participating in capital gains.

  QE was never anything other than an emergency expedient adopted by the Fed in light of the fiscal policy logjam in Congress. But the Fed itself was not insulated from the polarization of American politics.75 The FOMC vote on QE2 was split three ways. A vocal minority argued that the stimulus should have been much larger. The markets had already priced in a QE2 announcement at $75 billion. To have a substantial impact the Fed needed to deliver a surprise. Bernanke demurred. He did not want to stray too far beyond the sense of “normality” because to do so might in fact stoke a mood of anxiety and thus be counterproductive.76 As Bernanke put it at the meeting to critics on the board: “There is no safe thing to do. . . . I’d like to frame our decision today as a very conservative, middle-road approach, namely, we recognize that doing nothing carries serious risks of further disinflation and of a failure of the recovery to meet escape velocity.”77 On the FOMC there were also two votes objecting to QE2 not on the grounds that it was inadequate but because it was too expansionary.

  Beyond the Fed’s walls the reactions were more intemperate. In the superheated political climate of the Republican election triumph of November 2010, what hogged the headlines was the news that the Fed was embarking on a plan to “print” tens of billions of dollars every month. On the part of the conspiratorial right wing, Bernanke’s intervention reinforced the conviction that dark forces were at work. Glenn Beck warned his millions of Republican viewers on Fox that they should not be deceived by their congressional victory; the actual reins of power were held by liberal inflationists. What threatened America was a hyperinflationary “Weimar moment.”78 Meanwhile, a prominent list of conservative intellectuals, including—once again—historian Niall Ferguson and Amity Schlaes of the Council on Foreign Relations, joined Sarah Palin in calling on the Fed to “cease and desist.”79 Significantly, they pointed out that “[t]he Fed’s purchase program has also met broad opposition from other central banks” across the world. This was no exaggeration. After eighteen months of wrangling at the G20 over fiscal policy, QE2 produced an open rift over monetary policy.

  This was predictable, but it was not necessary. The two agenda-setting innovations of October and November of 2010—the Merkozy PSI agenda of Deauville and Bernanke’s QE2—could have been complementary. As Chopra of the IMF had laid out, the ideal accompaniment for aggressive debt restructuring in Ireland would have been an ECB bond-purchasing program designed to insulate the other fragile members of the eurozone from the fallout. The push for PSI and bond market intervention were both responses to the inadequacy of the course embarked upon in Greece in May 2010. But in the eurozone the two never joined hands. Instead, rather than seeing QE as the necessary accompaniment to a more sustainable resolution of the eurozone debt crisis, Berlin’s conservatives led the international front against monetary experiments.

  The Fed announced QE2 only days before President Obama and his team departed for the latest G20 summit, this time in Seoul. There they met unprecedented criticism. In the words of one of the US Treasury officials who ran the gauntlet, Seoul was a “**** show.” The Brazilians, as the putative leaders of the left wing of the emerging markets, inveighed against the risks of hot money and accused Bernanke of a beggar-thy-neighbor devaluation of the dollar. They warned of a “currency war.”80 For the Chinese, the Fed’s action was a sign that “[t]he United States does not recognize . . . its obligation to stabilize capital markets,” as Zhu Guangyao, China’s vice finance minister, put it. “Nor does it take into consideration the impact of this excessive fluidity on the financial markets of emerging countries.”81 Wolfgang Schäuble went furthest. Once more America had revealed itself as an agent of global economic disorder. First it had created the fiasco of Lehman. Then it had championed stimulus. Now the Fed was monetizing public debt. As the G20 convened, the German finance minister denounced American economic policy as “clueless” and as likely to “increase the insecurity of the world economy.”82 The Fed’s policies made “a reasonable balance between industrial and developing countries more difficult and they undermine the credibility of the US in finance policymaking.” Whereas Germany had stuck with its model of export success that did not need “exchange rate tricks,” the “American growth model” was, according to Schäuble, “in a deep crisis. The Americans have lived for too long on credit, overblown their financial sector and neglected their industrial base.”83

  The Americans did not go down without a fight. Tim Geithner countered that the real source of imbalances in the world economy was not US monetary policy but the mercantilist trade policies of China and Germany. The Fed was not deliberately depreciating the dollar. It was targeting domestic conditions, not the exchange rate.84 If others wanted to prevent their currencies from appreciating, all they had to do was to match the Fed’s low interest rate policy with an expansion of their own. What the critics dubbed a “currency war” could thus have been turned into a comprehensive program of monetary expansion, countering the slide into a double-dip recession not just in the United States but in Europe as well. If they didn’t choose to join the stimulus, then all they had to do was to allow their currencies to appreciate, which, as Washington had been preaching since the early 2000s, would restore balance naturally. It was Germany’s export dependence and China’s determination to peg its currency that put the United States in charge. If they wanted to free ride on American aggregate demand, they should at least have the grace to do so quietly. If there were grievances, Geithner suggested, why not agree to allow the IMF to resume the project begun before the crisis, of monitoring and overseeing international imbalances, not only America’s deficit, but China’s and Germany’s surpluses as well.85 But that was a nonstarter. Germany would never admit that its trade surplus was anything other than a reward for its competitiveness and productive virtue. The back-and-forth had the effect only of producing a dizzying moment of unreality. While tens of millions were without work and the European welfare state was hollowed out at the behest of the troika, Fox News terrorized its viewers with images of Ben Bernanke as a sorcerer’s apprentice unleashing Weimar-style hyperinflation and Germany’s finance minister denounced a proposal by the US Treasury secretary as reminiscent of the bad old days of Soviet-style “economic planning.”86

  Cash of Small/Large Domestic and Foreign Banks Versus Fed Band Reserves (in $ millions)

  Source: Federal Reserve, “Assets and Liabilities of
Commercial Banks in the United States—H.8,” https://www.federalreserve.gov/releases/h8/current/default.htm. Accessed 1 March 2018.

  While Berlin denounced QE as a source of instability, Europe’s banks took a very different view. For every billion dollars’ worth of securities the Fed purchased, it credited an account with a corresponding amount of dollars. But who was it that held those dollar accounts with the Fed and thus “funded” QE? As the Fed’s statistics show, it was not America’s banks that took advantage of QE to unload large portfolios of bonds or to hold cash, though some American pension funds and mutual funds did sell bonds to the Fed. The banks most actively involved in QE2 were not American but European, running down their US securities portfolios and building up Fed cash balances.87 From November 2010 there is a near one-for-one identity between the expansion of the Federal Reserve balance sheet and the expansion of dollar cash balances held by non-US banks with the Fed. This would suggest that, far from the Fed increasing the “insecurity of the world economy,” it was, in effect, acting as the world’s piggybank. As the eurozone stumbled back toward crisis, Europe’s banks abandoned the standstill agreement of May 2010. They shifted money out of Europe, shrank their US operations, deleveraged their balance sheets and built up a huge pile of cash. Thanks to QE2 they held that liquidity reserve not with the ECB but with the ultimate guarantor of the global financial system, the Fed. It was not a recipe for economic expansion. But in the absence of any solution to the eurozone crisis, it did at least promise a cushion of stability.