Stress Test

  “Extremely unhelpful and ill-considered,” she wrote.

  The desire to impose losses on reckless borrowers and lenders is completely understandable, but it’s terribly counterproductive in a financial crisis. In the United States, the FDIC’s insistence on haircutting WaMu’s creditors instantly panicked other creditors and raised borrowing costs for everyone else. In Europe, the talk of inflicting pain on Greece was having a similar effect on confidence and borrowing costs across the continent. The logic is inescapable: When lenders think a loan to WaMu or the Greek government will be worth pennies on the dollar, they get very cautious about extending new loans to anything that looks like WaMu or Greece, and very aggressive about calling in loans they have already extended. That rapid contraction of credit is what deeper recessions are made of, and that’s why talk about haircuts and default in Berlin was so damaging.

  Greece’s credit default swaps implied a 50 percent probability that it would default within five years; its two-year bond yields rose into double digits, while Germany’s remained below 1 percent. Italy came under severe pressure, and banks throughout the eurozone struggled to borrow dollars. We had a chilling scare on May 6, during a general market swoon triggered by concerns about Europe, when U.S. stocks suddenly plunged an additional 5 percent in a few minutes. The cause of this “flash crash” turned out to be a malfunctioning trading algorithm, but as it was happening we thought the fear in Europe might be spiraling out of control.

  “This sucks,” Rahm declared in a typically succinct email.

  On a G-7 conference call the next day, I told the Europeans they needed a much broader and more aggressive strategy to contain the crisis. The first and most important element would be a massive firewall to prevent the Greek inferno from spreading, a demonstration that Europe had the capacity and the will to prevent contagion. I also suggested that stronger European countries needed to start supporting growth across the continent, rather than adopting a generalized strategy of austerity, which would only lead to worse recessions, higher deficits, and a deeper crisis. Because of the monetary union, the weaker countries couldn’t devalue their currencies to ease their pain and boost their relative competitiveness; I thought the stronger countries at least ought to refrain from inflicting more pain.

  The Europeans said they actually were thinking about a firewall, a rescue fund of about 50 billion euros financed out of existing European Union funds. I was stunned. How would a pool of cash less than half the size of the loan to Greece reassure markets that the Europeans were willing to stand behind other countries? I interrupted before they could finish explaining their concept.

  “If you announce that, you’ll be laughed at,” I said. “You’ll be pouring gasoline on the fire. You should be thinking more like five hundred billion euros.”

  After huddling over the weekend, the Europeans announced a 500 billion euro rescue fund. The IMF indicated it would put up another 250 billion euros. And Jean-Claude Trichet announced that the European Central Bank would start buying the sovereign debt of Greece and other weaker European countries that private investors, spooked by the default fears and all the moral hazard rhetoric, had been abandoning in droves. Trichet, who had chastised me after the fall of Lehman destroyed confidence in U.S. financial firms, understood the danger of a similar run on European countries. He was a forceful advocate for escalation, complaining privately to me that Europe’s political leaders had no real understanding of markets and no idea how precarious the situation was.

  But the ECB couldn’t solve this itself. The most powerful country in Europe, Germany, was deeply committed to a strategy of austerity, and skeptical of forceful financial rescues. I had met Schäuble, a survivor of an assassination attempt that left him in a wheelchair, for the first time in Iqaluit, and I had found him compelling—direct, smart, strong. On substance, though, we were often far apart. He had a clear view: Greece had binged, so it needed to go on a strict diet. Other nations with unsustainable deficits had to do the same, even though it would cause pain for their citizens, even though many of them had been fiscally responsible before the crisis. Schäuble said Germany would slash its own budget in solidarity with the rest of the continent, to show that it wouldn’t ask for sacrifices it wouldn’t make itself. I thought that would just make the problem worse; in the near term, the German government and German citizens needed to do more spending and less saving.

  “You know, you sound a bit like Herbert Hoover in the 1930s,” I said. “You need to be thinking about growth.”

  The loan for Greece, the rescue fund for Europe, the ECB’s bond-buying program, and a Fed decision to reinstate its central bank swap lines did buy some calm. Markets came back a bit. European leaders also agreed to launch a round of stress tests for their banks, just as we had done. At times, they signaled a desire to take catastrophic risk off the table. German Chancellor Angela Merkel told President Obama and me that “we won’t do a Lehman,” which we took to mean that Europe wouldn’t allow a disorderly default of Greece. I thought Chancellor Merkel was smart and impressive, although I’m not sure the feeling was mutual; she turned to me in that meeting with the President and said Paul Volcker had told her I was “very close to the markets,” which I don’t think she meant as a compliment.

  Unfortunately, after building some credibility with the markets, the Europeans quickly squandered it, a pattern that would recur over time. They made a point of emphasizing that the Greek rescue was a one-off, reigniting fears about the rest of the continent. Their austerity targets for Greece seemed wildly unrealistic. They squabbled over the design of their new firewall, ultimately limiting its power. Investors again lost confidence in Europe’s ability to defuse the crisis.

  “It sort of feels like people are waiting for a rabbit to be pulled out of a hat,” Meg McConnell, my former New York Fed colleague, wrote to me on May 25, 2010. “Even the guy with the hat keeps peering in hopefully.”

  The initial European bank stress tests also inspired widespread scorn. They were virtually stress-free, concluding that eighty-four of Europe’s ninety-one largest banks already had enough capital, and that the other seven only needed another 3.5 billion euros. Two of those supposedly well-capitalized banks, Allied Irish and the Bank of Ireland, had to be rescued by the Irish government a few months after receiving their clean bills of health; their rescues would require twice as much capital as the stress tests had prescribed for the entire European banking system.

  The early fires of the European crisis contributed to the disappointment of our Recovery Summer. And Europe continued to burn in the fall. Ireland’s support for its failing banks was on the verge of bankrupting its government. Germany was pushing to make rescues from the new European fund conditional on haircuts for creditors—the euphemism was “private-sector involvement”—which further unnerved the markets.

  Meanwhile, austerity fever was spreading; Greece was the only country that had been exceptionally profligate in the lead-up to the crisis, but the bad economy was driving up deficits throughout the European periphery, which prompted some counterproductive anti-Keynesian efforts to tighten belts during a downturn. Spain and Portugal slashed spending in fruitless attempts to avoid ratings downgrades. The United Kingdom pivoted to austerity after David Cameron and the Tories ousted Gordon Brown, and would soon lapse back into recession. Meanwhile, Germany was pushing for a European fiscal union with the power to restrain the borrowing and spending of its members.

  French President Nicolas Sarkozy was understandably cool to the idea of giving Germany power over the budgetary decisions of other countries. Unfortunately, he defused this threat to French sovereignty by persuading Merkel to back off the fiscal union in exchange for his support for the German mandatory haircut policy. In other words, a European government would have to restructure its debt to be eligible for assistance from the European rescue fund. Not only was Europe failing to make a credible commitment that it wouldn’t allow a Lehman, it looked like it was committing to regular
WaMus. It was also increasingly evident that Greece’s initial rescue wasn’t going to be enough, and it wasn’t clear what would come next. Investors sprinted away from Ireland and Portugal, which looked like the nations most likely to need help. Their borrowing costs skyrocketed, which made it even more likely that they would need help, a frightening doom loop.

  By Thanksgiving 2010, Ireland’s government and banks clearly needed a rescue package. And Europeans were openly debating how deeply to haircut creditors. On another G-7 call, I told them that was crazy.

  “You’re going to accelerate the run,” I said. “Nobody’s going to lend to a European government or bank that’s showing weakness if they think you’re going to impose haircuts as a condition for your rescues. You’re undermining your defenses, and it’s going to cost you a lot more money in the long run.”

  Trichet was deeply concerned as well, as animated as I had ever heard him. We argued that the Europeans couldn’t force countries to restructure their debts until they had a credible plan to protect the rest of the system from contagion. The Lehman failure and the WaMu haircuts had been so disastrous in part because we didn’t have a firewall in place to protect other financial firms; Europe was similarly naked. I told them that at some point they might be able to safely restructure the debts of the weaker governments and banks, but right now they shouldn’t even be discussing it publicly. And making haircuts a necessary condition of all rescues would be like announcing that no loans to the weaker European banks or governments were safe.

  “You just cannot afford all this loose talk about haircuts,” I said.

  That weekend, the Europeans approved an 85 billion euro rescue for Ireland, and changed the proposed design of the permanent firewall. While they didn’t rule out haircuts, they agreed not to make haircuts mandatory. The markets rallied again, especially after Trichet suggested that “pundits are underestimating the determination of European governments” to end the crisis.

  I hoped that was true. But I suspected the pundits were right.

  BACK HOME, Republicans spent the fall of 2010 running a disingenuous Tea Party campaign against Big Government. They blamed President Obama for the budget deficit he inherited; they blamed the stimulus for the jobs problem it helped ease; they raged against the bank bailouts that saved the global financial system and the auto bailouts that saved the U.S. auto industry. They portrayed the President’s push for universal health insurance as the death of American liberty. With unemployment still hovering near 10 percent, the strategy worked. The midterm elections, as the President put it, were a “shellacking.” The Republicans reclaimed the majority in the House and gained six seats in the Senate. They pledged to slash spending, shrink the deficit, and force the federal leviathan to live within its means. They sounded more committed to austerity than the Germans.

  The national media were also caught up in the austerity fever, inspired by the Simpson-Bowles fiscal commission the President had created. On December 1, 2010, Alan Simpson and Erskine Bowles released a deficit reduction plan that mesmerized the Beltway. It called for $4 trillion in savings over ten years, including deep cuts in military spending, reductions in Social Security benefits, and an overhaul of the tax code that would raise $2 trillion in revenues. The plan would have been dead on arrival on Capitol Hill, but it never even arrived; the eighteen-member commission voted against sending it to Congress, with House Budget Committee Chairman Paul Ryan, the lead Republican on fiscal issues, among the no votes.

  There was a lot of good policy in Simpson-Bowles, including cuts in wasteful farm subsidies and increased infrastructure spending to boost growth, but the benefit cuts and tax reforms were pretty regressive and the health care savings very modest. Nevertheless, the plan would attain mythic status among Washington elites as a symbol of noble bipartisan seriousness. Our critics—including Ryan and other Republicans who wouldn’t accept any tax hikes under any circumstances, much less the $2 trillion in Simpson-Bowles—would cite the President’s failure to embrace it as proof of his irresponsibility. Larry had been wary of creating a commission we couldn’t control—he warned of “McChrystal risk,” a reference to the former U.S. commander in Afghanistan who ran a review of U.S. strategy that the White House thought boxed in the President—and, in retrospect, Larry was prescient about that, too.

  We were at the start of a big fight about how to get the government to live within its means—a fight worth having, but a little premature when unemployment was still above 9 percent and growth was still modest. We also faced a more immediate risk to the recovery.

  President Bush’s tax cuts were scheduled to expire on January 1, 2011, triggering a $3 trillion tax increase. For all their rhetoric about excessive debt, Republicans were still united in their allergy to taxes, especially taxes on the wealthiest Americans. They talked about reducing the deficit, but what they really wanted to reduce was spending, or at least nonmilitary spending. And while Democrats did want to let the Bush tax cuts expire for the top income brackets, the President wanted to preserve them for families earning less than $250,000 a year. He had vowed not to raise taxes on America’s cash-strapped middle class, and we were afraid that across-the-board tax hikes could push us back into recession.

  Republicans wouldn’t assume control of the House until January 2011, so the President and the lame-duck Democratic Congress—along with the Republican minority in the Senate, which could still filibuster legislation it didn’t like—would have to work together in December to avoid raising America’s taxes. Minority Leader McConnell made it clear that Senate Republicans would block any deal—and even any unrelated legislation—that did not extend all the Bush tax cuts, including the upper-income tax cuts.

  I thought the Bush tax cuts for the wealthy were unaffordable, unfair, and inefficient; extending them would provide windfalls for the Americans least likely to spend the extra money and stimulate the economy. In August, when Democrats were avoiding the tax issue during the campaign season, I had given a speech at the Center for American Progress making the economic case for letting top rates return to Clinton-era levels. “Borrowing to finance tax cuts for the top two percent would be a seven-hundred-billion-dollar fiscal mistake,” I said. I didn’t think it was too much to ask for the wealthiest beneficiaries of American freedoms to pay the rates they had paid in the 1990s to help their country pay for defense, health care, and other public investments that help give all Americans a chance to succeed. But my desire to restore slightly higher tax rates for the top 2 percent was not as strong as my desire to avoid a large tax increase on the bottom 98 percent. I also thought it was crucial to extend unemployment benefits and a slew of Recovery Act tax cuts that were about to expire. We couldn’t afford to dent the fragile recovery.

  Vice President Biden handled the negotiations, and at an Oval Office meeting on December 4, he outlined McConnell’s proposal: a two-year extension of all the Bush tax cuts, as well as a sharp reduction in estate taxes for a few thousand wealthy Americans. In return, Senate Republicans would be willing to extend unemployment benefits and some of the expiring Recovery Act tax cuts, but only if they were not “refundable,” which meant low-income taxpayers would no longer benefit.

  “We can’t accept that,” I said. “If they want to argue that we can’t raise taxes in a weak economy, then nobody’s taxes should go up.”

  I thought we should be willing to swallow two more years of the Bush tax cuts for the wealthy, but not if we had to add to the burden of the middle class and the working poor. After the meeting, Axelrod thanked me for saying what others were thinking.

  Over the next couple of days, McConnell agreed to most of what we wanted, although he insisted on keeping the egregious estate tax cuts for multimillionaires. We also engineered a clever switch conjured up by Gene Sperling, replacing the Making Work Pay tax cut for most of the American workforce—which Republicans hated because it was part of President Obama’s stimulus—with a one-year payroll tax cut. Not only was the payroll tax cut twic
e as large as Making Work Pay, but Gene (correctly) suspected that Republicans would agree to extend it again in 2011 rather than risk being portrayed as payroll tax hikers.

  On December 6, the President announced an $857 billion bipartisan deal. It was essentially another stimulus, although naturally we didn’t use that eight-letter word; despite all the austerity talk, we would avoid massive tax hikes and continue to give the economy some needed support. The upper-end Bush tax cuts and estate tax cuts were the weakest kind of stimulus, and they were anathema to many congressional Democrats. But they amounted to less than one-seventh of the package. The rest of the deal would benefit low-income and middle-class Americans, and private forecasts suggested that it would create more than a million jobs.

  Once the deal was done, McConnell kept his word to let the Senate resume its business, enabling a final flurry of legislative activity before the Republican takeover of the House. Before the lame-duck session was over, the Senate would ratify the START Treaty, a landmark nuclear arms reduction agreement with Russia; Congress would repeal “don’t ask, don’t tell,” a major civil rights victory that allowed gays to serve openly in the military; and Republicans would stop blocking health benefits for first responders to the September 11 attacks. I attended the signing ceremony for the “don’t ask, don’t tell” repeal, the most moving event I had witnessed in public life. It was such a refreshing contrast to the ugly politics of the Hill, and such a noble achievement for the President, allowing men and women who protect our country to live and love honestly and openly. As much as the President would have liked to let the upper-end tax cuts expire, he got to accomplish a lot in return for extending them.