The Alchemists: Three Central Bankers and a World on Fire

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When the first fissures became visible to the naked eye in August 2007, suddenly the most powerful men in the world were three men who were never elected to public office. They were the leaders of the world’s three most important central banks: Ben Bernanke of the U.S. Federal Reserve, Mervyn King of the Bank of England, and Jean-Claude Trichet of the European Central Bank. Over the next five years, they and their fellow central bankers deployed trillions of dollars, pounds and euros to contain the waves of panic that threatened to bring down the global financial system, moving on a scale and with a speed that had no precedent.Neil Irwin’s The Alchemists is a gripping account of the most intense exercise in economic crisis management we’ve ever seen, a poker game in which the stakes have run into the trillions of dollars. The book begins in, of all places, Stockholm, Sweden, in the seventeenth century, where central banking had its rocky birth, and then progresses through a brisk but dazzling tutorial on how the central banker came to exert such vast influence over our world, from its troubled beginnings to the Age of Greenspan, bringing the reader into the present with a marvelous handle on how these figures and institutions became what they are – the possessors of extraordinary power over our collective fate.  What they chose to do with those powers is the heart of the story Irwin tells.Irwin covered the Fed and other central banks from the earliest days of the crisis for the Washington Post, enjoying privileged access to leading central bankers and people close to them. His account, based on reporting that took place in 27 cities in 11 countries, is the holistic, truly global story of the central bankers’ role in the world economy we have been missing.  It is a landmark reckoning with central bankers and their power, with the great financial crisis of our time, and with the history of the relationship between capitalism and the state. Definitive, revelatory, and riveting, The Alchemists shows us where money comes from—and where it may well be going.About the AuthorNeil Irwin is a Washington Post columnist and economics editor of the Post’s Wonkblog web site. From 2007 to 2012, he led coverage of the global financial crisis, recession, and aftermath as the Post’s beat reporter covering the Federal Reserve and other central banks. He has an MBA from Columbia University, where he was a Knight-Bagehot Fellow in Economic and Business Journalism. Irwin appears regularly on television analyzing economic topics, including on MSNBC, CNBC, and the PBS Newshour. He lives in Washington.Excerpt. © Reprinted by permission. All rights reserved.Introduction:Opening the SpigotOn August 9, 2007, Jean-Claude Trichet awoke at his childhood home of Saint-Malo, on the coast of Brittany, ready for a day puttering about in his motorboat and enjoying the company of his grandchildren. It was time for his summer respite after a busy year as president of the European Central Bank. Mervyn King, the governor of the Bank of England, had also planned a leisurely Thursday: He would make his way from his ?at in London’s Notting Hill neighborhood to the Kennington Oval, on the city’s south side, to watch the British national cricket team play India. Ben Bernanke, the chairman of the U.S. Federal Reserve, was alone among the three men who would guide the world through the convulsions of the half decade to come in having scheduled a regular workday. His security detail was to drive him from his Capitol Hill row house to the Treasury Department, where he had an early breakfast with Secretary Henry Paulson. Bernanke would eat oatmeal. For the three men, the day would not go quite as planned.At about 7:30 a.m., Trichet’s phone rang. Francesco Papadia, the head of the ECB’s markets desk, was on the line from the central bank’s headquarters in Frankfurt. “We have a problem,” Papadia said.Gigantic French bank BNP Paribas had announced that it was suspending withdrawals from three investment funds it managed. The funds were invested heavily in U.S. home-mortgage-backed securities that had become nearly impossible to value. Customers’ money would be locked up until the bank could ?gure out exactly how much the investments were worth. In itself, it was a tiny development: The three relatively obscure funds held only €1.6 billion in assets.But the announcement con?rmed the worst fears of bankers across Europe. They’d been worried for weeks about the losses they were facing on U.S. home loans. Supposedly ultrasecure mortgage bonds that had traded freely earlier in 2007 had by late July hardly been trading at all. As more and more people who’d taken out risky loans to buy a house in Tampa or Cleveland or Phoenix found themselves unable to pay them back, all the assumptions on which those loans had been made started to be called into question. Maybe all those AAA-rated securities weren’t really AAA after all. Had the banks poured vast sums into bonds that weren’t worth what they’d seemed to be? And if BNP Paribas couldn’t ?gure out how much its own funds were worth, how could any other bank know its real exposure to mortgage-backed securities?It’s not for nothing that the word “credit” derives from the Latin creditus, “trusted.” Banks use highly rated securities as almost the equivalent of cash— whenever they need more dollars or euros, they hand the bonds over to another bank as collateral. It’s one of the basic ways they ensure they have exactly the amount of money they need to meet their obligations on any given day. But when it came to those mortgage-backed securities in early August 2007, that simple exchange suddenly became complicated. The problem wasn’t just that the securities were worth less than they’d been before—after all, banks can deal with losses. It’s that no one knew just how much less—and whether, if one bank had lent money to another down the street in exchange for mortgage-backed securities, it would ever get paid back.Papadia and his staff spoke regularly with treasurers at twenty major European banks known as the money market contact group, and its members had been warning for days that, as one ECB official put it, an “infarction” was imminent. That Thursday morning, it hit: After the BNP Paribas announcement, with each bank out only for itself, the usual supply of cash was fast evaporating. “Trust was shaken today,” Deutsche Bank chief european economist Thomas Mayer told the New York Times. As one executive of a major global bank said later, “It was something none of us had experienced. It was as if your entire life you had turned the spigot and water came out. And now there was no water.”It’s a more precise metaphor than it may seem, for liquidity is exactly what was disappearing in the banking system that day. No longer were euros, dollars, and pounds as easy to come by as water. History has taught again and again that when banks shut down and hoard their money, so too do the economies they serve. A banker who’s unwilling to lend to other bankers is likely also to be unwilling to lend to the businesses and households that need money to build a factory or buy a house. If unchecked, the banking crisis in Europe could in? ict untold damage on the world economy. Suddenly, the European habit of taking a lengthy late summer vacation had become very inconvenient.Gather the Executive Board, Trichet instructed Papadia. He needed to talk to the six officials from across Europe who share the collective authority to deploy the resources of the central bank—including the ability to create euros from thin air. ECB staff in Frankfurt began calling around to various villas and retreats in Spain, Italy, and Greece to arrange an emergency conference call. Trichet normally used the walled medieval port town of Saint-Malo as a retreat from the world, a place where he could enjoy the water and read poetry and philosophy. But now it would become the nerve center from which he would manage the ?rst phase of the ?rst great ?nancial crisis of the twenty-? rst century.By 10 a.m., the full Executive Board was on the line. Trichet was emphatic: “There is only one thing we can do, which is to give liquidity.” The ECB, he insisted, must ?ood the banking system with euros. He was proposing that the central bank ful?ll its traditional role as “lender of last resort,” stepping in when private banks were pulling back, and using a novel means to do so. The ECB would abandon its usual practice of pumping some ?xed amount of money into the banking system and instead make an unlimited number of euros available to the banks that needed them. The technical term for what Trichet and the Executive Board did at 12:30 p.m. central European time is to offer a “? xed-rate tender with full allotment.”Translation: Come and get it, guys. We’ll give you as many euros as you need at 4 percent. Some forty-nine banks took €95 billion.The Federal Reserve Bank of New York maintains a markets desk to monitor what’s going on across the world of ?nance, but during the early hours of the morning on the East Coast that Thursday, only a handful of young staffers were on duty to monitor overnight activity. It would take hours for the news to make its way to New York Fed president Timothy Geithner, who was on vacation on Cape Cod, and Bernanke, who was getting ready for his breakfast with Secretary Paulson.At 6:49 a.m., Bernanke received an e-mail from Brian Madigan, head of the Fed’s monetary affairs division, explaining that “as you’ve probably seen, markets have sold off again overnight” and updating him on activity in the European bond and stock markets. But Madigan hadn’t yet received word of the ECB’s action. It was nearly half an hour later, as Bernanke’s black Cadillac sped along Independence Avenue, driven by an officer of the Federal Reserve’s own police force, before the chairman received the ?rst word that the ECB had done something unusual. A 7:16, an e-mail arrived from David Skidmore, an offi cial in the Fed’s press office: “Apparently Deutsche Bank had two money market funds fail and the ECB is making tender off ers for dollar-denominated assets. Glenn Somerville of Reuters, who I’ve been talking to, is heading to the Treasury press room early.”The details were wrong: It was BNP Paribas, not Deutsche Bank, three funds, not two, and the tender offers were denominated in euros, not dollars. But the gist was right: The ECB had intervened in markets in a way it never had before. And the most powerful man at the Fed was ?nding out about it through garbled rumors from a Reuters reporter. By the time he sat down for oatmeal with Paulson at 7:30, it was clear that something big had happened, even if no one seemed to be sure exactly what it was.It wasn’t until 8:52 a.m. that Bernanke got a more accurate update, in the form of an e-mail from Kevin Warsh, a Fed governor who often acted as the chairman’s emissary to people in ?nancial markets and at other central banks. “This action by the ECB sends two signals,” wrote Warsh, who had been working the phones all morning. “First, they are ready to provide liquidity to ensure the smooth operation of European money markets. Second, they are providing liquidity at their policy rate, and thus far not viewing a liquidity squeeze as a more fundamental reason to adjust its policy stance.” The Americans quickly understood that Trichet was trying to draw a bright line between what the ECB was doing for the ?nancial system and what it was doing to address any underlying weakness in the European economy as a whole.After breakfast, Bernanke went to his office at the white marble Eccles Building in Washington’s Foggy Bottom neighborhood. At 11 a.m., he met with a man named Lewis Ranieri, looking to pick his brain. In the 1980s, as a bond trader at investment bank Salomon Brothers, Ranieri had played a crucial role in developing the very concept of mortgage-backed securities. In other words, he’d more or less invented the markets that were now imploding. At 2 p.m., Bernanke met with Raymond Dalio and others from the world of ? nance. Dalio managed the world’s largest hedge fund, Bridgewater Associates, with $120 billion under its control. He’d developed a sophisticated model for understanding what was happening with credit extension in the econ...