Seven Crashes, page 26
The expanding surpluses corresponded to high savings levels. They would have disappeared if there had been higher levels of consumption in the newly industrializing areas of the world. But the newly productive workers worried about their future in countries which had no organized social security provision for old age, and poor public medical care. There were also high levels of corporate and government savings, which held down demand and led to calls from the richer, older industrial countries that the new entrants should do more to boost global demand and hence growth.
Surpluses in the newly globalizing economies corresponded to deficits in some but not all major industrial countries. The phenomenon was most pronounced, and most analyzed, in the United States and the UK. In the early 2000s, Kenneth Rogoff, then chief economist at the IMF, warned about expansionist “Bushonomics,” driven by the large tax cuts of 2001 and 2003, when the government’s fiscal position moved from a surplus of 1.2 percent of GDP in 2000 to a deficit of 4.7 percent of GDP by 2003. Rogoff conjectured: “Suppose for a minute that we were talking about a developing country that had gaping current account deficits year after year . . . a budget ink spinning from black into red . . . open-ended security costs, and a real exchange rate that had been inflated by capital inflows. With all that, I think it’s fair to say we would be pretty concerned.”6 Mervyn King in the UK had delivered similar warnings. After the crisis, he put the issue together in a simple analogy of a sudoku game, pitting high savers in Asia against the Anglo-American low savers (see Table 6.1).
As King put it, the nine numbers in the simple table could not be chosen independently. Sudoku for economists was simpler than ordinary sudoku because only three numbers could be chosen. If both groups of countries wanted high or full employment levels, and the high-saving group was targeting a trade surplus, the low-saving group mathematically could not target a reduction in its trade deficit. “Either trade deficits must remain high, which is not likely to prove sustainable, or something else must give.” As King presented it, “Sudoku for economists shows that it is essentially a political and not a technical problem,” in which the low-saving countries (his own UK, or the United States) needed to stop acting in “the role of consumer of last resort.”7
Table 6.1. “Sudoku for Economists”: 2008 Data ($ billions)
Source: Mervyn King, speech at the University of Exeter, January 19, 2010
For the financial world, globalization meant something quite particular, not just the extension of manufacturing. Financial systems looked stable: the United States believed that Depression-era banking legislation including deposit insurance had solved the problem of bank runs; and the UK could point out that there had not been a major or generalized bank run since 1866, perhaps even since 1825. Lessons about financial instability that might have been drawn from previous crashes were thus ignored or forgotten. The United States was manufacturing debt that was then used to boost demand, and selling it merrily to the rest of the world, not just to the export-promoting superindustrializers. The braggadocios of Lehman Brothers put it quite brutally: “the Lehman financial guys tried to explain the need for globalization in the hope of obfuscating the bald truth, instead stressing the grand world expansion strategies that set us apart from the pack. That meant unloading the CDOs [Collateralized Debt Obligations] all over the planet, especially to Europe and Japan.” Richard Fuld of Lehman believed that globalization meant “decoupling from the US market because it was no longer all-powerful.”8 The Goldman Sachs trader who contemptuously referred to naive European banks and investors as “muppets” later explained: “Getting an unsophisticated client was the golden prize. The quickest way to make money on Wall Street is to take the most sophisticated product and try to sell it to the least sophisticated client.”9 Globalization could give greater access to unsophisticated money. The key linkage was the purchase of U.S. securities by European banks, which in turn financed themselves on the U.S. money market, in large part through the deposits in money market funds made by American retail customers.10
What eventually gave was the structure of credit in the United States. The crisis that shook the world in 2007–2008 unambiguously had its roots in the overblown financial system. At the time, it appeared as a collective nervous breakdown that originated in a collapse of property prices (see Figure 6.1). The mystery was how losses in the subprime sector, a relatively small sector of the U.S. housing market, could produce a general collapse of financial intermediation. The whole of finance suddenly looked like a minefield, where no one could know where the unexploded detonators lay, and in consequence financial players, and retail depositors, could trust no one. Large and complex financial institutions, vertically integrated and often including mortgage originating and repackaging, were vulnerable. The value of their assets, established by internal algorithms, was unclear and no market price existed. And then the collapse occurred. The interbank market, which had seemed an absolutely secure pool of constantly accessible liquidity, dried up as banks were unwilling to take on the suddenly unknowable risks of exposure to other financial institutions.
Figure 6.1. Residential housing price index for Germany, the United Kingdom, and the United States, 2005 –2020 (2005 = 100) (Source: St. Louis Federal Reserve FRED data)
The iconic event of the financial crisis, the failure of Lehman Brothers, occurred over the weekend of September 13 –14, 2008, with the bankruptcy filing on Monday morning, September 15. A slow-motion collapse was already well under way before the dramatic weekend negotiations. As funding dried up in the preceding week, it was apparent to everyone that Lehman would fail because the other banks had shut it off. On the Monday morning, the major newspapers, both the more free-market Wall Street Journal and the more liberal New York Times, welcomed the Fed’s and the Treasury’s decision to let an institution fail. Lehman was after all not a megabank (it was not Citigroup) and markets are supposed to punish bad behavior. It was only when it was clear that the Lehman failure would bring down AIG, a very large insurer and indisputably systemically important, that the authorities believed they were obliged to step in in order to prevent a universal collapse.
The result of the financial freeze was a sudden and abrupt economic downturn. Trade contracted, as ordinary commercial credit was unavailable. Unemployment soared, in the United States to a peak of 10 percent in October 2009. Manufacturing fell by around 20 percent, and new home construction by 80 percent. There was clearly a substantial output gap: the amount by which economic activity lay below potential. The IMF’s October 2009 World Economic Outlook calculated the output gaps as being −3.6 percent for Germany, −4.9 percent for the UK, and −4.5 percent for the United States: after revision, in 2020 the same figures were recalculated as −3.8 for Germany, −3.056 for the UK, and −7.403 for the United States. The extent of the U.S. collapse at the time, then, was underestimated.
The revisions are in part based on a downward adjustment of the growth paths of the western economies, more dramatically for the Europeans (and especially for Britain) than for the United States. The crisis produced a long-term scarring, affecting the chances of growth and pushing economies onto a slower path; and the longer the crisis continued, as in Europe, the greater the permanent losses inflicted by the downturn. Output losses and slower productivity gains were particularly pronounced in countries which had experienced major banking crises, and the effect was especially pronounced in the Eurozone.11 The shocks affected income and wealth distribution, and in consequence had a political effect of mobilizing populist discontent against the elite’s economic management. In the older economies, those countries with larger output and employment losses in the initial aftermath of the crisis registered greater increases in income inequality compared with their precrisis average.12
One of the additional drivers of a sense of crisis was the radical shift in the economic geography of the world. The past forty years of Chinese development had constituted the longest period of the highest rate of sustained economic growth in the economic history of the world. The date at which China was predicted to overtake the United States was constantly revised backwards in time. In 2003 a Goldman Sachs report estimated that it would be 2041; by 2007, before the severe financial crisis, that was revised to 2027; and after the financial crisis the Economist presented a calculation that showed 2019 as the date. In 2014, the Financial Times announced that “the US is on the brink of losing its status as the world’s largest economy, and is likely to slip behind China this year, sooner than widely anticipated, according to the world’s leading statistical agencies.”13 In 2020, the British economics consultancy Centre for Economics and Business Research forecast that China would overtake the United States by 2028, thanks to what at that time looked like a faster recovery from the Covid pandemic.
In retrospect, the 2007–2008 collapse appears as a debt crisis. The bid for home ownership was just one area where consumers, eager to acquire assets and a lifestyle they had once thought they could not afford, discovered they could use leverage.14 Continually rising property prices would make this a secure bet, as the value of the property would constantly increase and make the debt more affordable.
Low interest rates encouraged countries as well as individuals and corporations to borrow. But—unlike in the 1970s—governments in poorer or emerging market economies did not press to borrow, in part because of the legacy of the 1997–1998 East Asia crisis, which highlighted the dangers of indebtedness. Some of the most serious imbalances occurred within the industrial world, as central banks embraced solutions that made debt ever more affordable.
The official response went through two phases: first “big bazooka” rescues, followed by a reckoning with the fiscal but also the political cost. In the immediate aftermath of the sudden shock of 2007–2008, the financial sector—rescuing banks—was the focus of attention. The U.S. Treasury and the Federal Reserve planned measures to buy up problematic assets, so that the market would be given a floor. But the valuation was a very complex and time-consuming exercise, and so the U.S. administration turned to a simpler but apparently effective method that had been pioneered in the UK: recapitalize banks using government money, so that they would be in a position to carry eventual losses.15 This should prop up confidence. It was like treating a heart attack: the heart (financial services) needed to be massaged in order to restore circulation.
The same exercise was repeated in many rich countries. At the time, it was impossible to tell what the long-term fiscal implications would be: it was conceivable, after all, that the values of banks’ assets would recover, and that the government would in the end turn a profit on the deal. That happened in the United States, as well as in Switzerland; it did not happen in the UK or Ireland.16
The immediate financial rescue however looked like a public relations disaster for governments. The banks had largely caused the crisis through perverse incentives through which they (and their employees) took profits, but now proposed to socialize the losses: shouldn’t they be punished rather than rewarded?
It is possible to argue that a better course might have involved the reduction of unsustainably high debt, for American households, or for that matter for highly indebted countries such as Greece. Where debt meant insolvency, wasn’t the market answer the application of a “haircut”? A powerful book by Atif Mian and Amir Sufilater argued exactly that case for the central problem of highly indebted American households: that the mortgages that had provoked the subprime crisis should be written down, and that the application of such discipline would deter future overlending and misbehavior on the part of lenders.17 A substantial number of analysts, notably Kenneth Rogoff and Carmen Reinhart, made a similar point about country debt; prominent officials at the IMF pushed the same case in May 2010 as the Greek financial crisis erupted onto the international stage, and called on the advice of the world’s foremost expert in debt write-off, Cleary Gottlieb’s Lee Buchheit. What prevented the adoption of such a measure was the fear that it would spark market contagion, that other categories of debt and other countries would be affected, and that a debt restructuring would bring down a precariously balanced house of cards. There was an analogous argument in the case of American household debt, where it became clear that the problem lay not only in subprime mortgage debt, but much more widely, in the upper price segments of housing. The default rates had risen in areas where house prices had increased disproportionately as a result of high-income and high-credit-score purchases.18 In the middle of a crisis, the ramifications of debt write-off looked much too complex. Better to add purchasing power, boost asset prices, and stop any questioning of fundamental value. The easiest solution to a debt crisis was thus to add more debt.
The alternative of supporting consumers through fiscal measures was a crucial step in healing, and also a political necessity, and policy-makers might draw on the lessons of the Great Depression. In the initial phases of the crisis, the reaction to the demand shortfall was a traditional Keynesian stimulus. Former Treasury Secretary Larry Summers, who became an adviser to Barack Obama, called for a fiscal stimulus on December 19, 2007, saying it should aim to be “timely, targeted, and temporary.”19 On January 18, 2008, Treasury Secretary Hank Paulson announced a stimulus package: “Our economy is growing slower than expected, and that means we need to act quickly to put together a package that is temporary, simple enough to get enacted quickly, effective at boosting growth and job creation this year, and large enough to make a difference.”20 In November 2008, immediately after the election, Obama’s transition team recommended a $300 billion stimulus, and a month later raised the proposal to $600 billion. Berkeley economist Christina Romer proposed a much larger $1.7 to 1.8 trillion package, based on the size of a calculation of the output gap, but Summers objected to that; when this was brought down to $1.2 trillion, Summers told her, “$1.2 trillion is nonplanetary. People will think we don’t get it.” Thus the figure came down to $800 billion.21 The details of a $787 billion stimulus were quickly finalized, and the stimulus was launched on February 17, 2009, as “the most sweeping economic package in US history.”22 President Obama signed the legislation in Denver’s Museum of Nature and Science, intending to highlight how much of the spending was directed toward green jobs.23
In retrospect, the package was criticized by Democrats as inadequate, too small: Vice-President Joe Biden later noted, “And we paid a price for it, ironically, for that humility.” Democratic Senator Chuck Schumer concluded that “[w]e cut back on the stimulus dramatically and we stayed in recession for five years.” Another influential Democrat, Jim Clyburn, believed that “[o]ne of the—if not the—biggest mistakes that Obama made, in my opinion, was getting the Recovery Act done and not explaining to people what he had done.”24
The proposition that fiscal stimulus was needed was made at an international level too. In April 2009, the IMF argued that fiscal stimulus must be “at least sustained, if not increased in 2010, and countries with fiscal room should stand ready to introduce new stimulus measures as needed to support the recovery. As far as possible, this should be a joint effort, since part of the impact of an individual country’s measures will leak across borders, but brings benefits to the global economy.”25 Demand needed to be internationalized in order to ensure continuing prosperity.
With stunning speed, however, the world moved from an international consensus that fiscal stimulus was needed to deal with the threat of a new Great Depression to a concern about the long-term implications of the rise of debt and the threat of fiscal unsustainability. The causes of that reversal can be located in the psychology of financial markets, in the work of policy academics, in political maneuvers, in simple fatigue with both crisis and anticrisis measures, and finally in widespread frustration at the use of money in bank bailouts.
The first explanation focuses on financial markets, with bond vigilantes as the major villains. Their mantra was a much-quoted phrase of James Carville, an adviser to Bill Clinton, who responded to a rapid spike in bond yields in 1993 –1994 with a quip: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”26 In mid-2009, the bond market started to terrify. The yield on ten-year U.S. Treasuries had fallen from December 2008 (on December 18 the close was 2.77) to April, but from late April it started to rise and reached a close of 3.98 on June 10. On May 21, Moody’s Investors Service announced that it was “comfortable” with a AAA debt rating that would not be “guaranteed forever” against the backdrop of the United States’ deteriorating fiscal position, as a result of the need to borrow $2 trillion, or 14 percent of GDP.27
Edward Yardeni, who claimed to have coined the term “bond vigilante” in 1984, commented on the 2009 rise in Treasury yields, “Ten trillion dollars over the next 10 years is just an indication that Washington is really out of control and that there is no fiscal discipline whatsoever.” The investment manager and bond specialist Bill Gross claimed that “[t]here’s becoming an embedded inflationary premium in the bond market that wasn’t there six months ago.” Interestingly, the market was often personified as being China, as Chinese surpluses accumulated and were held in U.S. government securities: Chinese premier Wen Jiabao said in March that China was “worried” about its $767.9 billion investment in U.S. Treasuries. Former Fed Chairman Alan Greenspan was quoted as saying: “The yield spreads opening up imply that inflation premiums are rising. If we try to do too much, too soon, we will end up with higher real long-term interest rates which will thwart the economic recovery.”28 The Wall Street Journal commented, “It’s not going too far to say we are watching a showdown between Fed Chairman Ben Bernanke and bond investors, otherwise known as the financial markets. When in doubt, bet on the markets.”29 In Rio Rancho, New Mexico, Obama said, “We can’t keep on just borrowing from China. We have to pay interest on that debt and that means we are mortgaging our children’s future with more and more debt.” The foreign holders of American debt would eventually “get tired.”30
