It is often said that economists failed to see a crisis coming in 2008. That is only half trueby Duncan Weldon / July 17, 2018 / Leave a comment
Published in August 2018 issue of Prospect Magazine
As the 10th anniversary of the fall of Lehman Brothers approaches, many books on the financial crisis will be published. Few are likely to match Adam Tooze’s Crashed in scope, ambition or rigour. This is truly contemporary history—the book runs right up to the end of 2017. It is hard to think of another author who can write as authoritatively on such a wide range of subjects—from the workings of the credit default swap market to the intricacies of Italian politics and the geopolitics of Ukraine.
Tooze, an Anglo-German historian based in the US, is best known for his work on the first half of the 20th century: The Wages of Destruction (2006), a revisionist account of the Nazi economy and war effort; and 2014’s The Deluge dealt with the aftermath of the First World War, and the reshaping of the global order in the 1920s. So Crashed might, at first sight, seem like a radical departure. But the essential themes are familiar territory for him: the interactions of economics, finance and geopolitics—and how the world order is reshaped by catastrophe.
The twist is that Crashed examines the financial crisis through a new lens: a sharp focus is kept on bank balance sheets, and the (often cross-border) capital movements between them. This is less a work of contemporary macro-economic history and more a work of contemporary macro-financial history.
The global depression of the 1930s can be understood in a traditional macro-economic framework—in terms of nation states, the collapse in their willingness to invest and consume, and the knock-on effect on their national income and budgets. Many have tried to explain our crisis in the same old frame. But in truth, it was different.
The integrated global economy of the 1990s and 2000s cannot be understood by focusing on what’s going on within and between nation states; instead you need to concentrate on the macrofinancial “interlocking matrix” of bank balance sheets, and how money flows between them—often without much regard for national borders. Capital controls had, after all, ceased to operate a generation or more earlier in most of the west: Britain’s were abolished in 1979 by Margaret Thatcher.
As Tooze sees it, switching our attention to the macrofinancial carries a number of implications: finance comes to be seen not as something that grows out of the “real economy,” but rather as an independent cause of change within it. It becomes necessary to grapple with the arcane structures of banks, shadow banks and still stranger institutions in the financial system, and to recognise that it is this private system—dependent though it is on central banks—that is in charge of the world’s supply of money.
Financial flows around the world have grown out of all proportion to output, trade or anything else. The world and its banks have been woven together in a credit nexus, which had many effects, both good and ill—and also created a new potential for a great unwinding. As Tooze writes: “What the Europeans, the Americans, the Russians and the South Koreans were experiencing in 2008 and the Europeans would experience again after 2010 was an implosion in interbank credit.”
It is often said that economists failed to see a crisis coming in 2008, but this is only half true. Before 2008 there was, as Tooze shows, a rising chorus of voices warning a crisis was imminent. The problem was that they predicted the wrong crisis. Using the old macroeconomic lens, they foresaw a crisis in which the patience of creditor countries like China would suddenly snap with persistent spendthrift societies and deficit nations, such as the US. But it turned out the crisis we got wasn’t about countries’ trading surpluses or national debts: it was about the sudden faltering of flows of purely private finance around a remarkably integrated international banking system.
The roots of the supposed crisis and the crisis we actually got in 2008 can both be traced back to the breakdown of the Bretton Woods system, which governed the global economy from the end of the Second World War until the early 1970s. Under Bretton Woods the value of the dollar, the anchor of the global monetary system, was nominally tied to gold while other currencies were pegged to the dollar. Cross-border capital movements were severely curtailed. When the costs of maintaining that system became too high for the US, Nixon unilaterally dropped the dollar’s gold peg and the whole system fell apart. In the 1970s, for the first time in modern monetary history, no currency was limited by the need to maintain its value against a metallic standard. The result was a staggering rise in inflation, which in the UK in 1975 exceeded 25 per cent.
The eventual settlement—which in its original form was known as monetarism, and later “neoliberalism”—was to replace gold as an anchor with the “logic of discipline.” Government budgets, it was argued, should strive for balance, central banks should keep inflation low.
By the mid-1990s, policy-makers across the developed economies were heaping praise on themselves for achieving “the Great Moderation.” Growth was steady and (outside of asset and real estate prices) inflation was low.
But amid the mutual backslapping at the G-7 summits and IMF meetings, the more nervous policy wonks began to fret about what were termed “global economic imbalances.” In particular, by the mid-2000s, the US was consistently running a large trade deficit—essentially financed by dollars it could print without needing anything to back them up, for so long as it could persuade the world they were worth what they claimed to be. That sounded like an almighty hole in the supposed logic of discipline, and with the US running a widening budget deficit alongside the trade deficit, the concern grew that the US could soon face a Wile E Coyote moment: that, like the hapless cartoon character pursuing Road Runner, the US economy had already run off the edge of the cliff but hadn’t yet realised it was no longer on solid ground. Eventually, many believed, the Chinese and other foreign investors would cease to regard bonds issued by Washington as a safe haven to invest in, and also lose confidence in the dollar as a store of value. The result would be a crash in the dollar’s value, a sharp rise in US interest rates and a large pickup in inflation.
What actually happened after 2008 was almost the polar opposite: the dollar surged, interest rates collapsed and the looming threat was not inflation, but severe deflation. Concerns before 2008 had concentrated on US public debt—but it was private debt that was the canary in the coal mine. In the early days of the crash, it was called the “subprime crisis,” because the trouble started when the markets woke up to the fact that cleverly repackaging mortgages owed by “subprime” borrowers (people who would struggle to repay) didn’t turn them into fundamentally safe assets. Before long, however, it was not a niche subprime crisis, but a “global financial crisis” and indeed a “Great Recession.” Subprime turned out to be a mere catalyst, not the underlying cause.
Sure, subprime lending in the US was important, and so too was financial innovation—if such lending practices can really be termed “innovation.” But that innovation was itself dependent on wider global forces. The 1990s had seen a series of crises in emerging markets—Mexico in 1994, Thailand, South Korea and Indonesia in 1997, Russia in 1998, Brazil in 1999 and Argentina in 2002. In each case investors had suddenly lost confidence and stampeded out, crashing asset prices and the currency’s value and leaving recession and the need for an IMF bailout in their wake.
China had no intention of being a victim of such an outcome. Its solution was to keep the value of its currency artificially low, which made its imports competitive and thereby enabled it to run big trade surpluses, through which it could acquire its own stock of foreign currency reserves—a buffer against ever needing the IMF. Between 2000 and 2009 the annual value of China’s trade surplus with the US rose to a colossal $227bn. To hold the value of the renminbi down against the value of the dollar, the Chinese authorities had to continually buy dollars and sell renminbi. In 10 years they acquired £1.19 trillion worth of financial claims on the US.
The logic of the global economy had been flipped on its head. Rather than capital flowing from rich nations to poor ones seeking a better return, poor farmers and factory workers in China were essentially financing the higher standard of living in the United States—funding their borrowing and subsidising their imports. This was vendor financing—when a sofa company, for example, lends you the money to buy its products—on a continental scale.
This was the source of what Federal Reserve Chair Alan Greenspan called his “conundrum.” In the mid 2000s, the Fed was raising interest rates as it sought to cool a growing economy and keep inflation in check. Despite more than a dozen hikes in short-term interest rates, the longer-term interest rates the government can borrow at—which, in theory, should depend on the market’s expectations of the path of short-term rates—refused to budge. Such was the insatiable demand of Chinese (and other surplus countries’) foreign reserve managers for US government debt that those long-term rates remained low.
The US financial system was awash with cash, and since the rates of return on government bonds were low, that cash had to be put to work elsewhere to gain a decent return. Whereas traditional macroeconomics might emphasise bubbly demand for credit during times when the mood is good, Tooze’s perspective is more concerned with the need of the great glut of Asian savings in a globalised economy to find somewhere to go. The result was subprime mortgages.
It stepped up another gear when the credit rating agencies, those supposed guardians of prudence, gave their blessing to the complex engineering, which essentially argued that adding together lots of risky investments into one investment created a less risky end product. But that was just the twist. The basic peril of the great flood of money from China was not that this tide of cash could suddenly turn; the real peril was the mood of abandon it induced in western banks.
This story of Chinese capital flows as the root of the crisis is an excellent starting point. Crashed becomes even stronger when it adds European banks to the picture.
Subprime mortgage origination, engineering and selling-on was a profitable business in the 2000s and the Europeans wanted a piece of the action. German banks were especially keen—and not just giants like Deutsche Bank, but smaller regional German Landesbanken too. Around one third of all the riskiest mortgage backed securities was issued by British or European banks.
Traditional macroeconomic analysis tends to focus on the flow of capital from China to the US, which is the corollary of its national trade surplus. But using a macrofinancial lens—which focuses less on national borders, and more on where the money is flowing—gives a clearer view. Capital may have been flowing into the US, but its financial system was part of a much larger trans-Atlantic banking system. By 2007, European banks had claims worth $2.6 trillion on the US banking system, while US banks had claims on the Europeans worth $1.6 trillion. As Tooze writes, for all the attention given to Asian money flows into the US before 2008, “the central axis of world finance was not Asian-American but Euro-American.” The upshot is that the European banks were just as implicated as US ones.
Some Europeans might like to think of 2008 as a story of the US spreading its contagion to Europe, and of the later euro-crisis of 2010-12 as a nasty complication, but in Tooze’s view, this is totally misses the point. For the original lending boom in the eurozone was just as spectacular as in the US. And as Tooze notes, “The flow of funds around Europe, as around the global economy, was driven not by trade flows but by the business logic of bankers, who compared the cost of funding and the expected return.”
The traditional post-crisis narrative that funds flowed mainly from the industrious and thrifty “core” economies of the eurozone to the more cavalier “periphery,” obscures as much as it reveals. In reality, Europe replicates in miniature the global picture ahead of 2008: while economies were still, to a large regard, “nationalised,” finance had become “globalised.”
Tooze is scathing about how this story of irresponsible bank lending in Europe was rewritten into a story of irresponsible borrowers; and how a crisis of American-European finance was somehow refashioned into a crisis of public debt. This analysis is unlikely to win him many friends in official circles in Berlin or Brussels.
The crisis was global and so were the (partial) solutions eventually found. Tooze notes the centrality of the efforts of US central bankers in bailing out the dollar-based system, not just through electronically creating money (quantitative easing) at home, but also through the very quiet provision of “swap lines” to other central banks. These swap lines give them direct access to dollars with which to support their own financial sectors (as he wrote about in Prospect’s August 2017 issue in “The secret history of the banking crisis”).
Crashed shines a much-needed light on this crucial global role of the dollar in the global economy. It is still absolutely central, which produces tension because it is inevitably managed—in general—not for the global good but for the benefit of the US. When the Fed is setting interest rates its primary concern is the domestic economy. They are, of course, not blind to the impact that the value of the dollar has on other countries but, in the jargon, these are regarded as the international “spillovers” of their monetary policy, which matter if they then “spillback” on to the US.
If a hike in rates, for example, was likely to hammer Mexican growth in a manner that would damage US exporters, then that will be taken into account—but only to that extent. In effect, a technocratic panel in DC is making decisions that will have a large impact on the lives of workers in countries as diverse as Mexico and Turkey. This has had, as we have seen in recent years, profound political consequences with populists and strongmen in the ascendant.
Towards the end of the book, Tooze casts his eye to the future. He wonders how Trump would have dealt with 2008. If another crisis does hit, then the US’s seeming abdication of global leadership, coupled with the eurozone’s failure to provide an alternative, may not make for a bright outcome. For the origins of the next crisis, he calls on us to look “not to America and Europe, the old hub of transatlantic globalisation, but to China and the emerging markets, where the future of the world economy will be decided.”
The closing chapters—covering Brexit, Trump, Emmanuel Macron and the 2017 German election—end abruptly with the publisher’s deadline. The Italian election earlier this year, in which populists triumphed, coupled with the new trade war started by Trump, feel like the start of the next, as yet unwritten, chapters.
Indeed, Tooze may have taken on a Sisyphean task in attempting to write a history of the crisis. As he himself notes rather chillingly, a 10-year anniversary publication on how the 1929 crash had reshaped global politics would have been published in 1939. But whatever happens next, Crashed is likely to stand the test of time as the best history of 2008 written in its immediate shadow.
Crashed: How a Decade of Financial Crises Changed the World by Adam Tooze is published by Allen Lane, £30