The financial and economic crises of the Western world became visible in the summer of 2007 and reached their apogee in the autumn of 2008. The response was an unprecedented government-led rescue operation. That, in turn, triggered an economic turn-around in the course of 2009. But the recovery of the high-income countries was, in general, disappointing: output remained depressed, unemployment stayed elevated, fiscal deficits remained high, and monetary policy seemed, by conventional measures, unprecedentedly loose. This is beginning to look like a Western version of Japan’s prolonged post-bubble malaise.
 
One reason for persistent disappointment is that the Western crisis became, from 2010 onwards, also a deep crisis of the Eurozone. Crisis dynamics engulfed Greece, Ireland, Portugal, Spain and even Italy. All these countries were pushed into deep recessions, if not depressions.1 The price of credit remained high for a long time. By early 2013, the sense of crisis had abated. But chronic economic malaise continued, with no certainty of a strong recovery or even of enduring stability.
 
Meanwhile, emerging economies, in general, thrived. The worst hit among them were the countries of Central and Eastern Europe, many of which had run huge current-account deficits before the crisis. Like the members of the Eurozone in Southern Europe, these were then devastated by a series of ‘sudden stops’ in capital inflows. Other emerging and developing countries proved far more resilient. This was the result of a big improvement in policy over the previous decades. Particularly important was the move towards stronger external positions, including a massive accumulation of foreign-exchange reserves, particularly by Asian emerging countries, notably including China. This gave them the room to expand domestic demand and so return swiftly to prosperity, despite the crisis. Those emerging and developing countries that could not expand demand themselves were often able to piggyback on the stimuli of others, particularly China. That was particularly true of the commodity exporters. This represents an important – and probably enduring – shift in the world economy: the old core is becoming more peripheral. But the sustainability of the expansionary policies adopted by emerging economies, and so their ability to thrive while high-income countries continue to be weak, is in doubt. Particularly important is the risk of a sharp slowdown in the Chinese economy and the likely associated weakness of commodity prices.
 
1
 
From Crisis to Austerity
 
The central problem of depression-prevention [has] been solved, for all practical purposes, and has in fact been solved for many decades.
 
Robert E. Lucas, 20031
 
When I became Treasury secretary in July 2006, financial crises weren’t new to me, nor were the failures of major financial institutions. I had witnessed serious market disturbances and the collapses or near collapses of Continental Illinois Bank, Drexel Burnham Lambert, and Salomon Brothers, among others. With the exception of the savings and loan debacle, these disruptions generally focused on a single organization, such as the hedge fund Long-Term Capital Management in 1998.
 
The crisis that began in 2007 was far more severe, and the risks to the economy and the American people much greater. Between March and September 2008, eight major US financial institutions failed – Bear Stearns, IndyMac, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual, and Wachovia – six of them in September alone. And the damage was not limited to the US. More than 20 European banks, across 10 countries, were rescued from July 2007 through February 2009. This, the most wrenching financial crisis since the Great Depression, caused a terrible recession in the US and severe harm around the world. Yet it could have been so much worse. Had it not been for unprecedented interventions by the US and other governments, many more financial institutions would have gone under – and the economic damage would have been far greater and longer lasting.
 
Hank Paulson, On the Brink (2010)2
 
Hank Paulson is a controversial figure. For many Americans, he is the man who bailed out Wall Street too generously. For others, he is the man who failed to bail out Wall Street generously enough. In his thought-provoking book, Capitalism 4.0, the British journalist Anatole Kaletsky blames him for the disaster, writing that ‘the domino-style failure of US financial institutions that autumn [of 2008] was not due to any worsening of economic conditions – it was simply a consequence of the US Treasury’s unpredictable and reckless handling first of Fannie and Freddie, then of Lehman, and finally of AIG.’3
 
Whatever we may think of Mr Paulson’s culpability, we cannot deny his outline of what actually happened in 2007 and 2008. In this chapter, I will not attempt a detailed account of how the crisis that hit the core high-income countries in those years unfolded. That has been done in other publications.4 My aim here is rather to demonstrate its scale, the extraordinary policy response and the economic aftermath. I will postpone detailed discussion of the economic and financial origins of the crisis to Part II of the book and analysis of the very different impact upon emerging and developing countries to Chapter Four. By focusing on the high-income countries, I want to show that this was no ordinary economic event. To pretend that one can return to the intellectual and policymaking status quo ante is profoundly mistaken.
 
THE SCALE OF THE CRISIS
 
The world economy of the 2000s showed four widely noticed and, as we shall see, closely related characteristics: huge balance-of-payments imbalances; a surge in house prices and house building in a number of high-income countries, notably including the US; rapid growth in the scale and profitability of a liberalized financial sector; and soaring private debt in a number of high-income countries, notably the US, but also the UK and Spain. Many observers doubted whether this combination could continue indefinitely. The questions were: when would it end, and would it do so smoothly, bumpily or disastrously?
 
The answers, it turned out, were: in 2007 and 2008, and disastrously. Already in March 2008, I assessed the unfolding crisis as follows:
 
What makes this crisis so significant? It tests the most evolved financial system we have. It emanates from the core of the world’s most advanced financial system and from transactions entered into by the most sophisticated financial institutions, which use the cleverest tools of securitisation and rely on the most sophisticated risk management. Even so, the financial system blew up: both the commercial paper and inter-bank markets froze for months; the securitized paper turned out to be radioactive and the ratings proffered by ratings agencies to be fantasy; central banks had to pump in vast quantities of liquidity; and the panic-stricken Federal Reserve was forced to make unprecedented cuts in interest rates.5
 
Far worse was to follow in the course of 2008.
 
This crisis had become visible to many observers on 9 August 2007, when the European Central Bank injected €94.8bn into the markets, partly in response to an announcement from BNP Paribas that it could no longer give investors in three of its investment funds their money back.6 This event made it clear that the crisis would not be restricted to the US: in the globalized financial system, ‘toxic paper’ – marketed debt of doubtful value – had been distributed widely across borders. Worse, contrary to what proponents of the new market-based financial system had long and, alas, all too persuasively argued, risk had been distributed not to those best able to bear it, but to those least able to understand it.7 Examples turned out to include IKB, an ill-managed German Landesbank, and no fewer than eight Norwegian municipalities.8 These plucked chickens duly panicked when it became clear what, in their folly, they had been persuaded to buy.
 
On 13 September 2007, Northern Rock, a specialized UK mortgage-lender, which had been offering home loans of up to 125 per cent of the value of property and 60 per cent of whose total lending was financed by short-term borrowing, suffered the first large depositor ‘run’ on a British bank since the nineteenth century.9 Ultimately, the Labour government nationalized Northern Rock – paradoxically, very much contrary to the company’s wishes. Reliance on short-term loans from financial markets, rather than deposits, for funding of long-term illiquid assets had, it soon turned out, become widespread. This was also a dangerous source of vulnerability, since explicit and implicit insurance had made deposits relatively less likely to run than market-based finance. That lesson proved of particular importance for the US, because of the scale of market-based lending in the funding of mortgages. As managing director of the huge California-based fund manager PIMCO (the Pacific Investment Management Company), Paul McCulley in 2007 labelled this the ‘Shadow Banking System’ when he spoke in Jackson Hole, Wyoming, at the annual economic symposium of the Federal Reserve Bank of Kansas City. The label stuck.10 Both these lessons – the widespread distribution of opaque securitized assets (the bundling of debts into marketable securities) and the reliance of so many intermediaries on funding from wholesale markets – turned out to have great relevance as the crisis worsened in 2008.
 
Then, on 16 March 2008, the Financial Times reported: ‘JP Morgan Buys Bear Stearns for $2 a Share’.11 The Federal Reserve provided backup funding of $30bn for this operation, taking some of the credit risk in the process. Just a year before that calamity the Financial Times had reported: ‘Bear Stearns yesterday became the latest Wall Street bank to report strong earnings and insist that it does not see much lasting impact from the crisis in the subprime mortgage market.’12 It would say that, wouldn’t it? But the likelihood is that its management, along with almost everybody else, did not imagine the horrors to come. They were probably more fools than knaves.
 
The rescue prompted me to write in the Financial Times of 25 March 2008:
 
Remember Friday March 14 2008: it was the day the dream of global free-market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Joseph Ackermann, chief executive of Deutsche Bank, that ‘I no longer believe in the market’s self-healing power’. Deregulation has reached its limits.13
 
The US government took the two government-sponsored enterprises, Fannie Mae and Freddie Mac, which then guaranteed three-quarters of US mortgages, into ‘conservatorship’ on 7 September. This proved what investors (and critics) had long believed, namely, that the US government stood behind the vast borrowings of these allegedly private companies ($5,400bn in outstanding liabilities at the time of the rescue).14 Yet it then, controversially, allowed (or felt obliged to allow) Lehman Brothers to go bankrupt on 15 September.15 Merrill Lynch was sold to Bank of America for $50bn, or $29 a share, on the same day – a big premium above its share price of $17, but a reduction of 61 per cent on its share price of $75 a year before and 70 per cent from its pre-crisis peak.16 Then, promptly after refusing to rescue Lehman, the US government saved the insurance giant, AIG, taking a 79.9 per cent equity stake and lending it $85bn on 16 September.17 In his book, Mr Paulson argues that the decisions were not inconsistent, because, ‘Unlike with Lehman, the Fed felt it could make a loan to help AIG because we were dealing with a liquidity, not a capital, problem.’18 If the Fed really believed that, it was soon proved wrong. A more likely reason is that Mr Paulson believed (wrongly, as it turned out) that the markets would take Lehman’s failure in their stride, but was sure the same would not be true for AIG, given its role as a seller of ‘credit default swaps’ – insurance contracts on bonds, including the securitized assets that had become increasingly toxic.
 
Then, on 17 September, one of the money-market funds managed by Reserve Management Corporation (a manager of mutual funds) ‘broke the buck’ – that is, could no longer promise to redeem money invested in the fund at par (or dollar for dollar) – because of its exposure to loss-making loans to Lehman. That threatened a tsunami of redemptions from the $3.5tn invested in money-market funds, a crucial element in funding McCulley’s ‘Shadow Banking System’.19
 
PriceWaterhouseCoopers, the UK’s bankruptcy administrator for Lehman, seized the failed company’s assets in the UK, including the collateral of those who traded with it.20 This came as a shock to many hedge funds and US policymakers. The fact that bankruptcy regimes were different in different countries – obvious, one would have thought – turned out to be a significant problem in dealing with the aftermath of Lehman’s failure. As Mervyn (later Lord) King, governor of the Bank of England, famously quipped: banks were ‘international in life, but national in death’.21 Funding for Morgan Stanley and Goldman Sachs, the two surviving broker-dealers, dried up.22 On 21 September these two institutions turned themselves into bank holding companies, a change that gave them access to funds from the Federal Reserve.23 On 25 September the Federal Deposit Insurance Corporation took over Washington Mutual, the sixth largest bank in the US.24 Not long afterwards, on 9 October, Wells Fargo, the country’s fifth largest commercial bank, agreed to a takeover of Wachovia, the country’s fourth largest.25
 
The mayhem was not restricted to the US. On the weekend before the Lehman bankruptcy, the UK government refused to support the takeover mooted by Barclays. As Alistair Darling, then chancellor of the exchequer, claims in his memoir, ‘we could not stand behind a US bank that was clearly in trouble’. Why, indeed, should the UK government provide guarantees that the US government had rejected? Moreover, he adds, ‘I was determined that UK taxpayers would not end up having to bail out a US bank.’26 On 17 September, with government encouragement, Lloyds TSB announced a £12.2bn takeover of Halifax Bank of Scotland (HBOS). The government argued that the public interest justified clearing the deal, despite concerns over its adverse impact on competition, in order to ‘ensure the stability of the UK financial system’.27 On 29 September the government decided to nationalize Bradford & Bingley, the biggest lender in the UK’s ‘buy-to-let’ market, while its branch network was subsequently sold to Santander.28 Worse, it was becoming obvious that HBOS was too bad a bank for Lloyds to support unaided. Furthermore, the Royal Bank of Scotland (RBS), which had become the biggest bank in the world by assets, partly as a result of ill-considered takeovers, notably of ABN-Amro, was also in terrible trouble.
 
The crisis went far beyond the US and the UK, affecting Iceland, Ireland and much of continental Europe. As the panic worsened, credit markets froze and assets were dumped, causing a vicious spiral of shrinking availability of credit to speculators and so further forced sales.29 The economic consequences turned out to be less severe than those of the Great Depression of the 1930s, but the financial crisis was even worse. The earlier crisis brought down banks on the periphery of the world economy (a huge number of smaller US banks and banks in vulnerable European countries, such as Austria and Germany) more than those at the core. The more recent crisis, however, tore apart the heart of the financial system: the networks connecting the big financial institutions that dominate activity in the world’s two most important financial centres, New York and London. The private sector also ceased to trust almost all counterparties other than the governments and central banks of the most important and most unimpeachably creditworthy Western economies, first and foremost the US.