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between the illiquid and the insolvent and lend only at what Bagehot called”penalty” rates. This time around central bankers saved both bank and manynonbank firms, giving access to lines of credit at rates that were far frompunitive. Indeed, the mother of aJI banl<like runs had swept nonbank mort­gage lenders, S!Vs and conduits, hedge funds, interbank markets, brokerdealers, money market funds, finance companies, and even traditional banksand nonfinancialcorporate firms. Since banks were not lending to each otheror to nonbank financial firms or even to nonfinancial corporate firms, centralbanks were forced to become lenders of first, last, and only resort. Thestormengendered little in the way of the “creative destruction” that Joseph Schum­peter would have celebrated. !µstead, strong end weak alike remained in astateofsuspendedanimation,awaitingthefinalreckoning.

 

 

 

 

 

 

 

 

Chapter5

 

GlobalPandemics

 

 

 

A

n old saying in financial markets has it that “when the United Statessneezes, the rest of the world catches a cold.” However cliched, thatobservationcontainsplentyoftruth: theUnitedStatesisthebiggest,

most powerful economy in .the world, and when it gets sick, countries thatdepend on its insatiable demand for everything from raw commodities tofinished consumergoodsfind themselvesintroubletoo.

This dynamic takes on dangerous potency in times of financial crisis. Anoutbreak of some financial disease in the world’s economic powerhouse canswiftlybecomeadevastatingglobalpandemic.Acrashinthestock market,the failure of abig bank, or some otherunexpectedcollapse at theepicenterof global finance can become a countrywide panic and then a worldwidedisaster. It’s a scenario that has played out many times, whether in Britain inthenineteenthcenturyorintheUnitedStatessincethattime.

Nevertheless, as theUnited States succumbedto the subprime diseaselatein2006and2007,conventionalwisdomheldthattherestoftheworld

.would “decouple” from the financially ailing superpower. This idea, first pro­motedbyanalystsatGoldmanSachsandthentakenupastheconsei.,sus,

 

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argued that the booming economies of Brazil, Russia, India, and Chinawouldrelyondomesticdemandandgetthroughthecrisisunscathedbythe

subprime meltdown. The world’s economic upstarts would escape the curseofhistory.

So too would Europe, where many people clung to a similar belief. OnlytheUnited States, so thethinking went, had practiced le capitalisme sauvage,as the French disparaged it,.and it alone would suffer ihe consequences. InSeptember 2008 German finance minister Peer Steinbrtick declared, “ThefinancialcrisisisaboveallanAmericanproblem,”andadded,”Theother

GLOBALPANDEMICS                                            117

meltdowns,banking crises, and other dramatic distresses that had first sur­faced in the United States. What began as one country’s crisis thus became aglobal crisis. As usual, this was nothing new or out of the ordinary. Thecrisiswas following a path well worn by centuries of historical precedent. It was, inmoreways thanone,ablastfromthepast.

FinancingaPandemi.c

 

G7financialministersincontinentalEuropesharethisopinion.”Buatfew

 

days later much of the Europeaq, banking system effectively collapsed. Ger­many was forced to baif out banking giant Hypo Real Estate, and Steinbriickconceded that Europe was “staring into the abyss.” Bailouts of Europeanmegabanks soon followed, and Ireland issued a blanket guarantee for its sixbiggest lenders. Other nations in, Europe followed suit, including Britain,which effectively nationalized much of its banking system. By October 2008many European countries as well as Canada had gone so far as to guaranteenotonlythedepositsbutthedebtsofthebanksaswell.

Nor was the crisis confined to Europe and Canada. It hammered coun­tries on every continent, including’Brazil;Russia, India, and China. In somecases this shared affliction was a matter of global interdependence: the crisisrippled through various channels, infecting otherwise healthy sectors of othercountries’ economies. But the contagion: metaphor, so frequently invoked,does not fully explain the crisis. It was not simply a matter of a disease spread­ing fromasick superpower to otherwise healthy countries. Other nations,having long pursued policies that fostered homegrown bubbles, were vulner­ablewhenthecrisisstruck.Indeed,whatinitiallyseemedlikeauniquely

American ailment was in fact far more widespread than anyone wanted toacknowledge.

All of this caught most commentators by surprise. Having missed the cri­sisintheUnitedStates,manybullishfinancialpunditsclungtothedeco1+­pling thesis until it was impossible to defend. By the end of 2008 most oftheworld’s advanced economies had slipped into a recession, and numerousemerging-market economies in Asia, Eastern Europe, and Latin America hadsuccumbedaswell.Manyofthesesameeconomiessufferedthestockmarket

Crises rarely cripple perfectly healthy economies; usually underlying vulner­abilitiesandweaknessessetthe stageforacollapse.Nonetheless,forecono­mies outside the United States to catch the proverbial cold, some channelhad to be in place. The most visible were the institutions that make up theglobalfinancialsystem.

Money markets are one such institution: they’re the places where banksand other financial firms borrow and lend money on a short-term basis. Thesewebs of debt and credit have always been fragile in times of panic, spread­ing problems from one part of theglobal economy to another. The  reasonis simple: when one link in the very elaborate chain breaks and defaults onsomedebt,itcanleavecreditorsdangerouslyshortoffunds, unabletoguar­antee the credit of other firms. In this way, the consequences of one failurecanspread throughouttheentiremoneymarket.

For this reason, troubles in themoney market have long been a hallmarkof financialcrises. Intl1epanic of 1837, theBank of Englandrefusedtoroll over loans made to three major British financial firms, whereupon thosefirms failed. Theeffect was calamitous: the firms had extended short-termloans to merchants around the world, and their collapse voided tens of mil­lions of pounds’ worth of commercial paper. Financiers in Liverpool, Glas­gow, New York, New Orleans, Montreal, Hambu:g, Antwerp, Paris, BuenosAires, Mexico City, Calcutta, and elsewhere found themselves short of credit.The Times of London lamented, “It must be a very long time, years perhaps,beforetheentire effect of these failures is h1own, for they will extendmoreorlessoverthewholeworld.”

Thosewordscouldwellhavebeenutteredinthewakeofanyofthe

 

 

 

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crises that crippled international money markets in the nineteenth and earlytwentieth centuries. The worst crises typically followed the unexpected col­lapse of some venerable firm that occupied a prominent place within theglobal money market. In the panic of 1873, for example, the failure of JayCooke’s giant investment house helped trigger a worldwide crisis. In theGreat Depression it was the sudden implosion of Austria’s biggest bank,Credit-Anstalt.Manyoftheworld’smostpowerfulandimportantbanks

had lent money to it, and its failure triggered other bank failures around theglobe.

Intheinterveningdecades,financialmarketsbecameevenmoreintegratedand interdependent. Indeed, in the recent crisis, thecomplex websof borrowing and lending that bounc!’together the international financial sys­tem were almost impossibleto fully understand,much less disentangle. Infact, few people.likely understood that stress in the repo or commercial papermarket in one country could be quickly transmittedelsewhere.While therehadbeensomecrisesthatcrossednationalborders,nonecameclosetorival­

ingtheGreatDepression;understanding ofhowtheglobalfinancialsystemcould-andwould-unravelwaslimited.

ThatignoranceendedafterthecollapseofLehmanBrothersonSeptember 15, 2008. When it failed, the hundreds of billions of dollars inshort-term debt it had issued-most of it commercial paper and other bonddebt-became worthless, triggering panic among the various investors andfunds that held it. This panic prompted a run on the money market fundsthat provided lending to the commercial paper market and sowed furtherpanic throughout the global banking system. Banks that had made short­term loans to foreign banks jacked up their rates by over 400 basis points, anastronomicalincrease.Whatoverseasinvestorscalledthe”LehmanShock”

spread fear throughout global money markets, curtailing lending and eventu-allycripplingglobaltrade.               .

.  While the failure of Lehman Brothers helped transmit the crisis through­out the world’s financial system, it was hardly the only catalyst. A classicmechanism for spreading crises is the otherwise unremarkable fact that inves­tors in multiple countries hold identical assets. In a number of nineteenth­centurycrises,forexample,investorsaroundtheworld heldthesametypes

GLOBALPANDEMICS                                            119

 

of railroad securities, a popular international  investment. When the bub­ble behind these securities popped, investors in the United States, Britain,France, and elsewhere simultaneously saw their portfolios go up in smoke.Invariably,theycurtailedcredit, hoardedcash,andtriggeredapanic.

The recent crisis was comparable. The subprime meltdown spilled overfrom the United States to Europe, Australia, and other parts of the world forthe simple reason that about half of the securitized sausage made on WallStreet-the collateralized debt obligations and the mortgage-backed secu­rities from which they derived their value-were sold to foreign investors.During the housing boom, foreign banks, pension funds, and a host of otherinstitutions had snapped up these securities. When a subprime borrower inLas Vegas or Cleveland defaulted on his mortgage, it rippled up the securi­tization food chain, hitting everyone from Norwegian pensioners to invest­mentbanksinNewZealand.

Perhaps the largest portion of these securities ended up in the assetportfolios of European banks and their subsidiaries. Some banks had directexposure to the subprime crisis, holding tranches of CDOs and other instru­ments as ordinary assets. In other instances, most notably with BNP Paribasand UBS, hedge funds attached to these banks functioned as disease vec­tors, placing high-risk bets on a range of subprime securities. When thoseinvestments soured, the resulting losses ultimately hit the banks’ bottomlines.

The losses sustained by these banks caused considerable collateral dam­age to the corporate sector in Europe. Unlike American firms, which relymore on capital markets for their financing, European firms depend heavilyon bank financing. When the subprime crisis started to hammer reputableEuropean banks, they curtailed lending, limiting thecorporate sector’s abilityto produce, hire, and invest. This set the stage for therecession that grippedtheregioninthefinalmonthsofthecrisis.

Thedamage did not stop there. Many of these same European bankshad subsidiaries in other countries, particularly in emerging Europe-thecountries that had been freed of Soviet control after the end of the Cold War.These subsidiaries had pumped significant amounts of credit into Ukraine,Hungary,Latvia,andothercountries.Oncetheparentbankssufferedmassive

 

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losses, they became risk averse and withdrew credit across the board, staI”:”­ing their foreign subsidiaries. Theresulting collapse of credit in emergingEuropehelpedplungethesecountriesintorecession.

In this way, thesubprime problem in the United States rippled outwardvia financial ties. It first affected countries that did plenty of banking businesswith the United States, then radiated from there to financial institutions incountries on the periphery of the global economy. It was a classic case ofcontagion, in which the banking system served as theconduit for America’ssubprimeills.

But banks weren’t the only parts of the financial system to sow crisisaround the world. Stock markets played an important role as well. At dramaticturning points in the crisis, the ,American stock market plunged, followed byprecipitous drops on exchanges in London, Paris, Frankfurt, Shanghai, andTokyo, and in smaller financial  centers. This spread was partly a functionof the remarkable degree of interdependence between international stockmarkets. In a world in which traders can instantaneously track movementsin markets halfway across the globe, investor sentiment can easily spill overfromoneexchangetoanother.

Nonetheless,this growing synchronization was not merely a classic caseof herd behavior, in which spooked investors innecountry’s exchange sentinvestors elsewhere over the cliff. As the portents of disaster accumulated, thestock market became the medium through which investors registered theirgrowingaversiontorisk,bydumpingequities for.Jessriskyassets.

Thecontagion that raced through the stock markets may have beenmore pervasive, faster, and more synchronized than in any previous disaster.But it was merely the latest, most sophisticated version of a dynamic that hasexisted for well over a hundred years. Financial globalization, in other words,isnothingnew.In1875thebankerBaronKarlMayervonRothschild,uponobserving that global stock markets had plunged in unison, made a simplebuttimelessobservation:”Thewholeworldhasbecomeacity.”

IntegrationinRothschild’sday went beyondthestockmarkets:globaltrade too was extraordinarily interdependent and sensitive tofinancialcrises.’Sadly,littlechangedintheinterveningyears.Afterpanicieizedthefinan­

cialsystemin 2008,internationaltradehelpedspreadthecrisisaroundtheworld.

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DiseaseVectors

 

In the nineteenth century the British Empire was thereigning economicsuperpower,andwhenever itspiraledintoafinancialcrisis,itstradingpart­ners suffered collateral damage, as demand for raw materials and finishedgoods plummeted. In the twentieth century the United States inherited Brit­ain’s mantle, accounting on the eve of the crisis for about a quarter of theworld’s gross domestic product. Thanks to its $700 billion current accountdeficit, its real share of the world economy was even bigger. When it slippedinto a severe recession, the effects echoed around the world, in countries asvarious as Mexico, Canada, China, Japan, South Korea, Singapore, Malay­sia, Thailand, and the Philippines. Chinawas particularly at risk, as much ofits recent growth had depended on exports to the United States. Thousandsof Chinese factories shuttered, and employees returned from urban to ruralareas,casualtiesofacollapsehalfaworldaway.

.Theeffects of thedownturn in China were not limited to trading links.Many Asian countriesproducedcomputerchips and exportedthem toChina, where they would be assembled into computers, consumer electron­ics,andotheritems,to beshippedtotheUnitedStates.Whenthecrisishit

,the United States, it hit not just China but all the countries that China usedin its supply chains. Here decoupling was next to impossible: economiesthroughout Asia depended heavily on a wide range of direct and indirecttradingtiestotheUnitedStates.

Decoupling was particularly difficult to avoid once Lehman Brotherscollapsed; the usually boring world of trade financing was one of the firstcasualties. Normally banks issue “letters of credit” to guarantee that goods intransit from, say, China to the United States will be paid for when they reachtheir final destination. Once the credit markets seized up after Lehman’sfailure, however, banks stopped providing this essential financing. Globaltrade came close to a standstill; formerly obscure benchmarks like the BalticDry Index-a measure of thecost of shipping commodities-plummeted byalmost 90 percent. As one expert on global shipping observed shortly afterLehman’s collapse, “There’s all kinds of stuff stacked up on docks right nowthatcan’t beshippedbecausepeople can’tgetlettersofcredit.”

 

 

 

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Thecollapse of global trade that began with the U.S. recession an,dintensified with the demise of Lehman Brothers was unprecedented: only theGreat Depression can compare. At the peak of the crisis in early 2009, exportsfell-on a year-over-year basis-by 30 percent in China and Germany, and by37 or even 45 percent in Singapore and Japan. All these countries save Chinaslipped into a severe recession, and even China saw a dramatic collapse in itsannual economic growth from 13 percent to approximately 7 percent, belowthethresholdofwhat’sconsideredsustainableinthatcountry.

All this happened. with a speed and simultaneity that shockedmostmarket watchers. “The Great Synchronization/’ as two economists withthe  Organisation for Economic Co-operation  and Development  dubbedthe international trade collapse, was clearly a function of the global creditcrunch,butthatalonedoesn’texplainwhathappened.Asthecrisiswors­

ened, despite pledges to the contrary, many nations adopted tariffs, quotas,andotherbarriersto internationaltrade-legislation forcing governmentcontractors to buy from domestic manufacturers, for example. Such tit-for­tattradewarshadprovedinimicalto globaltradeandgrowthinthedepthsof

the Great Depression, and their recent recurrence, while less pronounced,didnothelpglobaltraderecover.

Finally, the crisis spread along paths taken ‘not only by goods but bypeople too. As the United States plunged into recession, migrant workersstopped sending money back to their home countries: Mexico, Nicaragua,Guatemala, Colombia, Pakistan, Egypt, and the Philippines, to name a few.Many of these migrant workers had gained regular work during the housingbooms, not only in the United States, but in Spain and Dubai, and whenthese booms becamebusts, remittancesback home collapsedtoo. Theeffectof this drop-off in remittances is hard to overstate. In.some Central Americancountries, more than IO percent of thenational income comes from citizenswho work abroad. In this way, thecrisis hurt countries that had never partici­patedinrecklessfinancialpractices.

While trade and labor ties have often enabled crises to jump nationalboundaries, commodities and currencies have played an even bigger role.The reason is simple enough: the prices of commodities and currencies aresetinworldmarkets.Whenthepriceofoilor copperoradollarrisesinoneplace,itriseseverywhere;whenitdeclines,itdeclineseverywhere.Forthat

GLOBALPANDEMICS                                             123

 

reason, sudden fluctuations in the prices of commodities and currencies canfuelinstabilityonaglobalscale.

This level of integration dates back at least two centuries. When theprrce of cotton in New Orleans rose to bubblelike heights in 1836 and thencrashed with the panic of 1837, the pain was felt not only domestically butin cotton-exporting nations around the world. Likewise, when a range ofcommodity prices fell by as much as 50 percent in the year following thecrash of 1929, export-driven economies suffered terribly. As prices fell foreverything from coffee to cotton to rubber to silk, the economies of Brazil,Colombia, the Dutch East Indies, Argentina, and Australia were distressed.Even Japan suffered, as a· disintegration of demand for raw silk crippled itseconomy. These countries saw their finances imperiled and their currenciesdepreciatedonaccountoffallingcommoditiesprices.

Commodities prices played a role in the recent crisis too, though in waysthat challenge the usual boom-to-bust narrative. Throughout 2007 and 2008theprices of oil, food, and other commodities rocketed upward. In thesum­mer of 2008 oil prices peaked at around $145 a barrel, up from $80 a yearearlier. The increase wasn’t remotely justified by economic fundamentals;rather, it was a function of investment or speculation driven by hedge funds,endowmentfunds,brokerdealers,andvariouscommoditiesfundsthathad

invested some of their portfolios in commodities. While the oil price spikemay have benefited the oil exporters, it hit all the oil importers hard: theUnited States, theEurozone, Japan, .China, India, and others. Several ofthese countries were already reeling from the effects of the financial crisis;theoilshockprobablypushedthemintoafull-blownrecession.

What was true on the way up was true on the way down. Exporters of oiland other commoditieswho had remainedinsulated from the financial crisisin 2007-8 struggledwhen demand from theUnited States and China col­lapsed. In the second half of 2008, demand for oil, energy, food, and mineralsfell even further, and theeffect was comparableto what happenedin theGreat Depression: commodity exporters in Africa, Asia, and Latin Americasaw theireconomiestumble. Oil producerswere. particularlyhardhit: thepriceofoil fell fromits peak to a low of $30 inthe first quarterof 2009.But the damage extended to a range of raw materials.In Chile, for example,thecollapseofdemandforcopperhammeredthatcountry’sexport-driven

 

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economy,propellingitintoarecession.Inallofthesedisruptions,acomod­ity boom initially helped trigger a global recession among commodity-import­ingnations;theconsequentcommoditybustpummeledtheexporters.

Fluctuations in currencies displayeda similar dynamic andprovedequally disruptive. In 2007, during the opening innings of the crisis, theAmerican econ6mic slowdown and the ensuing reduction in interest rateshelped undermine the value of the dollar. This devaluing hit countries thatrelied on exports to the United States: theUnited Kingdom, Japan, andmany nations in the Eurozone. As their respective currencies strengthenedrelative to the dollar, the cost of these goods to American consumers rose.Thisundercut the competitive  edge of these countries, setting them  up forarecession.

As thecrisis worsened, however, the process went abruptly into reverse.Thefear and panic that seized the financial markets over the course of 2008drove international investors to seek safe havens. Oneof them was, some­what paradoxically, thedollar. Even though theUnited States was attheepicenter of thecrisis, it seemed a safer bet than any number of emergingeconomies. As investors piled into dollars, along with the currencies of otherdevelopedcountries, they simultaneously dumpedthe stocks and bonds invarious emerging markets, further widening the gap between those countries’currenciesandthe”safer”currenciesofthedevelopednations.

The effects were calamitous. Before the crisis, households and firms inemerging Europe had obtained mortgages and corporate loans from banksin more established countries. They had turned to those banks because theinterest rates on euros, Swiss francs, and even.Japanese yen were lower thantheratesavailableintheirowncountries.FirmsinRussia,Korea,andMex­ico used the same borrowing strategy. But when the crisis hit and investorsfled from emerging-market currencies to safe havens like the dollar, the euro,and the yen, the cost of servicing those debts went through the roof, puttingenormousstrainsontheemerging-marketeconomies.

All of this followed a pattern established by crises past. Like the inter­nationalfinancialsystem,andliketheglobaltrading links,commoditiesandcurrenciesservedaspathways,enablingonenation’sfinancial crisistobecomeaneconomiccrisisofglobalproportions.

Thatsaid,therearelimitstowhatthecontagionmodelcanexplain.·

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Implicit within it is the idea that a sick country-the United States-gave therest of theworld one hell of a cold. That’s a comforting thought, but it’s partlywrong. Plenty of other countries hatched their own bubbles independently oftheUnited States and pursued policies no less reckless or foolish. They hadlittleimmunitytothesubprimesicknessbecausetheytoohadmadethem­

selveshighlyvulnerabletothedisease.

 

 

 

SharedExcesses

 

In 1837 Martin Van Buren, who was just ascending to the U.S. presidency,triedto explain  why “two  nations”-the  United  States and Britain-“themost commercial in th’e world, enjoying but recently the highest degree ofapparent prosperity …are suddenly …plunged into embarrassment anddistress.” He was referring to the horrific panic of 1837, which was well underway, and while many commentators blamed either theUnited States or Brit­ain for triggering the disaster, Van Buren recognized that the truth was morecomplicated. “In both countries,” he wrote, “we have witnessed the sameredundancy of paper money and other facilities of credit; the same spirit ofspeculation; the same partial successes; the same difficulties and reverses;andatlengthnearlythesame.overwhelmingcatastrophe.”

VanBuren’sassessmentwasnotfar·fromthemark.WhiletheUnited

States was arguably the worst offender in its unbridled enthusiasm for high­risk banking and real estate speculation during the 1830s, the British inde­pendently engaged in a mania for chartering banks and createdacomparablebubble, complete with a “reckless extension of credit and wild speculation”intextilesand railroads. When the Americaneconomy started to shake andfall, the British economy did as well. Not only was it inextricably intertwinedwith the American economy, but it suffered from many of the same vulner­abilities that had accumulated during the boom years. Thecrisis did notemanatefromasickcountrytoa healthyone;itstrucktwonations atnearly

thesametime.

This same pattern can be glimpsed  in other crises. When one coun­try’sboomgoesbust,othercountriesthathaverackedupthe samekindof

 

126                                 (;RJSJS  tGONUIVll(;S

 

excesses tend to collapse as well. In 1720, for example, the British South SeaBubble imploded around the same time that John Law’s speculative Missis’sippiCompanyfoundered.Acenturyandahalflater,thecrisisof1873cameon the heels of simultaneous booms in Germany, Central Europe, and theUnited States. These turned to brutal busts, first inAustria-Hungary, then inthe United States, and then throughout much of the rest of Europe. A littleover a century later speculative booms in emerging economies throughoutAsia that had been fueled with foreign investment went bad in quick succes­sion, hammering South Korea, Thailand, Indonesia, and Malaysia. Again,thiswasamatterof sharedvulnerabilitiesasmuchassimplecontagion.

Many of the economies that collapsed in the recent crisis, not surpris­ingly, had similar vulnerabilities as the United States. TheUnited States washardly the only country, for one thing, with a housing bubble. Dubai, Aus­tralia, Ireland, New Zealand, Spain, Iceland, Vietnam, Estonia, Lithuania,Thailand, China, Latvia, So4th Africa, and Singapore all had recently _seenhousing values appreciate at relentless rates. In 2005 The Economist calcu­lated that the total value of the residential properties in the world’s developedeconomieshadeffectivelydoubledfrom2000to2005.Thisgain, astunning

$40 trillion, was equivalent to the combined gross domestic products of allthe countries in question. “It looks like the biggest bubble in history,” themagazineobserved.

Someof these increases were staggering.’ While The Economistnotedthat American home prices appreciated by 73 percent between 1997 and2005, Australianprices rose 114 percent, and Spanishprices by 145 percent.In Dubai, locale of a massive real estate bubble, prices of villas rose a stag­gering 226 percent between 2003 and 2007 alone, according to real estateconsultants Colliers International. Figures on housing price appreciation inAsia and Eastern Europe are less dependable, but anecdotal evidence sug­gests that these regions enjoyed comparable booms. The United States wasbad, but it was hardly the worst offender, even if it may have generated moreproblemloansthananyothercountry.

Whatever the rate of appreciation, the reasons for the boom were invari­ably the same. Most of these countries had pursued easy monetary policies,sothatborrowingcoslshithistoriclows,atrendonlyreinforcedbyaglobal

 

 

savings glut By 2006, mortgage rates in every developed and developingeconomy had declined to single digits for the first time ever. And like theUnitedStates,mostcountriesdidlittletoregulatetheirmortgage andfinan­cial markets. The result was the same: as home prices went up, householdsin.these countries felt wealthier; they spent more and saved less. Theensuingboominresidentialinvestmentboostedmanyofthesecountries’GDP.

But this masked a deeper problem, much as it did in the United States.Low savings and high investment rates implied that the current accountbalance-thedifferencebetweenacountry’stotalsavingsanditstotalinvestments-was veering into negative territory.Unlike  countries  that runa current account surplus, countries that run a deficit need savings fromother countries to underwrite their investments. The latter was the situationwith the United States and other countries with housing bubbles: they hadgrown increasingly dependent on foreign capital to bring their accounts intobalance. This in tum led to inflated currencies and caused a further deterio­rationinthesecountries’currentaccountbalance.

When the housing bust hit the United States, all the other economieswith housing bubbles underwent comparable, if not greater, declines. Con­trary to conventional wisdom, their housing busts were not a direct conse­quence of the American subprime crisis. TheAmerican crash may have beenthe catalyst, but it was not the cause: most if not all of these countries withoverheated housing markets were poised for crashes as well. All they neededwas a push, which they got when the global economy plunged into a crisisandawidespreadrecessionin2008.

IftheUnitedStateshadcompanyinhatchinganenormoushousing

bubble, it had peers in other areas as well. Take, for example, the problem ofleverage and risk taking. While American financial institutions were reckless,their counterparts around the world were no less guilty. For example, by June2008, leverage ratios at European banks had hit new highs. Venerable CreditSuisse had levered up 33 to 1, while ING hit49 to 1. Deutsche Bank was upto its eyeballs in debt at 53 to 1, and Barclay’s was themost levered of all, at61 to 1. By comparison, doomed Lehman Brotherswas levered at a.relativelymodest31to1,andBankofAmericawasevenlower,at11to1.

ManyEuropeanbankshad avidlyjoinedinthefrenzyoffinancingand

 

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securitizing mortgages and other kinds ofloans. This left them holding to,sicmortgage-backed securitiesand CDOs that eroded invalue when thehous­ing crisis hit the United States. As markets for these securities dried up, manyEuropeanbanks saw their potentiallossesrise to frightening levels. By theendof2009,theEuropeanCentralBankraisedestimatesofwrite-downsto

€550billion,toppingearlierestimates.

Not all these assets came from the United States. Many banks in Europeengaged in their own securitization party, slicing and dicing mortgages fromhomeowners in European countries, with Britain, Spain, and the Nether­lands providing most of the loans. In 2007 alone, €496.7 billion worth ofEuropean loans became the basis of asset-backed securities, mortgage-backedsecurities, and CD Os. While th,:: excesses of this market paled in comparisonto those of the United States, standards remained lax. Even worse, many ofthe loans and securities that banks had in the securitization pipeline wereparked in conduits and SNs. When the crisis hit, banks had to bring thembackontotheirbalancesheets,muchastheirAmericancounterpartsdid.

Finally, many Europeanbanks made high-risk loans inemerging Europe,particularlyLatvia,Hungary,Ukraine,andBulgaria.Whenthecrisishit,manyof theseeconomiessawtheircurrenciesfallsharply,andpartlyasaresult,theycouldnolongermakegoodontheirloans.SuddenlyEuropeanbanks-especially thosein Austria, Italy, Bejgium,Sweden, and Germany­found themselves taking massive losses on their loan portfolios. As one Danishanalyst observedin early 2009, “the markets have decidedthat the [emerging]regionis thesubprimeareaofEuropeandnoweveryoneisrunningforthedoor.” It wasn’t the same subprimecrisisthat hit theUnitedStates,but itstemmedfromthesameunderlyingproblem:toomanyhigh-riskloans.

Hence the United States was hardly_ the only developed economy tofall during the  crisis. Indeed, many European  institutions got into troublein advance of their American counterparts. The French bank BNP Paribaswas one of the first, suspending several hedge funds in _the summer of 2007.TheGerman bank IKB imploded at the same time, a victim of runs on itsSIVs; another German bank, Sachsen LB, was bailed out later that summer.This was but the beginning: Iceland’s entire banking system would eventu­allycollapse,andmostbanksintheUnitedKingdomendedupnationalized.

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Similar problems eventually surfaced in Ireland, Spain, and a host of otherEuropean nations. And the bust of the real estate bubble in Dubai eventu­ally led Dubai World, the government-owned enterprise most involved inthese risky real estate developments, to seek a bailout from Abu Dhabi inDecember2009.

Throughout it all, the crisis was following a familiar path. Many econo­mies, particularly those in Western Europe, could not avoid the crisis becausetheysufferedfrommanyofthesamevulnerabilities:housingbubbles,an

• overreliance on easy money and leverage, and anenthusiasticembrace ofhigh-risk assetsandfinancialinnovation.

This fact highlights a brnader truth about crisis economics: similar crisesemerge in different places with seeming synchronization because of sharedweaknesses.Toooftenmarketwatchersrefertofinancialcrisesas’1pandem­ ics” or some other disease metaphor without acknowledging an importantunderlying truth: disease spreads most readily and quickly among those whoare weak and lack immunity. In the recent crisis, many economies in Eurnpeshared the same vulnerabilities as the U.S. economy. It’s no surprise, then,that when the United States sneezed, they caught the cold-or perhaps moreaccurately,theflu.

7                                                                                                                                                                                                                                 ‘

But not everyone got sick, and that too is revealing. Look, for exam­ple, at India’s experience. Though buffeted by the meltdown, its economyproved remarkably resilient In the years leading up to the crisis, its conserva­tive central bankers had gone down a different road than most of the world.Indian policy makers had resisted attempts to deregulate the financial system,and banks were forced to maintain hefty reserves. Where other countriesembraced the mantra of free markets, India kept a tight lid on its financialsystem.Asaconsequence.itwasrelativelyimmunetotheudisease1emanat­ ingfromtheUnitedStates.

Sadly, the same cannot be said for the world’s other emerging econo­mies, many of which-particuarly those in Central and Eastern Europe­followedafamiliarboom-to-busttrajectory.Still,theirfatewasnotpurelyafunction of shared vulnerabilities; rather, the peculiar way that developedandlessdevelopedeconomiescanbecomeentangledinamutuallydestruc­tiverelationshipcontributedtotheirfate.

 

 

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EmergingEconomies,ExistingProblems

 

Emergingeconomiesusuallydependoncapital frommoredevelopednations. That dependency, though mutually beneficial to both parties whentimes are good, can endup looking like a suicide pact whenthings fall apart.In the crisis of 1825, British investors flooded into the newly independentnation of Mexico as well·as several other Latin American states recently freedfrom Spanish control. In the first year of independence alone, some £150 mil­lion worth of funds flowedinto theregion, withmuchof themania focusedon gold and silver mining. AsJnvestors poured into these countries, the newnations flourished. So too did speculators back in London, as investors bid upthe prices of the new nations’ mining stocks andbonds.Unfortunately, manyof the ventures proved to b.e failures or even outright frauds, and the marketcollapsed. Investors fled stocks and pulled their funds out of Peru, Colom­bia, and Chile. The Latin American nations proved unable to service theirdebt, and in 1826 Peru defaulted, causing what one observed calied “consid­erablepanic”intheCity ofLondon.Theothercountriessoonfollowed.

In the nineteenth century the most crisis-prone of the emerging marketswas none other than the  United States. European  investors, in particularthe British, plowed enormous amounts of capital into the country, snappingup the bonds of state governments, canal and railroad securities, and a hostof other assets. Theinflux of funds helped underwrite booms in the UnitedStates, as well as speculative bubbles back in Europe. Most of them eventu­ally collapsed, and when they did, foreign investors abruptly divested them­selvesof”risky”Americanassets.

In every case the result was predictable: booms turned to busts on bothsides of the Atlantic. Many of the American banks and businesses that hadbenefited from the surfeit of foreign capital collapsed; many of their coun­terparts in Europe suffered too. In the wake of the panic of 1837, foreigninvestors fled en masse. Hundreds of banks perished in the United States,and a quarter of the individual states defaulted on so1I1e portion of the debtthey had issued; panic simultaneously seized the City of London. A simi­larflighttookplacein1857,afterwhichonecommentatorclaimed-with

GLOBALPANDEMICS                                            131

exaggeration-that the “distrust felt by nearly all foreignersin thefuture of the United States was so great that the larger portion of Americansecurities     heldinforeigncountries,werereturnedforsaleatalmostany

sacrifice:’ History repeated itself yet again in 1873, as the railroad boorn col­lapsed,promptingEuropeaninvestorstorunfortheexitsoncemore.

Otheremergingmarketshavesufferedsimilarfates.Inthe1990sanew

generation of emerging markets around the world were shaken bya   seriesof crises: Mexicoin_ 1994; SouthKorea, Thailand, Indonesia,and Malaysiain l997; Russia, Brazil, Ecuador, Pakistan, and Ukraine in 1998 and 1999;Turkey and Argentina in 2001. After flooding these countries with capital,foreign investors got spooked and fled in droves, leaving behind currencycrises, waves of failures in the banking and corporate sectors, and defaults ongovernment debt. Only the timely intervention of the IMF and the world’scentralbankspreventedaworldwideeconomicdisaster.

Emerging-marketcrisesalsoplayedaroleintherecentcrisis,thoughina

more mutedand complicatedway. Theones that conformed to thepreviouspatternincludedtheeconomiesof emerging Europe. Like their predeces­sors, they generally had one thing in common: large current account deficits.Sometimesthese deficits were fueledby a housing boomandhuge increasesinconsumerspending,alongwithadropinprivatesavings;othertimesitwasafunction of governmentdeficitsor evencorporate’borrowing.Whatever thereasonforthedeficits,thesecountriesborrowedextensivelyfrom investorsandbanksinmoredevelopednations.Theyborrowedanenormousamount:

between2002and2006,borrowingfromforeignsourcesincreasedby60 per­centeveryyear.Evenworse,muchoftheirdebtwasdenominatedinforeign

currences astrategythatwentawrywhentheirowndomesticcurrencies

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startedtodepreciateduringthe crisis.

Though the crisis hit countries as different as Romania, Bulgaria, Croatia,and Russia, it was the Baltic states-Latvia, Estonia, and Lithuania-as well asHungary and Ukraine that suffered the most All of them saw an abrupt reversalofcapitalflows,asskittishinvestorsfled”risky” markets-inotherwords,emerg­ing economies-andheaded for safer havens. Theresults were predictable, ifbrutal. Hungary, Iceland, Belarus, Ukraine, and Latvia all went hat in hand tothe IMF, begging for a bailout. All three Baltic countries saw spectacular risesinunemployment;allthreesawtheir bankingsectorsedgetowardacrisis.The

 

 

 

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Baltics suffered theworst consequences, registering double-digit unemploy­mentbythespringof2009.Latvia,arguablythehardesthitofall,sufferedriots,thedownfallofthegovernment,andthe collapseofitscreditrating.

These countries fit the classic pattern of emerging economies that boomwith an influx of foreign capital, then collapse when investors head for theexits. But another group of emerging economies that were hammered in thebust did not fit the usual profile: they enjoyed current account surpluses. Chinawasthemostprominentmemberofthisgroup,butBrazilandsmallercoun­triesintheMiddleEast,Asia,andLatinAmericafellinto thiscategorytoo.

Most countries with current account surpluses tend to see their curren­ciesappreciate.Butintheyearsleadinguptothecrisis,thegovernmentsinthese countries intervened aggressively in the foreign exchange markets inorder to keep their currencies undervalued. They did so because many ofthem depended on exports, and the cheaper their currencies remained, themore effectively they could compete in world markets. This kind of interven­tion helped underwrite exports, but it meant an accumulation of dollars andother currenciesathome,fuelingagrowthinthemoneysupply.

The  abundance of easy money and low interest rates then contributedto inflation and to asset bubbles, particularly on domestic stock exchanges.At their peak, stocks in China and India hit-price-to-equity ratios of 40 oreven 50 late in 2007-definite bubble territory. Many of these economiesoverheated in advance of the American financial meltdown, making themextraordinarily fragile and susceptible to sudden shocks. To a certain degree,their vulnerabilities had evolved independently of the excesses in the UnitedStates. Their eventual downfall had little direct relationship to the Americancrisis; rather, it was a consequence of policies pursued in the years before thebust. They ended up casualties of thecrisis, but to a remarkable extent, theywerethearchitectsoftheirownmisfortune:·

 

 

 

The  DeathofDecoupling

 

As the crisis gathered steam in early 2008, most policy makers outside theUnitedStates,despiteallthehistorical andcontemporaryevidencesuggesting

GLOBALPANDEMICS                                           133

 

that a global pandemic was imminent, dithered. Still smitten with the idea ofdecoupling, many worried that their economies might overheat, generatinginflation. Then central bankers in a number of emerging economies raisedinterest rates in an attempt to tighten monetary policy. Their counterparts inthe more advanced economies followed suit; and in mid-2008 the EuropeanCentralBankimplementedanill-fatedandmisguidedincreaseinpolicy

rates.

Tomakemattersworse,Europeanpolicymakersrefusedtoadoptanaggressivestimuluspolicy.TheEuropeaneconomiesthatcouldmostreadily

,affordsuch aprogram(Germanyinparticular)didrelativelylittleinitially,

and those who needed it the most (Spain, Portugal, Italy, and Greece) lackedthe money to implement one. These “Club Med” countries were alreadyrunning big budget deficits and carried a large stock of public debt relative tothesizeoftheireconomy;theyhadlittleroomtomaneuver.

Thesedecisionsillpreparedpolicymakersinbothadvancedandemerg­

ing economies to combat the effects of the unfolding crisis. It caught themby.surprise, and thanks in no small part to their flawed analysis, the globaleconomy sank into the worst recession since the 1930s.In the fourthquarterof 2008 and the first quarter of 2009, the global economy contracted at a ratethat paralleled, in size and in depth, the collapse from 1929 to 1931 thatbegantheGreatDepression.

Asfordecoupling,therestoftheworldactuallysufferedmorethan

the United States that winter. While the U.S. economy contracted duringthose two quarters at an annual rate of 6 percent, the contraction elsewherewas far more brutal. Economies that were supposed to decouple did not;they “recoupled” with a vengeance. Japan, which many initially hailed asimmuneto·thecrisis,sawitseconomycontractatanannualizedrateof

12.7 percent in the final quarter of 2008; South Korea saw an even biggerdecline of 13.2 percent.China managedto avoidanoutright recession, evenif its growth dropped below sustainable levels. Most of the rest of the worldwas not so lucky. In the finger-pointing that followed, many market watchersfocused on the collapse of Lehman Brothers, seeing in that catastrophe thecauseofalltheworld’sills.Evennowsomeconsiderthiseventthecatalyst

forthecrisis.

Thisinterpretationiscomfortingbutwrong.BythetimeofLehman’s

 

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collapse in September 2008, the United States had been in a recession fo, tenmonths, and much of the rest of the world was already in the same boat. The·global credit crunch had been in full swing for over a year, and global equitymarkets had been headed south for nearly thesame length of time. Thecrisisin the United States, which had started a year and a half before Lehman’scollapse, had already radiated to the rest of the world along a host of chan­nels:thefinancialsystem,traderelations,commodities,andcurrencies.

It did not infect these other countries by accident. For years, many ofthem had played host to housing and equity bubbles, credit bubbles, andexcessive leverage, risk taking, and overspending. Their vulnerabilities hadbeen building for years, and even countries that had taken a more prudentcourse-Chinaand much of j:he rest of Asia-depended far too much onexportsfortheircontinuedsurvival.Theytoowerevulnerable,ifinadiffer­entway: their continued prosperity depended on bubbles halfway around theworld,bubblesthathadalreadypoppedinadvanceofLehman’scollapse.

But the collapse of that famous firm did more than anything else tofocus the minds of policy makers on the reality that the risk of another GreatDepression loomed. At the end of 2008 they looked into the abyss a dgotreligion. They started deploying all the weapons in their arsenal. Some tac­tics, like cutting interest rates, came from the standard playbook. But manyothers seemed to come from another world, and in some cases another era.To the uninitiated, the names of these-tactics-“quantitative easing,” “capitalinjections,” “central bank swap lines”-defy definition. But these and manyother unorthodox weapons came off theshelf and were mustered into battle.Somehad beentriedbefore;othershadnot.Someworked;somedidnot..

Nonetheless,theircollectiveeffectarguablypreventedthe GreatReces­sionfromturningintoanotherGreatDepression.Whetherthecurewilltumout to be worse than the disease is another matter, and it is to that question­and the risks and rewards of using unconventional policy measures to dealwithfinancialcrises-thatweturnnext.

 

 

 

 

 

Chapter6

 

TheLastResort

 

 

 

V·

‘    V·hentheworstfinancialcrisisi  generationshittheUnitedStates

• .. · m 2007, Ben Bernanke had 1ust been appomted head of theFederalReserveayearearlier.Itwas aremarkablecoincidence,

for Bemanke was not just any central banker; he was one of the world’s lead­ing authorities on the Great Depression. Far more than almost any livingeconomist, Bernanke was acutely aware of the complicated dynamics behindthis watershed event. Over the course of his academic career, he had writteninfluential articles that helped untangle the causes and effects of the worstdepressioninthenation’shistory.

Bernankeself-consciouslybuiltonthepioneeringworkofmonetar­

ists Milton Friedman and Anna Jacobson Schwartz,’ whose writings he firstencountered in grad school. As we saw in chapter 2, these two scholars hadbroken with earlier interpretations of the Great Depression by arguing thatmonetary policy-courtesy of theFederal Reserve-wasto blame for thedisaster. According to this interpretation, the Fed’s inaction and ineptitudenot only failed to prevent the unfolding disaster but even contributed to theproblem.Bemankeelaboratedonthatthesis,showinghowtheconsequent

 

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