CHAPTER 2
The 2007–2008 Financial Crisis
Modern economic history is clearly divided into a pre-subprime and a post-subprime era. In 2007–2008 the world experienced the worst financial crisis since World War II, or maybe even since the 1930s. We are still not completely over it. And we are still uncertain as to whether the center—understood as our ability to make the system work—will hold, at least in its current shape. How can a financial system that seemed so solid reach the brink of collapse? We need to understand the sequence that occurred before bringing the common good into our reasoning. The Tower of Babel was so beautiful, why not build it higher? We can draw many lessons from this major crisis, and those lessons deserve serious consideration if we want to put our world and economy on a path that makes sense.
The Miracle of 1944: The Bretton Woods System
Everything started in the summer of 1944 with the signing of the Bretton Woods Agreement in the United States. The urgency then was to try to rebuild the Western world after the terrible war had torn it apart while ensuring the financial stability that strengthens international commerce. The lessons of the 1930s had been learned: the major advanced economies agreed on a system of fixed exchange rates, organized around the gold standard and the US dollar, which was the only currency convertible into gold. The mission of the central banks was to maintain a fixed parity between the national currencies and the reference currency. However, the exchange rate could be adjusted as needed, under the vigilant eye of the international community. Against a backdrop of strong economic growth, and because it was regulated (with a limitation on flows of capital between countries as well as restrictions on domestic credit, to avoid international speculation and domestic debt), the system worked relatively well during the 1950s and 1960s.
The depletion of the American current account balance, due primarily to the Vietnam War that the government was financing, sounded the death knell for this well-regulated mechanism. Since American gold reserves were entrusted with securing the whole system, their depletion undermined partners’ confidence. You may remember that at the time, Charles de Gaulle expressed his desire to exchange France’s francs for gold, and prepared to do so. In 1971 faced with watching the entire US gold reserve fly off to major exporting countries, President Nixon decided to suspend the convertibility of the US dollar into gold. This decision marked a turning point in international financial relationships: from a fixed exchange system, we moved to a flexible exchange system, “officially” adopted in 1976 by the Jamaica Accords that acknowledged the generalized floating of currencies. The obligation we had to central banks to stabilize exchange rates, and thus to have sufficient exchange reserves, was then cancelled.
The Deconstruction of the System and the Hidden Vices of a Well-Lubricated System
The election of Margaret Thatcher in 1979 in the United Kingdom, and then Ronald Reagan in 1980 in the United States, buried the Bretton Woods Agreement even deeper by starting a widespread revolution of financial liberalism. Controls on cross-border capital flows were lifted in advanced economies as well as in an increasing number of emerging countries, conferring a larger role on international commercial banks. At the same time, a large majority of countries lifted their restrictions on domestic credit, opening up an unbridled increase in real estate financing. Debt soared, and nominal financial flows increased, with greater and greater multiples of “real” underlying flows (e.g., trade and investments).
This liberalization of financial markets in the 1980s and 1990s ushered the world into an era of deregulation and massive debt. In the context of free competition, financial markets interconnected a bit more each day and became, in Adair Turner’s words, “markets like any other,” and credit became “a product like any other,” to be provided “at lowest cost and in optimal quantities.”1 Household debt no longer financed new capital investment but rather purchases of already existing assets, especially property.
The mechanism had its virtues. During the 30 years of financial liberalism and this international financial revolution, global poverty was reduced more than at any time in human history: in 1980 some 50 percent of the human population lived in poverty, compared to 10 percent today.2 This is the same dynamic that allowed the UN to affirm, in all seriousness, that eliminating this scourge from the face of the earth by 2030 was within our grasp. Finance is one of the critical ingredients that have enabled us to spread well-being, allocate resources in an optimal manner, and create growth without inflation, thanks to the positive trade-offs being made.
But also during this time, Western economies became deeply indebted. Humanity has been living on credit—governments, banks, companies, and households all play their own roles in this dangerous game, on a big or small scale according to the country. Everywhere, finance gained a greater weight compared to the “real economy.” Adair Turner notes that finance’s share in the American and British economies tripled between 1950 and 2000. In advanced economies, private sector debt increased from an average of 50 percent to 170 percent of national income between 1950 and 2006; likewise, capital flows between countries grew much faster than actual long-term investment.3 The extent of financial activities as a percentage of GDP has hit two peaks: in 1929 and 2007. It’s hard to believe that this is a simple coincidence. The cash machine was in overdrive to the point of creating well-known aberrations like the empty buildings in Spain and China or factories running at half strength.
When Icarus Flew Too Close to the Sun: Excessive Confidence, Despite the Warnings
The alarm had well and truly sounded several times, but no one wanted to pay attention to those who seemed to be crying wolf. The Asian financial crisis of 1997–1998 was the fifth time the world had seen a serious monetary and financial crisis in the space of 20 years. Most economists, as well as financial regulators and central banks, wanted to believe in the virtuous cycle of free debt creation and the multiplication of financial innovations such as securitization in the service of economic growth.4 So long as the system seemed rational, profitable, and socially useful, so long as central banks were there to ensure control, led by the best people, why worry?5
The system’s growing complexity, with increasingly sophisticated control and risk distribution mechanisms, in some ways represented a measure of stability: the more we distributed risks and dispersed debt, the more the system seemed to be self-correcting. Adair Turner notes that on the eve of the subprime crisis, the complexity of the secure credit system and shadow banking was “staggering”:6
The Federal Reserve Bank of New York attempted to map all the possible circuits and interconnections on a single map. It printed the results on a 0.90 × 120 cm (35 × 47 in) sheet of paper and recommended that anyone who wanted to understand the system do the same. It was impossible to represent it on a sheet of paper so small, and yet, it was already difficult to read the instructions.7
But the sophistication was reassuring, and it maintained the illusion of a “Great Moderation.”
I did not truly understand the excesses in the system until I witnessed the swelling and then bursting of the dot-com bubble as an investment banker at Lazard in London and then New York. I had scarcely left the Ministry of Finance, with my beliefs in the rationality of French technocracy intact, when I found myself in a senseless world where you had to put “.com” on all pitches made to clients. I personally produced “WHSmith.com” and “Sainsbury.com.” The worst part is that it worked!
As an illustration, a major player in certification8 saw its stock price soar in 2000 simply because it had signed a contract with a company that presented itself as the business web portal for China’s external trade, by betting on the “first mover advantage” and “winner takes all”: at that time, people could, quite seriously and without laughing, calculate that a minimum fee per transaction experiencing exponential growth would fall into the pocket of the certifier that entered the market first, thus making it shoot up in value. Vivendi, for instance, led at that time by Jean-Marie Messier, acquired the vizzavi.fr portal from an unknown person who had already filed the name (vis@vis) for the “modest sum” of 24 million French francs, or more than $4 million today! The values no longer made any sense. The speculative bubble grew steadily until it was ready to implode, with asset depreciations, bankruptcies, and the economic recession we all remember. There was an excess of finance to be purged.
Despite Alerts, Unquestionable Finance
The abuses continued, as well as the illusion of an untouchable financial system. It is interesting to consider September 11, 2001, from this viewpoint. On that day, the very heart of global finance was dealt a serious blow. I witnessed this human tragedy firsthand from the windows of my office at Lazard, on the 61st floor of a building at Rockefeller Center, where I had an unobstructed view of the World Trade Center. None of us who were there will ever forget it: it was a beautiful fall day . . . and then a plane crashed into the Twin Towers right before our eyes. They evacuated our building, the phone network overloaded, rumors started, and panic grew. We found ourselves in the lobby, across the street from NBC headquarters, which was scrolling the morning’s news in a loop like it was any other day—stock prices going up, Michael Jordan making a comeback to the NBA, and two planes hitting the Twin Towers. The atmosphere was surreal. Then we were allowed to return to our homes. When I went to the site a week later, I was immediately struck by a strong odor of asbestos and the countless bits of letterhead heaped on the ground. I was overwhelmed by a sense of loss. But things quickly went back to normal. The day after the disaster, I got a phone call from one of my Japanese clients who worked in one of the Twin Towers. He told me that he had lost all the data on a transaction we had worked on the previous week. He asked me to intercede with Tokyo so we could move forward and reconstruct the file. September 11 was staggering in its implications, and at the same time it was reassuring to see that life went on. Wall Street also went back to business quickly, even if stock markets saw a decline (naturally). The financial system had demonstrated amazing resiliency, as if all of the actors wanted to show that they would not let it fall. The fact that Wall Street had been hit and could resume working days after the attack seemed to stress the extraordinary resilience of the system. Like many at that time, I was puzzled. The US war against Afghanistan and Iraq paradoxically helped, by improving the health of the overall economy. That said, the September 11 attacks contributed to the idea that finance was a Tower of Babel looming over us all, which we could blindly trust.
2007–2011: The Fall of the Tower of Babel
What had to happen finally did. All it took was a grain of sand to clog up the mechanism and make the system implode. We had left finance without a master. The subprime crisis in the summer of 2007 was a harsh reminder that this was a profoundly irrational blind force, and that it was the toy of players with motivations that were often different from those who signed the Millennium Declaration and agreed on the Millennium Development Goals.
The subprimes, poor-quality mortgages in an amount based on the value of the property, were recklessly granted to less and less creditworthy US households, starting in the early 2000s. The whole concept was based on a rapid, continuous increase in property prices, without anyone thinking about prices going down.9 By transforming, securitizing, and marketing these mortgages, the financial mills were offering products with higher yields because of more and more sophisticated bundling methods and ever-increasing complexity in financial modeling. It would have been enough that the American real estate market reversed itself at the beginning of 2007 to put nearly 3 million households in default, sending the nation’s banks into a tailspin, and triggering an international financial crisis, but, in fact, the foundation of the entire financial products system was constructed out of high-risk components. The subprime assets were dispersed to virtually every corner of the earth, exposing the system to a risk that we thought was diluted and distributed to those with greater “appetites.” Henri de Castries, then CEO of AXA, used a particularly strong image to summarize the situation at the time—the subprimes are essentially like the anchovies in a salade Niçoise. They don’t amount to much on their own, but if they’re rotten, it’s enough to ruin the whole salad.10
That is how, after a string of implosions in 2007, the entire system started to gradually disintegrate. The chain reaction that followed made participants feel as though they were sliding downhill in a toboggan with no way to stop. For my part, I had just joined Crédit Agricole in Paris a week before it all started, in charge of finance at one of the largest banks in the world with a balance sheet of over $2 trillion. Suddenly, I was in the eye of a hurricane.
In August 2007 the announcement by the bank BNP Paribas of a temporary freeze on three funds exposed to subprime risk hinted that this would be more than just an American crisis. The European central banks, first among them the European Central Bank (ECB), were already forced to fly to the market’s rescue. The Kerviel affair, in which a rogue trader cost the investment bank Société Générale €5 billion, was exposed in January 2008 and nearly signed Société Générale’s death warrant. The affair highlighted an even greater loss of control and the scale of the threat that weighed on the global financial system. In March, Wall Street went in the red and the markets panicked before moving up again at the news of JPMorgan Chase’s takeover of the investment bank Bear Stearns at fire sale prices, with the decisive support of the Federal Reserve.
On September 15 an event took place that was emblematic of the crisis: 150-year-old Lehman Brothers, the fourth-largest investment bank in the United States, filed for bankruptcy, the largest in American financial history. Alan Greenspan famously said, “I’ve never seen anything like this!” The shock for global finance became even worse because at the same time, the prestigious investment bank Merrill Lynch was bought by Bank of America. Then insurance giant American International Group (AIG) announced the emergency sale of $20 billion in assets. A few days later, Goldman Sachs and Morgan Stanley gave up their status as investment banks to transform themselves into commercial banks, that is, normal banks that accept deposits and have access to the Federal Reserve’s refinancing capacities. On October 3, the federal government adopted Treasury Secretary Henry Paulson’s plan to save the American economy. The historic government intervention totaled $700 billion. France followed suit by adopting a “plan to support financing of the national economy” on October 13 (in fact, it was a plan to support banking institutions). Several days later, the European banks had to recapitalize again.
Throughout that long, terrible fall, pervaded with the craziest rumors and the utmost uncertainty, a loss of confidence could be seen among the financial players. Entering the crisis meetings each morning at Crédit Agricole, we would ask each other what new bank we were going to have to stop trading with, sending to every trader on the planet the horrible instruction “Do not deal.” It was hard for us to be the first to pull away the ladder, but clearly it was impossible to be the last! In the end, the central banks found themselves set up as traders of last resort. That black year ended with the arrest, in December, of financier Bernie Madoff, perpetrator of a massive $50 billion fraud through his investment fund. The glass is full! Enough was enough! As Warren Buffett noted, with dark irony, only when the tide goes out do you discover who’s been swimming naked.
The following year, 2009, was a triumph of internationalism and regulation. Two G20 summits—in London in April and in Pittsburgh in September—were followed by a meeting in St. Andrews, Scotland, in November of the finance ministers and governors of central banks for those same countries. The participants defined a framework for the financial system that included creation of a Financial Stability Board, consideration of banks’ off–balance sheet accounts in calculating prudential ratios, reform of accounting standards, and a compilation by the Organisation for Economic Co-operation and Development (OECD) of a list of countries that refused to exchange tax information with other governments. They also agreed on measures to restart the global economy, in particular with an agreement to bolster the resources of the International Monetary Fund (IMF). In the meantime, announcements about a return to profitability for American and European banks abounded.
The lull in troubling developments (if we can call it that, as growth was at a low ebb during this time) did not last long. In October 2009, the first tensions appeared that would lead to the euro crisis. The newly elected Greek Socialist government revealed the truth behind the country’s public finances—a deficit of 12.7 percent of GDP, compared to the 6 percent that had been claimed. In January 2010, Brussels jumped in, and the 27 member countries of the EU, led by Germany, held a summit in February to try to solve the problem. An agreement on a Greek bailout plan was finally reached in May: aid of €110 billion—on a scale unheard of anywhere in the world—shared between the EU and the IMF to be granted in exchange for a painful austerity cure. Several days later, it was the Eurozone’s turn as €750 billion was mobilized over three years to support the single currency, which was being attacked from all sides, and strengthen the budgetary discipline of member states. At the same time, the ECB acquired €74 billion in sovereign debt securities (Greek and Portuguese securities in particular) in order to reassure investors. In November the EU granted financial aid to Ireland.
During this time, the G20 continued to play a role in coordinating financial and economic policies. Summits in Toronto and Seoul struggled to pave the way to sustainable and balanced growth. But summer 2011 reignited the panic with the shock of leaders losing power: Papandreou in Greece and Berlusconi in Italy lost power in November, under pressure from their peers, a first in history. The year 2011 ended with a marathon meeting in Brussels, where the seventh summit in two years was held with the goal of saving Europe. When the Brits rejected the reforms proposed by France and Germany, the feeling was, as the December 10 issue of Le Monde put it, “L’Europe à 28, c’est fini” (The EU-28 is no more). It was a pronouncement that was six years too early. France’s loss of its own triple-A rating in January 2012, previously flaunted as a national treasure by France’s president, injected another shock wave, and a sense that the country had lost its bearings. And to increase the confusion in France, as previously in the United States, the end result in 2011 of this “catastrophic” downgrading was . . . lower lending costs. You lose your prime status, and despite that you pay less than before thanks to the general fall of rates. Many people were legitimately wondering how this could make sense.
The financial crisis led the world to an uncomfortable place. No real precedents existed to help this navigation into uncharted waters. And little trust was left for the helmsmen. And the loss of trust was not just among members of Occupy Wall Street and the equivalent movements that emerged in different countries. Now that the world had narrowly escaped a complete implosion, finance had become a kind of public enemy number one. It was far from being connected to any form of common good.