CHAPTER 3

One Main Lesson: Trust Is Gone

The Revelations of an Unprecedented Financial Catastrophe

The economic decline of 2007–2011 resulted from a triple crisis, which compounded the effects of a more “traditional” excess debt crisis, and helps explain the unexpected force and extent of its damage.

A Crisis of Innovation Out of Control

Above all, this was a crisis of financial innovation. Rapid development of securitization, off–balance sheet refinancing vehicles, and the infinite pooling of the subprime mortgages all contributed to the uncontrolled chain reaction that almost killed the system. Carried away by the idea of the great economic progress that the system was supposed to enable, financiers had adapted a number of products without trying very hard to measure the consequences. The connection between cause and effect was lost. They created debt, and with that debt they redeemed assets, the yields of which encouraged them to create more and more debt, thanks to financial innovations that grew more and more inventive, until all control was gone. Left to its own devices, the instrument manufactured artificial wealth until the bubble burst. The biggest lesson we can take from the 2007–2008 crisis is that, to paraphrase Rebelais, “Finance without conscience is but the ruin of the world.”¹ Domesticated, finance is a good servant, but left to itself, it becomes a poor master. Uncontrolled and allowed to run wild, it can lead the world to disaster. Paul Volcker, former chair of the Federal Reserve who advised Barack Obama on financial reform, bitterly said that there have been few true financial innovations and that the last real one was the ATM.

We must not forget that, contrary to traditional teaching, financial markets can be, and often are, dominated by the irrational. One example is the October 1987 crash, when the Dow Jones Industrial Average lost 22.7 percent of its value in a single day, even though there was no new information to explain the sell-off. The economy was certainly in a phase with sharply rising long-term interest rates, but why this black day? Sociologists talk about a “tipping point” or a “tolerance threshold,” meaning the critical moment when a singular phenomenon becomes commonplace. In the case of the stock market, this means that during a certain period, the players overlook a trend until it is so noticeable that the collective confidence shifts. Movements on the stock market are never permanent or regular but instead are marked by seesaws and adjustments. There is mimicry as well as mania. This was the case for tulips in Holland in the 17th century.² In two weeks, tulips rose in price from 50 to 1,000 florins without any discernible reason. A buying mania took hold, the masses followed suit, and then suddenly there was a panic and a crash. In both cases, a force that was both irrational and irresistible had taken over the markets, pushing prices higher until they suddenly broke and started their decline, ending with another crash. Every time, people say “this time it’s different,”³ but the phenomenon occurs over and over again, always taking us by surprise.

In the case of the 2007–2008 crisis, the problem was that, despite the inherent irrationality of the system, we wanted to believe, more urgently than ever, in the absolute rationality and effectiveness of our financial instruments. The alliance of finance with digital technology undoubtedly contributes to the persistence of this illusion. An algorithmic tool pushed the players to systematize use of value models, which gradually became standards. This is the danger of any model, which by definition simplifies reality. Human beings have always tended to want to substitute the representation for the real, even when it is just so that we can make a decision. With financial models, built around averages from which they too regularly deviate,⁴ the temptation to depart from them is often too great, at the risk of forgetting that this even is a departure. The models give false reassurance that extreme events are off limits and tempt us to test these limits. At heart the financial language and digital language are two of a kind. They are both universal languages, which, left unchecked, act as irresistible forces.  Thus, their convergence can be explosive. The convergence led to a major crisis in 2007–2008. Driven by a unique and irresistible language, the temptation of Babel is ancient and universal.

A Crisis of Incomplete Globalization

At the same time, 2007–2008 was a crisis of financial globalization itself. Starting in 1971, reinforced and pursued throughout the 1970s, 1980s, and 1990s with the liberalization of capital flows beyond national borders, and then with ever more sophisticated distribution of credit risks, the financial system did not stop growing, spreading, interconnecting, and creating interdependencies, to the point that, if any part whatsoever should fail, the whole would be weakened immediately.

Does this mean this crisis was truly “global”? I can still hear the Indian finance minister, P. Chidambaram, ironically noting that we call crises that affect the United States and Europe “global” while those that happen in India are deemed to be “local.” In fact, today the international financial economy is largely dominated by advanced economies (in the narrowest sense, the G7 countries; more broadly, members of the OECD). The world’s largest banks are still European, American, Japanese, and Australian, as are the major institutional investors, despite the emergence of Chinese players. Emerging countries feel like hostages to a system in which they would like to have more of a say. This is the purpose of the discussions that took place at the G20 summits starting in 2008. Remember that in the worst hours of the crisis, when we were repeatedly at the brink of a global bankruptcy, it was China that contributed to the rescue of the global economy, even if the debt it created then appeared as a sign of fragility a few years later. As the Chinese famously said, it was time to save capitalism. With its 2009–2010 stimulus policy, China made itself into one of the world’s economic locomotives. A number of financial flows were redirected then to emerging countries that had resisted the crash better, even if some of them are now seeing a painful economic turnaround.

A Crisis of Inappropriate and Poorly Supervised Regulation

It was a crisis of deregulation. Remember that deregulation was a key component of the neoliberal approach. We have not been able to regulate our global financial system; its complexity and distribution have largely escaped legislators’ grasp. A similar situation arose in the Middle Ages with regard to the Church not knowing how to rule on the regulation of weapons. The Church ruled yes to those whose effects you could see, such as axes and maces, and no to those you couldn’t see, such as ballistae and catapults. Not only have regulations barely been adequate to track the development of global finance, but the international community, blinded by its faith in the alleged benefits of the system, allowed existing regulations to be reduced. It granted an ever-increasing share of the assessment to financial actors—de facto self-assessment—who became bigger and bigger. Some banks attained balance sheets equal to the size of the GDP of major countries—close to $2 trillion for JPMorgan Chase and Bank of America, for example, which was comparable to France’s GDP. These actors were themselves left to blunt their own regulations, relying only on measurement and compensation mechanisms and incentives that had lost any idea of the collective. They took the system in an insane direction.

In short, we did not know how to control the forces the deregulation had unleashed. In the prophetic words of Adair Turner, “This catastrophe was entirely self-inflicted and avoidable.”⁵

Finally, a Devastating Crisis of Confidence

Finally, the economic damage caused by the 2007–2008 financial crisis revealed itself dramatically. After the Great Moderation, global community fell into a Great Recession that we have not yet completely recovered from. The cost of bailing out the financial system per se did not, however, weigh that much in the balance. In all the advanced economies, the governments support of the banks cost, in total, over 3 percent of GDP.⁶ But, at the same time, millions of people had lost their homes, their jobs, or seen their incomes and standards of living fall. Public debt increased in a spectacular fashion (in advanced countries, by an average of 34 percent of GDP between 2007 and 2014⁷) at the same time that public development aid, the first target of austerity cures, shrank. This was a modern confirmation of the old adage that “when the fat grow thin, the thin die,” as I explained in a book published around that time.⁸ Paul Tucker, then number two at the Bank of England, predicted 25 lost years. We are still counting . . . But the financial crisis had a still more damaging consequence in the long-term: the profound loss of confidence in banks, governments, elites, and “the system” in general. The public was appalled to learn that many bankers granted risky mortgages to Americans, as well as Irish, Spanish, and British real estate developers; that some had acted dishonestly by manipulating the LIBOR (London Interbank Offered Rate) or selling securities of questionable value to less scrupulous investors.⁹ François Hollande’s speech at Le Bourget, France, at the beginning of his presidential campaign on January 22, 2012, perfectly summarized the state of mind of many at the time:

My true adversary . . . does not have a name, a face, or a party. It will never present itself as a candidate, will never be elected, and yet, it governs. This adversary is the world of finance. Right in front of our eyes, over twenty years, finance has taken control of the economy, society, and our lives. . . . This control has become an empire. And the crisis that has raged since September 15, 2008, has strengthened, rather than weakening it.

I was overwhelmed by the negative image of bankers perpetrated by the media throughout the crisis, and by the popular resentment for them, because of the disparities between bankers and them-selves. During the four years I spent at Crédit Agricole, I went to the bank’s meetings of members, shareholders, and customers in various regions of France. I remember in particular my first such town hall in Blois, France, in March 2009, when Crédit Agricole shares were worth less than €6, compared to €30 before the crisis.¹⁰ The first question I was asked came from an older gentleman, leaning on his cane: “How much do you make, monsieur, and how much do all of these people, who have ruined me, make, who have put my grandson out of a job, and said nothing to us?” This man, along with many others, had been hurt by the crisis and the economic recession that followed. They had to pay and will pay more in the future, along with their children for this debacle for which they bore no responsibility. I so deeply felt for him for what he had revealed that night. They did not get the explanations they deserved to justify the emergency measures adopted to save the system. We should not be surprised that confidence vanished. As Deputy Prime Minister Tharman Shanmugaratnam of Singapore said in a speech in Aix en Provence, France, in July 2017, the three biggest issues we are facing today are all consequences of the crisis: the stagnation of the middle class in most advanced economies, the renewed lack of convergence between advanced economies and the rest of the world, and, more importantly, the loss of trust in most, if not all, domestic institutions as well as international ones. Of course, these issues are interrelated.

King Finance Suddenly Naked

For France one of the symbolic turning points occurred in the summer of 2008. The theme that dominated the national debate in France at that time was the Revenu de solidarité active (minimum social income) proposed by Minister Martin Hirsch. The experts struggled with whether this was necessary and if we should dedicate a budget of €500 million, €600 million, or €800 million to it. In September Lehman Brothers filed for bankruptcy. In no time, Nicolas Sarkozy mobilized €420 billion to fly to the rescue of the banks, while the United States found $700 billion for Wall Street. In short, we fought for two months to decide how many millions of euros to give to the poor, and one month later we had pulled billions out of a hat for finance! The irony cut deeper because in France these two subjects were being voted on in the same bill. The rupture with the people was inevitable. We will never be able to explain to the French people, no more than to the American people or any other citizens of the world, that this €400 billion or $700 billion were ultimately a good deal for governments, which made money out of the bailouts, that they were, above all, to avoid a disaster for every country by heading off the collapse of the banking system.

The second rupture came on September 24, 2008, in Toulon, France, when President Sarkozy declared that he would not accept “a single depositor losing a single euro,” that he would mobilize the state to protect citizens’ deposits. Suddenly, 65 million French people asked, “Why were my deposits at risk?”  Until then only a very few had realized that a bank was not a safe where their money patiently waited but that the banks reinjected the deposits into the financial system to use these resources, transform them, and reallocate them to the four corners of the world. Luckily, the Toulon speech did not trigger a panic and prompt the population to form lines in front of the banks to withdraw their savings. But all the financial players were quaking in their wingtips! This statement made in France echoed all over the world. People suddenly discovered what was behind the counters and ATMs of their banks. A famous cartoon spread around the world that said, “The 2008 Nobel Prize in Economics goes to Mrs. Jones for keeping her savings at home.” I keep a framed copy of that cartoon in my office.

People realized that finance was not what they thought it was and that, when unleashed, it was more complex and dangerous than initially envisaged. This amazing force we thought we had created to serve us had run out of control. Most people had admired finance without questioning it. Suddenly the veil was cut into pieces and finance appeared naked. And this was a scary vision.

Governments, like bankers, are still paying for their errors and flawed teachings. People are angry today because they have the feeling they have been “had.” They have gotten the impression that governments saved the powerful—these “cosmocrats,” to use John Micklethwait’s term,¹¹ people who are based in London or Paris and know New York and Singapore better than Detroit, Birmingham, or Marseilles—and abandoned the rest to deal with their own problems. The current global wave of populism is an expression of this vast disenchantment.

Even more disturbing is that the markets, as well as the governments themselves, question banks and central banks. All you have to do is watch the current debates in Germany over the “dictatorship” of the ECB, or the recurring temptation of the US Congress to increase its control over the Federal Reserve or have its decisions constrained by rules. In the eurozone, as in the G20 circle, everyone suspects everyone else of wanting to depreciate its currency, creating tension on the exchange market. As for investors, they have become ultrasensitive to reputation risks. An asset manager I met in 2010 in San Francisco as part of a Crédit Agricole quarterly road show told me: “I am no longer buying bank stocks for three reasons: (1) because people don’t like you anymore, if they ever liked you; (2) because with the new rules in effect, your profitability will decrease; (3) because even if you turn out to be profitable, you’re risky because people don’t really like you [see number 1] and you will easily be taxed or fined in the future, so you don’t interest me.”

Don’t even try to talk about a bank to a Scottish investor. In Edinburgh, where I had a chance to do a road show in 2009, the people I met were ashamed that two of the largest bank disasters in the United Kingdom were caused by the Royal Bank of Scotland and the Bank of Scotland.

Without Trust: No Capitalism, No Market Economy, and No Democracy

This loss of trust capital is the biggest loss caused by the financial crisis. This was Nicolas Sarkozy’s message during his speech in Lyon on January 19, 2012: “This is not an economic crisis, it is a financial crisis that created a crisis of confidence, which created an economic crisis.” The entire capitalist system, our entire modern Western civilization, relies on trust. Without it we can no longer make loans, make plans, or cooperate. Alain Peyrefitte analyzed this mechanism well in his book La société de confiance (The trust society): if development in Europe was possible, it was thanks to an “ethos of trust,” which upended the traditional taboos and favored innovation, mobility, competition, and rational and responsible initiatives. Without trust the entire society built by our ancestors is undermined. Yet this is precisely the poison that the financial crisis injected. Our system does not work as well today as it did 10 years ago because we have lost faith in it. And this issue goes well beyond finance. For example, think about the shock wave created by Volkswagen and its fraud concerning the automobile pollution measures or the Panama Papers or various accounting scandals. The level of trust in the system has decreased, putting the system in danger. Rebuilding this trust is an urgent task, one without which our world cannot thrive.¹²

A System Awaiting Rebuilding, but also Reform: Regaining Control over Money

The financial system was almost wiped out, but it finally managed to recover. By relying on the G20, the international community managed to bail out the financial institutions, set an agenda among the players, and establish new rules, including those for compensation. People, at least those who had and always will have access, can continue to place their money in the bank, deposit salaries electronically, and pay with credit cards. Currencies did not disappear, and a deflationary spiral was avoided. The financial system managed to organize itself. For now, we have avoided the catastrophic scenario of a repetition of the 1930s.

Make no mistake, however, about the nature of this restoration. The system has done nothing more than shore up the breaches and patch up the cracks. It has not in any way been rebuilt; it has not been given new foundations, and it certainly has not been given an overhaul. If it was necessary to ensure that dishonest or incompetent banks are sanctioned, that no bank becomes “too big to fail,” that financiers are compensated based on the overall performance and the duration of the undertaking and not just their individual performance, or that taxpayers will never again be asked to rescue the bankers like they did in 2008, the regulatory reforms are not focused on the crisis’s true problem, namely, that the financial mechanism is left to its own devices. Today, it is urgent to get this mechanism back under control.

To serve the common good, we need to regain control over money. To do this, we must give the players in the international financial system a new compass. The system has such a compass, but it does not know how or why to read it, or even the direction the market should be facing. Without figuring this out, we could see another major crisis that we cannot afford.

Institutional Investors: The New Depository of Trust in the Reshuffled System

If we need to rebuild the international financial system, we first need to know which players to call on to rebuild it, and we need to agree on who does what. Yet another major consequence of the crisis is the transformation of an economy dominated by the banks, now constrained by regulation, into a world where institutional investors reign: pension funds, insurers, sovereign funds, and other asset managers now have a predominant weight in the international financial system (soon they should be managing close to $100 trillion) and are the repository of our trust; they are managing our money! This re-shuffling of the cards poses a number of questions that urgently need to be answered if we want to maintain control over how our money is used.

What regulations should we adopt when some banking business is being sent outside the banks into shadow banking, where regulations are different? Since 2008 the financial system has put in place more solid regulations to control the banks and limit the risk of a new financial crisis. The problem is that some of the risks now lie outside these traditional institutions. How can we make sure that the new version of global finance is effectively controlled?

How can the resources held by the various players be mobilized to benefit the real economy, without depriving the investors, contributors, and retirees in the world? How can development, and specifically infrastructure, be financed? In fact, because of the regulatory changes and market expectations, today it is more costly and less attractive for a bank to grant long-term loans for complex, risky, and exotic projects. How can we make sure that institutional investors are ready to take the reins? They hold a more central place than ever in the financing of the economy and do not operate like banks (see Chapter 14). How can we guide them to a place where they are financing a shared prosperity for all?

The Meaning of Managing $5,000,000,000,000

We must collectively learn to maintain the stability of the international financial system in which these new institutional investors have more weight than the banks do, are more concentrated, and correlate more with one another. Today, the world has around 20 major asset management companies, such as Blackrock (the largest with close to $5 trillion in assets), Vanguard, and Amundi (which each manage more than $1 trillion), the latter based in France. At the risk of exaggerating, I suggest that humanity may end up depending on a close circle of chief investors and chief economists to allocate savings. These investors will say that their management is highly decentralized and fragmented and therefore has little chance of going in the same direction, but who will guarantee for us that all these people are not going to think in the same way at the same time, leading to a widespread financial panic—with the catastrophic consequences that we have all seen? We still don’t have the answer, and we will likely have to go through another financial crisis to test these scenarios. It is then fair to say that the shadow banking system is a real concern for institutions like the IMF, as well as for central bankers.

Technological Disruption Added to the Equation

The current financial system, as reshaped by the 2007–2008 crisis, is even more fragile than before because of the profound disruptions caused by technology. These disruptions include the development of online banking—combined with a vast movement to close physical branches—high-frequency trading, and even asset management by robots. Faced with these innovations, how can we make sure that they benefit everyone and do not create new gaps in society? The growing number of banking apps that are trusted by the younger generation also shows a loss of faith in traditional banking.

There are so many questions that we need to face head on, which remain the major challenges that the last crisis confronted us with: the challenges of regulation, globalization, and financial innovation. The question at the heart of all of our problems today is how can a poor master become a good servant? Can we reform a system that has laudable ambitions but that has taken a wrong turn? How can we restore a trust that must be earned, not demanded? Where do we start? The clock is ticking. How can we make sure that ultimately we all win? Can we regain control over finance and money?