2008: The Fed Saves the World Financial Order; 2018: Trump’s Assignment Is to Destroy It

Looking back ten years at what would be referred to as “The Great Recession,” it is easy to think of this event as somehow “minor” in comparison to the Great Depression of the 1930s.  Both involved greed, mismanagement, and the collapse of overinflated assets, but they differed dramatically in the financial environments in which events occurred.  The Great Depression unrolled on a timescale of years; that of the Great Recession, given a highly globalized financial community, required policy responses on the timescales of months-to-weeks, and even occasionally days.  Many believe that the crisis of 2008 was potentially more severe than that of the Great Recession, and it was only by the narrowest of margins that a far greater disaster was avoided.

Reviewing the events of ten years ago, when there truly were adults in the room, also provides an opportunity to make a comparison with the frightening situation we find ourselves in now.

Adam Tooze is a professor of history at Columbia University.  He provides a fresh look at the events that shook the financial world in 2008 to educate us on how catastrophe was averted.   His hope is to make us realize that it could happen again and the next time we may not be so fortunate.  He provided an excellent article in Foreign Affairs: The Forgotten History of the Financial Crisis: What the World Should Have Learned in 2008.

Tooze provides some perspective to justify the claim that the period of late 2008 produced “the worst financial crisis in global history.”

“Although more banks failed during the Depression, these failures were scattered between 1929 and 1933 and involved far smaller balance sheets. In 2008, both the scale and the speed of the implosion were breathtaking. According to data from the Bank for International Settlements, gross capital flows around the world plunged by 90 percent between 2007 and 2008.”

“As capital flows dried up, the crisis soon morphed into a crushing recession in the real economy. The ‘great trade collapse’ of 2008 was the most severe synchronized contraction in international trade ever recorded. Within nine months of their pre-crisis peak, in April 2008, global exports were down by 22 percent. (During the Great Depression, it took nearly two years for trade to slump by a similar amount.)”

According to Tooze, memories of the crisis and its consequences have dimmed.  In the US, it is the recklessness and criminality, both public and private, that is recalled.  In Europe, where the crisis was just as severe, “leaders are content to blame everything on the Americans.” 

The initiation of the problems was the fall in US housing prices that exposed the risky bundling of bad mortgages.  However, that was not sufficient to explain what followed.  That rapid loss of value had to be coupled with equally risky bank practices that allowed essentially a “run on banks” when credit suddenly dried up.

“What turned 2008 into the worst banking crisis in history was a new business model for banks. Traditionally, most banks had funded their operations through what is known as ‘retail’ banking, in which consumers lend money to banks in the form of deposits, which banks use to make loans. Beginning in the 1980s, however, banks across the world increasingly moved toward ‘wholesale’ banking, funding their operations through large, short-term loans from other financial institutions, such as other banks and money market funds. The motive for this shift was profit and competitive survival. Wholesale funding gave banks the ability to borrow much larger sums of money than they could in the retail market, allowing them to become more leveraged—and thus more exposed to risk—than ever before.”

This banking model had spread beyond the United States and was common in Europe, and to a lesser extent in Asia and Russia.  This tendency to increase the leverage on their assets was also coupled with the need to complete outstanding transactions in US dollars.  This was particularly a problem in Europe.  When financial markets were humming smoothly, gaining access to dollars was available in a number of ways.  However, when the collapse in asset values shocked markets to a standstill, these banks were in big trouble.

“But the real threat to the global economy was not just that banks in the United States, Europe, and, to some extent, Russia and Asia were becoming overleveraged; it was also that much of these banks’ short-term funding involved currency mismatches. In order to do business in the United States, non-U.S. banks needed dollars, which they obtained from wholesale markets through a variety of methods: borrowing unsecured cash from U.S. sources, issuing commercial paper (essentially short-term IOUs), and, crucially, using currency-swap markets to receive short-term dollar loans in exchange for their own local currencies, with a promise to “swap” the currencies back at the end of the loan term. In short, foreign banks were racking up sizable liabilities that had to be paid in dollars. If the money markets where they obtained these dollars ceased to function, many of the world’s banks would immediately be at risk of failure.”

The first indication that the problems in the US would spread globally arose when in August, 2007, the French bank PNB Paribus stopped transactions in some of its investment vehicles due to the US situation.  This bank was holding significant amounts of suspect mortgage assets and that indicated that the problem was much larger than just US financial institutions.  The British bank Northern Rock would soon become the first bank to face failure as uncertainty spread and shut down markets.

“The first big bank to fail spectacularly was the British lender Northern Rock, in August and September 2007. It had no exposure to American subprime mortgages, but its funding model relied overwhelmingly on wholesale borrowing from around the world. What cut off Northern Rock’s access to funding was BNP Paribas’ August 9 announcement. This sent a signal to wholesale lenders that more banks were holding bad assets than anyone had previously understood. With the extent of the contagion unknown, wholesale lending ground to a halt. Five days later, Northern Rock informed British regulators that it would need assistance.”

Europe was in serious trouble.

“The Bank for International Settlements estimated that all told, by the end of 2007, European banks would have needed to raise somewhere between $1 trillion and $1.2 trillion in order to cover the gaps on their balance sheets between dollar assets and dollar funding.”

“By the fall of 2007, officials in the United States had begun to fear that European banks, in a frantic bid to earn dollars to pay their bills, would liquidate their dollar portfolios in a giant fire sale. And because these banks owned 29 percent of all nonconforming, high-risk mortgage-backed securities in the United States, this was not just a European problem. The nightmare scenario for the Americans was that European banks would dump their dollar holdings, driving the prices of mortgage-backed securities to rock bottom and forcing U.S. banks, which held even larger quantities of those securities, to recognize huge losses, thus triggering a bank run that would have overwhelmed the furious efforts of the U.S. authorities to restore stability.”

“It was this risk of simultaneous implosion on both sides of the Atlantic that made 2008 the most dangerous crisis ever witnessed.”

Authorities on both sides of the Atlantic struggled through 2008 trying to keep their financial institutions afloat.  The Fed provided several paths to cheap cash for US institutions and allowed other countries to participate.  The Fed was becoming the lender of last resort for much of the world.  Nevertheless, the actions taken thus far were insufficient to stave off failure by the European banks.

“As the crisis intensified, however, the Fed’s leaders found that simply providing the European banks with access to the Wall Street liquidity programs would not be enough. Their funding needs were too great, and they lacked sufficient high-quality collateral in New York. So Geithner and the New York Federal Reserve resorted to an indirect mechanism for providing them with dollars, repurposing a long-forgotten instrument known as a ‘liquidity swap line’.”

“Liquidity swap lines are contracts between two central banks, in this case, the Fed and a foreign central bank, to temporarily exchange currencies: the Fed provides its counterpart with a fixed amount of dollars and in return receives an equivalent amount of that bank’s local currency. (The foreign central bank also pays a margin of interest to the Fed.)”

Tooze identifies the implementation of these swap lines as a major source of stability for foreign banks as they struggled through the 2007-2008 period.

“The major beneficiaries of the swap lines were the central banks of Japan, Europe, and the major emerging-market countries, which could now take dollars from the Fed to pass on to their own struggling banks. The Fed introduced the liquidity swap lines in December 2007, and they were rapidly increased to a permissible limit of $620 billion. On October 13, 2008, they were uncapped, giving the major foreign central banks unlimited dollar drawing rights. By December 2008, the swap lines were the single largest outstanding item on the Fed’s balance sheet. The swap lines operated over various terms, ranging from overnight to three months. But if, for accounting purposes, they were standardized to a 28-day term, between December 2007 and August 2010, the Fed provided its Asian, European, and Latin American counterparts with just shy of $4.5 trillion in liquidity, of which the ECB alone took $2.5 trillion.”

“The world’s central banks effectively became offshore divisions of the Fed, conduits for whatever dollar liquidity the financial system required. The Fed, that is, made itself into a global lender of last resort.”

This activity by the Fed was knowable by those who wished to know, but it was not advertised.  The Fed had no interest in bragging about using US resources to bail out foreign banks, and foreign governments were more comfortable being quietly grateful.

“The liquidity swap lines wound down rapidly in 2009, as private credit markets began to recover. The full details of the liquidity programs were not disclosed until 2011, when the U.S. Supreme Court ordered the Fed to release the data to reporters from Bloomberg.”

“The result, however, is that the Fed’s actions to save the global financial system have largely been forgotten. An unprecedented intervention effectively disappeared down a memory hole.”

The world financial order survived the crisis because the Fed took the initiative to make it happen—and the Fed had the resources to make it happen.  It was motivated by the knowledge that it was in the best interests of the US to assume this responsibility.  Required was a sense of mutual trust and responsibility among nations for the efforts to succeed.  Tooze worries that now, ten years later, the world and the US have become quite different places.  Should such a crisis appear in the future, could there be another similar response?

While pondering over that thought, a note appeared on talkingpointsmemo.com by John Judis: And Now for Something Completely Different: the Dollar Challenged.  He points out that the rather strange occurrence of a joint military exercise between Russia and China was also accompanied by some joint economic planning.

“While the country’s attention is riveted on Florence, Kavanaugh’s confirmation and Manafort’s plea deal, certain other developments around the world may in the end prove more significant. At a meeting earlier this month in Vladivostok, Russian President Vladimir Putin and Chinese leader Xi Jinping agreed to bypass the dollar and use their own currencies in commercial relations.”

That was not the only unusual financial planning taking place.

“This month, officials from France, Germany, and the UK have begun planning with China and Russia a special payments channel that would allow these countries to defy new American sanctions against any company doing business with Iran. This payment channel would bypass the American-dominated international banking system and the dollar.”

If the Europeans can bypass the US in Iranian transactions, they can bypass it in other situations if they wish.  Any effort putting the dollar at risk as the currency of choice in financial transactions brings with it extreme danger for the US.

“Much of American economic and global power rests on the universal use of the dollar as the settlements and reserve currency of choice. It allows the United States, among other things, to run huge trade and budget deficits and to impose crippling economic sanctions on other countries. If the American dollar became overnight a exotic national currency like Turkey’s Lira, then in order to balance its accounts and pay for its deficit, the U.S. would have to raise interest rates to attract foreign currencies, even if that meant crippling business and home finance.”

The impetus for this threat arises from the threatening and erratic moves Trump has made against both long-time allies and economic competitors.

“It’s happening largely in response to Trump’s Hobbesian diplomacy, which sees the U.S. engaged in a zero-sum battle against its longtime allies as well as against competitors like China and also by his fiscal policies that promise huge deficits in years ahead.”

Judis provides this insight from Taggert Murphy.

“Murphy says of the Chinese, Russian, and European efforts, ‘They are building the groundwork for the day when they can overthrow the hegemony of the US dollar. The day that happens is the day the American imperium ends’.”

Pundits who analyze Trump’s role in Putin’s master plan usually focus on short-term effects like disturbing the US national political scene and fiddling with election results.  Such activities do serve to distract and weaken the US and make it less capable of noticing and responding to any Russian power moves.  But what if Putin is after soft power, not hard power?  What if Trump’s true assignment is to so disrupt traditional alliances with the US that Europeans and others turn to Putin as a more reliable ally?  There is nothing he would like more than to eliminate the financial advantages of the US.  It is beginning to look like Trump has provided the groundwork to support such a move.