Adam Tooze’s Crashed: How a decade of financial crises changed the world was released today in the UK and will be out in the US next week. Of course, no matter where you are on the planet you can get the Kindle version from the UK store right away. [Full disclosure: Adam is a personal friend and soon-to-be doctoral advisor. I also helped a little bit as he was working on the manuscript. So, caveat emptor.]
Dozens and dozens of books have appeared on the global financial crisis. Many are blow-by-blow accounts that capture the drama of the GFC. Some are memoirs by actors in the eye of the storm. Then there are those, mostly by economists, that try to diagnose the causes of the GFC. It is the last that have failed spectacularly to impress … until now.
The principal reasons for the failure have varied. Too many are irredeemably US-centric; as if the GFC was an exclusively American affair. This is especially true of books that appeared before the eurozone crisis. Most are politically-biased; either focused on the crimes of the bankers or the misdemeanors of monetary authorities, political authorities, and above all, the Federal mortgage agencies. Some see the financial crisis as nothing but the latest rendition of financial manias and panics driven by irrational exuberance that have plagued the history of capitalism. Think Tulip mania, the Mississippi bubble, the “dot com” bubble, and so on. Finally, and perhaps most importantly, too many economists’ accounts have been incorrigibly wedded to a defunct picture of the global economy based on national economic statistics. For them, the roots of the GFC lie in persistent current account imbalances.
The GFC was not just an American subprime crisis but a crisis of global banking. It was not caused by the monetary policy of the Federal Reserve, even though ultra-low rates played their part in fanning a boom in mortgage lending (as they do in every cycle). It was not driven by Fannie and Freddie. The bulk of subprime loans made during the boom in 2004-2006 were not held by the agencies. Indeed, had that been the case there would’ve been no financial crisis.
The proof is straightforward. Even at the peak of the crisis, the week following the Lehman bankruptcy, the core component of the wholesale funding flywheel collateralized by default-remote bonds, US Treasuries and agency-RMBS (residential mortgage-backed securities issued by agencies with implicit US government backing), continued to spin just as fast. Investment banks that were understood to be over water, such as Goldman and JP Morgan, were still borrowing hundreds of billions of dollars in the tri-party repo market against agency-RMBS the day after the Lehman bankruptcy. Indeed, it was the introduction of default risk into the rapidly-spinning flywheel of the secured lending markets that was the source of instability. The whole thing imploded when escalating defaults forced a revaluation of the risk posed by private label-RMBS. That was the proximate cause of the GFC.
The mortgage lending boom was the giant sucking sound of the wholesale funding market. That is, the introduction of private label-RMBS into the rehypothecation flywheel was demand-driven. As Zoltan Pozsar argued, it was the demand for safe assets emanating from massive cash pools on the one hand and the demand for risk assets by leveraged bond portfolios on the other that drove dealers to slice and dice pools of mortgages to manufacture said assets. The construction of this manufacturing capacity required a dramatic transformation of banking practice, what Gowan called the New Wall Street System and now goes under the rubric of Shadow Banking. Here’s a map of the market-based credit system created by economists at the NY Fed.
Even the amplitude of the mortgage lending boom is not enough to understand the virulence of the global financial crisis. The other critical component was the leverage cycle. In a series of path-breaking papers, Adrian and Shin showed that unlike households, nonfinancial firms and even commercial banks, the leverage of wholesale-funded investment banks (ie, broker-dealers) is procyclical. This is not simply an artifact of the securities trading business. Because net worth goes up faster than liabilities when asset prices rise, leverage falls. Leverage is thus naturally counter-cyclical. The fact that leverage is procyclical for dealers implies that they aggressively manage their balance sheets. More precisely, when asset prices rise, value-at-risk falls; dealers respond by leveraging up; that in turn pushes up asset prices further. Conversely, when asset prices fall, value-at-risk rises; dealers respond by reducing leverage; which in turn pushes asset prices even lower. This is the “leverage cycle.”
The leverage cycle is exacerbated by the wholesale funding model. Since the value of collateral goes up along with asset prices, dealers not only want to but can borrow more on the same collateral. And on the way down, the falling value of collateral reinforces the doom loop. It was these dynamics endogenous to the financial intermediary sector that drove both the extraordinary amplitude of the financial boom and the virulence of the financial crisis.
Our account so far is seemingly US-centric. But that is far from the truth. As Shin has shown, European banks played a decisive role during the financial boom. The “round-trip” transatlantic circuit accorded “a pivotal role for European banks in determining financial conditions in the United States.”
Moreover, because “round-trip” flows get netted out, one gets the wrong picture from net capital flows (which correspond to current account imbalances). Instead, one must look at gross capital flows. As soon as we do that (next figure) we uncover the full scale of transatlantic finance. European capital flows into the United States utterly dwarfed the flows from Asia, even as the latter ran large current account surpluses.
To cut a long story short, what this means is that all accounts that trace the roots of the GFC to global imbalances are flat-out wrong. It was not Bernanke’s ‘global savings glut’; it was Shin’s ‘global banking glut’. More generally, what was responsible for the GFC was the ‘excess elasticity’ of the financial intermediary sector. The origins of the catastrophe must be traced to dynamics endogenous to high neoliberal global financial intermediation.
Before Crashed, the only books on the market that did even a little bit of justice to all these findings were Mehrling’s New Lombard Street (2010) that documented the functioning of market-based finance and Rajan’s Fault Lines (2011) that focused on the fragility of the global financial system. Mehrling tells the story of how the Fed became ‘the dealer of last resort’. Rajan pays more attention to international macro-financial linkages and spillovers. Both are definitely worth reading. But neither gets close to the full picture. Enter Adam Tooze.
Crashed gets more than just the functioning of the high neoliberal global financial system and origins of the global financial crisis right. As becoming of one of the most celebrated historians alive, Adam presents a properly historicized account of the political economy of the catastrophe and its enduring aftermath. His account does not stop with the end of the crisis in the United States with the deployment of ‘financial Powell doctrine’ or even the end of the eurozone crisis that fine day when Draghi promised to do whatever it takes (the eurozone version of the financial Powell doctrine). He goes on to chart the full unraveling of the international order that ensued in the aftermath of the GFC. (I’ll write about the geopolitical and political economy aspects of the book soon.)
We are of course still living very much in the shadow of the catastrophe so the story as they say is only half finished. That’s the risk one runs in writing contemporary history. Be that as it may, Crashed supersedes all book-length treatments so far on the origins of the catastophe.