Tamim Bayoumi
Published Date:
October 2017
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It is often said that it takes a decade to turn current events into history, a reckoning that probably makes this the first true history of the North Atlantic financial crisis.* The moniker is apt, as this narrative chronicles how after 1980 a succession of missteps by financial regulators, aided and abetted by policy makers’ intellectual blind spots, made the North Atlantic banking system so brittle that the failure of a medium-sized US investment bank toppled the world into the worst recession since the 1930s and the Euro area into a depression. It highlights the crucial and under-appreciated role played by increasingly shaky northern European mega-banks in financing remarkably similar financial bubbles in the US and southern Europe, which parasitically intertwined with the better known but equally misunderstood expansion of shaky US shadow banks. The common origin of the US and Euro area crises has been missed because it was overlaid by the longer and deeper Euro area recession coming from a flawed currency union that left often cash-strapped national governments responsible for expensive bank rescues. While some of the mistakes in the North Atlantic economy have been rectified, there remains an awful lot of unfinished business before we can be confident that the world will not continue to face serial financial instability and lackluster growth.

* * *

The Needle

The North Atlantic crisis is generally dated from the early afternoon of August 9, 2007, Paris time, when this press release flashed on dealers’ screens:

BNP Paribas Investment Partners temporally suspends the calculation of the Net Asset Value of the following funds: Parvest Dynamic ABS, BNP Paribas ABS EURIBOR and BNP Paribas ABS EONIA

The complete evaporation of liquidity in certain market segments of the US securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating. The situation is such that it is no longer possible to value fairly the underlying US ABS assets in the three above-mentioned funds. We are therefore unable to calculate a reliable net asset value (“NAV”) for the funds.

In order to protect the interests and ensure the equal treatment of our investors, during these exceptional times, BNP Paribas Investment Partners has decided to temporarily suspend the calculation of the net asset value as well as subscriptions/redemptions, in strict compliance with regulations, for the following funds:

  • Parvest Dynamic ABS effective 7 August 2007, 3pm (Luxembourg time)

  • BNP Paribas ABS Euribor and BNP Paribas ABS Eonia effective 7 August 2007, 1pm (Paris time)

The valuation of these funds and the issue/redemption process will resume as soon as liquidity returns to the market allowing NAV to be calculated.

In the continued absence of liquidity, additional information on the envisaged measures will be communicated to investors in these funds within one month of today.

Thursday, August 9 was an unappealingly cold and windy day in Paris even before this chilly financial message. Indeed, it turned out to be the coldest day of the month, with an overnight low of 11 degrees Celsius (51 degrees Fahrenheit) rising to a modest 18 degrees Celsius (64 degrees Fahrenheit) in the afternoon. On top of that it was blowy, with average winds of 16 kilometers per hour (10 miles per hour). At least it did not rain, in contrast to the otherwise similar days before and after. In short, it was not a pleasant few days to be a banker in Paris. Not that there were many bankers left in the city. The French predilection for taking August as vacation left Paris largely bereft of workers, replaced by the usual throngs of (in this case often shivering) tourists.

The head of BNP Paribas asset management, Gilles Glicenstein, authorized the press release from the semi-deserted BNP Paribas offices just a block from the Arc de Triomphe. Gilles was a well-respected up-and-coming banker who was known for being decent and careful, as well as for running marathons. He had joined BNP after four years at the French Ministry of Finance. He never regretted his decision to send out the press release, which he firmly believed had been the right thing to do. Tragically, he died of cancer in the spring 2009 at age 44.

The press release underlined how problems initially seen as a minor blip in US mortgages were affecting the European as well as US banks. The “certain segments” of the mortgage market that were in distress were securities that bundled subprime mortgages or securities that put these assets together into more complex collateralized debt obligations (CDOs) or even into CDOs-squared (CDOs of CDOs). The roaring market in these products rapidly collapsed as it became apparent that US house prices were falling, something that the proponents of these products had assured investors had not happened on a national basis in the United States in the sixty years since World War II. This unexpected development undid a market in which subprime mortgages had increasingly been issued with minimal assessment of the creditworthiness of the borrowers on the happy assumption that continued house price increases would validate the loans. The mortgage-backed securitization market collapsed along with its central dogma.

The BNP announcement was the second major blow to the European banking system from US subprime mortgages, coming less than a fortnight after the rescue of IKB Deutsche Industriebank AG. IKB was a small German bank specializing in loans to medium-size enterprises that was brought down by unwise investments in assets backed by subprime loans. In many ways, IKB was the more important financial shock. Jochen Sanio, the lead German bank regulator, is reported to have said that the hurried weekend rescue involving a wide swathe of the German banking industry (an arrangement designed to circumvent EU rules on state subsidies) was needed to avoid the worst banking crisis since 1931.1 However, the symbolism of having part of the business of the largest French bank felled by turmoil in US markets has remained the more potent talisman of the wider impact of the North Atlantic crisis, a somewhat ironic outcome as BNP Paribas actually weathered the crisis relatively successfully.

The financial chill that settled over Europe in the summer of 2007 has yet to be fully lifted. After reaching a peak in mid-July 2007, the rescue of IKB lowered Euro area equity prices by 5 percent and the subsequent BNP announcement wiped out another 5 percent.2 After a brief rally later in the year, the stock market started a long descent, falling to a nadir of under half its peak value in early 2009. A decade later, it is still below its July 2007 value. The BNP announcement was also the moment when the two most powerful central banks in the world started finding their traditional policy responses were largely ineffective. The press release prompted an injection of liquidity into the markets by the European Central Bank that was a precursor to many such moves on both sides of the Atlantic as well as policy rate cuts by the US Federal Reserve. Such palliatives had only limited effects, given market jitters coming from uncertainty about the viability of major banks. This financial equivalent of a phony war ended with the market panic that followed the collapse of Lehman Brothers, a mid-sized US investment bank, on September 15, 2008. The subsequent freezing of North Atlantic financial markets, global recession, and painfully slow recovery have forced both central banks to dabble with all sorts of “unconventional” policies such as buying assets and lowering interest rates below zero.

* * *

The Damage Done

Before outlining the origins of the North Atlantic crisis it is worth underlining its massive costs. Calculating the economic losses from a crisis is never easy. For example, it is not enough to simply focus on the output losses after the crisis, as these must be set against the booms that economies experience before financial bubbles burst. Indeed, in normal times economists assume that expansions (when output moves above potential) are offset by recessions (when output falls below potential) so that output is on average at its trend. However, financial busts are different as the disruption coming from sudden losses in access to loans can lead to major net losses in output. In the calculations below, the losses over the cycle are calculated using International Monetary Fund estimates of the deviation of output from its potential value from 2003 to 2021.3

Another cost of the financial crisis was the waste due to excessive investment in the crisis countries. In the national accounts, investment is measured by the cost of building (say) a house even though the benefits come only after people start living there. In general, it is safe to assume that each dollar put into housing generates somewhat more than a dollar of value in the future (since investors need to be compensated for patience and risk). In a bubble, however, investments can be much less productive. In the 2000s, a good chunk of the money poured into, for example, Spanish housing went into overbuilt neighborhoods in the wrong places. Such funds could have been much more usefully used to buy machinery, such as computers, or simply been given back to shareholders as dividends. Below, it is assumed that for the crisis countries (the United States, Italy, Spain, Greece, Ireland, and Portugal) any construction spending above the ratio to output prevailing in late 1999 was worth only 50 cents rather than a dollar, which implies that about one-tenth of all spending on construction was wasted.

There were also spillovers to other parts of the world, particularly the core of the Euro area (Germany, France, the Netherlands, and Belgium) whose banks provided much of the financing that supported excessive lending in the United States and the Euro area crisis countries. The resulting banking problems boomeranged back on the core economies. It also included many innocent bystanders, such as the emerging markets that were hit by the wholesale pullback from risky assets as well as the collapse in demand for durable goods in the US and Euro area and associated knock-on to their exports.4 This suggests three levels of analysis: The costs accruing to the crisis countries themselves, those applying to the rest of the Euro area, and those accruing to the rest of the world.

Putting this together, the United States suffered cumulative losses of around 10 percentage points of output while the typical Euro area crisis country experienced losses of more like 25 percent of output, with the composition varying in an intuitive manner (Figure 1). For example, in Ireland and Spain the bulk of the losses come from inefficient housing investment rather than the cycle since the real estate bubbles were large, the boom before the crisis was extensive, and the recovery from the downturn was relatively fast (details of the calculations for the Euro area crisis countries are provided in Figure 3 at the end of this chapter). Elsewhere, including the United States, direct output losses dominate.

Figure 1.Output losses were the highest in the Euro area periphery.

Source: Haver Analytics.

Figure 2.Output losses were mainly in the North Atlantic region.

Source: Haver Analytics.

Figure 3.Estimated output losses in Euro area crisis countries. Percent of GDP.

Source: Haver Analytics.

The spillovers to the core of the Euro area from the extended downturn total about 10 percent of output, similar to the United States but less than half that of the crisis countries. These losses reflect the financial problems these countries encountered due to imprudent lending to the United States and Euro area periphery, exacerbated by the inefficient design of the Euro area, where a structure that was intended to shield the rest of the region from national fiscal and financial shocks in practice amplified such spill-overs. In the rest of the world, the losses come more from the immediate impact of the downturn on output. Output in emerging and developing countries, which make up the bulk of the remaining countries, fell by 3 percentage points in 2009 but then rebounded robustly in the subsequent two years for an implied loss in output of around 4 percent.

Overall, the final tally of damages is estimated at some $4½ trillion in 2009 prices or around 8 percent of world output in that year (Figure 2). Put another way, it is as if the world economy shut down completely for a month—no factories, no supermarkets, no electricity, no restaurants, and no new cars. Most of the losses were in the North Atlantic region, with the Euro area crisis countries suffering larger losses than the core, and the Euro area as a whole suffering greater losses than the United States. The crisis cost the rest of the world “only” about $1¼ trillion. Striking as these numbers are, these deliberately conservative calculations are at the low end of estimates of losses from financial crises as they take no account of longer-term costs coming from the erosion in job skills and debilitating impact of lower investment by firms.5 Less conservative assumptions produce losses of more like 65 percent of output from a typical financial crisis, and can run as high as 140 percent.6 Using the 65 percent figure for the US and the Euro area crisis countries quadruples the global losses—equivalent to a four-month global shutdown. However you calculate it, the North Atlantic crisis was a massive blow to the global economy.

The stagnation in incomes after the crisis also generated a political backlash against the existing order and associated economic “experts”.7 This is exemplified by the British decision to leave the European Union, the election of President Trump, and the growing support for populist parties in the Euro area. These deep changes in popular sentiment underline the importance of the North Atlantic crisis as a watershed economic, political, and social event. Commensurate with the size of this event, the rest of this book explores the historical background that allowed the crisis to occur, and outlines the resulting policy responses and lessons. It focuses on the two regions most affected by the crisis, the Euro area and the United States, and discusses the experiences of other North Atlantic countries such as the United Kingdom and Switzerland only insofar as they pertain to these events. Despite the obvious attractions of including the Swiss and UK experiences (both countries experienced major banking problems) their addition would have involved adding a lot of country-specific detail without a commensurate increase in underlying insights.8

* * *

What Went Wrong

There have been many books about the crisis that followed the 2008 collapse of Lehman Brothers in the United States and the 2009 admission of the size of Greek debt in the Euro area. At the risk of oversimplification, the main strand of the US literature involves blow-by-blow accounts of the crisis in which (for example) large and complex banks appear fully formed, while the equivalent narratives on the Euro area are similar except that they provide greater historical background on the creation of the currency union.9 In both cases, the focus on how policymakers reacted to the new and largely unexpected challenges. In the United States, these include how to provide financial support to institutions that were outside of the Federal Reserve’s traditional safety net, how to sort through the long chains of ownership because of banks selling mortgage loans using securitizations, and how to deal with overinflated credit ratings. On the Euro area side, the challenges include regaining access to dollar liquidity, how to respond to market jitters about the solvency of banks, sovereigns, and their interaction, and how to enforce policy conditions on member countries. The experiences from these challenges are then used to distill lessons for the future. Finally, there is also a strand of the literature that uses the crisis to explore the instability of financial systems in capitalist economies and offer policy solutions.10

This book takes different and more holistic approach by examining the origins of the joint North Atlantic crisis. Rather than using the prism of the immediate crisis to distill lessons, it asks what can be learned from the process by which the North Atlantic region got itself into a position where such a cataclysmic crisis could occur. For example, rather than looking at the problems caused by securitization (the bundling of mortgages and other loans that were then sold to investors), it asks what drove the banks to want to sell mortgages through securitized markets in the United States and not in Europe. Similarly, rather than looking at the problems caused by massive European banks whose governments found difficult to bail out, it asks what led to the creation of so many mega-banks in Europe compared to the United States. Rather than focusing on the different triggers and responses to the US and European crisis, it asks why the major northern European banks were so involved in financing unsustainable financial bubbles in the United States and the Euro area periphery.

A parallel with the literature on World War I may provide a useful analogy. At the end of that bruising conflict there was again a desire to assess the lessons coming from the immediate experience of the war. This focus generated heroes, such as Lawrence of Arabia, and villains, most importantly the leaders of Germany who were seen as bent on aggression. Over time, however, the literature on the origins of World War I has come to a much more nuanced view in which the war is seen largely as the interaction of a range of diplomatic imperatives over a long period.11 Alliances hardened, military plans were refined, so that when the denouement occurred most of the actors felt like “sleepwalkers”.

Similarly, in the wake of the North Atlantic financial crisis there has been a focus on heroes, the policymakers, and villains. In the United States, the villains have generally been reckless financial firms run by greedy and crooked bankers aided and abetted by captured regulators.12 In Europe, the narrative more often involves malfeasance before the crisis by the central government (Greece), local governments (Spain), bankers (Ireland), and connected firms (Portugal and Italy), followed by an intransigent insistence on maintaining the rules in the face of the crisis by the Germans, due either to the dominance of market-orientated thinking across the elites or to divergences in the historical experience of the French and Germans.13

This book incorporates these perspectives, but argues that the structural defects that led to the North Atlantic crisis were more complex and came from a much wider range of actors and motivations. This perspective generates a narrative with fewer heroes or villains. This is not to say that there were not greedy and crooked people in banks in the US and Ireland or malfeasance elsewhere in the Euro area. There undoubtedly were. But then such people always exist. The point is that you can tell a narrative of the origins of the North Atlantic crisis without malfeasance being a central plank. Just as was the case for World War I, most people were playing roles that had been laid out because of earlier decisions—they were sleep-walkers. The system failed, not the individuals. Accordingly, I have almost exclusively used pre-crisis accounts to explain their actions.

Another parallel with World War I comes from the unexpected nature of the North Atlantic crisis, which added immensely to the subsequent costs. In 2008 nobody expected problems in US subprime loans, a seemingly small segment of finance, to fell the entire North Atlantic economy just as, in the run-up to August 1914, misplaced confidence in the ability of the Concert of Europe to finesse earlier crises led to diplomatic complacency over the apparently peripheral assassination of the heir to the Austro-Hungarian Empire by a Serb patriot. The unexpected nature of the North Atlantic crisis matters as it forced policymakers to improvise. Unsurprisingly, some of these decisions were successful while others were not. US policymakers vastly underestimated the impact of allowing Lehman Brothers to go bankrupt. Euro area policymakers were similarly hamstrung by the rules that constrained the Euro area from providing adequate support to crisis countries.

A final parallel with World War I is adequacy of the response. The Versailles Treaty agreed in the aftermath of the war unsuccessfully tried to patch up the pre-war economic order while punishing the Germans with large reparation payments. It led to serial financial and economic instability—and also to World War II. By contrast, the more radical revamp of the global economic order after World War II at the Bretton Woods conference ushered in a long period of growth and prosperity. The crucial question is whether the response to this crisis is a new Versailles or a new Bretton Woods.

The first section of this book, “Anatomy of the North Atlantic Financial Crisis”, explains how the North Atlantic financial system became so brittle. There was indeed a powerful anti-regulatory lobby in the United States comprising the large banks, the Federal Reserve, and (to a lesser extent) the Securities and Exchange Commission (SEC). However, the philosophy was not endorsed by other bank regulators, so that deregulation largely affected the areas where the Federal Reserve and SEC held sway, the (already lightly regulated) investment banks, securitization, and consumer protection of mortgages, even as the core regulated banking system remained relatively sound. Crucially, however, the US anti-regulatory philosophy was exported to the international banking system via the Basel Committee on Banking Supervision, which allowed large international banks to use their own internal models to calculate capital buffers for investment banking operations. This had a particularly large impact on the Euro area, where the European Commission had encouraged universal banking (universal as it combined commercial and investment banking under one roof) and the Maastricht Treaty on Economic Union left financial regulation in the hands of national supervisors. With the scope of banks defined by the Commission and capital buffers by the Basel Committee, national regulators became boosters for their national mega-banks. The resulting boom in loans helped finance bubbles in the US housing market as well as the Euro area periphery. In short, US deregulation did promote the US and Euro area financial crises, but indirectly via Basel and mega-banks in the Euro area.

The following section, “Misdiagnosing the North Atlantic Economy”, explains why the financial and macroeconomic warning signs were missed. The answer lies in intellectual overconfidence in the stability of private markets that led to a compartmentalization of policy decisions based on faulty underlying models. Disagreements on the purpose of the single currency between Germany and France led to a flawed Euro area that was designed for good times but not for bad ones. More generally, North Atlantic policymakers underestimated the value of financial regulation and the risks from free international capital flows, while overestimating the ability of central banks to stabilize the economy in the face of shocks. In sum, a free-market intellectual bubble obscured growing domestic, intra-Euro area, and inter-Atlantic macrofinancial bubbles. This explains why the crisis came as such a surprise, and why it was so costly to solve, particularly for the Euro area.

The final section, “Completing the Cure”, examines the policy responses to the crisis from this historical perspective. While much has been done to correct the defects that became apparent during the crisis, many deeper weaknesses remain. Examples include the continued focus on bank internal risk models in the Euro area, inadequate oversight of international debt flows, limited buffers to respond to shocks to Euro area members that are not prepared to submit to a program, and a new interest in reducing financial regulations. More generally, the world seems to be drifting back to policy compartmentalization, with monetary policy shouldering the burden of raising growth out of its doldrums while backing away from concerns about financial stability, despite calls for greater coordination with fiscal, financial, and structural policies. There is still an awful lot of unfinished business.

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