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between the illiquid and the insolvent and lend only at what Bagehot called "penalty" rates. This time around central bankers saved both bank and many nonbank firms, giving access to lines of credit at rates that were far from punitive. Indeed, the mother of aJI banl<like runs had swept nonbank mort­ gage lenders, S!Vs and conduits, hedge funds, interbank markets, broker dealers, money market funds, finance companies, and even traditional banks and nonfinancial corporate firms. Since banks were not lending to each other or to nonbank financial firms or even to nonfinancial corporate firms, central banks were forced to become lenders of first, last, and only resort. The storm engendered little in the way of the "creative destruction" that Joseph Schum­ peter would have celebrated. !µstead, strong end weak alike remained in a state of suspended animation, awaiting the final reckoning.

Chapter 5

Global Pandemics

n old saying in financial markets has it that "when the United States sneezes, the rest of the world catches a cold." However cliched, that observation contains plenty of truth: the United States is the biggest,

A

most powerful economy in .the world, and when it gets sick, countries that depend on its insatiable demand for everything from raw commodities to finished consumer goods find themselves in trouble too.

This dynamic takes on dangerous potency in times of financial crisis. An outbreak of some financial disease in the world's economic powerhouse can swiftly become a devastating global pandemic. A crash in the stock market, the failure of a big bank, or some other unexpected collapse at the epicenter of global finance can become a countrywide panic and then a worldwide disaster. It's a scenario that has played out many times, whether in Britain in the nineteenth century or in the United States since that time.

Nevertheless, as the United States succumbed to the subprime disease late in 2006 and 2007, conventional wisdom held that the rest of the world

. would "decouple" from the financially ailing superpower. This idea, first pro­ moted by analysts at Goldman Sachs and then taken up as the consei.,sus,

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argued that the booming economies of Brazil, Russia, India, and China would rely on domestic demand and get through the crisis unscathed by the

subprime meltdown. The world's economic upstarts would escape the curse of history.

So too would Europe, where many people clung to a similar belief. Only the United States, so the thinking went, had practiced le capitalisme sauvage, as the French disparaged it,.and it alone would suffer ihe consequences. In September 2008 German finance minister Peer Steinbrtick declared, "The financial crisis is above all an American problem," and added, "The other

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meltdowns, banking crises, and other dramatic distresses that had first sur­ faced in the United States. What began as one country's crisis thus became a global crisis. As usual, this was nothing new or out of the ordinary. The crisis was following a path well worn by centuries of historical precedent. It was, in more ways than one, a blast from the past.

Financing a Pandemi.c

G7 financial ministers in continental Europe share this opinion." Buat few

days later much of the Europeaq, banking system effectively collapsed. Ger­ many was forced to baif out banking giant Hypo Real Estate, and Steinbriick conceded that Europe was "staring into the abyss." Bailouts of European megabanks soon followed, and Ireland issued a blanket guarantee for its six biggest lenders. Other nations in, Europe followed suit, including Britain, which effectively nationalized much of its banking system. By October 2008 many European countries as well as Canada had gone so far as to guarantee not only the deposits but the debts of the banks as well.

Nor was the crisis confined to Europe and Canada. It hammered coun­ tries on every continent, including'Brazil;Russia, India, and China. In some cases this shared affliction was a matter of global interdependence: the crisis rippled through various channels, infecting otherwise healthy sectors of other countries' economies. But the contagion: metaphor, so frequently invoked, does not fully explain the crisis. It was not simply a matter of a disease spread­ ing froma sick superpower to otherwise healthy countries. Other nations, having long pursued policies that fostered homegrown bubbles, were vulner­ able when the crisis struck. Indeed, what initially seemed like a uniquely

American ailment was in fact far more widespread than anyone wanted to acknowledge.

All of this caught most commentators by surprise. Having missed the cri­ sis in the United States, many bullish financial pundits clung to the deco1+­ pling thesis until it was impossible to defend. By the end of 2008 most of the world's advanced economies had slipped into a recession, and numerous emerging-market economies in Asia, Eastern Europe, and Latin America had succumbed as well. Many of these same economies suffered the stock market

Crises rarely cripple perfectly healthy economies; usually underlying vulner­ abilities and weaknesses set the stage for a collapse. Nonetheless, for econo­ mies outside the United States to catch the proverbial cold, some channel had to be in place. The most visible were the institutions that make up the global financial system.

Money markets are one such institution: they're the places where banks and other financial firms borrow and lend money on a short-term basis. These webs of debt and credit have always been fragile in times of panic, spread­ ing problems from one part of the global economy to another. The reason is simple: when one link in the very elaborate chain breaks and defaults on some debt, it can leave creditors dangerously short of funds, unable to guar­ antee the credit of other firms. In this way, the consequences of one failure can spread throughout the entire money market.

For this reason, troubles in the money market have long been a hallmark of financial crises. In tl1e panic of 1837, the Bank of England refused to roll over loans made to three major British financial firms, whereupon those firms failed. The effect was calamitous: the firms had extended short-term loans to merchants around the world, and their collapse voided tens of mil­ lions of pounds' worth of commercial paper. Financiers in Liverpool, Glas­ gow, New York, New Orleans, Montreal, Hambu:g, Antwerp, Paris, Buenos Aires, Mexico City, Calcutta, and elsewhere found themselves short of credit. The Times of London lamented, "It must be a very long time, years perhaps, before the entire effect of these failures is h1own, for they will extend more or less over the whole world."

Those words could well have been uttered in the wake of any of the

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crises that crippled international money markets in the nineteenth and early twentieth centuries. The worst crises typically followed the unexpected col­ lapse of some venerable firm that occupied a prominent place within the global money market. In the panic of 1873, for example, the failure of Jay Cooke's giant investment house helped trigger a worldwide crisis. In the Great Depression it was the sudden implosion of Austria's biggest bank, Credit-Anstalt. Many of the world's most powerful and important banks

had lent money to it, and its failure triggered other bank failures around the globe.

In the intervening decades, financial markets became even more integrated and interdependent. Indeed, in the recent crisis, the complex webs of borrowing and lending that bounc!'together the international financial sys­ tem were almost impossible to fully understand, much less disentangle. In fact, few people.likely understood that stress in the repo or commercial paper market in one country could be quickly transmitted elsewhere. While there had been some crises that crossed national borders, none came close to rival­

ing the Great Depression; understanding of how the global financial system could-and would-unravel was limited.

That ignorance ended after the collapse of Lehman Brothers on September 15, 2008. When it failed, the hundreds of billions of dollars in short-term debt it had issued-most of it commercial paper and other bond debt-became worthless, triggering panic among the various investors and funds that held it. This panic prompted a run on the money market funds that provided lending to the commercial paper market and sowed further panic throughout the global banking system. Banks that had made short­ term loans to foreign banks jacked up their rates by over 400 basis points, an astronomical increase. What overseas investors called the "Lehman Shock"

spread fear throughout global money markets, curtailing lending and eventu- ally crippling global trade. .

. While the failure of Lehman Brothers helped transmit the crisis through­ out the world's financial system, it was hardly the only catalyst. A classic mechanism for spreading crises is the otherwise unremarkable fact that inves­ tors in multiple countries hold identical assets. In a number of nineteenth­ century crises, for example, investors around the world held the same types

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of railroad securities, a popular international investment. When the bub­ ble behind these securities popped, investors in the United States, Britain, France, and elsewhere simultaneously saw their portfolios go up in smoke. Invariably, they curtailed credit, hoarded cash, and triggered a panic.

The recent crisis was comparable. The subprime meltdown spilled over from the United States to Europe, Australia, and other parts of the world for the simple reason that about half of the securitized sausage made on Wall Street-the collateralized debt obligations and the mortgage-backed secu­ rities from which they derived their value-were sold to foreign investors. During the housing boom, foreign banks, pension funds, and a host of other institutions had snapped up these securities. When a subprime borrower in Las Vegas or Cleveland defaulted on his mortgage, it rippled up the securi­ tization food chain, hitting everyone from Norwegian pensioners to invest­ ment banks in New Zealand.

Perhaps the largest portion of these securities ended up in the asset portfolios of European banks and their subsidiaries. Some banks had direct exposure to the subprime crisis, holding tranches of CDOs and other instru­ ments as ordinary assets. In other instances, most notably with BNP Paribas and UBS, hedge funds attached to these banks functioned as disease vec­ tors, placing high-risk bets on a range of subprime securities. When those investments soured, the resulting losses ultimately hit the banks' bottom lines.

The losses sustained by these banks caused considerable collateral dam­ age to the corporate sector in Europe. Unlike American firms, which rely more on capital markets for their financing, European firms depend heavily on bank financing. When the subprime crisis started to hammer reputable European banks, they curtailed lending, limiting the corporate sector's ability to produce, hire, and invest. This set the stage for the recession that gripped the region in the final months of the crisis.

The damage did not stop there. Many of these same European banks had subsidiaries in other countries, particularly in emerging Europe-the countries that had been freed of Soviet control after the end of the Cold War. These subsidiaries had pumped significant amounts of credit into Ukraine, Hungary, Latvia, and other countries. Once the parent banks suffered massive

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losses, they became risk averse and withdrew credit across the board, staI":"­ ing their foreign subsidiaries. The resulting collapse of credit in emerging Europe helped plunge these countries into recession.

In this way, the subprime problem in the United States rippled outward via financial ties. It first affected countries that did plenty of banking business with the United States, then radiated from there to financial institutions in countries on the periphery of the global economy. It was a classic case of contagion, in which the banking system served as the conduit for America's subprime ills.

But banks weren't the only parts of the financial system to sow crisis around the world. Stock markets played an important role as well. At dramatic turning points in the crisis, the ,American stock market plunged, followed by precipitous drops on exchanges in London, Paris, Frankfurt, Shanghai, and Tokyo, and in smaller financial centers. This spread was partly a function of the remarkable degree of interdependence between international stock markets. In a world in which traders can instantaneously track movements in markets halfway across the globe, investor sentiment can easily spill over from one exchange to another.

Nonetheless, this growing synchronization was not merely a classic case of herd behavior, in which spooked investors in ne country's exchange sent investors elsewhere over the cliff. As the portents of disaster accumulated, the stock market became the medium through which investors registered their growing aversion to risk, by dumping equities for.Jess risky assets.

The contagion that raced through the stock markets may have been more pervasive, faster, and more synchronized than in any previous disaster. But it was merely the latest, most sophisticated version of a dynamic that has existed for well over a hundred years. Financial globalization, in other words, is nothing new. In 1875 the banker Baron Karl Mayer von Rothschild, upon observing that global stock markets had plunged in unison, made a simple but timeless observation: "The whole world has become a city."

Integration in Rothschild's day went beyond the stock markets: global trade too was extraordinarily interdependent and sensitive to financial crises. ' Sadly, little changed in the intervening years. After panic ieized the finan­

cial system in 2008, international trade helped spread the crisis around the world.

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Disease Vectors

In the nineteenth century the British Empire was the reigning economic superpower, and whenever it spiraled into a financial crisis, its trading part­ ners suffered collateral damage, as demand for raw materials and finished goods plummeted. In the twentieth century the United States inherited Brit­ ain's mantle, accounting on the eve of the crisis for about a quarter of the world's gross domestic product. Thanks to its $700 billion current account deficit, its real share of the world economy was even bigger. When it slipped into a severe recession, the effects echoed around the world, in countries as various as Mexico, Canada, China, Japan, South Korea, Singapore, Malay­ sia, Thailand, and the Philippines. China was particularly at risk, as much of its recent growth had depended on exports to the United States. Thousands of Chinese factories shuttered, and employees returned from urban to rural areas, casualties of a collapse half a world away.

.The effects of the downturn in China were not limited to trading links. Many Asian countries produced computer chips and exported them to China, where they would be assembled into computers, consumer electron­ ics, and other items, to be shipped to the United States. When the crisis hit

,the United States, it hit not just China but all the countries that China used in its supply chains. Here decoupling was next to impossible: economies throughout Asia depended heavily on a wide range of direct and indirect trading ties to the United States.

Decoupling was particularly difficult to avoid once Lehman Brothers collapsed; the usually boring world of trade financing was one of the first casualties. Normally banks issue "letters of credit" to guarantee that goods in transit from, say, China to the United States will be paid for when they reach their final destination. Once the credit markets seized up after Lehman's failure, however, banks stopped providing this essential financing. Global trade came close to a standstill; formerly obscure benchmarks like the Baltic Dry Index-a measure of the cost of shipping commodities-plummeted by almost 90 percent. As one expert on global shipping observed shortly after Lehman's collapse, "There's all kinds of stuff stacked up on docks right now that can't be shipped because people can't get letters of credit."

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The collapse of global trade that began with the U.S. recession an,d intensified with the demise of Lehman Brothers was unprecedented: only the Great Depression can compare. At the peak of the crisis in early 2009, exports fell-on a year-over-year basis-by 30 percent in China and Germany, and by 37 or even 45 percent in Singapore and Japan. All these countries save China slipped into a severe recession, and even China saw a dramatic collapse in its annual economic growth from 13 percent to approximately 7 percent, below the threshold of what's considered sustainable in that country.

All this happened. with a speed and simultaneity that shocked most market watchers. "The Great Synchronization/' as two economists with the Organisation for Economic Co-operation and Development dubbed the international trade collapse, was clearly a function of the global credit crunch, but that alone doesn't explain what happened. As the crisis wors­

ened, despite pledges to the contrary, many nations adopted tariffs, quotas, and other barriers to international trade-legislation forcing government contractors to buy from domestic manufacturers, for example. Such tit-for­ tat trade wars had proved inimical to global trade and growth in the depths of

the Great Depression, and their recent recurrence, while less pronounced, did not help global trade recover.

Finally, the crisis spread along paths taken 'not only by goods but by people too. As the United States plunged into recession, migrant workers stopped sending money back to their home countries: Mexico, Nicaragua, Guatemala, Colombia, Pakistan, Egypt, and the Philippines, to name a few. Many of these migrant workers had gained regular work during the housing booms, not only in the United States, but in Spain and Dubai, and when these booms became busts, remittances back home collapsed too. The effect of this drop-off in remittances is hard to overstate. In.some Central American countries, more than IO percent of the national income comes from citizens who work abroad. In this way, the crisis hurt countries that had never partici­ pated in reckless financial practices.

While trade and labor ties have often enabled crises to jump national boundaries, commodities and currencies have played an even bigger role. The reason is simple enough: the prices of commodities and currencies are set in world markets. When the price of oil or copper or a dollar rises in one place, it rises everywhere; when it declines, it declines everywhere. For that

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reason, sudden fluctuations in the prices of commodities and currencies can fuel instability on a global scale.

This level of integration dates back at least two centuries. When the prrce of cotton in New Orleans rose to bubblelike heights in 1836 and then crashed with the panic of 1837, the pain was felt not only domestically but in cotton-exporting nations around the world. Likewise, when a range of commodity prices fell by as much as 50 percent in the year following the crash of 1929, export-driven economies suffered terribly. As prices fell for everything from coffee to cotton to rubber to silk, the economies of Brazil, Colombia, the Dutch East Indies, Argentina, and Australia were distressed. Even Japan suffered, as a· disintegration of demand for raw silk crippled its economy. These countries saw their finances imperiled and their currencies depreciated on account of falling commodities prices.

Commodities prices played a role in the recent crisis too, though in ways that challenge the usual boom-to-bust narrative. Throughout 2007 and 2008 the prices of oil, food, and other commodities rocketed upward. In the sum­ mer of 2008 oil prices peaked at around $145 a barrel, up from $80 a year earlier. The increase wasn't remotely justified by economic fundamentals; rather, it was a function of investment or speculation driven by hedge funds, endowment funds, broker dealers, and various commodities funds that had

invested some of their portfolios in commodities. While the oil price spike may have benefited the oil exporters, it hit all the oil importers hard: the United States, the Eurozone, Japan, .China, India, and others. Several of these countries were already reeling from the effects of the financial crisis; the oil shock probably pushed them into a full-blown recession.

What was true on the way up was true on the way down. Exporters of oil and other commodities who had remained insulated from the financial crisis in 2007-8 struggled when demand from the United States and China col­ lapsed. In the second half of 2008, demand for oil, energy, food, and minerals fell even further, and the effect was comparable to what happened in the Great Depression: commodity exporters in Africa, Asia, and Latin America saw their economies tumble. Oil producers were. particularly hard hit: the price of oil fell from its peak to a low of $30 in the first quarter of 2009. But the damage extended to a range of raw materials. In Chile, for example, the collapse of demand for copper hammered that country's export-driven

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economy, propelling it into a recession. In all of these disruptions, a com od­ ity boom initially helped trigger a global recession among commodity-import­ ing nations; the consequent commodity bust pummeled the exporters.

Fluctuations in currencies displayed a similar dynamic and proved equally disruptive. In 2007, during the opening innings of the crisis, the American econ6mic slowdown and the ensuing reduction in interest rates helped undermine the value of the dollar. This devaluing hit countries that relied on exports to the United States: the United Kingdom, Japan, and many nations in the Eurozone. As their respective currencies strengthened relative to the dollar, the cost of these goods to American consumers rose. This undercut the competitive edge of these countries, setting them up for a recession.

As the crisis worsened, however, the process went abruptly into reverse. The fear and panic that seized the financial markets over the course of 2008 drove international investors to seek safe havens. One of them was, some­ what paradoxically, the dollar. Even though the United States was at the epicenter of the crisis, it seemed a safer bet than any number of emerging economies. As investors piled into dollars, along with the currencies of other developed countries, they simultaneously dumped the stocks and bonds in various emerging markets, further widening the gap between those countries' currencies and the "safer" currencies of the developed nations.

The effects were calamitous. Before the crisis, households and firms in emerging Europe had obtained mortgages and corporate loans from banks in more established countries. They had turned to those banks because the interest rates on euros, Swiss francs, and even.Japanese yen were lower than the rates available in their own countries. Firms in Russia, Korea, and Mex­ ico used the same borrowing strategy. But when the crisis hit and investors fled from emerging-market currencies to safe havens like the dollar, the euro, and the yen, the cost of servicing those debts went through the roof, putting enormous strains on the emerging-market economies.

All of this followed a pattern established by crises past. Like the inter­ national financial system, and like the global trading links, commodities and currencies served as pathways, enabling one nation's financial crisis to become an economic crisis of global proportions.

That said, there are limits to what the contagion model can explain. ·

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Implicit within it is the idea that a sick country-the United States-gave the rest of the world one hell of a cold. That's a comforting thought, but it's partly wrong. Plenty of other countries hatched their own bubbles independently of the United States and pursued policies no less reckless or foolish. They had little immunity to the subprime sickness because they too had made them­

selves highly vulnerable to the disease.

Shared Excesses

In 1837 Martin Van Buren, who was just ascending to the U.S. presidency, tried to explain why "two nations"-the United States and Britain-"the most commercial in th'e world, enjoying but recently the highest degree of apparent prosperity ... are suddenly ... plunged into embarrassment and distress." He was referring to the horrific panic of 1837, which was well under way, and while many commentators blamed either the United States or Brit­ ain for triggering the disaster, Van Buren recognized that the truth was more complicated. "In both countries," he wrote, "we have witnessed the same redundancy of paper money and other facilities of credit; the same spirit of speculation; the same partial successes; the same difficulties and reverses; and at length nearly the same .overwhelming catastrophe."

Van Buren's assessment was not far ·from the mark. While the United

States was arguably the worst offender in its unbridled enthusiasm for high­ risk banking and real estate speculation during the 1830s, the British inde­ pendently engaged in a mania for chartering banks and createda comparable bubble, complete with a "reckless extension of credit and wild speculation" in textiles and railroads. When the American economy started to shake and fall, the British economy did as well. Not only was it inextricably intertwined with the American economy, but it suffered from many of the same vulner­ abilities that had accumulated during the boom years. The crisis did not emanate from a sick country to a healthy one; it struck two nations at nearly

the same time.

This same pattern can be glimpsed in other crises. When one coun­ try's boom goes bust, other countries that have racked up the same kind of

126 (;RJSJS tGONUIVll(;S

excesses tend to collapse as well. In 1720, for example, the British South Sea Bubble imploded around the same time that John Law's speculative Missis' sippi Company foundered. A century and a halflater, the crisis of 1873 came on the heels of simultaneous booms in Germany, Central Europe, and the United States. These turned to brutal busts, first in Austria-Hungary, then in the United States, and then throughout much of the rest of Europe. A little over a century later speculative booms in emerging economies throughout Asia that had been fueled with foreign investment went bad in quick succes­ sion, hammering South Korea, Thailand, Indonesia, and Malaysia. Again, this was a matter of shared vulnerabilities as much as simple contagion.

Many of the economies that collapsed in the recent crisis, not surpris­ ingly, had similar vulnerabilities as the United States. The United States was hardly the only country, for one thing, with a housing bubble. Dubai, Aus­ tralia, Ireland, New Zealand, Spain, Iceland, Vietnam, Estonia, Lithuania, Thailand, China, Latvia, So4th Africa, and Singapore all had recently _seen housing values appreciate at relentless rates. In 2005 The Economist calcu­ lated that the total value of the residential properties in the world's developed economies had effectively doubled from 2000 to 2005. This gain, a stunning

$40 trillion, was equivalent to the combined gross domestic products of all the countries in question. "It looks like the biggest bubble in history," the magazine observed.

Some of these increases were staggering.' While The Economist noted that American home prices appreciated by 73 percent between 1997 and 2005, Australian prices rose 114 percent, and Spanish prices by 145 percent. In Dubai, locale of a massive real estate bubble, prices of villas rose a stag­ gering 226 percent between 2003 and 2007 alone, according to real estate consultants Colliers International. Figures on housing price appreciation in Asia and Eastern Europe are less dependable, but anecdotal evidence sug­ gests that these regions enjoyed comparable booms. The United States was bad, but it was hardly the worst offender, even if it may have generated more problem loans than any other country.

Whatever the rate of appreciation, the reasons for the boom were invari­ ably the same. Most of these countries had pursued easy monetary policies, so that borrowing cosls hit historic lows, a trend only reinforced by a global

savings glut By 2006, mortgage rates in every developed and developing economy had declined to single digits for the first time ever. And like the United States, most countries did little to regulate their mortgage and finan­ cial markets. The result was the same: as home prices went up, households in.these countries felt wealthier; they spent more and saved less. The ensuing boom in residential investment boosted many of these countries' GDP.

But this masked a deeper problem, much as it did in the United States. Low savings and high investment rates implied that the current account balance-the difference between a country's total savings and its total investments-was veering into negative territory. Unlike countries that run a current account surplus, countries that run a deficit need savings from other countries to underwrite their investments. The latter was the situation with the United States and other countries with housing bubbles: they had grown increasingly dependent on foreign capital to bring their accounts into balance. This in tum led to inflated currencies and caused a further deterio­ ration in these countries' current account balance.

When the housing bust hit the United States, all the other economies with housing bubbles underwent comparable, if not greater, declines. Con­ trary to conventional wisdom, their housing busts were not a direct conse­ quence of the American subprime crisis. The American crash may have been the catalyst, but it was not the cause: most if not all of these countries with overheated housing markets were poised for crashes as well. All they needed was a push, which they got when the global economy plunged into a crisis and a widespread recession in 2008.

If the United States had company in hatching an enormous housing

bubble, it had peers in other areas as well. Take, for example, the problem of leverage and risk taking. While American financial institutions were reckless, their counterparts around the world were no less guilty. For example, by June 2008, leverage ratios at European banks had hit new highs. Venerable Credit Suisse had levered up 33 to 1, while ING hit49 to 1. Deutsche Bank was up to its eyeballs in debt at 53 to 1, and Barclay's was the most levered of all, at 61 to 1. By comparison, doomed Lehman Brotherswas levered at a.relatively modest 31 to 1, and Bankof America was even lower, at 11 to 1.

Many European banks had avidly joined in the frenzy of financing and

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securitizing mortgages and other kinds ofloans. This left them holding to,sic mortgage-backed securities and CDOs that eroded in value when the hous­ ing crisis hit the United States. As markets for these securities dried up, many European banks saw their potential losses rise to frightening levels. By the end of 2009, the European Central Bank raised estimates of write-downs to

€550 billion, topping earlier estimates.

Not all these assets came from the United States. Many banks in Europe engaged in their own securitization party, slicing and dicing mortgages from homeowners in European countries, with Britain, Spain, and the Nether­ lands providing most of the loans. In 2007 alone, €496.7 billion worth of European loans became the basis of asset-backed securities, mortgage-backed securities, and CD Os. While th,:: excesses of this market paled in comparison to those of the United States, standards remained lax. Even worse, many of the loans and securities that banks had in the securitization pipeline were parked in conduits and SNs. When the crisis hit, banks had to bring them back onto their balance sheets, much as their American counterparts did.

Finally, many European banks made high-risk loans in emerging Europe, particularly Latvia, Hungary, Ukraine, and Bulgaria. When the crisis hit, many of these economies saw their currencies fall sharply, and partly asa result, they could no longer make good on their loans. Suddenly European banks-especially those in Austria, Italy, Bejgium, Sweden, and Germany­ found themselves taking massive losses on their loan portfolios. As one Danish analyst observed in early 2009, "the markets have decided that the [emerging] region is the subprime area of Europe and now everyone is running for the door." It wasn't the same subprime crisis that hit the United States, but it stemmed from the same underlying problem: too many high-risk loans.

Hence the United States was hardly_ the only developed economy to fall during the crisis. Indeed, many European institutions got into trouble in advance of their American counterparts. The French bank BNP Paribas was one of the first, suspending several hedge funds in _the summer of 2007. The German bank IKB imploded at the same time, a victim of runs on its SIVs; another German bank, Sachsen LB, was bailed out later that summer. This was but the beginning: Iceland's entire banking system would eventu­ ally collapse, and most banks in the United Kingdom ended up nationalized.

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Similar problems eventually surfaced in Ireland, Spain, and a host of other European nations. And the bust of the real estate bubble in Dubai eventu­ ally led Dubai World, the government-owned enterprise most involved in these risky real estate developments, to seek a bailout from Abu Dhabi in December 2009.

Throughout it all, the crisis was following a familiar path. Many econo­ mies, particularly those in Western Europe, could not avoid the crisis because they suffered from many of the same vulnerabilities: housing bubbles, an

· overreliance on easy money and leverage, and an enthusiastic embrace of high-risk assets and financial innovation.

This fact highlights a brnader truth about crisis economics: similar crises emerge in different places with seeming synchronization because of shared weaknesses. Too often market watchers refer to financial crises as '1pandem­ ics" or some other disease metaphor without acknowledging an important underlying truth: disease spreads most readily and quickly among those who are weak and lack immunity. In the recent crisis, many economies in Eurnpe shared the same vulnerabilities as the U.S. economy. It's no surprise, then, that when the United States sneezed, they caught the cold-or perhaps more accurately, the flu.

But not everyone got sick, and that too is revealing. Look, for exam­ ple, at India's experience. Though buffeted by the meltdown, its economy proved remarkably resilient In the years leading up to the crisis, its conserva­ tive central bankers had gone down a different road than most of the world. Indian policy makers had resisted attempts to deregulate the financial system, and banks were forced to maintain hefty reserves. Where other countries embraced the mantra of free markets, India kept a tight lid on its financial system. As a consequence .it was relatively immune to theudisease1 emanat­ ing from the United States.

7 '

Sadly, the same cannot be said for the world's other emerging econo­ mies, many of which-particuarly those in Central and Eastern Europe­ followed a familiar boom-to-bust trajectory. Still, their fate was not purely a function of shared vulnerabilities; rather, the peculiar way that developed and less developed economies can become entangled in a mutually destruc­ tive relationship contributed to their fate.

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Emerging Economies, Existing Problems

Emerging economies usually depend on capital from more developed nations. That dependency, though mutually beneficial to both parties when times are good, can end up looking like a suicide pact when things fall apart. In the crisis of 1825, British investors flooded into the newly independent nation of Mexico as well·as several other Latin American states recently freed from Spanish control. In the first year of independence alone, some £150 mil­ lion worth of funds flowed into the region, with much of the mania focused on gold and silver mining. AsJnvestors poured into these countries, the new nations flourished. So too did speculators back in London, as investors bid up the prices of the new nations' mining stocks and bonds. Unfortunately, many of the ventures proved to b.e failures or even outright frauds, and the market collapsed. Investors fled stocks and pulled their funds out of Peru, Colom­ bia, and Chile. The Latin American nations proved unable to service their debt, and in 1826 Peru defaulted, causing what one observed calied "consid­ erable panic" in the City of London. The other countries soon followed.

In the nineteenth century the most crisis-prone of the emerging markets was none other than the United States. European investors, in particular the British, plowed enormous amounts of capital into the country, snapping up the bonds of state governments, canal and railroad securities, and a host of other assets. The influx of funds helped underwrite booms in the United States, as well as speculative bubbles back in Europe. Most of them eventu­ ally collapsed, and when they did, foreign investors abruptly divested them­ selves of"risky" American assets.

In every case the result was predictable: booms turned to busts on both sides of the Atlantic. Many of the American banks and businesses that had benefited from the surfeit of foreign capital collapsed; many of their coun­ terparts in Europe suffered too. In the wake of the panic of 1837, foreign investors fled en masse. Hundreds of banks perished in the United States, and a quarter of the individual states defaulted on so1I1e portion of the debt they had issued; panic simultaneously seized the City of London. A simi­ lar flight took place in 1857, after which one commentator claimed-with

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exaggeration-that the "distrust felt by nearly all foreigners in the future of the United States was so great that the larger portion of American securities held in foreign countries, were returned for sale at almost any

sacrifice:' History repeated itself yet again in 1873, as the railroad boorn col­ lapsed, prompting European investors to run for the exits once more.

Other emerging markets have suffered similar fates. In the 1990s a new

generation of emerging markets around the world were shaken bya series of crises: Mexico in_ 1994; South Korea, Thailand, Indonesia, and Malaysia in l 997; Russia, Brazil, Ecuador, Pakistan, and Ukraine in 1998 and 1999; Turkey and Argentina in 2001. After flooding these countries with capital, foreign investors got spooked and fled in droves, leaving behind currency crises, waves of failures in the banking and corporate sectors, and defaults on government debt. Only the timely intervention of the IMF and the world's central banks prevented a worldwide economic disaster.

Emerging-market crises also played a role in the recent crisis, though ina

more muted and complicated way. The ones that conformed to the previous pattern included the economies of emerging Europe. Like their predeces­ sors, they generally had one thing in common: large current account deficits. Sometimes these deficits were fueled by a housing boom and huge increases in consumer spending, along with a drop in private savings; other times it was a function of government deficits or even corporate'borrowing.Whatever the reason for the deficits, these countries borrowed extensively from investors and banks in more developed nations. They borrowed an enormous amount:

between 2002 and 2006, borrowing from foreign sources increased by 60 per­ cent every year. Even worse, much of their debt was denominated in foreign

currenc es a strategy that went awry when their own domestic currencies

7

started to depreciate during the crisis.

Though the crisis hit countries as different as Romania, Bulgaria, Croatia, and Russia, it was the Baltic states-Latvia, Estonia, and Lithuania-as well as Hungary and Ukraine that suffered the most All of them saw an abrupt reversal ofcapital flows, as skittish investors fled "risky'' markets-in other words, emerg­ ing economies-and headed for safer havens. The results were predictable, if brutal. Hungary, Iceland, Belarus, Ukraine, and Latvia all went hat in hand to the IMF, begging for a bailout. All three Baltic countries saw spectacular rises in unemployment; all three saw their banking sectors edge toward a crisis. The

132 CRISIS ECONOMICS

Baltics suffered the worst consequences, registering double-digit unemploy­ ment by the spring of 2009. Latvia, arguably the hardest hit of all, suffered riots, the downfall of the government, and the collapse of its credit rating.

These countries fit the classic pattern of emerging economies that boom with an influx of foreign capital, then collapse when investors head for the exits. But another group of emerging economies that were hammered in the bust did not fit the usual profile: they enjoyed current account surpluses. China was the most prominent member of this group, but Brazil and smaller coun­ tries in the Middle East, Asia, and Latin America fell into this category too.

Most countries with current account surpluses tend to see their curren­ cies appreciate. But in the years leading up to the crisis, the governments in these countries intervened aggressively in the foreign exchange markets in order to keep their currencies undervalued. They did so because many of them depended on exports, and the cheaper their currencies remained, the more effectively they could compete in world markets. This kind of interven­ tion helped underwrite exports, but it meant an accumulation of dollars and other currencies at home, fueling a growth in the money supply.

The abundance of easy money and low interest rates then contributed to inflation and to asset bubbles, particularly on domestic stock exchanges. At their peak, stocks in China and India hit-price-to-equity ratios of 40 or even 50 late in 2007-definite bubble territory. Many of these economies overheated in advance of the American financial meltdown, making them extraordinarily fragile and susceptible to sudden shocks. To a certain degree, their vulnerabilities had evolved independently of the excesses in the United States. Their eventual downfall had little direct relationship to the American crisis; rather, it was a consequence of policies pursued in the years before the bust. They ended up casualties of the crisis, but to a remarkable extent, they were the architects of their own misfortune:·

The Death of Decoupling

As the crisis gathered steam in early 2008, most policy makers outside the United States, despite all the historical and contemporary evidence suggesting

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that a global pandemic was imminent, dithered. Still smitten with the idea of decoupling, many worried that their economies might overheat, generating inflation. Then central bankers in a number of emerging economies raised interest rates in an attempt to tighten monetary policy. Their counterparts in the more advanced economies followed suit; and in mid-2008 the European Central Bank implemented an ill-fated and misguided increase in policy

rates.

To make matters worse, European policy makers refused to adopt an aggressive stimulus policy. The European economies that could most readily

,afford such a program (Germany in particular) did relatively little initially,

and those who needed it the most (Spain, Portugal, Italy, and Greece) lacked the money to implement one. These "Club Med" countries were already running big budget deficits and carried a large stock of public debt relative to the size of their economy; they had little room to maneuver.

These decisions ill prepared policy makers in both advanced and emerg­

ing economies to combat the effects of the unfolding crisis. It caught them by.surprise, and thanks in no small part to their flawed analysis, the global economy sank into the worst recession since the 1930s. In the fourth quarter of 2008 and the first quarter of 2009, the global economy contracted at a rate that paralleled, in size and in depth, the collapse from 1929 to 1931 that began the Great Depression.

As for decoupling, the rest of the world actually suffered more than

the United States that winter. While the U.S. economy contracted during those two quarters at an annual rate of 6 percent, the contraction elsewhere was far more brutal. Economies that were supposed to decouple did not; they "recoupled" with a vengeance. Japan, which many initially hailed as immune to·the crisis, saw its economy contract at an annualized rate of

12.7 percent in the final quarter of 2008; South Korea saw an even bigger decline of 13.2 percent. China managed to avoid an outright recession, even if its growth dropped below sustainable levels. Most of the rest of the world was not so lucky. In the finger-pointing that followed, many market watchers focused on the collapse of Lehman Brothers, seeing in that catastrophe the cause of all the world's ills. Even now some consider this event the catalyst

for the crisis.

This interpretation is comforting but wrong. By the time of Lehman's

134 CRISIS ECONOMICS

collapse in September 2008, the United States had been in a recession fo, ten months, and much of the rest of the world was already in the same boat. The· global credit crunch had been in full swing for over a year, and global equity markets had been headed south for nearly the same length of time. The crisis in the United States, which had started a year and a half before Lehman's collapse, had already radiated to the rest of the world along a host of chan­ nels: the financial system, trade relations, commodities, and currencies.

It did not infect these other countries by accident. For years, many of them had played host to housing and equity bubbles, credit bubbles, and excessive leverage, risk taking, and overspending. Their vulnerabilities had been building for years, and even countries that had taken a more prudent course-China and much of j:he rest of Asia-depended far too much on exports for their continued survival. They too were vulnerable, if in a differ­ ent way: their continued prosperity depended on bubbles halfway around the world, bubbles that had already popped in advance of Lehman's collapse.

But the collapse of that famous firm did more than anything else to focus the minds of policy makers on the reality that the risk of another Great Depression loomed. At the end of 2008 they looked into the abyss a d got religion. They started deploying all the weapons in their arsenal. Some tac­ tics, like cutting interest rates, came from the standard playbook. But many others seemed to come from another world, and in some cases another era. To the uninitiated, the names of these-tactics-"quantitative easing," "capital injections," "central bank swap lines"-defy definition. But these and many other unorthodox weapons came off the shelf and were mustered into battle. Some had been tried before; others had not. Some worked; some did not..

Nonetheless, their collective effect arguably prevented the Great Reces­ sion from turning into another Great Depression. Whether the cure will tum out to be worse than the disease is another matter, and it is to that question­ and the risks and rewards of using unconventional policy measures to deal with financial crises-that we turn next.

Chapter 6

The Last Resort

' V· hen the worst financial crisis i generations hit the United States

V ·

· .. · m 2007, Ben Bernanke had 1ust been appomted head of the Federal Reserve a year earlier. It was a remarkable coincidence,

for Bemanke was not just any central banker; he was one of the world's lead­ ing authorities on the Great Depression. Far more than almost any living economist, Bernanke was acutely aware of the complicated dynamics behind this watershed event. Over the course of his academic career, he had written influential articles that helped untangle the causes and effects of the worst depression in the nation's history.

Bernanke self-consciously built on the pioneering work of monetar­

ists Milton Friedman and Anna Jacobson Schwartz,' whose writings he first encountered in grad school. As we saw in chapter 2, these two scholars had broken with earlier interpretations of the Great Depression by arguing that monetary policy-courtesy of the Federal Reserve-was to blame for the disaster. According to this interpretation, the Fed's inaction and ineptitude not only failed to prevent the unfolding disaster but even contributed to the problem. Bemanke elaborated on that thesis, showing how the consequent

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