CHAPTER TEN
Hitting Bottom
ON THE SAME DAY in August 1998 that Russia became the first of the crisis countries to default on its foreign debt, the President testified before a grand jury and made a televised speech apologizing to the nation about Monica Lewinsky. On September 10, he convened a meeting of the cabinet in the White House residence to apologize for misleading us. After Clinton apologized and explained himself, others got a chance to speak.
I wasn’t planning to say anything. But I thought to myself: We’re all human, and we all make mistakes—sometimes very large ones. And Clinton’s mistakes should be seen in the context of his accomplishments. I also thought that the whole issue—though certainly serious—had been disproportionately covered by the news media, with the result that other issues of great significance, including the momentous events in Indonesia and Russia, hadn’t gotten enough attention.
After a while I finally raised my hand. “You know, Mr. President, there’s no question you screwed up,” I said. “But we all make mistakes, even big ones. In my opinion, the bigger issue is the disproportion of the media coverage and the hypocrisy of some of your critics.”
I truly admired the way Clinton had dealt with the crisis—even though the crisis was of his own making. He was remarkably focused and intent, doing his work while the storm raged around him. Talking to the President about Russia, you wouldn’t have known he had anything else to worry about. He came to work every day and did his job as President. I remember one afternoon when he invited about fifty members of Congress—split evenly between Republicans and Democrats—to discuss Social Security reform. This was at a moment when the Lewinsky problems were at their height and Republicans were aggressively calling for impeachment. We all sat around the table at Blair House, and he led the discussion as if nothing else were going on in the world. It was a remarkable seminar on the many aspects of this issue. Even Clinton’s demeanor was relaxed, engaged, and engaging—as much with Republicans trying to impeach him as with the Democrats who were supporting him.
Like everyone else, I wondered how the President could do this. Sometime later, we had an interesting conversation. We’d been discussing the Vice President’s campaigning difficulties during the primaries, and Clinton told me that he had used “mental devices” to help him through the Lewinsky period. I didn’t ask him specifically what those were, but he thought Gore might use similar techniques to overcome his difficulties and campaign more effectively.
Whether or not it might have helped Gore on the campaign trail, the notion of consciously adopting the right frame of mind did help my tennis game by reducing my tendency to hesitate and to be too tentative, something that impedes most amateur players. While playing, I kept in mind the thought that even a very good basketball player misses 55 percent of his shots. Even a fine tennis player makes a lot of errors; the object is to focus on hitting the shot as well as possible and not to worry about either the likelihood of messing up or the outcome of the point. When I told Steve Friedman that the Lewinsky matter had improved my tennis game, he waited with bated breath for what I had to say. He may have been somewhat disappointed by my explanation.
Did the Lewinsky scandal harm Clinton’s second term on a substantive level? Some people argue that the administration missed opportunities as a result, particularly with regard to reform of the Social Security system. But my instinct is that Clinton could not have gotten more done, at least in this area, even if the scandal had never struck. We had begun to explore Social Security reform in 1997. When we floated one relatively modest change—revising the annual cost-of-living adjustment to better reflect inflation—we basically had our heads handed to us by Democrats in Congress and interest groups. Projections of a budget surplus had just materialized, and while they didn’t at all solve Social Security’s very serious long-term problems, they provided politicians with an easy way out. First, instead of reforms, they’d use the new surpluses to fund the Social Security deficits, and second, they’d put part of the Social Security trust fund into equities in the hope of earning greater returns.
Some might argue that Clinton should have gone to war with his own supporters on this issue or that he could have done so if he hadn’t needed their support in the impeachment fight. But well before the scandal, we already felt stuck. If we put a proposal out that was dead on arrival, the reaction would not only require us to retreat but would also make ultimate progress on the issue more difficult. No one will ever know whether the politics might have worked out differently in a more normal environment, but my sense is that meaningful changes weren’t viable independent of the impeachment issue. What is certain, however, is that the hangover from the Lewinsky matter did make Gore’s job as a presidential candidate more difficult.
BY AUGUST 1998, we had been fighting to contain the Asian crisis for close to a year. But no sooner did one country’s problems seem to be under control than pressures would erupt somewhere else. The most dramatic and final stage began in August 1998, when the Russian government defaulted on its debt, triggering what we’d feared all along and had come close to in December 1997 in South Korea. Markets around the world, including in the United States, were severely disrupted, and the world felt the threat of a truly global financial crisis.
Large IMF loans had been a key part of the crisis response. But those loans were provided only when matched by adequate policy reforms. The crisis countries had eventually put reforms in place, even though it took a while in Indonesia, enabling the IMF money to continue to flow. But in the case of Russia, the point came when the IMF had to say no.
Our concerns about Russia had been intensifying during the spring of 1998. The growing turmoil there reflected elements of most of the previous crises. The ruble exchange rate was linked to the dollar’s. The government had a significant budget shortfall financed by issuing large amounts of short-term ruble-denominated bonds known as GKOs. Attracted by the promise of high yields and a boom mentality, foreign investors had bought these bonds aggressively. Though the post-Soviet economy clearly had enormous problems, investors had assumed that the IMF would step in to help during any emergency. Russia was, as the saying went in markets, “too nuclear to fail.”
But as the psychology that had tripled the price level of the Russian stock market in a single year shifted, Russia found itself in terrible difficulty. Yields on Russia’s debt skyrocketed, hitting 60 percent in May 1998. It became doubtful whether Russia could continue to roll over the GKOs, which were coming due at the rate of $1 billion per week, or meet the payments on other Russian bonds. Yet the country’s political system seemed paralyzed, lacking the will or desire to take the kind of steps—such as collecting taxes, cutting government spending, and letting the ruble float—that would have helped to restore confidence. For us, Russia raised a new version of a by now familiar problem: What to do about a country that isn’t prepared to participate adequately in its own rescue? And what if that country happens to be an unstable former superpower with thousands of nuclear warheads still pointed at you?
Larry and David Lipton had been deeply involved in trying to help Russia since 1993. Their hopes for an economic transformation had waxed and waned with the coming and going of reform-minded politicians within Boris Yeltsin’s government. As Russia’s economic situation deteriorated in the spring of 1998, such optimism as remained was closely tied to the figure of Anatoly Chubais, a deputy prime minister who had handled a series of major privatizations. Chubais, who spoke not only good English but the more arcane jargon of Western finance officials, visited Washington in May 1998 to push for a large new IMF support package. Larry and David felt that Chubais was an honest figure fighting to do the right thing in a corrupt environment. My only real sense from meeting him was that he was a shrewd operator with a considerable degree of Russian pride.
My view of Russia was considerably more pessimistic than David and Larry’s—and the President’s. Bill Clinton spoke to his friend Boris Yeltsin regularly and was very focused on trying to be helpful to Russia in whatever way possible. I fully recognized the importance of helping Russia but also felt that the country had poor economic policies and enormous problems. I didn’t know a great deal about the subject, but my view had been colored by a few experiences I’d had before joining the government. In 1992, I had traveled to Moscow with Judy. The impression I formed on that trip was of pervasive corruption and economic disarray. I remembered some of the stories related by my friend Robert Strauss, who was then serving as the American ambassador. One in particular stuck in my mind, about a high Russian official who had been demanding enormous payments from American businessmen to allow routine transactions to go forward. Bob had solved the problem in a quiet meeting where he threatened public disclosure of this extortion.
I supported the $23 billion program for Russia that was announced by the IMF in July on strict probabilistic grounds. Larry and David agreed with me that the odds were against the program being successful, but the risks to the United States from destabilization in Russia seemed so enormous—from both economic and security standpoints—that going ahead made sense despite the relatively limited chance of success. I also accepted a point that Strobe Talbott, the State Department’s chief Russia specialist, often made about the danger of further alienating the Russian public. Even if the chances of success were remote, just trying to be helpful to Russia’s government could be valuable in this way. Supporting the reformers was also important, because failure to do so could strengthen the hand of reactionary political forces and endanger the prospects for change in Russia, a particular concern given its nuclear stockpile. (The issue wasn’t so much whether the arsenal would be used but whether Russia would sell nuclear materials to Iran and other nations and whether Russian nuclear scientists would sell their expertise to countries hostile to the United States.) At that point, Boris Yeltsin was desperate for assistance, and all the emphasis within the Clinton administration was on trying to find a way to respond affirmatively. A small chance of success was worth a high risk of failure. And as usual with IMF programs, the money would not be disbursed all at once, leaving the option of withholding later drawings if policies went off track.
Something less than $5 billion of the total IMF loan was disbursed at the outset. But within a very short time, it became apparent that releasing additional money would be highly unlikely to confer an additional chance of success. The clearest sign was the Russian Duma’s refusal, later in July, to support Yeltsin and Chubais on the issue of tax collection and other reform measures that were conditions of the IMF loans. Even though Yeltsin overrode the Duma unilaterally, I didn’t think more money would raise the odds of Russia getting on the right track without a broader commitment from the Russian government.
At that point, both continuing the flow of IMF money and not continuing it had potentially very damaging effects, and those effects had to be weighed against each other. If Russia’s economic deterioration led to the wrong people coming into power in Russia and blame was put on the IMF, the decision to cut off aid might later appear disastrously wrong. On the other hand, sending more money in the face of the Duma’s defiance, in addition to almost surely being futile in terms of promoting recovery, would have undermined the credibility of the IMF in its efforts to apply conditionality elsewhere in the world and created an immense moral-hazard problem with respect to creditors. Investors were buying Russian bonds at tremendous yields in the expectation of being bailed out. Providing more money to Russia without imposing appropriate conditions could do serious harm by giving foreign investors and domestic oligarchs just enough breathing space to get their money out before a collapse. All of this raised the moral-hazard problem we’d been dealing with to a new dimension. An additional dimension of the debate was whether to also put up money from the Exchange Stabilization Fund. My own judgment was that, weighing these competing considerations, the better choice was to discontinue the IMF program and do nothing with the ESF.
One problem in this episode was that the people in the geopolitical sphere tended not to relate fully to the issues in the economic sphere, and vice versa. Even after the Duma vote, members of the Clinton foreign policy team were still very focused on trying to find a way to help Russia. Sandy Berger called a meeting in the White House Situation Room to persuade Treasury to agree to more support. Many people were on his side of the issue, including Secretary of Defense Bill Cohen, Madeleine Albright, and General Henry “Hugh” Shelton, chairman of the Joint Chiefs of Staff. They all argued for doing everything we could to help the Russian people and avoid the national security nightmare that could ensue if Russia disintegrated. After these officials made their comments, they turned to me and asked what I thought.
I said that in one sense they were right. We all wanted to support the forces of reform in Russia and avoid further alienation of the Russian people. But I also thought that the Duma’s unwillingness to act meant that the odds of more money helping were close to nil, especially given the immense role of organized crime and corruption in the Russian economy. Then I turned to Steve Sestanovich, a Russia expert at the State Department who was sitting in back of me, and asked him if he disagreed. He said that some parts of Russia were more corrupt than others—which seemed to be a reluctant assent.
I also argued that providing money under these conditions would create an immense moral-hazard problem. I had lived in the markets, and I could feel people taking advantage of the situation. I knew that if I were running a trading operation, I’d be trying to make sure my firm profited from it. During all my time at Treasury, I was very conscious of market sensitivity and avoided discussing Treasury matters with friends in New York, many of whom still worked in the financial markets. Even by asking a question, a Secretary of the Treasury can indicate what’s on his mind. But Treasury and Fed officials do need to understand what market participants are thinking, which requires listening carefully to what people are saying as well as monitoring what the markets are doing. In the midst of the Russia debate, a friend of mine on Wall Street told me that investors were assuming the United States wouldn’t allow a Russian default. At the same time, David Lipton mentioned that earlier in the year he had heard investors refer to people buying Russian government bonds at 80 percent yields as a “moral-hazard play.”
On the whole, the foreign policy and economic teams worked together well on Russia as on other issues. But at this meeting, there was a lot of pressure on us to proceed with less conditionality. I recognized the validity of the argument about the need to appear helpful even if additional support was exceedingly unlikely to do any good. But I believed very strongly that the risks on the other side were greater—so strongly that I felt that if they wanted to get another Treasury Secretary who would use the ESF, or who would try to force the IMF to act, that was fine with me.
But declining to provide more liquidity didn’t mean giving up on encouraging Russia to take the steps that would allow the IMF to disburse more money. The IMF was in Russia, working very hard to persuade the Russians to implement the needed measures, and had warned the government in late July that if it did not act it would likely face the prospect of being forced into a default and devaluation as it ran out of reserves. On August 10, David Lipton flew to Moscow to try to give us at Treasury a direct sense of what was happening on the ground. He also conveyed to Russian officials the message that their country faced very dire consequences by not confronting the rapidly deteriorating situation, and that there would be no further disbursement of IMF funds unless its conditions were met. Russia’s reserves were falling faster than most politicians knew, and the “burn” rate could accelerate dramatically if the government failed to take the necessary steps to reform and IMF talks failed. But David’s sense was that no one in the government seemed to understand how precarious the situation was or to be too concerned about the loss of reserves. Many in the government simply opposed reforms without having any idea how dangerous the failure to take action could be.
On August 17, Russia announced that it was devaluing the ruble and defaulting on its foreign-held debt. The default triggered immediate consequences, not just for the Russian people but for financial markets around the globe, which became increasingly volatile. The moral-hazard problem that had preoccupied us, of course, diminished. A lot of investors paid a high price for their faulty assumptions about our willingness to provide support without Russia’s meeting the appropriate conditions.
Several days after the default, I left for a vacation in a place that used to be Russia—Alaska, where I aspired to catch some fish. There I was, fly casting for silver salmon at a lodge a short plane ride away from Anchorage, with a Secret Service agent standing a few feet away. Silver salmon are much smaller than Atlantic salmon—they weigh eight or twelve pounds—but they’re strong. You wade into the river or fish from the bank, wearing polarized lenses to reduce glare so you can spot the salmon under the water and cast to the fish you see.
Right at noon on my first day of fishing, the Secret Service agent, an enormous man named Kevin Gimblett, told me that Betty Currie, the President’s secretary, was on the cell phone for me. He relayed the message that the President wanted to talk to me about Russia in an hour. Clinton, who was on vacation on Martha’s Vineyard, was terribly concerned about the situation, and I’d been briefing him regularly. I assumed the President wanted to discuss the latest bad news, which was that the default had led to a suspension of ruble-dollar transactions and a run on the Russian banks.
“Kevin, I’ll bet you that at five to one I get a fish on the line,” I said. And sure enough, at 12:55, I hooked a big silver salmon. While I was wrestling with it, Kevin’s phone rang.
So I said to Kevin, “Just tell the President that I’m someplace else and you’ll have to go get me.”
“I can’t do that Mr. Secretary,” Kevin said. “I’m a Secret Service agent.” He had a point—it wouldn’t look so great if he said he’d lost track of me someplace where I could be eaten by bears.
So I said, “Okay, just ask Betty if I can call the President back in a few minutes.” And he did. I finished catching my fish, released it, and phoned the President to talk about Russia again.
RUSSIA’S DEFAULT USHERED in a period of grave danger for the global economy—and for the second time in less than a year (the first was when South Korea had stood on the brink of default), I was very worried about the threat to our own economy and financial markets. So was President Clinton. He had been deeply engaged in the Asian crisis from its beginnings in 1997, holding private discussions with leaders from the region as well as the heads of the other major economies. For some months, he’d been content for Treasury to take the lead on our public response.
But as the situation worsened in 1998, the President felt more and more strongly that he should speak out. In times of crisis, he said, leaders should be engaged with the public. Larry and I disagreed with this idea. We worried that we did not have a strong enough policy message for the President to communicate and that a presidential speech without concrete measures could be counterproductive for confidence. Clinton countered that engagement itself, even in the absence of definitive answers, could engender confidence—by showing a thoughtful understanding of the issues and providing a sensible discussion of possible approaches. As the crisis wore on, other world leaders began to take a similar view. They wanted to hold a joint meeting to emphasize their commitment to resolving the crisis. We all agreed that financial market disruptions tended to feed on themselves and that providing reassurance before the turmoil spread further was important, but the question was how and when to do so. The President felt strongly about his view and brought it up several times. Initially, he acceded—though reluctantly and somewhat irritably—to our suggestion to wait.
To the American public, the most visible spillover effect from Russia was a period of worrying instability and decline in the stock market. One day in late August, the Dow dropped 357 points, and by early September, the index was down nearly 20 percent from its summer peak. Our concerns went beyond what was happening in the stock market. The U.S. economy had stayed remarkably strong throughout the crisis, but we were unsure how long that could last. On September 4, Alan Greenspan captured our fears in a speech in Berkeley, California, when he warned that the United States could not remain an “oasis of prosperity” if the rest of the global economy continued to weaken. Financial markets, attuned to every nuance in the Fed chairman’s carefully chosen words, understood the signal: short-term interest rates in the United States might be heading down.
The Fed had last moved the federal funds rate—which is the overnight lending rate between banks and the key rate the Fed directly controls—in March 1997, tightening it a notch to fight inflation against the backdrop of a strong economy. In the eighteen months since, the official interest rates had been on hold and the market rates for government and corporate borrowing had broadly followed the Fed’s lead. But developments in the bond markets now became extremely troubling. Bond traders like to talk about the “spread” between the yield on Treasury bonds, which are considered as close as you can come to absolutely safe investments, and the yields of various other bonds, from high-grade corporate debt to lower-grade, higher-yielding “junk” bonds and emerging-market debt. When the spread between Treasuries and other bonds widens, investors are demanding more of a “risk premium,” i.e., a higher return for investments that aren’t as secure. In the fall of 1998, investors were fleeing from risk. This was now affecting not just emerging-market debt but countries and companies around the world, including in the United States. As a result, companies had to pay more to borrow from the capital markets. At the beginning of the year, lower-grade corporate debt had been yielding only around 2.75 percent more than Treasury bonds with similar maturities. Now, eight months later, the spread over Treasuries was 6 percent.
If it lasted, this increase in the cost of longer-term credit would dampen the economy and undermine investment and jobs just as surely as a deliberate tightening by the Fed of the short-term interest rates it controlled. Moreover, credit wasn’t just becoming more expensive. It was also getting harder and harder to obtain as both creditors and investors became less willing to take risks. Fed and Treasury officials focused on how to relieve these strains before a severe credit crunch took hold.
The easing signal from Greenspan helped somewhat. But a cut in U.S. interest rates alone seemed unlikely to quell the sense of a world in crisis. Now Larry and I agreed with President Clinton: we should try to elicit as powerful a statement as possible from the world community, and the President himself should deliver a message to the American people. Views had been crystallizing around steps to bolster the international response to the crisis. With the IMF quota increase still languishing in Congress, these included a new mechanism to speed provision of money from a group of individual countries, if needed, alongside that from the IMF. In the tight-knit circle of central bankers, the Fed was trying to convince colleagues in other countries of the need for an infusion of liquidity, with lower interest rates across the industrialized world. I remember Alan Greenspan saying, first privately, then publicly, that in watching markets for fifty years, he had never seen a set of circumstances like this.
At first, we had considerable difficulty convincing some of our major partners in Japan and Europe of the need to act. On the eve of his Berkeley speech, Alan Greenspan and I flew to the West Coast to meet the Japanese finance minister, Kiichi Miyazawa, whom Alan had known for many years, and Japan’s central bank governor. We were troubled at how little Japan was doing to address its deepening malaise; one major bank had collapsed, and the situation seemed very fragile. Miyazawa, a very sensible man with a keen appreciation of Japan’s problems, nevertheless seemed to view the meeting more as a negotiation about how we would refer publicly to Japan’s economy than as a substantive exchange between the two major economic powers about a situation that was extremely threatening to both.
In Europe, officials had been focusing on preparation for the run-up to European monetary union and for the introduction of a new currency, the euro, to replace the national currencies of the union’s member countries. Many also had qualms about the IMF’s big financing packages and the effects of moral hazard on financial markets. It took days of intense discussions and negotiations to convince them that global recession was now a bigger threat than inflation or the moral hazard from IMF lending. Finally we were able to reach agreement on a carefully worded joint communiqué by the G-7 central bank governors and finance ministers. At the last minute, one central bank governor got cold feet and tried to back off the statement, but Alan Greenspan talked him into coming back on board. The communiqué said that the “balance of risks has shifted” on monetary policy, away from solely fighting inflation and toward the need to promote growth. Those five words—probably anodyne-sounding to most people—were a big deal in the global financial world and had a significant impact. Every war has its weapons, and when you’re dealing with volatile financial markets and jittery investors, the subtleties of a carefully crafted communiqué—signed by the top financial authorities in the world’s seven largest industrialized nations—can make a crucial difference.
In the United States, President Clinton delivered a major address at the Council on Foreign Relations in New York. He made a broader case for U.S. leadership in resolving the crisis, and outlined a series of new proposals for doing so. As Clinton put it, continued turmoil in the emerging world could create a real risk to democracy, reducing support for democratic liberties as well as for free and open markets. Looking back, I think Clinton was right about the value of making a statement like this. In a period of high anxiety, leaders need to communicate with the public. If they convey a sensible understanding of the complexity of issues and discuss alternative approaches thoughtfully, that in itself can have an impact on the psychology around a crisis. Gordon Brown, Britain’s chancellor of the exchequer, strongly supported that view and skillfully orchestrated subsequent joint public statements by heads of state as well as by finance ministers and central bank governors. Though the sense of gloom persisted for several months, in retrospect I think this public engagement of and focus by major leaders on the global problems was an important step in eventually turning around the crisis.
ANOTHER BLOW to an already strained system came only days later. Russia’s default had triggered a chain of events in financial markets that now threatened the solvency of a huge hedge fund in the United States, Long-Term Capital Management, whose failure many feared could significantly exacerbate the stresses on the U.S. markets. The weekend after the President’s speech, I was at home in New York when Gary Gensler, then our assistant secretary for financial markets and a former partner at Goldman Sachs, called me. Gary said that LTCM, which had made enormous profits trading on the basis of mathematical models, was on the verge of collapse. Gary wanted to go out to the firm’s headquarters in Connecticut with Peter Fisher, an official from the Federal Reserve Bank of New York, to investigate the situation. I told him to go ahead.
Gary called again on Sunday evening, September 20, to tell me what he had learned. LTCM had taken vast positions financed by billions of dollars in loans from major financial institutions—positions that would work out only if the financial markets calmed down and the spreads reverted to more normal relationships. Now LTCM was facing massive losses, and its imminent bankruptcy portended uncertain effects on the financial markets. My first reaction was to say to Gary, “I don’t understand how someone like John Meriwether—who was thought of as such a sophisticated and experienced guy when he worked at Salomon Brothers—could get into this kind of trouble.” Before founding LTCM, Meriwether had run a massive trading operation at Salomon and had done very well over a long period. He had some of the top minds in finance—Nobel Prize winners Robert Merton and Myron Scholes—working with him at LTCM. I was amazed that they had done what it seemed they had, betting the ranch on the basis of mathematical models, even ones built by such sophisticated people.
Models can be a useful way of looking at markets and can provide useful input to making decisions. But ultimately traders have to make judgments because reality is always far messier and more complicated than even the most sophisticated models can capture. In fact, LTCM’s models may have been valid, over a long enough time frame. As a theoretical proposition, yield spreads probably would have returned to the mean, and I gather that many of LTCM’s positions would have worked out in time. But LTCM was essentially betting that a return to normal would come without some prior highly aberrational move. The unusually high degree of leverage LTCM employed meant that the firm lacked the staying power to weather severe temporary aberrations. Creditors would require additional margin as spreads moved against LTCM. LTCM’s forecasts might be vindicated long after it had gone broke.
I remembered this kind of situation well from 1986, when Steve Friedman and I had taken over responsibility for the fixed-income division at Goldman Sachs. As in the LTCM case, the problem then wasn’t just that one company had a set of bad positions. Traders at other firms had similar kinds of positions, because they all used similar models and similar historical data. When positions began to move against them, they all wanted out at the same time, exacerbating the movement. And since the major players already had these positions, there were no buyers. That meant that traders and investors had to unload other, better investments to obtain cash. This selling skewed the ordinary relationships and patterns that traders expected. Bond spreads that according to historical norms should have contracted instead got wider, and spreads that should have widened got narrower.
Everyone who had similar positions lost money. But LTCM was faced with massive losses that threatened to become much larger than the remaining capital the firm held. The immediate public policy question this raised was what kind of harm a forced liquidation of LTCM’s assets could do. In normal circumstances, governments shouldn’t worry about the tribulations of any particular firm or corporation. But if a situation threatens the financial system, some kind of government action might be the best among bad choices. No one wanted to rescue LTCM’s partners or investors. But there was a concern that liquidating such large positions could lead to a general unraveling of the markets. With the hedge fund’s creditors—Chase, Citigroup, Goldman Sachs, Bear Stearns, Morgan Stanley, Merrill Lynch, and many others—all selling into the same decline, the entire financial system could freeze up, with a spillover into the real economy as confidence was damaged and businesses and consumers found credit less available and more expensive.
The ideal solution would have been for LTCM’s creditors to agree to extend their loans on terms that might be somewhat harmful to each of them but less harmful to all than a default—as in South Korea. But doing anything to promote this kind of agreement raised tricky problems. The Fed regulates financial institutions and wouldn’t want to be seen as coercing the lenders to act. Yet without some outside pressure, LTCM’s creditors would almost surely not come together in their own self-interest. The banks collectively would benefit from working out an agreement that would prevent LTCM from going into default. But each of the banks stood to benefit even more by free riding on whatever agreement was reached—that is, by pulling out at full value while the others made some sacrifice to keep LTCM intact.
New York Federal Reserve president Bill McDonough convened the heads of the big investment and commercial banks at the Fed’s New York headquarters. He walked a fine line, calling the CEOs of the country’s biggest banks in but then leaving the room so they could work out the details on their own. After a lot of jockeying, fourteen different institutions agreed to provide a total of nearly $4 billion in additional credit to LTCM, with strict terms attached. This capital infusion gave the hedge fund breathing room to liquidate its positions in a more orderly fashion. Although I did not share the view that a collapse of LTCM was likely to lead to systemic disruptions, I thought the concerns—and Bill’s actions—were sensible and appropriate, given the general market and economic duress at the time.
The broader public policy question arising out of the LTCM mess was whether anything could be done to reduce the probability and severity of this kind of event in the future. This was a frequent topic of discussion among Larry, Alan, and me, with some of the discussion taking place in meetings of the Financial Markets Working Group, which also included Bill McDonough; SEC chairman Arthur Levitt; Brooksley Born, the chair of the Commodity Futures Trading Commission; the heads of the other principal financial market regulatory bodies; and Gene Sperling from the NEC. Some members of this group thought that derivatives—instruments such as options, futures, and forwards whose value depends on the performance of an underlying security, currency, or commodity and whose value can change in complicated ways that is hard for even experienced traders to anticipate—by their nature could pose a systemic risk. Others thought the unrestricted leverage available to hedge funds such as LTCM was a problem. Some thought neither was a problem.
I thought both derivatives and leverage could pose problems. I had been involved with derivatives from the pioneering days of the founding of the Chicago Board Options Exchange. Derivatives serve a useful purpose by providing a means to manage risk more effectively and precisely, but they can create additional problems when the system is stressed. One way to contain those risks is by limiting the permissible leverage of buyers and sellers of derivatives. If you think periodic market excesses are inevitable because human nature is likely to lead to excess, you should try at least to limit the damage to the system. Capital requirements and margin requirements—both leverage limits—help to do that, both by decreasing the size of positions and by increasing the amount of money backing each position.
Larry thought I was overly concerned with the risks of derivatives. His argument was characteristic of many students of markets, who argue that derivatives serve an important purpose in allocating risk by letting each person take as much of whatever kind of risk he wants. That is right in principle, but it is not the whole story. Throughout my career, I had seen situations where derivatives put additional pressure on volatile markets (for example, through the additional selling in the stock market that can occur when portfolio managers sell calls to arbitrageurs, who in turn hedge by shorting stock against the calls for protection as the market falls). I also thought that many people who used derivatives didn’t fully understand the risks they were taking—the situation we had found ourselves in at Goldman in 1986. Larry’s position held together under normal circumstances but seemed to me not to take into account what might happen under extraordinary circumstances. Of course, Larry thought I just wanted to keep markets the way they were when I’d learned the arbitrage business in the 1960s—his point about “playing tennis with wooden racquets” again.
THE ASIA CONTAGION finally hit Latin America in late summer 1998, adding to the sense of gloom during the darkest period of the crisis. In September, people began to talk about Brazil, the world’s eighth-largest economy, the way they’d been speaking about Russia a few months earlier. Brazil had a fixed currency, large current account and budget deficits, a great deal of short-term debt coming due, and an impending presidential election. The turmoil in the bond market, exacerbated by Russia and LTCM, was making it difficult and expensive for Brazil to roll over its debt. Underlying worries about debt sustainability and fiscal control in the country’s provinces—problems that had been present for some time—now came to the fore. Foreign banks started to reduce their lines of credit, and foreign investment slowed to a trickle. The central bank’s once very large foreign currency reserves were being depleted rapidly as the government clung to an exchange rate fixed against the dollar. Market rumors began to fly that Brazil was on the verge of defaulting on its debts, devaluing, or both.
With financial markets under great strain worldwide, we were fearful that either event could have severe consequences for the global economy. The IMF, U.S. Treasury, and Federal Reserve and other major countries began to work intensively on putting together a convincing rescue package. The stakes were high enough to warrant putting U.S. government money at risk alongside that of the IMF, provided the IMF could reach agreement with Brazil on a workable reform program.
Unlike in Russia, we had considerable confidence in Brazil’s commitment to reform. Under the leadership of President Fernando Cardoso, Brazil’s historic hyperinflation problem—the subject of my senior thesis in college—seemed finally to have been solved. The nation, which accounted for around 45 percent of South America’s GDP, had taken important steps toward implementing sound macroeconomic policies since recovering from the debt crisis of the 1980s and had a political leader prepared to call upon his people to support measures that, while difficult in the short term, were necessary for stability and growth. Cardoso’s highly capable and experienced economic team—headed by Finance Minister Pedro Malan—recognized that the alternative would have been even worse.
But there was one enormous issue in dispute: the country’s exchange rate policy. President Cardoso adopted some significant reforms that made sense in light of Brazil’s fiscal deficit, such as cutting spending and raising taxes. But the Brazilians were unwilling to devalue the real. Cardoso had been elected in 1994 largely on the promise of his Plan Real, which had fixed Brazil’s currency to the U.S. dollar and, by so doing, had succeeded in taming a 2,700 percent annual inflation rate. Brazilian policy makers had a deep-seated and understandable fear of their economy’s historical demon and felt that going to a float risked reviving inflation. But we thought floating the real—which was significantly overvalued—could prove essential to making an IMF program work. This left us with the unhappy choice between proceeding with a huge IMF program in a situation where the odds seemed unfavorable or trying to force a devaluation by refusing to lend unless Brazil agreed to a floating exchange rate. I thought there was only a fifty-fifty chance, at best, of an IMF support program working with a fixed, overvalued currency. But we were hesitant to push the issue too hard, because the inflation problem was genuine and Cardoso and his team could be right that letting the real decline would tip Brazil back into an inflationary spiral.
As with Russia, Indonesia, and South Korea, some in the U.S. administration thought a robust IMF program, backed by money from the ESF, should settle the problem. If Brazil had X billion in reserves and Y billion in loans coming due, a Z billion program should cover it. But there’s one other number that is incalculable and can swamp all those other numbers in the calculation: the size of potential domestic capital flight. For some reason, most discussions of the subject ignore what can be the largest issue in crisis recovery. If Brazilians started losing confidence in the country’s currency and converted their reals to dollars, then the potential would exist for vast additional outflows.
But proceeding with a loan to Brazil that fall was nonetheless compelling, even without the devaluation and despite the unfavorable odds. In Russia, concerns about politics and nuclear weapons had been the key. In the case of Brazil, the external environment tipped the balance. The fragility of the global economy was so great that I believed that a program was worth trying. Even buying only a few months of breathing room could be enough to get through a dangerous period of financial market strain. And demanding that Brazil float the real in the fall of 1998 in the face of the continuing instability in world markets could be very risky. A disorderly currency devaluation in Brazil could lead to additional currency disruption and contagion elsewhere, and Brazil could go into a deeper crisis. After Asia, Russia, and LTCM, and in an already fragile environment, another such shock to the system could lead to a true global meltdown.
To me, there was never a real question about whether or not to help Brazil, although the decision to go ahead without floating the exchange rate was a hard one. I remember sitting at a meeting in Larry’s office and thinking to myself that this was another choice among bad options: The odds aren’t in our favor. But even if it fails, it could still be the right decision. While the chances of success are small, the risks of inaction are enormous. And even if we fail to save Brazil, we can probably defer the impact of the collapse for six or eight months, and that will more than justify the effort. I did not believe these arguments would forestall criticism. If the Brazilian program failed, nobody was going to look at the quality of the decision or the benefit of deferral. They were just going say: you took a whole bunch of the American people’s money and threw it down the drain.
I remember this as another case where Clinton’s understanding and intuition were rather extraordinary. Larry and I had gone to the Oval Office and laid out our case for supporting an IMF program and putting U.S. money on the line alongside the IMF funds, not just as a backup option. We had persuaded other major governments to do the same. Clinton agreed that we should go ahead. But then he said, “You know, I felt very good about the Mexico program. I had a feeling it was going to work. I don’t feel as good about this one working. It just seems chancier to me.”
The large IMF program did help Brazil for a while, during November and December. But then the instability returned with a vengeance in January 1999, when Brazil did not follow through on some of its planned fiscal actions, monetary policy was loosened prematurely, and Brazil’s second-largest state refused to make debt payments that were due to the central government. Brazil’s deteriorating fiscal position sent investors running for the exits once again, further diminishing the government’s foreign reserves. With the coffers emptying, the central bank governor resigned. Brazil tried, as Mexico had, to modify its exchange rate policy in a staged way that didn’t work. A controlled devaluation seldom, if ever, works once trouble has begun—and didn’t in this situation, collapsing after only two days. The real plunged dramatically, losing 10 percent of its value in a day and more than 30 percent by the end of January. In less than three weeks, the new central bank governor was also out.
But by then the global environment was much better and the financial markets took the renewed problems in Brazil in stride. In that important sense, our bet paid off; by that point, the Fed had cut interest rates three times and the monetary easing had contributed greatly to calming financial markets. Finally letting the exchange rate go also proved a turning point for the Brazilian economy. The Brazilians’ fear that a floating exchange rate would bring back inflation turned out not to be realized. This had a lot to do with Cardoso and Malan’s choice of Arminio Fraga, a respected economist and experienced market trader, who arrived as central bank governor at the beginning of February. Fraga moved quickly to raise interest rates and make the central bank more credible.
In line with a growing international focus on involving the private sector—a particular concern for our European colleagues who had put their own government money forward for Brazil—the IMF and G-7 had been searching for ways to “bail in” foreign banks. By this time, global capital markets had calmed sufficiently that we weren’t as concerned about prompting creditors to pull back from risk, whether in the United States or in other emerging markets. In a meeting in the New York Fed’s office, Brazil’s major U.S. bank creditors agreed to extend Brazil’s credit while the IMF agreed to release additional support funds. A short time later, the worst of the crisis seemed to be over in Latin America and there were reassuring signs of a healthier economy around the globe.
BY APRIL, conditions really seemed to be getting better. In the United States, financial markets were operating normally again and the sense of fear had abated. This owed much to the Fed’s swift action to provide liquidity and cut interest rates. Brazil was able to borrow in private capital markets again. Its economy actually grew in 1999, and inflation was in check. South Korea was making early repayments on its IMF loans and was also able to borrow privately. Other Asian countries were returning to a growth path.
The pattern of recovery, though different in every country, seemed to me to validate the international community’s response to the crisis. Across the board, the switch to floating exchange rates, although initially painful, was now providing a basis for recovery as a surge in exports led the crisis countries back to growth. In Thailand, South Korea, and Brazil—countries that had taken ownership of the broader array of reforms—confidence was returning and substantial foreign reserves were building up. The combination of international loans and policy reform had been effective. For others, notably Indonesia and Russia, the picture was more mixed. Exchange rate declines were helping them to become more competitive and less reliant on foreign capital. But continued confusion about the direction of policy and how their debt difficulties would be worked out cast a shadow. Investors, both domestic and foreign, would be reluctant to put their money at risk until these uncertainties were resolved.
Looking back, I feel even more strongly that our approach to combating the crisis made sense. Cooperation and engagement between the IMF and World Bank with the United States and other governments helped to reverse the financial turmoil in countries that took appropriate actions. These efforts led to great improvements in economic fundamentals and growth prospects in developing countries and helped avoid a more severe global crisis that could have greatly affected the industrial countries.
That doesn’t mean that even the “success stories” came out of the crisis with their problems resolved. As the sense of crisis abated, the politics of economic reform in many of those countries once again became more difficult. And the closer one looked, the clearer it became that no economy in the world had perfect policies. There was something too neat about the way many people tried to explain the faults of those countries that ran into serious trouble. No matter how sound economic policy and practices may appear, every economy falls far short of perfection—including our own.
I remember something Caroline Atkinson said about this in one of our team’s many meetings. We had the whole crowd around a conference table during the Brazilian phase of the crisis. Someone was saying that Brazil had all of these strong policies and that ought to make it easier for an IMF program to work. In economic terms, it was a “good” country.
And Caroline jumped in and said, “Yeah. And if they go into default, then we’ll say they were hopeless all along and look at all their horrible mistakes and bad policies.” That was an insightful comment. Every country has various unsound policies and structural problems, as well as various advantages. If the United States faced some kind of economic crisis, people would point to a whole host of problems as the reasons—our low savings rate, our large trade deficit, our high levels of consumer and corporate debt, and today I would add the deeply troubled long-term fiscal situation.
While many—particularly in the financial community—seemed to believe that financial crises were solely a function of the structural and policy problems of developing countries, I believed that the excesses of credit and investment in good times were also to blame. As Anwar noted, every bad loan had a creditor as well as a borrower. The tendency to go to financial excess seems to stem from something inherent in human nature, as does the remarkable failure to draw lessons from past experience. The collapse of the southwest real estate bubble in the United States didn’t prevent investors from overinvesting in Asia. The Asian crisis didn’t prevent the NASDAQ bubble from developing. The proclivity to go to excess is a phenomenon of collective psychology that seems to repeat itself again and again.
I was surprised, nonetheless, by how rapidly the crisis mentality vanished. People can forget the lessons of a painful experience very quickly, and that can lead to poor decisions. An illustration is what happened when South Korea was first able to borrow again in private markets. This was a massive step forward for the country. Borrowing privately at a reasonable rate of interest would create confidence in South Korea’s postcrisis economy, underscore the credibility of the policy direction the country was pursuing under Kim Dae-jung, and promote growth.
A new South Korean finance minister was stopping in Washington on his way to New York to sign a new loan agreement. But before he came to visit us at the Treasury, our people told me that the minister wasn’t going to go ahead with the loan after all because their investment bankers told him it was going to cost 25 basis points—or one quarter of 1 percent—more than he had expected.
“You’ve got to be kidding,” I said. Here was a country that a year earlier had been on the verge of a default that could have had vast, even calamitous consequences. And now the government wasn’t going to raise money when it could because of 25 basis points? Perhaps he was under political pressure from home not to pay more than someone’s idea of the right price—but I still almost didn’t believe it. The chance for South Korea to reestablish itself with global financial markets through this bond issue was worth vastly more than 25 basis points.
The finance minister came in with his interpreters, and they all sat down at the table in my conference room. We started talking, and I said, “I understand you’re going to raise this money and there’s a little problem because you think it’s twenty-five basis points too high. What difference are twenty-five basis points, or one hundred basis points, when reestablishing yourself is so important?”
The finance minister said, well, 25 basis points are 25 basis points. We shouldn’t have to pay so much. I told him I’d been around markets a long time and my advice was to take the money while they could get it—circumstances can change very quickly in markets. If the issue went well, South Korea could borrow more and probably would see some rate improvement. But pulling out could raise doubts again in investors’ minds. But our debate continued, and after a while I began to lose my patience a bit. “You know something?” I said. “I don’t really care what you do. It’s your country, not mine.” Everyone in the meeting looked at me as if I’d taken leave of my senses. And perhaps I had, momentarily. South Korea’s government and the South Korean people had done a remarkable job. But I was reacting to the spectacle of intelligent people behaving shortsightedly with respect to financial markets. I’d seen this kind of behavior many times at Goldman Sachs, on the part of both traders and clients. Someone who has gotten into trouble is offered what might be a brief opportunity to escape. And often the person’s response is to forget the mess of a few days earlier and resume quibbling over a quarter point.
By the summer of 1999, I’d been in Washington for six and a half years, and I was ready to leave. Sandy Berger once said about working in government that as time goes on, the positives provide less reinforcement and the negatives feel more onerous. For me, the lines had clearly crossed. I felt I wanted to be free of the weight I’d been carrying. And now, with the impeachment battle finished and the Asian crisis ebbing, there was a moment when I could go. I wasn’t abandoning a President under fire. And should new economic problems develop, the administration would have strong leadership with Larry at Treasury and Gene in the White House. I wasn’t going to press my luck holding out for another quarter point.
As for the Asian crisis, critics argued that a categorical position of one kind or another would have worked better than our pragmatic approach to restoring confidence and addressing policy problems. But these conceptual views, which often came with important insights, didn’t take into account all the complexities of responding to an actual crisis. Dealing with crises was messy because the reality was messy. At one point, aiding Russia made sense. At a later stage, it didn’t. As much as one might have wished for one, there was no categorical response or absolutist position that could definitively solve these problems. In hindsight, there were some elements of the programs that could have been done better. But, having said that, the people of these countries were far better off as a result of our engagement than they would have been otherwise. Dwelling on the mistakes tends to obscure the larger point, which is that a market-based approach—of IMF loans combined with essential reforms—led to relatively rapid recovery in countries that took a reasonable degree of ownership of reform and avoided the real risk of much more severe global disruption. Perhaps the best testimonial to the market-based approach—as opposed to trying to solve these problems through additional regulation, capital market controls, and trade restrictions—comes from decisions taken by emerging-market governments themselves, including some with an electoral mandate from the disadvantaged in their societies. Both Kim Dae-jung in South Korea and, more recently, President Luiz Inácio Lula da Silva in Brazil had come to power on populist platforms. Both chose to embrace global integration and policy regimes designed to engender market confidence as a part of fulfilling their mandates to reduce poverty and raise living standards.
At the same time, the entire Asia experience left me with the view that future financial crises are almost surely inevitable and could be even more severe. The markets are getting bigger, information is moving faster, flows are larger, and trade and capital markets have continued to integrate. So it’s imperative to focus on how to minimize the frequency and severity of such crises and how best to respond if and when they do occur. It’s also important to point out that no one can predict in what area—real estate, emerging markets, or wherever else—the next crisis will occur. I remember something John Whitehead said to me at Goldman Sachs at the time of the Penn Central bankruptcy. “Now we’ll put in all sorts of new processes to deal with commercial paper,” he said. “But the next crisis will come from a direction nobody is focused on now.”
The global economic crisis also left me deeply concerned about the politics of globalization. For many people, the Asia crisis highlighted the potential hazards and shortcomings of globalization for the first time. These problems appear against the backdrop of benefits that on balance are far greater but are often inadequately recognized. In the midst of the Asia crisis, Congress failed to renew President Clinton’s fast-track authority to negotiate international trade agreements. As I prepared to leave Washington—some months before protestors took to the streets in Seattle to demonstrate against the World Trade Organization—I could already see that maintaining support for market-based policies and trade liberalization was becoming a far greater political problem around the world.
Sometime later, sitting at my breakfast table in New York, I read some comments in the paper by President Bush’s newly appointed Treasury Secretary, Paul O’Neill. O’Neill was highly critical of the way we’d handled the Asia crisis. He called me the “chief of the fire department” and said that our theory of interconnected markets was a passing fashion that needed to be retired like the “hula hoop.” O’Neill’s view of crisis response was that the new administration could avoid the moral-hazard problem simply by letting poorly managed emerging-market economies fail.
I liked Paul. I didn’t even mind him calling me the chief of the fire department. But as I read the story, I said to myself: They say they won’t intervene. But they will.
And they did. When Turkey erupted in early 2001, the Bush administration got involved because of the country’s strategic importance. When Argentina got into trouble that same year, the administration supported another large IMF program, before refusing to do so again at the end of 2001. The following year, it provided direct U.S. money through the Exchange Stabilization Fund to Uruguay and supported a very large IMF program in Brazil. Whether the administration was philosophically in favor of support programs or against them, it was bound to end up doing them, because U.S. self-interest was so much involved, geopolitically and economically. A lot of people begin their analysis with a priori constructs. But the orderly view from one’s armchair is not the perspective you have when you’re facing the messy reality of a global financial crisis.