CHAPTER FIVE THE CRASH
Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits. — Hyman Minsky
On 15 September 2008, Lehman Brothers, one of America’s largest and oldest banks, filed for bankruptcy. The bank held $600trn worth of assets, making this the largest bankruptcy in American history.1 Financial markets looked on in shock. Just days earlier, the US government had nationalized Fannie Mae and Freddie Mac — two highly subprime-exposed mortgage lenders. The fact that the US government had allowed Lehman Brothers to collapse sparked a worldwide panic. With mortgage default rates skyrocketing, there was no telling how many other banks were exposed to subprime losses on a similar scale to Lehman’s.
The trouble had started the year before, when mortgage defaults had begun to rise in the US. Many mortgages that had been issued in the boom years were flexible: subject to low fixed interest rates for the first few years of the loan, followed by higher ones down the line. People who took out these loans were assured that they would always be able to refinance their mortgage when the teaser rates expired. But at the beginning of 2007, refinancing became more difficult, and many consumers found themselves stuck with high interest payments that they couldn’t afford. House prices levelled off in 2006 and then began to fall. Defaults escalated, and banks began to worry. Had the trouble ended at US mortgages, we may have been left with a US, and perhaps a UK, housing crisis. But by 2007, mortgages were no longer just mortgages. The debt that had been created by the banks in the boom between the 1980s and 2007 had been transformed into the plumbing of the entire global financial system. Every day, millions of dollars’ worth of mortgages were packaged up into securities, traded on financial markets, insured, bet against, and repackaged into a seemingly endless train of financial intermediation.
As the crisis escalated, it was presented as an archetypal financial meltdown, driven by the greed and financial wizardry of the big banks, whose recklessness had brought the global economy to its knees. But whilst the big banks’ relentless desire for returns had escalated the crisis, it’s causes could be traced back to what was taking place in the real economy: mortgage lending.2 And this was driven by financialisation. The Anglo-American model of finance-led growth — described in this book so far from the British perspective — was uniquely financially unstable, even as policymakers believed that they had mastered boom and bust. The Anglo-American model was premised upon the kind of debt-fuelled asset price inflation that has always resulted in bubbles. The one that burst in 2008 just happened to be the largest, most global, and most complex bubble that has ever been witnessed in economic history.
In this sense, 2008 wasn’t simply a transatlantic banking crisis, it was the structural crisis of financial capitalism, emerging from the inherent contradictions of finance-led growth itself. The political regime of privatised Keynesianism, necessary to mitigate the fall in demand associated with low-wage, rentier capitalism, was always inherently unstable. Bank deregulation had created a one-off rush of cheap money that had inflated a bubble in housing and asset markets. The state allowed this bubble to grow for reasons of political expediency, rather than deflating it in the interests of financial stability. An economy that is creating billions of pounds worth of debt used for speculation rather than productive investment is an economy living on borrowed time. And in 2008, that time ran out.
As the financial crisis cascaded throughout the global economy, the Queen famously asked a group of economists why no one had seen “it” coming. All over the world, economists were asking themselves the same question. For the previous decade, the profession had been patting itself on the back for having “solved” the major problem at the heart of economic policy: mitigating the ups and downs of the business cycle. By absorbing some of Keynes’ insights on aggregate demand into the classical economic framework, the “neoclassical” economists — as they came to be known — claimed to have built highly accurate macroeconomic models that were able to produce the perfect answer to any policy question. Their success at prediction was, they argued, what underlay the so-called “Great Moderation” that preceded the financial crisis: a period of high growth, low inflation, and relative stability. As it turns out, the Great Moderation was no such thing. As the upswing in asset prices continued, greater amounts of risk built up in the system.3 Part of the reason the financial crisis of 2008 was so big is that the period of exuberance that had preceded it had been so long.
According to Hyman Minsky, “stability is destabilising” — long periods of calm in financial markets encourage behaviours that lead to instability.4 Minsky’s work built on Keynes’ theory that investment is driven by human psychology more than by any objective market rationality. The combination of these psychological factors, and the ability of modern capitalism to create huge amounts of debt, gives rise to financial systems that are fundamentally unstable. Financial markets tend to be characterised by periodic bubbles and panics, which in turn impact the real economy, causing credit crunches and recessions.
Instability results from the psychological factors that drive investment under conditions of uncertainty. Investment decisions are determined by the cost of the investment and the expected returns to be derived from it. Keynes argued that these two variables – costs and expected returns – are governed by different price systems. Keynes’ two price theory – later added to by Minsky – showed that costs associated with an investment — including the costs of financing the investment if the business is borrowing, and the risks associated with that borrowing — are determined by what is going on in the economy now. The other side of the equation — the expected returns derived from the investment — are driven by what businesses think is going to be happening in the economy tomorrow. These expectations are subject to uncertainty — about future economic growth, the potential for bankruptcy, etc. — and are therefore more subject to the caprices of human psychology.
This understanding of the relationship between uncertainty and prices is one of Keynes’ most important theoretical innovations. Human beings are generally quite bad at understanding the nature of uncertainty, often confusing it with risk. But whereas risk is quantifiable, uncertainty is not. Risk measurements can be applied to simple events like rolling a dice but trying to measure uncertainty is like trying to determine whether or not I’ll still own the dice in ten years’ time. I can invest on the basis that the economy has grown for the last several quarters, assessing the probability that this trend will continue, but there is no way I can account for the possibility that a major new invention will be brought to the market or that Earth will be hit by an asteroid. Optimism and pessimism therefore matter when it comes to investment, perhaps even more than the issues traditionally accounted for by economics, like current costs or growth rates. If investors are optimistic, they will not only expect that their future returns will be higher, they may also anticipate their future borrowing costs will fall and judge it quite unlikely that they will go bankrupt. As a result, they are much more likely to invest and to borrow to invest. The important thing to note here is that what drives this investment decision is not so much what is going on in the economy today, but what business owners think is probably going to happen tomorrow — a time horizon over which they can’t claim to have certain knowledge.
On aggregate, these differences in behaviour can lead to the emergence of bubbles. When the economic cycle is on the upswing, the prices of financial assets like stocks and shares start increasing. Investors buy these securities, expecting the good times to continue for the foreseeable future. When lots of investors buy the same asset, the price rises. Think, for example, about the increase in the price of Bitcoin, which was driven by expectations about the crypto-currency’s future value almost entirely divorced from its utility. As investors experience several periods of strong returns, they start borrowing greater sums to invest. Banks also tend to lend more to businesses when the economy is doing well. More money enters the financial system, pushing up asset prices even further and creating a self-reinforcing cycle of optimism-driven asset price inflation.
Eventually, the financial cycle enters a phase of “Ponzi finance”, with investors piling into assets one after another based purely on the speculation-driven price rises of the recent past. Just like a Ponzi scheme which uses new recruits to pay off old lenders, investors end up taking out debt simply to repay interest. This underlies Minsky’s famous insight that “stability is destabilising”: when investors experience an extended period of high returns without any crashes, they become overexuberant about the prospects of future growth and take risks they otherwise might not.
But eventually lending dries up, investment slows, and asset prices start to level off. Investors begin to sense that the party might be coming to an end and either hold off buying or start to sell their assets. Asset prices begin to fall on the back of slowing demand, just as they rose due to rising demand during the upswing. Believing that their assets will continue to fall in value, investors begin to panic sell, catalysing a chain reaction throughout the financial system. In extreme cases, this panic selling can cause prices to fall in the real economy. Falling asset values dampen profitability, reducing investment and wages, and investors’ and households’ wealth, lending to lower spending. Unrestricted lending exacerbates these dynamics by prolonging the upswing and exacerbating the downturn. Falling profits may require firms to sell off even more assets, or lay off workers, to repay their debts. Those who have used debt to purchase assets during the upswing may find themselves in negative equity — with assets worth less than the total amount of debt they have outstanding. They will put off all but essential purchases in an effort to pay off their debts, reducing demand, but they may still end up going bankrupt.
Historically, these observations have been applied mainly to business investment but the financialisation of the household meant that they could be applied to ordinary consumers too. Before 2007, consumers were borrowing huge amounts to purchase houses, increasing house prices and turning mortgage lending into a speculative game. With house prices rising, and credit more readily available than ever, houses became incredibly valuable financial assets. People began purchasing housing not just because they needed it, but because they expected that it would continuously rise in value. Some bought second homes, third homes, and fourth homes, all financed by debt. People also began to refinance their homes to “release their equity”, allowing them to purchase yet more assets — or even just to pay for holidays and new TVs.
This bubble was so big, and went on for so long, for two main reasons. On the one hand, instability emerged naturally due to changes that had taken place in the real economy. The financialisation of Anglo-American capitalism witnessed in the latter half of the twentieth century led to a falling labour share of national income and a rising rentier share. Rising inequality threatened to dampen demand and reduce growth. Bank deregulation and privatisation concealed these trends by expanding access to credit and asset ownership, allowing some working people to benefit from the increase in asset prices, even as others were left behind. The financialised state, meanwhile, used its control over economic policy and financial regulation to promote the interests of the elites that were doing so well out of the boom. Soon the bubble took on a life of its own. Rising house prices left consumers feeling wealthier, and therefore able to take out even greater amounts of credit, even as their wages declined relative to their productivity. This surge in private debt left both the British and American economies uniquely vulnerable to a crash. But this instability can be traced back to the chronic shortfall in demand that emerged from the disparities naturally created by finance-led growth.
On the other hand, the reason this boom was able to go on for so long was that financial globalisation and bank deregulation dramatically increased the amount of liquidity in the international financial system. Financial globalisation allowed banks and investors to draw on capital that had been stored away in states with lots of savings. Financial deregulation reduced restrictions on lending and allowed banks to use this capital to create more money. International banks developed ever more ingenious ways to evade the restrictions on lending that continued to exist. Mortgages were the dynamite at the centre of the explosive device that caused the economic crisis, but the explosive device itself had been transformed due to the financial innovation seen before the crash.
This transformation had several features. The removal of restrictions on capital mobility led to a wave of financial globalisation associated with significant increases in capital flows. The development of “securitisation” allowed ordinary mortgages to be turned into financial assets that could be sold to investors. The rise of the shadow banking system meant that banks were able to lend more than otherwise would have been possible. Finally, banks’ reliance on market-based finance — i.e. borrowing from other financial institutions rather than state-backed bank deposits — allowed investors from all over the world to get in on the game, but also left global banks uniquely exposed to any changes in lending conditions.
When talking about the financial crisis, commentators have tended to focus on this latter set of issues. But whilst the intricacies of global finance are important in determining the way the crisis happened, it is also critical to bear in mind that these factors merely served to prolong underlying trends that had their roots in the real economy — in the rise of finance-led growth that had led to falling wages, rising inequality, and ever higher levels of private debt. It was the combination of financialisation at the level of the real economy, and the growth of an interconnected, highly leveraged and unstable financial system, that explains the unique depth and breadth of the crisis, as well as much of what has taken place since.
With the collapse of Bretton Woods and the removal of restrictions on capital mobility, capital was now free to flood into nearly every corner of the globe, giving rise to a new era of financial globalisation. Total cross-border capital flows increased from 5% of global GDP in the mid-1995 to 20% in 2007 — three times faster than trade flows.5 Amongst the so-called “advanced economy” group ownership of foreign assets rose from 68% of GDP in 1980 to 438% in 2007. In other words, by 2007, the amount the advanced economies owed was more than four times the size of all these economies added together.6
Financial globalisation has transformed states’ relationships with the rest of the world.7 According to traditional macroeconomic models, international trade is governed by the same principles of general equilibrium that govern national economies. Exchange rates, interest rates, trade, and financial flows are meant to adjust in order to bring supply and demand for different economies’ goods, services, and assets into balance. When a country runs a current account deficit — when it buys more from its trading partners than it sells to them — domestic currency flows out of the country. This is because the income from the current account has to come in the form of the domestic currency — if a consumer in the USA wants to buy a widget from the UK, they have to convert their dollars to sterling. High supply and low demand for a currency means falling prices. In other words, running a current account deficit means a falling exchange rate — your currency becomes less valuable relative to other currencies. A less valuable currency makes your exports cheaper to international consumers and should therefore increase demand for those exports. Over the long term, countries with current account deficits should experience falling exchange rates, making their exports more competitive, increasing demand for those exports, and reversing the deficit — and vice-versa for surplus countries. The relationship between the current account and the exchange rate is supposed to lead to equilibrium at the global level — no country should be able to run a current account deficit, or surplus, for a long time.
But from around 1990, large imbalances arose at the global level between “creditor” countries with large current account surpluses, and “debtor” countries with large current account deficits. Countries like the US and the UK had large and growing current account deficits, whilst Japan, China, and Germany had big surpluses. Where was the equilibrium? The US and the UK — deficit countries — should have seen large falls in the value of their currencies. China, Germany, and Japan — surplus countries — should have seen increases. Depreciations should have led to export growth in the deficit countries, and appreciations should have led to export falls in the surplus ones.
To understand what was going on, one must understand the relationship between the current account — which measures flows of income — and the financial account — which measures investment flows. If you think of the current account as like the current account of an individual, then it is mainly composed of income and expenditure. Income from a wage or another source goes in (like income from selling exports) and expenditure goes out (like expenditure from buying imports). But in modern financialised economies these are not the only sources of income available to consumers. They are also likely to have another account that contains, say, a mortgage. This is a form of income — a big cash transfer from a bank that has been used to buy a house — which also entails a certain amount of expenditure in the form of repayments. In the same way, countries are able to “borrow” money from the rest of the world via their financial accounts by selling assets.
The financial account (once known as the capital account) measures flows into and out of UK assets. To stay with the mortgage example, if a UK consumer borrows £500,000 from a foreign bank to buy a house, that will represent a £500,000 inflow via the financial account. This can seem counterintuitive: even though the consumer has borrowed from the rest of the world, they have still received £500,000 now, which counts as a positive sum on the financial account. If a foreign investor built a factory in the UK for £500,000, this would also represent an inflow via the financial account — but just like the loan, it also represents a future liability, because the income the factory generates will flow back to that investor over the long term.
Before the crisis, the US and the UK were seeing lots of capital flow out of their economies via the current account, meaning an increase in the supply of their currencies on international markets. This should have led to depreciations of their currencies. But demand for sterling and the dollar remained high, because there was high demand for British and American assets. The UK might have been losing sterling via the current account, but international investors were lending it back to us in exchange for our assets via the financial account. The rising value of house prices, and the proliferation of mortgage-backed securities (MBSs), meant that investors from all over the world, just like those in domestic markets, wanted to put their money into Anglo-American financial and housing markets. To do so they had to buy dollars or sterling, which maintained demand for these currencies, even as their current account deficits increased. Households were also able to purchase more imports because rising house prices made them feel wealthier.
All in all, this meant that the current account deficit expanded even as the currency appreciated. This created a self-reinforcing cycle. Rising currency values made British exports seem less competitive and imports seem cheaper. British exporters — especially manufacturers — found it harder to compete on international markets. Between the 1970s and 2007, the share of manufacturing in the British economy fell from 30% to just 10%. These economic changes reinforced financialisation by increasing the relative importance of the finance sector in driving economic growth. By the early Noughties, even if we had wanted to get off the train that was careering towards a cliff edge, we would have been unlikely to be able to do so.
Securitisation, Shadow Banking and Inter-Bank Lending
On its own, rising capital mobility would not have been sufficient to turn several large, but localised, housing bubbles into a global financial crisis. International investors needed assets to invest in — housing alone wasn’t enough. New, giant international banks, based mainly in Wall Street and the City of London, were only too happy to oblige. These banks placed British and American mortgages at the heart of the global financial system by turning them into financial securities that could be traded on financial markets — a process called securitisation.8 The securitisation of Anglo-American mortgage debt was central to both the long pre-crash boom and the swift collapse of the banking system in 2008. The American aspect of this equation was many times larger than the Anglo part, and far more important to the global financial system, but relative to the size of their respective economies, both experienced a surge in securitisation.
The process of securitisation involves turning claims into financial securities. A claim is a contract that entitles the holder to an amount of income at some point in the future. For example, a loan made by a bank to an individual or company is a claim on being paid back at a later date. Financial securities are claims that are traded in financial markets, and include equities (stakes in the ownership of a corporation, also called stocks or shares), fixed-income securities (securities based on underlying agreements to repay a certain amount of money over a certain period of time), and derivatives (bets on the future value of other securities or commodities). For example, a bank with some mortgages on its books may want to sell those mortgages now rather than waiting a few decades for the debt to be repaid. To access the money to which they are now entitled, they can turn the mortgage into a security and sell it on to another investor. The price of the security will reflect the underlying value of the loan, subject to interest rates, inflation, risk and other factors.
In the run up to the financial crisis, banks wanted to increase their lending to meet rising demand for credit. They were, however, constrained by regulation that required them to hold a certain proportion of the amount they lent out as cash, shareholders’ equity and certain other liquid assets. If they wanted to lend more, they needed more cash. Banks therefore took the mortgages on their books, placed them “off balance sheet” (in the shadow banking system described below) and securitised them, allowing investors to invest in them. In doing so, they were essentially selling other investors the future income stream that the mortgage would generate, pocketing the cash today, and then lending it to other individuals to create new mortgages. Minsky predicted that this kind of behaviour would come to dominate financial markets, when he wrote “that which can be securitised will be securitised”. In the US, the issuance of residential mortgage-backed securities (RMBSs) peaked at $2trn in 2007. US securities were sold to investors in the rest of the world, which bought them based on the assumption that they were as safe as US government debt, but with higher returns.
But securitisation didn’t just increase banks’ access to liquidity, it also allowed them to disguise the risks they were taking. Once they had lent as much as they could to creditworthy borrowers, banks started to increase their lending by issuing mortgages to customers who might not be able to repay them. The American government supported the emergence of what came to be known as “sub-prime” lending in an attempt to extend mortgages to a wider section of the electorate, just as Thatcher sought to increase home ownership in the UK through right-to-buy and financial deregulation. US federal bodies like Fannie Mae and Freddie Mac – both Government Sponsored Enterprises (GSEs) – would purchase mortgages from the banks and package them up into financial securities, before selling them on financial markets, backed by a state guarantee. 9 This created a large and deep market for mortgage-backed securities (MBSs) of varying qualities, and allowed the banks to lend more to less creditworthy consumers, because they would receive an immediate return — and insulate themselves from risk — by selling the mortgage to a GSE.
Eventually, the GSEs started to package up good mortgages with bad ones, using complex mathematical models to get the balance just right. The GSEs would take a bunch of good mortgages and add in just the right number of sub-prime mortgages to allow them to create financial securities that investors (and ratings agencies) would consider risk-free. Imagine baking a cake and adding just the right amount of poison to make sure it doesn’t kill whoever eats it — the cake is like the security that has just the right amount of sub-prime to make it look risk free. As the housing bubble expanded, more and more subprime mortgages were created. As more of these sub-prime mortgages were baked into these securities, the quality of the securitised products deteriorated, culminating in the creation of the collateralised debt obligations (CDOs) that appeared to make even the riskiest mortgages risk-free. At the same time, new financial institutions got into the securitisation game, competing with Fannie Mae and Freddie
Mac to parcel up mortgages into securities that could be bought and sold. The so-called “originators” would create mortgages, and either sell them to securitisers, or securitise them themselves.
Armed with the latest mathematical insights, the securitisers were confident that, even if some people started to default on their mortgages, their securities would retain their value. The rating agencies, who received their revenues from the financial institutions they were supposed to be rating, unsurprisingly agreed. The ratings agencies agreed to continue to give US MBSs and CDOs high ratings — similar to those they granted to US government debt — even as the quality of these securities deteriorated. This process was reinforced by the insurance industry. Companies like AIG allowed the owners of these securities to hedge against a potential default by the mortgage-holder by taking out infamous “credit default swaps”. If the value of the security fell, the owners would be due an insurance pay-out. The government, securitisers, rating agencies, and insurance industries collaborated to make it seem as though they were making huge amounts of money without having taken any real risk. And as long as house prices kept rising and securities kept being issued, their gamble paid off. But eventually this long period of stability destabilised the entire financial system.
We heard earlier about Keynes’ insights on the difference between risk and uncertainty — and they are central to understanding why securitisation wasn’t as safe as people thought.10 Risk is measurable and quantifiable — simple measures of probability are built on the measurement of risk. We may not know what the outcome will be when we roll a dice, but we can predict that the probability of rolling a 5 is 1/6. But not all events are like rolling a dice. In fact, few events are — especially in a complex system like the economy. In such situations, all we can do is predict the future based on the past, and the future is therefore uncertain — there are too many variables interacting with one another to allow us to predict outcomes with any certainty. Uncertainty is a completely different beast to measurable risk. Unlike risk, uncertainty is unquantifiable — the future is not only filled with known unknowns, but unknown unknowns.
As Fred Knight, an American economist, pointed out almost a century ago, human beings treat uncertainty like risk. We use past experience to extrapolate the likelihood that an event will occur in a particular way. Having invested in one company in a particular industry and received a large return on our investment, we might assume that investing in another business in the same industry will be equally as profitable. But we have no way of knowing what will happen to the business, or indeed the industry, in the future — there is too much uncertainty to give a reliable estimate of the probability that the business will provide a good return on investment. In quantifying and mitigating the risks associated with defaults, the securitisers claimed to have created completely risk-free products. But whilst mathematical models can help to mitigate risk, they can’t mitigate uncertainty. Perversely, the exuberance created by the belief that risk had disappeared encouraged investors to take even greater risks based on uncertain assumptions about the future.
This approach to predicting the future wasn’t confined to the banks themselves. Regulators also viewed their role as mitigating future risks, which could be predictably measured from institution to institution.11 The approach to regulation before the crisis largely focused on making sure each bank had enough capital to allow it to withstand a crisis of moderate severity. The Basel Accords, first agreed by the Basel Committee on Banking Supervision as Basel I in 1988 and amended during rounds II and III in 2004 and 2010, aimed to harmonise international regulation on banking by setting minimum capital requirements for banks. Bank capital consists of highly liquid — or easy to sell — assets, like cash and shareholders’ equity. For example, if a bank makes £10m worth of loans, then a capital requirement of 10% will mean they have to hold £1m in the form of highly liquid capital. Capital requirements limit banks’ profits, because they force them to hold some non-profitable but safe assets like cash and shareholders’ equity. But if a bank got into trouble and investors started to demand their money back, they ensure that the bank has enough cash to be able to pay them.
The Basel accords rested on the idea that regulation should serve to measure and mitigate predictable risks — they were not built to deal with a crisis of generalised uncertainty. The regulators could encourage banks to hold a specific amount of capital that would allow them to mitigate any foreseeable risks, but they should have realised that it would be impossible to predict when, where, and what kind of financial crises might arise over the course of the financial cycle. In an interconnected financial system, regulators should have realised that banks might be subject to unpredictable systemic risks that would affect the entire financial network, not just individual banks.
In fact, the Basel Accords ended up contributing to the crisis. Banks were required to hold different levels of capital against different assets depending on how risky the asset was judged to be. Riskier assets were associated with higher capital requirements. Mortgages and MBSs were judged to be low-risk, so banks had to hold less capital to insure themselves against potential losses. Banks worked out that they could increase their profits under Basel by holding low levels of capital against risky mortgages that provided them with high returns. This “regulatory arbitrage”— opportunities for profit-seeking created by regulation — encouraged banks to hold securities based on mortgage debt, even though they were often far riskier than many other assets.
Capital requirements also fostered the growth of the shadow banking system by encouraging the banks to undertake many activities “off balance sheet” in the less-regulated shadow banking sector. Shadow banks are institutions that lend money without taking deposits guaranteed by the state, and without direct access to central bank funding. Shadow banking is riskier than conventional banking because shadow banks should not be able to access central bank funds when they get into trouble. Because the state takes less responsibility for activities that take place in the shadow banking system, they are subject to less regulation. Basel II encouraged banks to create shadow banking entities “at arm’s length” from the main, regulated banking system. The banks could place riskier assets in the shadow banks, allowing them to disguise their exposure to these assets, without insulating them from the risks associated with this lending. These shadow banks were able to take more risk, and earn higher profits, even if these risks would ultimately be borne by the traditional banks themselves. As regulation on the traditional banking sector increased, the shadow banks — many of which were set up by the banks — increased their market share. Banks’ share of lending in the US fell from almost 100% before 1980 to just 40% in 2007.
Another change that took place in the international financial system before 2008 concerned the way in which banks raise funds.12 The traditional, neoclassical view of banking is that banks simply intermediate between savers and borrowers by receiving deposits and lending these to borrowers. State reserve requirements would determine the amounts that banks were able to lend — and they would lend as much as they were able to under domestic law. For example, if a bank had £10,000 worth of deposits, and regulation required it to keep 10% of its deposits in reserves at the central bank, it could only make £9,000 worth of loans. But this story hasn’t been true of the sophisticated financial systems that have emerged in the global North for decades — in the UK, for example, banks haven’t had any reserve requirements since 1981. Instead, banks lend as much as they can — limited only by demand — and then borrow to meet regulatory requirements. So, a bank might lend as much as it can to borrowers, before borrowing the capital it needs to meet capital requirements from an investor or another bank by the end of the day.
One source of funding for the banks in the pre-crisis period were the so-called “money market funds” (MMFs). Wealthy savers seeking out higher interest rates than were available in traditional bank accounts deposited their cash in MMFs, which were seen as equivalent to normal bank deposits. Investors could take out their cash at any time — the only catch was that MMFs weren’t guaranteed by the state, but this was far from the minds of most investors before 2007. The MMFs would then lend their capital to the banks, often via the shadow banking system, which could offer them a relatively high rate of return. They were joined by the other institutional investors that had emerged in the 1980s, who agglomerated the savings of corporations and wealthy individuals and lent these to the banks.
Another source was the development of the “repo” — short for “repurchase agreement” — markets. Repo transactions allow one investor to loan a security to another investor and buy it back at a later date at a pre-agreed price. Banks would borrow from investors by “repo-ing” MBSs with another investor, before buying it back a few weeks later. Effectively, repo transactions are a form of collateralised loan, with banks borrowing from investors using securities as collateral. In repo-ing the MBS, the bank would take a haircut, meaning it would have to use some of its own money to fund the transaction. This process allowed banks to invest in billions of dollars’ worth of securities, using a tiny fraction of their own cash.
During the 2000s, all of the innovations described so far came together to create an incredibly risky and complex matrix at the heart of the international financial system.13 Banks would set up “structured investment vehicles” (SIVs) — shadow banks — and then place assets like mortgages into these SIVs. The SIVs would raise funds by borrowing on the money markets, rather than taking cash from depositors, for example by issuing asset-backed commercial paper (ABCP), a form of short-term corporate bond. The SIVs packaged up the loans into securities and sold some on, often to investors in surplus countries, but kept others — particularly the lower quality mortgages that were harder to sell. Shadow banks would also engage in complex repo transactions using the securities as collateral, relying on the assumption that they would always be able to roll these loans over. The traditional banks that had set up the SIVs were ultimately responsible for any losses made on these assets, meaning that any problems in the SIV would have a knock-on impact on the bank that had set it up and funded it.
In the early 2000s, the global economy had emerged from the bursting of the tech bubble stronger than ever. Investors were convinced that economists really had managed to tame the business cycle once and for all. But by 2006, the “goldilocks” economy — as some termed the neither too hot nor too cold economic conditions that prevailed during the early Noughties — had begun to falter. US house prices peaked in 2006, and then started to fall. Similar trends prevailed in the UK.14
Banks had forayed into subprime markets and started to offer mortgages with low or no deposits based on the assumption that house prices would continue rising forever. As a result, when they started to fall, many homeowners fell into negative equity — meaning that they owed more in mortgage debt than their house was worth. In such a situation, consumers had a choice: keep a mortgage worth more than their homes or sell. Those who could opted to sell, some at any price, sending prices tumbling even further.
Falling house prices cascaded through the financial system. The financial securities that banks had been selling rapidly lost their value when the quality of the underlying mortgages was called into question. Many of these assets were held in the shadow banks that were operating at much higher levels of leverage than traditional banks, meaning even a small fall in asset prices could render them insolvent. These shadow banks, and many traditional banks, had also been financing much of their borrowing on international financial markets over very short time horizons. The securities that were tumbling in value had often been used as collateral for this lending. Combined with the general climate of fear and uncertainty as to who was solvent and who wasn’t, banks and their counterparts in the shadow banking system suddenly lost access to funding.
When banks could no longer rely on borrowing from other financial institutions to finance their liabilities, they started to sell their assets. Fire sales of asset-backed securities sent their prices tumbling even further. The repo markets that had developed before the crash, which allowed banks to borrow from one another using debt-based securities as collateral, seized up. Adam Tooze puts it succinctly: “Without valuation these assets could not be used as collateral. Without collateral there was no funding. And if there was no funding all the banks were in trouble, no matter how large their exposure to real estate”. Retail bank runs had been a thing of the past since the introduction of deposit insurance, but what happened in 2007 was essentially a giant bank run, led by other banks, which created a liquidity crisis – the banks didn’t have enough cash to meet their current liabilities. But the fire selling that resulted rapidly turned this liquidity crisis into a solvency crisis – the banks’ debts grew larger than their assets.
The panic quickly spread across the pond to the City of London. Whilst the subprime crisis was mainly driven by US consumers, the resulting panic and falling value of MBSs, CDOs and similar instruments affected securities from all over the world. As these securities fell in value, funding markets seized up, and many UK banks found themselves in the same situation as their US counterparts. British banks were part of the same international financial system as American ones: they were reliant on wholesale funding, and they had been exposed to billions of dollars’ worth of US mortgage debt. But the British banks had also been involved in the securitisation game themselves.
By the end of 2007, mortgage lending in the UK had reached 65% of GDP — just eight percentage points lower than in the US — and British banks issued £227bn worth of residential and commercial mortgage-backed securities in 2008 — 12% of GDP.15 Many of these mortgages had very high loan-to-value ratios (i.e. the loan was worth more than the value of the house), as well as the kind of adjustable rates that had become so popular in the US.16 In 2008, the Bank of England’s Financial Stability Report stated that “adverse credit and buy-to-let loans [have] risen from 9% at the end of 2004 to 14% at the end of 2007”. The bank expressed a concern that many of these loans had adjustable rates and that it was becoming more difficult to refinance, meaning borrowers will face rising interest rates. The Bank wrote:
As in the United States, this repayment shock is occurring at the same time as house prices are falling. Those who bought in recent years with high loan to income multiples and/or high LTV ratios will be particularly vulnerable to further shocks to their disposable income, such as higher inflation or unemployment.
In fact, the UK housing market had begun to turn at around the same time as that in the US.17 The subprime market wasn’t as large in the UK, but underwriting standards had been deteriorating for many years. Banks like Northern Rock were issuing mortgages worth much more than the underlying value of the home and securitising them in the same way as their US counterparts, whilst relying on similar funding models. The crisis began in the US — a far larger and more systemically important market, with unique vulnerabilities18 — but the boom would have ended in the UK at some point anyway. 2008 was a crisis of the Anglo-American model, also pursued by states like Iceland and Spain, and now Australia and Canada — not simply a crisis in US mortgage markets. The size, severity, and global nature of the crash was undoubtedly a result of its genesis in US markets, but what 2007 showed is that the model of debt-fuelled asset price inflation is inherently unstable. At some point, the debt has to stop growing. And when the debt stops growing, the entire system breaks down.
When the crash hit, governments around the world looked on in horror.19 When it began, they had treated the financial crisis like any other financial panic — as an issue of liquidity, or access to cash. They assumed that the panic would pass, revealing that the banks were creditworthy. Trillions of dollars’ worth of loans was made available to banks by central banks all over the world. But regulators quickly realised that this wouldn’t be enough. As panic spread through the system and prices tumbled, banks became insolvent, not just illiquid — i.e. they weren’t just facing a cash-flow problem, they were bankrupt. They needed capital — cash, equity, and other high-quality assets. They needed a bailout.
It was Gordon Brown who first realised what was going on. Having spent his holiday reading up on the events surrounding the Wall Street Crash, he realised that the panic selling that had started in 2008 had eroded the value of banks’ assets to such an extent that many were now effectively insolvent. Giving them access to central bank funding would involve throwing more money into a never-ending hole. Some of the UK’s banks — notably RBS and HBOS — had become unimaginably large and overleveraged, only to see the value of their assets plummet overnight. Mervyn King, the governor of the Bank of England, agreed. The problem was capital, not liquidity. In effect, the banks had to be forced to take money from the state in exchange for shares — they had to be nationalised.
On 8 October 2008, the government announced that £500bn would be made available to the banks — some in the form of loans and guarantees to support liquidity, and some in the form of taxpayer investment in exchange for equity. Most of the investment went to the basket case that was the Royal Bank of Scotland, indebted up to its eyeballs after its recent purchase of the Dutch bank ABN AMRO under the reckless leadership of Fred Goodwin. The US was forced to take a similar approach, eventually spending over $200bn on purchasing bank equity, and a further $70bn bailing out the distressed insurer AIG. Socialism for the banks saved the global economy from the Great Depression 2.0.
Aside from the bailouts themselves, what prevented the crash from becoming a new global depression were the coordinated international stimulus packages implemented by the world’s largest economies. Keynesian economics was back in vogue. In most states, automatic stabilisers — the falling tax revenues and rising welfare payments associated with recessions — combined with discretionary fiscal spending — i.e. planned, not automatic, increases in spending — limited the impact of the downturn. The US American Recovery and Reinvestment Act — worth over $800bn between 2009 and 201920 — helped to stem job losses by channelling investment into infrastructure, and supported demand by providing financial support to the unemployed. Other G20 states followed suit with their own stimulus programmes. But it was China that saved the day. The Chinese stimulus programme — which included measures to stimulate bank lending as well as increases in central and local government spending — was worth almost 20% of GDP in 2009.21 Ongoing expansionary fiscal and monetary policy — far more than exports — have supported high growth rates in China and its major trading partners ever since.
Monetary policy changes pursued by the world’s four major central banks — the Federal Reserve (the Fed), the Bank of England (BoE), the European Central Bank (ECB), and the Bank of Japan (BoJ) — also helped. Interest rates were reduced to historic lows. But with households already heavily indebted, businesses uncertain of the future, and banks unwilling to lend, cutting interest rates wasn’t going to be enough. So, the world’s central banks tried something new: quantitative easing (QE). Since 2009, these four central banks have pumped more than $10trn of digitally-created money into the global financial system by purchasing government bonds, which has pushed up asset prices across the board.22 The Fed’s balance sheet peaked at around $4.5trn in 2015, or a quarter of US GDP — the value of the UK’s programme as a percentage of GDP peaked at a similar level.23 The BoJ’s apparently unending QE programme has seen its assets climb to over $5trn, larger than Japan’s entire economy.24 In many countries, it is hard to see how this expansion in central bank balance sheets will ever be reversed.25
For a time, it looked as though this coordinated action might bring a relatively swift end to the series of overlapping recessions then taking place in the economies of the global North. But then came the Eurozone crisis. Just as Chinese money had flooded into US debt before the crisis, German money, derived from its large current account surplus, flowed into debt booms in the UK and the Eurozone — notably in Ireland and Spain. In Europe’s periphery, states like tiny, overindebted Latvia faced similar problems. The tell-tale signs of finance-led growth — rising debt, housing booms, and rising current account deficits — started to afflict many EU economies. As Tooze points out, several EU countries were staggeringly “overbanked” by 2007 — the liabilities of Ireland’s banks were worth 700% of its GDP. When the crisis hit, Europe’s banks needed bailing out too.
But there were no mechanisms to orchestrate such a bailout at the EU level. Instead, the burden fell on individual economies like Greece, Spain, Portugal, and Ireland to save their bloated financial systems. Unable to print their own currency, states like Greece and Ireland were forced to seek bailouts from the international institutions formerly restricted to bailing out low-income states in the global South. But there was a problem: many of these countries were effectively insolvent. Their debts were too large ever to be repaid. Rather than accept that the debts needed to be written off, and the system transformed, the EU — helped along by the IMF — decided to impose austerity on the struggling economies, immiserating a large portion of Europe’s population. The nationalised banks received easier treatment than the indebted states that had bailed them out: this was socialism for the banks, and ruthless free-market capitalism for everyone else.
In the wake of the Eurozone crisis, it didn’t take long for Keynes to fall out of favour again. The Greek crisis was exacerbated by its inability to print its own currency due to its membership of the Euro. But the idea that the financial crisis was sparking a new wave of sovereign debt crises, from which no economy would be safe, spread like wildfire. Rather than identifying the root cause of the crisis — the model of finance-led growth constructed in the 1980s — politicians, academics, and commentators around the world seized on the narrative that the recession stemmed from too much government borrowing. Governments, they patiently explained, are like households — they can only spend as much as they earn. If they borrow too much one year, they must save to pay it back the next year. And if they borrow too much over a short period of time, they were passing down the burden of those debts to their grandchildren. For the good of future generations, governments around the world would have to tighten their belts. Nowhere — other than in bailed-out Greece — did this go further than in the UK, where the coalition government implemented an austerity programme so harsh that it has been linked to 120,000 deaths over the last decade.26
Having socialised the costs of the banks’ recklessness, financialised states around the world failed to use their control over the banking system to support growth for fear of interfering with the operation of the “free market”. The British state, now a majority owner of several banks, refused to use its control over several large banks to direct lending to productive purposes. Despite the rhetoric about paying down the debt, the government did not even try to sell its shares in the banks at a competitive price, instead selling them at a loss to the taxpayer, even as it asked the British people to foot the bill.27 These decisions were justified using familiar tropes. The market, on this one occasion, had failed. But that didn’t undermine capitalism as a social and economic system; and state ownership of the banks certainly didn’t undermine their commitment to enforcing private property. In fact, the way the bailouts were conducted reinforced the logic of finance-led growth: the state would use its power to give the markets what they wanted, and working people would be forced to pick up the tab.
Transatlantic Banking Crisis or Structural Crisis of Financial Capitalism?
Reading this account on its own could lead one to conclude that what happened in 2007 was simply a transatlantic banking crisis with its origins in the US. It then spread around the world due to a combination of financial globalisation and financial innovations like securitisation. In the aftermath of the crash, this is the view that dominated. It was the parasitical rentiers in the international finance sector that had brought the global economy to its knees. Greedy bankers, out-of-touch economists, and regulators asleep at the wheel all shared the blame in popular readings of the crisis.28 Such accounts undoubtedly deliver an accurate analysis of the events surrounding 2008, but they do not tell the whole story. Finance is not some ethereal activity that sits atop the “real” economy — it has its roots in normal economic activity. International banks may have been playing reckless games with one another, but the source of their profits was lending to households and businesses.
The global financial crisis may have broken out in the US in 2008, but it had its origins in the unique Anglo-American model of finance-led growth pursued since the 1980s. The financialisation of the firm provided an immediate fix to the profitability crisis of the 1970s – a fix built on the repression of wages and productive investment. The states that had encouraged the financialisation of the firm deregulated their banking sectors in order to give households greater access to credit and expand asset ownership. In doing so, they were attempting to disguise the chronic shortfall in demand finance-led growth threatened to create, and to make the system politically sustainable. Rising mortgage lending increased house prices, eventually inflating a bubble that saw the British and American housing markets turned into a giant Ponzi scheme. Banks took this mortgage debt, packaged it up and sold it on international financial markets, disguising the amount of risk they were taking. Capital flooded into the US and the UK to take advantage of the boom, and repressed activity in the rest of the economy. The spark that set the whole thing alight came from the US, but the fallout extended throughout the financialised economies of the global North, and was particularly severe in Britain, whose economy had been buoyed by rising debt and asset prices for decades. Whilst 2008 may look like a transatlantic banking crisis, it was more than this: it was a structural crisis of financialised capitalism.
Understanding the financial crisis therefore requires adopting an historical approach to analysing the evolution of a model that was born forty years earlier. This allows us to recognise that financialisation, as a fix to the contradictions of the previous model, contains its own inherent contradictions. Just as Kalecki helped us to understand the contradictions of social democracy far before the system broke down, economists like Keynes and Minsky also helped us to understand the contradictions of financialised capitalism far before that system collapsed. The fact that these things were predictable means they were endogenous to the functioning of the system – they were inherent features of finance-led growth. And that is the most important message to take from this story. The global financial crisis wasn’t an aberration; it wasn’t a couple of bad years in an otherwise well-functioning economy. It represented a deep-seated crisis, the roots of which lay in the economic model pursued in Anglo-America up to 2007.
Today, just like those living through the crisis decade of the 1970s, we are living in what Gramsci called the interregnum: that moment between the death of the old and the birth of the new. The implications of this insight will be discussed in the next chapter. But if the reader takes only one thing from this book, let it be this: poor regulation, bad economics and greedy bankers all contributed to the particularly explosive events of 2008, but the financial crisis had far deeper roots. A crash — if not necessarily the crash that we got — was woven into the DNA of the economic system that was built in 1980. And nothing but wholesale economic transformation will deliver us from its shadow.