The Alchemists: Three Central Bankers and a World on Fire (17 page)

“The TAF laundered the crisis,” one Fed official said years later. “It made it look like we were solving a U.S. problem, when the real problem was the exposure of European banks to the dollar.”

When the extent of lending to foreign banks was publicly disclosed—three years later, after it was forced by congressional order—Fed officials pointed to the role that those institutions played in supporting U.S. credit markets. The foreign banks, after all, were one of the key ways that Europeans’ savings were funding Americans’ credit cards and home mortgages. Moreover, the Fed was legally prohibited from discriminating against foreign-owned banks in its lending at the discount window, which is what TAF effectively was. But it’s hard to imagine that the Fed could have thrown its resources so readily to foreign banks had the American public—and its legislative representatives—understood what it was doing.

For their part, Trichet and the ECB were worried that announcing an exotic new program to channel dollars to European banks could create deeper fears for their solvency, forcing investors to conclude that things were even worse than they’d thought. So they publicly spun participation almost as a favor European banks could do for the Fed to help its efforts to unfreeze lending markets in the United States. “
We think it is a right way to cooperate
in the month of January,” Trichet said in a 2008 press conference. The connections between the swap lines and the TAF may have been little understood by the American public and policymakers, but they were well understood at the ECB as being two ways to address the same problem: European banks running short of dollars. Internally, they even referred to their own dollar lending as “Euro-TAF.”

The joint action helped ease the sense of panic in the money markets at the end of 2007, but the relief was short-lived. A dangerous pattern was setting in: Bernanke’s dreaded financial accelerator. When credit tightens and banks become more cautious, they cut back on lending out money and injecting it into the economy. Less lending means slower economic growth—fewer houses built or goods consumed. A weaker economy causes banks’ losses to mount, making them pull back on lending all the more. It was just this vicious cycle, Bernanke argued, that made the Great Depression great.

Early in 2008, the financial accelerator was revving up in the United States. While the economy had weathered the earlier phase of financial panic, by December 2007 the nation was officially in recession. With every piece of economic data, it became more evident that the U.S. economy was sinking into a downturn, while most economies in Europe were merely slowing down—and the developing world was growing gangbusters.

The problems that had been most severe among European banks had, by March 2008, pivoted across the Atlantic to the U.S. investment banks. Whereas more traditional U.S. banks like Bank of America or J.P. Morgan fund themselves in large part with deposits from individuals and businesses—money that tends to stay put—investment banks like Bear Stearns rely on faster money. They fund their operations to a large degree in the “triparty repo market”—effectively depending, every single evening, on lenders being willing to extend them credit against solid collateral. It was usually a steady source of funds. After all, Bear Stearns had been around since 1923, surviving eighty-five years’ worth of crises without its lenders having lost any money. Even on March 13, 2008, long after the firm’s business of packaging mortgages into securities had begun falling apart, shares of its stock were worth a combined $8 billion.

But investors were paralyzed by the potential for future losses, as well as skeptical that the assets Bear had on its books were worth what it claimed they were. And the firm had left itself little room for maneuver: It had $398 billion in total assets on its books, but also owed $387 billion in debts. That meant it wouldn’t take much of a dip in the value of mortgage securities for Bear Stearns to become insolvent. On the evening of Thursday, March 13, the lenders didn’t show up: They refused to give the firm the overnight money that was its lifeblood.

Bear Stearns was functionally bankrupt, and Bernanke had a predicament. The Fed had long acted as lender of last resort—but only to traditional banks. Bear Stearns may have acted like a traditional bank in many ways, but it was a different sort of animal. It wasn’t regulated by the Fed. It didn’t obey capital rules set by the Fed. It had no access to emergency lending by the Fed. Bernanke had no obligation to do anything but watch Bear Stearns go bankrupt and try to clean up any damage to the economy afterward.

Among the key lessons of Bernanke’s academic work on the Great Depression, however, was that when financial institutions are allowed to fail, they can bring an entire economy down with them. In terms of size, Bear Stearns was less than three times as large as Northern Rock. But in terms of importance—how deeply intertwined it was with the rest of the financial system—it was far more consequential. Bernanke and his inner circle were convinced that the impact of Bear’s bankruptcy on world financial markets would be devastating.

There was no time to do any careful number crunching, but their best guess, in discussions that went all night, was that Bear Stearns’ collapse would instantly cause funding to dry up for the next-largest investment bank, Lehman Brothers, and possibly more beyond that. It could lead to a collapse in money market mutual funds, the savings vehicles where millions of individuals and businesses parked their cash and which had invested in the short-term debt of firms like Bear. And it would precipitate perhaps a 25 percent drop in the overall stock market, devastating Americans’ wealth. None of this was based on rigorous analysis. Rather, a decision involving billions of taxpayer dollars would have to rely on the gut instincts of a handful of crisis fighters: Geithner, career Fed official Don Kohn, former investment banker and Bernanke inner circle member Kevin Warsh, and New York Fed markets chief Bill Dudley.

If they could do anything to stop all that from happening, they decided in predawn discussions that Friday morning, they must. The option they came up with was to invoke a provision in the Federal Reserve Act, known as 13(3), that allowed the Fed to lend money to any “individual, partnership, or corporation” in “unusual and exigent circumstances.” In a single morning, they’d thrown out ninety-five years of precedent and placed the resources of the Fed behind not a bank but a securities firm. Over the ensuing weekend, Geithner and the Fed hammered out a deal to resolve the Bear Stearns crisis: The Fed would take on $30 billion worth of Bear assets, and J.P. Morgan would buy what was left over. At the same time, the Fed, using that same emergency 13(3) authority, opened its discount window to all the investment banks—Lehman Brothers, Goldman Sachs, Morgan Stanley—aiming to head off a cash crunch at those firms.

For nearly a century, the Fed had been lender of last resort to American banks. In the space of three months, it expanded that role to encompass both banks headquartered across Europe and the masters of the investment universe on Wall Street. No less a figure of authority than Paul Volcker, the former Fed chair and conquerer of inflation who had a unique moral authority, noted the historic change.

“
What appears to be in substance
a direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central-bank mantra in time of crisis: Lend freely at high rates against good collateral,” Volcker told the Economic Club of New York less than a month after the Bear bailout. “Test it to the point of no return.”

The summer of 2008 was another of the intermittent lulls in the storm, a time when the financial crisis seemed to be fading and other concerns rose to the fore. That led both Trichet and King to make costly mistakes.

That summer, an epic run-up in the cost of oil and almost every other global commodity was driving overall prices higher. Corn, copper, concrete—the price of anything that comes from the ground—was going up as booming demand in China and other developing countries outpaced supply. Such a jump in prices has the effect of making the economy too hot and too cold at the same time: Consumers have to spend more on fuel, which means they have less to spend on everything else, worsening economic conditions overall. Normally, central bankers don’t adjust monetary policy to counteract short-term changes in commodity prices. After all, just because oil soars one month doesn’t mean it will the next. The hike is a one-time thing.

But that logic breaks down when rises take place so often that consumers start to believe they’re not one-time things but a permanent state of affairs. Businesses pencil in steady price increases. Unions demand higher raises. Lenders levy higher interest rates to make up for the fact that the euros they are repaid in the future will be worth less than those they loan out now. Once those things happen, inflation is self-perpetuating. And in that summer of soaring fuel prices, Trichet saw exactly that starting to happen: Airlines were adding surcharges to their ticket prices. Labor unions were demanding pay hikes of 4 or 5 percent, not the 2 or 3 percent with which the ECB would be more comfortable.

To this point in the crisis, Trichet had been determined to keep the ECB’s attempts to prop up the European banking system separate from its monetary policies. In September 2007—just as the Federal Reserve was starting to cut interest rates as part of an all-out assault on the crisis and its possible economic effects—he drew a telling analogy. “
Television dramas
tend to be made about medical-rescue teams, hospital emergency rooms, and heart surgeons, not about the internists who regularly take your blood pressure and check your cholesterol,” Trichet said in a speech in Frankfurt. “A central bank has one emergency room, which—sporadically—tackles casualties of car accidents and applies angioplasty and bypass surgery. But these activities—critical as they are to the functioning of the system—make up a small fraction of their duties. Central banks are for the most part made up of legions of internists who stare at your X-rays and engage in sober consultations.”

And in their sober consultations in the summer of 2008, Dr. Trichet and his team of
médecins
saw rising inflation as the greatest risk on the horizon.

The ECB’s monetary policy group is large and diverse, with members drawn from across the eurozone. In the Eurotower, a modern skyscraper near the train station in downtown Frankfurt, they gather every month around a circular table in the thirty-sixth-floor boardroom to debate monetary policy (with a second monthly meeting occurring for administrative matters). The president and five other executive board members are appointed by the heads of state of Europe in a secretive process rife with backroom dealing. In practice, four of the six slots are usually filled with people from the four biggest eurozone economies: Germany, France, Italy, and Spain. In total, the meetings include the heads of each national bank in the eurozone—from the mighty Bundesbank, responsible for the financial well-being of eighty-two million people, to the minuscule Central Bank of Malta, which safeguards the wealth of only 418,000.

Ireland is the only eurozone nation in which English is the native language of a majority of the population. The selection of English as the language in which ECB business is conducted represents a compromise: The Germans couldn’t stomach their central bank deliberating in French, and the French couldn’t stomach it using German. In theory, the people gathered around the table for the Governing Council are there to argue, with varying degrees of English proficiency, for what’s best for the eurozone as a whole, not their own nations. In practice, of course, it doesn’t always work that way. But to try to forestall any nationalistic temptations, the ECB keeps minutes and voting records secret for thirty years. It’s easier for the head of the Bank of Italy to vote for a policy that isn’t helpful to Italy, goes the logic, if nobody knows about it for a generation. (The Fed and the Bank of England, by contrast, release the information within weeks.)

This sprawling committee of twenty-three people of different nationalities actually made it easier for Trichet to practice his delicate art of managing a group toward consensus. On the first Thursday of the month, the same day the Bank of England makes its decision, the group would gather at 9 a.m. The bank’s chief economist would spend the first hour walking through his staff’s analysis. Then Trichet would give his own view of what the committee ought to do. That ensured that those without strong opinions would gravitate to what the president had argued. Then, in summarizing the discussion and counting votes, Trichet would interpret anyone who didn’t specifically say how he or she was voting as being on his side in the debate.

The sheer size of the committee, and the need to make a decision in time for the announcement to be made at noon, meant that each member could be granted only five minutes or so to state his or her view, which worked in Trichet’s favor: Long debates that might lead somewhere he didn’t want couldn’t really break out, because there just wasn’t time. And the fact that open dissent was, officially at least, to remain secret meant that Trichet didn’t have to worry if a few of his committee members weren’t happy with a decision. It would be breaking the rules of the game for them to blab about their objections to the press.

A statement announcing the outcome of the meeting would be released within hours, at 1:45 p.m. At 2:30, Trichet would take the stage for a press briefing to explain the decision, where by 2008 he was a master at sending the subtle signal he intended the markets to receive, no more and no less. He had come to use code words to signal to the world what the ECB had up its sleeve. For example, if he said that the council would be monitoring inflation with “strong vigilance,” it was a signal that an interest rate hike would almost certainly be coming the next month.

At the June 8, 2008, meeting of the Governing Council, the group was divided. As Trichet put it that day, “
We exchanged many opinions
and views around the table, as always, with a very candid exposition of our analysis. A number of us thought that . . . we had a case for increasing rates. A number of us considered that there was a case for increasing rates, but at a later date, and some amongst us considered that there was not necessarily a case for doing so.” The compromise: This time, Trichet wouldn’t pledge “strong vigilance” and a near-certain rate hike but rather “heightened alertness,” which raised the possibility of a hike without committing to it; often, central bank communications is the art of managing such fine distinctions.