The Real Cost of the 2008 Financial Crisis

September 15th marks the tenth anniversary of the demise of the investment bank Lehman Brothers, which presaged the biggest financial crisis and deepest economic recession since the nineteen-thirties. After Lehman filed for bankruptcy, and great swaths of the markets froze, it looked as if many other major financial institutions would also collapse. On September 18, 2008, Hank Paulson, the Secretary of the Treasury, and Ben Bernanke, the chairman of the Federal Reserve, went to Capitol Hill and told congressional leaders that if they didn’t authorize a seven-hundred-billion-dollar bank bailout the financial system would implode. Some Republicans reluctantly set aside their reservations. The bailout bill passed. The panic on Wall Street abated. And then what?

The standard narrative is that the rescue operation succeeded in stabilizing the financial system. The U.S. economy rebounded, spurred by a fiscal stimulus that the Obama Administration pushed through Congress in February, 2009. When the stimulus started to run down, the Fed gave the economy another boost by buying vast quantities of bonds, a policy known as quantitative easing. Eventually, the big banks, prodded by the regulators and by Congress, reformed themselves to prevent a recurrence of what happened in 2008, notably by increasing the amount of capital they hold in reserve to deal with unexpected contingencies. This is the basic story that Paulson, Bernanke, and Tim Geithner, who was the Treasury Secretary during the Obama Administration, told in their respective memoirs. It was given an academic imprimatur by books like Daniel Drezner’s “The System Worked: How the World Stopped Another Great Depression,” which came out in 2014.

This history is, on its own terms, perfectly accurate. In the early nineteen-thirties, when the authorities allowed thousands of banks to collapse, the unemployment rate soared to almost twenty-five per cent, and soup kitchens and shantytowns sprang up across the country. The aftermath of the 2008 crisis saw plenty of hardship—millions of Americans lost their homes to mortgage foreclosures, and by the summer of 2010 the jobless rate had risen to almost ten per cent—but nothing of comparable scale. Today, the unemployment rate has fallen all the way to 3.9 per cent.

There is much more to the story, though, than this uplifting Washington-based narrative. In “Crashed: How a Decade of Financial Crises Changed the World,” the Columbia economic historian Adam Tooze points out that we are still living with the consequences of 2008, including the political ones. Using taxpayers’ money to bail out greedy and incompetent bankers was intrinsically political. So was quantitative easing, a tactic that other central banks also adopted, following the Fed’s lead. It worked primarily by boosting the price of financial assets that were mostly owned by rich people.

As wages and incomes continued to languish, the rescue effort generated a populist backlash on both sides of the Atlantic. Austerity policies, especially in Europe, added another dark twist to the process of political polarization. As a result, Tooze writes, the “financial and economic crisis of 2007-2012 morphed between 2013 and 2017 into a comprehensive political and geopolitical crisis of the post–cold war order”—one that helped put Donald Trump in the White House and brought right-wing nationalist parties to positions of power in many parts of Europe. “Things could be worse, of course,” Tooze notes. “A ten-year anniversary of 1929 would have been published in 1939. We are not there, at least not yet. But this is undoubtedly a moment more uncomfortable and disconcerting than could have been imagined before the crisis began.”

In the years leading up to September, 2008, Tooze reminds us, many U.S. policymakers and pundits were focussed on the wrong global danger: the possibility that China, by reducing its huge holdings of U.S. Treasury bills, would crash the value of the dollar. Meanwhile, American authorities all but ignored the madness developing in the housing market, and on Wall Street, where bankers were slicing and dicing millions of garbage-quality housing loans and selling them on to investors in the form of mortgage-backed securities. By 2006, this was the case for seven out of every ten new mortgages.

Tooze does a competent job of guiding readers through the toxic alphabet soup of mortgage-based products that Wall Street cooked up: M.B.S.s, C.D.O.s, C.D.S.s, and so on. He looks askance at the transformation of commercial banks like Citigroup from long-term lenders into financial supermarkets—“service providers for a fee”—in the decades before 2008, and he rightly emphasizes the enabling role that successive Administrations played in this process, not least Bill Clinton’s.

But the great merit of Tooze’s tome—it runs to more than seven hundred pages—is its global perspective. Tooze maps the fallout as far afield as Russia, China, and Southeast Asia. He lays out the role played by European banks and cross-border flows of financial capital. And he provides a detailed account of the prolonged crisis in the eurozone, which, he maintains, “is not a separate and distinct event, but follows directly from the shock of 2008.”

The subprime fever originated in the United States, but soon spread to European behemoths like Deutsche Bank, HSBC, and Credit Suisse: by 2008, close to thirty per cent of all high-risk U.S. mortgage securities were held by foreign investors. Although the major international banks were domiciled and regulated in their individual countries, they were operating in a single, integrated capital market. So, when the crisis struck and many sources of short-term bank funding dried up, the European banks were left tottering. In some respects, they were in even worse shape than the American banks, because they needed to roll over their dollar-denominated mortgage assets, and Europe’s central banks and lenders of last resort—the European Central Bank, the Bank of England, and the Swiss National Bank—didn’t have enough dollars to tide them over.

Paulson and Bernanke didn’t predict any of this when they made the fateful decision, on September 14, 2008, to let Lehman fail. Paulson, in particular, was keen to escape the label of “Bailout King,” which he had been saddled with earlier in the year after orchestrating a rescue of Bear Stearns. An international banking disaster was avoided only because the Fed agreed to provide its European counterparts with virtually unlimited dollars through currency-swap arrangements, and to give troubled European banks access to various emergency lending and loan-guarantee facilities that it established in the United States. “The U.S. Federal Reserve engaged in a truly spectacular innovation,” Tooze writes. “It established itself as liquidity provider of last resort to the global banking system.”

But the Fed hid much of what it was doing from the American public, which was already choking on the U.S. bank bailout. It wasn’t until years later, as a result of the Dodd-Frank financial-reform act and a freedom-of-information lawsuit filed by Bloomberg News, that the details emerged. The sums involved were huge. According to Tooze’s tally, the Fed provided close to five trillion dollars in liquidity and loan guarantees to large non-American banks. It also provided roughly ten trillion dollars to foreign central banks through currency swaps. As with the seven-hundred-billion-dollar bailout for domestic banks, practically all this money was eventually repaid, with interest. But, had the full scope of what the Fed was doing emerged at the time, there would have been an uproar. Fortunately for the policymakers, there was no leak. An official at the New York Federal Reserve, which helped enact many of the covert lending programs, told Tooze that it was as if “a guardian angel was watching over us.”

Many of the politicians who came to be associated with the financial crisis and the bank bailouts weren’t so lucky. In 2009 and 2010, the center-left parties that occupied positions of power in the United States, Britain, and Germany all suffered electoral setbacks. In Berlin and London, new center-right governments committed themselves to slashing budgets and reducing deficits, which rose sharply as jobless rates went up and tax revenues went down. Keynesian economists warned that the recovery was too fragile to withstand austerity measures, but many conservative economists strongly supported them. Germany itself recovered even after it passed a balanced-budget amendment to its constitution and enacted the deepest spending cuts in the history of the Federal Republic. Yet the refusal of Europe’s largest and most powerful economy to act as a locomotive, and to help offset deflationary forces elsewhere, was to have some very negative consequences for the eurozone as a whole.

Tooze dwells at length on the European transition from stabilization to austerity, which coincided with the emergence of a sovereign-debt crisis in three peripheral members of the eurozone: Greece, Ireland, and Portugal. The “euro crisis” is often framed as a story of spendthrift governments run amok, but the real sources of the trouble were underlying faults in the euro system and the creation of too much credit by private-sector banks—the same phenomenon that led to the subprime-debt crisis in the United States.

In 1998, eleven Continental countries adopted the euro as their common currency, including the big three: France, Germany, and Italy. Greece followed suit the next year. (Seven more countries have since joined.) Under the euro system, individual countries gave up the freedom to set their own interest rates and adjust their own currencies. Instead, there would be a single interest rate, set by the European Central Bank, in Frankfurt, and a single exchange rate, set by the market. Member countries were also obliged to meet strict targets for their budget deficits.

Over time, many of the weaker European economies came to chafe at these restrictions. At first, though, the system seemed to be a miracle drug. Investors had traditionally treated countries like Greece, Ireland, and Portugal as risky bets, and demanded generous yields on the bonds those countries issued. After these countries adopted the euro, however, international investors loaded up on these bonds as if they were on a par with French and German bonds, even as yields fell. Tooze points out that, of the nearly three hundred billion euros’ worth of bonds that the Greek state had issued by the end of 2009, more than two hundred billion were foreign-owned.