The following is an excellent excerpt from the book “THE ONLY GAME IN TOWN: Central Banks, Instability, and Avoiding the Next Collapse” by Mohamed A. El-Erian from Part II: “Context: The Rise, Collapse, and Resurrection of Central Banking” from Chapter 6: “Cascading Failures” on page 38 and I quote:
“Everyone has a plan until they get punched in the mouth.” –Mike Tyson
“These are days when the improbably can become the inevitable.” –Jim Dwyer
“Rather than mark a decisive victory over the vagaries of the business cycle, the golden age of central banking ended up underpinning an historic period of excessive and irresponsible risk taking. The economic and financial chaos that followed was so intense as to totally discredit the concept of great economic moderation and of sophisticated risk management by the private sector. In the process, it dismantled the notion of central bank dominance, along with their sterling reputation.
By 2007, it started to become clear that finance-dependent economies had gone too far in trusting and enabling banks, and in regulating them just with a “light touch” that assumed adequate “self-regulation.” This was not just the case in the United States and the United Kingdom, which had engaged in a vigorous battle that pitched New York versus London as the dominant global financial center. It was also the case for places such as Dubai, Iceland, Ireland, Switzerland, and elsewhere, which sought to use finance to escape the domestic limitations of small economic size by leveraging and internationalizing their financial institutions.
It also started to become clear, albeit only very slowly at first and then in a frighteningly accelerating fashion, that national authorities may had been pushed into an awful catch-22: either bail out financial miscreants using taxpayers’ funds, or allow a financial debacle to cause even greater havoc to an already-struggling real economy.
The first public sign of problems surfaced in the first week of August 2007, when Paribas, a sizeable French bank, announced losses and restricted investors’ ability to withdraw their capital from some investment funds. The shock was notable because it involved two of the elements that market participants fear the most, and, understandably so. In fact, they fear them much more than large adverse price movements: First, access to funds was restricted as the bank could no longer provide the liquidity that its clients desired, expected, and had assumed was automatic; second, the disruptions sent broader tremors as they undermined the normal functioning of markets.
Recognizing the threat at hand, the ECB under its experienced president Jean-Claude Trichet responded quickly and decisively. In doing so, it managed to deal with the immediate threat. That was the good news. The less good news is that neither the ECB nor the central banking community as a whole seemed to fully grasp the notion that the Paribas shock, rather than being isolated and institution-specific, was indicative of something that was much bigger and much more consequential–that is, the formation of a potentially catastrophic tsunami.
If anything, the central banks’ reaction function ended up being too gradual and way too piecemeal. Its design was a tactical one, lacking both the sufficient analytical foundation and the more comprehensive follow-through of a well-thought-out strategic approach. With hindsight, it was yet another illustration of the extent to which they (and much of society) still lacked sufficient understanding of realities on the ground–and not only in areas that had migrated outside their formal supervisory purview but also for activities that were taking place right under their regulatory noses.
Increasingly, central banks found themselves caught between conflicting internal/external narratives. To the outside world, they displayed a sense of calm, highlighted by the often-quoted remarks by Chairman Bernanke reassuring the world on the soundness of the U.S. housing market and of its heavily exposed banks and specialized institutions. Internally, they had started to play a game of catch-up with dangerous circumstances that gradually became increasingly obvious over the next year, culminating in cascading failures that very few policymakers and market participants will ever forget.
The second big visible tremor hit in March 2008. Bear Stearns, once one of America’s most established and reputable investment banks, found itself on the verge of collapse. Once again, complex financial engineering and extremely leveraged positioning were at the heart of the problem, together with inadequate understanding at the heart of the problem, sloppy supervision, and lax accounting given the extreme risk taking that all this entailed. And once again, dramatic central bank action–this time quarterbacked by the Federal Reserve under chairman Bernanke–was needed to restore calm before things got really out of hand.
Unlike the ECB’s emergency response seven months earlier involving liquidity injections, the Fed’s intervention made broader use of the public balance sheet. Importantly, it provided financial (loss-protected) backing for a shotgun wedding between failing Bear Stearns and solid-standing JPMorgan Chase.
Central banks’ hope was that these two very sudden and disturbing shocks, together with the exceptional nature of the policy response, would entice banks to de-risk in an orderly manner. Instead, banks seemed beholden to what economists call “moral hazard”–that is, the inclination to take more risk because of the perceived backing of an effective and decisive insurance mechanism.
There is perhaps no better example of this phenomenon that what Chuck Prince, the then CEO of Citigroup, one of the biggest and most closely followed banks in the world, told the Financial Times in a front-page interview. Commenting on the prospects for problems down the road, he stated: “When the music stops, in terms of liquidity things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” And when the music did indeed end, Chuck Prince lost his job and Citi almost went bankrupt.
In effect, good old-fashioned human blind spots, inadequate mindsets, cognitive narrowness, hubris, and institutional rigidities were in play. Their potentially disastrous impact was amplified by excessive risk taking associated with misaligned financial incentives, classic principal-agent problems, and excessive short-termism. And the results were cumulative deteriorations on the ground that had already far outpaced the ability of the whole system to adequately understand the problem and play catch-up. As such, it wasn’t long before the consequences became scarily obvious to all.
By the summer of 2008, it was no longer a question of crisis prevention; the world was thrown into full crisis management mode–and on a scale and scope that few had ever thought possible in our modern global economy.
This type of potential economic calamity had not been seen since the Great Depression. It ran counter to deeply held beliefs about the efficiency and self-regulatory nature of modern capitalism. It placed huge demands on crisis managers who still had not fully grasped the enormity of the issues. And it involved some private sector leaders who were either too blind or too proud to realize the extent of irresponsible business that had taken place under their noses during their leadership tenures.
With multiplying banking disruptions and some spectacular bankruptcies, including the disorderly collapse of investment bank Lehman Brothers in September 2008, it quickly became blatantly and horribly apparent to all that finance had brought the world to the edge of a multi-year great depression. In the process, the popular perception of central banks went from enabler of sustainable prosperity to inadvertent accomplice in allowing irresponsible financiers to gamble with the fate of current and future generations.
The sudden popular dismay, including accusations that financial authorities had been on the receiving end of a massive “regulatory capture,” was accompanied by panic among central bankers that, in addition to lacking sufficient first responder tools to deal with the emergency, they also had only partial information on critical economic and financial linkages.
Noting that the transcripts of the Fed’s 2008 meetings (a 1,865-page document released to the public in 2014) presented “one of the most detailed portrayals of the fear and confusion that reigned in the autumn of 2008,” Robin Harding wrote, “When Lehman Brothers collapsed, the U.S. Federal Reserve struggled to comprehend the danger facing the global economy.”
The battle to understand the full extent of the calamity was combined with the need to mentally pivot on a number of issues–a pivot that challenged many established and entrenched mindsets.
The transcripts of the 2009 meetings that were released in March 2015 show Federal Reserve officials intensely worried and quite pessimistic as they scramble to come to grips with an economy “spiraling into Japanese-style economic crises.” Chair Yellen, who then sat on the FOMC in her capacity as president of the San Francisco Fed, remarked that a quick V-like rebound was implausible and that “even a gradual U-shaped recovery was unlikely.” She added that, in applying aggressive policy measures, “we are desperately trying to power a bicycle uphill rather than pressing an accelerator on a high-powered sports car.”
Coming into the crisis, quite a few Fed officials were caught looking at the wrong set of risks. As the transcripts show, they were much more concerned about the threat of inflation than the possibility of a financial “sudden stop” that would bring the world to the edge of something really sinister.
Commenting on this, Matthew O’Brien of The Washington Post undertook a simple yet illuminating word count in a blog post for the Brussels-based Bruegel think tank. He found that, in the run up to the Lehman collapse, the mentions of inflation” in the transcripts vastly outnumbered those for “system risks/crises”: 468 versus 35 at the June 2008 FOMC meeting and 322 versus 19 at the August meeting. Even more notable: At the September 16, 2008 meeting [that is the day after Lehman failed] there were 129 mentions of inflation. . . and only 4 of systemic risks/crises.”
This was in turn related to a massive historical underestimation of the extent to which a once much-admired and sophisticated financial network could go from being an efficiency creator/risk mitigator to a complex disseminator/amplifier of financial and economic chaos.
As such, central bankers–acting both nationally and in a coordinated global fashion–struggled to trip whatever circuit breakers they could come up with. As failures cascaded from one place to another, however, they struggled to find enough to trip, and they were nowhere near finding the major switch.
By the fall of 2008, Ben Bernanke, the chair of the Federal Reserve, the world’s most powerful central bank, had no choice but to go to Congress and warn of a massive economic calamity that was hitting America and the world. Accompanied by Treasury secretary Hank Paulson, they essentially begged lawmakers to approve, in record time no less, previously unthinkable amounts of funding to stabilize a financial system that had lost all of its anchors and was now spreading damage far and wide. There are even stories of Secretary Paulson going down on one knee to urge congressional leader Nancy Pelosi to back his controversial and expensive rescue plan.
A shocked and scared global citizenry started wondering how central banks had allowed the situation to get so out of hand, so desperate, and so dangerous. Many routine economic and financial activities were now subject to disruptive sudden stops. People like me started receiving multiple calls, not only from bewildered lawmakers and policymakers around the world, but also from everyday individuals and family members–including requests to speak at schools, libraries, and other venues to explain what was going on and why.
Facing a potential chaos that had been deemed by so many to be unlikely if not unimaginable, some central bankers were seemingly “flapping around like fish on a slab.” Even the more qualified ones were “bewildered by the speed and novelty of the events unfolding before them.” And this was before they were able to fully comprehend the scope and scale of the calamity.
The fourth quarter of 2008 turned out to constitute one of the most dramatic modern collapses in output and trade. Unemployment shot up, with the United States alone losing 8 million jobs (Figure 2). Cross-border trade came to almost a virtual stop (Figure 3), adding to the collapse in economic activity. Letters of credit were virtually impossible to open. Even successful companies with robust balance sheets found themselves cut off from working capital.
Prices across a very broad set of financial assets hit huge air pockets. And many of those that were able to deploy cash quickly to take advantage of striking bargains lost their willingness to do so, even when confronted with what a few weeks earlier they would have regarded as dirt- cheap prices and historic bargains.
As catastrophic as things seemed at the time, it was only later that many realized how really bad things actually were. And all this paled in comparison to what would have occurred had the “sudden stop” continued. For well beyond the visible economic and financial disruption lay a much less visible weakness that nonetheless constitutes one of the greatest Achilles’ heels of market economies and an interlinked global economy–the erosion of trust in the payments and settlement system.
Living in California, a car-oriented culture with a soft spot for drive-through fast-food joints (and now drive-through Starbucks, too), I have used a simple analogy to illustrate what happened during those dramatic few days. This was the period when Lehman’s disorderly bankruptcy and its aftermath brought the whole leverage edifice down, taking the world to the edge of a disastrous multi-year depression. It was a situation that no country in the world could have escaped unscathed.
Imagine a customer ordering a Big Mac meal at her local McDonald’s drive through. She is directed to two windows after placing the order–one to pay for the meal (“payment”) and the other to get the food (“settlement”). It is just a few yards between the two. Yet aware of a recent bankruptcy in which clients at another fast-food joint had been stranded in between these two windows–having paid for but not received their meals–she requests instantaneous settlement at the time of payment. But the system isn’t built for such simultaneous payments and settlement. It assumes a certain amount of trust.
Unwilling to take the risks of the few feet between the payment and settlement windows, the client refuses to pay. Despite being hungry, she ends up driving away with no food. And, remember, she has both access to food and the means to pay for it. Meanwhile, the restaurant is also worse off. It is forced to throw away a perfectly good meal that would normally suit the customer.
Basically, this is what was fueling cascading market failures whose occurrence was deemed unthinkable and whose implications were disastrous. And those of us on trading floors with direct exposure to all this were stunned by the difficulties faced in completing the most basic financial transactions–those involving the placement of cash into the financial system and the exchange of highest-quality collateral.
I remember particularly vividly the day when the instability spread to the U.S. money market segment, with one large fund being forced to “break the buck” (that is, it was unable to meet its client redemption requests at par). In fact, markets had become so dysfunctional that day that I called my wife during the later California afternoon and suggested that she go to the ATM and withdraw the maximum allowed for us per day ($500 I think it was). When she asked me why I responded that I felt there was some chance that the banks would not open the next day.
I doubt many would have believed me at that time. After all, the United States was no fragile developing country with immature financial institutions and a badly managed central bank. We were living in a mature capitalistic country with a sophisticated financial system, a powerful central bank, and crisis circuit breakers.
It was only many months later that my worries were validated by the public recollections Chairman Bernanke and Treasury secretary Paulson, including Bernanke’s characterization of those “very, very dark hours.” Yes, the United States and therefore much of the rest of the world had come very close to declaring a “bank holiday” that would have shut down the financial system in order to subsequently reset it in a sustainable fashion.
Moreover, as Secretary Geithner noted in his book on the crisis, members of the economic team “talked openly” about nationalizing major banks. And this was but one of several issues over which they found themselves “at odds,” though the message from his book is that these “disagreements did not turn out to be consequential.”
With the world suffering significant damage and dangerously standing on the edge of an even greater calamity as a result of financial irresponsibility, it was only a matter of time until the blame game started in earnest. Banks would find themselves in the direct line of fire, of course, and understandably so. Central banks would also be targeted, if only because they had evolved–inadvertently–into naive enablers of malfeasance.”
(THE FOLLOWING IS A QUOTE FROM NOURIEL ROUBINI ABOUT THIS BOOK AND I QUOTE:
“This book is a must-read for anyone interested in the global economy. A masterful account of how central banks became the only game in town after the global financial crisis but also how other structural and fiscal policies are necessary to resolve key global economic issues. El-Erian is the best thinker on the key global issues of our times.” — Noriel Roubini, chairman, Roubini Global Economics and professor of economics, Stern School of Business, NYU
LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran