Blank Cheques and Balances: Origins of the Global Debtocracy

‘There’s a tsunami coming our way, Hank, and you’re on the beach hesitating over what color of bathing suit we should wear!’ Thus Christine LaGarde, currently head of the IMF and formerly the French finance minister, reportedly fumed at US Secretary of the Treasury Hank Paulson in the summer of 2007. ¹ Dubbed ‘the Snake’, Paulson was formerly CEO of Goldman Sachs, the Wall Street investment bank. A year later, on 15 September 2008, Lehman Brothers filed for bankruptcy protection, the largest bankruptcy in US history, involving a $600 billion loss. Rapidly sifting through torrents of data on Blackberries and Bloomberg screens, financial traders and tycoons like Paulson ‘could not detect the tectonic shifts occurring on the ocean floor that would generate the destructive tsunami wave’ (Roeder in Hale and Hale, p. 294). LaGarde, and many other European officials, were irked that American financiers did not act more promptly to avert the crisis.

Transatlantic and nationalist tensions have ballooned since the inception of the credit crunch. At the G-20 summit in Mexico on 18–19 June 2012, Manuel Barroso, President of the European Commission, placed the blame on Americans: ‘This crisis was not originated in Europe […]; this crisis originated in North America and much of our financial sector was contaminated by […] unorthodox practices, from some sectors of the financial market.’ ² A poll of Europeans taken in the summer of 2012 showed that 54 per cent believed the crisis in the Eurozone (European Monetary Union, or EMU) was the American banks’ fault, while 46 per cent blamed European leaders and institutions. ³ Two recently published books by David and Lyric Hale, and John Mauldin and Jonathan Tepper, respectively, add to our collective knowledge of the origins of the crisis and speculate about what lies ahead. So who, or what, caused the global debt crisis? This article will show that leaders – and consumers – on both sides of the Atlantic bear responsibility for the situation we face today. At least nine long-term and short-term causes of the crisis can be pinpointed, some of which the authors acknowledge and others that they do not.

First, one can ultimately trace the debt crisis directly back to the advent of the ‘fiat’ (arbitrary decree) money system. In July 1944, 44 Allied nations convened in the state of New Hampshire to sign what became known as the Bretton Woods accord. Among other things, they agreed to peg their currencies to the US dollar, which was in turn convertible to gold at the fixed rate of $35 per ounce. In 1971, however, without consulting the Allied nations or even the US State Department, President Richard Nixon abandoned the Bretton Woods accord. In the 1960s and 1970s, the Federal Reserve had expanded the money supply to pay for the wars in Korea and Vietnam. Increasingly, countries like France suspected this was happening and began to convert their US dollar reserves back into gold at $35 per ounce, in order to preserve their wealth. As a result, US gold reserves began to dwindle. By closing the ‘gold window’, foreign central banks were left holding US dollars, which were then devalued further by continued US money printing. (These foreign banks were in the position that China is in today.) The US dollar henceforth became the world’s reserve currency, and the fiat money system began. With the link to gold severed, governments around the world were free to print money as they wished.

Thus, debt itself is nothing new. In the wake of the sweeping deregulation of the US and European banking systems in the 1980s and 1990s (a second cause), debt has skyrocketed, however. Highly speculative, unregulated derivatives trading has now risked not only the solvency of whole sovereign nations, but also the stability of the global economy. The term ‘casino capitalism’ has been used to describe this phenomenon of irrational risk-taking. (The irony is that derivatives were first created specifically to reduce or ‘hedge’ risk.) In the United States, after the Glass-Steagall Act of 1933 was repealed by the Gramm-Leach-Bliley Act in 1999 during the Bill Clinton administration, US investment banks were no longer kept separate from commercial banks and insurance companies. This meant that the banks were now allowed to loan huge sums of money (customers’ deposits) on speculative ventures, knowing that they could then sell these ‘investments’ to their domestic and international clients for greater profits. These investment managers thrive on short-term incentives (hefty commissions and bonuses up front for their sales) and are thus indifferent to whether borrowers will default on their mortgages a few years later. In the United States, investment banks ‘leveraged’ (gambled) as much as forty to one with FDIC-insured taxpayers’ money. Officials like Clinton’s first Secretary of the Treasury Robert Rubin (like Hank Pauling, a former manager at Goldman Sachs), second Secretary of the Treasury Larry Summers and US Federal Reserve Chairman Alan Greenspan (an Ayn Rand devotee) believed that no regulation was best.

In 2010, the Dodd-Frank Act was passed, but, as Michael T. Lewis explains, the ‘too big to fail’ government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac remain, and should they go bankrupt again, US taxpayers will again be liable for billions of dollars in additional losses (Hale and Hale, p. 266).

Europeans can rightly point to a third cause – the ‘home mortgage lending crisis’ in the United States – as a key cause of the global debt crisis. Mortgages were bundled together (‘securitised’) and sold off to other investors, and thus no one cared any more whether the original mortgage was ever paid off. Since it no longer mattered whether the borrower could ever pay off the mortgage, ‘predator’ banks aggressively campaigned among low-income ethnic minorities in the United States. Debt became a form of currency, a product in and of itself. The bursting of the US ‘housing bubble’ – when interest rates rose to 5.25% in January of 2007 and borrowers could no longer make house payments – damaged financial institutions globally.

Not content to lend just to uncreditworthy (‘sub-prime’) borrowers in America, Wall Street banks also began predatory lending to sub-prime nations, or nations considered to be less creditworthy. Mauldin and Tepper omit to mention a fourth cause of the crisis: the secret role of US investment banks like Goldman Sachs in helping Greece to disguise the extent of its debt. In 2002, a year after Greece gained admittance to the European monetary union (EMU), Goldman Sachs brokered cross-currency swaps that made Greece’s total public debt appear smaller in the present, but it would increase ten or fifteen years later. ⁴ This was widely publicised in February 2010, a few months before the first Greek bailout in May 2010.

Thus, to a certain extent, Europeans are justified in blaming the United States. The Lehman Brothers’ bankruptcy and the Eurozone crisis are tightly linked. Many European hedge funds contained these ‘toxic’ US sub-prime mortgages. The recession sent shock waves throughout the European banking system, massively increasing the amount of debt in Europe, and – when governments bailed out the banks – private debt became sovereign debt, to be paid by innocent European taxpayers. While multinational banking corporations like Goldman Sachs and JP Morgan Chase did not singlehandedly create the Eurozone’s debt crisis, they did enable Greece, and other European countries, to borrow beyond their means, creating what Greek filmmakers Katerina Kitidi and Aris Hatzistefanou call a ‘debtocracy’ (rule by debt indefinitely). ⁵

Indeed, Greece has also become a favourite fall guy of many Europeans. Mauldin and Tepper devote a chapter to the Hellenic Republic, while the contributors to the Hales’ book mention the Greek debt problem briefly in five of the chapters. Even after admittance to the Eurozone in 2001, Greece – as many other countries – continued to run considerably large deficits, which is a fifth cause of the crisis. Even before 2008, Greece’s public debt was much higher than the threshold of 60 percent of GDP set by the founders of the Eurozone. Mauldin and Tepper explain that Greece had very inefficient railways and public schools and exorbitantly expensive entitlement programmes (p. 222).

The financial shock of 2007–8 walloped Greece especially hard since its main industries – shipping and tourism – were sensitive to changes in the business cycle. Thus, the government of Kostas Karamanlis spent heavily to keep the economy functioning and the country’s debt ballooned even more out of control. Despite the ‘no bailout’ clause in the European Union (EU) Constitution, the European Central Bank (ECB) was forced to bail out Greece in May 2010, followed by Ireland in November 2010 and Portugal in May 2011. As noted by Lord Kerr, the British diplomat who drafted the clause in the constitution, ‘it took only ten minutes to tear up a constitution that took ten years to negotiate’ (Kaletsky in Hale and Hale, p. 57).

Alas, these bailouts were only temporary bandages. Mauldin and Tepper – like top economists Paul Krugman and Nouriel Roubini – predict that at some point Greece will default (p. 231). Indeed, since the publication of his book in 2011, the ECB has provided Greece with a second bailout package of 130 billion euros in February 2012. This time it included a debt restructure agreement – the largest in world history. According to Forbes Magazine, Greece’s restructuring in fact represents a default. ⁶ Greece’s credit rating by Standard and Poor’s is now ‘CCC’, or eight levels below investment grade. ⁷

While Greek debt has greatly weakened the Eurozone, it is not the main cause of the debt crisis; in fact, EU officials and European politicians had known about the domestic situation in Greece, Spain and Italy for years, but made little effort to tackle these problems. One must examine a sixth cause – the structural flaws of the EMU – and understand the political and historical motives for its creation. The chapters by Kaletsky and Keith Jefferis do this to a certain extent (Hale and Hale, p. 58, p. 122). In the 1980s, both German Chancellor Helmut Kohl and French President François Mitterand – neither of whom was an economist – had cherished the dream of a ‘United States of Europe’. The ‘never again’ mentality after the Second World War galvanised the two men. After the Berlin Wall fell in 1989, many Europeans felt that a European union was the only way to contain the unified, more powerful Germany. As Kaletsky points out, the ECB’s bailouts to Greece, Ireland and Portugal forced Eurozone leaders to face the fact that a monetary union (i.e. control of the money supply and interest rates) without any coordination of the Eurozone members’ fiscal policies (i.e. government taxation and spending) was doomed to fail.

Now locked into the euro, the peripheral countries cannot print money and must appeal to the ECB. As Kaletsky aptly explains, with each new bailout, the poorer peripheral countries lose more sovereignty as the ‘core’ countries with current account surpluses, like Germany, Austria and the Netherlands, impose more demands for austerity (Hale and Hale, p. 61). Increasingly uncompetitive, with high corporate taxes and labour costs, these peripheral countries are further compelled to import from Germany and other core countries, increasing their trade deficits. Contrary to the dream of Kohl and Mitterand, the European Union has become more unequal and divided, the core countries versus the increasingly dependent and uncompetitive peripheral countries.

Germany also bears responsibility for the current debt crisis in the Eurozone. Mauldin and Tepper explain what can be seen as a seventh underlying cause of the crisis. When the euro was introduced in 1999, the Germans – deeply scarred by the hyperinflation of the 1920s – insisted on keeping interest rates very low. The results were predictable. European banks readily lent money to the ‘peripheral’ countries of Portugal, Italy, Ireland, Greece and Spain (PIIGS) at these low interest rates, since they shared the same currency as creditworthy Germany. With this cheap credit, housing ‘bubbles’ quickly resulted in these peripheral countries. One could borrow money cheaply, buy a house or apartment whose value was rising rapidly, then sell the property, pay off the loan and make a sizeable profit.

One can point to an eighth contributing factor – omitted by Mauldin and Tepper, as well as Hales’ contributors – that, as early as 24–25 November 2003, the Eurozone’s two strongest members – Germany and France – violated the EU’s rule about keeping the budget deficit below 3 per cent of the country’s GDP in a given year. (The deficit is the excess of expenditures over revenues in a one-year period only; it should not be confused with total government debt.) This set a poor example for the other Eurozone members, many of which then flouted the rule in the ensuing years. Borrowing by governments and private banks within the whole Eurozone spun out of control.

Moreover, as in the United States, banks throughout the Eurozone also became increasingly deregulated in the 1990s and 2000s. The EMU mandated these changes, partly in order to enable rapid capital transfer from one Eurozone member to another. Sub-prime mortgages were rife in Spain, for example. Unlike the other Eurozone members, Spain did abide by the official threshold levels of government borrowing, but the risky loans provided by the Spanish Banco Santander and other European private banks fuelled one of the worst property bubbles in Europe. Although Mauldin and Tepper neglect to make this distinction about Spain, they do observe that Spain now has ‘as many unsold homes as does the United States’, although Spain is six times smaller (p. 223).

Meanwhile, in the United Kingdom – a member of the EU but not of the Eurozone – many citizens now breathe a sigh of relief that Margaret Thatcher, British Prime Minister from 1979 to 1990, had spiritedly opposed the UK’s entry into the Eurozone, warning about the loss of sovereignty. Although some of the contributors to the Hales’ book mention it, only Mauldin and Tepper devote a chapter to the United Kingdom. They exclude the harsh, but valuable, lesson the UK learned during the ‘Black Wednesday’ incident of 16 September 1992 – when the Conservative government led by Prime Minister John Major had to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM).

Yet, while the UK is free from the euro straitjacket, it faces other, unique problems that can be traced directly to its hoary rivalry with New York City to be the world’s ‘financial capital’. Each city’s financial gurus competed to see who could deregulate faster. In fact, rapid deregulation of London’s banking industry actually began under Thatcher, with the passing of the Building Societies Act (1986) and the Financial Services Act (1986) and the ‘Big Bang’ stock market reforms – more than a decade before the Gramm-Leach-Bliley Act in the United States. As the largest, or second largest, banking centre in the world, London was thus ‘uniquely exposed to the worst ripples of the credit crisis’, Mauldin and Tepper write (p. 266). The assets of UK banks are ‘more than five times the country’s GDP’, whereas in the United States the ratio is closer to one (p. 266).

Indeed, as Mauldin and Tepper recount, the first bank failure occurred in the UK, a full year before the collapse of Lehman Brothers. Banks stopped lending money to each other soon after officials from the French bank BNP Paribas stated on 9 August 2007 that they could not value bonds backed by US house mortgages (p. 23). Northern Rock, a small bank based in Newcastle upon Tyne, had few customer deposits and relied heavily on borrowing from other banks to fund its lending. Rumours spread, and on 15 September 2007 customers queued to withdraw their savings from Northern Rock, the first such bank run in the UK in more than one hundred years (p. 266). In the first week of October 2008, just two weeks after the Lehman Brothers collapse, the Bank of England pumped more than fifty billion pounds – almost twice the country’s defence budget – into three of the main high-street banks: Lloyds-TSB, Royal Bank of Scotland and Halifax Bank of Scotland (Mauldin and Tepper, p. 266).

Not confined to the euro, the Bank of England has engaged in a programme of money printing (‘quantitative easing’ or QE) even more colossal than that in the US, buying UK sovereign debt (known as ‘gilts’). As Saul Eslake notes, although money printing lowers the value of the pound, thus increasing British exports, it also risks inflation and hurts key exporters to the UK like Germany and the Netherlands (Eslake in Hale and Hale, p. 140). Inflation erodes the value of citizens’ savings, but historically it has been a useful tool for governments in reducing debt. As Mauldin and Tepper write flippantly, the UK is a ‘wonderful case of how a central bank creates a housing bubble, props up the economy after the banking system collapses, and works hard to inflate away debt through stealthy inflation’ (p. 261). It is ‘the only country in the world that currently fits the bill for hyperinflation, where 100 percent of the budget deficit is monetized by the central bank’ (p. 173).

Contrary to the statement by Mauldin and Tepper, the inflation rate has dropped as the UK enters a deflationary spiral. The strict fiscal policy inaugurated by David Cameron’s Conservative–Liberal coalition government was initially greeted with enthusiasm in 2010, since its goal was to reduce the government deficit to 3.5 percent of GDP by 2013. As Karetsky notes, the UK has not only the largest exposure to financial services and property of all the G-7 countries, but also the biggest deficits and highest levels of household debt (Hale and Hale, p. 59). However, as Mauldin and Tepper correctly suspected, the spending cuts ‘bit too hard’, shrinking demand, and in 2012 the UK sank again into recession, defined as at least two consecutive quarters of contraction (Mauldin and Tepper, p. 271). According to the Chinese rating agency Dagong Global, both Britain and France deserve only an ‘AA-’ credit rating (Mauldin and Tepper, p. 198).

Unfortunately, this unprecedented level of sovereign debt is like metastatic cancer; the bigger the debt (tumour), the faster it grows. The longer one ‘monetizes’ the debt, the longer and more painful the recovery will be. As the contributors to the Hales’ book show, the cancer has not reached all countries around the world in equal measure. Their book (What’s Next? Unconventional Wisdom on the Future of the World Economy) is divided into eight parts, the first four of which survey the economic health of selected countries and regions. The other parts analyse the future of the US dollar and gold rally; the energy market, Iranian politics, climate change, neuroeconomics, and policy issues such as financial regulation. Generally, the countries hit hardest after the 2008 recession – apart from the United States and Great Britain – were those with the greatest exposure to the toxic assets in Wall Street investment banks, those that relied heavily on the US consumer market, those which hold debt in a foreign currency, those whose currency is artificially pegged to the euro, and those countries already using the euro who cannot print their own currency. These include all the Eurozone members, other European countries, the Baltic states and Japan. The banking systems in Australia, Canada, much of Latin America and Africa, and, of course, China, were less seriously impacted (although they were still affected by increased food prices and decreased worldwide demand for their commodity exports).

Like the title of the Hales’ book, the title of Mauldin and Tepper’s book (Endgame: The End of the Debt Supercycle and How It Changes Everything) also alludes to the future. Although Mauldin is vague on this point, ‘endgame’ is presumably when bond buyers, including foreign investors, lose faith in the United States’ ability to pay back the money and either stop buying bonds or demand higher yields (interest rates on their loans). Mauldin writes (p. 111): ‘The point of no return for countries is when interest rates rise faster than their growth rates. At that stage, there is no hope of stabilizing the deficit.’ Despite the gloomy title, Mauldin and Tepper profess to be ‘inveterate optimists’, because numerous life and time-saving inventions will manifest simultaneously in biotechnology, telecommunications and nanotechnology. ‘In 2021 or 2031, no one will want to return to the ‘good ole days’ of 2011’, they write (p. 297). David Hale is also optimistic about the future. ‘We are witnessing the growing pains of the internationalization of markets’, he writes, but this ‘will lead to long-term stability’. He states that ‘the outsourcing of US manufacturing to China is already reversing itself’, because of rising costs of labour and logistics in China (p. xii).

Both books are well worth reading and cover many other topics apart from the roots of the debt crisis. However, they overlook or skim over certain key issues, such as the Asian recycling of US trade deficits, the Chinese and Japanese purchases of mortgage bonds, the speculative activities of the German Landesbanks and Dutch banks, and the rising oil and food prices. To varying degrees, both books would fit well in graduate and undergraduate courses in international political economy. Mauldin and Tepper use clear examples to illustrate economic principles, but often their writing style is inappropriately colloquial, and they rely heavily on other authors’ work. The observation that ‘Japan is a bug in search of a windshield’ is repeated throughout the book, to give just one example. Chapter 5 amounts to a reprinting of large sections from the insightful book This Time Is Different (2009) by Carmen Reinhart and Ken Rogoff.

While it contains several excellent essays, the Hales’ book sorely lacks a concluding chapter to unite the disparate essays and to answer the grave question in the book’s title (What’s Next?). Some of the chapters are written for specialists (Bressand), while others are perhaps too broad in scope (Jefferis) or lack a clear thesis and relevance to the book’s central purpose (Safavi).

Readers should consult additional literature that provides more historical perspective, explores solutions more fully, and covers the European and American debt crisis equally. In the abovementioned This Time Is Different, Reinhart and Rogoff surveyed more than 250 financial crises in 66 countries over 800 years in order to discern their similarities and differences. They pessimistically conclude that the crisis has only just begun and much pain will be felt around the world as countries pay off their debts (‘deleverage’). Researchers should consult two books by Nobel Prize winner Joseph Stiglitz: The Price of Inequality: How Today’s Divided Society Endangers Our Future (2012) and Freefall: America, Free Markets, and the Sinking of the World Economy (2010). In both, Stiglitz lays out a comprehensive agenda for avoiding a future crisis and achieving a fairer and more dynamic economy. In Saving Europe (2012), the Italian financial journalist Carlo Bastasin provides a detailed political history of the origins of the Eurozone crisis, focusing on the role of national politics and the lack of commitment to European unity as a whole. A more controversial book is Crisis in the Eurozone, published in 2012 by Costas Lapavitsas, which calls for a break-up of the Eurozone because European austerity measures are too counter-productive to the economies of the so-called peripheral countries.

To conclude, at least nine factors, both long term and short term, gave rise to the global debt crisis we face today: the initial departure from the Bretton Woods era gold standard in 1971, the deregulation of both the US and European banking systems in the 1980s and 1990s, the securitisation of sub-prime mortgages, Goldman Sachs’ cross-currency swaps to hide Greek debt, the excessive levels of Greek debt, the structural flaws of the EMU, Germany’s insistence on low interest rates, and Germany and France’s violation of the budget limits in 2003. A final, ninth cause of the crisis lies in common human foibles: the cognitive biases of financiers and legislators on both sides of the Atlantic. Wishful thinking and oversimplification are exemplified by Hank Paulson’s belief that the European credit crunch in 2007 would not reach American shores; by Alan Greenspan’s belief that no regulation was best for the economy; and by the Eurozone planners’ belief that political unity could be achieved through monetary unity. Human greed – limited only by one’s imagination and risk tolerance – prevailed in both the predatory lenders and the gullible consumers buying real estate on cheap credit. Credit ‘bubbles’ arose not only in the US, but also in the United Kingdom, Greece, Ireland, Hungary, Iceland and Latvia. Avoidance of responsibility and widespread blaming – of Greece, of Wall Street, of Eurozone planners – have predominated over rational problem solving. We must re-establish honesty in financial markets by making the risky derivatives trading more transparent and re-establishing the Glass-Steagall Act to break up the monopoly of financial corporations. Only perfectly competitive economies are self-regulating. The deregulation of financial markets has resulted in the concentration of wealth in fewer hands, giving the banking industry power over US and European politicians. Sadly, since the American Bankers Association is one of the richest and most powerful lobbies on Capitol Hill, regulation of the shadow banking system is unlikely, given the US Supreme Court’s 2010 decision (Citizens United v. Federal Election Commission) permitting all corporations to spend unlimited sums of money on ‘electioneering communications’ right up to the day of elections. This ruling grants banking lobbyists even more power in Washington, just when the American people desperately need to check the banking lobby’s power to buy politicians. Until governments stop issuing blank cheques to the ‘too large to fail’ banks and establish a sturdy system of checks and balances, the tectonic plates on the ocean floor will shift again and the next, even more destructive, financial tsunami will engulf the world.