Crash! The Ides of August 2007

SUMMER ESSAY

“There is a tide in the affairs of men. Which, taken at the flood, leads on to fortune; Omitted, all the voyage of their life, Is bound in shallows and in miseries. On such a full sea are we now afloat; And we must take the current when it serves, Or lose our ventures”.

Julius Caesar, William Shakespeare

August 2007

Alphen, Netherlands. 9 August. This blog is devoted to big stuff! Ten years ago today something really, really big began to happen which would have profound geopolitical consequences for the West, and the wider world.  BNP, a well-regarded French bank, suspended three mortgage investment funds because management was no longer sure of their value. It was the harbinger of what is now believed to have been the worst financial crash since at least the 1930s, and which was caused by power and money becoming too close. The ensuing intertwined banking, financial, economic, and political crises effectively marked the end of the West’s dominance, and the start of a new age of Great Power competition that sees ‘might’ steadily eclipsing ‘right’.  What was the real cost of his disaster, why did it happen, and what are the continuing geopolitical implications?

The financial cost of baling out the broken Western banking system, and trying to save the political skins of a failed elite was staggering.  According to the International Monetary Fund the crash cost $11.9 trillion to ‘fix’, which is about the size of China’s annual GDP, or about $2000 for every person on the planet.  In 2009-10 the crisis consumed a fifth of the entire globe’s annual output, costing developed countries some $10.2 trillion.  Due to the overbearing importance of their respective financial sectors to their respective economies, the British and American taxpayers bore a particularly heavy burden.  The cost to the UK taxpayer of supporting broke banks and mortgage lenders has cost some 81.8% of Britain’s GDP. The diversion of taxpayer’s money also crippled the public finances, with sectors such as defence particularly hard hit.  In 2006, the US budget deficit stood at around 2.5% of GDP, in 2009 it leapt to 13.5%, whilst the UK deficit in 2006 was some 2.6% of GDP, whilst in 2009 it leapt to 11.6%.

The Casino Causes of the Crash

There were several factors that caused the August crash. However, at its most simple the crash was caused as much by an accounting failure as a banking failure, as the need for money outstripped the availability of money.  Indeed, the crisis began because bank debt became too high leading to a sudden and catastrophic weakening of actual bank balance sheets, as opposed to the fantasy balance sheets many banks had been peddling. When crucial inter-bank lending, which was central to a system of flawed risk mismanagement, suddenly collapsed each bank looked to save itself.  The rest, as they say, has become a sorry history.

However, there was a range of deeper, structural, and cultural factors that were also at play, not least so-called ‘casino banking’. Rapid globalisation had seen the demand for financing grow rapidly beyond the ability of even the largest Western banks to meet.  The banks sought to close the resultant financing gap via the use of increasingly complex ‘financial instruments’, labyrinthine forms of mutual lending which also saw a steady increase in interlocking mutual risk.  Much of that risk was embedded in investments that ignored the traditional fundamentals of sound banking, such as the US mortgage sector and so-called ‘sub-prime loans’, which were not only hidden in financial instruments, but also backed by major ‘too big to fail’ American financial houses, most notably Lehman Brothers.  A mixture of ignorance, short-termism and ‘we’ve never had it so good’ demand led to banks taking on excessive debt or ‘leverage’ which far exceeded the capital reserves of many of them.  Such risk was justified by the false belief that if it was spread across the entire financial system ‘risk’ itself was effectively banished. In fact, all casino bankers did was to put the entire Western banking system at risk.  In August 2007 this house of cards began to crash down.   

In 2010 the banking crisis turned into a sovereign debt crisis when the growing cost of money became too great to fund for fragile states already mired deep in debt.  Some Eurozone countries were particularly hard hit because they had been bingeing on borrowing since the Euro’s creation in 1999.  With the advent of the Euro the many structurally weak European economies organised around Germany, such as Greece, Italy, and Spain, suddenly discovered that they could borrow at the same low interest rates as Berlin, as the early ‘naughties’ saw the cost of money for them plummet.  Many of them over-borrowed in the false belief that the Eurozone also implied debt mutualisation and that, in the event of any crisis, German, Dutch and the taxpayers of wealthier northern and western European states would bail them out.  For a time it suited the Germans to accept such risk as the Eurozone created a German export boom, and helped offset the high cost of their domestic productivity, enabling Berlin to escape from a long period of economic malaise. In August 2007 the cost of money to ‘Club Med’ began to shoot up.  Several were effectively bankrupted, most notably Greece.  It is a crisis yet to be resolved.

America and Britain? See no evil, hear no evil, and speak no evil.  The US and UK governments simply ignored the dangers traditionally associated with excessive public debt, preferring instead to see their financial sectors as tax bonanzas to exploit at a time when low taxes and high spending were in political vogue. Consequently, the years prior to 2007 had seen sound regulation of the banking and wider financial sectors effectively abandoned as the respective governments backed New York and London as world financial hubs. The US could console itself that if its banks were too big to fail so was the US, given that much of the world held dollars in their reserves as the reserve currency. Britain was not so lucky. The situation was made far worse for the British by a Labour government which, prior to 2007, allowed personal debt to spiral, and a dangerous property bubble to develop. Britain was made even more vulnerable by an excessive level of government borrowing in the run-up to the crisis in the guise of investment. 

Geopolitical Consequences

The strategic consequences were profound, and continue to be so.  The crisis, and the bankers who caused it, destabilised the world as the ability of the leading Western states to exercise influence and power dramatically declined.

In 2007 US influence was already on the wane given the failing campaigns in Afghanistan and Iraq. The fact that the crisis originated in New York further damaged America’s reputation for sound strategic leadership, particularly in Europe.  Most Western countries reacted to the crisis by imposing austerity programmes that radically reduced the level of public debt by stringent cuts to public expenditures. However, income inequality grew rapidly to politically toxic levels as those at the lower end of the social and economic pile were hardest hit by efforts to re-establish sound money.  The political implications are there for all to see as crisis clearly played a profound role in Britain’s 2016 decision to leave the EU, as well as the election of President Trump in the US.  In Britain’s case this can be partly explained by the interaction between open door immigration, and a sudden and catastrophic recession that came close to a depression, with all the subsequent and consequent political and social tensions thus created.

The search for sound money also undermined sound defence. Europeans cut their defence budgets by 30% between 2008 and 2014. However, such cuts not only saw a loss of ‘men’ and materiel. It also critically undermined the strategic ambition of key Western powers, most notably Britain and France.  Worse, an on-paper economically far weaker Russia was emboldened by the crisis. In 2008 Russia invaded Georgia and began a programme of military modernisation and strategic agitation that continues to this day. Several Middle Eastern and North African economies, already challenged by weakening demands for oil and gas, allied to a boom in the number of young people they had to feed, educate and employ, also became dangerously unstable.

 

However, perhaps the most telling consequence of the crash was the rapid relative rise in the power and influence of China. China was a responsible actor during the crisis, using its large reserves and dollar holdings to help prevent a collapse of a system that served its strategic ambitions well. China also used the crisis to begin to exert influence far beyond its borders, most notably in Europe. Beijing achieved this ‘strategic objective’ via a series of ‘strategic’ loans and investments that had the effect of weakening transatlantic political and economic bonds, the strategic consequences of which have yet to be fully grasped. Like Russia, China also invested in its armed forces and began to expand what Beijing sees as its rightful hegemony across much of East Asia with the creation of a far-reaching Exclusive Economic Zone, and by establishing illegal military bases in the South China Sea, the strategic consequences of which are again yet to be fully grasped.

Winners and Losers

There have, of course, been winners and losers.  The winners at the geopolitical level include the world’s illiberal Great Powers, such as China and Russia, who have begun to tip the balance of power in their favour away from the West.  At the political level incumbent authority has lost much of its prestige, and popular trust in Western government has by and large collapsed, opening the door to hitherto marginal populists and radicals. And, of course, the very bankers who helped cause the crisis were not only propped up by their far poorer compatriots, but continue to enjoy incomes that others can only dream of.  Too big to fail, too grand to jail?

The real losers? You and me.  Savers have been robbed of millions of euros/dollars/pounds of interest as interest rates were driven lower by central banks in an effort to maintain some level of economic growth.  Taxpayers continue to bail out banks, whilst in the Europe the European Central Bank is quietly transferring huge amounts of ‘public’ money to prop up failed banks, most notably in Italy. As for debt mutualisation, expect to hear more about that after September’s German federal elections…but certainly not before.

Greed and Power

Ultimately, the financial crisis was the result of greed and Western political, bureaucratic, and financial elites becoming too close.  The result was that principles underlying good politics, effective oversight, and sound financing were abandoned.  Such closeness reflected the trend, particularly prevalent in the EU at the time, for elites to remove power ever further from the people in the name of ‘efficiency’ and give it to unelected bodies in the name of institution (i.e. elite) building. Democratic oversight was effectively replaced with sham forms of ‘accountability’ further ‘overseen’ by sham democracy. Little has changed.

The limited good news is that today the banks are more stable than back in 2007 because of the extra capital they are now required to hold. However, there is absolutely no guarantee that a still fragile system could not rapidly collapse in the face of another financial or economic shock.

The future?  The relative decline of the West looks likely to continue, and with it the emergence of strategic competitors in many forms.  It need not be this way.

You were screwed. We all were!

Julian Lindley-French