The Alchemists: Three Central Bankers and a World on Fire (14 page)

In the hundreds of pages of transcripts from Fed policy meetings in 2005—not made public until years later—there are occasional glimpses of officials understanding the problems that were emerging. They almost seemed onto something when Mark Olson, a Fed governor, said he had heard that lending was being funded more by the private pools of mortgages being ginned up by Wall Street than by the more traditional mortgages backed by the government-sponsored Fannie Mae and Freddie Mac.

“
Not in the United States
. I don’t know what country or planet,” said Lehnert.

Olson cut him off.

“The planet was Earth. The country was the United States,” he retorted. “And the person making the observation was talking about . . . what they see as a growing and undisciplined secondary market.”

They quickly figured out that Olson was talking about the flow of new debt being issued, while Lehnert was thinking of the total amount outstanding. That miscommunication cleared up, the subject was immediately dropped.

What the Fed lacked in this and other discussions about risks to the economy wasn’t technical expertise. It had that in spades. It wasn’t attention or discipline either. The discussions were exhaustive, involving a group of very smart people trying earnestly to come to the right answer. What the Fed lacked was creativity, the ability to see how housing and finance could interact with one another and cause greater damage than either could independently—particularly how the rapid increase in housing prices could threaten the financial system worldwide. In eight closed-door meetings over the course of that year—the transcripts take up nearly eleven hundred pages—there wasn’t a single mention of some of the developments in the financial system that could allow the popping of the housing bubble to turn into a global crisis: the excessive use of borrowed money by investment banks, for example, and the deep insinuation of mortgage-related securities of questionable safety into the machinery of modern finance.

In the Fed’s 2005 meetings, the moment of most brutal clarity about the situation the U.S. economy faced wasn’t in any of the technical discussions of home price indices or the evolution of securitization markets. It was in a wry aside, made by Director of Research David Stockton. Stockton noted that a number of indicators suggested the housing boom could be ending. He continued:

I offer one more piece of evidence
that I think almost surely suggests that the end is near in this sector. While channel surfing the other night, to the annoyance of my otherwise very patient wife, I came across a new television series on the Discovery Channel entitled “Flip That House.” As far as I could tell, the gist of the show was that with some spackling, a few strategically placed azaleas, and access to a bank, you too could tap into the great real estate wealth machine. It was enough to put even the most ardent believer in market efficiency into existential crisis.

In other words, the underlying causes of the global financial crisis were hiding in plain sight. Plenty of central bankers fretted about a global housing bubble. A smaller number worried about a global debt bubble—not just in mortgages, but also in consumer and corporate debt. A smaller number still saw a vast and rapid expansion of the financial sector as something that could threaten worldwide financial stability. And you had fundamental imbalances in the global economy that were at the root of it all—which central bankers were well aware of but undecided about how to correct. They just didn’t see how all these pieces fit together.

Ironically, part of the problem was the very success of central bankers. Investors had learned a lesson from the Great Moderation: that central bankers had mastered the economy. Inflation, in all the advanced nations and a growing number of emerging ones, had been conquered. Central banks could contain the impact of any adverse event that might come along, whether a financial crisis in fast-growing Asian economies or a popped stock market bubble in the United States, and prevent any widespread losses. In a seemingly riskless world, investors were willing to take all the more risk.

Greenspan, who held more power over the financial future than any other individual on the planet, understood these interconnections, if not the degree to which the world economy was in peril. Lower risk premia—the compensation investors demand for taking on extra risk—that were “
the apparent consequence of a long period of economic stability
” had helped to push asset prices higher, he said from the lectern at Jackson Hole. The rising prices of stocks, bonds, and homes had led to much greater wealth and purchasing power, and the vast increase in the value of those assets was, Greenspan said, “in part the indirect result of investors accepting lower compensation for risk.”

“History,” he noted, “has not dealt kindly with the aftermath of protracted periods of low-risk premiums.”

•   •   •

B
ut one of the other economists at Jackson Hole that year was more prescient than even Greenspan—or, indeed, anyone else who speculated about what the world had to fear at that moment of economic triumphalism.

In hindsight, many have pointed to a paper that International Monetary Fund chief economist
Raghuram Rajan
presented as a rare moment of clarity at the 2005 conference. Rajan indeed had an astute understanding of the ways in which the financial industry, with misguided compensation policies that encouraged risk-taking, was making the world a more dangerous place: Bankers were paid big bonuses for making money in the short run even if they were betting poorly in the long run. But he identified only one portion of what could go horribly wrong.

It was Hyun Song Shin, then a professor at the London School of Economics, who in a response to Rajan’s paper most accurately portrayed the state of the global economy.

“
I’d like to tell you about the Millennium Bridge in London
,” he began. In order to celebrate the advent of the year 2000, the British built a stunning new pedestrian bridge across the Thames. Its lateral-suspension design precluded the need for clunky-looking columns, making it a study in engineering elegance.

“The bridge was opened by the queen on a sunny day in June,” Shin continued. “The press was there in force, and many thousands of people turned up to savor the occasion. However, within moments of the bridge’s opening, it began to shake violently.” The day it opened, the Millennium Bridge was closed. The engineers were initially mystified about what had gone wrong. Of course it would be a problem if a platoon of soldiers marched in lockstep across the bridge, creating sufficiently powerful vertical vibration to produce a swaying effect. The nearby Albert Bridge, built more than a century earlier, even features a sign directing marching soldiers to break step rather than stay together when crossing. But that’s not what happened at the Millennium Bridge. “What is the probability that a thousand people walking at random will end up walking exactly in step, and remain in lockstep thereafter?” Shin asked. “It is tempting to say, ‘Close to zero.’”

But that’s exactly what happened. The bridge’s designers had failed to account for how people react to their environment. When the bridge moved slightly under the feet of those opening-day pedestrians, each individual naturally adjusted his or her stance for balance, just a little bit—but at the same time and in the same direction as every other individual. That created enough lateral force to turn a slight movement into a significant one. “In other words,” said Shin, “the wobble of the bridge feeds on itself. The wobble will continue and get stronger even though the initial shock—say, a small gust of wind—had long passed. . . . Stress testing on the computer that looks only at storms, earthquakes, and heavy loads on the bridge would regard the events on the opening day as a ‘perfect storm.’ But this is a perfect storm that is guaranteed to come every day.”

In financial markets, as on the Millennium Bridge, each individual player—every bank and hedge fund and individual investor—reacts to what is happening around him or her in concert with other individuals. When the ground shifts under the world’s investors, they all shift their stance. And when they all shift their stance in the same direction at the same time, it just reinforces the initial movement. Suddenly, the whole system is wobbling violently.

Ben Bernanke, Mervyn King, Jean-Claude Trichet, and the other men and women at Jackson Hole listened politely and then went to their coffee break. It would be two more years before the bridge started to wobble, and three more before it came falling down.

PANIC, 2007–2008

The Committee of Three

T
wo years after Alan Greenspan’s grand send-off in Jackson Hole, the question for the conference was whether his successor could make the trip at all. Markets were in chaos in August 2007, and the symposium was to take place just three weeks after the European Central Bank’s surprising intervention during the BNP Paribas crisis. Ben Bernanke’s closest advisers debated whether they could jet off to the wilds of Wyoming with the markets so on edge. Cell phone coverage had arrived at the Jackson Lake Lodge only a few years earlier, and Internet connectivity was still iffy. If another wave of panic broke out, would they be able to gather the information they needed and act decisively?

But if they canceled their usual appearances, markets could become even more jittery:
If they can’t even go to Jackson Hole, this thing must be even worse than we thought.
So Fed information-technology and -security staffers from Washington were dispatched to Jackson. Across the hall from Bernanke’s second-floor room at the lodge, away from the main event spaces, they set up a conference room with secure phone lines, Internet connections, and Bloomberg financial-data terminals so Fed officials—and their international counterparts, if it came to that—could do their jobs from a distance.

Bernanke and his inner circle—New York Fed president Tim Geithner, Board of Governors vice chairman Donald Kohn and member Kevin Warsh, Fed monetary affairs director Brian Madigan—spent much of the two days of proceedings in their secure conference room on the second floor, plotting their response to the emerging panic.

It was too bad: The topic of that year’s conference was housing finance, and some of the presentations were quite prescient. Robert Shiller of Yale, for example, warned that the long housing boom was soon likely to go bust, with severe economic consequences. “
It does not appear possible
to explain the boom in terms of fundamentals such as rents or construction costs,” he argued. “A psychological theory, that represents the boom as taking place because of a feedback mechanism or social epidemic that encourages a view of housing as an important investment opportunity, fits the evidence better.”

Still, the discussion was overwhelmingly focused on the United States, with no real recognition of just how deeply all those bad U.S. home loans had become embedded in the world’s financial infrastructure, from European banks to giant insurer AIG. There was little sense that the problem went beyond subprime mortgage securities. The Millennium Bridge was wobbling, and everyone was uneasy—but not uneasy enough. And that was as true of the three leading Western central bankers as anyone.

Jean-Claude Trichet and the ECB were injecting money into the European banking system, a practice they’d begun with no real warning to their counterparts in Washington and London. Bernanke and the Federal Reserve were acting as lender of last resort to banks too, as well as weighing whether to start trying to protect the overall economy by cutting interest rates. Mervyn King and the Bank of England were standing by, content for the moment to let the banks suffer the consequences of years of risky lending.

The three men didn’t know it yet, but they were in the early stages of what would become perhaps the world’s most important partnership—one in which their varied backgrounds, different personalities, and unique pathways to power would shape the course of all that was to come.

•   •   •

J
ean-Claude Anne Marie Louis Trichet was a career bureaucrat with decades of crisis-fighting experience—and also a reader of poetry, philosophy, and literature who saw his profession as a central banker as being about something much bigger than economics. “
I am convinced
that economic and cultural affairs, that money and literature and poetry, are much more closely linked than many people believe,” he said in 2009. “Poems, like gold coins, are meant to last, to keep their integrity, sustained by their rhythm, rhymes, and metaphors. In that sense, they are like money—they are a ‘store of value’ over the long term. They are both aspiring to inalterability, whilst they are both destined to circulate from hand to hand and mind to mind.”

To Trichet, the ECB was the most concrete symbol of European unity, an answer to the discord that had roiled his continent for hundreds—even thousands—of years. “Economic and monetary union is a magnificent undertaking that forms the basis of Europe’s prosperity and shared stability,” he said in the same speech, citing the words of Derrida, Dante, Proust, and Goethe as representing the philosophical underpinnings of a united European continent.

Trichet was part of a generation of leaders determined—and newly able—to learn from the mistakes of their parents and build a different order for Europe. He was the consummate European, which for elites of his generation meant being devoted to an identity beyond one’s status as a Frenchman or German or Italian. As a child, that meant traveling to Germany, Austria, and Italy with a favorite uncle and having a pen pal in Britain. As an adult, it meant quite a bit more. As Trichet told French news magazine
L’Express
, “
It was . . . a very emotional moment
” when on June 17, 2004, he held his first telephonic meeting of the ECB’s General Council, a sprawling group that includes even central bankers from European countries that don’t use the euro. “I went round asking if everyone was there. The governor of Estonia? ‘Yes, I’m here.’ Lithuania? Malta? Cyprus? They were all there. That’s what Europe is all about, and it is impressive.”

The son of a professor of Greek and Latin, Trichet displayed an early enthusiasm for literature and philosophy. After parental encouragement to study mathematics and the sciences, he served an engineering traineeship deep underground in a coal mine. But he was drawn to politics and soon left mining to study at the École Nationale d’Administration, the finishing school for the French civil service. It was a time of tumult, coming just after clashes between radical students and police in 1968. Like many, Trichet was involved with left-wing student activism. For his dedication to workers’ rights, his fellow members of the Unified Socialist Party nicknamed him “Justix,” a punning reference to the indefatigable Gallic hero of the
Asterix
cartoon series. Trichet finished near the top of the Administration class of 1971—fifth out of one hundred—began a long career at the French treasury, and married Aline Rybalka, a Ukrainian-born translator for the French foreign ministry.

Trichet came of age as a policymaker during the arduous negotiations toward European unity, in which sheer stamina—the ability to stick to a position into the wee hours of the night—could be as important as anything else. He led the ECB governing council, a sprawling group of twenty-three central bankers, using all that experience, using control over the agenda and the clock to almost always guide interest rate decisions in his preferred direction. He was a master of using whatever advantages his role as chairman offered: He once led negotiations with representatives from twenty-seven nations on bank capital rules in 2011. The meeting started first thing in the morning, but as the lunch hour passed and staffers put out sandwiches in the hallway, Trichet didn’t call for a break.
By late afternoon
, the increasingly hungry negotiators were more willing to yield, if only so they could get something to eat.

Depending on the situation, Trichet could deploy not only persistence, but also arm-twisting, head-knocking, logrolling, or whatever he might need to close the deal. These were the skills that enabled him to rise to head of the treasury sixteen years after graduation and to governor of the French central bank six years after that. “If I had to choose any of us to represent me in a complicated transaction, to negotiate on my behalf, it would be Trichet, without hesitation,” said one of his fellow central bankers. He was among those representing France in the negotiations over the Maastricht Treaty, which would create the euro. From 1985 to 1993, he was chairman of the Paris Club, a group of global financial officials that negotiates debt restructuring for troubled Latin American and other developing nations.

From that experience, Trichet was as prepared as anyone on earth for the kinds of difficult talks between banks and governments that arise when a nation’s finances get out of control and its economy hovers on the brink. “
Crisis is part of his DNA
,” Finnish Central Bank governor Erkki Liikanen once said of him. More diplomat than economist, by 2007, he was as experienced a manager of financial crises as anyone on earth.

With his mellifluous accent and stylish attire, Trichet could be a charmer as well. “
With slightly condescending flattery
and a touch of the well-appointed courtier, Trichet greets interlocutors with unfailing respect,” noted longtime ECB watcher David Marsh. “He kisses ladies’ hands with old-fashioned gallantry—whether they be [German] Chancellor Angela Merkel or the wives of Frankfurt-based journalists—and flamboyantly addresses former British Chancellors of the Exchequer as ‘
Monsieur le Chancelier.
’” Yet even people who’ve spent hundreds or thousands of hours in his company professionally have said they felt little sense of a strong personal bond. Trichet remained, whatever the situation, formal and proper, relentlessly on message, reluctant to show even a hint of self-doubt. He was easy to respect but hard to know.

As head of the Banque de France, Trichet oversaw the logistical details of preparing for his nation’s incorporation into the eurozone, frequently clashing with politicians who viewed his
franc fort
(“strong franc”) policy as damaging to French exports and hence jobs. It was said that Trichet “spoke French with a German accent,” meaning that despite being a Frenchman by birth, he had the same hard-money philosophy as a German—which made him a perfect choice to be one of the initial leaders of the ECB when it was established in 1998.

After being exonerated in a scandal over disclosures of information by the large commercial bank Crédit Lyonnais while he was at the treasury, Trichet was appointed to his eight-year term as ECB president in 2003. An exceptionally hard worker, he was attuned to every detail of managing the central bank, personally reviewing department budgets and tweaking language in press releases in an institution with sixteen hundred employees.

“
My life compass
has been the deepening of European unity based upon reconciliation and a profound friendship to the service of prosperity and pace,” Trichet once said. The crisis that began with a phone call to Saint-Malo on August 9, 2007, would scramble that compass, as the currency he’d helped create to unify a continent would instead threaten to pull it apart.

•   •   •

U
nlike Trichet, whose career was one long ascent through the ranks of European leadership, Ben Shalom Bernanke was in many ways an unlikely titan of the global economy. Born in Georgia in 1953 and raised in tiny Dillon, South Carolina, he showed uncommon intelligence at an early age, skipping the first grade, representing South Carolina in the 1965 National Spelling Bee, and getting the highest SAT score in the state, a near-perfect 1590. His achievements were enough to win him admission to Harvard, but his mother was reluctant to let him go to college so far away. She relented only after being assured by Kenneth Manning, a young African American from Dillon who had himself attended the school and encouraged Bernanke to apply, that “
there were Jews up in Boston
.”

Bernanke excelled at Harvard, winning an award for best undergraduate economics thesis. He went to graduate school at MIT in a time when the institution was turning out a slew of PhDs who would go on to be significant shapers of economic policy. In 1977 alone, the program produced Mario Draghi, Trichet’s successor as ECB president; Olivier Blanchard, the International Monetary Fund’s chief economist; and Paul Krugman, the Nobel laureate and influential
New York Times
columnist. Bernanke finished two years after them, studying under Stanley Fischer, later an IMF chief economist and head of the Bank of Israel and something of an intellectual godfather to a generation of central bankers.

“
If you had known Ben Bernanke as a student
you would have never picked him as a future central banker,” Robert Solow, a Nobel laureate economist at MIT, later told Bloomberg News. Bernanke didn’t even look the part, Solow added: “He had a lot of hair, and when I say a lot of hair, I mean a lot of hair.”

Indeed, in the early years of his career, Bernanke showed little inclination to be anything other than a first-rate academic. He married Anna Friedmann, a Wellesley grad who would go on to be a seventh-grade Spanish teacher, and they moved first to California and then to New Jersey, where he became a star economist at Princeton. He wrote important papers on the intersection of finance, economics, and monetary policy, exploring the policy failures that created the Great Depression and emerging as an advocate of “inflation targeting,” or establishing a goal for how much prices should rise and adjusting monetary policy accordingly.

But even as he produced outstanding academic work, Bernanke began to discover his talent for guiding groups of people to a decision. A skilled listener and persuader, he became economics department chair at Princeton in 1996. It is a thankless job, with all the responsibilities of leadership but little explicit power—high-powered academics, after all, don’t like being told what they should teach or research. Bernanke often joked that his biggest responsibility was deciding whether to bring bagels or doughnuts to faculty meetings, though that undersells the scope of his duties. He navigated the faculty through decisions on, for example, whether to increase course offerings in finance, in such a way that everyone could feel like part of the process, even if he or she disagreed with the ultimate decision.

Bernanke also served on the Montgomery Township, New Jersey, school board at a time when it was deeply divided over whether to raise taxes to build more schools. The issue was so hard-fought that a fistfight broke out outside one meeting. Bernanke’s instincts were to side with the low-tax group, former colleague Dwight Jaffee told the
Washington Post,
but “
he would look at the numbers
and make computations about whether it made sense to build new schools. . . . He really has faith in doing the numbers right and then living with them.” His was ultimately the tie-breaking vote for a bond issue that raised local property taxes.