The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

The bankers were looking for ways not merely to deal with the panic roiling the financial system, but also to handle, in Geithner’s terminology, the “theater” correctly. Apart from the substance of what they might do, they reasoned, the simple fact that all the world’s central banks were acting in concert might help boost confidence. A German bank would be more inclined to lend dollars to a Swiss bank if it could be confident the Swiss bank wasn’t going to find itself short of cash when it was time to pay the money back. “Making it known that we were getting the fire engines rolling was almost as important as what the engines would do once they arrived at the scene,” said one American official.

  Unlike the earlier phase of the crisis, when Mervyn King and the Bank of England were reluctant partners in the crisis-fighting efforts, this time everyone was on the same page. At 3 a.m. New York time on September 18, four days after the Lehman failure, the fire engines cranked up their sirens. At the end of 2007, the Fed had announced a combined $24 billion in swap lines with the ECB, Bank of England, Bank of Canada, and Swiss National Bank. Now, according to an announcement made in time to beat the opening of European markets, that amount would be enlarged by $180 billion. Six days later, again with a middle-of-the-night announcement, the Fed added to the program another $30 billion and another four central banks—those of Australia, Denmark, Norway, and Sweden.

  It was the basic strategy of late 2007 blown out: More dollars were pumped into the banking system, in more different countries, on easier terms. There were legal guarantees to make sure American taxpayers wouldn’t lose money on the deal, but the real assurance came not from anything written on paper but from the bonds of trust established in years of talks in Basel and elsewhere. It was unfathomable, Bernanke and his colleagues believed, that their counterparts across national borders would ever try to renege.

  When members of Congress asked about the swaps, Bernanke emphasized that the European banks benefiting from the program also made loans in the United States, so the action could be seen as benefiting the U.S. economy directly. But more fundamentally, he was convinced that the world financial system was so deeply interconnected that Europe’s fortunes were the United States’ fortunes too. “In a way,” a European central banker said later, “we became the thirteenth Federal Reserve district.”

  By December 10, foreign central banks had borrowed $580 billion of Fed money—a quarter of the U.S. central bank’s total assets. The Fed also pumped dollars into individual foreign banks that had U.S. subsidiaries: at peak levels, $85 billion for the Royal Bank of Scotland, $77 billion for Switzerland’s UBS, $66 billion for Deutsche Bank, $65 billion for the UK’s Barclays, $59 billion for Belgium’s Dexia, and $22 billion for Japan’s Norinchukin. The scale of lending to foreign banks, revealed more than two years later only after congressional legislation and a Freedom of Information Act lawsuit that the banking industry appealed to the Supreme Court, was a closely guarded secret even by the standards of the always secretive Fed. Normally, dozens of people within the Federal Reserve System would have been privy to data about which banks were borrowing money. During the panic, this information was so closely held—and, had it been known publicly, so potentially explosive—that only two people at each of the dozen reserve banks were allowed access to it.

  Beginning in October, a new round of supplicants came calling. In formal letters to Bernanke, in whispered asides to his deputies in the hallways in Basel, several of the world’s developing nations made a request: Help us out. As late as March 2009, when Fed governor Kevin Warsh was representing the central bank at a meeting of the finance ministers of the Group of 20 economic powers in Horsham, England, emissaries from one after another of the world’s emerging nations tried to buttonhole him in the hallway to make their pleas for help.

  Banks in these economies were facing the same shortage of dollars as their counterparts in wealthier neighbors. Behind closed doors, this became the subject of a thorny new debate. The Fed didn’t have the same intimate, long-standing relationships with the Central Bank of Brazil or the Bank of Mexico that it did with the Bank of England or the Bank of Canada. And there had already been rumblings of concern among some of the reserve bank presidents that the lending of dollars across international borders amounts to fiscal, not monetary, policy. The Richmond Fed in particular had a long tradition of dissenting from any type of swap arrangement for that very reason; its president, Jeffrey Lacker, often clashed with the New York Fed’s Tim Geithner on that and many other issues.

  But most important, sending money to poorer countries with less stable political systems would be a greater risk. So Bernanke and his colleagues came up with criteria for safely expanding Fed swap lines: The country had to want access to them. (China and India weren’t particularly interested.) The country had to be a significant player in the world economy or a significant financial center, so that Bernanke could justify the assistance to Congress as being in the interest of the U.S. economy. (Brazil, Mexico, South Korea, and Singapore qualified; Peru didn’t.) The country had to have a central bank that was viewed as politically independent and trustworthy. (Russia, for example, would have been ruled out.) On October 29, 2008, came an announcement: “Today, the Federal Reserve, the Banco Central do Brasil, the Banco de Mexico, the Bank of Korea, and the Monetary Authority of Singapore are announcing the establishment of temporary reciprocal currency arrangements.”

  Since its founding, the Federal Reserve had been the lender of last resort for the United States. In late 2008, Ben Bernanke’s Fed became the lender of last resort to much of the world.

  • • •

  On the evening of Wednesday, September 17, just a day after making the decision to bail out AIG, Bernanke and his staff gathered in his office overlooking the National Mall. The Fed chief had decided it was time to make clear to Paulson that the central bank could no longer bail out individual insolvent firms. It was one thing for the Fed to support illiquid firms or markets, where disruptions were caused by fear rather than balance-sheet facts. It was another for it to support insolvent institutions, a job for Congress and the administration. Bernanke told Paulson in a phone call that he thought they needed to go to Congress to ask for a rescue package. The next morning, Bernanke was prepared to make the same point more emphatically in another call, but Paulson cut him off: The treasury secretary had reached the same conclusion.

  That afternoon, the two men met with President George W. Bush at the White House. With his blessing, they then traveled to Capitol Hill to speak with the leaders of Congress. In an ominous meeting in House Speaker Nancy Pelosi’s conference room, they warned congressional leaders that the entire financial system was on the verge of implosion, and that the consequences for the U.S. economy—not yet obvious at that early date—could be disastrous. “It is a matter of days,” Bernanke told the lawmakers, “before there is a meltdown in the global financial system.” Congress needed to enact massive legislation to allow the Treasury the latitude to address the problem—and fast.

  That day, and in a series of difficult congressional hearings that followed, Bernanke stood by Paulson’s side, explaining and advocating what would become the $700 billion Troubled Asset Relief Program. His vigorous support was essential. Paulson, a former Goldman Sachs executive, had plenty of intensity, but he also had trouble explaining complex economic concepts to nonspecialists. Reporters covering his hearings often joked about the difficulty of quoting him because of the way his sentences circled back on themselves in an unintelligible mess. (“What we are seeking to address with this,” Paulson said in a September 23 Senate Banking Committee hearing, “is we are seeking to address—first of all, we’re dealing with complicated securities, mortgage and mortgage-related, and we’ve got various asset classes here, and we need different approaches for different asset classes. But when we use the market mechanisms, we want—we’re looking at thousands, you know, of institutions, because to make this run properly, we need to deal with big banks, smal
l banks, S&Ls, credit unions, because what we’re trying to do here, and I think we’ll be successful, is to develop mechanisms where we—where we get values out there, where there’s some value that the market can look at.”)

  Bernanke’s experience as a scholar of the Great Depression gave him credibility, and his clear, methodical speaking style made him persuasive. He viewed his role as not to advocate for a specific law, but to explain the economics of the situation and the necessity for immediate, bold action. Although Bernanke wasn’t involved in the detailed negotiations over the TARP—he figured out that an initial vote on the proposal had failed in the House when he glanced at the Bloomberg data terminal on his desk and saw a giant dive in the stock market—he would be forever associated with the unpopular legislation by both lawmakers and the public.

  Congress finally passed the TARP on October 3. Ten days later, Paulson summoned the heads of nine of the biggest and most important banks in the United States into the Treasury building. He lined them up, each with a nameplate, on one side of a twenty-four-foot mahogany conference table. They had been told the night before to be there at 3 p.m. without being told why; a few resisted the last-minute request, though by 2:59 all were lined up in their assigned spots. Paulson, Bernanke, Geithner, and FDIC chair Sheila Bair entered and took the seats across from the bank executives. Paulson ran the meeting: The banks would each be taking billions of new capital from the new government bailout program, he said. Any who refused would surely be hearing from their regulators on the matter—here the presence of Bernanke and Bair strengthened the implicit threat. Geithner read off how much capital each bank would be taking: $25 billion for Citigroup, $10 billion for Morgan Stanley, and so on. Some of the executives, worried about diluting existing shareholders and the new restraints that might come on their own salaries, raised various objections. Bernanke, ever the conciliator, said, “I don’t really understand why there needs to be so much tension about this.”

  The TARP was among the most unpopular programs the U.S. government has ever undertaken; when Paulson and Bernanke had their meetings with the bankers, CBS and the New York Times were conducting a poll that would show only 28 percent support of the newly passed bailout plan, and even two years later senators who voted for it were pummeled by their opponents for doing so. The whole point of the program was to shift the burden of rescuing the banks away from Bernanke and the Fed and into a program that had more democratic legitimacy. But by standing by Paulson’s side at every step of the way—on Capitol Hill, and in telling the bankers about the money they would be taking—Bernanke would be haunted by the TARP and its political taint for many years to come.

  • • •

  In Europe, Trichet was also being forced into the political arena.

  In the early morning hours of Tuesday, September 30, the leaders of Ireland, a nation of four million people and the world’s fifty-seventh largest economy, with a GDP smaller than Louisiana’s, made a decision that set in motion events that altered the history of Europe. The country’s banks were overburdened with bad loans for Irish and British real estate, and the people who funded the banks—both ordinary Irish savers and the global investors who bought the banks’ debt—were fast losing confidence.

  Trichet had called Irish finance minister Brian Lenihan to deliver a stern message. “You must save your banks at all costs,” Trichet said, Lenihan recalled later. Trichet warned Lenihan and Bank of Ireland governor John Hurley that the panic that had started with Lehman was rapidly spreading to the banks of Europe. Plenty of institutions were in trouble—in Germany, the Netherlands, and France. But on that Monday, Ireland was hit particularly hard. Anglo Irish Bank shares declined a whopping 46 percent to lead a national stock market crash of nearly 13 percent—the worst one-day drop in the country’s history.

  Lenihan called a meeting of the heads of the biggest Irish banks that evening to figure out what to do. The government decided, at about 4 a.m., and without consultation with anyone outside the borders of this small country, to guarantee the liabilities of six major Irish banks—to guarantee that all the bondholders and depositors owed money by these private concerns would be made whole, at the government’s expense.

  Hurley called Trichet at 6 a.m. to tell him of the plan. British chancellor of the exchequer Alistair Darling found out about it on the BBC morning news. The reaction across Europe was of shock—and, as time passed, anger. For one thing, Trichet and his colleagues thought that the extensive steps they had taken to funnel euros (and dollars, through the swap lines) to banks would be enough to keep them from experiencing runs. For another, Ireland had just taken a step that would expose its government to huge expense if the banks’ losses turned out to be worse than it appeared. And Ireland had created a situation in which its banks had stronger state guarantees than other European banks.

  It would take more than a year for investors to ask the important question: Could the Irish government even afford to guarantee its banks? At the time, money gushed into Irish banks—and out of banks in the rest of Europe, particularly Britain. Darling called Lenihan at about nine that morning, telling him that the actions had placed Britain in an “an impossible position,” inasmuch as the British government had no desire—or, it feared, resources—to create a similar guarantee for its own massive banking system. European nations were grappling with the sudden realization that not only were their banks more exposed to the United States than they would have imagined—“What were they doing screwing around in the United States?” French president Nicolas Sarkozy was said to have asked his staff after a $9.2 billion bailout of the Franco-Belgian bank Dexia)—but also that the crisis could soon turn into an every-man-for-himself situation in which money flitted from nation to nation depending on which was offering the best guarantees.

  In private conversations with European finance ministers and heads of state, Trichet argued for consistency. It simply wouldn’t do, he told them, for every European nation to have a different set of policies for guaranteeing the obligations of its banks. National leaders agreed with that idea in principle; they just couldn’t agree on the details of how to abide by it. Sarkozy called leaders of Germany, Britain, and Italy to the magnificent Élysée Palace in Paris the following weekend to try to hammer out a coordinated plan. The French were floating the strategy of creating a pan-European backstop for the banks, a single authority backed by the whole of the union that would make it unnecessary for Ireland and Belgium and every other country to take action independently.

  There were huge technical and political challenges to enacting such a sweeping plan with the kind of speed needed. But most significantly, Germany, the largest economy in Europe, wasn’t on board. It preferred to keep bank rescues a strictly national affair. It’s no coincidence that under such a scheme, Germany would likely end up covering the costs of a bank bailout in a smaller, less economically powerful country like Ireland. “To put it mildly, Germany is highly cautious about such grand designs for Europe,” said German finance minister Peer Steinbrück just before the summit in Paris. “Other countries are free to think about it. I just don’t see any German interest in it.”

  Sarkozy reportedly turned to his aides after meeting with German chancellor Angela Merkel and whispered, “If we cannot cobble together a European solution then it will be a debacle. But it will not be my debacle; it will be Angela’s. You know what she said to me? ‘Chacun sa merde.’” To each his own shit.

  Like Bernanke during the TARP debate, Trichet played the role of influencer, not decider. At the summit, he emphasized the importance of making new financial backing for banks consistent among nations. But he wasn’t a vigorous advocate for socializing the cost of bank bailouts across the EU, as the French government preferred. Whatever his true preference at the time, he was the consummate dealmaker, and he saw no deal to be made given the vehemence of the opposition from Germany. Said one European official who observed Trichet at work, “He is very adapta
ble. He has a skill for adjusting his position according to what is possible at the time.”

  Publicly, Trichet was dismissive of the idea that Europe’s lack of a central government hampered its response to the banking crisis. “Who can say we’ve done worse than the other side of the Atlantic?” he told reporters on October 6. “There is no lack of coordination—there is a European spirit. We have different governments, and they have different means of intervention.”

  The meeting in Paris closed with agreement on a strategy so vague as to be meaningless. Sunday night, Angela Merkel rushed back to Berlin, where adviser Jens Weidmann warned her that people were withdrawing 500-euro notes at a remarkable pace; the beginnings of a German bank run were under way. Merkel went on television to reassure her public. “I’m telling all citizens with savings that their deposits are safe,” she said. “The federal government will guarantee that.” A spokesman later explained that she wasn’t announcing a specific legal guarantee of German banks, but merely stating a broad principle. That didn’t matter much, though: It sounded to the rest of the world like she’d just announced that Germany would be doing exactly what she’d spent the previous six days attacking Ireland for doing.

  Over the ensuing days, European leaders would reach a broader agreement on how deposit guarantees should work. But it had no hint of common financial resources. That is to say, Germany would back German banks, Spain Spanish banks, and so on. This was particularly problematic for countries that had banking systems that were huge relative to their economies: Ireland’s bank guarantees meant putting the government on the hook for bank liabilities that added up to four years’ economic output!

  Bernanke would spend the three years that followed dealing with fallout from his successful lobbying of Congress on bailing out the banks. Trichet would spend his time dealing with the results of European political leaders’ failure to act in concert for the same purpose.