Three days that saved the world financial system

March 29, 2013

Adapted from “The Alchemists: Three Central Bankers and a World on Fire,” by Neil Irwin (The Penguin Press, available April 4).

The BlackBerrys all started buzzing, just before dinner was to begin at the Palacio da Bacalhoa, a 15th-century estate outside Lisbon. The 21 men and one woman charged with charting the course of Europe’s economy looked down to find startling news that evening of May 6, 2010.

Across the Atlantic, the U.S. stock market had plummeted. In only 15 minutes, the Dow Jones industrial average had fallen about 1,000 points, razing the stock prices of some of America’s biggest companies to a single penny. It would later be known as the “flash crash” and would be chalked up to strange technical factors. But in the heat of the moment, it flashed a different sort of danger. To the leaders of the European Central Bank who made up the Governing Council, who that very day had dismissed risks to their financial system, the crash seemed a striking referendum on what they had done — or rather, not done.

That afternoon, their leader, a Frenchman named Jean-Claude Trichet, had told the world in a news conference that the group hadn’t so much as discussed deploying its bottomless resources — its power to print money — to fight the crisis that was enveloping Europe and increasingly throwing into question the ability of nations to pay their debts.

Did we botch this? the central bankers wondered. What do we do now?


Adapted from “The Alchemists: Three Central Bankers and a World on Fire,” by Neil Irwin. Irwin, a Washington Post columnist and economics editor of Wonkblog, was the Post’s beat reporter covering the Federal Reserve and other central banks from 2007 to 2012. The book, including this excerpt, is based on reporting that took place in 27 cities in 11 countries. It tells of how the central bankers came to exert vast power over the global economy, from their 17th century beginnings to the present, and tells the inside story of how they wielded that power from 2007 on as they fought a global financial crisis. Excerpted by permission of The Penguin Press, a member of the Penguin Group (USA), © Neil Irwin.

The events that followed were, to most Americans, just one more series of headlines about a global crisis.

But in fact, what happened over three days and four nights in May 2010 is essential to understanding the economic predicament in which the world still finds itself. In that moment, the major Western central banks — and their leaders, Ben S. Bernanke of the U.S. Federal Reserve, Mervyn King of the Bank of England, and Trichet of the ECB — made a series of decisions that created the world economy we inhabit today, and likely far into the future.

Through half a decade of crisis that spanned every continent on Earth, it was this triumvirate of central bankers who responded on a scale and with a speed that presidents and parliaments could never muster. They deployed trillions of dollars, pounds and euros, often in concert, always trying to contain the damage. They made plenty of mistakes, some of them costly. But they also have kept the world from a disastrous economic collapse of the sort their predecessors had allowed eight decades earlier, setting the stage for the rise of the Nazis and World War II.

This is the inside story— based on dozens of interviews with people involved first-hand along with documents and other resources — of how, at one particularly crucial turning point, the central bankers pulled it off.

Lisbon, May 6

In Lisbon, the European leaders proceeded with dinner, distracted by the stream of news on their handheld devices but unable to speak frankly about their next steps in front of top Portuguese government officials and their spouses. Later, in an underground conference room at the palace, they talked it out.

The euro currency union was in crisis. Investors were fast losing confidence that money lent by some of its then-16 nations would be repaid.

Just the previous weekend, European leaders and the International Monetary Fund had announced a 110 billion-euro bailout deal for Greece, the country in the most trouble. But traders across the globe, deciding the rescue wasn’t enough, were selling off Greek bonds. The nation, which earlier that year had been able to borrow money for 10 years at at about 5 percent, had to pay a ruinous 7.6 percent interest rate on May 6. The rate seemed to rise by the day as investors lost confidence in the authorities and sold bonds as fast as they could.

The panic was fast spreading to other European countries. Ireland and Portugal were next in the line of fire, and then Spain and Italy, home to a combined 107 million people and $3.7 trillion in economic activity. Too big to fail, but also, for the rest of Europe, too big to bail out.

On the markets, traders were beginning to bet against the idea of European unity itself, to wager that the euro zone, the most concrete achievement in half a century of work toward creating a peaceful Europe, would unravel. The value of the euro was falling by the day, from $1.50 at the end of 2009 to $1.25 that May 6.

As is often the case in financial crises, it was a matter of market psychology turning, and then becoming self-fulfilling. If the rout continued and European nations’ borrowing costs kept rising, they would be frozen out of the markets. And the thing investors feared — defaults and the collapse of the euro — would become more likely. The selling fed on itself.

As is also often the case, it is the central bankers who step in to break that vicious cycle, deploying their bottomless capacity to create money from thin air.

In that underground conference room, one man stepped up to suggest a path the mighty European Central Bank might take.

“We must buy government bonds,” he said.

It was Axel A. Weber. The head of the German Bundesbank, big and barrel-chested, with an erect Teutonic posture and slicked-back hair, he looked a little like the television gangster Tony Soprano.

He was suggesting that the ECB use its unlimited supply of euros to go onto the financial markets and buy bonds of Greece and the other nations that were having trouble financing themselves. Many of the others in the room were stunned — not just by the suggestion, but also by its source.

Weber and the Bundesbank tended to be the staunchest defenders of monetary orthodoxy in the currency union — protectors of the idea that a central bank must never fund governments, lest inflation take hold. The memory of the early 1920s, when runaway inflation rendered savings worthless, was deeply entrenched in the German psyche. Weber, at the helm of the Bundesbank, was charged with making sure that it would never happen again.

Now Weber was suggesting just a little bit of flexibility. The ECB wouldn’t be funding governments directly, he noted that night in Lisbon, just strategically intervening in markets to prevent rampant and irresponsible speculation from bringing down the euro. It wouldn’t be printing money at all, he argued; the ECB could intervene on the bond markets while sucking an identical amount of money out of the banking system, reducing the risk of inflation.

Trichet knew that if he had Weber on board, the path to intervention to contain the crisis would be easier. Weber seemed the likeliest candidate to succeed Trichet at the helm of the ECB. He represented Europe’s largest economy, and he had a force of intellect that made him a formidable presence on the Governing Council.

The meeting disbanded, and they all went to bed.

Maybe, when Weber woke up on Friday, May 7, he reevaluated in the cold light of day ideas he had kicked around in an academic, theoretical way the night before. Maybe he realized how much internal blowback he would face at the Bundesbank and from the German press if he endorsed bond purchases. Maybe the ghost of Rudolf von Havenstein, the German central banker who presided over the 1920s hyperinflation, visited him in the night.

Whatever the case, by morning Weber had changed his mind. And he was not one to keep his opinions to himself. On the three-hour flight from Lisbon to Frankfurt, he typed an e-mail: If the ECB bought government bonds without the governments making an ironclad commitment to back one another’s finances, the central bank would be ultimately responsible for Europe’s financial well-being. Greece was fundamentally insolvent, and ECB lending wouldn’t change that. Further, the purchases would violate the spirit of the treaty that created the central bank in the first place.

If the Governing Council outvoted him and bought bonds, Weber continued, he wanted his opposition to be known publicly, and if Trichet did not tell the world of Weber’s opposition, he would do so himself.

It was an unveiled threat. Weber hit “send” on the e-mail upon landing in Frankfurt, and the 22 council members all knew that if they moved to buy bonds as a strategy to save Europe, it would come at the cost of deep fissures within their central bank.

Washington, May 6

Timothy F. Geithner, then the U.S. Treasury secretary, practiced a particularly energetic variety of economic diplomacy. His was always a packed schedule, and between meetings he constantly worked the phones to gather information, compare notes, and try to persuade his interlocutors of what they ought to do or say or write. That was never more true than that Thursday, May 6.

He arrived at his office at 1500 Pennsylvania Ave. at 7:30 a.m., and in the 15 hours that followed would testify at a hearing of the Financial Crisis Inquiry Commission across town; walk next door to the White House three times, once for the senior staff meeting and twice to meet with President Obama; and make at least 26 phone calls: to a variety of U.S. politicians and White House aides, to journalists from The Washington Post, New York Times and Wall Street Journal, and to old friends from the world of central banking. Before coming to the Treasury, Geithner had led the Federal Reserve Bank of New York, where he was among the most influential members of the rarefied club. On May 6, he spoke with Fed chief Bernanke, Bank of England governor King, and twice with Trichet.

The message from Geithner to the Europeans was simple but insistent: This is getting bad. It is time for the ECB to step up to stop things from spiraling out of control.

Geithner and Bernanke weren’t the only ones applying international pressure on the Europeans for decisive action. That same day, Britons went to the polls to vote in elections that would toss the Labour party from power after 13 years of control.

Britain’s Conservative Party didn’t win an outright majority of seats in Parliament that day, though. To take the reins of power, they would need to form a coalition with the Liberal Democrats, who had won 23 percent of the vote. And hanging over negotiations that ensued between the Tories and the Lib Dems were the words of an economist loyal to no political party: Mervyn King.

King had, in the preceding months, become an increasingly vocal proponent of the idea that Britain needed to immediately begin reducing its huge budget deficits, to fix its finances even as the nation’s unemployment rate was hovering near 8 percent. King saw it as crucial for risk management: Investors might shun the British pound and government bonds if they did not see a path to lower deficits. His criticism of the state of British fiscal policy had become more pointed as the election approached, leading many in the Labour party to feel he was using his authority as governor of the Bank of England to give their electoral opponents an edge; the conservatives were not shy about using his words as a cudgel.

As negotiations on the terms of the coalition commenced — Lib Dems were more skeptical of fiscal austerity, while Conservatives favored more rapid deficit reduction — King was at the ready to provide the ammunition for a push toward austerity. The deficit, wrote David Laws, one of the negotiators for the Lib Dems, “was the spectre which loomed over our talks. This was the reason that the Governor of the Bank of England stood ready to brief us on his perspective on the risks to the UK.”

So as the fateful weekend approached, and Europe’s economic future hung in the balance, so did those of Britain and the United States.

Brussels, May 7

On Friday, May 7, as Weber wrote his fateful e-mail en route to Frankfurt, Trichet was headed to Brussels to meet with the heads of European governments on the seventh floor of the Justus Lipsius building, a giant glass-and-concrete monument to European unity that looks like a convention center. Trichet’s mission was to convince them that the Greek bailout of the previous weekend wasn’t enough.

Going in, many of the prime ministers and presidents of Europe seemed not to comprehend the degree of risk. Trichet presented a chart showing the sell-off of European bonds that had accelerated over several days. “Some of you behaved very improperly and created an element of vulnerability for your own country, and by way of consequence for Europe,” he told them, as he recalled later in a television interview. “Now the situation calls for taking up responsibilities.”

The responsibilities he had in mind: creating a credible assurance that the governments of Europe would stand together, that they would act collectively to ensure none would become unable to pay its bills. Trichet was confident after the late-night meeting in Lisbon that he had the votes on the ECB Governing Council to begin buying bonds. But that wouldn’t offer a permanent solution to Europe’s dilemma. He needed to dangle the possibility of ECB bond purchases as a carrot, a reward for government action if they acted decisively.

At the same time, Trichet didn’t want to be explicit about the possibility. After all, the whole point of an independent central bank is that it makes the decisions it thinks best, not as part of a negotiation with elected officials. So the discussion in Brussels became an exercise in insinuation, a quid pro quo in which the quid could not be named.

“We will see what we do,” said Trichet, his charts looming behind him on a screen. “But we cannot be responsible for ourselves and you. We need your action; we have an absolute need for your reaction.” He became louder and more animated as the presentation progressed. By dinner time, as they ate asparagus and turbot, the leaders understood what he was getting across.

Basel, May 8

The next day, Saturday, May 8, the central bankers arrived jet-lagged and bleary-eyed, from all points of the Earth, carrying sheaves of paper and emerging from black Mercedes sedans, some with a burly security guard or two in tow. For the central bankers, Basel — pronounced “Bahl” by the cognoscenti and like the name of a fragrant summer herb by everyone else — is supposed to be a place of refuge.

Six times a year, they check into their preferred hotels — the Americans favor the Hilton; many of the Europeans the rather more grand Three Kings — and step temporarily into the close camaraderie of people who understand the unique burdens of a central banker. They head to a fortress of a building that might have been designed as a workplace for George Jetson: a cylindrical tower that looks as if someone squeezed it slightly in the middle, with a base that wraps around without a straight line in sight, the elegance of the curves hiding the imposing thickness of the blast-protective stone.

The building may be steps from the Basel train station, but it isn’t on Swiss soil. Like the United Nations headquarters in New York, it’s an entity without a country, belonging to the world. The sign out front reads “Bank for International Settlements,” but the place might more easily be thought of as the central bank of central banks. This is where Trichet, Weber and most of the other leading central bankers would spend the fateful hours of decision over how far they were willing to go to save Europe. Coincidentally, one of the regularly scheduled meetings fell on the same weekend that Europe was on the brink.

Most of the bankers’ time in Basel is devoted to serious and sober debate about the global economy. But on Sunday evenings, they feast. The innermost circle of the leading central bankers is the “Informal Dinner for Governors of the Economic Consultative Committee.” It is the most exclusive regular dinner party on the planet. The heads of the world’s most important central banks gather, usually on the BIS’s 18th floor: the chairman of the Federal Reserve and president of the Fed’s New York outpost, the president of the European Central Bank, and the heads of the central banks of Japan, Britain, Germany, France, Italy, Canada and Switzerland. The group was expanded in 2009 to include the central bankers of China, India, Brazil and Mexico, a signal that their countries had arrived on the global stage.

The diners eat well, with black-clad waiters delivering a progression of precise, subtle dishes — lobster, duck, lamb — each in a rich, buttery sauce. They drink even better, with generous pours of Bordeaux and Burgundies, which Global Economy Meeting attendees jokingly refer to as “grand cru BIS.” Early on in his time as Fed chairman, Bernanke, noting that the event is called an informal dinner, remarked to a colleague that “this is one of the four most formal meals I’ve had in my life.”

While the central bankers gathered in Basel that Sunday, May 9, the European finance ministers were in Brussels. ECB Vice President Lucas Papademos, who would later serve a turn as Greek prime minister, was there monitoring the talks, reporting back by cellphone to Trichet in Basel. Other ECB officials were at the bank’s headquarters at the Eurotower in Frankfurt. An open-line conference call connected finance ministries and central banks in capitals including London, Washington and Tokyo to the action.

Geithner made a series of private calls to European officials, attempting to apply whatever weight that came by virtue of his experience as a crisis manager and the finance minister of the world’s largest economy. Early in the conference call, there was discussion of putting together an emergency fund of perhaps 60 billion euros. Geithner, flabbergasted at the paltry amount, suggested that it wasn’t nearly enough. To show markets they were serious, the officials would need 10 times as much, something on the order of the U.S. government’s TARP bank bailout in 2008. The Europeans reluctantly came to agree and set to work on a bigger package.

Washington, May 8

Bernanke had dispatched vice chairman Donald Kohn to represent the Fed in Basel while the chairman gave a commencement speech at the University of South Carolina, in his home state (Topic: “The Economics of Happiness”). Around the time Bernanke was finishing his speech that Saturday, at 12:55 p.m. on the East coast, he received an e-mail from an aide about a pressing message from Italy’s central bank governor, Mario Draghi, who was among the more respected and influential of the European central bankers.

“Governor Draghi asked me to forward this to the chairman with suggestions that a statement like the following be issued jointly late Sunday or early Monday morning by the Fed, ECB, SNB, BOE, BOJ, BOC” — that is, the central banks of the United States, the European Union, Switzerland, Britain, Japan and Canada. Draghi proposed they jointly announce, “Major central banks stand ready to supply the financial system with adequate and immediate liquidity in the days ahead.” Let’s work together to address foreign currency funding shortages, suggested the e-mail Bernanke received. If the Europeans were going to act, they wanted the Americans to step up, too.

The most useful weapon the Americans had in their crisis-fighting arsenal was one used intensively during the crisis but subsequently shelved. The Fed had lent vast sums — $530 billion at the peak — to the ECB and other central banks, which in turn lent money to their domestic banks. It was a key tool, little understood by most Americans, by which Bernanke and the Federal Reserve became lender of last resort to the world in 2008. Might the Fed reopen these “swap lines” with the ECB and other central banks to help combat the newest wave of crisis?

On one hand, Bernanke and Kohn were eager to do whatever they could to help ease the financial pressures on Europe and signal the joint resolve of the global central banks to combat the crisis. But it was also a delicate time for the Fed, as the Senate was set to vote on amendments the following week addressing key aspects of the Dodd-Frank Act regulating Wall Street that affected the Fed. Headlines about the Fed offering potentially billions of dollars in new loans to foreigners would hardly help things. Bernanke couldn’t make a round of calls to key lawmakers in advance of a decision, either, in hopes of receiving their blessing; the very principle he was fighting for was that the Fed must make its decisions away from politics and any interference by elected officials.

Bernanke called an emergency meeting of the Federal Open Market Committee, which sets U.S. monetary policy, for Sunday morning, by videoconference; the Washington-based Fed governors gathered in the Special Library, an intimate-but-ornate conference room down the hall from the chairman’s office, and the rest of the Fed officials joined in from their respective cities, each face in a different square like the lead-in to the old TV show “The Brady Bunch.” Kohn, from Basel, explained the state of play among the Europeans. The committee supported Bernanke and Kohn’s recommendation: that the Fed reopen swap lines, but if, and only if, the Europeans could agree on a sweeping response of their own.

Essentially, all the actors in the crisis were linking hands and agreeing to jump at the same time: the European governments, the ECB and the global central bankers. Each refused to go unless the others would do their part as well.

After the FOMC call ended, Nathan Sheets, the Fed’s top international economist who had joined Kohn in Basel, went around to the offices set aside for use of visiting central bankers to see which of them would join in the announcement of swap lines. He was a door-to-door salesman, and his product was billions of dollars.

Basel, May 9

Sunday evening, Trichet again assembled the Governing Council, many of them in person in a conference room at the Bank for International Settlements in Basel while others called in from Frankfurt and a few from their respective countries around Europe. It was time to make a formal decision on the idea they’d been discussing since Thursday night in Lisbon. Would the ECB engage in targeted purchases of Greek, Irish and Portuguese bonds in order to push interest rates in those countries down a bit, ease the sense of crisis and ensure that it maintained control over monetary policy? Or would it stick with a more doctrinaire view of its powers and avoid violating the spirit of its treaty in order to keep all the pressure on elected officials to rescue Europe? Trichet argued forcefully for the former.

He proposed that even as the ECB bought government bonds on the open market, it should withdraw an identical amount of money out of the euro-zone economy through other tools so that the bond purchases would be “sterilized” — that is, not increase the overall number of euros in existence.

Weber and Juergen Stark, an ECB Executive Board member, argued with equal vehemence against the move, using logic similar to what Weber had expressed in his e-mail two days earlier. The ECB should intervene in the bond market only if things got worse — bad enough to force government leaders into more decisive action than anything they were cooking up in Brussels that weekend.

In the end, the council was overwhelmingly in favor of buying bonds — but also in favor of keeping that decision a secret from the finance ministers and heads of state until they had reached their own deal. If they found out that the ECB had decided to intervene, it would remove the pressure on them to act. The vote was a triumph of pragmatism over principle. Weber and Stark led the opposition, joined by Nout Wellink of the Dutch central bank.

The ECB had decided. It would buy bonds under what it called the “securities market program.” Early Monday morning, the Rubicon would be crossed. Now it just had to keep quiet until the politicians did their part.

With the ECB in action, the Fed was ready to move on swap lines as well. At 7:46 p.m. Basel time, 1:46 p.m. Washington time that Sunday, Kohn sent Bernanke an e-mail, with the subject line, “Swaps are a go.”

Brussels, May 9-10

That evening in Brussels, the talks among the finance ministers had bogged down. First there was a long delay in finding a negotiator for the Germans; the finance minister, Wolfgang Schaeuble, had fallen ill on the way there and a stand-in had to be flown in to represent Europe’s most populous nation. And once the German negotiator was in place, it was clear that the Germans and the French were on different pages.

“With all due respect to Australia,” French Finance Minister Christine Lagarde said, “Let’s forget about Sydney, concentrate on Tokyo, and take a break.” In other words, they were going to miss the deadline of 1 a.m. local time, when the Australian stock market was to open, and so would focus on getting a deal in place by the 2 a.m. opening of the Japanese market.

There was an active open line that afternoon and evening, with finance ministers and central bankers from the leading nations of the world connected to the action; one American official dialed in from home and the hours-long international call ended up costing $800. At one point, the European finance ministers put their line on mute to negotiate among themselves; King of the Bank of England, an avid sports fan, impishly read off the day’s soccer scores to pass the time.

The Europeans arrived at a deal just in time, the French and Germans agreeing on a 440 billion-euro rescue. The IMF pledged another 250 billion, which helped assure the Germans that there would be tough budget-cutting conditions placed on the recipients of bailout money.

It also was something of a mirage: While Dominique Strauss-Kahn, the managing director of the IMF, pledged the money, he had no authority to do so; that would require a vote of the IMF Executive Board. The supremely self-confident Strauss-Kahn focused on getting the theater right and worrying about the bureaucratic niceties later.

At 3:15 a.m., the finance ministers had finally finished their hard-fought series of compromises and announced their measures. They missed the Japanese deadline as well, but apparently the sense that European leaders were furiously working toward a deal was enough to calm the markets.

The ECB followed shortly thereafter with its announcement, as did the Fed and the other central banks participating in swap lines. “The Governing Council . . . decided on several measures to address the severe tensions in certain market segments which are hampering the monetary policy transmission mechanism,” the ECB announcement said, the first of countless moments in which its leaders argued that their action wasn’t about rescuing troubled governments at all, but about ensuring it had control over the value of the euro.

For Weber, losing the argument over bond buying wasn’t the end of things. The rules under which ECB Governing Council members operate call for them to keep quiet about how they vote. Unlike the Fed and the Bank of England, which release minutes of their meetings that detail how committee members voted, the ECB keeps such information secret for 30 years. The theory, of course, is that this should make it easier for officials to make decisions that are in the best interest of the euro zone as a whole, rather than represent the interests of their own countries. Another fundamental principle is that the national banks of Europe — the Bundesbank and Banque de France, for example — would carry out the orders of the ECB Governing Council and buy and sell securities accordingly. Like the twelve U.S. Federal Reserve banks, it is these institutions that actually carry out policy set by the committee.

To Weber, the Governing Council had so thoroughly ignored its own rules and orthodoxies that those principles were now in question.

Shortly after the Governing Council meeting Sunday evening, Weber convened a conference call of the Bundesbank Executive Board. He and colleague Andreas Dombret were still in Basel, the other board members in various locations in Germany. Officially Weber wasn’t supposed to tell anyone what the Governing Council had decided, but this was so momentous that he posed a serious question to the board members: Should we do it? Should the Bundesbank follow its marching orders from the ECB and buy billions of euros’ worth of Greek and Portuguese bonds, violating its long-cherished principle of not using the printing press to fund governments?

If they had answered “nein,” it’s nearly certain that the euro would have unraveled within days, the ECB would have lost all credibility and Germany would have been forced to reinstitute the mark as its currency. The global financial markets would have entered a tailspin more dramatic than what followed the bankruptcy of the Lehman Brothers financial firm in 2008. Staring at that precipice, the Bundesbank leaders decided it was better to hold their nose and violate orthodoxy than to unleash such dangerous consequences.

That night, the world came closer to financial catastrophe than all but a few insiders knew at the time. But by the time people around the globe lumbered to work Monday morning, there were billions of euros devoted to maintaining a united Europe, a new coalition was coming together to lead Britain committed to bringing down its budget deficits, and the U.S. Federal Reserve had again served its role as lender of last resort to the world.

While the world slept, the central bankers in Basel, London, Washington and beyond had done their work, and the global flow of commerce trudged forward yet again.

From “The Alchemists: Three Central Bankers and a World on Fire,” reprinted by arrangement with The Penguin Press, a member of the Penguin Group (USA), © Neil Irwin.

Irwin is a Washington Post columnist and economics editor of Wonkblog; he was The Post’s beat reporter covering the Federal Reserve and other central banks from 2007 to 2012.

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