Chapter 23. Politics and Institutions
“Now, as through history, financial capacity and political perspicacity are inversely correlated.... So inaction will be advocated in the present even though it means deep trouble in the future. Here, at least equally with communism, lies the threat to capitalism. It is what causes men who know that things are going quite wrong to say that things are fundamentally sound.”
J.K Galbraith, from The Great Crash 1929, written in 1954
Confidence in political institutions is vital to markets, and usually taken for granted. Once lost, it is expensive to replace. When Congress voted down the TARP bailout plan and then the European Union showed itself incapable of coordinating a response to runs on European banks, markets lost their confidence in governments—and the super-bubble burst.
Traders on the floor of the New York Stock Exchange do not spend much time watching politics. They are much more concerned by stock prices. But that changed on September 29, 2008.
The United States had just lived through a week of political drama. Figures on both left and right in Congress had principled reasons to dislike Henry Paulson’s so-called TARP—Troubled Assets Relief Plan. The idea was to buy up troubled mortgage-backed securities, and thereby ease pressure on the banks holding them. But for those on the left, it was an anathema to bail out Wall Street when Main Street America was suffering. Those on the right believed the market should be allowed to take its course. And they were being asked to ratify a $700 billion bailout a month before they faced reelection. Barack Obama and John McCain, the two presidential candidates, both took part in highly publicized talks while the incumbent president, George W. Bush, looking as pale as a ghost, made a national broadcast to sell the deal.
Eventually, a compromise emerged, and leaders of both parties in the House decided to put it to a vote. Traders assumed that they would not have done so, with so much at stake, unless they were sure they had the votes to pass it. And in any case, it seemed clear that politicians had no choice but to hold their noses and pass the legislation.
As the debate in the House of Representatives started that Monday morning, trading on the exchange floor was desultory. Politicians were unsettling background noise. As they moved to a vote to give the Treasury $700 billion for a bailout, Wall Street trading ground to a halt. The votes slowly tallied at the top of the television screen—and, unbelievably, the Nays accumulated faster than the Yeas. They were still ahead when the vote ended. Television commentators dickered over whether this was the end for the bailout, but the traders reacted in the only way that made sense. They sold.
Normally the bulk of trades in Wall Street come at the beginning and end of the day, as traders reconcile the orders they have taken from outside. Even the biggest news cannot disrupt that pattern. But on this day, the dealing that took place in a few frantic minutes after midday swamped anything else seen all day.
In “raw” points terms the Dow Jones Industrial Average ended down exactly 777 points, the worst day in its history. But the total market value wiped out in the United States alone came to about $1.5 trillion, or nearly double the amount that Congress had decided not to spend on the toxic assets problem. As most of the U.S. stock market ultimately belongs to taxpayers, the attempt to safeguard voters’ personal budgets had, at least initially, been hugely counterproductive.
The problem for the markets was not the money involved, or even the toxic assets, per se. The TARP plan was muddled, and many thought that any rescue plan should be very differently structured. Rather, it was that Congress had unintentionally shown them that they could not rely on politicians to get their house in order, to take action when it was needed, or even to pay attention to critical financial issues. The institutions on which the markets rely for order simply did not function. Weak institutions like this had always been perceived as part of the risk of investing in emerging markets; now American political institutions were revealed to be no stronger.
Bringing the issue to the vote, only to see it go down, was much worse for confidence than doing nothing at all. Art Cashin, known as the dean of the trading floor, where he had worked for 47 years, commented that it was as though the traders were on a ship in a storm—and had suddenly seen the officers and crew in a pitched battle with each other.1
This is what was truly toxic. Finally passing the TARP (which happened four days later with the aid of huge and unrelated amounts of government largesse, or “pork,” directed at the districts of prominent “no” voters) did not correct it. It was beyond doubt that the politicians did not understand the situation and did not have their act together. And investors around the world focused on the risk that other politicians would handle the situation no better than the Americans.
The United States had been around for more than two centuries. Its institutions were stable. What chance, then, was there for the European Union? A group of different countries, speaking different languages, and in some cases, harboring deep historic grudges against each other, had to grapple with problems just as difficult. On the same day that Congress voted down the TARP, Ireland stemmed what looked like a nascent bank run by announcing far more generous deposit insurance. It quintupled the amount of each deposit covered from €20,000 to €100,000, making it by far the most generous insurance scheme among the countries that used the euro. The next day it went further, making a blanket guarantee of all Irish deposits. They had a big incentive to do this, as Ireland’s banking system was blatantly “too big to fail,” with assets four times greater than the country’s GDP. For comparison, U.S. bank assets were exactly equal to GDP.2
Anxious Europeans started to pull their funds from local banks and move them to Ireland. This was easily done with Internet banking, as all the accounts were denominated in euros. Hence funds flowed out of the continent’s biggest banks. Leaders tried to agree on a common standard for deposit insurance with a €350 billion price tag, an idea that appeared to originate from France, but by the weekend the talks were mired in acrimony.
Traditional European enmities bubbled up once more. On Thursday of that week, Angela Merkel, Germany’s chancellor, depth-charged the talks, saying: “The federal government cannot and will not issue a blank check for all banks, regardless of whether they behave in a responsible manner or not.”3 Then on Sunday, as the panic deepened, she announced that the German government would do just that, guaranteeing all private German bank accounts.4
This rammed home that Europe’s politicians could not speak with one voice. In a crisis, when decisions had to be made swiftly, its big and cumbersome institutions did not allow a coherent response—especially when Europe’s banks were obviously even more bloated, and would be even harder to rescue, than U.S. banks. Confidence in politicians was lost.
Like a functioning banking system, a coherent political system tends to be taken for granted. People notice it only when it goes missing. But good governance matters. The lack of strong institutions or politicians that investors could trust was a key reason why emerging markets were cheaper than developed markets in the first place. Now it turned out that developed markets were no better. At the end of September 2008, markets suddenly lost the “stability dividend” that decades of stable government in the United States and Europe had given to markets.
Recovery would be impossible until that confidence could be bought back. And the price of buying back confidence would prove much higher than the original $700 billion price tag on the TARP.
In Summary
• Coherent government institutions are a necessary condition for properly functioning markets.
• Lost confidence in U.S. and European governments’ capability to respond to the banking crisis provided the final catalyst for the crash of 2008.