The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  Instead of fixing the fundamentals of their economy, the Greeks were cooking their books. One widely covered instance was a series of currency swaps arranged with the assistance of Goldman Sachs in the early 2000s that essentially allowed the Greek government to borrow money without issuing debt that would show up in official statistics. Less widely known were such tricks as underreporting how much the nation was spending on its military (a particularly large expense given perennially tense relations with Turkey) and the failure to account for debts owed to hospitals that Papaconstantinou’s budget analysts discovered. The government fudged its numbers by selling off long-term assets—the rights to future airport fees, for example—in order to fund immediate spending. “The gravest thing was the fact that they didn’t know themselves that they were lying,” said one eurozone central banker. “We discovered progressively that you had an immense problem of the state functioning—the cheating, the mistakes in the figures, things done orally and not written down.”

  There’s an old saw that it’s only when the tide goes out that one learns who was swimming naked. The financial crisis triggered by the Lehman Brothers failure in September 2008 brought out the tide—and exposed a beach full of naked Greeks.

  In Frankfurt, Jean-Claude Trichet received the news of Greece’s dire public finances with the same surprise that Papaconstantinou had. Up to this point, the European Central Bank had most of its staff devoted to monitoring conditions in the bigger economies in the eurozone. A single economist spent only part of his time tracking the Greek economy. That changed in late 2009, as the ECB became more alarmed at Greece’s fiscal situation with every basis-point rise in the nation’s borrowing costs. In the Eurotower, a team of economists was assembled to delve more deeply into the nation’s budget. By Christmas, it had been dispatched on a secret mission to Athens to gather information on the ground, primarily from the Bank of Greece and the finance ministry.

  In hindsight, financial markets responded to the disclosures of Greece’s dire situation surprisingly slowly: When the new government took office in early October, the country’s bonds were yielding 4.44 percent. By the end of the month, that had risen only to 4.65 percent, and to 5.77 percent by the end of the year. Ironically, it was only as Papandreou’s government started announcing its plans to rein in spending and collect more in taxes—a plan that disappointed markets with its timidity—that rates started to rise dramatically, to 7 percent by the end of January 2010.

  But even those modest rises in the cost of borrowed money had huge implications for the nation. It’s called “debt dynamics”: When a country has high levels of debt, even small increases in the interest rate it must pay mean big trouble. In 2009, Greece’s total debt equaled 129 percent of its annual economic output, so even a single percentage-point increase in interest rates would make repayment vastly more difficult. Greece was on the verge of a dangerous situation in which huge debts make interest rates rise, and those higher rates in turn make the debts unsustainable.

  This is hardly novel. Countries throughout history have found themselves in just such a predicament. In 1944, an institution was created for the sole purpose of dealing with such a debt crisis: the International Monetary Fund, which can lend money to nations in financial trouble to help them get back on their feet. Over the six decades of its existences—making plenty of mistakes along the way—the fund has learned how to structure the financial rescues of debt-laden states. But it has also learned, in Asia in the late 1990s and Latin America in the early 2000s, the dangers of forcing a country to slash its budget too rapidly—that the resulting depression can bring social unrest and political instability. In the early days of the Lehman crisis, it put together a so-called Crisis Veteran Team to ensure that the accumulated knowledge of its most seasoned staffers would be passed along to their younger colleagues.

  At the helm of the IMF was Dominique Strauss-Kahn, a charismatic and politically connected former French finance minister who came from his nation’s center-left socialist party. It was an open secret that he was a likely candidate to challenge Nicolas Sarkozy for the French presidency in 2012—assuming, of course, he could avoid any nasty scandals resulting from his well-known sexual appetites.

  Strauss-Kahn’s standing as the possible next president of France boosted his credibility among many European leaders, but for Trichet and some others, the idea of bringing in the IMF was anathema. Part of it was cultural arrogance: We are Europe, birthplace of civilization, not some tinpot nation in need of an international bailout. It would be a “humiliation,” Trichet once said, for the IMF to step in. Trichet was similarly resolute that there could not, would not be any default. Greece would pay its bills.

  Trichet embraced a view, especially common in Germany, that was rooted in a sort of moralism. Greece had spent too much and taken on too much debt. It must cut spending and reduce deficits. If it showed adequate courage and political resolve, markets would reward it with lower borrowing costs. He put a great deal of faith in the power of confidence: Resolute action by political authorities would put the Greek economy back on a path of growth by improving confidence among investors, businesses, and consumers. “It is very important,” Trichet said in January 2010, for those nations “which have a special deterioration to redress the situation in taking the appropriate bold and courageous measures for their own prosperity and recovery. We trust that this is essential to improve confidence, and you know the extent to which we consider that confidence is key in the present economic situation in Europe as well as in the world.”

  So Trichet was, through the end of 2009 and start of 2010, convinced that Greece could solve its own problems, reforming its tax system and cutting government spending and so regaining the confidence of bond markets. No need for a bailout from the IMF—or anyone else. Said one IMF official, “The attitude from the ECB was, ‘Get out of our face, we don’t need you guys, we are the eurozone, we created this, and we can take care of our own.’” Added another IMF official, “Trichet was the leader of the pack insisting, ‘No IMF!’ And the reason was not because he was against the IMF, but because he wanted the European governments to shoulder their responsibilities.”

  Trichet was equally insistent that the ECB would not take any action to bail out Greece: “No government, no state can expect any special treatment from us,” he said in a January 2010 Q&A session in Frankfurt. Already, however, some American and British commentators were warning that Greece’s financial troubles could force it to drop out of the eurozone. What did Trichet think about that possibility?

  “I do not comment myself on absurd hypotheses,” the ECB president replied.

  • • •

  Make your way to the French Canadian metropolis of Montreal. Then, if you have the proper connections, hop on a military jet and fly four hours due north. You’ll find yourself in Iqaluit, a town of fewer than seven thousand people on the southeastern coast of Baffin Island, directly across the Davis Strait from Greenland. At one time it was a pit stop for American fighter planes being sent across the Atlantic to fight in World War II. Now it’s the capital of Nunavut, the largest and newest territory in Canada, but one so remote it has no roadways connecting it to the rest of the country.

  This is the voyage that the world’s leading finance ministers and central bankers made in the dead of winter in 2010. Canada wasn’t the first nation to choose a less than convenient location for an international summit, though the meeting place of the Group of Seven finance ministers that February is among the more extreme examples.

  The choice could have been made for a variety of reasons: to isolate officials from any potential distractions, including any noisy protestors; to celebrate the area’s native Inuit culture; to try to persuade the Europeans that they should lift their recent ban on the importation of commercially hunted seal products; to remind attendees of Canada’s deep connections to the Arctic—and hence its rights to the region’s oil reserves. Whatever the re
lative weights of these factors in the Canadians’ thinking, the results of these talks at the top of the world would have far-reaching consequences across the planet.

  With the temperature an unseasonably warm 0° Fahrenheit, the attendees were treated to demonstrations of igloo making and other examples of native culture. The British press had fun with a photograph of Mervyn King wearing a giant fur-lined coat and riding a dogsled. “For God’s sake, just don’t get photographed clubbing a baby seal,” said one central banker’s communications adviser on the banker’s way out the door. Or, for that matter, get caught eating any: All the officials except the Canadians skipped the final meal, at which raw seal meat was served. The Americans tried to fly home early Saturday, but were waylaid in Boston for the night; ironically, after they had experienced relatively pleasant weather in the Arctic, their plane couldn’t land because Washington was being buffeted by a snowstorm.

  Wearing sweaters and sport coats rather than their usual dark suits, the finance ministers and central bankers assembled in a circular conference room at the Frobisher Inn (“the largest full-service business hotel in the Eastern Arctic”) under a domed ceiling of exposed wooden beams evocative of an igloo. Trichet made an impassioned plea to his European colleagues, one that suggested he might be changing his mind about giving Greece “special treatment”: The Greek situation wasn’t sustainable, he said. The government’s borrowing costs were rising even in the face of its deficit reduction plans. Major banks in France and Germany and Spain owned hundreds of billions of euros of Greek debt, so a worsening of conditions in Greece could endanger the entire continent’s banking system. And in financial markets, it was already becoming clear that whenever investors became worried about Greece, they also began shedding the debt of other European countries that seemed to have precarious finances, particularly Portugal and Ireland but also Spain and Italy.

  Making one of his characteristic appeals to grand principle, Trichet argued that the threat wasn’t just to Greece, but to the European project as a whole. It must be taken seriously. European leaders left the Arctic with a greater understanding of what was at stake. As Trichet departed Iqaluit, the gathered reporters asked how he was feeling about Europe’s outlook. “Confident,” he replied.

  And a second thing happened at the summit: In the isolation of the Canadian wilderness, the leaders of the world economy collectively agreed that their great challenge had shifted. The economy seemed to be healing; it was time for them to turn their attention away from boosting growth. No more stimulus. The Greek problem was seen as evidence that it was time for all the nations of the world to begin reducing budget deficits. No more ultra-easy-money policies. Even Ben Bernanke, more wary of tightening monetary policy than most of his counterparts, would explain in a presentation a few days later how the Fed planned to exit from easy money. “We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively,” he assured the House Committee on Financial Services.

  Iqaluit was the moment the world’s central bankers and other financial leaders began a great pivot toward tighter money and austerity. “The global economic situation has, of course, improved and is improving,” said Canadian finance minister Jim Flaherty, the host of the gathering, summing up the conclusions reached in a press conference on February 6, 2010. “We need to . . . begin to look ahead to exit strategies and move to a more sustainable fiscal track.” In other words: We’re out of the woods.

  It would turn out to be a wildly premature—and costly—pronouncement.

  Three weeks later, Jürgen Stark, a member of the ECB’s Executive Board and the central bank’s chief economist, traveled to Athens. He was officially there as an observer of talks between the Greek government and Olli Rehn, the European commissioner for economic and monetary affairs and the euro. But there was more to his trip than that. Eurozone officials, persuaded by Trichet’s efforts in Iqaluit, were ready to offer some financial backstop to the Greek government in case it lost access to bond markets.

  But they insisted that Greece enact a wide-ranging program of budget cuts, privatizations, and improved tax collection in exchange. Trichet’s belief in confidence-inducing austerity had won the day. The German government, however, wanted to ensure that Rehn and the European Commission would be adequately tough in their negotiations. That’s where Stark came in. The ECB, with its roots in the Bundesbank, could serve as a powerful counterbalance for any temptation to let the Greeks off the hook. Stark, himself German, was to join Rehn in Athens as a sort of enforcer.

  When Stark walked into the room for the talks at the Greek finance ministry on the morning of March 1, Papaconstantinou visibly tensed. He initially ignored Stark, speaking only with Rehn. But Stark wasn’t shy about speaking up, and unbeknownst to Papaconstantinou, he and Rehn had eaten breakfast together that morning to plot their strategy. Divide and conquer wouldn’t work in this meeting.

  The Greek finance minister presented a plan for his nation to cut its budget deficit by about a third in 2010—from around 13 percent of economic output in 2009 to 8.7 percent. That would imply around 4 percent less economic activity in Greece, which amounts to a very steep recession. (By comparison, the U.S. economy contracted 3.3 percent in 2008.) To avoid a painful contraction, the budget cuts would have to be offset by some other economic change: lower interest rates from the ECB, for example, or trade partnerships that could drive up exports, or the sort of international investments in the country that, Trichet presumed, would result from increased confidence. But the talks that day in Athens weren’t focused on the risk of recession or any steps that might relieve the pain. They were focused on the how and when of austerity.

  The good news for Papaconstantinou was that both of the men on the other side of the table liked what they heard. Stark and Rehn left persuaded by the finance minister that his nation had an aggressive plan for reforming its finances, as well as the political will to carry it out. The Greeks described plans to increase the nation’s value-added tax and step up tax collection, to freeze public pensions, and to eliminate the “fourteenth month’s salary” for government employees. Greek workers, in addition to monthly paychecks, received so-called thirteenth- and fourteenth-month’s checks to cover their holiday spending and summer vacations. Cutting one of them would be effectively slashing pay for those workers by 7 percent.

  “The effort is not easy, however the reduction of deficit and debt is necessary and will contribute significantly to the improvement of the economy,” Rehn told reporters. “The commission will continue to support the Greek authorities and the Greek people so that the economy will regain its viable course.” Stark, meanwhile, reported back to his colleagues in Frankfurt that Papaconstantinou was serious about budget cutting.

  Even as the urbane Papaconstantinou, with his dapper suits, rimless eyeglasses, and PhD from the London School of Economics, negotiated with European authorities, there were early signs of the strain that austerity would put on Greek politics. Three days after meeting with Stark and Rehn, about two hundred members of a union group affiliated with the Greek Communist Party stormed the finance ministry, draping a banner from its roof calling on workers to rise up against the proposed budget cuts.

  And the streets of Athens weren’t the only place where there was discontent. As discussion of a Greek bailout heated up, anger swelled in Germany as well. If Greeks hated the idea of losing their fourteenth paycheck or seeing their pensions cut, Germans hated nearly as much the idea of coming to the financial rescue of a country with such free-spending ways. In the pages of the Bild, a lowbrow, high-circulation tabloid, populist outrage at Greece turned alarmist and xenophobic. Its front-page headlines in the winter of 2010 included, “Is Greece making the German banks bankrupt?” and “Greeks quarrel and strike, instead of saving”—even “Sell your islands, you rotten Greeks, and the Acropolis too.
”

  Nonetheless, by March 2010, the pieces for a eurozone rescue of Greece were finally coming together. The morning of March 25, Trichet stepped before the European Parliament in Brussels to deliver his regular testimony about the state of the monetary union. “Sehr geehrter Herr Präsident,” he began in German, before moving to a few lines in French, then, for the bulk of his testimony, English. Near the end of the twenty-two-hundred-word presentation, he inserted a single sentence that sounded so obscure that many in attendance didn’t realize its significance: “It is the intention of the ECB’s Governing Council to keep the minimum credit threshold in the collateral framework at investment grade level (BBB−) beyond the end of 2010.”

  Translation: Even as Standard & Poor’s and Moody’s are downgrading their assessments of the creditworthiness of Greece and other European nations, we’ll allow banks to post Greek bonds as collateral at the ECB in exchange for ready access to cash. It was an explicit reversal from Trichet’s stated position of barely two months earlier; the ECB was willing to risk losses in order to keep cash flowing into Greece and prevent a fire sale if European banks suddenly started unloading Greek debt.

  It wasn’t Trichet’s only reversal. German chancellor Angela Merkel had by this point changed her mind on involving the IMF in a Greek bailout, having concluded that the fund could offer not only extra financial firepower and experience, but also credibility-enforcing “conditionality,” or demands for reform. Quite a few domestic critics, as well as French president Nicolas Sarkozy, thought her new position was an embarrassment—and that IMF involvement would give the United States, the fund’s largest shareholder, power over Europe.