The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  Italy, and to a lesser degree Spain, was seeing the exact sequence of events that had led Greece and then Ireland and then Portugal to require a rescue—except that now it wasn’t at all clear whether a rescue would even be possible. According to calculations by economist and journalist Carlo Bastasin, if France and Germany had to offer backing to Italy on the same scale relative to its debt levels as they had for Greece, Portugal, and Ireland, they would increase their own debt-to-GDP ratios by 23 to 25 percentage points, suddenly putting their own creditworthiness in question. Italy, which was actually running quite small annual deficits but had accumulated a large total debt, needed to find a way out of its problems on its own, or the whole continent could be in trouble.

  Making conditions worse on global markets, at the end of July and start of August the United States was in the midst of a standoff between the Obama administration and Republicans in the House of Representatives over raising the nation’s debt limit. Failure to do so could have meant that the United States, whose bonds are the bedrock of the global financial system, would begin defaulting on its debt. An accord wasn’t reached until July 31, only two or three days from potential suspension of debt payments. On August 5, Standard & Poor’s downgraded the U.S. government’s credit rating from AAA to AA+, citing political gamesmanship in the wealthiest nation on the planet.

  Trichet, speaking with Tim Geithner, said at one point that “this is two thirds our fault and one third your fault.” All global markets were moving together. On days when investors could see no end to the megacrisis, they sold off U.S. and European stocks, Spanish and Italian bonds, and futures in oil and other commodities. On days when they believed that global policymakers were starting to get their arms around the problem, they bought those assets and sold off what were considered safer but lower-yielding investments: German and U.S. government debt and currencies like the Japanese yen and the Swiss franc.

  Trichet’s gambit of ending bond buying and hiking interest rates to force European leaders to act had worked. But suddenly, the very scenario that eurozone crisis fighters had spent two years trying to avoid was starting to materialize, with the panic pivoting to the major economies of Europe and seemingly at risk of getting beyond the capacity of policymakers to solve. The ECB president had just three more months in office, and the whole thing was threatening to spiral out of control. It was time for more decisive action. The alternative—sitting and waiting—seemed to risk the whole European experiment’s unraveling, a risk that Trichet could not abide.

  At its meeting on Thursday, August 4, the Governing Council decided to reactivate its old Securities Markets Programme, which had been dormant since the spring, and once again go into the market and buy bonds directly. Trichet played it cagey. In his press conference that afternoon, when Brian Blackstone of the Wall Street Journal asked if the bank would resume buying bonds, Trichet replied, “You will see what happens. I would not be surprised if, before the end of this press conference, you would see something in the market. Don’t exclude that.” Another reporter, apparently having received an e-mail from a colleague or a source, asked, “Mr. Trichet, traders are telling us at the moment that the ECB is on the market for Southern European bonds. Can you confirm or comment on that action?” The president replied, with a bit of a grin, “I commented in advance it seems to me. Thank you very much indeed.”

  Next question, please.

  The markets tanked that day. The ECB, it turned out, had only resumed purchases of Irish and Portuguese bonds, not expanded its program to Italy and Spain. It was an action that didn’t seem commensurate with the size of the problem, and the coyness out of Frankfurt had sent a puzzling message. Was Trichet really prepared to do whatever it took to stop the panic enveloping Europe? And if he was, what would he demand in return?

  The pressure was on Trichet from all sides. Merkel, Sarkozy, and other European political leaders wanted the ECB to come into the market on a grander scale to ease the pressure on Italy and Spain before it was too late. So did the Americans and the British and Christine Lagarde at the IMF. All argued the case for bond buying privately and delicately, given the tradition that the central bank must make its decisions independently and free of political influence. On the other side were German members of the Governing Council—Jürgen Stark of the ECB Executive Board and Jens Weidmann, who had replaced Axel Weber as head of the Bundesbank—as well as some like-minded leaders of other national central banks. The old debate from May 2010, of principle versus pragmatism, of whether to violate the spirit of the Maastricht Treaty by buying bonds in order to save the eurozone, was back.

  There may not have been the resources or the will to put in place a full-scale troika bailout program for the third and fourth largest eurozone economies. But Trichet, the seasoned fighter of economic crises, saw the need to get ahead of the problem—just as much as Trichet the wily strategist of European unity saw the need to attach strings to any promises of help. The day after the Governing Council meeting, August 5, Trichet sent secret letters to the prime ministers of Italy and Spain spelling out what they needed to do to regain the confidence of markets, with the none too subtle implication that if they agreed to the plan described, the ECB would come in and buy bonds to ease the market pressure on them. The Italian letter, addressed to Prime Minister Silvio Berlusconi and signed by Trichet and Mario Draghi in the latter’s capacity as head of the Banca d’Italia, laid out in 720 words of English the entire policy agenda that the ECB expected Berlusconi to carry out as the price of receiving the central bank’s help. It all boiled down to making the sclerotic Italian labor market better able to adjust to economic realities.

  “The full liberalisation of local public services and of professional services is needed,” the letter said—and that included “large-scale privatizations.” It also demanded “further reform [of] the collective wage bargaining system” that would allow employers to tailor wages and jobs to their needs more easily, as well as changes to the rules on hiring and firing of workers that would allow Italy to achieve smoother “reallocation of resources towards the more competitive firms and sectors.” Other demands included laws to enforce deficit reduction plans. It was all to be ratified by the Italian parliament by the end of September. “We trust that the Government will take all the appropriate actions,” wrote Trichet and Draghi.

  The letter was received with anger by Berlusconi’s government. Officials viewed it as one more volley in the long battle between the technocrats who kept the country running and elected leaders. Berlusconi’s allies saw the Banca d’Italia as a left-wing, pro-union organization and the letter as primarily written by Draghi. It was an odd reading of the situation, given that much of what the letter demanded was anathema to Italian unions. Central-bank sources say the letter was drafted by Trichet and the ECB, with Draghi and the Banca d’Italia suggesting only modest changes; when they needed help most, Berlusconi’s government was grumbling over the details.

  The contempt with which Berlusconi’s government held its marching orders from the central bankers would have lasting consequences, but the prime minister and Finance Minister Giulio Tremonti saw little choice but to acquiesce. Berlusconi called a press conference and pledged to accelerate deficit reduction and institute other changes to make Italy more competitive. It lifted global markets nicely.

  The press conference was a public acceptance of the terms spelled out in the secret letter. Trichet also received private assurances from the Italian government, though given Berlusconi’s track record of bombast and unreliability, they didn’t count for much in the eyes of ECB officials. “There was private communication, but what counted was what was said publicly,” said one senior official who was involved with the confidential communiqué. “You can trust only the public commitment.”

  It was about six weeks before a Milan newspaper, Corriere della Sera, got hold of the Italian letter. The text of the message from Trichet and Banco de España governor Mig
uel Angel Fernandez Ordóñez to Prime Minister José Luis Zapatero never even leaked. Spain, it seemed, was ready to accept its lot. The deeply unpopular Zapatero had already acknowledged that his Spanish Socialist Workers’ Party was done for if he remained at its head and had called for early elections, saying he would step down. Unlike Berlusconi, ever attuned to his own political survival, Zapatero agreed to the ECB recommendations without protest.

  With both Italy and Spain having accepted Trichet’s conditions, the Governing Council met again on the afternoon of Sunday, August 7. The six members of the Executive Board gathered in Trichet’s office on the thirty-fifth floor of the Eurotower in Frankfurt. Others dialed in from their respective capitals or whatever vacation retreats they had made their way to in the three days since their last meeting. Trichet marshaled his arguments: that they had to act to keep the situation from spiraling out of control, that they were merely ensuring their ability to guide monetary policy by keeping different countries’ interest rates from getting too far out of whack, that he had pledges from Spain and Italy to undertake reforms and from France and Germany to ramp up the European Financial Stability Facility more quickly. Merkel and Sarkozy put out a joint statement as the ECB was meeting, pledging their commitment to finish setting up a structure for the EFSF so that, they strongly implied, it could take over bond-buying responsibilities from the central bank.

  The skeptics on the Governing Council weren’t having it. They just saw the ECB abandoning principle yet again and putting its resources at risk to help profligate countries. Jürgen Stark was the most vocal dissenter. He had been even more staunchly opposed to the bond purchases of a year earlier than his fellow German Axel Weber, but he had been more discreet publicly, never making his disagreement known to the world. But Stark was furious that the ECB was set to double down on what he saw as a mistake. He viewed the letters to the Spanish and Italian governments as the ECB going far beyond its mandate, inappropriately setting up the central bank as a European version of the IMF and violating all norms of democratic legitimacy and central-bank independence. After all, if buying Italian and Spanish bonds is monetary policy, then it should be carried out regardless of what those governments did or didn’t agree to. If it’s fiscal policy, then it isn’t the job of the ECB and should be undertaken by the European Commission and the IMF. Stark was vocal and direct, and while he didn’t threaten to go public with his objections the way Weber had, some fellow Governing Council members thought it unlikely that Stark would stay at the ECB much longer if he lost on this issue.

  After about four hours of deliberation, Trichet held the vote. Stark, Bundesbank president Weidmann, and the heads of the central banks of the Netherlands and Luxembourg held fast—and were soundly outvoted. The next morning, the ECB for the first time started buying up Italian and Spanish bonds. It was enough to push the nations’ borrowing costs down by 0.8 and 0.9 percentage points, respectively.

  At first, Italy seemed to live up to the budget-cutting and liberalization policies it had agreed to as part of the implicit deal to get bond market relief from the ECB. On August 12, Berlusconi’s cabinet agreed to €45 billion in budget cuts that put it on track for a balanced budget by 2013. The package included higher taxes on the affluent, with a 5 percent income tax surcharge on those making more than €90,000 a year, and called for municipalities to cut back on local government expenses. With typical grandiosity, Berlusconi that day blamed Italy’s dire financial situation on its earlier participation in the Greek bailout. “Our hearts pour with blood if we think that our point of pride was that we had not put our hands in the pockets of Italians,” the prime minister said. “But the global situation has changed and we are facing a planetary challenge.”

  Soon, Italian tax collectors, stealing a strategy from the Greeks, were noting the registration numbers of Ferraris and Maseratis and checking to see if their owners claimed an implausibly low annual income. “Here’s the real problem with Italy,” a member of the Italian parliament told the Washington Post. “You have people with villas and back yards the size of a park still declaring 15,000 euros a year.”

  But just three weeks later, Berlusconi backed off under pressure from members of parliament, dropping the tax surcharge on those making €90,000. But the ECB wasn’t without power as the Italian government seemed to be losing resolve. The yield on ten-year Italian debt reached a low of 4.32 percent in mid-August, as the ECB bought a total of €22 billion in bonds its first week in the market and €14 billion the second. But as word that Berlusconi was balking made its way from Rome, Trichet throttled back on bond purchases. The third week, the central bank bought only €5 billion in bonds, almost all certainly Spanish issues rather than Italian. Italian ten-year bond yields rose to 4.92 percent in early September. It was a strange game in which traders in Frankfurt were using their purchases to reward the Berlusconi government when it behaved and punish it when it didn’t. Monsieur Trichet giveth, and Monsieur Trichet taketh away.

  “Who do I call if I want to call Europe?” That line, frequently attributed to Henry Kissinger (though he doesn’t think he said it), reflects the frustration of American and other global officials over having no single point of contact in Western Europe, no one person who can act with authority and decisiveness on behalf of a continent with dozens of countries and languages. But by August 2011, that had changed. There was a centralized authority in Europe—a man with a French accent who worked in Frankfurt, who used his bottomless supply of euros to direct the actions of prime ministers and parliaments across the continent. As one analyst said to Bloomberg News that month, “Trichet has become the de facto president of Europe.”

  But as would soon become all too clear, there are limits on what even a president can do.

  September and October 2011 were unproductive months for European unity. Berlusconi, amid his gamesmanship with the ECB and the looming possibility of indictment for corruption, was a joke. The Spanish government was in flux in the run-up to elections. Markets swung wildly in response to the latest rumor or announcement.

  Jürgen Stark, after he had lost the argument over new ECB bond purchases in early August, had begun quietly laying the groundwork for his exit. To avoid roiling markets, he wanted to ensure that Merkel and the German government had time to line up a replacement on the Executive Board. Technically, there was no seat officially reserved for Germany, but it was unthinkable that the six-member board could have no representative from the continent’s largest economy. Stark announced his resignation on September 9. Although the ECB’s official statement said he was leaving “for personal reasons,” anyone close to Stark knew that those personal reasons were that he thought the ECB’s massive purchases of Italian and Spanish bonds were feckless and violated the central bank’s rules.

  The markets went into a yet another tailspin that day amid fears of a divided ECB. “It’s a very bad sign,” said an analyst quoted by the International Herald Tribune. “It means that the split within the E.C.B. that we thought was far down the road is here now.” But the commentary that day missed the real lesson of Stark’s resignation. It was quickly leaked that Merkel sought to replace Stark with a close aide of hers, German finance ministry official Jörg Asmussen. Earlier in the year, she had picked Jens Weidmann, another close adviser, to replace Axel Weber as Bundesbank chief. What the two choices had in common was that they didn’t represent the hard-line, by-the-book approach traditionally favored by the Bundesbank.

  Merkel could have chosen for either job a Bundesbank insider, like Andreas Dombret, its financial stability chief, or any of several hard-money German academics. Instead, she went with economic experts of a more political bent, those who might be expected to show greater flexibility about doing whatever was needed to preserve the eurozone—in the process relieving some of the pressure on Merkel and the German government to shoulder the burden of rescuing Europe. (Weidmann ended up hewing more to the traditional Bundesbank view of things once in
office, opposing a reopening of the ECB’s bond-purchasing program. But ex-ante he had seemed more inclined to support bailout actions than Weber had been.) Stark’s departure was indeed a reflection of a divide within the ECB. But his exit meant the divide was becoming less severe, not more.

  The ECB’s bond purchases had been buying time, but the governments of Europe still needed to create some lasting, secure structure through which they could stand ready to assist one another. The French remained inclined toward “eurobonds,” by which debt would be issued by and guaranteed by the eurozone nations collectively, much as U.S. government debt is guaranteed not just by California or New York but the nation as a whole. That was attractive to the countries facing trouble, but it was viewed unfavorably by Germany and the other creditor nations, which didn’t want to be formally put on the hook for the perceived profligacy of the debtors. They would begin to consider such an arrangement only if the nations of Europe gave up a great deal of power over their tax and spending policies to centralized authorities in Brussels.

  But that, of course, would mean asking European nations to cede much of what makes them sovereign. And it would even have violated a September 7 ruling of the German Constitutional Court, which often circumscribed Merkel’s maneuvering during negotiations over a permanent European stability mechanism. On this occasion, it said that the German government couldn’t hand over its power to a central European authority without a treaty governing the arrangement.

  There were other, more exotic possibilities floated, such as giving the European Financial Stability Facility a banking license, allowing it to issue bonds on its own and use its resources to buy up European countries’ debt as necessary. Trichet hated this idea because it would mean giving the fund access to the ECB’s lender-of-last-resort programs, essentially using ECB resources to support individual governments. Tim Geithner argued that the Europeans needed to find a way to place the potentially massive resources of the ECB behind its government rescue fund, much as the Americans had combined the resources of the Treasury and Fed in their rescue of the financial system in 2008. That too struck Trichet as a violation of the spirit of the Maastricht Treaty.