Crashed

by Adam Tooze

  Merkel has come to be seen as the figurehead of Europe’s political center—oscillating between conservative stances on economic and financial policy and cultural modernization.16 When she first emerged on the political scene her profile was harder edged. In the 2005 election that brought her to power, Merkel ran on a strong promarket platform. It was unpopular and she subsequently softened her stance. But there is little doubt that the 2005 agenda expressed the chancellor’s basic personal vision. It can be summarized in three numbers: 7, 25 and 50. As Merkel is fond of pointing out, Europe has 7 percent of the world’s population and 25 percent of global GDP. But it is responsible for 50 percent of global social spending.17 This, as Merkel sees it, is not sustainable. Germany’s growth is steady, but slow at best. Germany’s population, along with that of much of Europe, is aging. What has to give is government spending. Fiscal consolidation is the deep continuity of Merkel’s administrations. As she announced in her first speech at Davos in January 2006: “To understand the social market economy as a NEW social market economy in the twenty-first century we must first of all reorder the priorities of politics toward an understanding of politics that is directed ahead, toward future generations. For us in Germany that means first of all clearing up our financial situation, our budgets. We have a demographic problem. We know that we have too few young people and nevertheless we live at the expense of the future by running up debts. That means that we rob future generations of their room for investment and development and that is immoral.”18

  Needless to say, this was music to the ears of business lobbyists concerned to see taxation and state spending held in check. But Angela Merkel’s first government was a grand coalition with the defeated SPD.19 Fiscal consolidation, like Hartz IV, commanded a consensus across the center ground of German politics. The finance ministry was claimed by Peer Steinbrück, an acolyte of the legendary SPD chancellor of the 1970s and 1980s, Helmut Schmidt.20 Steinbrück was profoundly committed to a supply-side, anti-Keynesian vision of economic policy. For him restoring “fiscal room” was not merely a matter of financial stability. The ossification of the government budget under the impact of quasi-automatic entitlement spending and interest payments was indicative of a broader problem affecting the developed world: the crisis of democratic politics and democratic participation. What choice could political parties offer to voters if the room for budgetary maneuver was restricted by “entitlement spending,” debt service and low tax rates to 1 percent of GDP one way or another? One could of course go the route of the Cheney wing of the Republicans and simply blow up the deficit. But if one was not willing to take that risk, one was forced into the center ground. In a proportional representation system like Germany’s, this led to disaffection among the voters and the splintering of the party political landscape, with the once-dominant CDU and SPD huddling together in the center. Merkel’s grand coalition was indicative of the impasse. It was not for nothing that “postdemocracy” became one of the buzzwords of German political discussion in the early 2000s.21 For Steinbrück, paradoxically, present-day discipline was a promise of freedom to come.

  Beyond these high-minded considerations, German fiscal strategy was also driven by more basic calculations of electoral advantage. Over the two decades since unification, West Germany had poured more than a trillion euros into reconstruction and regional subsidies for the East.22 In 2005–2006, as Merkel’s grand coalition took office, the mood in the western Länder, and particularly the rich southern states, was resentful. They had been conscripted into a gigantic act of solidarity with the East. Now they had had enough. Capping deficits was a not-so-covert promise to the rich southern states to rebalance priorities away from the needy and indebted eastern and northern members of the Bund. Fatefully for the future of the eurozone, the problem of fiscal control was cast by German politics already from the early 2000s as one of equity within a federal transfer union. Well before the Greek crisis broke, the most prosperous regions of West Germany had made clear their refusal to take responsibility for other people’s debts, German or otherwise. The argument that the debts “shouldered by the West” to pay for spending “in the East” had generated huge orders for West German business—in effect exports within Germany from West to East—cut no ice. After 2010 the same argument would cut no ice at the European level either. What the most influential voters and voices in German public opinion wanted was simple: discipline all around. In 2006 a commission was set up to devise a new federal fiscal settlement. The idea, following the Swiss example of 2001, was to adopt a “debt brake” to block any further expansion of debt at the Bund, Länder or Commune level. Hammering out the multilevel political deal was slow work. But Steinbrück and the Federal Ministry of Finance were sanguine. As the global economic horizon began to darken in 2007–2008, the German finance ministry was projecting a budget surplus by 2011.23

  Of course, national politics and the drama of reunification gave a particular hue to the German discussions. But there is no need to construct a new narrative of the peculiarities of German history, or to search for some particular German trauma that will explain Berlin’s newfound preoccupation with fiscal rectitude. In fact, there are striking similarities between the debates in Germany and those in Rubinite circles in the United States. On both sides of the Atlantic, globalization, competitiveness and fiscal sustainability were key issues. Nor should this be surprising. The rise of China and the funding problems of the modern welfare state were common challenges. The Bush administration might have been political poison in Europe. But in the late 1990s, Clinton’s Democrats had been an inspiration for Gerhard Schroeder’s Red-Green coalition.24 Merkel was nothing if not an Atlanticist. But if there was a common agenda, there were common blind spots too. For all the focus in the eurozone on the need to make labor responsive to the demands of global competition, for all the calls for common fiscal discipline, there was an almost total lack of recognition of the destabilizing forces unleashed by global finance. In Europe, as in the United States, it was politicians, workers and welfare recipients who were seen as the problem, not banks or financial markets.

  II

  If Europe did not have a common fiscal policy or labor market policy, it did at least have a common monetary policy. Its guardian was the ECB, headed from November 2003 by Jean-Claude Trichet.25 This was precisely the bargain that Mitterrand had hoped for: a Frenchman in charge of Europe’s money. But the other side of the bargain was that the ECB’s operational DNA came from the Bundesbank. And Trichet was perfectly suited to play this dual role. He was a deeply conservative former head of the Banque de France. The ECB’s independence was his highest value and he guarded it jealously. The ECB’s constitution provided plenty of safeguards. Its deliberations were shielded from public scrutiny by minimal transparency requirements. To prevent it from being put to work as a vehicle of fiscal policy, it was banned from monetizing newly issued government debt. Unlike the Fed, which had a dual mandate for price stability and maximum employment, the ECB had price stability as its only target.

  All this made the ECB the most remote of all the modern central banks.26 To call it apolitical would be a misnomer, because it, in fact, entrenched a conservative bias against inflation as the unquestionable doxa of Europe. Nor would it be fair to say that anti-inflation politics were the ECB’s only ambition. It also wanted to promote Europe as a financial center and the euro as a reserve currency, and that meant actively developing European debt markets. Specifically, it meant importing to Europe the American model of a repo market for government debt. Being able to repo government securities made them much more attractive as assets. This was a lesson that France had learned in the 1980s. Faced with the financial pressures exercised by Germany, France had actively promoted the market for its own debt by offering American-style repo facilities.27 The easier it was to trade French debt for instant liquidity, the more actively it would be purchased and the more accepting the market would be of France’s borrowing requirements. Ove
r the resistance of the Bundesbank, repo was adopted as a core operational model by the ECB. Unlike the more traditional central banks, like the Bank of England or the Fed, the ECB did not hold large quantities of government debt. It managed Europe’s financial system by repoing a wide range of bonds including both private debt and public bonds.28 Rather than the ECB, it was Europe’s banks that bought their governments’ debt. But they did so with the understanding that if they needed cash in a hurry, the bonds could be exchanged with the ECB on a repurchase basis. The terms of the repo and the size of the ECB haircut were the basic regulating variables in the unified financial system of the eurozone. In this respect, market logic was internal to the operation of the ECB to a degree that was not the case at either the Fed or the Bank of England.

  If it had wished to maximize pressure on Europe’s government to preserve fiscal discipline, the ECB could have adopted a discriminatory system of nationally specific repo haircuts, imposing tougher conditions on less credible peripheral eurozone borrowers. Haircuts in the bilateral repo market in the United States varied widely across different types of bonds. A higher haircut would require banks to hold more capital against their bond holdings and shrink their portfolios of that debt. In Europe in the late 1990s, Greece had had to offer far higher interest rates to attract lenders than had Germany. But instead of discriminating, the ECB took the view that a single currency implied a single rate. It would repo the bonds of all European sovereigns on the same terms.29 Unsurprisingly, this produced a dramatic convergence of yields as investors bid up the price of higher-yielding debts from countries like Greece, Italy, Portugal and Spain, which in the eyes of the ECB were now equivalent to Bunds, Germany’s rock-solid government bonds. The result was a self-reflexive loop in which the ECB relied on markets to exercise discipline over public borrowers while the markets came to assume that the ECB’s “one bond” policy implied an implicit European guarantee for even the weakest borrowers.

  The result was that Greece and Portugal could borrow on terms that were better than ever before in their history, and one might have expected this to produce a huge surge in new public borrowing. Reading some commentary on the eurozone crisis, one might imagine that this was indeed what happened.30 But, despite the unprecedentedly low interest rates, there was, in fact, no public debt boom after 2001. Certain countries borrowed more than others. But overall, the Maastricht rules limiting deficits exercised an effective restraint, especially when one considers the inducement to borrow provided by the convergence of yields. Despite the profound ambiguity of the institutional structure, the sense of calm was preserved by the fact that no major public borrower was grossly abusing the situation. Indeed, as economic growth moved into a higher gear, the ratio of public debt to GDP across the eurozone fell by 7 percent.31

  The countries that failed to meet the eurozone’s budget rules were a mixed bag. Portugal had the most rapidly rising public debt ratio and its budgeting was undeniably lax. But when it joined the euro, its debt was at a low level. Unfortunately, Lisbon made the mistake of entering at an uncompetitive exchange rate. The sharp deterioration in the debt-to-GDP ratio that followed was due as much to a deceleration in growth as it was to irresponsible borrowing.32 Greece was the other reprobate. In the 1990s, to qualify for eurozone membership, Greece, like Italy, had eked out primary surpluses (on the budget excluding debt service). Even with interest costs running at 11.5 percent of GDP, this had held the deficit in check. After the formation of the eurozone, Greek borrowing costs and debt service charges fell by more than half. It could have been the opportunity for a substantial fiscal consolidation. Instead, Athens let its tax revenue decline. The primary surpluses evaporated and the deficit expanded to 5.5 percent, twice the Maastricht limit. This was bearable only because nominal income growth was so rapid.33 What made Greece’s situation dangerous, however, was not the pace of borrowing after 2001 but the debts built up in the 1980s and 1990s, when modern Greek democracy had been established on the back of a huge surge in government spending and expensive borrowing.34 In 2000 Greece’s debt already amounted to 104 percent of GDP.

  Though the degree of Greece’s problems was not fully appreciated, it was a known problem case and it was small fry. More politically significant in the early 2000s was the violation of the Growth and Stability Pact rules by France and Germany. This definitely eroded the authority of fiscal discipline. But what were the economic consequences? There was ample demand in financial markets for German Bunds and France’s Treasurys, also known as OATs. Interest rates remained low. France maintained a level trade balance. Germany’s government ran up debt, but combined it with consumer and investment spending so repressed that it produced an ever-larger current account surplus. From the point of view of the eurozone’s macroeconomic balance, it would have been better if Germany had broken the fiscal rules more comprehensively.

  It may fly in the face of conservative assumptions about “democratic deficits” and the spendthrift habits of irresponsible politicians, but the formation of the eurozone without an ironclad fiscal constitution did not lead to a festival of unrestrained sovereign borrowing. The backdrop to the eurozone crisis was, indeed, a gigantic surge in debt, but it was in the private, not the public, sector. The eurozone played host to the same runaway, market-driven process of credit creation that European banks were contributing to so actively in the North Atlantic economy.

  Growth in Private and Public Debt in the Eurozone, 2000-2009 (year-on-year)

  Source: Richard Baldwin and Daniel Gros, “The Euro in Crisis: What to Do?,” in Completing the Eurozone Rescue: What More Needs to Be Done (2010), 1–24, figure 3, http://voxeu.org/sites/default/files/file/Eurozone_Rescue.pdf.

  III

  As the Financial Times’s economic commentator Martin Sandbu has remarked, it was the euro’s “great misfortune” to be born “into the greatest private credit bubble of all time.”35 To which one might add that it was not entirely a matter of bad luck. Giving Europe the scale necessary to cope with the wild fluctuations of global capital unleashed in the early 1970s was always the chief raison d’être of the European Monetary Union. But the global credit expansion of the early 2000s put anything hitherto experienced in the shade, and Europe’s banks were at the leading edge of the boom. French, German, Italian, Benelux, Spanish, Irish and British banks poured credit into profitable hot spots of growth. The eurozone allowed them to do so without regard to borders or currency risk. Cross-border lending within the eurozone exploded, rising even more rapidly than cross-border finance globally.36 Europe’s bankers used the same array of modern banking techniques in the eurozone that they were putting to such profitable use in London and New York. Securitization had long been a method of mortgage finance in Europe. Notably in Germany, the Pfandbrief model had been a staple since the eighteenth century. But from the early 2000s, American-style securitization took off in Europe as well. In 2007 more than $500 billion in loans were securitized in Europe. In 2008 the total reached $750 billion in European asset-backed security issuance with UK and Spanish banks particularly active.37

  Once again, as in the case of America’s international finances, it is easy to deceive oneself about the direction of these intra-European flows. We have a clear map of the economic hierarchy of Europe in our heads. We know where the loans went—Greece, Spain, Ireland. We know that Germany was the main “surplus” and “creditor” nation. So does that mean that Germany financed the credit boom? Certainly it had the largest trade surplus and was thus the largest net exporter of capital. But as far as overall financial flows within Europe are concerned, that simple mental map is as misleading as the exclusive focus on Sino-American financial relations is on a global scale.

  Thanks to the work of economists at the European Commission, we can map the flow of funds within Europe as part of the broader circulation of funds throughout the world economy. In the bottom right-hand quadrant of the following table, we see the outline of th
e world economy that we have mapped in previous chapters. But if we focus on intra-European flows, it is clear that Germany, despite its export prowess, did not dominate the European financial system. Germany was the largest net lender. Its status was like that of China in relation to the US economy. But financial flows within Europe no more mapped onto trade than they did in the world economy. Germany was a champion exporter of cars and machinery, but in banking and finance others led the field. The UK, France, the Benelux and Ireland (the latter hidden within the category “Rest of Euro area”) were the key hubs for financial flows. The City of London, home to banks from around the world, including all the leading German banks, stands out as the major financial partner for every eurozone member, even though it was not a member of the currency union. France and the Benelux were particularly important because they served as channels through which funds flowed into the eurozone from the outside. American and other lenders from the rest of the world clearly preferred to do business with well-known French, Dutch and Belgian counterparties, who then channeled the funds to the European periphery. France was a major financial hub, not because it had a huge trade surplus but because it had large, ambitious banks that were willing to borrow to lend: 445 billion euros flowed out of France and 447 billion flowed in, leaving a net imbalance of merely 2 billion euros. At the same time, 602 billion euros flowed out of the Benelux banking centers and 559 billion flowed in. The Dutch trade surplus made up the difference.