Crashed
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At the G20 in Toronto in June 2010 the scene was set for another round in the transatlantic argument over fiscal policy. Ahead of the meeting Obama published an open letter calling for fiscal consolidation to be staggered so as to avoid jeopardizing recovery.39 Schäuble took to the pages of the Financial Times to defend his country’s distinctive long-term approach to economic policy against US short-termism. He championed the debt brake as a stability anchor for Europe.40 He had the backing of Prime Minister Cameron as well as that of the Canadian hosts. At the insistence of the Obama administration the final text of the G20 communiqué referred to the need to sequence fiscal consolidation so that “the momentum of private sector recovery” was not jeopardized.41 But this was trumped by demands for fiscal consolidation.42 After the worst economic crisis since the 1930s, at a time when, according to the OECD, 47 million people were unemployed across the rich world, and the total figure for underemployed and discouraged workers was closer to 80 million, the members of the G20 committed themselves to simultaneously halving their deficits over the next three years.43 It was the householder fallacy expanded to the global scale. It was a recipe for an agonizingly protracted and incomplete recovery.
Total Government Expenditures in Real Terms: Eurozone and US, 2005Q1 to 2014Q2=Q3
Note: Eurostat for Europe, downloaded November 29, 2014. Eurozone Government Expenditures are for the 18 countries that make up the current membership in the eurozone.
Sources: BEA for US, downloaded November 29, 2014.
For Germany even that was not enough. The lesson that Berlin drew from the Greek crisis was that the eurozone’s Stability and Growth Pact had failed. Germany, or rather the Red-Green coalition that had ruled Germany back in 2003, had to accept a measure of responsibility. Now, with Merkel and Schäuble at the helm, Berlin would take the lead in rededicating the eurozone to self-discipline. This was vital not only to restore economic health. It was essential for the politics of the eurozone. The Greek crisis had shown that Europe’s governments would have to work together. Federalists like Schäuble still insisted that the ultimate answer to the crisis would be “more Europe.” But for that to be acceptable to the taxpayers of Northern Europe, they had to be reassured that everyone was playing by the same rules.
As the crisis in the eurozone gathered in intensity and Germany’s pivotal role became ever more pronounced, the rhetoric became more heated. Protesters waved placards showing Merkel’s face graffitied with a Hitler mustache. This was not only offensive and grotesquely unfair. It also represented a fundamental misunderstanding of Germany’s position. When it was accused of imperialism, the German political class could honestly reply that it did not harbor ambitions for continental domination. But Berlin did have a vision of economic and fiscal discipline, which had to be generally accepted before Germany would consent to any further steps toward integration.44 For reasons of global competitiveness it was essential that government spending and debt be brought under control. Europe’s demographic pressures made the case only more urgent. As for labor markets and unemployment, the rest of Europe had to learn the lessons of Germany’s Hartz IV reforms. When Keynesians worried about domestic demand, the German answer was exports. An aging continent should be exporting to the world and building up a nest egg of financial claims on the fast-growing emerging markets. On this, Merkel’s new coalition with her probusiness FDP partners was clearer than ever. Germany had passed a constitutional amendment in the form of the debt brake. If Germany was to agree to pool financial liabilities with the rest of the eurozone, it must insist on nothing less from its partners. Prosperous as they were and as much as they benefited from European integration, taxpayers and voters in the CDU heartlands would simply not accept the transformation of the EU into a continental “transfer union.” It was only if the rest of Europe could guarantee conformity to a common set of rules that Berlin could contemplate pooling sovereignty. The problem was that those rules had to be decided, upheld and imposed. And that is where things got uncomfortable.
Over the summer of 2010, rival plans for a new regime of European economic governance were being prepared by teams working separately for President Barroso of the EU Commission and Herman Van Rompuy, the first permanent head of the European Council, a position created by the Lisbon Treaty and designed to reinforce the intergovernmental character of EU decision making.45 Berlin’s ultimate goal was to have constitutional debt brake provisions like the one it had passed in 2009 written into law for all the eurozone members. Those deviating from the rules would be subject to an automatic system of sanctions, including the suspension of voting rights. For those in real financial trouble the sanctions would be even more severe. As Trichet put it, “[W]hen you activate a support mechanism, a country loses de jure or de facto its fiscal autonomy.”46 France, for its part, resisted automatic sanctions. Not surprisingly, smaller countries that had reason to fear that the rules might be applied more strictly to them opposed any talk of the suspension of voting rights.
These were weighty issues for Europe’s future. But how did they relate to the short-term question of financial stabilization? By the summer it was already clear that the fix devised to contain the Greek crisis in May 2010 was not sustainable. The worst fears of the more pessimistic IMF analysts were rapidly being confirmed. Not only was the PASOK government slow to push through the changes the troika demanded, but when it did, the results were counterproductive. In a classic Keynesian downward spiral, demand fell and unemployment surged further, reducing incomes. In 2010 Greek GDP would fall by 4.5 percent. Worse would follow in 2011.47 The tax revenues flowing to Athens, which even at the best of times were hardly ample, slowed to a trickle as wages, profits and consumer spending contracted. The May 2010 program had been premised on the assumption that Greece would be able to return to capital markets within two years. But with the deficit expanding and its debt burden rising, there was little chance of that. By the end of August 2010 the yield spread of the Greek ten-year bond relative to Bunds had surged to 937 points, higher than it had been even at the height of the spring crisis.48 And yet in the face of failure, the troika remained committed to holding Greece to the May 2010 program.
If there was any justification for the protracted torture of Greece, it was the fear that an immediate debt restructuring would unleash contagion to other sovereign debtors across the eurozone and destabilize Europe’s banks, thus causing a far wider crisis. So the immediate priority for European economic policy ought to have been to use the time bought by extend-and-pretend to strengthen the resilience of the eurozone financial system and the health of the banks. If one were to follow the American example, the obvious next step was to conduct a stress test to estimate likely losses, and then to carry out an energetic recapitalization with either public or private funds.
Both in 2009 and 2010 the Europeans conducted stress tests of a sort. The 2010 exercise went further than that in 2009 in naming individual banks. But it too was a farce. The results published on July 23, 2010, proclaimed that of ninety-one leading European banks, only seven would see their primary Tier 1 capital reduced to dangerous levels by a sovereign bond crisis.49 In total the Committee of European Banking Supervisors estimated that Europe’s banks needed to raise no more than 3.5 billion euros in new capital. But, as was pointed out by skeptical analysts, this optimistic result depended on assuming that the vast majority of the sovereign debt held by banks, had zero risk of default, or was fully protected by the EU’s financial stability facility.50 According to the reckoning of the OECD, on less rosy assumptions the potential loss to Europe’s banks from a peripheral bond crisis was not the 26.4 billion euros allowed for by the official results, but 165 billion euros. These losses would be concentrated in the national banking systems of the vulnerable countries—Greece, Ireland, Portugal and Spain. They would suffer catastrophic damage. If the crisis were to spread to Spain or Italy, that would put both the German and the French banking systems in j
eopardy. As always, the most serious risks were concentrated in the balance sheets of a few dangerous banks. Dexia and Fortis were at the top of the list, as was Germany’s troubled Hypo Real Estate. According to the OECD, Hypo’s capitalization was so inadequate that a sovereign debt crisis in any one of Italy, Spain, Ireland or Greece would put its survival in question.
The European institutions did not have the authority to intervene in national banking policy. The funds for recapitalization that had been created in 2008–2009 were spotty and facultative rather than mandatory in their application.51 National governments were too complacent and unwilling to disturb the comfortable status quo. Instead, Europe engaged in a double pretense. The troika went on pretending that Greek debt was sustainable, if only Athens adopted enough austerity. This was not true, as was becoming evident month by month: Greece was simply being driven into the ground. Meanwhile, the stress tests purported to show that Europe’s banks were robust, which they clearly were not. Indeed, their weakness ought to have been the best argument for refusing to risk Greek restructuring. This, however, was not an argument that the ECB could make out loud, for fear of triggering panic. Furthermore, it would have necessitated serious action on the recapitalization front, which both the banks and the national governments resisted. Caught in this double bind, the troika was reduced to pretending that all was well on every front. Meanwhile, in Greece unemployment rose from a low of 8 percent in the summer of 2008 to more than 12 percent in 2010. For young people it was already more than 30 percent.
If the Greeks were the victims of extend-and-pretend, who were the beneficiaries? Billions of euros from the first tranche of the May 2010 program were disbursed to Athens, which in turn paid them to its creditors. Those who were lucky enough to hold debt expiring in 2010 or 2011 were paid on time and in full. Those banks that decided to cut their losses and sell out could find buyers among the hedge funds who picked up debt for as little as 36 cents on the euro, gambling that things could only get better and that in the worst case they would get some cut of a final settlement.52 French and Dutch banks seem to have been most active in breaching the informal embargo on Greek bond sales. French bank holdings of Greek debt fell between March and December 2010 from $27 billion to $15 billion, Dutch from $22.9 billion to $7.7 billion.53 But the flight out of Greek bonds did not extend to the entire periphery. As they sold off Greek and Irish bonds, Europe’s banks chased yield by rotating their money into Spanish and Italian bonds.54 In general one might have expected European banks with an interest in their own survival and prosperity to be energetically recapitalizing and reorienting their businesses for a future beyond the crisis. But there was little sign of that. Whereas America’s big banks operated under the discipline of annual “capital plans” and were required to retain whatever profit they didn’t distribute as bonuses so as to rebuild reserves, Europe’s banks were free to do as they saw fit. In a desperate effort to keep their shareholders happy, they paid out what little profit they earned in dividends in the hope that at some point in the future they would be able to raise new capital.55 But that moment was not now.
III
In the Greek case the question of restructuring debt and forcing the banks to recognize losses had been kept off the agenda. But Ireland forced it back into play. Astonishingly, in the summer of 2010 all of Ireland’s banks were passed as fit by the European stress tests, even Anglo Irish Bank, the most notorious basket case of 2008. At that point Irish bank borrowing from special ECB facilities already came to 60 billion euros and the entire Irish banking system was only weeks away from a “funding cliff,” when the government guarantee issued in September 2008 would expire and they would lose all access to funding markets. Thereafter they would be entirely dependent on the Irish central bank and the ECB. On September 30 the Irish government announced that, given its obligation to backstop the banks, in 2010 Ireland’s public borrowing requirement would surge from 14 percent to a jaw-dropping 32 percent of GDP. This would take Ireland’s public debt from a modest 25 percent of GDP in 2007 to 98.6 percent in 2010. The Irish government, once a paragon of austere public finance, was forced to withdraw from the bond market.56
If Ireland were to continue to honor the entire debt burden of its banks, owed in large part to foreign investors, the impact would be harrowing. Since the onset of the crisis in 2008, Irish incomes had been subject to emergency levies, young people’s job-seeker allowances had been slashed, health benefits for those over seventy were means-tested, public sector pay was cut between 5 and 10 percent, welfare recipients saw cuts of 4 percent and child benefits were reduced.57 The bank bailout costs announced in September implied further cuts and tax increases. Informally, with the assistance of the IMF, Dublin began exploring its options.58 A vocal faction within the IMF had never reconciled themselves to their retreat over Greek debt restructuring. Ireland presented an opportunity to bail in the investors who had profited from Ireland’s financial boom. If only the creditors of the most troubled Anglo Irish Bank took a haircut, the savings were estimated at 2.4 billion euros. If investors in all four of the protected banks were haircut, the budgetary relief might amount to as much as 12.5 billion euros. In relation to total tax revenue of 32 billion euros, these were huge savings. The position of the ECB was well known by this point. It would fight restructuring to the last ditch. But what would be the position of the rest of the eurozone? German public opinion was running ever hotter against any further eurozone programs that did not require the banks and their investors to contribute.59
On October 18, 2010, Sarkozy and Merkel were hosting President Medvedev of Russia at the Norman seaside resort town of Deauville. Somewhat to the alarm of Washington, the announced agenda of their meeting was to discuss future areas of cooperation for foreign policy, notably in the Middle East.60 The news from Deauville would make headlines. But it was not the Atlantic alliance that was at stake. It was the eurozone. Without consulting with their eurozone partners, the ECB or the United States, Merkel and Sarkozy—soon to be dubbed “Merkozy”—hammered out a new agenda. It consisted of a blend of French and German ideas. The Stability and Growth Pact first agreed in 1997 would be reinforced with German-style constitutional debt brake rules. But the French got Germany to agree that when it came to disciplinary measures there must be an element of political discretion. Sanctions would be triggered only by a qualified majority vote in cases where governments ran deficits greater than 3 percent of GDP or debts in excess of 60 percent of GDP. Sanctions would be tough—up to and including deprivation of voting rights. But discipline was not all. There would also be an institutionalized version of the European Financial Stability Facility, which would be put on a solid legal footing by 2013 at the latest, by way of treaty change. It would provide emergency loans to any eurozone member in trouble. But there would be no repeat of the Greek deal. Merkel and Sarkozy agreed that as of 2013, in any future crisis, creditors would be bailed in. It would not just be taxpayers who put up new funds. Haircutting the creditors would help to bring debts down. It was equitable. And it would serve a useful disciplining function. Creditors would take their responsibilities more seriously if they knew that they had skin in the game. The package was announced without forewarning in a press release late in the afternoon of October 18, 2010.
To say that Deauville came as a shock would be an understatement. France and Germany had acted alone. It smacked of the old days, of the Europe of the Six, not the new Europe of the post–cold war era. Not only had they acted alone but they had addressed what everyone knew was the hot-button issue of the crisis—PSI and debt restructuring—unilaterally and without preparing either the markets or their partners. For Trichet it was a disaster. The unspeakable contingency of restructuring had been blurted out in public. When the news of Merkel and Sarkozy’s deal reached Luxembourg, where the finance ministers were meeting, the president of the ECB was incandescent. “You’re going to destroy the euro,” Trichet shouted across the conference table at the French
delegation. Ten days later Trichet confronted Sarkozy face-to-face. “You don’t realize how serious the situation is,” he belabored the French president, only for Sarkozy to snap back: “Maybe you’re talking to bankers. . . . We are responsible to citizens.”61 Trichet might have prioritized confidence in financial markets, but Merkel and Sarkozy had to consider the indignation of European voters. In the Bundestag Merkel knew that majorities for her European policy would be fragile, at best, if haircuts were not part of the deal.62 As Mario Draghi, Trichet’s successor, would later acknowledge, talk of PSI might be premature from the point of view of the markets, but “to be fair again, one has to address another side of this. The lack of fiscal discipline by certain countries was perceived by other countries [i.e., Germany] as a breach of the trust that should underlie the euro. And so PSI was a political answer given with a view to regaining the trust of these countries’ citizens.”63
How much damage did the Deauville announcement really cause? Advocates of extend-and-pretend would insist forever after that it was Merkel and Sarkozy who tipped Ireland over the edge, that Trichet was right, that this was Europe’s “Lehman moment”: an unforced, politically motivated error. But, as in the case of Lehman, political and technical judgments were mingled. Given its gigantic budget deficit and the expiry of the 2008 guarantee for its banks, Ireland was heading into rough waters in any case, with or without Deauville. Spreads on Irish government debt were already surging before Merkel and Sarkozy’s surprise announcement. Deauville did not help. But it did not cause a market panic. The markets were already reckoning with the risk of a bail-in.64 The main impact of Deauville was to harden the attitude of the ECB. Trichet was determined that Dublin should not use Merkel and Sarkozy’s announcement as cover to burn the banks’ bondholders. Instead, Ireland must accept a program like that imposed on Greece. And, as in Greece, with Irish banks wholly dependent for their day-to-day survival on ECB funding, Trichet had the whip hand.65