Crashed

by Adam Tooze

  This alarmist interpretation of the accounting data should be seen less as a piece of economic analysis than as a symptom of the increasing loss of legitimacy on the part of the euro system. What the TARGET2 balances registered was not a “loan” by Germany to the rest of the system. The TARGET2 balances were the offsetting official counterpart to an enormous movement of private funds into German bank accounts from the eurozone periphery. Some of those moving funds were rich Greek or Spanish businesses. But in large part it was Germany’s own investors bringing their euros home. They were able to do so without risk of currency losses or a massive Deutschmark appreciation, which would have hurt Germany’s exporters, thanks to the monetary union and the ECB’s clearing system. Sinn liked to inflame his readers with dark scenarios in which a breakup of the euro resulted in a loss of Germany’s bookkeeping claims on the ECB. It was a grim and uncertain prospect. But one thing was certain: The funds that anxious investors had already moved to safety in Germany were very unlikely to leave. What Germany was benefiting from was something akin to the exorbitant privilege enjoyed by the United States in the global economy. At times of stress, global money moved into dollars. In the eurozone, money moved to Germany.35 It was a privilege measured by the yield spread. As the yields on crisis-country bonds soared, those on Bunds eased. It was one of the factors that helped to feed Germany’s prosperity bubble. That a flow of funds into Germany should come to be seen as a burden was symptomatic of the feverish discourse of the crisis.

  TARGET2 Balances for Select Eurozone Nations (in billions of euros)

  Source: Bruegel, National Central Banks.

  III

  By May 2011, confidence was so shaky that a secret Eurogroup meeting was hurriedly convened in Luxembourg. Scheduled for Friday, May 6, it was meant to restore unity and coherence. Instead it turned into a PR disaster. When Schäuble insisted that they must start by discussing restructuring and PSI, Trichet stormed out. He wouldn’t countenance such talk. On the other hand, to proceed without him was impractical, as the only thing keeping the Greek banks alive was ECB support.36 No one fancied the idea of having to restructure them too. When Der Spiegel got wind of the meeting and markets in the United States began to react, the spokesman for Jean-Claude Juncker, the veteran prime minister of Luxembourg and Eurogroup chair, flatly denied that any meeting was taking place.37 Hours later the same spokesman was forced to admit that the leaders had indeed met. “There was a very good reason to deny that the meeting was taking place,” he told the assembled journalists. “We had Wall Street open at that point in time.” The euro was plunging. Lying was a matter of “self-preservation.” When the Wall Street Journal asked whether such deception might undermine the “market’s confidence in future euro-zone pronouncements,” Juncker’s spokesman retorted that the market already appeared to discount any comments by ECB president Trichet and France’s finance minister, Lagarde. Whatever they said on the subject of Greece’s debt, “nobody seems to believe it.” So what further harm could be done by a convenient lie? Juncker himself had come to similarly stark conclusions: “Monetary policy is a serious issue,” the Eurogroup chair told an audience in April. “We should discuss this in secret, in the Eurogroup. . . . If we indicate possible decisions, we are fueling speculations on the financial markets and we are throwing in misery mainly the people we are trying to safeguard from this. . . . I am for secret, dark debates. . . . I’m ready to be insulted as being insufficiently democratic, but I want to be serious. . . . When it becomes serious, you have to lie.”38 By May 2011 the effort to defend the indefensible, to uphold extend-and-pretend, had resulted in a complete breakdown of credible and coherent communication about the eurozone’s economic policy. Juncker was unusual only for feeling that he didn’t need to dress it up, which, as far as a tiny bourgeois tax haven like Luxembourg was concerned, might have been true. Projected onto a larger stage of the EU, the implications of Juncker’s “realism” were rather more disconcerting.

  With Europe’s credibility draining away, what was needed was a “reset,” a clarifying intervention that would restore credibility and stop the crisis of confidence from widening. That is what Dominique Strauss-Kahn, as head of the IMF, seems to have had in mind when he scheduled meetings, first with Angela Merkel and then with the Eurogroup, for mid-May 2011. Strauss-Kahn “was going to push for a big firewall,” recalled one senior US official. “We were putting a considerable amount of expectation on the outcome of those meetings.”39 Inside the IMF, a new head of steam of opposition to extend-and-pretend was building. The Fund’s Ireland team had never been satisfied with the inequitable deal forced on Dublin by the ECB and the G7 in November 2010. Ireland’s problems, Ajai Chopra insisted, were not merely Irish in scope, “they are a shared European problem” that required joint European action.40 What was needed was to beef up the EFSF, giving it more resources and wider authority to intervene. Furthermore, as Ireland showed, Europe’s banks were too big to bail by any but the largest states. So Chopra insisted that if banks could not raise enough capital from private sources, there should be coordinated recapitalization across the EU.41 Already a year earlier, in March 2010, Strauss-Kahn had challenged the Europeans to establish a jointly funded bank resolution authority.42 Without that, any steps toward major debt restructuring were dangerous to contemplate.

  By May 2011 the IMF had clearly formulated the basic logic of a eurozone fix that went beyond extend-and-pretend, and Strauss-Kahn seems to have been bent on delivering it. But minutes before his departure from JFK on May 14, the managing director of the IMF was hauled off his flight by officers of the NYPD to face charges of sexual assault and unlawful imprisonment. It was a bewildering turn of events. Much of European opinion was in uproar at the spectacle of such a prominent figure being reduced to the indignity of a New York perp walk. Did the presumption of innocence not hold in America?43 In France those who did not blame the Americans blamed Sarkozy, who was widely suspected of plotting to eliminate Strauss-Kahn as a rival for the presidency.44

  Meanwhile, the hope that the IMF might shake the eurozone out of its paralysis evaporated and the Fund was left without a managing director. The question of succession opened a sore wound. In 2007 the emerging markets had been promised that the next head of the IMF would be one of theirs. Now, faced with the eurozone crisis, it was argued that because the IMF was so deeply engaged in Europe, it was crucial to have a European at the helm. Had Latin Americans, Asians or Africans ever had the temerity to make the analogous case, one can only imagine the reaction. The Europeans didn’t even blink. Their candidate for the job was Christine Lagarde, who had proven both her loyalty and her competence as Sarkozy’s finance minister. She had the backing of Europe, the United States and China. Meanwhile, as the eurozone spiraled toward crisis, the IMF’s push for decisive action was aborted. While Lagarde readied herself for her new role, the helm was taken by John Lipsky, the IMF’s American number two. Lipsky was all for large-scale support actions in the interest of systemic stability. If there were to be private sector involvement, on the other hand, it would have to be voluntary, and modest in scale. The priority of systemic stability and preventing contagion reasserted itself. This was no time for dangerous talk about debt restructuring or bank recapitalization. What mattered was containing the crisis and preventing uncertainty spreading from Europe.

  IV

  Strauss-Kahn never made it to his discussion with Merkel. But on June 5 the German chancellor headed to Washington.45 By inclination, Merkel was an Atlanticist. But not since 2003 had relations been so strained. On economic policy Germany and America had been out of step since the crisis began. The storm over QE2 had been embarrassing. And where had Germany been in Libya? What was Berlin’s plan for Europe? The discussions with Obama were intense. Merkel returned home on June 8 with a Presidential Medal of Freedom and a new tune. There would be no more talk of Greek default or Grexit. In exchange for further austerity from Greece, there would b
e another aid package. Private sector involvement, i.e., debt restructuring, would be part of the bargain, as Germany had wanted from the start. But it would be voluntary. It would be a creditor-led restructuring, with the banks exercising a veto over the manner and scale of the debt write-down. What was still missing from Berlin’s pronouncements was any bold plan for a European bond fund or recapitalization. The net effect, therefore, was to heighten the tension. What the markets heard was that there would be PSI but without an adequate safety net.

  On June 29 the battered Greek government pushed the fourth round of austerity through parliament, including privatization, tax increases and pension cuts. It did so in the wake of the violent clearance of Syntagma Square occupation and a two-day general strike. It did so in the face of IMF calculations that suggested that to achieve debt sustainability Greece needed to sell off public assets to the tune of 50 billion euros. Indeed, according to a further IMF assessment released on July 4, even that would not be enough.46 It would take not only austerity and privatization but a truly heavy bondholder haircut to get Greece to sustainability. The tone of the talks with the International Institute of Finance (IIF), which had begun on June 27, suggested that there was little prospect of that. The banks and other bondholders were making only modest concessions. That suited the ECB, which was desperate that there should be no “default event,” but it stood in jarring contrast to the tens of billions of euros in cuts that Athens was imposing on its citizens. For Greece, the new Merkel-Obama dispensation was revealing itself to be extend-and-pretend in a new guise.

  By June, as the S&P ratings agency downgraded Greece to CCC—the lowest score awarded to any sovereign borrower—and spreads surged to 1,300 points, the markets were asking a new question. If the eurozone couldn’t handle Greece, what if it faced more serious trouble? What if it had to deal with a crisis in Spain, or in Italy? Twenty years earlier, in the early 1990s, Italy had been on the rocks. Since then Italy’s debt had stabilized. Rome managed primary surpluses. But its debt was still dangerously high in relation to GDP. And given the size of the Italian economy—the eighth largest in the world by nominal GDP—its debts were enormous: 1.8 trillion euros. Alarmingly, in the last days of June 2011, following the decision to implement PSI in Greece, 100 billion euros of Italian debt had been sold off. European banks were pulling back, with French banks leading the way. The share of foreign holding of Italian debt fell from 50 to 45 percent in a matter of weeks.47 That was enough to send Italy’s borrowing costs up from 4.25 to 5.54 percent between June and August of 2011. That might not seem like a large number. But given Italy’s huge refinancing needs, it spelled disaster. Between the second half of 2011 and the end of 2014 Rome calculated that it would need to borrow 813 billion euros in refinancing and new loans. A 25 percent increase in the cost of servicing such a huge volume of debt was a serious matter indeed. If a run began on Italy, it might well be game over for the eurozone.

  Contrary to North European prejudice, the Italian political class was by no means oblivious to the seriousness of the situation. Italian economists, notably the “Bocconi boys,” named after the preeminent business school in Milan, had contributed as much as anyone to the new consensus of spending cuts and “expansionary austerity.”48 Faced with the emergency of 2008–2010, Italy had permitted itself virtually no stimulus. The question was whether Rome had the will and capacity to respond to the new panic in the bond market. And, in particular, how Prime Minister Berlusconi would react.

  Berlusconi was a figure wreathed in scandal.49 He had faced allegations for crimes including racketeering, large-scale tax evasion and corruption. But on February 15, 2011, in the most embarrassing charge of all, he had been indicted for paying for sex with a minor and abuse of office in his efforts to cover up his liaison with an exotic dancer and call girl known as “Ruby the Heartstealer.” Rather than resigning, Berlusconi clung to his office. On April 6, 2011, as financial markets watched anxiously, Italy’s prime minister went on trial. The proceedings were immediately adjourned, but hearings would resume at the end of May. Meanwhile, a dark cloud of uncertainty and disrepute hung over the Italian government. Further doubts were raised at the end of May, when Berlusconi’s political alliance between Forza Italia and the Lega Nord lost control of Milan, his personal fiefdom.50 Even at the best of times, Berlusconi’s instincts were those of a crowd pleaser. Now that he was fighting for his political life, could he be counted on to push through the kind of austerity that his finance minister, Giulio Tremonti, was demanding?

  Over the weekend of July 9–10 Merkel intervened personally with Berlusconi to urge on him the seriousness of the situation. Europe’s future hung on Italy. But was it Italy, or was it, in fact, Germany that was the weak link? To many in Europe it was unclear whether Merkel herself was truly committed to holding the euro together. Ugly whispers began to circulate that Germany’s veteran chancellor, Helmut Kohl, father of the euro and German reunification, was questioning whether his European legacy was safe in Merkel’s hands. “This girl [Merkel] is destroying my Europe,” Kohl was reported to have told one journalist.51 Only reluctantly were Merkel and Schäuble persuaded to defer summer travel plans and call an emergency meeting of the European Council on July 21 to discuss eurozone stabilization. The issues were predictable: fiscal adjustment and austerity, PSI, restructuring and debt sustainability, ECB bond buying. Only Europe-wide bank recapitalization, the final element in a coherent crisis-containment strategy, was not yet on the table. But what was Berlin’s game? Were Merkel and Schäuble engaged in truly hair-raising brinksmanship? Or, cocooned in their relative prosperity, did the German political class simply not understand the pressures the rest of the eurozone was under?

  On July 14, 2011, in response to market pressure, the Italian parliament adopted a severe 70 billion euro austerity program, on a par with Germany’s 2010 effort.52 But doubts remained as long as Berlusconi was at the helm. And the issue of PSI in Greece remained unresolved. Trichet was sticking to his guns. If there was anything approaching full-blown restructuring of Greek debt, the ECB would disallow Greek bonds as eligible collateral. Panic was again spreading through eurozone debt markets. What had originally been a problem of small fry, like Greece and Ireland, was rapidly becoming a comprehensive crisis of Southern Europe, including large economies like Spain and Italy. Whereas in 2007 eurozone bond investors had regarded Greek debt as equivalent to that offered by Germany, by September 2011 the CDS spreads on Italy and Spain were higher than those of Egypt in the throes of revolution.53 The three countries in the world judged most likely to default were all in the eurozone—Greece, Ireland and Portugal—well ahead of Belarus, Venezuela and Pakistan.54 The revolutionary mood seemed to have jumped the Mediterranean. The violent scenes in Athens fed fantasies of social disorder spreading across Europe. Supposedly serious financial analysts were talking of “hyperinflation, military coups and possible civil war.”55 But it wasn’t any longer a matter of individual predatory hedge funds, or one or two overexcited analysts talking the euro down; commercial banks and pension funds from across Europe and the United States were pulling tens of billions of euros out of Italy and the program countries.56 Once eurozone sovereigns lost their standing as issuers of safe assets, institutional investors had no option but to reallocate their portfolios. And that affected the European banks too. In the summer of 2011 wholesale funding was drying up.57

  With only days to go until the July 21 summit, the possibility dawned on Paris that Merkel might be willing to let the upcoming talks fail.58 The debt reduction so far agreed with the bank lobbyists was too low to satisfy Berlin. The resources and mandate for the EFSF were insufficient to reassure the French, calm the markets or persuade Trichet to resume bond buying. If the talks failed, no one would be safe, including France. To break the deadlock Sarkozy realized that he would have to deal with Merkel one-on-one. The French president arrived in Berlin on July 20 at 5:30 p.m. and immediately hit a roadblock over the EFSF. It soon b
ecame clear that Berlin and Paris could not settle the matter without involving Trichet. He was summoned from Frankfurt, arriving on the last plane into Berlin at 10:00 p.m. The deal had to be done not between Germany and France but between Germany, France and the ECB. In the early hours of July 21 Sarkozy and Merkel took turns on a single cell phone to read out to Van Rompuy, the president of the European Council, the terms of their agreement. That afternoon in Brussels the package was formally presented to and voted on by the other governments.

  Greece would receive an additional 109 billion euros, meeting its financing needs through 2014 and enabling the IMF to continue as part of the troika. The interest it paid on its loans would be lowered to 3.5 percent. Maturities would be extended and, through a menu of PSI options, Greece’s creditors would make a contribution, though the precise amount remained to be determined. The ECB would be indemnified for any losses it suffered. If the Greek banks suffered irreparable damage they would be recapitalized out of troika funds.59 Most important, the governments stated emphatically that PSI applied only to Greece. It was the only insolvent eurozone sovereign. All others would honor their obligations without fail. To contain contagion the EFSF would be beefed up and at the behest of the ECB it would be empowered to enter the secondary market and to establish credit lines for nonprogram countries, such as Spain and Italy. The EFSF would no longer act only as an ultima ratio, as Merkel had insisted since March 2010, but as a preemptive agency, helping to stabilize markets to forestall any threat arising. These, finally, were the elements of a workable solution—buy-in by the Greeks, debt restructuring, further loans, cooperation with the ECB and backstopping by a newly empowered EFSF. There was even partial recognition of the need for bank recapitalization. The general structure was fine. But did the sums add up? And who was to pay?