by Adam Tooze
The very least one can deduce is that the optimistic dogma under which democracy and markets were seen as natural and necessary complements—the mantra of the aftermath of the cold war—was dead.5 In its place the crisis had put a more realistic awareness of the potential tension between the two. But this generalization too has its risks, particularly when it is assumed that it is financial markets, not politics, that force the tension. Certainly in the course of the eurozone crisis that had not been the case. The pressure the more fragile members of the eurozone were under depended not on some inescapable clash of peoples and markets, or global capitalism and democracy.6 It was dictated, first and foremost, by the willingness, or not, of the ECB to buy bonds. In the markets many banks and traders were not just crying out for the EU to undertake a stabilization effort but betting billions that it ultimately would. What delayed the stabilization and escalated the conflict between democracy and markets to an extraordinary pitch was the struggle among Germany, France and the ECB over the future governance of the eurozone, a question in which politics and economics were inseparably intertwined. Ironically, the result, as in 2010, was to escalate the crisis to the point that European affairs could no longer be safely left to the Europeans.
I
The compromise of July 21 on a new Greek aid package was supposed to be flanked by a new round of bond buying by the ECB. Ireland and Portugal, at least, were judged to be making sufficient progress under their IMF-supervised programs. So on August 4, 2011, the ECB let it be known that it was once again in the market for their bonds. Prices and yields promptly stabilized. This was the cheery backdrop to Coelho’s visit to Berlin. But as far as Italy and Spain were concerned, Trichet did not want to let them off the hook so easily. The ECB needed further proof of conformity. To make the point, on August 5 Trichet dispatched a confidential memo to prime ministers Zapatero and Berlusconi, spelling out what would be necessary for the protection of the ECB’s bond purchases to be extended to them.7 In the case of Italy, weight was added to the missive by the signature of Mario Draghi, head of the Italian central bank and Trichet’s anointed successor at the ECB.
Neither Spain nor Italy had applied for a troika program, but that did not stop the ECB from demanding huge cuts to government spending and increased taxation. In the Italian case, Trichet and Draghi called for the privatization of local public services, a proposal that had recently been decisively rejected in a nationwide referendum.8 The ECB also called for dramatic changes to labor market policy, infringing on rights of Italian and Spanish trade unions. Such changes were necessary, the ECB insisted, to cut unemployment and increase growth. It was a blatant attempt to shift the balance of social and political power by means of monetary policy, poorly disguised by the ECB’s proviso that care should be taken to ensure that the social safety net remained intact. In case these unpopular measures encountered opposition, Trichet and Draghi suggested that the Italian government should invoke the decree powers of Article 77 of the Italian constitution, which allowed executive action “in cases of extraordinary need and urgency.” Originally designed to counter the specter of Communist insurrection during the cold war, Article 77 was a legal fig leaf that had been repeatedly invoked since the 1970s to cover “emergency measures.”9 Its overuse had been criticized by the Italian courts. If Berlusconi was worried about the legality of these proceedings, Trichet and Draghi advised that he should apply retrospectively for parliamentary sanction. Perhaps not surprisingly, legally minded members of Berlusconi’s cabinet wondered whether it was their malodorous prime minister or Draghi and Trichet who posed the greater risk to the rule of law.
The Spanish government chose to keep the ECB’s letter secret. If it was to be humiliated it preferred not to have the fact made public. As a sign of their compliance, Spain’s two largest political parties agreed to amend the Spanish constitution, unchanged in thirty-three years, to provide for a balanced budget amendment.10 By contrast, Berlusconi accepted Trichet’s terms but under public protest. He would later say that the ECB’s instructions “made us look like an occupied government.”11 But rather than embarrassing the ECB, the expostulation from Rome served only to enhance Trichet’s reputation as a hard-liner, which, in an ironic twist, freed him to act. On August 7 the ECB began buying Italian and Spanish bonds under the Securities Markets Programme (SMP).12
This was enough to calm the markets and stave off the immediate risk of a disaster. But Berlusconi’s government was evasive about the full scale of the austerity measures it was willing to adopt. The Italian economy was perched on the edge of a severe recession. Markets remained jumpy. And as everyone realized, things were going to get worse before they got better. The compromise on Greece hammered out on the weekend of July 20–21 had been inadequate from the start. Rather than achieving sustainability, Greece’s consolidation program was falling consistently behind schedule. To escape insolvency Greece needed a haircut far larger than that squeezed out of the bankers over the summer: not 21 percent but something closer to 50 percent. If this was not to cause panic, it would need to be framed by a solid Franco-German agreement on the future governance of the eurozone. France was truly the last line of defense. If the crisis spread by way of Rome to Paris, the game would be up. Ominously, in the fall of 2011, as the ECB intervened to prop up Italian public debt, the spread of the ten-year French bonds relative to bunds nudged upward to 89 basis points.13 In reaction, Merkel and Sarkozy tightened their alliance. What Sarkozy desperately needed was a wall of money. With the ECB pursuing a strategy of tension, the only way to really calm markets would be to expand the EFSF or to agree to a wholesale mutualization of eurozone public debt. It was Berlin’s agonizingly slow acceptance of these basic facts that set the pace of the crisis.
On September 29 the Bundestag finally voted on the puny expansion of the EFSF bond market stabilization fund agreed on July 21. It was widely seen as a decisive vote for the future of Merkel’s coalition.14 Though the EFSF was supported by the majority of the Bundestag, on the German right wing the bond buying of the ECB had triggered a furious reaction. At the crucial ECB board meeting in August, Merkel’s hard-line new appointee as head of the German Bundesbank, Jens Weidmann, once a star pupil of Axel Weber and Merkel’s personal economic adviser, not only voted against bond buying but made his opposition public.15 On September 9 Jürgen Stark, the German member of the ECB board and the bank’s chief economist—the man widely thought to be behind the ECB’s interest rate hikes earlier in the year—resigned in protest. To stop the momentum of the conservative rebellion Merkel needed to win the EFSF vote in the Bundestag, not with the votes of the pro-European SPD opposition but on the basis of her own Kanzlermehrheit—with the votes of her coalition partners. In the event, on September 29 Merkel got the votes, but by a painfully narrow margin. Out of the 330 members of the government coalition, only 315 voted for the motion, 4 more than the 311 needed. Merkel was on top, but she had little room for maneuver.
In any case, as soon as the Bundestag had voted it was clear that it had been overtaken by events. As everyone in the markets realized, the EFSF fund that had been agreed over the summer was too small. The Bundestag vote on September 29 was simply the occasion to start talking about how the fund might be leveraged, something that had been explicitly ruled out by Schäuble ahead of the vote.16 Unless the markets suddenly calmed, Merkel’s government would soon be rolling the parliamentary dice again.
II
In the summer it had finally been acknowledged that any Greek debt restructuring would require a full-scale bailout of Greece’s own banks. They held so much Greek public debt that their balance sheets would not survive the debt write-down. What the European governments were still struggling to accept was that the problem was far wider than that. The politics of extend-and-pretend might have the benefit of deflecting attention from the creditor banks to the bankrupt government borrowers. It was the citizens of the troika-supervised countries who paid the price. But it also allo
wed European policy makers to avoid getting to grips with the underlying problems of financial stability. The assumption, presumably, was that given time the banks would take care of themselves. But despite the fairy-tale numbers produced by the European stress tests, it was clear that this was wishful thinking. In fact, Europe’s banks were sliding back toward the cliff edge in the fall of 2011. They were struggling to cope with pressure from six directions at once. The legacy losses from 2007–2008 were still on their books. Their holdings of European sovereign debt were increasingly impaired. The troubles of the eurozone economy were bad for new business. The new capital and liquidity requirements of Basel III required painful balance sheet adjustment. In their most profitable niche markets in the United States, Europe and Asia, the European banks faced fierce competition from the resurgent American and Asian banks. And in light of all this, wholesale money markets were increasingly leery about offering funding. A slow contraction of balance sheets was one thing. If funding markets shut down, Europe would face a repeat of 2008. Given that acute threat it was not without risk to openly address the long-term issues of the sector. But if the problem of recapitalization was not squarely faced, how would the banks ever be made safe?
In August 2011, as she established herself as managing director of the IMF, Christine Lagarde took up the baton that Strauss-Kahn had dropped when he was carted off to Rikers Island jail. Already in 2009 IMF analysts had highlighted the inadequacy of European bank recapitalization.17 Now, two years later, in light of the escalation of the eurozone sovereign debt crisis, the IMF estimated that the minimum the European banks needed was $267 billion in new capital.18 It was a daunting challenge, but without it, all other crisis-fighting measures on the side of fiscal and monetary policy would lack a solid foundation. European political obfuscations were obscuring the basic lesson of 2008: Questions of macroeconomic policy and systemic stability could not be hygienically separated from the workings of megabanks, now more politely known as systemically important financial institutions.
The banks, of course, defended what they took to be their own interests. Never one to shrink from alarmism where bank regulations were concerned, the Institute of International Finance estimated that Basel III plus national regulations would force banks worldwide to raise their capital by $1.3 trillion by 2015.19 It was a huge ask and many banks might simply prefer to shrink their balance sheets, flattening the fragile recovery. At the meeting of the Financial Stability Board on September 23 in Washington, Jamie Dimon of J.P. Morgan counterattacked. He condemned the new capital rules and challenged Mark Carney, the chairman of the Bank of Canada and head of the SFB, so violently that Lloyd Blankfein of Goldman Sachs felt it necessary to personally intercede.20 Bizarrely, Dimon denounced the Basel III rules as anti-American, whereas, in fact, the pressure they placed on the Europeans was far more severe. Rather than raising capital, like their American counterparts, Europe’s main lenders were deleveraging en masse, cutting the size of their loan business. On the basis of plans published by the banks themselves, analysts predicted a contraction of between 480 billion and 2 trillion euros. From the point of view of the regulators, this was exactly what was intended. The banks needed to “derisk.” But it wasn’t only a matter of corporate strategy. What was driving the contraction as much as anything else was the collapse in demand for loans. That spelled trouble ahead for the eurozone economy and it threatened a vicious circle in which a widening depression forced banks to make ever larger provisions for a new wave of nonperforming loans, further tightening pressure on their balance sheets.
Europe’s Banks Under Pressure: Fall 2011 (in billions of euros)
2008 legacy assets
PIIGS debt
Expected deleveraging
RBS
79.6
10.4
93–121
HSBC
54.3
14.6
83
Deutsche Bank
51.9
12.8
30–90
Crédit Agricole
28.2
16.7
17–50
Sociéte Générale
27.5
18.3
70–95
Commerzbank
23.8
19.8
31–188
Barclays
20.7
20.3
20
BNP Paribas
12.5
41.1
50–81
Note: PIIGS debt refers to holdings of Portuguese, Italian, Irish, Greek and Spanish sovereign debt.
Sources: Bank of England, Financial Stability Report 30 (December 2011), and http://www.forecastsandtrends.com/article.php/770/.
It was not the misery of youth unemployment in Spain and Greece that made the eurozone crisis into an object of global concern. The world would wake up late to what would be dubbed the “populist danger.” In 2011 it was the prospect of European banking crisis that seized the attention of policy makers around the world. If the trillion-dollar balance sheets of the French, German, Swiss, Italian and Spanish banks were shaking, then the City of London and Wall Street would not be safe. And, as in 2008, the influence ran both ways. If the withdrawal of funding from American sources put the European banks under excessive pressure, they would drastically curtail their business in the United States. As William Dudley of the New York Fed later explained to Congress: “Money market mutual funds which were providing dollar funding to the European banks during the summer and fall [of 2011] were pulling back. Other lenders, large asset managers, were also pulling back from the European banks. And this was causing those banks to start to get out of their dollar book of business. . . . [T]his was going on at a pretty feverish pitch through the late fall and in through the early winter.”21 The panic was spreading to the American banks themselves. In the fall of 2011 the premium on American bank credit default swaps began to rise ominously.22
III
On the morning of September 16, 2011, Treasury Secretary Geithner flew to Warsaw to attend, for the first time, the monthly meeting of European finance ministers and central bankers. In his widely leaked remarks he apparently began on a humble note.23 “Our politics are terrible, maybe worse than they are in many parts of Europe,” he said. The debt ceiling battle had ended in Congress only six weeks earlier. “Given the damage we caused the world in the early stages of the financial crisis and given the challenges we have, we are not in a particularly strong position to provide advice to all of you, so I come with humility.” But he then went on to insist that the “ongoing conflict” between Europe’s governments and the ECB was “very damaging.” “You have to, governments and the central banks have to, take out the catastrophic risk from markets.” Austria’s outspoken finance minister, Maria Fekter, later commented that the American Treasury secretary’s tone had indeed been “very dramatic.”24 What Geithner proposed was standard American maximum-force firefighting doctrine. “The firewall you build has to be perceived as larger than the scale of the problem. You can’t succeed by shrinking the problem to fit your current level of financial commitments. . . . It’s more dangerous to escalate gradually
and incrementally than with massive preemptive force.” According to the Treasury’s own estimates, the eurozone needed a fund of at least 1 trillion euros and preferably 1.5 trillion.25 Picking up an idea launched by Mark Carney of the Bank of Canada and Philipp Hildebrand of the Swiss Central Bank, Geithner argued that the European Financial Stability Fund should be leveraged to give it sufficient firepower to act as a firewall.26 The EFSF could borrow against the capital invested in it by Europe’s governments. It was a neat solution, but controversial in Europe, particularly in Germany, because as it increased the fund’s firepower, it also increased the liability for losses.
It was the Europeans who invited Geithner to Warsaw. But in the wake of the Wall Street crash of 2008 and the congressional budget crisis of July 2011, there was probably no moment in living memory in which Europe was less willing to listen to financial advice from America. Jean-Claude Juncker refused point-blank to discuss Geithner’s bailout fund proposal with a nonmember of the eurozone. Geithner stalked out of the encounter refusing comments to the press. As one New York analyst commented: “I’m not sure it’s productive for Secretary Geithner to have gone to Poland given the European resentment towards the U.S. . . . I fear that it may cause Europeans to cut off their nose to spite their face.”27 That trivializing diagnosis was telling in its own right. But the rebuff to the United States was undeniable. On Geithner’s return, the New York Times ran an unflattering piece contrasting the reception he had received with the triumphalism of the 1990s, when Time magazine had hailed his mentors—Greenspan, Summers and Rubin—as “The Committee to Save the World.” In September 2011 Sheila C. Bair, Geithner’s longtime nemesis as the chair of the FDIC, commented that the Treasury’s advice might have been more compelling if it had come jointly from the United States and China, a point that the Chinese would make at the next G20 meeting.28