Crashed

by Adam Tooze

  On June 28, 2012, the European Council convened in Brussels in an atmosphere of “deep crisis.”42 Spain was clearly sliding toward the abyss. Three days earlier Madrid had formally applied for 100 billion euros in external assistance to recapitalize and restructure its banks. To stop the impending disaster, there was no alternative but for the council to approve the creation of a banking union. This would provide for the direct recapitalization of banks, independent of their home country governments, once an effective overall supervisory regime was established. Finally, a structural solution adequate to the crisis was coming into view. In the short term Germany agreed to an immediate bailout for the Spanish banks, provided a strict stress test was applied. This was a step of enormous significance. Four years on from 2008, what Europe was finally acknowledging was that even more than a fiscal union, what the eurozone needed was joint responsibility for its financial sector.

  What this did not resolve, however, was the boiling uncertainty in government debt markets. For Italy and Spain, facing interest rates rising toward 7 percent and beyond, this was a life-or-death issue. They could not hope to stabilize their public finances unless bond markets were calmed. On the evening of June 28 Monti and Rajoy forced a showdown.43 Just as council president Van Rompuy was about to announce Europe’s crowd-pleasing new Growth Pact to the press, they declared that they would veto the pact unless there was an agreement also to address the new crisis in sovereign bond markets. It was an ambush. For Merkel to have lost the Growth Pact would have left her vulnerable in the Bundestag. But she had also promised to hold the line on bank bailouts and bond buying and now she was at risk of capitulating on both. It took until 4:20 in the morning on June 29 for the chancellor to finally give way. After a negotiating session lasting a total of fifteen hours, Barroso and Van Rompuy went before the press to announce agreement not only on the Growth Pact but also on a plan that would permit support by the ESM for the government debt of all countries that were in compliance with the rules of fiscal governance agreed in December. It would be the entitlement of all eurozone members, not emergency assistance granted by way of a humiliating application to the troika. As he left the meeting, a jubilant Monti exclaimed, Europe’s “mental block” has been broken!44

  It was indeed a breakthrough. But in both political and financial terms, in July 2012 the eurozone was still in flux. Merkel’s retreat did not pacify the German conservatives. The new Greek government was still regarded as a liability. Meanwhile, Spain was spiraling toward disaster. To trigger the bond market support mechanism, a eurozone member had to conform to the 3 percent deficit rule. Spain was a long way from that. In the summer of 2012 it was struggling to slash its budget deficit from 11.2 to 5.4 percent of GDP. The Eurogroup was still working out the details of the Spanish bank recapitalization. As the Spanish banking system suffered a silent bank run and the interbank lending market shut down, Spain’s banks drew a massive 376 billion euros in funding from the ECB.45 The regional governments across Spain were in trouble. In July Valencia applied to Madrid for aid. Catalonia might be next. On July 23 the Spanish ten-year bond surged to 7.5 percent and its CDS shot up to 633 basis points. That same day the Spanish minister for economic affairs, Luis de Guindos, jetted to Berlin in the hope of obtaining an endorsement from Schäuble that might reassure markets and open the door to ECB bond buying. Spain was facing, De Guindos warned, “an imminent financial collapse.”46 But Schäuble was grudging in the support he was willing to give his fellow Christian Democrat. For Germany to approve immediate bond buying, Madrid would need to make changes to its pension system and demonstrate its commitment to budget balance. Conformity to Germany’s idea of the European social bargain was the price for backing from Berlin. The eurozone still hung in the balance.

  Three days later, on Thursday, July 26, Mario Draghi flew to London ahead of the opening of the Olympic Games to attend a Global Investment Conference designed to promote the UK as a business center. The mood in London was not friendly.47 Mervyn King, speaking ahead of Draghi on the panel, let it be known that he did not regard European political union as a possible solution. As Draghi later confided to a friend: “I really got fed up! All those stories about the dissolution of the euro really suck.” The expression he used in Italian was apparently rather more colorful.48 So Draghi decided to change the script. The markets needed to understand the qualitative change that Europe was undergoing. The eurozone might have started life as an ill-shapen construction, but under the pressure of the crisis it was developing fast. Global markets needed to appreciate the fundamental changes that were reshaping Europe. Following the December 2011 fiscal pact, the summit of June 2012 was a turning point because for the first time since 2008 all the leaders had restated with a powerful voice that the “only way out of this present crisis is to have more Europe, not less Europe.”49 The forward motion of the EU’s integration machine was resumed. The point that Draghi wanted to drive home to global markets was political. “When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro,” he told the skeptical City of London crowd, “very often non-euro area member states or leaders underestimate the amount of political capital that is being invested in the euro.” These were not empty words because “actions have been made, are being made to make it irreversible.” And there was “another message” that Draghi wanted investors to hear: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.” Then, pausing for effect, he added: “And believe me, it will be enough.”

  IV

  In retrospect, Draghi’s “whatever it takes” speech has come to be seen as the turning point of the eurozone crisis. In the aftermath, markets immediately calmed. Yields for the most vulnerable borrowers came down. There was no more talk of a eurozone breakup. It is an explanation with deep appeal. The ECB had held the key to stability all along. Draghi, finally, was the one to turn it. But this is a retrospective construction. The more or less open struggle over the direction of ECB policy that had begun back in 2010 was not ended by Draghi’s speech on July 26. His initial intervention was extremely fragile. It could easily have been undone. It took a lot of help to make Draghi’s speech into a historic turning point, and even then it was painfully incomplete.

  Whatever It Takes: Spanish and Italian Sovereign Bond Yields, January–October 2012

  Source: Thomson Reuters, from Marcus Miller and Lei Zhang, “Saving the Euro: Self-Fulfilling Crisis and the ‘Draghi Put,’” in Life After Debt (Basingstoken, UK: Palgrave Macmillan, 2014), 227–241.

  In the hours that followed Draghi’s address, as its import sank in, there was confusion at ECB headquarters in Frankfurt. As one senior ECB official commented to Reuters: “Nobody knew this was going to happen. Nobody.”50 The ECB’s media department and the editors of the bank’s Web page did not have an advance copy of the speech to make available to the press. Draghi had vaguely discussed his plan with a few of his fellow executive board members. But given its likely impact, he had clearly felt it was better to hold the decision close and to present the world with a fait accompli. Significantly, Jens Weidmann, president of the Bundesbank, was among those who learned about Draghi’s message through the news. None of Europe’s capitals had received advance warning, nor had Klaus Regling, the head of the EFSF, whose agency would play a key role in Draghi’s plan. Draghi had had “nothing precise in mind,” said an official at the ECB’s headquarters in Frankfurt. “It was a rash remark.” As Reuters put it: Draghi’s “words were a gamble. . . . [T]he speech was just the beginning.”

  If Draghi’s speech was a rallying call, what mattered was who followed. Over the weekend, Eurogroup chief Jean-Claude Juncker threw himself behind Draghi: “The world is talking about whether the eurozone will still exist in a few months,” he declaimed. Europe had “arrived at a decisive point.”51 Juncker warned the German government about allowing itself the luxury of “getting caught up in
domestic politics in euro questions.” Meanwhile, Merkel, Monti and Hollande issued joint statements insisting on their determination to hold the euro together. To complete the eurozone quadrilateral, Monti announced that he would shuttle to Madrid to meet with Rajoy.

  Washington was quick to jump on Draghi’s bandwagon. On the morning of Monday, July 30, Treasury Secretary Geithner flew to Europe to visit Schäuble at his vacation residence on Sylt. The media were divided over what transpired. Some reported agreement, others a dogged refusal by the German to compromise.52 Geithner was concerned that Germany was still toying with dumping Greece out of the eurozone. As he wrote in his memoirs: “The argument was that letting Greece burn would make it easier to build a stronger Europe with a more credible firewall. I found the argument terrifying.” Letting Greece go could create “a spectacular crisis of confidence.” The flight from Europe “might be impossible to reverse.” It wasn’t clear to Geithner either “why a German electorate would feel much better about rescuing Spain or Portugal or anyone else.”53 After seeing Schäuble, Geithner dropped in on Draghi in Frankfurt. As Geithner later recalled, the upshot was far from reassuring. Draghi told Geithner that his remarks in London had been prompted on the spot by the deep skepticism he had sensed in his audience of hedge fund managers. He realized that he would need to shake the markets. As Geithner put it, “[H]e was just, he was alarmed by that and decided to add to his remarks, and off-the-cuff basically made a bunch of statements like ‘we’ll do whatever it takes.’ Ridiculous . . . totally impromptu . . . Draghi at that point, he had no plan. He had made this sort of naked statement.”54 On his return to Washington Geithner was pessimistic: “I told the President that I was deeply worried and he was, too. . . . [A] European implosion could have knocked us back into recession, or even another financial crisis. As countless pundits noted, we didn’t want that to happen in an election year, but we wouldn’t have wanted that to happen in any year.”55

  In fact, German opposition to Draghi’s initiative was fierce.56 Some insiders are convinced that it was not until the German government’s joint meeting with its Chinese counterparts on August 30 that Merkel and Schäuble were finally committed to backing the ECB’s initiative and holding Greece in the currency zone.57 Chinese prime minister Wen Jiabao certainly made clear that he held the major European countries, Germany and France, responsible for the destiny of the eurozone and that continued Chinese purchases of European bonds depended on their taking effective action.58 Perhaps the position of the Obama administration was too familiar by this point and the battle lines too clearly drawn to carry much additional weight. As usual, the inflation hawks at the Bundesbank were aghast at the idea of ECB bond buying. But for Merkel it was the better of two bad options. For Spain to have been supported out of the funds of the ESM would have raised far more serious political and legal issues.59 On September 6 the Bundesbank made its displeasure known by casting the lone vote against Draghi’s plan. Indeed, Weidmann was so indignant that he demanded an interview with Draghi to impress upon him that the Bundesbank should not be regarded as just another vote on the ECB’s council. It must have a veto.60 But with backing from both Merkel and Schäuble the die was cast. The ECB formalized its new role as a conditional lender of last resort, under the title of Outright Monetary Transactions (OMT).61 But this was a strictly conditional promise. The ECB would go into action only if the country in question had agreed on an austerity and aid program approved by the ESM. It was hedged with far more conditions than the unconditional bond buying in which the ECB had engaged under Trichet.

  Even after Draghi’s “whatever it takes” speech, the ECB’s monetary policy was profoundly constrained. The same was not true to the same degree for its counterpart in the United States. In 2012 the pace of the US recovery was flagging. The conservative stampede that had opposed any further expansion of monetary activism in 2011 had run its course. On September 13, 2012, the FOMC voted for QE3.62 It would be the biggest Fed expansion yet. Initially, the Fed committed to purchasing $40 billion per month in Fannie Mae and Freddie Mac agency bonds. What was different was that it undertook to do so until the Fed saw “substantial improvement in the outlook for the labour market.” Additionally, the FOMC announced that it would likely maintain the federal funds rate near zero as long as unemployment remained above 6.5 percent and the Fed’s inflation forecast did not exceed 2.5 percent. On December 12, 2012, the FOMC announced an increase in the amount of purchases from $40 billion to $85 billion per month. Because of its open-ended nature, QE3 would earn the popular nickname “QE Infinity.”

  In his memoirs, Bernanke commented: “Like Mario Draghi, we were declaring we would do whatever it takes.”63 But this was far too kind to the Europeans. Draghi’s OMT as it emerged by September 2012 was a conditional confidence-building measure. It worked by calming markets and stopping the panic. But beyond that it provided no stimulus to the eurozone economy. In truth, the ECB’s possibilities were limited. QE for Europe with Germany’s conservatives on the warpath was unthinkable.64 As the eurozone economy stagnated and its banks deleveraged, the LTRO facilities were progressively paid back. Unlike the Fed, whose balance sheet Bernanke was actively expanding, the ECB’s balance sheet contracted back to where it had been in the crisis-ridden fall of 2011. Europe was sliding ever deeper into its second recession.

  Fed and ECB Balance Sheets, 2004-2015

  Source: Fed, ECB.

  V

  If one asks how the acute phase of the eurozone crisis was finally halted, Draghi’s July 26 speech offers two answers. One was that given by Draghi himself. The eurozone crisis was halted because of the enormous investment of political capital made by Europe’s governments. It was halted by the construction of a new apparatus of government: the Greek restructuring, the fiscal compact, banking union, ESM, the ECB’s OMT facility. Those who bet against the eurozone’s future misjudged the scale of the investment being made by Europe’s governments. That was the message that Draghi wanted to ram home. As Draghi said, it was a political message about the seriousness of European state building. The delays might come at a huge cost to its citizens. But in its usual crablike fashion, Europe was moving once more toward “ever closer union.”

  But the answer extracted from the speech by most of those who heard Draghi that day in the City of London was rather different. They remained skeptical of the EU and uninterested in the details of its politics. What they took from Draghi’s speech was not its specific content or the sea change in eurozone politics that made it possible. They heard one single and simple message. Here was a powerful central banker and he was saying that he would do “whatever it takes.” Finally, a European policy maker had realized what was needed. He was speaking the language of the financial Powell Doctrine, in the City of London, to an audience of investors, in English. What Draghi was signaling was that Europe, finally, “got it.”

  Implicit in this rendition of what happened in the summer of 2012 is another narrative, at odds with Draghi’s intended meaning. “Whatever it takes” was, in fact, a form of surrender. The eurozone was finally giving in to what Anglophone economic commentators had been calling for all along. If only the ECB had moved to the Fed model earlier, as Obama had spelled out at Cannes, the worst of the eurozone crisis might have been avoided. What Draghi now promised was what Geithner, Bernanke and Obama had been preaching to the Europeans since 2010: “Do it our way.” Nor was it a coincidence that it was Draghi—an American-trained economist; a Goldman Sachs associate; a paid-up member of the global financial community; a “friend of Ben”; an internationalized, urbane Italian, not a provincial German—who delivered this conclusion to the agonizing story of the eurozone crisis. The Draghi formula—America’s formula—was self-fulfilling. He spoke the magic words. The markets stabilized. The eurozone was saved by its belated Americanization.

  Looking back over the course of events since 2007, if one stopped the historical clock in the autumn of 2012,
the story of the North Atlantic financial crisis could thus be twisted back into a familiar shape. Faced with a crisis of historic proportions, after its own fashion, the Obama administration had delivered a twenty-first-century demonstration of hegemonic leadership. It lacked the urgency and razzmatazz of the Marshall Plan era, but the upshot was decisive. Not only had America led the way through its own domestic stimulus and monetary policy programs. Through discreet diplomacy and the Fed’s massive liquidity programs, it had helped Europe across its worst crisis since the end of World War II. Americanization was the answer. Nor were the exponents of US economic policy shy about trumpeting their achievements. The Courage to Act would be the title of Bernanke’s memoir. The melodrama caused his more bashful European colleagues to wince. It was not the kind of language one associates with the recollections of an academic economist turned central banker. Other, more academic titles in the wake of the 2012 stabilization echoed the general mood of optimism. In the end, it had turned out to be a Status Quo Crisis.65 The System Worked.66 The global economy had survived and America had reasserted a new version of liberal hegemony. Europe resumed the forward march to a United States of Europe it had begun under American guidance in 1947. Among academic commentators, a cottage industry grew up on both sides of the Atlantic benchmarking Europe’s new efforts at integration against American history. Was Europe still at the Philadelphia stage, or was a Hamilton moment on the horizon?67