The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  “I guess older people will be upset or feel a sense of national humiliation,” said Niamh Norton, a college student quoted by the Observer. “But the truth is that it’s the big countries of the world that dictate what’s going on. . . . Ireland is a small country.”

  • • •

  The cast of international officials may have been a little different, but the small-country script being staged in Ireland had been well rehearsed in Greece a few months earlier. Brought together on the fly in the spring of 2010 and by fall the most powerful partnership in Greek politics, the team of Masuch, Danish economist Poul Thomsen, and Belgian fiscal policy expert Servaas Deroose represented, respectively, the ECB, the IMF, and the European Commission. This was the “troika,” suddenly responsible for the economic future of some eleven million Greek citizens.

  Over room-service sandwiches and sometimes a Mythos beer in an Athens hotel suite, they talked about what they’d learned that day. Where was the Greek government following through on its promises? Where was it not? How might they steer their discussions tomorrow to have more of the former than the latter? Downstairs in a conference space, their staffers—forty, fifty, or more people—divided into teams, ate catered food, and discussed among themselves their own conclusions and plans for the next day.

  In quarterly missions, usually lasting two weeks or so (although a few stretched out to more than a month), the representatives of the troika interrogated midlevel staff at all sorts of government agencies—the tax collectors, the energy regulators, the bank supervisors—to try to figure out whether Greece was living up to the agreements its leaders had made in exchange for the international bailout received in May. The meetings, most of them conducted in English, tended to be civil affairs, with the Greek officials understanding that all present were there to do a job. Some of their interlocutors even seemed pleased to finally have the outside pressure needed to enact reforms they had long sought.

  There was more animosity outside the corridors of power, where the citizenry saw the visitors as the reason wages and pensions were being slashed. The faces of Masuch, Thomsen, and Deroose (and later Matthias Mors, who took over as the European Commission’s representative), each relatively anonymous at his respective organization, were splashed on newspaper front pages. The men had to travel with a police escort and eventually had to change hotels. At first they’d stayed at the Grand Bretagne. But when sometimes violent protests erupted in the square it overlooks, they moved to the Hilton a few blocks away.

  The three officials tried to work out disagreements among themselves—for example, how hard to press on cutting wages for government workers as opposed to encouraging longer-term privatization projects. Ironically, while the IMF became a more visible target of populist ire on the streets of Athens, the organization was more worried than other troika members about the economic impact of immediate austerity. That reflected both the fund’s experiences in Asia in the 1990s and Latin America in the 2000s—and the fact that it was led by Dominique Strauss-Kahn, a man of the left who embraced Anglo-American-style Keynesian economics more than many continental Europeans. The ECB and the EC were the greater enthusiasts for steep and immediate spending cuts. Still, the three men—and their bosses in Washington, Frankfurt, and Brussels—managed to keep their disagreements confined to the suite in the Hilton and present a united front.

  “It seemed they were very well coordinated with each other so as not to create friction points that were evident to us,” said one Greek official who worked across the negotiating table. “I have heard there were disagreements, but they were never able to undermine the collectivity of the troika.”

  It remains the fact, though, that this was the situation in which Greece found itself in 2010: As the price of a bailout, its central bank was part of a team that was giving instructions to elected leaders on what to do about pensions, taxes, and privatization of state-owned industries.

  Democracy had been born in Greece. And democracy, it was said, had died there.

  Issues of national sovereignty aside, things were moving in the right direction. The series of interventions hatched over the weekend of May 9, 2010, had succeeded. European institutions—both the governments and the ECB—had shown the resolve necessary to keep the Greek crisis from spiraling out of control. Sure, the European stability fund was more an idea than a reality, but so long as the GIPSI governments carried out what they’d promised, an investor could feel assured that no eurozone nation would be allowed to default on its debts. And the ECB’s interventions in the bond market proved surprisingly effective. After an initial burst of purchases of Greek, Irish, and Portuguese debt in May and June, markets were functioning well enough that the buys were allowed to taper off. By the last week of August, the ECB’s total bond holdings under the securities-market program added up to only €61 billion.

  It was a victory for Jean-Claude Trichet’s approach to crisis management. He was a big believer that even small interventions by a central bank, if made at just the right time and in the right way, could cause a significant shift in market sentiment. The start of bond purchases punished those who were betting on a eurozone collapse in the spring and made anyone thinking of selling off bonds wary of betting against the ECB and its limitless balance sheet. Markets eased pressure on the GIPSI countries. Spanish ten-year borrowing costs, for example, fell from 4.9 percent in June to 4 percent at the start of September.

  The government of Greek prime minister George Papandreou was even having some success—with prodding from the troika—meeting its ambitious goals of cutting pensions and raising taxes. Finance Minister George Papaconstantinou even approached the Institute of International Finance, an association of giant global banks that are among the major buyers of government debt, to arrange a “non-deal road show”—an occasion for him to go to major financial centers and meet with investors to persuade them of Greece’s commitment to repairing its finances, in hopes that they might eventually resume buying its bonds.

  The actions of May had bought Europe some time to address its economy’s underlying problems. Yet by the fall of 2010, none of its structural defects had been fixed. Greeks were still paid more than their levels of productivity would suggest was sustainable, and German and French banks were still sitting on piles of debt issued by governments with shaky finances. The continent’s bank regulators conducted a coordinated “stress test” of their various banking systems to examine potential weaknesses and announced its encouraging results on July 23: Most banks could survive losses totaling hundreds of billions of euros. But the test assumed that the debt of all eurozone countries would be fully repaid, which amounts to begging the question.

  There were also early signs of cracks in that sense of common resolve, as the governments of Europe went about figuring out the details of the stability fund they had agreed to. Then came perhaps history’s most consequential stroll on the beach.

  • • •

  German chancellor Angela Merkel was grappling with competing pressures. Her ability to resolve them would, more than any other factor, determine the future of Europe.

  On the one hand, her countrymen were aghast that they were being asked to bail out the Greeks. The very day the bailout package was being negotiated, May 9, her coalition lost massively in regional elections in North Rhine–Westphalia, in part due to discontent over the push to aid Greece, and she would face seemingly constant challenges in Germany’s constitutional court as to the legality of the bailout measures to which she had committed the nation. On the other hand, the most powerful woman on the continent was also very much a European, determined to realize the vision of a united continent that her political mentor, Helmut Kohl, had set. “Ladies and gentlemen, let’s not talk around it,” she said in a speech in Aachen on May 13. “The crisis over the future of the euro is not just any crisis. . . . This test is an existential one. It must be passed. Failing it, the consequences would be incalculable for Europ
e and beyond. But succeeding, then Europe will be stronger than before.”

  In the fall of 2010, it was antibailout fervor toward which Merkel was most attentive. Even some within her own government were starting to pose some fair but uncomfortable questions: Why were German taxpayers being asked to aid Greece—what about the people who’d lent the nation all that money in the first place? And wasn’t Greece effectively bankrupt? When a company goes bankrupt, its investors lose some of their money. Yet the banks and pension funds that had bought Greek bonds were, under the plan being pursued, not to receive a euro less than they were owed. Why, German politicians asked, shouldn’t they suffer the same losses any other unwise investor would? Ironically, this put the questioners in common cause with many Greek politicians, who’d have been more than happy to see their debt burden actually reduced, rather than just restructured.

  If that was the mentality in Berlin, the sense in Frankfurt, both at the Eurotower and the Bundesbank, was quite the opposite. European central bankers saw grave risk in forcing losses upon Greek creditors. As Trichet and other ECB officials saw it, if Greek bondholders were forced to take haircuts, it could inspire a dangerous and unpredictable chain reaction. Investors would judge the debt of all the at-risk eurozone nations as riskier and likely dump Irish, Portuguese, Spanish, and Italian bonds. Even France could find itself in the line of fire. German and French banks, major holders of Greek bonds, could find themselves undercapitalized and require a new bailout.

  And those were just the knowable effects. Government bonds are the bedrock of the financial system. As with the Lehman Brothers failure, a Greek default could have rippling second-order effects that would be very hard to predict. It was one thing for a nation to stiff bondholders when it had its own currency, as Argentina did in 2001 and Russia did in 1998. But to do so as a member of a shared currency union could cause all manner of unforeseen problems. Bailing out not just the Greek government but also Greek creditors was, in the ECB’s view, a small price to pay to prevent them.

  On October 18, when the finance ministers of Europe gathered in Luxembourg to try to hash out details of the stability fund they’d agreed to five months earlier, the two most important of their number were not present. Wolfgang Schäuble of Germany and Christine Lagarde of France, representing the largest and most powerful nations of Europe, had dispatched deputies. The ministers themselves were in Deauville, a small tourist town on the coast of Normandy with a star-studded history. Elizabeth Taylor and Coco Chanel had vacationed there. So had the fictional Tom and Daisy Buchanan of The Great Gatsby. And Ian Fleming had likely based the setting of his first James Bond novel on the town’s casino. Now Schäuble and Lagarde’s respective heads of state were about to put the town on the map all over again.

  The purpose of the Deauville gathering wasn’t to talk economics—it was, rather, a regular meeting of German, French, and Russian heads of state devoted to diplomacy and security issues. But Merkel and French president Nicolas Sarkozy decided to use the occasion to work out, between the two of them, an accord on the path forward for Europe. They met at the Hotel Royal Barrière, and in sight of reporters, Sarkozy gave Merkel a hug and sent an aide to retrieve her coat. Against a stunning late fall sunset, tailed by security guards and with photographers clicking from a distance, the pair strolled along a boardwalk overlooking the English Channel and worked out a deal.

  Merkel, responding to domestic political pressure, wanted to ensure that the bailout fund agreed to in May wouldn’t be part of a permanent source of funding for nations with weak finances. She insisted that, starting in 2013, any nation needing financial assistance would have to allow haircuts for bondholders. Sarkozy initially resisted, but he agreed to the update in exchange for Merkel’s dropping her earlier insistence that governments failing to meet deficit restrictions face automatic sanctions, a measure designed to ensure budgetary restraint in the future.

  Shortly after their talk, the French government issued a “Franco-German Declaration” consisting of 391 words in English, most of which would be unintelligible to all but the most knowledgeable student of intra-European economic policy. (“In enforcing the preventive arm of the Pact, the Council should be empowered to decide, acting by QMV to impose progressively sanctions in the form of interest-bearing deposits . . .”) Most of the debate within Europe in the days that followed was around what the statement meant for new fiscal rules. But for the investors who buy government bonds, the real news was located near the end of the document. Treaties should be amended, the communiqué stated, “providing the necessary arrangements for an adequate participation of private creditors.”

  Translation: If there are more bailouts, bondholders will pay.

  The finance ministers in Luxembourg first learned of the bargain struck on the beach in Deauville from a news report. At just after 5 p.m., Jörg Asmussen, standing in for Schäuble, printed out an e-mail from his colleagues in Deauville outlining the agreement. Many of the ministers were angry; they’d been trying to hammer out their own arrangement, and the two biggest economies of Europe had just gone off on their own to make a deal that would affect them all. (“We’re more or less used to Germany and France cooking things up,” said an anonymous diplomat quoted by the Financial Times. “But this was really flagrant.”) Across the Atlantic, the Americans hadn’t even realized that such a major accord was in the offing. If they had, Treasury officials would surely have recommended that President Barack Obama place a call to Merkel and Sarkozy to suggest a different approach.

  But no one was angrier at what he’d learned that Monday afternoon than Jean-Claude Trichet.

  The plan that Merkel and Sarkozy had agreed upon was the exact opposite of what Trichet and the ECB were recommending. Trichet wanted strict fiscal restraint from countries getting assistance, paired with total protection for bondholders to prevent a new wave of crisis. The bargaining in Deauville had delivered the opposite in both cases. In Luxembourg with the finance ministers, he shouted in French to his home country’s delegation, “You’re going to destroy the euro!” Ten days later, when the heads of the European governments met in Brussels, he was more pointed still. He aimed to teach the assembled national leaders about the workings of bond markets—and impress upon them just how much the threat of haircuts could endanger the eurozone.

  He spoke for only about fifteen minutes, invoking his experience heading the Paris Club for international debt negotiations two decades earlier. Introducing the prospect of losses for creditors was shortsighted, he argued, essentially begging bond investors to shun government debt across the eurozone, making the need for bailouts self-fulfilling. It’s one thing if governments do all they can and it turns out their finances are unsustainable. But to warn investors that they’ll undoubtedly face haircuts is ludicrous; it just makes the possibility of a default more likely. Spain might be in fine financial shape when it can borrow money for 5 percent, but if bond purchasers believe they will face a loss in any rescue, that rate might rise to 8 or 10 percent, making the bailout necessary. “We must be clear about how the markets work,” Trichet said. “If the crisis mechanism involves the private sector, it will be much more vulnerable.” Trichet was, in his characteristic style, animated, even enraged, dramatically gesticulating to make sure he got the officials’ attention.

  The European leader who was the most convinced by Trichet’s argument was British prime minister David Cameron. But given that Britain wasn’t in the eurozone and wasn’t helping to pay for the stability fund, his opinion didn’t matter nearly as much as those of Sarkozy and Merkel. Sarkozy had a particularly negative reaction, though his attacks seemed motivated by more than the matter at hand. Sarkozy had often attacked the unelected, Frankfurt-based leadership of the ECB, despite the presence of one of his countrymen at its top. He’d even made the central bank a campaign issue a few years before, when he’d argued that its inflation-focused policies were hurting French business.

  W
ord of Trichet’s impassioned opposition to Sarkozy and Merkel’s plan soon leaked to the press, even though his public statements were more restrained than what he’d said in Brussels. At a news conference a few days later, the ECB president made his point in a rather more roundabout way, emphasizing that the IMF doesn’t announce in advance that bondholders are likely to be punished if the fund comes to a country’s aid. “The IMF does not make necessarily the ex-ante working assumption that the relationship with markets, investors, and savers is interrupted,” Trichet said on November 4.

  His warnings were too late. In the days after Deauville, the bond markets started to behave exactly as Trichet had feared they would. Borrowing rates for Italy, Portugal, and Spain all rose. But most worrisome was Ireland: The day Sarkozy and Merkel went for their walk, the nation could borrow money for a decade for 6.25 percent; by November 11, that had risen to nearly 9 percent. The economic leaders of Europe, in Seoul for a Group of 20 summit on November 11 and 12, issued a statement seeking to ease market pressure, saying that the holders of current bonds would be protected from any haircuts and that losses wouldn’t happen until 2013 at the earliest. But that wasn’t enough to assuage rising fears about Ireland.

  Irish real estate and banking busts had slowed economic activity, which had reduced tax revenues. The country’s bank guarantees alone amounted to 40 percent of GDP. In 2010, the Irish government’s budget deficit rose to a stunning 31 percent of GDP, from basically nothing three years earlier, putting total debt at 92.5 percent of GDP. When worries about European public finances first emerged in late 2009, Ireland had moved more proactively than Greece or other nations to cut spending and try to reduce deficits. But its monetary policy was set by the ECB based on what was best for all seventeen member nations of the eurozone. The Central Bank of Ireland couldn’t work independently to offset the contracting economy with cheaper money. With too-tight monetary policy added to the rest of it, the result was nothing short of an Irish depression.