The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  Prime Minister George Papandreou had done a lot to transform the Greek government. The son and grandson of previous Greek prime ministers, Papandreou was particularly proud of his strategy of using Google Earth to identify houses with swimming pools that hadn’t been reported for use in calculating property tax bills. It turned out there were 16,974 suburban homes with swimming pools, not the 324 that had been reported. Tax investigators also wandered the parking lots of Greek nightclubs writing down the registration numbers of luxury cars. They found about six thousand people who drove cars worth more than €100,000 yet had reported implausibly low annual incomes of under €10,000.

  But going after affluent tax cheats was the easy part. Even among members of the troika, there was a recognition that Papandreou faced a difficult political task. “Greece has a road ahead, but it is not the autobahn,” said a senior European official involved with the troika in June 2011.

  Privatization held a special appeal for the troika because it could address many of Greece’s problems at once. Should the government comply with demands that it, for example, sell off its majority stakes in the monopoly electrical utility, or the ports of Piraeus and Thessaloniki, two of the busiest in the Mediterranean, it could immediately generate revenue that would help it repay its debts. The action would also help end a cycle of patronage that had kept Greek wages artificially high—politicians maintaining high pay and lavish benefits at state-owned companies in order to secure their workers’ votes. That would help Greece’s wages become more competitive and improve its longer-run economic prospects. Thus privatization could help achieve Trichet’s long-sought goal of cutting Greece’s unit labor costs—even more so if the new private owners found ways to make workers more productive. In that case, wages wouldn’t need to come down quite as much to make Greece competitive with the rest of Europe.

  One irony was that a socialist government was being forced to desocialize the Greek economy. Many of Papandreou’s own party members were threatening to defect rather than vote for privatizations that seemed to violate their convictions. The prime minister offered to step down if the opposition center-right party, New Democracy, would agree to form a coalition “unity” government with his Panhellenic Socialist Movement, or PASOK. But New Democracy saw too much political advantage in letting Papandreou twist in the wind and forcing his fellow party members to take a series of wildly unpopular votes for austerity.

  “To this demonstrably mistaken recipe I will not agree,” its leader, Antonis Samaras, said on May 24, after meeting with Papandreou and declining to cooperate with the plan his government was developing to assuage the troika. The far left was even less cooperative. “I didn’t come to discuss the looting of Greek society with Mr. Papandreou. I came to tell him that he must not . . . go ahead with this crime against the Greek people,” said Alexis Tsipras, head of the coalition of communist parties.

  Papandreou was on his own to try to ram privatization through parliament, so he offered his party a stark choice: Implement the troika-ordered austerity measures or dump me as your leader. He called for a confidence vote, and on June 17 shook up his cabinet, bringing in his old rival Evangelos Venizelos as his new finance minister. Venizelos may not have had the economic expertise of his predecessor, George Papaconstantinou, with his PhD from the London School of Economics, but he was the more experienced politician, a savvy tactician who had led the country’s preparations for the 2004 Olympic Games.

  Just two days later, Venizelos was dispatched to Luxembourg for a meeting of European finance ministers. French finance minister Christine Lagarde was on track to become Strauss-Kahn’s permanent successor at the IMF, but in the meantime, Lipsky took a hard line and stuck to it. Over seven hours of talks that lasted until 2 a.m., he insisted that before releasing the next €12 billion in IMF funds to Greece, he required two things: that the Greek government pass its austerity measures, which Venizelos vowed was imminent, and that the rest of Europe pledge to support Greece’s cash needs for a year to come. Lipsky was demanding that the IMF not be left high and dry—and threatening to withhold its resources if he couldn’t get assurances it wouldn’t be. “We will all require assurances that the program is financed, and that involves assurances from our Eurogroup partners that adequate finance is available,” Lipsky told reporters that night. “That needs to be done before we can move forward and we are hopeful that those conditions will be met with alacrity.”

  On June 22, Papandreou was able to twist enough arms among members of his party to win his confidence vote. Seven days later, with a narrow 155-vote majority in the three-hundred-seat parliament, Papandreou and Venizelos brought before the reluctant legislature two bills: €50 billion in privatization and €28 billion in budget cuts. Hanging over them was an explicit threat of default. If they were rejected, the troika would withhold its next disbursement and the Greek government would find itself unable to pay its bills. The measures passed—and Papandreou promptly expelled from his party the one PASOK member of parliament who’d voted against them.

  In Syntagma Square, immediately outside parliament, thousands of demonstrators assembled. Most were peaceful, but some groups set fire to the finance ministry and threw rocks and Molotov cocktails toward riot-gear-clad police. In response, police flung flash bombs and tear gas canisters into the crowd. Across Athens, ninety-nine people ended up in the hospital as a result of the demonstrations.

  Greece had enough money to pay its bills for another day, but a very long and hot summer had only begun.

  • • •

  Once in a while, a country will unilaterally default on what it owes—as Russia did in 1998, when an IMF-backed bailout failed to restore global investors’ confidence in the debt-laden nation’s government bonds. But more commonly, when a country can’t afford its debts, a lengthy series of negotiations with its creditors takes place. Lenders, of course, prefer to be paid every penny of what they’re owed, on the terms under which they originally made the loans. But failing that, they want to have a seat at the table to negotiate an orderly restructuring of the debt, not simply to be told how much of their money they’ll be getting back and on what terms. For the country involved, the process helps ensure that it will be able to borrow money in the future. For the lenders, it provides a deal that’s more favorable to them than if the borrower had just stopped making loan repayments.

  In Greece in the spring of 2011, public debt was pushing 160 percent of GDP. Was this something that could be borne even in the best of circumstances, let alone amid a shrinking economy? International bankers with exposure to Greece were increasingly concluding that they would ultimately have no choice but to accept a debt restructuring, voluntarily accepting losses in exchange for those losses being arrived at as part of an orderly dialogue. Greece, they were concluding, was functionally bankrupt, burdened by debts that it would never be able to repay—and it was time to acknowledge that fact, even if some of the European authorities didn’t want to.

  The euphemism of choice was “private-sector involvement,” which since the early 1980s has meant calling in the Institute of International Finance, or IIF, a Washington-based organization founded by global bankers to represent them in exactly this type of high-stakes negotiation. Soon, another three initials would be joining the IMF, the ECB, and the EU in determining Greece’s economic future.

  IIF managing director Charles Dallara, a former U.S. Treasury official and J.P. Morgan banker, learned at a gathering of fifty or sixty representatives of his group’s members that they were ready to accept some kind of restructuring plan. He called George Papaconstantinou, then Trichet. The ECB president chose his words carefully in speaking to Dallara, whom he had faced across the negotiating table a generation earlier when he worked on issues around restructuring Latin American debt and Trichet was president of the Paris Club. “I respect that your mind is shifting,” Trichet said to Dallara, or words to that effect. “But I don’t believe this is the way for
ward and I don’t wish to be engaged with you on this matter.”

  Trichet was as emphatic in public as he was in private: “We are not in favor of restructuring and haircuts,” he said in his June 2011 press conference. “We exclude all concepts that are not purely voluntary or that have any element of compulsion. We call for the avoidance of any credit events and selective defaults or default. This is our position, which we have made clear for a long period of time.” His reasoning was rooted in fears that a restructuring could destabilize other European nations and set a dangerous precedent. He was ever thinking about the effects of Greek haircuts not just on Greece but on the other finanancially precarious European states, and on the future of the European experiment as a whole.

  He also likely had concerns about how private-sector involvement might affect the ECB itself. For one thing, banks in Greece were being kept alive by their ability to pledge the nation’s bonds as collateral to the ECB and receive euros in return. If Greek bonds were restructured, the ECB would either have to suffer losses or cut off the banks and allow them to collapse—or both. And it was lost on no one that the ECB, through its bond purchases, was a major owner of Greek debt—€45 to €50 billion worth, according to analyst estimates. That too could mean losses for the ECB in a Greek restructuring, unless the ECB’s holdings were given special treatment.

  If there were Greek haircuts, in other words, the ECB stood to lose money. If the losses were great enough, the bank could even need to return to the continent’s governments to recapitalize. And the minute the ECB needed to raise more capital, the politicians of Europe would have power over what had been an independent central bank—a dangerous thing for central bankers who prize their autonomy. Trichet himself never articulated this set of worries in public, always casting his arguments against private-sector involvement in terms of overall financial stability. Even people close to him don’t recall him making the independence case in private. But it helps explain why the ECB was more opposed to any kind of debt reductions than other participants in the talks, including both the IMF and the private bondholders themselves.

  Within the IMF, Strauss-Kahn and then Lipsky were generally okay with the ECB view that there need not be debt restructuring. But their staffers weren’t so sure. A long-held principle of IMF lending is that it should occur only as part of a sustainable package for the country involved—that is, only when the fund has every reason to believe it will be paid back and the country can come out the other side with a reasonable level of debt at a manageable interest rate. When that’s not the case, the IMF is happy to advocate for creditors taking losses. That bondholder losses would likely have bigger consequences for the global financial system if they happened within the eurozone than outside of it was a big complication, but there was a sound logic behind the underlying idea: If a country is broke, better to face up to it rather than send good money after bad.

  That’s exactly the conclusion IMF officials on the ground in Greece were beginning to reach. The IMF acknowledged the ECB argument that “a sovereign default or disorderly bank failures could send shockwaves through Europe’s financial sector and liquidity could well dry up again, with potentially strong and negative global spillovers,” according to a July staff report. But while the other two members of the troika believed such negative ripple effects would happen only after a default, the IMF “saw serious risks of contagion, even under a strategy which tries to avoid default.”

  By the start of the summer of 2011, it was clear that Trichet’s passionate opposition was for naught. Where the ECB president saw questions of system-wide risk and moral hazard, just about everyone else saw a math problem with no other solution. That didn’t, however, include the Greek government, which had to that point considered any talk of debt restructuring as tantamount to treason. “Any talk of restructuring was a total taboo,” an anonymous Greek official told the New York Times. “We never even brought it up. If we made this case to Europe, we would have been pariahs forever.”

  In late June, Dallara traveled to Athens to meet with Papandreou and Venizelos. When he explained that a restructuring seemed inescapable, Dallara later recalled, “There was shock and surprise on their faces. They could not believe it.”

  The time had come for creditors to cooperate, to work out a voluntary restructuring of Greece’s debts as part of the next round of aid to the country. The evening of July 20, Trichet flew from Frankfurt to Berlin to hammer out the outlines of a deal with German chancellor Angela Merkel and French president Nicolas Sarkozy. They agreed that the ECB wouldn’t stand in the way of haircuts for bondholders so long as they were voluntary, the central bank received guarantees to guard it against losses, and there would be public assurances that Greece was a unique case and debt restructuring wouldn’t happen with other eurozone countries. At about 1 a.m., Trichet, Merkel, and Sarkozy called Brussels with news of the agreement. Then talks between bankers and finance ministers proceeded, in a conference space that became known as the “banker war room.”

  There, inside the European Council headquarters, a team headed up by Dallara and Josef Ackermann, the chief executive of Deutsche Bank and the chairman of the IIF, led a negotiation that was complex even by the standards of the eurozone. It pitted the European government (which wanted bondholders to take as large a loss as possible) against the banks (which, naturally, wanted to take as small a loss as possible—and had the upper hand, in the sense that they could always walk away from a voluntary agreement). It pitted the countries whose banks had more Greek exposure (like Germany, which wanted the banks to get new, safer bonds to help offset the losses from Greece) against those with less (who preferred that the banks just take their losses outright). And it pitted the ECB against everybody.

  In effect, each negotiator was fighting for the other guys to endure more of the burden of restructuring Greek debt. Ironically, the one actor without a major role was Venizelos. By this point, Greece was hardly a shaper of its own destiny.

  The agreement that emerged from all that wrangling, announced July 21, 2011, extended the maturities and lowered the interest rates of Greek bonds, giving the government more time to pay back less money, and eliminated some obligations entirely. Overall, the arrangement would save Greece €135 billion through 2020, lengthening the average maturity of its bonds from six to eleven years and reducing what it owed in “net present value” terms by 21 percent. The ECB, meanwhile, would receive both the protection from losses and the public assurance that Trichet had demanded. The IIF was confident that 90 percent of bondholders would accept the deal, preventing the damage to the European financial system that might have resulted had a eurozone member defaulted on its own.

  “With this offer, the global investor community is stepping forward in recognition of the unique challenges facing Greece,” Dallara said in a statement announcing the deal. True enough—but the global investor community also didn’t have any better options.

  Following the dramatics over Greece in June and July, markets were jittery. One recurring feature of the eurozone crisis was that authorities seemed to make decisions based on the dilemma immediately in front of them—Greece, say—with seemingly little concern for how their actions would change the behavior of markets with regard to the other GIPSI countries. What seemed like the right thing to do to address Greece might make no sense if it just led bond markets to expect the same for Ireland or Spain or Italy. Trichet was the strongest voice trying to persuade European political leaders of the importance of being sensitive to these effects, with assists at various times from Tim Geithner and Mervyn King, as well as other U.S. and British authorities and, at least until his arrest, Strauss-Kahn. But no matter how many impassioned speeches Trichet gave in some Benelux summit, or how many times his warnings were proved by events, he seemed not to get through.

  Indeed, after haircuts were finally negotiated for Greek bondholders, global investors began to look around to wonder what other European cou
ntries’ bondholders might be stuck taking a “voluntary” loss down the road. Ireland and Portugal were already under agreements that gave them a source of emergency funding, and both countries were fulfilling their bailout obligations more reliably than Greece had, so there was little reason to think they would be cut off from the IMF/EU spigot. Logically, investors shifted their attention to the remaining GIPSIs: Spain and Italy.

  If those countries went under, the risk to Europe and the world financial system would be far greater than it had been up to now. Spain and Italy together have about four times the population of Greece, Ireland, and Portugal. Whereas the earlier rescues were easily affordable by the other European countries and the IMF, the cost to rescue Spain and Italy could stretch their resources to the breaking point. The nations were simultaneously too big to fail and too big to save.

  At the end of June, the Italian government could borrow money for a decade for 4.25 percent, or about 1.25 percent more than Germany could. On July 14, while the Greek haircuts were being negotiated, the Italian government held one of its regular auctions of bonds, seeking to sell €5 billion worth of five- and fifteen-year securities to pay off older ones that were coming due. But the investors who would normally buy them, in Milan and Frankfurt and London and beyond, didn’t place bids in line with anything resembling the bonds’ typical cost. With all the uncertainty swirling around the eurozone’s future, they would buy the bonds only if they received a higher yield than usual. It was just one of many days that month on which the appetite for Italian bonds fell and their rates rose. By the early days of August, the prevailing interest rate had soared to 5.54 percent.