6. Super Mario
A SPIKED PRUSSIAN MILITARY HELMET , a Pickelhaube, decorates Mario Draghi’s office on the 35th floor of the Eurotower in Frankfurt, the headquarters of the ECB. It was a gift from the editors of Bild, a German tabloid newspaper, intended as both a compliment to his reputation as “the most German” of the candidates to run the central bank (after the resignation of Axel Weber) and a warning to the former Italian central banker not to let down his guard against inflation. As he took charge of the ECB at a time of great peril for the euro zone he had to act boldly, though he knew he could ill-afford to allow austere northerners to accuse him of turning the ECB, the heir to the uncompromising Bundesbank, into a European version of the Banca d’Italia.
Replacing Jean-Claude Trichet in November 2011, Draghi brought a new style. His meetings were shorter, he delegated much more responsibility to colleagues and, having spent time at Goldman Sachs, he was more in tune with markets than his predecessor, as well as rather less stuffy. His first act in November (and also in December) was to reverse his predecessor’s misjudged rate rises earlier in the year, catching most analysts by surprise. It was a hint that, instead of being compelled to respond to events, he would try to change the market’s expectations. The fiscal compact he had asked for also gave him political cover for a bolder move: the provision of vast amounts of emergency liquidity for Europe’s banking system, called Long Term Refinancing Operations (LTRO). Banks and sovereigns were facing a large refinancing hump in 2012, and banks were running short of collateral.
Draghi acted to prevent any funding “accidents” that might be the spark for another crisis. The first wave of cash was announced just before the December 9th summit that endorsed the fiscal compact. The second wave was released in February 2012. In all, the ECB provided €1 trillion worth of three-year loans at a 1% interest rate, and also eased collateral requirements. Nicolas Sarkozy gleefully let everybody know that the banks, especially in southern Europe, would use much of the money to buy high-yielding sovereign bonds; in other words, this was bond-buying through the back door of the banks. Yet the “Sarkozy trade”, as it came to be known, did not save France from losing its AAA rating from Standard & Poor’s (S&P) in January. Eight other euro-zone countries were also downgraded. By leaving Germany as its only AAA-rated euro-zone sovereign with a “stable” outlook, S&P destroyed the symbolic parity between Germany and France. Europe’s dividing line shifted from the Alps and the Pyrenees to the Rhine. Moreover, by chastising so many, S&P made clear that the problem was not just individual countries, but the euro zone as a whole. The October summit deal had been inadequate and did not provide enough support for troubled states. It said: 1 The outcomes from the EU summit on Dec. 9, 2011, and subsequent statements from policymakers, lead us to believe that the agreement reached has not produced a breakthrough of sufficient size and scope to fully address the euro zone’s financial problems… We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the euro zone are as much a consequence of rising external imbalances and divergences in competitiveness between the euro zone’s core and the so-called “periphery”. As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.
Over the following weeks Draghi’s cash would ease the spasm. The euro zone breathed more easily. Bond yields for Italy and Spain dropped markedly, by about 250 and 90 basis points respectively between January and March. The long-drawn-out second Greek bailout, with its large haircut on privately held government bonds, was concluded in February and markets seemed unconcerned by the triggering of credit-default swaps that had once been so feared.
Draghi quietly retired Trichet’s official bond-buying operation in February. Yet no sooner had he told Bild in March 2012 that “the worst is over” than the crisis entered another, more perilous phase. The LTRO drug was wearing off, and the euro zone had entered a double-dip recession at the end of 2011, caused in part by the previous year’s turmoil. Markets’ concern shifted from the deficit to shrinking output, that is, from the numerator to the denominator in the ratio of borrowing to GDP.
The pain in Spain
Through the crisis the spread of a country’s bond yields over German ones has been the temperature chart of the euro zone’s sickness. The spread in bond yields between Italy and Spain tells its own story of comparative illness. Before the credit crunch, Italian bonds would yield 10–20 basis points more than Spanish ones. In January 2010 the lines flipped, in part because conservative Italian banks seemed in better shape than Spanish ones, crippled as they were by the property crash. In August 2011, though, Italy was again the riskier bet as Silvio Berlusconi’s government began to collapse. In March 2012, the order was inverted once more.
There were two main reasons for the latest switch. First, Italy’s Mario Monti became the darling of Europe, feted in Germany and the United States alike. Monti, some officials said, was Italy’s real firewall. In Spain, meanwhile, doubts spread about the credibility of the new conservative government of Mariano Rajoy, even though it had been resoundingly elected in November 2011 on a promise of tough deficit-cutting and structural reforms. Second, Spain’s economy and its banks were taking a turn for the worse.
In late February Spain announced it would miss its 2011 deficit target by a surprisingly wide margin, 8.5% of GDP instead of 6%. On March 2nd Rajoy unilaterally changed the 2012 target to 5.8%, instead of the EU-mandated 4.4%. That he made the announcement on the margins of an EU summit at which 25 leaders signed the fiscal compact recommitting governments to budget discipline, informing nobody of his move, caused much irritation; a feeling heightened by the fact that he withheld publication of his 2012 budget until after a regional election in Andalusia to be held at the end of the month (his party lost anyway).
Spain’s woes caused a deeper rethink among European policymakers. Spain gave strong cause to question the diagnosis of the euro’s problems. This was not a case of profligacy, as in Greece, or reckless “Anglo-Saxon” capitalism, as in Ireland. Spain had run a budget surplus before the crisis and had boasted of having one of the best financial regulatory systems. Moreover, Spain’s persistent budget deficit raised questions about the favoured prescription of hard, front-loaded austerity. In April the IMF published the first of a series of studies suggesting that fiscal multipliers, which measure how badly growth would be affected by budget austerity, were larger than expected in circumstances, such as those of the euro zone, in which interest rates were close to zero, credit was tight and neighboring countries were all cutting their deficits. The Fund urged euro-zone countries to slow the pace of fiscal consolidation.
Above all, the alarming state of Spain’s banks highlighted a facet of the crisis that had been semi neglected: the banking crisis of 2009, masked by the panic over sovereign debt, had not been resolved. In fact the two were interconnected. In Greece the bankrupt sovereign was bringing down the banks. In Ireland, and increasingly now Spain, bust banks were endangering the sovereign. The outflow of capital that Spain had suffered from the summer of 2011 abruptly accelerated pace in March 2012. Spain’s financial regulator had proved unable or unwilling to clean up banks wrecked by bad property loans. Across the euro zone, and beyond, banking was one of the last bastions of protection within the EU. Regulators treated banks as national champions. They were reluctant to reveal losses, either for lack of money to recapitalise banks, or for fear that they would be taken over by foreigners.
Often governments wanted to avoid rescued banks being forced to divest themselves of assets under state-aid rules designed to preserve fair competition. By mid-2012, say EU officials, national regulators had overestimated bank assets in almost all cases the Commission had investigated, probably in an attempt to mask the scale of public assistance. Repeated stress tests conducted by the European Banking Authority had been discredited: in July 2011 it gave a clean bill of health to Dexia, a French-Belgian group that was bailed out in October 2011, and to Spain’s Bankia, part-nationalised in May 2012. The LTRO money had provided brief relief, but by encouraging banks to buy more bonds had worsened the deadly feedback loop.
In sum, Spain provided strong evidence that the problem was not just the behaviour of individual countries, or the enforcement of fiscal rules. Instead, it was property bubbles, imbalances and the unstable structure of the euro zone. Indeed, the euro zone found itself in the grip of three separate crises – banking, sovereign debt and growth – with each connected to the other through destabilizing feedback loops. Figure 6.1 shows how premiums for credit-default swaps for Spanish sovereign bonds and Spanish banks closely followed each other. Weak banks endangered sovereigns that were called upon to save them, and weak sovereigns endangered banks holding bonds at risk of default. Recession worsened the debt ratio, but austerity to reduce borrowing suppressed growth, or caused even worse recession. Federal governments attenuate such doom-loops by providing fiscal transfers (for example, through unemployment benefits) and dealing with shocks to the financial system. But the euro zone had no budget or central authority.
One response was gradually to ease austerity. Already the second Greek programme in February had relaxed the pace of fiscal consolidation and softened repayment terms on bail-out loans. In late May, despite the irritation with Rajoy’s antics, the Commission gave Spain an extra year to meet its deficit target of 3% of GDP by 2014, instead of 2013. In June it was given a partial bail-out when finance ministers agreed in principle to lend it up to €100 billion to help clean up and recapitalise its banks. Unlike Greece, Spain was given only “light” conditions, and the sum included a generous safety margin to address unforeseen needs. But the deal had little impact on borrowing costs. And now Spain’s troubles were once again pushing up Italy’s bond yields.
Europe à I’Hollandaise
The election on May 6th 2012 of a Socialist president in France, François Hollande, who had campaigned on an anti-austerity platform, was greeted with mixed feelings: hope that the Merkozy diktat would end, but also worry that the untested Merk Holland might lead to paralysis or worse. There was not much of a honeymoon. On the same day, Greek voters crushed both main centrist parties, the centre-right New Democracy and especially the Socialist Pasok. The old giants barely mustered 30% of the vote between them. It was, in a sense, as if the abortive referendum that cost George Papandreou his job had been held after all. But having expressed their revulsion with the political elite, Greek voters were less clear about what should replace it. Votes were scattered among anti-austerity factions ranging from the Stalinist left to the neo-Nazi right. A second ballot was called in June to break the stalemate, amid hopes that the Greeks would behave rather like the French: voting with their hearts in the first round but with their heads in the second.
Hollande soon cast himself as the champion of the south. His promise to renegotiate the fiscal compact was fobbed off with a “growth compact” that was little more than a repackaging of several modest and pre-existing European spending initiatives. He also revived the idea of Eurobonds. It was unfair that Spain had to borrow at 6% while Germany could do so almost free of interest, said Hollande at an informal EU summit to welcome him on May 23rd. But Angela Merkel would not hear of debt mutualisation. That evening Herman Van Rompuy appointed himself to write a report with a vague remit to find ways of deepening euro-zone integration. It would look not only at Eurobonds but also, crucially, at “more integrated banking supervision and resolution, and a common deposit insurance scheme”.
The idea of a “banking union”, as an alternative to the “fiscal union” pushed by France, was thus taking shape as a response to the Spanish crisis. Economists had long argued that, in an integrated financial market, centralised European authorities should be responsible for supervising banks and for winding them up when they failed. In February 2011 a paper by Bruegel, a Brussels think-tank, declared that “nothing less than supranational banking supervision and resolution bodies can handle the kind of financial interdependence that now exists in Europe”. Such ideas had been considered for Jacques de Larosière’s report on financial regulation in February 2009, but were deemed too ambitious. The new European supervisory authorities – three new regulators for banks, insurance and markets, and the European Systemic Risk Board to monitor threats to the overall financial system – that emerged from the report were little more than loose co-ordinating bodies.
A separate but related idea was the direct recapitalisation of troubled banks by the EFSF or the future ESM, to avoid the burden falling on vulnerable sovereigns. The concept had been pushed by the IMF in July 2011. France had also wanted to draw on the EFSF to recapitalise Dexia in October 2011 but had been turned down. In April 2012 the IMF returned to the charge, this time with a more detailed longer-term proposal for a single European supervisor with a single resolution authority and fund, and a Europe-wide deposit-guarantee scheme. By the end of May the chorus of supporters for “banking union” grew louder, as the ECB and the Commission joined in. Under the deliberately understated title of “integrated financial framework”, banking union was one of the four pillars of Van Rompuy’s June 26th report on the future of the euro, alongside fiscal union (including tighter budget controls and a timetable for Eurobonds), economic union (co-ordination of labour-market and other policies) and political union (to give democratic legitimacy and accountability to the other three pillars).2
The breakthrough came at a secret meeting of finance ministers from Germany, France, Italy and Spain and senior European officials, at the Sheraton Hotel next to Charles de Gaulle airport in Paris (for greater discretion) on June 26th. The discussion focused on another old French demand, that the firewall be boosted by giving the ESM a banking licence so it could borrow from the ECB. Changing tack, Pierre Moscovici, the new French finance minister, suggested direct bank recapitalisation by the ESM to help Spain. His German counterpart, Wolfgang Schäuble, caused a stir when he suggested it might be possible – but only if there were direct supervision of banks. This was in line with Germany’s mantra: greater solidarity could only come with greater control. But would Merkel agree to any of this?
Two Super Marios
The European football championship, in which Italy met Germany in the semi-final at the national stadium in Warsaw on June 28th 2012, became a metaphor for the political battle taking place the same night in Brussels: north and south, discipline against guile, creditors versus debtors. The football-mad Merkel would step out of the meeting room to watch replays of key moments, such as Mario Balotelli’s winning goal for Italy in the 36th minute. In the summit she was confronted by another Super Mario, the Italian prime minister, Mario Monti. His game was a form of catenaccio, the unyielding Italian defence, played with his Spanish colleague. They stubbornly blocked agreement on the final communiqué, including Hollande’s “growth pact”, until the chancellor had agreed to their demands. Rajoy wanted the direct recapitalisation of Spanish banks by the EFSF; Monti wanted an automatic mechanism to help bring down the borrowing costs of vulnerable but “virtuous” countries (that is, Italy).
For Italy, in particular, this was an unusual change of behaviour. Berlusconi, though dominant for years in domestic politics, typically said very little at European summits. Now the technocrat who had succeeded him was daring to play hardball against the mighty Germans. The difference, perhaps, was down to the fact that Italy under Monti had regained some credibility, and therefore some room for manoeuvre. With some skilful bureaucratic midfield play by senior officials in Brussels, Monti and Rajoy got their way at around 4am, having overcome a sustained rearguard action by Finland and the Netherlands (one senior euro-zone official called these last two emmerdeurs, a fruity French word that translates roughly as “pains in the arse”.)
Thus the opening sentence of the euro-zone statement declared grandly: “We affirm that it is imperative to break the vicious circle between banks and sovereigns.”3 Leaders agreed to set up a single supervisor, based at the ECB, to oversee the euro zone’s 6,000-odd banks. Thereafter, the rescue funds could be used to recapitalise troubled banks directly. Ireland was also promised unspecified help, in tacit recognition that it had been forced to take on much of its banks’ debts. The second concession was to allow the EFSF, and in future the ESM, to intervene to stabilise bond markets for members respecting a long list of European commitments without a full-blown troika-monitored programme.
Rajoy probably scored the winning goal on the night, but Monti was the playmaker. He certainly acted as the victor, as he emerged from the summit speaking teasingly about “many important discussions, sometimes tense, with many emotional aspects, often concentrated on football”; his supporters would later say that an oblique reference in the communique to the ECB’s role as an “agent” for bond-buying by the rescue funds was the harbinger of a bigger role for the ECB. Across Europe, newspapers could not resist parallels between Germany’s defeat in European football and Merkel’s concession in European politics. Pro-Berlusconi papers, no fans of Monti, were particularly crude. One showed Balotelli kicking a football in the shape of Merkel’s head; another splashed with the headline “Ciao, Ciao Culona” (“Bye Bye Fat Arse”), a reference to an intercepted phone call in which Berlusconi is alleged have described the German chancellor in particularly crude terms.4
The euro zone was crossing an important threshold: responsibility for the banks might now be shared. Some EU officials spoke of the summit as the most important act of integration since the Maastricht treaty. Of itself, the creation of a single supervisor would amount to a substantial surrender of national sovereignty. The change would be greater still if and when other pillars of banking union were created: a euro-zone resolution authority with access to a common pot of money to wind up bust banks; a single deposit-guarantee scheme; and a common fiscal backstop. The US Federal Deposit Insurance Corporation (FDIC) is set up along such lines, able to draw on a line of credit from the Treasury if necessary. From the start of the financial crisis to the end of 2013, it has wound up more than 400 (mostly small) banks, in contrast with a handful in Europe (and about 40 banks that have received state aid). Merkel may have told members of her coalition that she could not envisage wholesale Eurobonds in her lifetime. But joint liability of a different form might now come via the back door of the banks. In the end, the need for taxpayers ultimately to stand behind the banking system means that a real banking union would become a step towards a fiscal union.
Still not enough
Yet the euphoria in the markets was short-lived. Part of the blame lies with European leaders’ love of bickering. The Dutch prime minister, Mark Rutte, tried to peg back Monti’s exuberance, insisting countries would still face conditions if helped by the fund. Finland demanded collateral, and later seemed to muse about leaving the euro (officials said comments to this effect by Jutta Urpilainen, the finance minister, had been mistranslated). Germany put out the message that, even in the case of direct recapitalisation, national governments would be liable for any banking losses. And there was another worry. Germany’s constitutional court was due to deliver its verdict on the legality of the permanent new rescue fund, the European Stability Mechanism, in September. A negative decision would remove the euro zone’s safety net, inadequate as it may have been. More bad news came from Moody’s, a ratings agency, which announced it had placed the AAA credit rating of Germany, the Netherlands and Luxembourg on “negative outlook” because of the danger of financial instability if Greece left the euro, and the possible costs of helping Spain and Italy.5
On top of this was the chronic, seemingly insoluble problem of Greece. Despite two bail-outs, two rounds of debt restructuring and, as in Italy, the appointment of a technocrat to head the government, Greece needed still more billions to avoid default. All attempts at reform had come to a halt during the Greek election campaign. The second ballot on June 17th allowed Antonis Samaras, leader of New Democracy, to cobble together a broad coalition with his arch-rival, Pasok. Yet Samaras was poorly regarded by European leaders. In opposition his refusal to support the first bail-out was deemed to have crippled Papandreou. Later, when he backed the unity government of Lucas Papademos, Samaras was evasive about the terms of the second rescue. And by forcing early elections in the midst of a wrenching adjustment, he was blamed for opening the door to extremists.
For better or worse, Samaras was now the last hope for Greece. Barroso flew to Athens to warn him to stop talking about renegotiating Greece’s bail-out conditions. In private and in public, he told him: “Deliver, deliver, deliver.” To the outrage of many in Brussels, Merkel’s government continued to entertain the idea of pushing Greece out, even though its citizens had voted for pro-European parties. Philipp Rösler, leader of Germany’s liberal Free Democrats, Merkel’s junior coalition partner, declared on July 22nd: “A withdrawal of Greece has long since lost its terror.” By then Spanish ten-year bond yields had passed the psychological threshold of 7%, and Italian ones were not far behind. Terror had returned to the euro zone.
Whatever it takes
To some, Cannes and its aftermath in late 2011 was the cruelest moment of the entire crisis. To many others, the moment of greatest despair came in the summer of 2012. Draghi, spending a few days in London at the end of July, was worried about financial data: economic fundamentals had not changed and there was ample liquidity. Yet money was fleeing north, regulators were telling banks to keep their money within national borders, cross-border bank lending had all but stopped, and sovereign spreads were rising along with credit-default swaps. To the ECB this was evidence of the euro zone moving towards the “bad equilibrium” evoked by Paul De Grauwe, then a professor of economics at the Catholic University of Leuven. He had argued in 2011 that, unless the ECB acted as a lender of last resort, countries in the euro zone were effectively borrowing in a foreign currency and could easily be pushed into default by panicked markets. Draghi thought that fear of the euro’s break-up was becoming a self-fulfilling process. Only the ECB could put an end to the “redenomination risk”.
On July 26th, the eve of the summer’s other big sporting festival, the London Olympics, Draghi addressed a group of investors gathered in the splendour of Lancaster House in London. The single currency, he recalled,6 had once been described as a bumblebee which, as scientific lore had it, should not be able to fly. The euro area was “much, much stronger than people acknowledge today”; outsiders were underestimating recent reforms and the political will to make the euro irreversible. Then came a seemingly unscripted sentence that made his audience sit up. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” said Draghi, pausing for a moment. “And believe me, it will be enough.” Dealing with markets’ fear of “convertibility risk”, declared Draghi, was within the remit of the ECB.
Markets had usually ignored leaders’ promises to do whatever it took to save the currency. But Draghi’s words had an immediate effect, even though nobody was quite sure what would follow – not even all members of the ECB’s executive board. There could not simply be a return to Trichet’s Securities Market Programme (SMP), by now regarded as an expensive mistake that had lumbered the ECB with more than €200 billion-worth of vulnerable bonds, to little effect. Draghi never forgot how Berlusconi had reneged on his promises of reform the previous year. The ECB concluded that the SMP had suffered from multiple flaws. It had no means of compelling countries to reform. It was limited in scope, so never amounted to the “big bazooka” needed to ward off speculators. Its resources were scattered across a range of maturities. And it left the ECB exposed politically. So now Draghi reinvented the formula. His new policy of outright monetary transactions (OMT), outlined on August 4th and then set out in detail on September 6th, would require countries seeking ECB intervention to request help from the rescue fund and sign up to a macroeconomic adjustment programme. The fund would have to intervene in the primary bond market. Only then would the ECB decide whether to intervene in the secondary market, where it would concentrate on buying short dated bonds with a maturity of less than three years. Crucially, there would be no pre-set limit to the quantities it could buy. In other words, it would be left to governments to decide whether a country was solvent, and overtly to impose reforms, rather than leaving the ECB to send out secret letters. And the ECB would concentrate its potentially huge firepower on a narrow front of the bond market.
Even so, OMT was resisted by the Bundesbank’s president, Jens Weidmann, who voted against the policy, saying it was akin to printing money. But unlike his predecessor, Axel Weber, he did not resign. Tellingly, his colleagues from Finland and the Netherlands – the traditional emmerdeurs – voted in favour. And the German government made clear its support for Draghi. Weidmann sounded increasingly like a prophet in the wilderness, declaring that saving the euro was a job for elected leaders, not central bankers. At one point he couched his criticism in literary terms, by quoting Goethe’s Faust: in the play the Holy Roman Emperor complains of being short of gold; Mephistopheles persuades him to sign a document which is then reproduced and distributed as paper money; but after the initial economic upswing comes inevitable inflation and collapse.7 The lesson, said Weidmann, was that central banks must avoid the temptation of solving short-term problems by creating money lest they create long-term damage. To which the ECB’s insiders retorted: the Bundesbank always has a solution for the long term, never for the short term.
The impact of OMT exceeded all expectations. From the end of July onwards, bond yields of the most troubled states came down almost continuously. By the end of 2012 Italian and Spanish bond yields had fallen to about 5% each (the spread over German bonds was still 200 basis points). More good news came in September, when Germany’s constitutional court gave the go-ahead for the ratification of the ESM, the permanent rescue fund, subject to minor caveats. The fund came into existence in early October. Based on paid-in capital rather than guarantees, the ESM was a more robust instrument than the EFSF it was replacing (the two will overlap for some years).
Draghi would later tell senior euro-zone policymakers that the commitment to start a banking union had created the conditions for OMT. As another ECB insider put it: We were willing to build a bridge, but it could not be a bridge to nowhere. The leaders had to build a road on the other side.
At the time of writing, markets had not called Draghi’s bluff. OMT, according to one ECB insider, was “by far the most significant intervention of monetary history.” It had not cost a cent, and did not stoke inflation. Even Weidmann would admit, in private, that it had worked better than he would have expected.
Even with the ECB’s intervention, the future of the euro zone could not be settled until the question of Greece was resolved. What to do? Merkel had never been among those most militantly pushing for the expulsion of Greece; she had even described herself in private conversations as the only person in Germany still willing to keep the Greeks in. As she told the Bundestag in February 2012, “I should and have to take risks, but I cannot embark on adventures.” She had allowed her ministers to use the threat of expulsion to exert pressure on Greece to abide by its programme and, latterly, to convince voters to support pro-European parties.
Throughout the crisis, Merkel had received contradictory advice, both at home and abroad. Some at the IMF thought Greece would be better off returning to the drachma given the euro zone’s muddled policies. At the same time, José Manuel Barroso, president of the European Commission, warned Merkel that Grexit might cause so much political instability as to provoke another military intervention. But during August 2012 Merkel made a firm decision: Greece would stay in the euro, even if that took more money. Some think the moment of clarity came during her walking holiday in the Italian Alps, or soon after her return to Berlin. Others suggest the final decision was taken during a trip to China at the end of the month, when she was grilled by Chinese leaders about the future of the euro zone. What made up her mind were her conversations with Weidmann and the ECB’s Jörg Asmussen. Neither could offer any assurance that the consequences of Grexit could be contained.
When the newly elected Samaras, recovering from eye surgery, visited Berlin on August 24th, Merkel already sounded much more sympathetic to the plight of Greece. She told him privately she was ready to “help” if Greece wanted to leave the euro; but if it wanted to stay, she needed assurances that Samaras would deliver reform and fiscal discipline. The Greek prime minister said Grexit was inconceivable, and he would resign immediately if it were ever on the cards.
The strongest signal that Greece would stay came on October 9th, when Merkel made her first trip to Greece, expressed her desire that the country should stay in and offered “practical” assistance with structural reforms, such as German experts to help overhaul tax administration and modernise local government. Her attempt to empathise with the Greeks was not universally welcomed. Protesters outside parliament waved banners declaring “Angela you are not welcome”. Municipal workers in full Nazi uniform, one of them with a Hitler moustache, drove a jeep flying swastika flags through the streets as a reminder of the German occupation in the Second World War. Riot police resorted to tear gas and stun grenades to keep protesters from the parliament building.
Although Germany no longer wanted to throw Greece out, it still did not want to lend it more billions to keep it in. A third programme would not go down well in the Bundestag. So Greece had to find large savings (worth more than 7% of GDP) in 2013 and 2014 to make up for the time lost earlier in the year and to deal with the consequences of a deeper-than-expected recession. It would be given two more years to reach its target of a primary budget surplus of 4.5% of GDP in 2016 instead of 2014. That would require more loans in future, and more loans would raise the debt. For now the most contentious issue was the tug-of-war between the IMF and the euro zone over the size of Greece’s debt. Greece’s economic outlook was so poor that it would probably miss by a long shot the target of bringing debt down to 120% of GDP by 2020. The figure was now expected to be 144% of GDP. The IMF sought outright forgiveness of debt, now mostly held by the official lenders (hence the term official sector involvement, or OSI). It said a write-off would be the strongest possible signal of the euro zone’s intent to keep Greece in, and so would boost investor confidence. Yet OSI was unacceptable ahead of Germany’s general election in September 2013; it would have vindicated critics who said money lent to Greece would never be repaid.
After much wrangling, a deal in November again cut Greece’s interest rate, deferred payment for ten years and doubled maturities to 30 years. It included a commitment to cut Greece’s debt to 124% of GDP in 2020 and to “substantially below” 110% of GDP two years later, with the promise to take more action if necessary once Greece reached a primary budget surplus. Nevertheless, an important line had been crossed. Without saying so too loudly, the euro zone was ready to pay to keep Greece in the currency. Spain and Italy were already lending to Greece at a lower rate than they could borrow.
The largest cloud over the unaccustomed optimism in the autumn of 2012 was Germany’s backtracking on banking union. The Commission rushed out its legislative proposals for a single bank supervisor in September but Germany made sure that key parts of the document, such as a timetable for the creation of a common deposit-insurance system, were excised. There was only a vague commitment to creating a bank-resolution authority for the euro zone to complement the supervisor.
The immediate focus would be on harmonising national banking rules across the EU as a whole, including “bail-in” procedures to impose losses on shareholders, bondholders and large depositors in order to spare the taxpayer.
Even the supervisor was not entirely to Germany’s liking. The Commission wanted the ECB-based supervisor to oversee all 6,000-plus banks in the euro zone. Germany insisted it should focus only on the bigger “systemic” banks, leaving supervision of smaller banks, including its own often-troubled Sparkassen and Landesbanken, in national hands – even though Spain’s experience showed that trouble in small lenders could become systemic. Germany also slowed down the timetable for the supervisor to start work (originally January 1st 2013) on the grounds that such an important task should not be rushed. Thereafter, direct bank recapitalisation should only take place once the system had shown itself to be “effective”.
Worse was to come. On September 25th Wolfgang Schäuble, the German finance minister, and his Dutch and Finnish colleagues sought to limit the commitment to direct recapitalisation: it should apply only to new problems, not “legacy assets”, and should only be a “last resort”, after using private capital and then national funds. Spain gave up on the idea of direct recapitalisation of its banks. In December it borrowed €41 billion of the €100 billion allocated by the euro zone, which would increase its debt ratio by about 4% of GDP. Ireland’s hope that its bank debt would be taken over retroactively was similarly dashed.
At the end of 2012 finance ministers reached a compromise on the scope of the new supervisor: it would directly oversee the biggest “systemic” banks in the euro zone (about 130), while day-to-day control of smaller lenders would be left to national regulators, subject to central rules and the right of the euro-zone supervisor to assume oversight of any bank if deemed necessary. Beyond banking union, the other pillars of Van Rompuy’s “genuine” economic and monetary union were also crumbling. In October he had dropped the idea of a timetable for Eurobonds. At a summit in December he tried to push the concept of “fiscal capacity”, a French-sponsored idea to create a central budget to act as a counter-cyclical economic tool to stabilise countries undergoing a downturn, maybe by providing benefits for short-term unemployment. But this was killed too.
What remained of Van Rompuy’s roadmap was only a timetable for the next step on banking union – the creation of a bank-resolution mechanism – along with the wisp of a German idea to have “contracts” between governments and the Commission to promote structural reforms. In a nod to France, these could include some extra money. This was less ambitious than early German ideas to establish some kind of system of transfers to help the most troubled countries. It was certainly not the French idea of an automatic stabiliser. The Commission published its own “blueprint” for reform in November to try to keep some of these ideas alive, but EU leaders had lost interest in making great federalist leaps, if they ever harboured the notion in the first place. Ahead of the German election due in September 2013, Merkel was wary of taking on new liabilities. She had already lost her “chancellor’s majority” in votes to approve bail-out programmes, meaning that she now had to rely on votes from the opposition Social Democrats.
In some ways Draghi’s threat of unlimited intervention worked too well. As pressure from markets eased, so did the pressure to fix the euro zone. The danger of moral hazard did not apply just to debtors; it applied to creditor countries too. Leaders may have pledged to do “whatever it takes”, but more often it was a matter of doing “as little as we can get away with”.
Ugliness on Aphrodite’s island
The new doctrines of banking union would be tested sooner than expected, in the case of Cyprus. The Commission’s proposed rules on “bail-in” were pencilled in to apply from 2018. Germany wanted them in 2015. But in Cyprus bail-in would be applied immediately, and in the most chaotic manner possible.
The easternmost country in the European Union, closer to Syria than to Belgium, France or Germany, Cyprus has always been an awkward member. It entered the EU in 2004 as a divided island, voters in the Greek-Cypriot republic having rejected a UN plan to reunite with the Turkish-Cypriot north (where the plan was supported) on the eve of its accession to the EU. The Greek-Cypriot government used and abused EU institutions to wage its feud with its northern rival and Turkey, and to lend support to Russia. With an oversized financial sector (more than eight times GDP), catering mostly for Russian expatriates, Cyprus was vulnerable when the financial crisis struck in 2008. It was shut out of markets in May 2011 and then suffered a double blow: its banks took large losses as a result of their exposure to Greece (including losses equivalent to 25% of GDP as a result of the haircut on Greek bonds); and the main power station, generating about half of Cyprus’s electricity, was destroyed by the explosion of a cache of weapons stored carelessly nearby.
Cyprus’s pre-crisis boom was clearly unsustainable. A long-running current-account deficit gaped ever wider. Companies and households were hugely in debt. And government debt, though comparatively low, was rising because of overgenerous civil-service pay and benefits (including index-linked pay rises twice a year). With a short-term loan from Russia running out, and a ratings downgrade that meant Cypriot debt was no longer eligible as collateral at the ECB, Cyprus belatedly turned to the EU for help in June 2012, just as it took over the rotating EU presidency. Negotiations progressed slowly. Ahead of the presidential election in January 2013, the communist incumbent, Demetris Christofias, said he would not stand again. But he refused to entertain the fiscal cuts the troika would demand; and he was firmly opposed to any privatisation. The euro zone was in no rush: it had enough on its plate with Greece and Spain, and nobody was keen to bail out banks stuffed with Russian money, some of which might have been the fruit of corrupt dealings. Better to wait until after the election, many felt.
Merkel had been among leaders of the conservative European People’s Party who went to Cyprus to support Nicos Anastasiades, leader of the centre-right DISY party, a month before he comfortably won the presidential election in February 2013. But his political “family” was less than generous when it came to negotiating a bailout. The IMF, now less malleable as a result of the fiasco in Greece, said lending Cyprus the €17 billion needed to recapitalise its banks and finance public spending would make its debt unsustainable. Greek-style haircuts on government bonds were unappealing, because much of the debt was held by Cypriot banks. Moreover, the euro zone had vowed that the Greek PSI would be an exception. The expected bounty of natural gas off Cyprus’s coast was too uncertain, and the prospect of commercial exploitation too tangled in regional geopolitics. So a large share of the money would have to come from the two big banks: Bank of Cyprus and Cyprus Popular Bank, known as Laiki.
On March 16th Anastasiades stayed in Brussels at the end of an EU summit to be on hand for bailout negotiations. The talks turned ugly when he rejected any large-scale hit on depositors, the ECB threatened to cut off liquidity to the large Cypriot banks, and Anastasiades threatened to leave the euro. A compromise was found, but it was a bad one. All depositors would be subject to a one-off “levy”: 9.9% on large deposits and 6.75% on those below the €100,000 deposit-guarantee limit. Somehow the euro zone, working late at night and run by a novice (Jeroen Dijsselbloem, the Dutch finance minister, had recently become chairman of the Eurogroup), agreed to raid the savings of grandmothers rather than impose a bigger haircut on Russian oligarchs. The mess came down to a fetish about round numbers. Germany said the euro zone would lend no more than €10 billion; the IMF insisted the island’s debt should be kept below 100% of GDP by 2020 (a more exacting standard than for Greece, on the grounds that it was a small economy); and Anastasiades was adamant that any tax on big depositors should be below 10%.
As banks were shut in Cyprus to avoid an outrush of money, there followed a week of brinkmanship, including a 36–0 vote in the Cypriot parliament to reject the terms, street protests, a failed attempt by Cyprus to throw itself at Russia’s feet and a public ultimatum by the ECB. Van Rompuy stepped in to try to fix the mess. On March 24th Anastasiades was flown back to Brussels on a Belgian air force plane. He resisted the IMF’s attempt to wind up both Bank of Cyprus and Laiki. That would crush the island’s economy, he said. In the end he agreed to sacrifice Laiki to save a rump of Bank of Cyprus. Laiki’s bad assets and all its uninsured deposits were put into a “bad bank”. Its viable assets and insured deposits were put into a “good bank” and transferred to Bank of Cyprus (along with, questionably, Laiki’s obligation to repay the ECB’s liquidity loans). Bank of Cyprus would be restructured by wiping out shareholders. Junior and senior bondholders were bailed in and given equity. Uninsured depositors were subjected to haircuts of 47.5%, also in exchange for equity.
The remaining deposits were for the most part put into term deposit accounts for up to two years. The new deal was better than the old one, in that it protected insured depositors and concentrated the pain on the two largest banks, which had been the cause of the problem. It restored a sensible hierarchy of creditors in bank resolution, whereas under the previous agreement, senior bondholders would have been spared but small depositors hit. But it came at a cost. The Cypriot economy was pushed into a deep slump, albeit perhaps not as catastrophic as some feared. The euro zone for the first time introduced capital controls, meaning that a euro in Cyprus no longer carried the same value as a euro elsewhere. The reputation of the euro zone in managing the crisis was further tarnished. And the judgment of the ECB, now charged with supervising the biggest banks, was also questioned. It had provided liquidity to Laiki, even though it was bust, and then insisted on being repaid fully when the bank was wound up. Moreover, it had been party to the original deal that undermined the EU-wide €100,000 guarantee to depositors.
Had Cyprus walked out of the euro, as some expected, European officials were ready with a proposals for a blanket guarantee on all deposits in the euro zone and the activation of OMT. Such ideas were dismissed by the Germans. The proposition was never tested, as Anastasiades caved in. Tellingly, sovereign- and corporate-bond markets were sanguine throughout the week-long standoff. Draghi’s firewall held firm. Plainly, Cyprexit in 2013 did not hold the same terror as Grexit had in 2011 or 2012.
Good news, at last
Little seemed to scare the euro zone any more. The possibility of a bailout for Slovenia, which was grappling with the collapse of its opaque banking system, part of a web of political patronage, was treated as a tidying-up exercise. Through 2013 bond yields in peripheral countries declined gradually but steadily, perturbed only on occasion. Spreads over German bonds, which had exceeded 600 basis points for Spain and 500 for Italy in July 2012, fell steadily to below 200 basis points for both by February 2014. Their bond yields fell to pre-crisis levels. Even Greece, whose spread peaked at 2,900 basis points in June 2012, was down to about 650. And, haltingly at first, economic growth returned to the euro zone. No country had left the euro, and several still wanted to join. Latvia, the poster-child for hard, front-loaded austerity with a fixed currency (its currency was pegged to the euro) joined on January 1st 2014, following Estonia, which entered in 2011. Lithuania wants to be next Current-account deficits in the periphery narrowed, not just because imports collapsed but also because exports were rising. With the easing of the financial crisis, the pace of austerity was sensibly relaxed. In May 2013 France, Spain and Slovenia were given an extra two years to meet their deficit target of 3% of GDP. The Netherlands and Portugal got an extra year. Italy came out of its excessive deficit procedure in June. That said, tougher fiscal rules known as the “two-pack” came into force in the autumn of 2013, obliging countries to submit their draft budgets for 2014 to the Commission for comment before being sent to national parliaments. Increasingly, the Commission focused its yearly policy recommendations on promoting structural reforms, though even that was resented by France, with Hollande telling Brussels not to “dictate” specific reforms. To the irritation of Merkel’s government, the Commission plucked up the courage in November to launch an in-depth study of Germany’s large and persistent current-account surplus.
Both Ireland and Spain opted for a “clean” end to their bailout programmes at the end of 2013. The move may yet prove to be hubristic. IMF programmes usually end with a line of credit to facilitate a full return to market financing. Ireland and Spain may not have had much choice in the matter. Merkel was not keen to ask the Bundestag for more money. It suited her to have the strongest possible demonstration of the success of the policies she had enacted (and often changed). And it suited her Irish and Spanish counterparts to boast that they were free of the dreaded troika. But their emancipation may result in prolonged servitude for Portugal. Despite its compliance with bail-out conditions, Portugal suffered a wobble in the spring of 2013 when its constitutional court blocked some deficit-cutting measures. Its deficit is lower than Spain’s but its debt is larger and its growth weaker. If a stigma is attached to a precautionary line of credit, Portugal might yet be pushed into a second bail-out.
The wooden union
After a long pause caused by the German election in September 2013, which saw Merkel returned to power at the head of a grand coalition with the Social Democrats, the euro zone resumed work on banking union in the autumn of 2013. At its heart, banking union requires trust. Germany must feel able to share liabilities for everybody’s banks. And all countries must agree to stop coddling their banks so that more pan-European lenders can emerge.
Legal work on the single supervisor was finalised in November. It was due to be fully operational a year later, with Danièle Nouy, secretary-general of France’s bank and insurance supervisor, as its first boss. The next stage, potentially involving public money, was more difficult: the creation of a single resolution mechanism to wind up or restructure bust banks. Germany had stubbornly opposed a central authority with access to pooled funds (levied from the banks), pushing instead for a network that would leave German money in German hands. Wolfgang Schäuble, reappointed as German finance minister after the election, had said in May that the euro zone should start with a “timber framed” banking union; a steel one would require changing the treaties.8 But with the approach of an end-of-year deadline, Germany began to shift.
First, common bail-in rules that would apply to all EU countries – whether in or out of the euro zone – were approved in December. These would ensure there could not be another Cyprus-style fiasco. Shareholders and bondholders would have to take the first losses – up to 8% of the bank’s total assets – before any resolution funds could committed. Thereafter there would be a clear hierarchy of creditors, so that senior bondholders would take the hit before depositors, and deposits below €100,000 would be protected at all times.
Then Schäuble made an important concession. The joint euro-zone resolution fund would start with national “compartments”, but over a ten-year period these would be progressively pooled until there was a single European fund of about €55 billion ($60 billion). In other words, he agreed to mutualise the money of German banks, if not yet that of German taxpayers. And Germany’s answer to the question of trust was to give the new supervisor time to root out the problems. The principle could one day be applied to other reforms: how about the phased introduction of Eurobonds? For now, Schäuble’s legal nitpicking produced a complex legal structure (mixing EU treaty provisions for the single market with an inter-governmental treaty). The decision-making process to wind up a bank would be almost comically convoluted, raising worries about whether a failing bank could really be dealt with over a weekend.
After some brinkmanship, the European Parliament and Council agreed a compromise on March 20th 2014, concluding banking union in just two years. MEPs objected to inter-governmentalism but relented because the alternative was to have no resolution mechanism at all. In return they obtained some streamlining of decision-making. With backing from the ECB, they shortened the period for the pooling of funds (from ten to eight years) and permitted the fund to borrow money on the markets. All knew that if the issue were not settled before the May 2014 European elections, it risked being delayed indefinitely.
Despite heady talk of “a revolution”, banking union remained incomplete. There was still no single deposit-guarantee scheme. The promise of direct recapitalisation was remote: first losses had to be borne by shareholders and creditors; the burden would then be taken up by governments and only in extremis by the euro-zone rescue fund. The most glaring flaw was the lack of a common backstop, left to be decided at a future date. In the transition, national treasuries would step in if the resolution fund ran out of money; only if the burden threatened to ruin a country could it turn to the ESM. The obvious solution, to allow the ESM to extend a line of credit to the resolution fund, as the US Treasury does to the FDIC, was rejected by Germany. Saving taxpayers’ money is a laudable aim. But banking union cannot be credible without some assurance that taxpayers collectively stand behind it if a big crisis strikes.
Banking union did not live up to the promise to help Spain or Ireland in the current crisis. Nor will it be much use should the new supervisor find large holes in the banks when it publishes the results of a thorough examination of bank balance sheets at the end of 2014. At best, and only if done properly, banking union could help prevent and lower the cost of a future crisis. For the foreseeable future banking union, like the currency union itself, will remain a timber-framed construction.
Beware of Europhoria
After the long crisis, markets seemed in the grip of “Europhoria” by early 2014, particularly as their worries shifted to emerging economies. The elation was probably overdone. The euro zone was hardly in good health.
The euro zone stopped shrinking in the first half of 2013 but was forecast to grow only slowly in 2014, when just Cyprus and Slovenia were still expected to be in recession. A weak recovery left the euro zone vulnerable to another slump. Unemployment in the periphery remained at worryingly high levels. Financial markets had been fragmented by the crisis, with firms in the periphery of the euro zone paying higher rates of interest for their loans – that is, when credit could be obtained at all – than equivalent companies in “core” economies. Comparable business on either side of, say, the border between Italy and Austria could pay markedly different interest rates on bank loans.
Beyond this, the danger of Japan-style deflation began to worry policymakers by early 2014, as the inflation rate for the euro zone as a whole slowed to 0.7% in February, well below the ECB’s already conservative target of holding inflation in the medium term at close to but below 2%. Falling prices – already a reality in Greece, Cyprus, Portugal and Slovakia – hamper recovery, prompt consumers to postpone purchases in expectation of lower prices and increase the burden of debt on national economies. As Christine Lagarde, the IMF boss, put it in January 2014: “If inflation is the genie, then deflation is the ogre that must be fought decisively.”
Two issues, in particular, highlighted the fragility of the euro zone’s condition. First was the oldest and most intractable problem: Greece. Astonishingly, poor blighted Greece made it to a primary budget surplus (before interest) at the end of 2013, for once exceeding expectations, thanks in part to a bumper tourist season. This was despite losing a quarter of its economic output since the start of the crisis, and with 27% of its workforce unemployed. In Germany, Samaras was being hailed as one of the saviours of the euro. This should have brought closer the promised day when the euro zone would ease its burden of debt, forecast to reach 176% of GDP at the end of 2013.
But at the beginning of 2014, just as Greece took over the rotating presidency of the EU, things started to sour again. Germany said it would not talk of dealing with Greece’s debt until the second half of the year, that is, until after the European election. The delay might help the German government stem the rise of the new anti-euro Alternative for Germany party, but would make it harder for Samaras to resist the more dangerous charge of the radical leftist party, Syriza, which was leading in opinion polls. Moreover, the negotiations with the troika, in particular the IMF, got badly stuck.
On the face of it, the argument with the troika was about whether Greece should continue the long years of fiscal consolidation. Greece had a short-term problem, with a small gap in its financing requirements in the second half of 2014, and a longer-term problem over how to reach a primary budget surplus of 4.5% of GDP by 2016, as foreseen in its troika programme.
Samaras, having survived thus far with an ever-shrinking parliamentary majority, announced he could no longer take any across-the-board austerity measures. Henceforth, his government said, the budding recovery should not be stifled; Greece would simply grow its way to the promised surplus. For veterans of the IMF, still defensive about having badly misjudged the first Greek bail-out, optimistic growth forecasts did not amount to a credible policy.
Beneath the question of how much more belt-tightening Greece would require lay deeper problems. One was whether Greece’s debt relief, if and when it was agreed, should be in the form of a write-off in the nominal value of the debt, or whether softening the terms of its already soft loans by extending maturities and reducing interest would be good enough. The IMF thought a write-off would boost confidence among investors; the creditor countries said that was politically unacceptable. So “extend and pretend” seemed likely to win.
A more worrying issue was that Greece, even though it had largely complied with the demands of fiscal consolidation, was far behind in its promises to enact structural reforms and privatise state assets. Some of these had an impact on fiscal matters. But the more important ones had to do with liberalising the country’s sclerotic economy to release its growth potential.
Greece has sharply cut its unit-labour costs, but mostly by reducing wages rather than by raising productivity. And despite the fall in labour costs, Greek exports were falling once the murky trade in fuel and volatile tourism revenues were stripped out of the data. This was alarming. In Spain, Portugal and Ireland lower labour costs boosted exports. Some Greeks blamed a lack of credit. Others noted that the country’s main export market, the EU, had been in recession. But the real problem was an economy that produced few tradable goods. Greece had shot up the World Bank’s ranks for the ease of starting firms; but in the wider measure of ease of doing business, it ranked 72nd in the world, behind Azerbaijan, Kyrgyzstan, Belarus and Kazakhstan. All this was evidence of a country still in need of far-reaching structural reform if it was to survive with a hard currency, at a time when its political system was running out of will for further change. European countries were pushing the IMF to give Greece a break, at least ahead of the European elections. But this was a particularly odd request, given the unwillingness of creditor countries to help Samaras by giving him early debt relief.
The other cloud over the euro zone was the future of Draghi’s “whatever it takes” promise to intervene in bond markets through his policy of OMT. The long-delayed judgment by Germany’s constitutional court was issued on February 14th, and it turned out to be a scathing denunciation of OMT. The court said it saw “important reasons to assume that it exceeds the European Central Bank’s monetary policy mandate and thus infringes the powers of the member states and that it violates the prohibition of monetary financing of the budget”. The court refrained from telling German institutions to stop implementing the policy, but reserved the right to do so after referring the case to the European Court of Justice (ECJ). This bought OMT at least another year, and the ECJ may well support the ECB’s contention that the policy falls within its remit. Nevertheless, the Karlsruhe court has introduced a note of doubt that may prove dangerous should the debt crisis ever reignite.