The Alchemists: Three Central Bankers and a World on Fire (27 page)

There were still a few more steps to go before what became known as the Dodd-Frank Act would become law, including a series of all-night conference committee votes at which the differences between the House and Senate bills were hammered out. In that process, one final provision that the Fed detested—for making the powerful president of the New York Fed a presidential appointee rather than a technocrat appointed by a private board of directors like at other Fed banks—was defeated. On every meaningful front—audits of its monetary policy, its role in regulating banks big and small, Bernanke’s confirmation—the battle for the Fed was over, and it was the mighty Federal Reserve System that had won.

But why? What allowed this deeply unpopular agency to emerge from the crisis scratched and bruised but, if anything, more powerful than it had been before?

However much Congress may have wanted to punish the Fed for its actions during the crisis, the task of regulating trillion-dollar banks is too complex to hand over to just anyone. The Federal Reserve, lawmakers began to realize as they studied the details, really did have the expertise and the means to do so.

But there was some luck involved, too. Having a Fed man as treasury secretary and the president’s closest adviser on financial reform ensured that the administration would help fight for the central bank. A different treasury secretary and different president might have had different priorities. Bernanke would never be confused with a master legislative strategist, but his approach to dealing with lawmakers proved a good match for the moment: He was earnest and straightforward at a time when the great knock on the Fed was that it was excessively secretive and obfuscatory.

The Fed also found a surprising source of strength in the very structure that made its governance a mess: those dozen reserve banks scattered around the country, with their private boards of directors and thousands of community banks under their regulatory umbrella. The community bankers lobbied not just on the issues of their own narrow concern—who would regulate them—but also on issues that mattered to the Fed as a whole, such as monetary policy independence and Bernanke’s confirmation.

The series of compromises made to pass the Federal Reserve Act back in 1913 may have created something of a monster. But its tentacles turned out to be so tightly wrapped around American business and politics—large and small, national and local—that it was almost impossible to kill.

The New Greek Odyssey

A
re you sure?” asked the younger man.

“Are you
sure
?” he repeated in disbelief.

The older man, George Provopoulos, the governor of the Bank of Greece, was sure. The younger, George Papaconstantinou, Greece’s newly installed finance minister, was learning that the job he’d long coveted might be a lot more challenging than he’d imagined.

Papaconstantinou and his colleagues in the Panhellenic Socialist Movement party had initially made their spending plans assuming that their nation’s budget deficit would be about 6 percent of its economic output. But in the months before the election, the previous government had ramped up spending while collecting taxes less aggressively. By the time voters went to the polls, on October 4, 2009, Papaconstantinou was looking at a deficit of 8 to 10 percent of gross domestic product.

The Greek government may have its budgets and projections, but the Bank of Greece does the actual work of accepting tax payments and clearing outgoing checks. It knows better than any other entity what shape the country’s finances are really in. The startling message the central bank governor had for the new finance minister on the morning of October 7: You, sir, are looking at a deficit of 12.5 percent—or higher. (Years later, Greek politicians were still trading accusations about just how much the incoming government knew of the shortfall as it campaigned on a platform of maintaining social spending—an agenda that would prove impossible to enact.)

The new government began working through its budget, setting a dozen or so analysts to work around a giant conference table. Every day, they found new expenses that hadn’t been properly accounted for—€600 million owed to hospitals, for example, with no accurate record of when the expenses had even been incurred. Every evening, Papaconstantinou would leave and say, “Okay, guys, is that it?” It never was. “Basically, we were discovering that the Greek government
had
no budget,” said Papaconstantinou later.

When all the numbers were in, even Governor Provopoulos’s grim estimate would prove overly optimistic: The 2009 Greek budget deficit would end up amounting to 15.7 percent of its economy, the highest in the world.

It would fall to three men named George to try to narrow this chasm—Papaconstantinou, Provopoulos, and Papandreou, the prime minister. The decisions they made in Athens—and the reactions to them by Jean-Claude Trichet and the leaders of Germany, France, and other Western powers—would remake Europe and the world.

•   •   •

S
ome countries experience financial crises because their banks face collapse. Others experience them because their public finances are out of control. But history teaches one consistent lesson: Regardless of how the crisis starts, it will soon spread. When a banking system fails, the economy inevitably collapses, straining public finances at the same time that the government takes on the extra expense of bailing out the banks. When a government faces a debt panic, that nation’s banks inevitably come under strain as well, as budget cutting leads to a weaker economy and banks suffer huge losses on the government bonds they own.

Banking crises and public debt crises, in other words, are two sides of the same coin. But the wave of panic that began with that realization of the true state of Greek public finance in October 2009 had an added layer of interconnection. Greece’s decision to adopt the euro in 2001 had yoked the fortunes of all of Europe to that of this relatively small country—and left the three Georges and their eleven million fellow citizens without the usual tools needed to deal with a crisis.

Greece was, at first glance, an unusual choice to join the seventeen-nation eurozone. Its economic output per person, about $13,000 in 1999, was only about half that of France and Germany. Its business environment was dysfunctional, with rampant bribery, onerous regulations, and unpredictable enforcement of them. Its political system was fragile, its democratic institutions not well entrenched—the nation had been governed by a military dictatorship as late as 1973. But Greece had something that neighbors such as Bulgaria and Turkey did not: It was where democracy was invented, the birthplace of the European idea, the original European empire. In geopolitical terms, it was the traditional border between Europe and the Arab world. Greece, for all its problems, was special.

And the idea of joining the eurozone was particularly attractive to the Greeks themselves. Long after most industrialized Western nations had conquered inflation, prices in Greece rose at double-digit rates every single year from 1973 to 1994. That meant the drachma became steadily less valuable as the years passed, which was a boon to the nation’s tourism sector but meant that ordinary Greeks’ savings blew away with the wind. Inflation was so high that lenders would give money to the Greek government or its citizens only on onerous terms. After all, they had to take into account the fact that the drachmas they were repaid would be worth less than those they had loaned.

In 1992, when low-inflation Germany could borrow money for a decade at 8 percent, Greece had to pay 24 percent. Both the major Greek political parties, the center-left Panhellenic Socialist Movement and the center-right New Democracy, were enthusiasts for joining the eurozone, with only the communist left and neofascist right, together amounting to around 20 percent of the population, opposing. Greece’s problems during the 1980s and 1990s were anemic growth, double-digit inflation and interest rates, and large deficits. “With the adoption of the euro, Greece gained the credibility of the European Central Bank, which itself was modeled after Germany’s Bundesbank,” said George Provopoulos, the Bank of Greece governor, who was an academic at the time. “Gaining credibility meant low interest rates and inflation rates, which is what happened.”

With decisions on monetary policy handed over to Jean-Claude Trichet and his colleagues in Frankfurt, Greek inflation hovered around 3 percent through the first decade of the 2000s. The cost of borrowing plummeted. Without the perceived risk of inflation, investors were willing to hand money over to the Greek government for pretty much the same interest rate they received for giving it to the German or French governments. In 2007, on the eve of the crisis, German ten-year borrowing costs averaged 4.02 percent. Greek rates were 4.29 percent. Investors had become complacent, viewing Greek debt as an essentially risk-free substitute for bonds issued by better-run countries like Germany, France, or the Netherlands. Indeed, under the bank regulations in effect in Europe, banks from those strong countries could buy Greek debt and treat it as a risk-free asset against which they needed to hold no capital, giving them every incentive to load up on the stuff. Unfortunately for Greece, and eventually all of Europe, the nation didn’t take advantage of that environment. “What Greece needed to do was take advantage of this low-inflation-rate and interest-rate environment to adjust its economy,” said Provopoulos.

Instead of fixing the fundamentals of their economy, the Greeks were cooking their books. One widely covered instance was a series of currency swaps arranged with the assistance of Goldman Sachs in the early 2000s that essentially allowed the Greek government to borrow money without issuing debt that would show up in official statistics. Less widely known were such tricks as underreporting how much the nation was spending on its military (a particularly large expense given perennially tense relations with Turkey) and the failure to account for debts owed to hospitals that Papaconstantinou’s budget analysts discovered. The government fudged its numbers by selling off long-term assets—the rights to future airport fees, for example—in order to fund immediate spending. “The gravest thing was the fact that they didn’t know themselves that they were lying,” said one eurozone central banker. “We discovered progressively that you had an immense problem of the state functioning—the cheating, the mistakes in the figures, things done orally and not written down.”

There’s an old saw that it’s only when the tide goes out that one learns who was swimming naked. The financial crisis triggered by the Lehman Brothers failure in September 2008 brought out the tide—and exposed a beach full of naked Greeks.

In Frankfurt, Jean-Claude Trichet received the news of Greece’s dire public finances with the same surprise that Papaconstantinou had. Up to this point, the European Central Bank had most of its staff devoted to monitoring conditions in the bigger economies in the eurozone. A single economist spent only part of his time tracking the Greek economy. That changed in late 2009, as the ECB became more alarmed at Greece’s fiscal situation with every basis-point rise in the nation’s borrowing costs. In the Eurotower, a team of economists was assembled to delve more deeply into the nation’s budget. By Christmas, it had been dispatched on a secret mission to Athens to gather information on the ground, primarily from the Bank of Greece and the finance ministry.

In hindsight, financial markets responded to the disclosures of Greece’s dire situation surprisingly slowly: When the new government took office in early October, the country’s bonds were yielding 4.44 percent. By the end of the month, that had risen only to 4.65 percent, and to 5.77 percent by the end of the year. Ironically, it was only as Papandreou’s government started announcing its plans to rein in spending and collect more in taxes—a plan that disappointed markets with its timidity—that rates started to rise dramatically, to 7 percent by the end of January 2010.

But even those modest rises in the cost of borrowed money had huge implications for the nation. It’s called “debt dynamics”: When a country has high levels of debt, even small increases in the interest rate it must pay mean big trouble. In 2009, Greece’s total debt equaled 129 percent of its annual economic output, so even a single percentage-point increase in interest rates would make repayment vastly more difficult. Greece was on the verge of a dangerous situation in which huge debts make interest rates rise, and those higher rates in turn make the debts unsustainable.

This is hardly novel. Countries throughout history have found themselves in just such a predicament. In 1944, an institution was created for the sole purpose of dealing with such a debt crisis: the International Monetary Fund, which can lend money to nations in financial trouble to help them get back on their feet. Over the six decades of its existences—making plenty of mistakes along the way—the fund has learned how to structure the financial rescues of debt-laden states. But it has also learned, in Asia in the late 1990s and Latin America in the early 2000s, the dangers of forcing a country to slash its budget too rapidly—that the resulting depression can bring social unrest and political instability. In the early days of the Lehman crisis, it put together a so-called Crisis Veteran Team to ensure that the accumulated knowledge of its most seasoned staffers would be passed along to their younger colleagues.

At the helm of the IMF was Dominique Strauss-Kahn, a charismatic and politically connected former French finance minister who came from his nation’s center-left socialist party. It was an open secret that he was a likely candidate to challenge Nicolas Sarkozy for the French presidency in 2012—assuming, of course, he could avoid any nasty scandals resulting from his well-known sexual appetites.

Strauss-Kahn’s standing as the possible next president of France boosted his credibility among many European leaders, but for Trichet and some others, the idea of bringing in the IMF was anathema. Part of it was cultural arrogance:
We are Europe, birthplace of civilization, not some tinpot nation in need of an international bailout. It would be a “humiliation,” Trichet once said, for the IMF to step in. Trichet was similarly resolute that there could not, would not be any default. Greece would pay its bills.

Trichet embraced a view, especially common in Germany, that was rooted in a sort of moralism. Greece had spent too much and taken on too much debt. It must cut spending and reduce deficits. If it showed adequate courage and political resolve, markets would reward it with lower borrowing costs. He put a great deal of faith in the power of confidence: Resolute action by political authorities would put the Greek economy back on a path of growth by improving confidence among investors, businesses, and consumers. “
It is very important
,” Trichet said in January 2010, for those nations “which have a special deterioration to redress the situation in taking the appropriate bold and courageous measures for their own prosperity and recovery. We trust that this is essential to improve confidence, and you know the extent to which we consider that confidence is key in the present economic situation in Europe as well as in the world.”

So Trichet was, through the end of 2009 and start of 2010, convinced that Greece could solve its own problems, reforming its tax system and cutting government spending and so regaining the confidence of bond markets. No need for a bailout from the IMF—or anyone else. Said one IMF official, “The attitude from the ECB was, ‘Get out of our face, we don’t need you guys, we are the eurozone, we created this, and we can take care of our own.’” Added another IMF official, “Trichet was the leader of the pack insisting, ‘No IMF!’ And the reason was not because he was against the IMF, but because he wanted the European governments to shoulder their responsibilities.”

Trichet was equally insistent that the ECB would not take any action to bail out Greece: “No government, no state can expect any special treatment from us,” he said in a January 2010 Q&A session in Frankfurt. Already, however, some American and British commentators were warning that Greece’s financial troubles could force it to drop out of the eurozone. What did Trichet think about that possibility?

“
I do not comment myself on absurd hypotheses
,” the ECB president replied.

•   •   •

M
ake your way to the French Canadian metropolis of Montreal. Then, if you have the proper connections, hop on a military jet and fly four hours due north. You’ll find yourself in Iqaluit, a town of fewer than seven thousand people on the southeastern coast of Baffin Island, directly across the Davis Strait from Greenland. At one time it was a pit stop for American fighter planes being sent across the Atlantic to fight in World War II. Now it’s the capital of Nunavut, the largest and newest territory in Canada, but one so remote it has no roadways connecting it to the rest of the country.