The Alchemists: Three Central Bankers and a World on Fire (40 page)

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

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

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

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

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

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

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

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

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

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

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

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

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

Still, Ireland wasn’t Greece. Even with borrowing costs having skyrocketed, the Irish government actually had plenty of cash on hand, thanks to pension reserves. It had suspended issuing new bonds in hopes that rates would decline again, and it had enough money to last until the summer of 2011, according to internal estimates. But depositors in Irish banks, fearful that questions about the government’s solvency meant their deposits could be at risk, started pulling their money out. Irish banks then turned to the ECB—still fulfilling its role as lender of last resort to eurozone banks—to get the cash they needed to cover withdrawals. Because the ECB had lowered its collateral standards for emergency lending programs so that even downgraded government debt could be pledged in exchange for central-bank cash, those Irish banks were able to offer Irish bonds as loan security.

By November 2010
, Irish banks were relying on central-bank funding from elsewhere in Europe to the tune of €138 billion—equivalent to 89 percent of the country’s annual economic output. Spain, with more than ten times the population and a banking crisis of its own, was relying on about a third as much central-bank support for its banks. All this lending was making central bankers around Europe nervous: The more Irish banks relied on them for funding, the more the Bundesbank and the Banque de France and the others would be exposed if the Irish government ultimately defaulted on its debts.

Trichet wrote a letter to the Irish government that expressed his unease, not so subtly suggesting that the ECB’s assistance for Irish banks wouldn’t be bottomless. He even said publicly that “
it is not a normal situation
to have institutions that are ‘addicted’ [to central-bank funding] and we are continually reflecting on how to deal progressively with this problem.” Comments like that made the Irish banking crisis worse, as depositors saw a risk that the ECB would start tightening up its emergency lending standards and leave the banks unable to pay off creditors with central-bank cash.

Trichet proposed to Irish leaders that they restructure their banks, including putting new capital into them, as part of an ECB/IMF/European Commission–overseen program of the sort Greeks had enacted earlier in the year. The ECB mind-set was that the biggest failure of the Irish government had been an unwillingness to slash spending quickly enough to restore confidence among bond buyers. “
We took all the opportunities
to tell the Irish Government that they had to take bold actions very quickly,” said ECB Executive Board member Lorenzo Bini Smaghi in a later interview with the
Irish Times
. “In private conversations, Mr. Trichet mentioned this several times on the margins of the European council or the euro group. . . . In 2009 when the Government announced bold measures, this had a very strong impact on the markets. This kind of boldness was not repeated in 2010.”

This is what Bini Smaghi was saying: In the middle of a year in which the Irish unemployment rate would rise five full percentage points in part because of budget cuts already being phased in, he wished that the government had doubled down on spending cuts and tax increases that may or may not have been enough to regain the confidence of bond investors. Clearly, Ireland couldn’t do much more on its own.

It was time to call in the troika.

On November 21, the Irish government formally acknowledged what was increasingly apparent: A troika-backed bailout was forthcoming. By November 28, negotiations concluded with an €85 billion assistance package. The IMF was willing to lend Ireland money at 3.1 percent, but European stability funds were at much higher rates, so the price Ireland would pay to borrow money worked out to 5.8 percent, hardly a bargain-basement rate—and a reflection of the ongoing effort to punish those countries receiving help. Britain, with its deep ties to Ireland and particularly to Irish banks, kicked in €3.8 billion, in contrast to its unwillingness to help pay for the Greek rescue.

“
I don’t believe there were any other real options
,” Prime Minister Brian Cowen told reporters.

In negotiations with the troika, Cowen’s government agreed to €15 billion in spending cuts by 2013—€6 billion of them introduced in 2011—a newly created property tax, a one-euro cut in the minimum wage to €7.65 an hour, and an elimination of twenty thousand public-sector jobs.

But the real flashpoint of the talks was what to do about troubled banks Anglo Irish and the Irish Nationwide Building Society. Both were effectively insolvent and had been nationalized, and the government wanted bondholders who’d lent money to the institutions to share in the losses. Trichet and the ECB, focused on preventing a broader loss of confidence in European banks, wanted those creditors made whole.

As the lender of last resort keeping the Irish banking system afloat as well as a member of the troika, the ECB had the negotiating leverage to largely get its way. Whatever the benefits of Trichet’s hard line on overall economic stability, the politics—and even the morality—were terrible: At a time when the Irish economy was in shambles, with public employees being fired, taxes raised, and social welfare benefits slashed, the government was paying billions to investors in bank bonds.

Cowen’s party, Fianna Fáil, suffered the worst results in its history in the February 2011 elections, and he was ousted as taoiseach, as the Irish call their head of government, in March. Cowen thus became the first national leader to be swept from office by the eurozone crisis. He wouldn’t be the last.

Nine days before Ireland reached its bailout agreement, Ben Bernanke visited Frankfurt to speak at a conference at the ECB. In his remarks to the attendees, he observed that cooperation among international central bankers can be very helpful in addressing crises. “Indeed,” he said, “given the global integration of financial markets, such cooperation is essential.”