The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (49 page)

‘We have a treaty,’ he replied, ‘and the treaty states what our primary mandate is, namely to maintain price stability. Also, the treaty prohibits monetary financing. I am old enough to remember that, when this treaty was written in the early 1990s, some of the countries around that table were actually doing what you suggest doing now, namely some of the central banks of these countries were financing the government expenditure of their governments through money creation, and the consequences were there for all of us to see. That is why, in a sense, this treaty embodies the best tradition of the Deutsche Bundesbank, whereby monetary financing has always been prohibited.’

Yet at the same time, one trillion euros were being ploughed into the Eurozone banking system via the LTRO (long-term refinancing operations). Some of this found its way back into government bond markets, through the banking system. This was not so far off the
verboten
quantitative easing. But it spectacularly calmed the worst excesses of Eurozone bank panic. Dollar funding that had basically stopped for French banks, for example, restarted. This echoed an earlier inconsistency under Jean-Claude Trichet. Direct sovereign bond purchases from governments were prohibited, and instead were bought from the financial markets. The purchases were ‘sterilised’ with offsetting ‘sales’ – essentially one-week deposits. The idea was that the inflationary impact of bond purchases would be neutralised. When it came to private debt held by banks, secured by property, then no such safeguards were required. The ECB launched two programmes for ‘covered bonds’, the German-designed instrument that had seen no defaults since its creation by Frederick the Great in the mid-eighteenth century. Was the €400 billion of covered bonds that were secured on Spanish real estate really less risky than a sovereign bond? (See Chapter 8,
here
.) Is there any reason why it is any more moral to fund a private bank’s credit excess and yet absolutely prohibit direct funding of a nation’s fiscal excess? In a tight squeeze, the ECB programme did help maintain, against the odds, the incredible historical record of Frederick the Great’s creation.

At Axel Weber’s farewell in May 2011, following his resignation, Trichet, in a manner described as ‘poisonous’ by the
Frankfurter Allgemeine Zeitung
, politely omitted any mention of the bitter public debate over ECB purchases of government bonds. Trichet instead ‘delightfully’ explained that the ECB had ‘followed Axel’s advice’ in deciding to support the ‘German innovation’ of covered bonds from May 2009. It was the ‘most notable’ contribution of Bundesbank expertise to the ECB’s crisis-fighting weaponry, Trichet said. Put slightly differently, in other respects the Bundesbank was far from helpful.

‘The Bundesbank has this habit of following up what has been decided after a governing council agreement. This is not correct,’ another central bank governor suggested to me. ‘The idea is that [Jens] Weidmann [Bundesbank president and a member of the governing council] is speaking for himself. He is not there on behalf of the Bundesbank. It helps him form an idea, but these are not country or [national] central bank-backed decisions. It is the ECB council’s decision.’

It is July 2012, the eve of the London Olympics. Around the Eurozone, Greece has managed to stay in the club, Cyprus has just begun its game of trying to stave off a bailout for a few months, and Italy, Spain and Europe’s banks are still borrowing at disastrous rates. Indecisive political summitry has left the dangerous doom loop between sovereign and banking debt intact and reinforced. It is going to take an Olympian effort to douse the Eurozone’s flames. Mario Draghi arrived at a conference nakedly designed by the British government to promote investment and trade on the back of the Olympic opening ceremony. Cookies dusted with icing sugar and formed in the shape of the Olympic rings tempt delegates. Mayor Boris Johnson entertains CEOs from across the world with jokes about how London has more Michelin-starred restaurants than Paris and less rain than Rome. The setting is Lancaster House, a mansion owned by the UK Foreign and Commonwealth Office. The place has seen some history – including the birth of new nation-states such as Malaysia, South Africa and Zimbabwe. And before that, in 1944, it was in Lancaster House that the European Advisory Committee of the UK, USA and the Soviet Union first recommended the postwar partition of Germany and its capital, Berlin.

Whether it was history, bonhomie or the inspiration of competitive sport, Mario Draghi pushed the ECB and Europe further than it had gone before. In off-the-cuff remarks, he at first likened the euro to a bumble bee that ‘should not fly’, one that was in the process of ‘graduating into becoming a real bee’. He rambled on about how the Eurozone’s employment, debt and deficit numbers were better than those of the USA and Japan, and how Europe had a ‘degree of social cohesion you would not find in those two countries’. It raised the odd eyebrow amongst the highbrow audience. But he had a central message to the world: ‘The euro is irreversible.’ This was because of the political capital invested by Europe in the project.

Then, with the shuffle of an actor about to deliver the killer line of a play, he looked down at his notes. ‘There is another message I want to tell you today. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.’ He paused for dramatic effect, before continuing, ‘And, believe me, it will be enough.’

The remarks were prepared, but unscripted. Confusion reigned outside. Had Draghi finally announced the ‘bazooka’? Or was he just riffing? One of his G7 colleagues felt that the ECB president had genuinely believed that he simply could not do UK-style bond purchases, and the trillion-euro LTRO bank-funding operation would solve the Eurozone problem. ‘No one-off operation can do that, though,’ one of Europe’s most senior central bankers told me. ‘A current account deficit needs perpetual flows to fund it.’ The Draghi speech was not planned, it had no formal text, but after seeing that the LTRO was no longer working, my informant opined that ‘Draghi saw no point in presiding over the sinking of the euro’.

The markets gave a rapturous reception to Mario’s musings. But the remarks had not been cleared with other members of the governing council, nor, it appeared, with members of his own staff. He spent the next few weeks working hard to get around the objections of the Bundesbank. Draghi did not actually have the authority to promise ‘whatever it takes’. Like Mo Farah running the 10,000 metres at the Olympic Park, Draghi was bouncing the Germans into running at his pace.

In August the blueprint was outlined, and by September the details of the programme known as Outright Monetary Transactions (OMT) had been fleshed out. The Bundesbank briefed against the plan, and Jens Weidmann never voted for it. But Merkel and the new French president, François Hollande, did back the approach, despite German critiques of Draghi.

In Berlin, Chancellor Merkel had entertained Chinese investors and the leaders of smaller EU nations. All warned her of the impact of jettisoning Greece from the Eurozone – the ballast theory. She went with the domino concept, and backed Draghi’s efforts. As one influential observer of the Eurozone put it: ‘[Before July 2012] The ECB seemed to detach itself from an interest in the survival of the currency of which it was the central bank, which I think was totally disastrous… it was like a priest arguing against the existence of God.’ Draghi had changed that, and he had brought Merkel with him.

OMT was a lifeline as Europe squabbled over new rules for fiscal and banking union. The clever part was designed to avoid the Berlusconi-style run-around of the year before. Unlimited bond purchases were on offer, but only for governments with agreed EU bailout programmes, inspections and conditionalities. The idea was that the elevated interest rates charged by markets to borrowing Eurozone nations could be decomposed into a part due to the fiscal profligacy of that nation, and a part due to the existential fear about the collapse of the Eurozone. As Ignazio Visco, governor of the Italian central bank, explained to Italian newspapers in Rome, two-fifths of the spread between Italian and German borrowing rates was fair. The other 300 basis points, the additional 3 per cent interest rate premium charged to the Italians, was down to the redenomination risk of a euro collapse and the return of the lira. The point of OMTs was to shrink the interest premium charged because of fear of euro collapse, while maintaining the tough conditionality required to shrink interest charged to cover domestic fiscal risks. Draghi called it ‘a fully effective backstop to prevent potentially destructive scenarios’. A colleague of his on the governing council said, ‘It is a bridge that basically shows you cannot grow Europe by monetary means, but it is a bridge that makes the euro irreversible.’

The very clever thing about the OMT was the sheer cunning of its game theory. For the first year, OMT achieved the Holy Grail: it offered a theoretically unlimited intervention to scare markets off, but was sufficiently credible to be believed – so much so that it was not actually required. It was a magic trick, or perhaps more precisely a confidence trick. Not a cent was spent, but confidence returned and interest spreads collapsed. Draghi had killed the doomsday scenario. The euro was here to stay.

This was ‘conditional irreversibility’, which sounded like a fundamental internal contradiction. Others in Germany felt that Draghi had cunningly limbo-danced under an important red line. The natural result of this would surely be the weakening of ‘market pressure’ on the programme nations for economic reforms and borrowing discipline.

The OMT is essentially an ambulance with doors that will not open if the injuries are self-inflicted. In reality, if tested, the distinction would prove rather arbitrary. If a country qualified, and then reneged on the conditions, then the ECB is supposed to sell bonds, in a mildly punitive manner. This would go well beyond the ‘seditious’ and connote effective control. It would be unthinkable for, say, the US Federal Reserve to do this to a bankrupt California. ‘Does the ECB pull the plug and cause another crisis in this case?’ asks one leading central banker. ‘The Bundesbank can see this. The German people were promised that the ECB was a Bundesbank for Europe. It’s not.’ There is no difficulty seeing why the Germans felt OMT was a pathway to a more straightforward form of monetary financing, and likened it to a narcotic.

The key question, however, is this: why did Jens Weidmann, president of the Bundesbank, not resign? Two German predecessors resigned over similar versions of the same policy. Equally, it is difficult to imagine how this scheme would have survived without the tacit backing of Chancellor Merkel. She was already taking a considerable domestic political risk in backing an Italian to head the ECB. Trichet went as far as he could, given there was no explicit transfer union (the promise to transfer funds from wealthy and fast-growing parts of the EU to the poorer parts, a fundamental practical and theoretical feature of any currency union, but not the Eurozone). The ECB is becoming the backdoor mechanism for an implicit transfer union that most economists feel is necessary for the euro’s long-term survival. Nobody has told the German public that it is their historic duty to fund the Eurozone, just as Spanish, Greek and Italian politicians are unwilling, explicitly, to tell their public that the price of euro membership is lower wages. The default line runs straight through the middle of the doughnut-shaped table in the ECB’s governing council meeting room.

There are two democratic deficits in the whole way that the European Central Bank is seeking to save the euro. For crisis nations the ECB is stepping beyond its mandate in inflicting conditionalities upon sovereign states. For donor nations, the ECB is beyond its mandate in its role as a backdoor transfer union.

‘The way we designed OMT was exactly to address this point,’ says one of the architects of Draghi’s plan. ‘To make sure that our action is being complemented by clear political decisions by the national governments, coping with their own problems. If we had done this like we did it two years ago with the SMP, which was formally, officially unconditional, I think we would have been much less effective.’ Yet, I ask him, is this not just fudging the issue of lack of democratic accountability, whereby Germany is obliged to pay up, and the crisis nations are obliged to endure more pain? ‘The democratic legitimacy of this is guaranteed,’ he responds, ‘because the debtor countries have to go to their parliaments to legislate for fiscal consolidation or structural reforms. The creditor nations too, when they use the European Stability Mechanism have to go to their parliaments in Germany, or the Netherlands. So all in all the OMT has improved democratic accountability.’

Alternatively, one might say that the policy had bought a year’s space and relative calm ahead of Germany’s 2013 federal elections. In the meantime, however, the European Central Bank had a fundamental change of view about how to make economic and monetary union function. A fiscal pact was now necessary but insufficient for the euro. The experience of Spain and Ireland showed that the euro required oversight of the continent’s banking systems too. Both nations had descended into financial bedlam, despite mainly sticking to the euro’s Stability Pact. The problems had come in the banking system. The ECB was willing to step up. Yet it had absolutely no experience of banking supervision.

Suddenly the ECB’s democratic deficit threatens to turn into a chasm. The origins of the need for central-bank independence over monetary policy have strong foundations. But is a strong political independence appropriate when the central bank is the driving force behind labour-reform policies, fiscal plans, and now continent-wide banking policy?

By 2014, the ECB will face its first of a series of huge new tests. Lee Buchheit, the lawyer who helped Greece renegotiate its private sector debts (see
here
), feels it is going only one way: Official Sector Involvement. Again the instinct to acronymise a problem remains strong. OSI really means that the official sector, and the taxpayers that fund the official sector, will be asked to provide debt relief to the countries whose private creditors have been paid out using official sector loans. Basically Germany and friends face a cruel choice in 2014.