EUROPEAN UNION WORLD

EUROPEAN CRISIS IS THE EUROPEAN UNION ABOUT TO COLLAPSE

7. The changing balance of power

AS WELL AS CONSTITUTING THE MOST SERIOUS CHALLENGE to the European project since its inception, the euro crisis has had a huge impact on its political and economic balance, at every level. Among countries, it has hugely increased the influence of some, notably Germany, and decreased that of others, notably France. It has fostered a growing north–south divide in the European Union, which has to an extent replaced the previous east–west one. It has sharpened the division between those countries that are in the euro and those that are not. Among the EU institutions, it has strengthened the role of the European Council at the expense of the European Commission and the European Parliament. And although it has led to deeper integration of sorts, especially in fiscal policy, it has also reduced the political weight of the central EU bodies and increased that of national governments. Many if not all of these shifts in power will endure. Most will profoundly affect the workings of the wider EU as well as the euro zone.

Start with the institutions. Throughout the history of the European project, the balance of power among them and between them and national governments has altered, sometimes for structural reasons, sometimes as a reflection of individual personalities. In its early years the Commission was especially important: many new rules and directives were needed, there was no directly elected parliament and European leaders did not yet meet in the European Council. Yet the French president, Charles de Gaulle, who mistrusted the Commission and much preferred inter-governmentalism, was hugely important. It was de Gaulle who in 1965 precipitated the “empty chair” crisis when France refused to accept a treaty-prescribed move towards majority voting in the Council of Ministers. After a long French boycott of EU meetings, the eventual outcome was the 1966 Luxembourg compromise which, at least according to the French interpretation (now shared by the British), preserves the national veto if a country invokes its “vital national interests” even in legislation meant to be decided by the system of qualified-majority voting enshrined in the Rome treaty and later strengthened in the Single European Act.

The influence and power of later Commissions have fluctuated, but the institution reached its apogee under the presidency of Jacques Delors after 1984. He was a driving force behind both the single market and the single currency; indeed, in the late 1980s he turned into a hate-figure for British anti-Europeans (and for Margaret Thatcher) after he addressed the Trades Union Congress in 1988. He was hugely important for the adoption of EMU. Yet his influence in Brussels had diminished long before he stepped down from the job, somewhat disillusioned, in 1994.1 And neither of his first two successors as Commission president, Jacques Santer and Romano Prodi, was able to re-establish the institution’s previous pre-eminence.

When the Portuguese Prime Minister, José Manuel Barroso, took over as Commission president in 2004, he allied himself firmly with liberalising countries such as the UK, the Netherlands and, to a lesser extent, Germany (while not neglecting the interests of his own country). Under him the Commission has continued to play a crucial role in providing analysis, implementing the rules and drawing up legislative compromises, as well as protecting the interests of smaller countries and of a wider Europe. But it has proved hard to restore the Commission’s political clout at a time of rising scepticism in public views of the European Union. Many national governments have come to see the Commission as too keen on petty regulation and too ready to appease the European Parliament, moving away from its supposedly neutral position between Parliament and Council – a perception that is likely to grow now that, under the Lisbon treaty, the Parliament has been given the explicit role of “electing” the Commission president after he or she has been nominated by heads of government.2

As the Commission’s political influence has waned, the Parliament’s has waxed. Besides its new role in the choice of a new president, the co-decision procedure for almost all legislation under the Lisbon treaty has given it extra powers. In its work on the new excessive-deficits procedure during the euro crisis, the Parliament played a positive role, especially over the new six- and two-pack legislation, which its economic and monetary affairs committee under a British MEP, Sharon Bowles, helped to shape. Yet national governments and EU leaders, even those traditionally keen to give the Parliament more powers, are nowadays increasingly disillusioned with it. This was especially obvious during repeated rows over the EU budget and the multi-annual financial framework during 2013: the Parliament’s instinctive push for even more EU spending than the Commission had asked for won it few friends among net contributor countries. The growing presence of populist and extremist parties in the Parliament, while making it more representative, will not improve its image with national governments.3

The biggest winner from the euro crisis among the EU institutions has been the European  Council of heads of state and government, because it brings together the 28 national leaders. That is partly because Herman Van Rompuy, the little-known, haiku-writing Belgian prime minister who was picked to be the European Council’s first permanent president (and was promptly accused by Nigel Farage, leader of the UK Independence Party, of having “all the charisma of a damp rag and the appearance of a low-grade bank clerk”), has in fact proved an adept choice. As an economist from a euro-zone country, he was good at diagnosing the euro’s ills; he has often pointed to the madness of not watching more carefully the rise in current-account deficits. From his background in Belgian politics he has also learnt the art of political compromise. His ability to speak English, French and German, shared also with Jean-Claude Juncker, who chaired the Eurogroup, has been useful. The jobs of European Council and Eurogroup summit president (which he added) have become more significant partly because of how he has done them. And, for the most part, he has forged a good working relationship with Barroso, with the Commission continuing to provide much of the technical and legal support for the work of the European Council.

The main reason the European Council is where the action now happens is that the euro crisis has increased the clout of national governments. This is largely because only national governments can command the resources needed to bail out excessively indebted countries or banks. It is also because, to raise the necessary money, most governments have needed to secure the consent of their national parliaments. In effect, the euro crisis has laid bare a tendency that could be detected long before 2009.

This is that national governments and their leaders (with an increasingly large role played by finance ministers at the expense of foreign ministers, formerly the main actors in Brussels) have become the driving force of the euro zone and, by extension, of the EU as a whole.

Broad political power is thus shifting from the supranational European institutions and towards national governments thanks to the euro crisis. Yet at the same time many more intrusive powers are being vested at the EU level, because the euro zone has been forced to move in the direction of greater political as well as economic integration. The ECB is taking on the supervision of most euro-zone banks, for example, and it will also gain the power to require them to increase their capital or, in some cases, to shut them down. As part of the European semester, the Commission is getting extensive new monitoring powers, including the possibility of sanctions, over national budgets. The Parliament is arrogating to itself the job of scrutinising contracts for reform that are being debated and could yet be drawn up between national governments and Brussels. What explains the paradoxical combination of greater intrusive powers within the euro zone and the declining influence of the EU institutions?

Country-club rules

The answer is to be found in the shifting balance of power among EU countries, which is perhaps where the greatest impact of the euro crisis can be seen. The underlying fiction of the European project from the beginning was that member countries were broadly equal. Most institutions worked on the basis of one representative per country, although until the Nice treaty big countries were entitled to two commissioners. Admittedly, qualified-majority voting in the Council gave more weight to big than to small countries, but the system was still biased towards the small – and the most important decisions were almost always taken unanimously. Seats in the Parliament do reflect population size, but even there small countries have tended to be overrepresented (Malta has proportionately five times as many MEPs as Germany).

Yet despite all this, the notion of equality within the EU remains largely false. In practice, two countries have always acted as the principal engine in the European motor: France and Germany. Italy, the other big country in the original six, has never been able to match the clout of these two, partly because for many years its political system led to frequent elections and innumerable changes of prime minister, and partly because, after a long period of catch-up growth that lasted into the 1980s, its economic performance has been so dismal. Although the Netherlands has occasionally dissented, and has also in recent years turned noticeably more sceptical towards the European institutions, the Benelux trio have generally been willing to go along with Franco-German leadership. It has been hard for any newcomers, including largish countries such as the UK, Spain and Poland, to break in.

In the early years of the European project, especially after the Elysée treaty of 1963 that cemented links between the two countries, it was France that saw itself as in the lead politically, leaving the then West Germany to pay most of the bills. Indeed, this was one reason the French were reluctant to let the UK join in the early 1960s: in the words of the French foreign minister at the time, they did not want another cock on the dunghill. The EU institutions, including commissioners and their cabinets, were largely designed on French lines. The Commission’s first secretary-general was French. The common agricultural policy, the common fisheries policy, the customs union and the budget were all drawn up in many ways to the benefit of the French at the expense of the Germans (and, sotto voce, of the British when they were eventually let into the club in 1973).

By then the relationship across the Rhine had become more one of equals, as (West) German economic power asserted itself. The response of successive French presidents and German chancellors was to forge still closer bilateral links, even though they often came from opposing political families: Valéry Giscard d’Estaing with Helmut Schmidt, François Mitterrand with Helmut Kohl, Jacques Chirac with Gerhard Schröder. It became understood that, if France and Germany could agree on something, so (most of the time) could the rest. Even when the personal relationship was scratchy, the institutional bond between the two countries was close. The UK’s attempts to insert itself into a possible trilateral relationship usually failed: the prime minister who came closest to pulling this off was Tony Blair, but his European credentials were tarnished when the UK declined to join the euro, and even more so when he later backed George Bush’s war in Iraq, vehemently opposed by both the French and German leaders.

By this time, however, the Franco-German relationship was becoming more obviously lopsided. The turning point came with German unification in 1990, which made Germany significantly bigger than France both in population and in economic weight. That was indeed one reason Mitterrand pushed so hard for a single European currency: he hoped that it would give France more say in economic and monetary policy, which was increasingly being dictated for all EU members by the German Bundesbank. But as the years went by, it became ever more obvious that the Franco-German relationship had become a mechanism that was deployed to disguise German strength and French weakness.

There was a brief respite at the start of the euro when the German economy looked particularly weak, partly because Germany had joined the euro at a relatively high parity. The Economist, echoing Hans-Werner Sinn, a German economist, called Germany the sick man of Europe as recently as 2003.4

But German industry responded to the challenge by determinedly cutting costs and holding down wages, while the Schröder government’s Agenda 2010 reforms of the labour market and welfare system increased the German economy’s flexibility. Rising demand from China for German-made machine tools and other products also boosted German exports. The result was that, by the time the euro crisis broke out openly in 2009–10, the gap in economic and financial strength between the two leading countries in the euro had become gapingly wide.

Germany’s moment

This presented a big new challenge to the next incarnation of the dual leadership, after May 2007: Nicolas Sarkozy as French president and Angela Merkel as German chancellor. True to form and despite both coming from the centre-right, their relationship got off to a rocky start, not least because they were polar opposites in style. Sarkozy is a nervy, hyperactive showman. Merkel was a cautious, somewhat dour scientist. The two were known to find each other unbearable even though they had to work together – in English, no less, because neither spoke the other’s language. They quickly clashed after Sarkozy became president when he floated plans for a new “Mediterranean Union” that appeared to be meant to exclude Germany. But it was the global financial crisis that really tested them. At first France seemed to fare better during the crunch than Germany (and indeed the UK), with a much smaller loss of GDP in 2008–09.5 Along with the British prime minister, Gordon Brown, Sarkozy played a big role in meetings of the G8 and G20 that tried to co-ordinate an international fiscal boost to stop the crisis turning an inevitable recession into a deep 1930s-style depression. At one point, he even cheekily announced to the press that France was acting while Germany was merely thinking about it. But when the euro crisis erupted in 2010 the structural weakness and relatively greater indebtedness of France compared with Germany soon became a huge problem. Like so many of his predecessors, Sarkozy’s response was to try to get closer to Merkel. He played up France’s AAA rating as a key asset underpinning the successive rescue funds that had to be devised for Greece, Ireland, Portugal and later Spain and Cyprus. He and Merkel joined forces to suggest policy changes such as, at Deauville in October 2010, the involuntary involvement of the private sector in future debt restructurings. He pushed German-inspired fiscal austerity and did not press hard for an immediate agreement to the issuance of Eurobonds. The markets began to talk of “Merkozy” as the key tandem seeking to steer the euro zone out of its debt and growth crises. And the two leaders played a crucial role in 2011 in engineering the departures of Silvio Berlusconi in Italy and George Papandreou in Greece and their replacement by technocrat-led governments.

Yet as the crisis dragged on, the pretence that France counted as much as Germany wore thin. Increasingly, it was the chancellery, the Bundestag and the German constitutional court in Karlsruhe, as well as public opinion in Germany, that were doing the most to determine the shape and speed of the euro zone’s various rescue packages. As other countries, especially but not only those that had been bailed out, cut public spending, reduced budget deficits and pushed through structural reforms, an unchanged and unchanging France seemed to be turning into part of the problem rather than part of the solution. To Sarkozy’s embarrassment, France lost its first AAA rating in early 2011. And then, in May 2012, he lost the presidential election to the Socialist candidate, François Hollande.

Hollande was a stronger pro-European than Sarkozy, as well as being easier to deal with on a personal level. Although he came from the opposite political camp to Merkel, he was on the right of his Socialist Party. Yet as the man who led the party when it split over the referendum on the EU’s constitutional treaty in 2005, he was wary of any new treaty changes that the Germans might seek. Moreover, before his election he spoke out strongly against Merkel’s austerity policies and in favour of more growth; he wanted to see some form of debt mutualisation, which was anathema to Merkel; and during the campaign he said next to nothing about the need for structural reforms or public spending cuts at home, instead proposing tax increases, including a new 75% top rate of income tax.6

After he came to power, far from seeking to reinvigorate the Franco-German axis, he tried to make common cause with the Italian and Spanish leaders in urging more growth-oriented policies in place of excessive austerity.

The response from Germany was frigid in the extreme. After two years of crisis-fighting, the last thing Merkel wanted was to see a weakened France deserting the “northern” camp of creditor countries like Germany, Austria, the Netherlands and Finland and joining instead the “southern” camp of debtors, whose instinctive answer to any problem was to borrow and spend more. France, it was noted darkly in Germany, had not balanced its budget since 1974. One reason the Germans decided during 2012 that it would be too dangerous to let any country, even Greece, leave the euro was because they feared that it might lead to the currency eventually unraveling all the way up to the Rhine.

In short, France had now become, in German eyes, part of the problem and not of the solution.  At a budget summit in February 2013 Hollande was so distant from the German position that he even failed to show up for a bilateral meeting with Merkel, something unheard of before. As one observer of EU summits noted, everybody always stopped to listen to Merkel; nobody paid any attention when Hollande took the floor, instead fiddling with their Blackberries and iPhones. The marginalisation of France is also denting public opinion in that country, which is increasingly turning against both the euro and the EU. The French industry minister, Arnaud Montebourg, has taken to attacking the EU for its “free-market fundamentalism”. Another striking example even among the pro-European elite was a 2013 book by François Heisbourg, from the Foundation for Strategic Research, in which he argued that the euro should be scrapped in order to preserve the European Union.7

Angela alone

In effect, Europe once again has what historians have called a German problem (with plenty of reason to hope that the solution will be more peaceful than in the past). The revival of a German problem is not at all comfortable for Merkel. Following the departure of Jean-Claude Juncker as prime minister of Luxembourg in late 2013 and of Estonia’s Anders Ansip in 2014, she is the longest-serving national leader in the EU. With France so weak and Hollande so ineffectual, she is also the unchallenged head of the northern creditor camp in Europe. And with German unemployment and youth unemployment both at 20-year lows, GDP back above pre-crisis levels, a budget close to balance and a continuing huge current-account surplus, her country is the uncontested economic hegemon of Europe. France and Italy are, at best, bystanders; at worst, largely irrelevant.

Yet Germany remains a reluctant hegemon, not least for historical reasons. Its foreign and defence policies are inward-looking, commercially driven and instinctively pacifist, unlike the UK’s and France’s. Merkel may enjoy wielding power in Europe, and being seen by the rest of the world as the continent’s most important leader, but neither she nor her country is entirely happy being treated too openly as such. Post-war German chancellors have traditionally seen more Europe as the answer to the German problem. But to critics of Merkel, especially during the euro crisis, her call for more Europe has often seemed like a call for a more German Europe, an effort to transform all euro-zone countries into mini-Germanys. The sensitivity this arouses was well demonstrated in November 2011 when a public claim by Volker Kauder, chairman of the Bundestag’s foreign affairs committee, that “suddenly, Europe is speaking German” was swiftly disowned by most of his colleagues.8

Germany, in short, remains highly attuned to outside criticism. It also has many blind spots economically. This not only embraces the crude caricatures of Merkel with a moustache and talk of a new Third Reich that are seen and heard in Greece and elsewhere. It also includes more serious complaints from the likes of the IMF and the US Treasury that Germany relies too much on exports and too little on domestic consumption for growth; and that, by running such a large current-account surplus, determinedly holding down wages and failing to generate sufficient internal demand, the Germans contributed to the problems of the euro zone in the first place.

Such claims are vigorously rejected in Germany. Ever since the Greek crisis erupted in late 2009, the Germans have seen two roots of the problem: fiscal profligacy and a loss of competitiveness. On this diagnosis, the cure for the first is public-spending cuts and tax rises; for the second, it is structural reforms to labour and product markets to reduce unit labour costs and restore competitiveness.

Germany has long kept its public finances under better control than others and it also pushed through the Agenda 2010 reforms in 2003. Other euro-zone countries simply have to copy this example. The notion that Germany might need to do more, for instance increasing wages or public spending, or boosting domestic investment, is often greeted with disbelief. German business, it is said in reply, must compete on a global stage; trying to rebalance within Europe by making it less competitive externally would be disastrous for the entire continent. That the coalition agreement in Germany may have this effect, by introducing a high minimum wage and lowering the retirement age for certain workers, reflects politics rather than policy choices.

As Merkel has come increasingly to be the main or even only voice that counts in the euro crisis, she has also become more dubious about the value of the EU institutions. Admittedly, she has quietly sided with the ECB against criticisms from the Bundesbank, even when two of her most loyal lieutenants, Axel Weber and Jürgen Stark, resigned in protest. But she has dragged her feet on banking union, and her response to calls from the Commission or from other European countries for debt mutualisation has been cold. For her, keeping in line with public opinion at home and satisfying both the Bundestag and the constitutional court in Karlsruhe matter far more than any dreamy euro federalist vision. She has at times been criticised by such predecessors as Helmut Kohl and Helmut Schmidt for this. The current coalition agreement suggests a number of changes to the Commission, including reducing its propensity to regulate.

It must be conceded that, at least for Merkel, this approach to Europe has worked wonders. For all the brickbats hurled at her, especially from abroad, for being too slow to move, too eager to impose austerity on the Mediterranean, too unwilling to boost demand at home and too leery of explaining to Germans how much they would lose if the euro were to break up, she has retained enormous popularity at home. Almost all other euro-zone countries have seen their leaders pushed out by voters as a result of the euro crisis. Merkel, however, took an impressive 42% of the vote in the federal election in September 2013, and she has since gone on to form a grand coalition with the Social Democrats that clearly leaves her and her finance minister, Wolfgang Schäuble, in charge of German policy on the euro. German voters, it seems, instinctively trust her both to do the right thing and to protect their interests.

Mediterranean angst, northern bravado

Worries about French weakness and about being lonely at the top have prompted the Germans to look around for other potential partners in the European Union. The UK is out, as it is seen as too semidetached from the project. The Mediterranean countries are also broadly no good. Most of them have received help from European bail-out funds and are still struggling to comply with their reform programmes and sort out their banks. Spain is likely to be the first to come good but still faces severe economic and political difficulties. Only Ireland has become the German poster-child for how a bailed-out country can change itself.

Italy is the perpetual underperformer in the EU: a big economy, second only to Germany in manufacturing, but seemingly incapable of reforming itself to regain lost competitiveness. Alone among euro-zone countries its income per head is lower now than when the euro began in 1999.

During his brief technocratic administration in 2011–12, Mario Monti promised to be a firm ally of Merkel’s, and he tried, with only partial success, to push through structural reforms, including to pensions. But at EU meetings he tended to side with those criticising Germany for not doing enough to boost domestic demand and the ECB for failing to act to lower interest rates in the periphery. Italy has raditionally favoured ever-closer union in Europe, on the basis that many Italians prefer rule from Brussels to rule from Rome, but such an approach is now out of favour in Germany.

Monti was forced to call an election in February 2013 in which he did badly. After complex bargaining, Enrico Letta, the young deputy leader of Italy’s centre-left Democratic Party, succeeded in putting together a broad coalition together with Berlusconi’s People of Freedom (PdL) party and a scattering of centrists – the same broad coalition that had backed Monti. The country came out of its excessive deficit procedure in June, giving Letta a political boost, but Italy’s politics remained as dysfunctional as ever. Letta found it no easier to enact reforms than did Monti. He survived an attempt by Berlusconi to bring down the government in October, just before the old rogue lost his parliamentary immunity following conviction on charges of fraud. Berlusconi’s move backfired; instead of bringing down the government, his own PdL party split, with a faction of moderates sticking with Letta. But Letta then faced a deadlier challenge from his own side. The turbo-charged former mayor of Florence, Matteo Renzi, took over the leadership of the Democratic Party in December, and then pushed Letta out of power in February 2014.

Like Monti, Letta had been popular with Merkel partly because he was not Berlusconi and partly because he understood the case for structural reforms at home. But Merkel was never confident of seeing much in the way of radical reform from his baggy left-right coalition. It remains to be seen what she will make of Renzi. This young and energetic new leader is now widely seen both inside and outside Italy as the last great hope of his country’s reformers. But his coalition is not much stronger than Letta’s, and he is vulnerable to the charge of being yet another unelected leader imposed on Italian voters.

That leaves the northern group in the euro zone, most of which are natural allies of Germany. Austria, Finland and Luxembourg are the only other AAA-rated countries that help to sustain the rating of euro-zone rescue funds. But all are small. The Dutch and Finns usually support German calls for austerity. Yet the Netherlands was downgraded in 2013 as the Dutch economy struggled to overcome the after-effects of a housing bust. The eastern newcomers to the euro, Slovakia, Slovenia, Estonia and (from January 2014) Latvia, are small countries as well, and Slovenia has  hovered on the brink of needing a bail-out for its indebted banks. However, these two groups give powerful support to the broad German narrative, which is that the cure for the euro crisis is to be found in fiscal austerity and structural reform at home. The Baltic countries, especially Latvia, went through almost as wrenching an adjustment in the early 2000s as Greece, and without provoking riots. They are among the strongest advocates that other heavily indebted countries should follow suit. Latvia’s is now the fastest-growing economy in the EU.

What the euro crisis has clearly done is to break what used to be the EU’s east–west division.  Most of the countries that joined in 2004, and even more so Bulgaria and Romania, which joined in 2007, remain significantly poorer than the others, but they are catching up as they benefit from EU structural funds. The new economic and political division in Europe is increasingly a north–south one. This is potentially troubling for the entire project. For its first 50 years until 2007, it always functioned on the basis that it was bringing about convergence between member countries. Since the euro crisis hit, the pattern has been more one of divergence. And that could easily stir up still more popular resentment of the EU in the south.

Germany is also looking to some non-euro countries as potential new partners, especially Poland and, to a lesser extent, Sweden. Indeed, were Poland to join the single currency, it is not too fanciful to see it vying with France and the UK as Germany’s main allies (French suspicion of eastern enlargement was often attributable to its worry about losing influence within the club to Germany). Bilateral German–Polish relations are warmer than they have been in 500 years. Merkel respects Donald Tusk, the Polish prime minister, so much that she briefly toyed with putting him forward for the Commission presidency. Radek Sikorski, the foreign minister, has been widely touted as a candidate for one of the top EU jobs, at least since his notable November 2011 speech in Berlin when he announced that he was “probably the first Polish foreign minister in history to say this, but here it is: I fear German power less than I am beginning to fear German inactivity”.9

The increasing influence of Poland does, however, throw the spotlight on the remaining big division in the EU, besides an economic north-south one. This is between the 18 euro-zone ins and the ten outs. As the euro zone pursues deeper political integration, including of fiscal policy and banking regulation, and even toys with setting up its own separate institutions, it is becoming increasingly clear that the single currency is the most important subgroup in the broader European club. That raises huge dangers for the maintenance of the wider single market at 28, and especially for the position of the most recalcitrant country of all: the UK.

Europe 2010 - The European Union: Managing the Crisis

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.

No Grexit

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.

Banking disunion

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.

European Union and crisis to the East

5. Trichet’s test

OF THE SENIOR FIGURES IN THE EURO ZONE, it was Jean-Claude Trichet, president of the European Central Bank, who gave the clearest warnings of the danger of growing deficits. He was a hawk about respecting the stability and growth pact. Moreover, from 2005, he would turn up every month at ministerial meetings with charts setting out his concerns about economic imbalances. A favourite one showed the divergence in unit labour costs across the euro zone. Another tracked the giddy rise of public-sector wages. His main concern was that the loss of competitiveness would harm growth. But he also knew the euro zone was not a federal country; there was no central budget to help countries that got into trouble. The countries of the euro zone, he would say, were like La Cigale et la Fourmi, Jean de la Fontaine’s fable about the improvident cicada and the hard-working ant. Those in the periphery sang in the warm sunshine, while the industrious Germans held down their wages and put money aside for a rainy day. But when winter came, Trichet could scarcely stand aside. Central banks wield the power of financial alchemy, able to produce an endless quantity of money out of thin air.

Often only the ECB had the means to provide the vast amounts of liquidity needed to stop a run on sound banks, or on solvent sovereigns.

The ECB’s treaty-prescribed independence gives it a peculiarly remote, Olympian status. In public, the dialogue between governments and the central bank is detached and reverential.

Governments are frowned upon if they demand action from the ECB too vehemently in public. Behind the scenes, the ECB has been an intensely political actor, from designing and monitoring bail-out programmes to engaging in hand-to-hand combat with leaders over reforms. The Gallic rows between Trichet and the French president, Nicolas Sarkozy, became legendary. Of the ECB’s component banks, Germany’s Bundesbank is the most important and pure in its conviction that it is not the job of central bankers to get politicians out of fiscal trouble. Its president, Jens Weidmann, believes the ECB should act like Odysseus before the sirens: lash itself to the mast with strict rules and tell the sailors to stuff their ears with wax to shut out the politicians’ calls. This is the backdrop to the crisis as it developed from 2007.

Chacun sa merde

As global credit dried up after the collapse of subprime mortgages in the United States, the ECB was the first to open the cash tap on August 9th 2007, making an extra €95 billion available to banks, soon followed by the central banks of the United States, Canada, Japan and Australia. The trigger was the announcement that BNP Paribas, a French bank, was suspending withdrawals from two funds heavily exposed to subprime credit. It said a shortage of liquidity made the assets impossible to value. Any doubts that Europe would feel the force of the financial crisis were quickly dispelled. A few days earlier IKB, a German bank that had played recklessly with asset-backed investments, had been bailed out; a month later there was a run on Northern Rock, a British lender that would eventually be nationalised. Trichet’s quick and firm response prompted the Financial Times to pick him in December 2007 as its “Person of the Year”.

It was the bankruptcy of Lehman Brothers on September 15th 2008 that really caused global panic.

The decision by Ireland a fortnight later to extend an unlimited guarantee to all banking debt provoked both anger at a rash move that was sucking deposits from the rest of Europe and a scramble by other countries to issue their own guarantees. Sarkozy, whose country held the rotating presidency of the EU, sought to control the free-for-all by calling a summit of leaders of the four biggest European economies on October 4th. He pushed for the creation of a common European bank-rescue fund, worth perhaps €300 billion, but was slapped down by Angela Merkel, the German chancellor. “Elle a dit, chacun sa merde” (“she said everybody should deal with his own shit”) was how Sarkozy scathingly recounted the conversation to his aides. At another summit in Paris eight days later, this time of all euro-zone leaders plus the UK’s prime minister, Gordon Brown, Merkel changed her tune. Her mind concentrated by the collapse between the two summits of Hypo Real Estate, she now accepted the need for a massive European response. It would be worth €1.9 trillion in loan guarantees and capital injections to prop up the banks. The move was co-ordinated and subject to EU state-aid rules, but each country would still have to clean up its own banking mess. The hyperactive Sarkozy then flew off to Camp David (taking along the president of the European Commission, José Manuel Barroso) to persuade President George Bush to call a global summit on the financial crisis (it would become the G20 summit).

Under the Irish single-market commissioner, Charlie McCreevy, the Commission had hitherto favoured light-touch regulation of finance. But in October Barroso enlisted a former IMF boss and French central-bank governor, Jacques de Larosière, to produce a report on how to tighten control over the financial sector. It was delivered within three months. After much resistance from the UK, the report would lead to the creation in 2011 of four new European financial supervisory bodies: three new regulators for banks, insurance and markets, and the European Systemic Risk Board to monitor threats to the overall financial system. The task would be pursued with zeal after 2010 by McCreevy’s French successor, Michel Barnier, who vowed that no aspect of finance would escape regulation.

Soon after Lehman’s demise, staff at the IMF’s European department predicted that “it’s going to rain programmes”. The first came in the form of a classic balance-of-payments crisis that hit the newer, fast-growing eastern EU members that were outside the euro. As foreign money fled and currencies came under pressure, Hungary and then Latvia applied for IMF bail-outs in October and December 2008, respectively. Romania followed in March 2009. These bail-outs were co-financed by the EU, the World Bank and others. The eastern turmoil fed the illusion that the euro had brought protection from the worst of the crisis. Trichet called the single currency “a shield” against global turbulence. Slovakia was more than glad to be able to slip into the single currency on January 1^st 2009. To the fury of some, the euro zone resisted pressure to soften its admission criteria so that others could follow.

But the combined impact of bank rescues, fiscal stimulus and the start of recession aggravated the public finances of several countries. Might the crisis spread to the euro zone after all? Ireland and Cyprus were likely candidates for assistance because of their outsized banking sectors. Spain looked fragile because of its property bust. Others thought that Austria was vulnerable because of its banks’ exposure to central and eastern Europe. However, the first euro-zone debt crisis would begin in a country whose banks were reasonably sound, but whose public spending had run out of control and whose statistics were dodgy: Greece.

Greek tragedy

Oddly, perhaps, the first blow to Greek debt was not financial but political. The death of a 15-year-old schoolboy, shot by the police in December 2008, set off a fortnight of riots across the country. Even for people used to a degree of ritualised street clashes, the scale of the unrest was unprecedented since the restoration of democracy in 1974. The violence seemed to reflect a deep malaise over high youth unemployment, a dynastic political system based on patronage, a kleptocratic and ineffective public administration, educational reforms – and the public bail-out of banks. Other European leaders worried that the rebelliousness might spread (Sarkozy cancelled a planned school reform, fearing “regicidal” mobs).

The teetering Greek Prime Minister, Kostas Karamanlis, sacked his finance minister, George Alogoskoufis, a month later and then loosened the public purse-strings ahead of an election. Greek bond yields had been drifting upward from the start of the credit crunch in 2007. But with the riots the spread over German bonds blew out, rising from about 160 to 300 basis points in late January 2009, after Standard & Poor’s had downgraded Greece’s debt. The European Commission placed Greece (and five others) under surveillance for breaching the 3% deficit limit. It said Greece and Ireland should step up deficit-cutting.

Senior French and German officials held secret meetings about how to respond should Greece lose access to bond markets. But the problem seemed to resolve itself, helped by reassurances from the German finance minister, Peer Steinbrück, that weaker euro-zone members would be helped if they got into trouble. The comments were echoed by the Commission and the ECB. For a while the unspoken assumption that countries of the euro zone would stand behind each other in case of trouble appeared to have been reaffirmed. Spreads narrowed again. Then the Greek Socialist opposition party, Pasok, won a landslide victory in the election on October 4th 2009. Its leader, George Papandreou, son and grandson of previous Greek prime ministers, had campaigned on a policy of fiscal stimulus. He had promised above-inflation pay rises, investment in green energy and other spending to “kick the economy back into action again”. Output was at a standstill because of a drop in summer tourism and shipping revenues had fallen because of shrinking global trade. But Papandreou breezily declared that “the money exists”.

It didn’t. On October 16th, less than a fortnight after coming to power, Papandreou announced that the previous government had left an enormous hole in the budget. His finance minister, George Papaconstantinou, said the deficit for 2010 would be above 10% of GDP, a figure promptly revised up to 12.7%. Yet surprisingly, fellow European leaders at first paid little attention to this opening act of the Greek tragedy. Policy debate focused on financial regulation, how to end stimulus programmes amid signs of a tentative recovery and the conclusion of the long saga of the Lisbon treaty. An EU summit in November did not even discuss Greece, but rather who should fill the two big jobs created by the treaty: the eventual choices were Herman Van Rompuy as European Council president and Catherine Ashton as foreign-policy chief. Meanwhile, as ratings agencies downgraded Greece, finance ministers chastised the country. At a summit in December Papandreou delivered an unusually candid admission of Greek corruption before fellow leaders. Yet many still hoped that Greece would somehow get itself out of trouble by tightening its belt.

Solvay doesn’t solve it

Van Rompuy’s inaugural act was to call an informal summit at the Bibliothèque Solvay in Brussels on February 11th 2010 to hold a general debate on the EU’s growth-promotion strategy. But as Greek bond yields spiked over the 7% mark in late January, he realised something would have to be done, or at least said. Van Rompuy had little idea how much his presidency would be dominated by the Greek crisis. But his mild, self-deprecating manner – and his experience as Belgium’s budget minister in bringing down his country’s debt – made him an ideal backroom dealmaker. He delayed the start of the summit for more than two hours, closeting himself with Papandreou, the leaders of France, Germany, the European Commission and the ECB. The previous year French and German officials had spoken privately of extending bilateral lines of credit should Greece get into trouble, but the German coalition had since changed and the public mood was hostile to any idea of lending money. Germans had been promised they would never have to pay for other countries. Perversely, perhaps, it was easier to help non-euro EU countries in financial trouble than to lend money to the likes of Greece.

From the outset the discussion reflected national prejudices and personal traits that would shape the subsequent response. The imperious Sarkozy wanted European leaders to react quickly and forcefully; the cautious Merkel was in no rush to respond. The former thought the crisis would go away if governments just put up enough money to see off the speculators; the latter was convinced that the crisis would be assuaged if Greece just took serious action to cut its deficit and reform its economy. In a country that had not run a budget surplus since 1974, French voters did not share the same resentment as German ones over Greek profligacy. Sarkozy also rejected the involvement of the IMF as an affront to Europe. Trichet concurred, perhaps also because he thought the IMF would try to impose conditions on the ECB. Both men may have been conscious that the IMF was run by Dominique Strauss-Kahn, a potential Socialist challenger to Sarkozy. Yet after sharing these initial qualms, Germany came round to insisting on IMF involvement to ensure rigour.

Van Rompuy papered over these differences with a statement that declared support for Greece “to do whatever is necessary” to curb its deficit, and announced that the Commission would “monitor” the implementation of the promised deficit-cutting, “drawing on the expertise of the IMF”. He said eurozone members “will take determined and co-ordinated action, if needed, to safeguard financial stability in the euro area as a whole”. But to get Merkel to swallow the implicit commitment to a bailout, he added a final sentence: “The Greek government has not requested any financial support.”

Irrational ultima ratio

By March everybody knew the request would come. The “troika” that would negotiate the bail-out –consisting of the IMF, the European Commission and the ECB – was born and made an initial secret visit to Greece in early March. Amid ugly German headlines telling Greeks to “sell your islands” and a magazine cover depicting Venus de Milo giving Europe the middle finger, a summit on March 25^th prepared what Greece called a “loaded gun”. Member countries declared that they stood ready to pool bilateral loans into a fund that, along with the IMF, was ready to bail out Greece. Germany attached several conditions: a decision had to be taken unanimously and include “strong conditionality” to reform, and loans would be extended at “non-concessional” interest rates, reflecting the risk of lending to Greece. Above all, the mechanism could be used only on the basis of ultima ratio, as a last resort to prevent Greece from defaulting on its debt. This German doctrine, born of tactical, domestic and legal considerations, would come repeatedly to hamper the euro zone’s ability to respond decisively.

Germany believed, with good reason, that countries would cut their budget deficits and reform their economies only under extreme pressure from markets. Moreover, Merkel could hope to win over her outraged voters to the idea of a bail-out only if she could demonstrate that it was needed to save the euro. And given that opponents would inevitably petition the constitutional court in Karlsruhe, she could justify the breach of the no-bail-out rule in European treaties only on the grounds of a genuine emergency, on the well-known principle of Not kennt kein Gebot: “Necessity knows no law”. Lawyers in Brussels also noted that the no-bail-out rule was hardly categorical. The Lisbon treaty says only that countries that shall “not be liable for or assume” the debt of others; it says nothing of lending money.1

That the euro zone would later invoke another article dealing with assistance for natural disasters says much about the legal discomfort.2

The loaded gun did not frighten the markets. The Euro group then cocked the weapon on April 11th, saying that it stood ready to lend Greece €30 billion in the first year of a programme, to which the IMF would add another €15 billion. A premium of 300 basis points would be added to the borrowing costs – a steep price, but not as steep as the 7% yield that markets were demanding for Greek ten-year bonds. This still provided no deterrent. In late April Standard & Poor’s downgraded Greek debt to junk status, and also cut its ratings for Portuguese and Spanish bonds. On May 2nd, responding to a formal request for help from Papandreou, who said his country was “a sinking ship”, the Euro group agreed to the inevitable bail-out. It had grown to €110 billion over three years – the largest ever provided to a single country – as it became obvious that private investors would not roll over existing debt.

Even so, the deal was filled with contradictions. Greece was supposedly being rescued, but it was subjected to an unworkable programme and punitive rates of interest (Merkel boasted that Germany would make a profit on the loans). IMF staff thought there should be less up-front austerity and more structural reforms, but the Europeans were still focused on fiscal rules. The debt-sustainability assessment relied on optimistic assumptions. One IMF official was blunter: “We lied.” Indeed, it would emerge later that many members of the IMF’s board had deep misgivings about the programme.3 Brazil’s executive director, Paulo Nogueira Batista, was prescient when he argued that the risks of the programme were immense. Rather than a bail-out of Greece it could become a bail-out of investors and banks as they dumped their bonds onto official lenders. The whole thing could prove “ill conceived and ultimately unsustainable”. Critics argued that Greece’s huge debt should instead have been restructured immediately. That said, even the most hawkish IMF staff members thought it was too dangerous to do this in the middle of a market panic. But the lingering dispute would, later on, harden the IMF’s attitude to Greece and future rescues. Even the tripling of the Greek bail-out failed to quell the markets. And the crippling adjustment demanded of Greece – deficit reduction of 11 percentage points over three years in the teeth of a recession, nearly half of it front-loaded in the first year – provoked riots outside the Greek parliament, and the death of three people when anarchists set fire to a bank. As Greek bonds rose beyond 12%, contagion pushed Irish yields close to 6% and Portuguese ones up above 7%. Stock markets around the world slumped as investors fretted about the financial and political stability of a block that made up around a quarter of global output.

Save the euro

After months of indecision and half measures, the euro was now in mortal danger. The mood of foreboding grew darker still on May 6th 2010, the day of a strange “flash-crash” on Wall Street, in which the Dow Jones Industrial Average collapsed by about 1,000 points before recovering within minutes, perhaps because of a technical glitch. The ECB’s governing council, in Lisbon that day for its monthly meeting, faced a momentous decision: should it start buying sovereign bonds to stop the panic? The Federal Reserve and the Bank of England had been doing so under their policy of quantitative easing to bring down long-term borrowing costs. But the ECB had not gone so far, wary of the prohibition against anything resembling “monetary financing”, that is, printing money to finance public debt. After the official meeting, Trichet told journalists that the subject of bond-buying had not been discussed. Later on over an informal dinner, however, the council had reached a tentative agreement to start selectively buying the bonds of vulnerable countries.4 The next day, as leaders gathered in Brussels for a euro-zone-only summit, ostensibly to endorse the bail-out of Greece, many participants seemed unaware that they would be called upon to do something much bigger: set up a safety net for the whole euro zone.

Trichet delivered a stern lecture. He told leaders the euro was in danger, and that they were to blame for the mess through reckless policies. It was now their responsibility to fix it. Trichet would not disclose his readiness to buy bonds until the leaders had taken decisive action; the ECB would not risk acting alone, or being seen to do so under political pressure. The summit could not reach agreement, so finance ministers were told to take up the task two days later, a Sunday, before markets reopened in Asia. The Commission then tabled a proposal, based on its aid programme for central and eastern Europe, to create a €60 billion war chest for the euro zone. The money would be raised by issuing bonds on the market guaranteed by the EU budget. The British Prime Minister, Gordon Brown, who had just lost a general election on May 6th, had to be asked for his approval. Member countries, including the non-euro UK, would be liable for possible losses.

Yet too little money could be raised this way. And ministers would not extend loan guarantees to the Commission to expand the fund. Instead, a special-purpose company, incorporated in Luxembourg and backed by government guarantees, would be created to ensure national governments retained full control over the money. The final deal could not be concluded until nightfall, after polling stations closed in the German state of North-Rhine Westphalia (Merkel’s Christian Democrats lost).

Consensus was then quickly reached on the amount: €440 billion. Thus were born the Commission’s European Financial Stabilisation Mechanism (EFSM) and the larger inter-governmental European Financial Stability Facility (EFSF). The IMF would match every two Euros put up by the euro zone with one of its own, an unusual entry into rich-world affairs. The total made available to defend the euro zone amounted to €750 billion, or roughly around $1 trillion. Trichet now had the political cover he needed. The ECB announced that it would buy bonds under the Securities Market Programme (SMP), not to help crippled countries but on the grounds that dysfunctional markets were “hampering the monetary policy transmission mechanism”. At the same time, the ECB opened the tap for liquidity to the banks, while the Federal Reserve and other central banks helped out by reopening dollar swap lines, in essence a means for the Federal Reserve to extend dollar liquidity in the global financial system via other countries’ central banks (which would continue to bear the credit risk). The enormous sums mobilised that weekend were supposed to be a deterrent, a weapon never to be used. But, just as with the “big bazooka” that Hank Paulson, then the American treasury secretary, had talked about in 2008, it would not be long before it had to be deployed.

The ECB’s U-turn on bond-buying, following an earlier U-turn on taking Greek bonds as collateral for banks, raised questions about its independence. Tellingly, Merkel gave the bank the nod to buy bonds even though Axel Weber, the Bundesbank president, who briefly flirted with the idea, opposed the move. It is easier for politicians to have the central bank put up the money than ask for it from taxpayers. Moreover, governments could not make up their minds about markets. They denounced speculators for plotting to destroy the euro, yet set out to borrow hundreds of billions from the same financiers to save the single currency. They blamed ratings agencies for ignoring the dangers of dodgy financial engineering, then excoriated them for exaggerating the threat of sovereign default. But the events in May established one principle: faced with catastrophe, governments would act. The ECB would act too, though only if governments moved first. Yet delay raised the price of resolving the crisis, and also fed doubts about whether the euro could survive.

Merkozy in Deauville

The European summits in June and September 2010 were more or less routine affairs, although spreads started creeping up again in the summer after the market euphoria in May. Governments turned to reforming the institutional set-up of the euro. Part of the price Merkel demanded for bailing out Greece was a strengthening of the stability and growth pact, and closer co-ordination of economic policies to improve the competitiveness of the weaker countries. This became part of her mantra: greater control in exchange for greater solidarity. Sarkozy was not keen on such notions. But he liked the idea of creating a smaller, more exclusive core club that would keep out pesky liberal free traders from the UK and other north European countries. In March Sarkozy had started pushing an old French concept of an economic “government” for the euro zone, later softened in official communiqués as “governance”. To his mind, economies should be run by leaders with lots of discretion, not by rule bound bureaucrats. One undeclared aim was to restrain competition by harmonising taxes and social spending to French levels.

Reconciling these positions was made harder by two problems. First, the Franco-German relationship, the traditional engine of European integration, was working poorly. Second, both Sarkozy and Merkel were deeply suspicious of the European Commission. So in March 2010 EU leaders appointed Van Rompuy, not Barroso, the Commission president, to draw up a plan to toughen fiscal rules. But the Commission then pre-empted Van Rompuy’s report by publishing its own package of six legislative proposals on economic governance (later known as the “six-pack”). Beyond deficits, the six-pack put greater emphasis on reducing the stock of debt (to Italy’s dismay). And beyond the fiscal targets, EU surveillance would look at a broader range of economic indicators to detect underlying imbalances. Lastly, it inverted voting rules so that sanctions against miscreants no longer required a qualified majority of countries; instead, penalties recommended by the Commission would be approved unless blocked by a qualified majority.

Germany also pushed two more radical ideas. One was to suspend the voting rights of profligate countries. Such provisions existed for countries breaching fundamental values of democracy and human rights; the same should apply for breaches of the euro zone’s fiscal rules, thought Merkel. Her other demand was a mechanism for the “orderly insolvency” of governments. This idea was not new.

After Argentina’s default on its foreign debt in 2001, the IMF proposed a statutory “sovereign debt restructuring mechanism”, an insolvency regime for governments akin to the US bankruptcy for companies. The aim was to make default less messy and painful, and ensure that bailouts do not serve just a few lucky creditors. But the proposal ran into insurmountable opposition, not least from the United States, which did not want to cede power to a supranational authority to coordinate the process. The crisis in Greece brought the idea back to the fore. In the euro zone, at least, the idea of a supranational body was well-established though at times accepted only grudgingly.

All this was part of Germany’s determined effort to minimise the risk that it would be called upon again to bail out another country or, indeed, to bail out Greece a second time. Tougher fiscal rules, monitoring and sanctions would reduce the chances of countries getting into trouble. And if another debt crisis did take place, and the country needed a bail-out, the taxpayer should not be made to carry the whole burden. Moreover, the threat of losses should sharpen the vigilance of bond markets.

Other countries for the most part accepted the need to strengthen the stability and growth pact. But governments, and above all the ECB, were resistant to any notion of facilitating debt restructuring. One reason was a reluctance to bear the stigma: defaulting on debt was something that happened in poorer countries, not the industrialised world. Another was a concern that, in a world in which countries could more easily restructure debt, the borrowing costs for all sovereigns might be raised. A third was the fear of rekindling market turbulence. Instead of ensuring that markets enforced discipline on governments in future, debt restructuring might prompt another panic that would push governments into immediate bankruptcy. After all, Greece was not the only European country with a large burden of debt.

Some of the changes that Germany demanded would require a change of the treaties, which many countries were reluctant to embark on after the political agony they suffered over the constitutional and Lisbon treaties. But Merkel favoured treaty change anyway, despite the promise that Lisbon would be the last revision in a generation. She worried that the legal basis of the EFSF might not stand up to challenge in the Karlsruhe court. Even if it did, the fund was due to expire in 2013 and would surely have to be replaced by something more permanent.

On October 18th Van Rompuy called a last meeting of his taskforce of finance ministers in Luxembourg. Christine Lagarde, then the French finance minister, predictably sought to amend the “automaticity” of the sanctions. But all were astounded to hear the then German deputy finance minister, Jörg Asmussen, declare he was in complete agreement with her. What were France and Germany up to? The answer came later in the evening from the French seaside resort of Deauville, where Sarkozy was hosting Merkel for a Franco-German summit (as well as a three-way summit with Russia). France and Germany now supported a new treaty to make possible the creation of a “robust and permanent” crisis-resolution system. Germany got a promise that, in future bail-outs, there should be an “adequate participation by the private sector”; in other words, private bondholders would have to bear part of the pain in future crises. France obtained a softening of the “automatic” sanctions.

In Brussels the accord was seen as the worst of political deals. Many worried about the weakening of the commitment to fiscal discipline and feared that the threat of future debt restructuring, known as private-sector involvement (PSI), might cause alarm in markets that seemed to be calming down. Even Sarkozy’s senior advisers warned him against it. They worried that the implicit assumption of solidarity within the euro zone was being explicitly rejected through PSI, with unforeseeable consequences. But he overruled them.

Deauville thus marks the start of the “Merkozy” era. Merkel became the dominant figure in Europe while Sarkozy decided that the only way to manage the crisis, and to keep markets off France’s back, was to hug her close. Deauville also marked a second, more dangerous phase of the story. Investors started to walk away from vulnerable sovereigns and, within days, to run after a spate of bad news. A statistical revision raised Greece’s 2009 deficit above 15% of GDP, and its overall debt by about 12 percentage points to 127% of GDP; Greece admitted it was having problems collecting taxes; and PIMCO, one of the biggest fixed-income managers, predicted that Greece was likely to default within three years.

The mood at the next EU summit on October 28th was grim. Leaders of smaller countries were annoyed by the Franco-German diktat and the pressure to reopen the treaties. And Trichet, who had demanded that the Van Rompuy report formally note his reservations over weakened sanctions, warned leaders over dinner that the threat of debt restructuring would spook markets. “You don’t realise the gravity of the situation,” began Trichet. But he was cut off by Sarkozy: “Perhaps you speak to bankers. We, we are answerable to our citizens.” Merkel joined in: taxpayers could not be asked to foot the whole bill, not when they had just paid to save the banks. And Merkel got most of what she wanted, with surprising ease. The summit agreed to revise the treaty although, to make sure it was a “limited” change that could be passed with a smaller risk of referendums, Merkel had to abandon the demand to suspend voting rights, which Sarkozy had conceded at Deauville.

The euro zone thus abruptly moved from the idea of bailing out debtor countries to bailing in  bondholders. The principle was sound but the execution contradictory, not least because, as explained initially by the Germans, PSI was likely to apply to all future bailouts. In May governments had declined to impose haircuts on Greek bonds for fear of destabilising markets, thus pretending that Greece’s insolvency was merely a matter of a shortage of liquidity. Now they seemed to be threatening all future investors in euro-zone bonds with possible losses; in other words, even countries with liquidity problems might be treated as insolvent. For Trichet this was a betrayal of the ECB’s politically risky decision to start buying government bonds to hold down borrowing costs. By the time of the G20 summit in Seoul on November 12th, yields on Portuguese and Irish bonds were well over their previous peaks in May. European finance ministers said the issue had been misunderstood: existing bonds were safe; only new bonds issued from 2013 might be subject to haircuts. But the damage of Deauville was done.

No luck for the Irish (or Portuguese)

Alarm now focused on Ireland. Having already poured billions into the banks, the government announced in September 2010 its “final estimate” for bank losses. Anglo Irish Bank, the most cavalier of the lot, would cost €30 billion. Added to Ireland’s already large budget gap, the one-off cost of the banking bust pushed Ireland’s budget deficit in 2010 to 32% of GDP. Fears for the solvency of the state pushed up bond yields. Deauville made a bad situation impossible. In mid-November Ireland started negotiating the terms for a bail-out, despite protests that it had enough cash to survive for months to come. But the ECB had had enough of propping up Irish banks. By the end of November Ireland had agreed to a €67.5 billion assistance package from the euro zone and the IMF, with bilateral loans from the UK and Sweden.

The liquidity provided by the ECB had proved to be a mixed blessing. It allowed Ireland to avoid a sudden stop in funding, as had previously happened in Iceland (which was not in the EU). But the ECB also prevented the Irish government from protecting taxpayers by imposing losses on senior bank creditors, again as had happened in Iceland (it also wiped out foreign depositors). Even so, the banking bust was not the only or even the main cause of Ireland’s economic troubles; the recession caused by the bursting of the property bubble created a budget deficit of 12% of GDP in 2010. But the bad banks, and Deauville, tipped Ireland into seeking a bail-out. It also led to an early election and the fall of the Fianna Fail-led government of Brian Cowen in February 2011.

In Portugal, meanwhile, it was the resignation of the Socialist government of José Sócrates, which had failed to win parliamentary support for a fourth austerity budget in March 2011 that pushed the country into the arms of euro-zone rescuers. Portugal applied for a bail-out in April and finalised the negotiation for a €78 billion package on May 4th. Its debt was not as high as Greece’s, nor did it have an out-of-control banking sector like Ireland. Instead, its woes were more like Italy’s: years of chronically low growth. And whereas the euro zone had been reluctant to help Greece, it was now keen for both Ireland and Portugal to apply for assistance to try to stop contagion from spreading to bigger countries like Spain or Italy.

The programmes for Ireland and Portugal were devised with more plausible figures than the one for Greece. The two countries benefited from having fully functional governments and, especially in the case of Ireland, had export sectors that could benefit from the process of “internal devaluation”. In contrast with Greece, moreover, both had opposition parties that for the most part agreed with the bail-out programmes. The election of Fine Gael’s Enda Kenny in Ireland and of Pedro Passos Coelho of the Social Democratic Party in Portugal (both fiscal conservatives, despite the misleading name of the latter’s party) caused little disruption to the troika’s programme for fiscal consolidation and structural reforms.

Comprehensive failure

The new bail-outs in the winter of 2010–11 pushed European leaders to seek what they called a “comprehensive solution”. There was, inevitably, much disagreement about what this would entail.

Some thought the priority should be more “solidarity” to help countries cope with high bond yields. In December 2010 Jean-Claude Juncker, Luxembourg’s veteran prime minister and president of the Euro group, co-authored a call with Italy’s finance minister, Giulio Tremonti, for the euro zone to start issuing common Eurobonds, guaranteed jointly by all euro-zone countries. This would “send a clear message to global markets and European citizens of our political commitment to economic and monetary union, and the irreversibility of the euro”.5 But Germany would have none of it. To begin with, joint bonds were illegal under the treaties, Germany argued. Moreover, guaranteeing the debt of others would mean taking on large and potentially unlimited liabilities, and would provide an incentive for profligacy. Instead, Germany wanted more control and discipline.

Its priority was the finalisation of the treaty change to create a permanent bail-out fund, to be known as the European Stability Mechanism (ESM). This was followed by moves to encourage more structural reforms. Over two summits in March 2011 leaders agreed to a voluntary pact to promote labour-market flexibility and other action. It was first known as the Competitiveness Pact, then the Pact for the Euro and, in its final form, the Euro Plus Pact. Once a year, countries would make reform commitments that would be scrutinised by peers. Some countries, like Belgium, disliked the challenge to their wage-indexation systems; others, like Ireland, worried about the pressure to raise their low corporate taxes. But perhaps the strongest reaction came from non-euro countries that disliked the commitment, pushed by France, to hold special euro-zone summits at least once a year. The Euro Plus Pact turned out to be ineffectual, and was soon forgotten. Many aspects of economic policy remained the competence of national governments, so the commitments would not be binding. A bit of peer pressure from Europe could not overcome the resistance at home that such reforms would inevitably provoke.

The question of solidarity could not be avoided for long. By spring it was apparent that the EFSF was underpowered, not just because it was starting to use up its resources for Ireland and Portugal, but because its real lending capacity was only about €250 billion, not the advertised €440 billion. Its ability to borrow on AAA terms was limited by the fact that only six countries had that credit rating.

There was also growing pressure to turn the EFSF into a more flexible crisis-management tool, not just a fund of last resort. The “comprehensive package” announced on March 24th allowed both the temporary EFSF and the new ESM to buy bonds on the primary market (but not the secondary market). The ESM would not be operational until 2013. But the final agreement to enhance the EFSF, by increasing loan guarantees so that it could borrow to its full headline level, would have to wait until June, after an election in Finland.

On April 7th, the day that Portugal applied for its bail-out, the ECB decided perversely to raise its interest rate. The change was small – just 0.25% – but it was a wrong-headed signal nonetheless.

Recovery in the euro zone was weak, with the notable exception of Germany. Headline inflation was slightly higher than the ECB’s target of “below but close to 2%” because of higher oil prices, but core inflation was around 1%. The real argument was political. The ECB’s bond-buying policy had prompted the resignation in February of Axel Weber, president of the Bundesbank and the most obvious successor to Trichet. It must have seemed a good moment for any hopefuls to establish their inflation-busting credentials.

Default options

By March 2011 the Greek problem was returning to the fore. Early on Papandreou had earned praise for some brave belt-tightening, but worries grew that structural reforms were falling behind and privatisation had made no progress at all. Matters were not helped by successive statistical revisions, which revealed Greece’s fiscal hole to be deeper than expected. And the recession was also worse than expected. Behind closed doors at a summit on March 11th, Papandreou spoke about the grim options facing his country: leave the euro, impose haircuts on bondholders or change the market’s perceptions.

A softening of the bail-out terms was an attempt to keep the third option alive: interest would be reduced by a point and loan maturities extended to 7.5 years (against a promise to step up privatisation). Ireland was denied the same terms because Kenny resisted pressure from Germany and especially France to raise its low rate of corporate tax, even though attracting investment and boosting exports offered the best hope of repaying its debt.

Despite the concession to Greece, the focus would quickly shift to debt restructuring. Talk at Deauville about PSI was pushing Greek bonds into a self-fulfilling spiral. Greek yields rose from mid-April amid growing talk of haircuts and even of Greece leaving the euro. Plainly, Greece would not be able to start borrowing from markets in 2012, as its bail-out programme projected. And unless the financing gap was filled, the IMF would have to suspend payments because of its rule that programmes be fully financed for a year in the future. The choice came down to granting Greece a second bail-out, belatedly restructuring its debt mountain, or some combination of the two. Germany and some IMF staff favoured imposing at least some losses on private bondholders. But they ran into two separate problems. The first was the arrest on charges of sexual assault (eventually dropped) of Strauss-Kahn, the IMF’s chief. His deputy, John Lipsky, opposed debt restructuring; IMF hawks would have to bide their time until the arrival of Lagarde in July. The second and greater obstacle was the implacable resistance of the ECB to any of the various degrees of failure to repay debt fully and on time. No selective default, no credit event, no default, insisted Trichet; nothing should cast doubt on the “sovereign signature”.

Greek politics also became more fraught. In June Papandreou replaced his finance minister, George Papaconstantinou, with Evangelos Venizelos, a party heavyweight. The new man made a poor impression at his first Eurogroup meeting when he insinuated that the euro zone could not afford to let Greece go bust.

No PSImple haircut

The summit in July 2011 turned into two separate negotiations, one among leaders and a parallel one with bankers, represented by the Institute of International Finance, for a “voluntary” contribution.

After more than seven hours of talks, euro-zone leaders agreed to give Greece a second bail-out worth €109 billion. “Voluntary” PSI would bring in an extra €37 billion, resulting in an estimated cut of 21% in the debt burden (calculated in terms of net present value). The repayment terms on loans were greatly softened. The interest rate was brought down by another 150 basis points, to around 3.5%, and the maturities extended from 7.5 to between 15 and 30 years, with a ten-year grace period. Crucially, the same terms were extended to Ireland and Portugal, with a promise that the euro zone would continue to fund countries until they regained access to markets, as long as they complied with reform conditions. The decision proved to be a godsend for Ireland, whose bond yields progressively dropped, against the trend in southern Europe.

Leaders more or less buried Deauville when they declared that PSI had been an “an exceptional and unique” solution for Greece; all other countries would “honour fully their own individual sovereign signature”. This had been one of three conditions set by Trichet in return for relenting on a limited debt restructuring. The others were that the ECB’s holdings of Greek debt would be spared the haircut, and that the ESM would relieve the ECB of the burden of buying bonds on the secondary market. Indeed, the ESM was made more flexible in other ways too. It was also allowed to lend money to governments to recapitalise banks and extend precautionary loans.

The deal would prompt ratings agencies to declare a temporary “selective default” (the EFSF would have to offer the ECB alternative collateral), but its voluntary nature ensured it would not count as a “credit event” that triggered payments of credit-default swaps, a form of insurance against sovereign defaults. However, the deal proved to be the worst of both worlds: the haircut was too small to turn around Greece’s public finances, but big enough to spread fear that other bonds were at risk. Markets had other reasons to worry. The original banking crisis had never been satisfactorily resolved; it had only been masked by the Greek turmoil and, to a great extent, worsened by the sovereign-debt crisis. The second round of bank stress tests in July turned out to be another half-baked job. Plainly, sovereign bonds could no longer be treated as risk-free. But only the bonds in banks’ trading books were accounted for at market value; those in the banking books were counted at face value because they would supposedly be held to maturity. Analysts derided the effort (only 9 out of 90 banks tested were found to require additional capital), but for senior officials, particularly in France, the tests already went too far in questioning the value of sovereign bonds. Even more alarming was a sharp warning by Lagarde, in her first speech as the new IMF chief, delivered at the annual central bankers’ retreat in Jackson Hole at the end of August, when she called for mandatory recapitalization of banks:

Banks need urgent recapitalisation. They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. If it is not addressed, we could  easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis.

Night letters

In many ways, the euro crisis was always about Italy. A collapse of the third-largest economy in the euro zone, and its second-largest debtor in absolute terms, would surely sink the euro. Spain mattered not only because it was larger than the other bailed-out states, but also because it was the the last link in the chain of contagion before Italy. The size of the euro zone’s firewall was inadequate because it could not protect Italy. Eurobonds were unacceptable because they would mean Germany having to guarantee Italy’s gargantuan debt. And the fear of moral hazard was acute, in part because nobody trusted Italian politicians to reform. Italy at least had the foresight not to engage in fiscal stimulus, and its primary budget (that is, before interest payments) was in surplus. Moreover, its banks seemed in reasonable shape, and domestic savings were high. Even so, by the start of August its borrowing costs had spiked above the 6% mark (matched by Spain’s yields). Everybody knew Italy was too big to save. Only the ECB could help it stay afloat.

On August 5th 2011 Italy’s prime minister, Silvio Berlusconi, received a stern letter signed jointly by Trichet and Draghi. It urged him to take “immediate and bold” measures to speed up Italy’s deficit cutting and balance the budget by 2013, a year earlier than planned. It also set out a list of “significant measures to enhance potential growth”, including the liberalisation of professional services and more labour-market flexibility. In the longer term there had to be a constitutional reform to enshrine fiscal rules, an overhaul of the public administration and the abolition of costly layers of government. A similar letter was sent to Spain’s Prime Minister, José Luis Rodríguez Zapatero, though its contents did not leak for two years.

A day earlier the ECB had revived its bond-buying programme, initially only for Portugal and Ireland. The implied message was clear: if Italy and Spain wanted help they had to reform fast, as if they were under a troika programme. As the bank started buying up unprecedented amounts of Spanish and Italian bonds, Jürgen Stark, the German chief economist on the ECB’s executive board, announced his resignation “for personal reasons”: that is, his disapproval of bond-buying. Predictably enough, Berlusconi soon started watering down his proposed austerity budget, and did virtually nothing by way of structural reforms to accelerate Italy’s sclerotic growth. His government was crumbling and his relationship with his finance minister, Giulio Tremonti, had all but broken down. On September 20^th Standard & Poor’s downgraded Italy, expressing doubt about its ability to reform. The ECB downgraded it silently, by sharply slowing down bond purchases. Amid mounting scandals over allegations of fraud and whore mongering, trade unions and bosses alike called for Berlusconi to resign.

The Merkozy duo vowed to deal with the crisis decisively in two summits in October (or rather four summits, given that each was split into an EU summit of 27 followed by a euro-zone meeting of 17). At the first gathering on October 23rd, Berlusconi was given an ultimatum to present credible reforms at the next meeting three days later. Asked at a press conference whether they were reassured by his response, Merkel and Sarkozy hesitated a bit too long, looked at each other and, as the room erupted in laughter, smiled and smirked. Involuntary, perhaps, but it was a humiliation for Berlusconi and a gesture of no confidence in Italy.

On October 26th the euro zone announced yet another “comprehensive solution”. Italy promised  to reform labour markets and pensions, cut red tape, abolish minimum charges for professional services and more. It would be subject to special monitoring by the Commission. And after another round of negotiations between leaders and banks, which barely seemed to involve the hapless Papandreou, Greek bonds would be subject to a 50% cut in face value (resulting in a 76% cut in terms of net present value). The aim was to bring Greece’s debt down to 120% of GDP by 2020, a threshold chosen to match Italy’s debt, which, by definition, had to be solvent.

To contain the impact, the euro zone needed bigger firewalls. Germany had been unwilling to increase its guarantees to the EFSF and many others were unable to do so, given the risk to their credit rating. France favoured giving the EFSF a banking licence, so that it could borrow from the ECB. But Trichet blocked the idea at a bad-tempered impromptu meeting on October 19th on the fringes of his official farewell celebration at Frankfurt’s old opera house. So the summit set out two options. The EFSF could offer “credit enhancements” to insure investors against part of the loss on sovereign bonds; or it could create a special-purpose vehicle in which other countries willing to help Europe could invest. Leaders also agreed to bolster rickety banks by forcing them to find about €106 billion of extra capital by the end of June 2012 to meet a higher 9% threshold of “highest quality capital”, after marking sovereign debt to market prices.

The deal was sealed with another layer of the favourite Franco-German mix: Sarkozy secured a commitment to hold twice-yearly euro-zone-only summits with the option, in future, of having a separate president; Merkel obtained support for yet another revision of the treaty aimed vaguely at “strengthening economic convergence within the euro area, improving fiscal discipline and deepening economic union”. Yet within days the markets were struck by another bombshell: the Greek prime minister announced on October 31st that he would hold a referendum to approve the terms of the new rescue programme. Markets tumbled. The ECB worried that bank runs would start in Greece. After two years of crushing austerity, nobody could be expected to vote for more of it. Greek bond yields shot up, pulling everyone else along. Italian bonds again pushed past the 6% mark. The euro zone was close to breaking.

Caned in Cannes

The system of peer-pressure, shy at first and then ever more insistent as the crisis worsened, reached its logical and brutal climax at the G20 summit hosted by Sarkozy in Cannes on November 3rd–4^th 2011. Papandreou was summoned before Sarkozy, Merkel and leaders of European institutions on the eve of the summit. He was told he had shown himself “disloyal” after fellow leaders had worked hard to lift a large chunk of debt off Greece’s shoulders. Until Greece approved the new programme, neither the euro zone nor the IMF would disburse a cent (pas un sou), said Sarkozy. And if Papandreou insisted on the referendum, the question should not be about the terms of the bailout but about Greece’s membership of the euro. If the cost of saving the euro was to let Greece go, so be it. Perhaps Greece could come back in after ten years, the French president suggested.

At a joint press conference by Sarkozy and Merkel the ultimatum was made public: “Does Greece want to remain in the euro zone, or not?” asked Sarkozy. For the first time in the crisis, the prospect of the euro breaking up was being openly discussed by its most important leaders. Papandreou vacillated. He left Cannes saying the question would indeed be about Greece’s future in the euro, but once in Athens he declared it would be about the bail-out terms after all. Venizelos, who had been a brooding presence at the encounter in Cannes and was urged by some of those at the meeting to help stop the referendum, made his move: he declared his opposition to the ballot and led a revolt that precipitated Papandreou’s downfall a week later.

On the morning of November 3rd, it was Berlusconi’s turn to be roasted. Sarkozy and Wolfgang Schäuble, the German finance minister standing in for Merkel, demanded that Italy should apply for a precautionary line of credit from the IMF. Lagarde bluntly told the Italian prime minister that nobody believed him. With Zapatero in the room, the French president noted with disappointment that a Spanish-style political solution – an early election in which the prime minister would not stand again – was not on offer in Italy. There was a touch of personal animosity: Sarkozy blamed Berlusconi personally for Italian newspapers’ attacks on the French first lady, the Italian-born model and singer Carla Bruni.

For his part, Berlusconi seemed detached from the severity of his predicament and unprepared for the assault; “he was completely depressed,” recounted one witness. Italy had always lived with high debt, Berlusconi told his peers; it could survive for a long time with higher interest rates and domestic savers could be counted on to buy bonds. He would refuse to take the IMF’s line of credit – doing so would be tantamount to admitting that Italy had become another Greece, said his officials – but he would agree to intense monitoring by the Fund and the Commission. If Berlusconi was deflated inside the room, outside he tried to brazen his way out of isolation. “There is no crisis,” he told journalists.

“The restaurants are full and you cannot find a seat on the flights.” The Italian prime minister still enjoyed a degree of understanding from at least some in the room, including the placid Van Rompuy and the more irascible Barroso. Both thought a precautionary line of credit worth some €80 billion was far too small to help Italy’s finances, and would only raise doubts about its solvency. That night Berlusconi also got unexpected support from Barack Obama, who normally had little time for Berlusconi but on this occasion sided with the doves. The American president all but took control of a side meeting of European leaders at the G20 summit. He urged the Europeans to act decisively, and concentrated his efforts on trying to convince Germany to enhance the European firewall. If the ECB persisted in refusing to intervene in an unlimited manner (for example, by issuing the EFSF a banking licence), how about contributing the Europeans’ unused allocations of “special drawing rights”? SDRs are created by the IMF as a reserve asset, a sort of virtual gold, and their supply was greatly boosted in 2009 to give countries extra liquidity in the financial crisis. Now the tables were turned on Merkel. The idea was firmly blocked by the Bundesbank, which held Germany’s allocation and regarded their use as tantamount to printing money. The German chancellor said she might relent if Italy accepted an IMF precautionary programme, but the idea did not fly. Merkel came under such concerted pressure, some of those in the room reported, that she was in tears, saying: “I was the hero, and now I am the villain.”

Goodbye George and Silvio. And David too?

Within days of the Cannes summit, the pressure from Europe, markets and internal dissent had forced both George Papandreou and Silvio Berlusconi to resign, on November 8th and November 12^th respectively. In their place came two technocratic prime ministers. Lucas Papademos, governor of the Greek central bank and a former vice-president of the ECB, was appointed in Athens. Mario Monti, a former European commissioner, was installed in Rome. Both were chosen, with a private nod from Brussels, for their close links to European policymakers. Their main task was to restore the credibility of their countries before their European peers and the faceless markets. Indeed, the arrival of the technocrats may have saved their countries from imminent economic disaster. But though they were called upon to clean up the mess created by the politicians, and endorsed in parliamentary votes, the manner of their appointment left a profound worry about democracy in Europe: as well as dictating economic policies, Europe was now, directly or indirectly, dictating the choice of political leaders.

Papademos and Monti could not, on their own, deal with a market crisis that was corroding the entire euro zone. Given the failure of the Cannes summit to bolster the firewall, the last line of defence was now the ECB. All eyes turned to the new man in Frankfurt, Mario Draghi. Appearing for the first time before the European Parliament on December 1st, he spoke opaquely about the advisability of a “fiscal compact”, some kind of additional commitment to budgetary discipline. The effects of previous reforms and of the arrival of technocrats in Italy and Greece were not yet being felt, he explained. A compact enshrining new balanced-budget rule in a more formal framework would send an additional signal of credibility. He thus allied himself to Germany’s cause for yet another treaty change.

The idea of a revision horrified just about everybody – even those outside the euro zone. For David Cameron, the British prime minister, the idea of a treaty revision was bound to stir his increasingly restive backbenchers to demand that he use the opportunity to win something for the UK. Cameron’s diplomatic campaign was ill-prepared, particularly in his misreading of Merkel. His officials did not spell out the UK’s demands – essentially the protection of the City of London from new EU financial regulation – until the eve of the December summit. The British had been lulled by EU legal experts into believing that the euro zone could not get around a UK veto. But when the crunch came in the small hours of December 9th, Cameron’s attempt to veto the new fiscal compact treaty backfired.

First, the EU’s lawyers said the compact could, after all, be adopted as a separate agreement outside the EU’s treaty. Second, most of the euro “outs” signed up to it, leaving the UK isolated. Back home Cameron was briefly hailed as a conquering hero, even though he had vetoed nothing at all. Sarkozy boasted privately that “we gave the British a slap in the face”.

Desperate times

The brutality of the politics at the end of 2011 reflected the desperation of the moment. After nearly two years of errors and missed opportunities, the euro was close to breaking point. It was apparent that the Greek bail-out programme had been badly misjudged. The euro zone leaders tended to pin the blame on the impossible Greeks. If only they were more like the stoical Balts and just got on with controlling their deficit, said advocates of hard front-loaded austerity, they would have got over their pain more quickly. Latvia had suffered large losses of output, pegged its currency to the euro, suffered a banking bust and had to be bailed out by the IMF and European Commission. Yet Latvia rejected the IMF’s advice to devalue the currency, and chose instead the agony of internal devaluation. It subsequently emerged as one of the fastest-growing countries in the EU. In the view of its leaders, the key ingredient was political will. Estonia underwent a similar experience. And as it joined the euro in 2011, Estonia intensely resented having to contribute to the bail-out of the far richer Greeks. Internal devaluation is difficult at the best of times. The IMF’s deputy managing director, Nemat Shafik, once memorably compared the process of recovering competitiveness to painting a house: If you have an exchange rate, you can move your brush back and forth. If you don’t have an exchange rate, you have to move the whole house.

Successful adjustment requires flexible labour markets and an open economy that can export its way back to growth, as well as a population willing to put up with the pain. Greece had none of these: it was a closed, rigid economy and its politics was polarised by a history of occupation, civil war and military rule. As such, Greece was the most recalcitrant of the euro-zone countries to be rescued.

Greek leaders, even as they slashed the budget, did not understand how extensive structural reforms needed to be, and made no progress on privatisation. IMF experts returning from missions to Greece were increasingly alarmed by the dysfunctional public administration they found. And the Greek government was not helped by the opportunistic opposition that it had to contend with from the New Democracy party, which had, after all, run up the deficit in its last stint in government.

Even so, it was plain to all that Greece was being pushed into a recession that was far deeper than anyone had predicted. The situation was aggravated by successive statistical revisions that kept pushing back the country’s starting point, and the crushing loss of investor confidence caused by the growing talk of Greece leaving the euro.

To many, the Deauville bargain is the grievous error that turned an admittedly risky Greek programme into a catastrophe. In reality, Deauville was only part of a wider confusion that gripped the Europeans from the start. They were in a muddle about whether Greece was solvent or bust, and thus vacillated over how to deal with its accumulated debt. They first chose a complete bail-out; then at Deauville suddenly flirted with the idea of across-the-board bail-in of creditors; and then backed away from the idea more or less entirely. By July, when they got around to cutting Greece’s debt, the haircut was too modest and came too late. Months were wasted seeking a “voluntary” contribution from private creditors that would not trigger credit-default swaps (CDS); in the end CDS contracts were paid out anyway. The same uncertainty affected their judgment about the pace of fiscal consolidation.

To make the numbers fit within the money made available by the euro zone and the IMF, Greece was forced into excessively harsh deficit-cutting (and at first had to pay high rates of interest). In contrast with Latvia, which cut its budget as its main trading partners were still stimulating their economies, Greece was trying to consolidate its budget while others were reducing deficits as well. Crucially, the Baltic States also had low debts to begin with; even after the worst of its recession, Latvia’s debt stood at about 45% of GDP, less than half of Greece’s at the start of its troubles.

A sober assessment in May 2010 should have judged that Greece’s debt was unsustainable, and that it would have been better to cut the debt sooner rather than delay the inevitable. This would have resulted in a more realistic programme, focused less on austerity and more on structural reform, and better able to absorb the inevitable political and economic bumps. At the time, however, it might have been difficult to convince Germany that its banks had to take losses on Greek debt even as German taxpayers were being called upon to lend enormous sums to Greece. That said, even a large debt write-off would not have spared Greece a painful adjustment to close a budget deficit gap of 15% of GDP and a current-account deficit of similar magnitude.

Fudged assessments, unsustainable debt, inadequate financing, Greece’s many political failures and uncertainty about the euro all fed the constant fear of a chaotic default. The Greek death spiral, and the incoherence of the euro zone’s leaders, threatened to take down the whole currency. Contagion threatened to bring down Italy, the scariest debtor of all. Even with the will to act more decisively, governments would have struggled to find the money to stabilise the euro zone once Italy started to wobble. By the end of 2011, only the central bank had the resources to stabilise the system. What would it take for it to stand as the euro zone’s lender of last resort?