The Alchemists: Three Central Bankers and a World on Fire (43 page)

The euphemism of choice was “private-sector involvement,” which since the early 1980s has meant calling in the Institute of International Finance, or IIF, a Washington-based organization founded by global bankers to represent them in exactly this type of high-stakes negotiation. Soon, another three initials would be joining the IMF, the ECB, and the EU in determining Greece’s economic future.

IIF managing director Charles Dallara, a former U.S. Treasury official and J.P. Morgan banker, learned at a gathering of fifty or sixty representatives of his group’s members that they were ready to accept some kind of restructuring plan. He called George Papaconstantinou, then Trichet. The ECB president chose his words carefully in speaking to Dallara, whom he had faced across the negotiating table a generation earlier when he worked on issues around restructuring Latin American debt and Trichet was president of the Paris Club. “I respect that your mind is shifting,” Trichet said to Dallara, or words to that effect. “But I don’t believe this is the way forward and I don’t wish to be engaged with you on this matter.”

Trichet was as emphatic in public as he was in private: “
We are not in favor of restructuring and haircuts
,” he said in his June 2011 press conference. “We exclude all concepts that are not purely voluntary or that have any element of compulsion. We call for the avoidance of any credit events and selective defaults or default. This is our position, which we have made clear for a long period of time.” His reasoning was rooted in fears that a restructuring could destabilize other European nations and set a dangerous precedent. He was ever thinking about the effects of Greek haircuts not just on Greece but on the other finanancially precarious European states, and on the future of the European experiment as a whole.

He also likely had concerns about how private-sector involvement might affect the ECB itself. For one thing, banks in Greece were being kept alive by their ability to pledge the nation’s bonds as collateral to the ECB and receive euros in return. If Greek bonds were restructured, the ECB would either have to suffer losses or cut off the banks and allow them to collapse—or both. And it was lost on no one that the ECB, through its bond purchases, was a major owner of Greek debt—€45 to €50 billion worth, according to analyst estimates. That too could mean losses for the ECB in a Greek restructuring, unless the ECB’s holdings were given special treatment.

If there were Greek haircuts, in other words, the ECB stood to lose money. If the losses were great enough, the bank could even need to return to the continent’s governments to recapitalize. And the minute the ECB needed to raise more capital, the politicians of Europe would have power over what had been an independent central bank—a dangerous thing for central bankers who prize their autonomy. Trichet himself never articulated this set of worries in public, always casting his arguments against private-sector involvement in terms of overall financial stability. Even people close to him don’t recall him making the independence case in private. But it helps explain why the ECB was more opposed to any kind of debt reductions than other participants in the talks, including both the IMF and the private bondholders themselves.

Within the IMF, Strauss-Kahn and then Lipsky were generally okay with the ECB view that there need not be debt restructuring. But their staffers weren’t so sure. A long-held principle of IMF lending is that it should occur only as part of a sustainable package for the country involved—that is, only when the fund has every reason to believe it will be paid back and the country can come out the other side with a reasonable level of debt at a manageable interest rate. When that’s not the case, the IMF is happy to advocate for creditors taking losses. That bondholder losses would likely have bigger consequences for the global financial system if they happened within the eurozone than outside of it was a big complication, but there was a sound logic behind the underlying idea: If a country is broke, better to face up to it rather than send good money after bad.

That’s exactly the conclusion IMF officials on the ground in Greece were beginning to reach. The IMF acknowledged the ECB argument that “
a sovereign default or disorderly bank failures
could send shockwaves through Europe’s financial sector and liquidity could well dry up again, with potentially strong and negative global spillovers,” according to a July staff report. But while the other two members of the troika believed such negative ripple effects would happen only after a default, the IMF “saw serious risks of contagion, even under a strategy which tries to avoid default.”

By the start of the summer of 2011, it was clear that Trichet’s passionate opposition was for naught. Where the ECB president saw questions of system-wide risk and moral hazard, just about everyone else saw a math problem with no other solution. That didn’t, however, include the Greek government, which had to that point considered any talk of debt restructuring as tantamount to treason. “
Any talk of restructuring was a total taboo
,” an anonymous Greek official told the
New York Times
. “We never even brought it up. If we made this case to Europe, we would have been pariahs forever.”

In late June, Dallara traveled to Athens to meet with Papandreou and Venizelos. When he explained that a restructuring seemed inescapable, Dallara later recalled, “
There was shock and surprise on their faces
. They could not believe it.”

The time had come for creditors to cooperate, to work out a voluntary restructuring of Greece’s debts as part of the next round of aid to the country. The evening of July 20, Trichet flew from Frankfurt to Berlin to hammer out the outlines of a deal with German chancellor Angela Merkel and French president Nicolas Sarkozy. They agreed that the ECB wouldn’t stand in the way of haircuts for bondholders so long as they were voluntary, the central bank received guarantees to guard it against losses, and there would be public assurances that Greece was a unique case and debt restructuring wouldn’t happen with other eurozone countries.
At about 1 a.m., Trichet, Merkel, and Sarkozy called Brussels
with news of the agreement. Then talks between bankers and finance ministers proceeded, in a conference space that became known as the “
banker war room
.”

There, inside the European Council headquarters, a team headed up by Dallara and Josef Ackermann, the chief executive of Deutsche Bank and the chairman of the IIF, led a negotiation that was complex even by the standards of the eurozone. It pitted the European government (which wanted bondholders to take as large a loss as possible) against the banks (which, naturally, wanted to take as small a loss as possible—and had the upper hand, in the sense that they could always walk away from a voluntary agreement). It pitted the countries whose banks had more Greek exposure (like Germany, which wanted the banks to get new, safer bonds to help offset the losses from Greece) against those with less (who preferred that the banks just take their losses outright). And it pitted the ECB against everybody.

In effect, each negotiator was fighting for the other guys to endure more of the burden of restructuring Greek debt. Ironically, the one actor without a major role was Venizelos. By this point, Greece was hardly a shaper of its own destiny.

The agreement that emerged from all that wrangling, announced July 21, 2011, extended the maturities and lowered the interest rates of Greek bonds, giving the government more time to pay back less money, and eliminated some obligations entirely. Overall, the arrangement would save Greece €135 billion through 2020, lengthening the average maturity of its bonds from six to eleven years and reducing what it owed in “net present value” terms by 21 percent. The ECB, meanwhile, would receive both the protection from losses and the public assurance that Trichet had demanded. The IIF was confident that 90 percent of bondholders would accept the deal, preventing the damage to the European financial system that might have resulted had a eurozone member defaulted on its own.

“
With this offer
, the global investor community is stepping forward in recognition of the unique challenges facing Greece,” Dallara said in a statement announcing the deal. True enough—but the global investor community also didn’t have any better options.

Following the dramatics over Greece in June and July, markets were jittery. One recurring feature of the eurozone crisis was that authorities seemed to make decisions based on the dilemma immediately in front of them—Greece, say—with seemingly little concern for how their actions would change the behavior of markets with regard to the other GIPSI countries. What seemed like the right thing to do to address Greece might make no sense if it just led bond markets to expect the same for Ireland or Spain or Italy. Trichet was the strongest voice trying to persuade European political leaders of the importance of being sensitive to these effects, with assists at various times from Tim Geithner and Mervyn King, as well as other U.S. and British authorities and, at least until his arrest, Strauss-Kahn. But no matter how many impassioned speeches Trichet gave in some Benelux summit, or how many times his warnings were proved by events, he seemed not to get through.

Indeed, after haircuts were finally negotiated for Greek bondholders, global investors began to look around to wonder what other European countries’ bondholders might be stuck taking a “voluntary” loss down the road. Ireland and Portugal were already under agreements that gave them a source of emergency funding, and both countries were fulfilling their bailout obligations more reliably than Greece had, so there was little reason to think they would be cut off from the IMF/EU spigot. Logically, investors shifted their attention to the remaining GIPSIs: Spain and Italy.

If those countries went under, the risk to Europe and the world financial system would be far greater than it had been up to now. Spain and Italy together have about four times the population of Greece, Ireland, and Portugal. Whereas the earlier rescues were easily affordable by the other European countries and the IMF, the cost to rescue Spain and Italy could stretch their resources to the breaking point. The nations were simultaneously too big to fail and too big to save.

At the end of June, the Italian government could borrow money for a decade for 4.25 percent, or about 1.25 percent more than Germany could. On July 14, while the Greek haircuts were being negotiated, the Italian government held one of its regular auctions of bonds, seeking to sell €5 billion worth of five- and fifteen-year securities to pay off older ones that were coming due. But the investors who would normally buy them, in Milan and Frankfurt and London and beyond, didn’t place bids in line with anything resembling the bonds’ typical cost. With all the uncertainty swirling around the eurozone’s future, they would buy the bonds only if they received a higher yield than usual. It was just one of many days that month on which the appetite for Italian bonds fell and their rates rose. By the early days of August, the prevailing interest rate had soared to 5.54 percent.

Italy, and to a lesser degree Spain, was seeing the exact sequence of events that had led Greece and then Ireland and then Portugal to require a rescue—except that now it wasn’t at all clear whether a rescue would even be possible.
According to calculations by economist and journalist Carlo Bastasin
, if France and Germany had to offer backing to Italy on the same scale relative to its debt levels as they had for Greece, Portugal, and Ireland, they would increase their own debt-to-GDP ratios by 23 to 25 percentage points, suddenly putting their own creditworthiness in question. Italy, which was actually running quite small annual deficits but had accumulated a large total debt, needed to find a way out of its problems on its own, or the whole continent could be in trouble.

Making conditions worse on global markets, at the end of July and start of August the United States was in the midst of a standoff between the Obama administration and Republicans in the House of Representatives over raising the nation’s debt limit. Failure to do so could have meant that the United States, whose bonds are the bedrock of the global financial system, would begin defaulting on its debt. An accord wasn’t reached until July 31, only two or three days from potential suspension of debt payments. On August 5, Standard & Poor’s downgraded the U.S. government’s credit rating from AAA to AA+, citing political gamesmanship in the wealthiest nation on the planet.

Trichet, speaking with Tim Geithner, said at one point that “this is two thirds our fault and one third your fault.” All global markets were moving together. On days when investors could see no end to the megacrisis, they sold off U.S. and European stocks, Spanish and Italian bonds, and futures in oil and other commodities. On days when they believed that global policymakers were starting to get their arms around the problem, they bought those assets and sold off what were considered safer but lower-yielding investments: German and U.S. government debt and currencies like the Japanese yen and the Swiss franc.

Trichet’s gambit of ending bond buying and hiking interest rates to force European leaders to act had worked. But suddenly, the very scenario that eurozone crisis fighters had spent two years trying to avoid was starting to materialize, with the panic pivoting to the major economies of Europe and seemingly at risk of getting beyond the capacity of policymakers to solve. The ECB president had just three more months in office, and the whole thing was threatening to spiral out of control. It was time for more decisive action. The alternative—sitting and waiting—seemed to risk the whole European experiment’s unraveling, a risk that Trichet could not abide.

At its meeting on Thursday, August 4, the Governing Council decided to reactivate its old Securities Markets Programme, which had been dormant since the spring, and once again go into the market and buy bonds directly. Trichet played it cagey. In his press conference that afternoon, when Brian Blackstone of the
Wall Street Journal
asked if the bank would resume buying bonds, Trichet replied, “You will see what happens. I would not be surprised if, before the end of this press conference, you would see something in the market. Don’t exclude that.” Another reporter, apparently having received an e-mail from a colleague or a source, asked, “Mr. Trichet, traders are telling us at the moment that the ECB is on the market for Southern European bonds. Can you confirm or comment on that action?” The president replied, with a bit of a grin, “I commented in advance it seems to me. Thank you very much indeed.”