Act III: The Euro Crisis (2010/11)
How Greece becomes a pawn in the hands of investors. How the European Central Bank goes astray. Why the world no longer makes sense to the Greeks. How the Maastricht bet goes bad.
In October 2009, Marko Mršnik's analysts at rating agency Standard & Poor's computed that Greece's debt would increase to 125 percent of economic output in 2010. On the same day, it became more expensive to hedge Greek bonds against default. The default insurance instruments, known in market jargon as credit default swaps (CDS), were an indicator of how bad things stood for Greece. It was now costing $189,000 a year to hedge a $10-million Greek government bond against default. For major investors, it was a signal to get out of Greece.A few people had also become nervous at the headquarters of the Pacific Investment Company (PIMCO) in Newport Beach, California, about an hour's drive south of Los Angeles.
PIMCO is by far the world's largest investor in government bonds. The company lends governments money by buying their bonds. When PIMCO stops buying a country's bonds, it's a clear sign that the country is on the verge of crisis and possibly even bankruptcy.
PIMCO controls more than $1.3 trillion (€1.05 trillion) on behalf of its customers. It is an absurd number, even in these times of superlatives, times of bailout funds and banks being supported with billions upon billions in taxpayer money. Though far from a household word, PIMCO has four times the German national budget to invest.
That's why almost all governments maintain close ties to PIMCO. They send their finance ministers, the heads of their central banks and sometimes even their national leaders to see CEO Mohamed El-Erian and convince him to buy their government bonds.
In the last few weeks of 2009, PIMCO sold all of its Greek bonds. El-Erian says the company wanted to get out before everyone else noticed that the numbers weren't adding up. The company never relies on outside assessments. Instead, it employs hordes of analysts, some of whom used to work at the International Monetary Fund, where El-Erian began his career.
The analysts spend all of their time digging through large quantities of data and the financial statements of nations, re-calculating, preparing projections and feeding numbers into computers. When they don't like what they see, PIMCO gets out.
When Greece was accepted into the euro zone, it was one more reason for PIMCO to buy Greek bonds. El-Erian says the sentiment at PIMCO was that if the Greeks were being granted membership in such an elite club, then Athens would follow the rules -- or the government would be severely sanctioned if it didn't. But that didn't happen. Instead, political concessions were made and the rules were ignored. That, El-Erian argues, is what brought the cancer into the euro zone.
So why didn't the financial markets penalize Greece earlier? Why was the same yardstick applied to Greek government bonds as to German bonds, until only a few years ago? Why did the markets continue to buy the country's bonds?
The Crash of Greek Bonds
On April 27, 2010, a country's debt was downgraded to junk status for the first time in the history of the young currency. Standard & Poor's downgraded Greece's bond rating by three notches, to BB+, putting it at the same level as Azerbaijan and Egypt, and just ahead of countries like Ecuador, El Salvador and Zimbabwe.
Mršnik wrote that Greece's government debt had to be "restructured" -- a fancy word for bankruptcy. Restructuring involves a debt haircut, so that owners of Greek bonds might only get 30 percent of their money back, that is, lenders are only repaid a fraction of the money they lent. The markets view a downgrade as the kiss of death. At this point, anyone who was still holding Greek bonds in his portfolio was crazy -- or a charitable donor.
But the market is neither crazy nor charitable. As soon as the downgrade was announced, Greek bonds were thrown onto the market, causing their prices to plunge. If the Greek government had introduced two-year bonds into the market at that point, it would have had to promise buyers a 13-percent interest rate, up from only 6.3 percent a few days earlier. The rate for 10-year bonds climbed to above 10 percent.This came as a shock to many European banks. After the Lehman bankruptcy, they had invested heavily in the supposedly safer government bonds, with small yields that suggested security. But now it wasn't only Greek bonds that were seen as risky; confidence was also dwindling in Portugal, Ireland, Spain and even Italy.
Fear in Europe's Financial Capitals
Fear began to spread in places like Frankfurt and London. European banks had invested more than €700 billion in government bonds from the five crisis-stricken countries. And Greek banks alone were holding €50 billion in Greek government bonds. When the government bond rating was downgraded, so were the ratings of Greek banks, as part of a chain reaction that would not stop at Greece's borders.
Government bonds also serve as collateral when banks borrow money from the European Central Bank. The bonds are a key link in monetary transactions, and when their value becomes questionable, the supply of money to economies begins to falter....
Greece was adrift in a storm of mistrust, unleashed by the rating agencies and reinforced by the financial markets. The lower the country's rating fell, the more expensive it became to refinance debts, the greater the debts became, the lower the rating went, and so on. All of this spelled a golden opportunity for foreign currency traders, hedge funds and speculators. They could bet on the decline of the euro and on the euro partners bailing out the Greeks. One of the instruments they used was the credit default swap, which the financial crisis had already spread around the globe following the Lehman bankruptcy.
Although CDSs were designed to insure against the risk of credit default, someone who holds government bonds can also use them to speculate. It's as if someone had purchased fire protection insurance for a house he didn't own. He could conceivably have a strong interest in the house actually going up in flames. Those who bought CDSs for Greek bonds without owning any bonds themselves were betting that the bonds would lose value. If that happened, they could sell the swaps later on at a higher price.
A €26 trillion gray market for CDSs had developed outside the official markets. The premium that had to be paid to hedge a Greek government bond doubled within a few weeks, and by now it was 10 times as high as the premium for a German bond.
In June 2010, Greece's credit rating was downgraded by four additional notches, due to "considerable" general economic risk. Greek government securities now had the status of junk bonds. Investors in Greece had already begun moving their money to Cyprus, Malta and Switzerland. Greece had been ejected from the family of creditworthy nations. But the effect of the downgrade was also detrimental to the entire euro project, even through Europe felt that it had reacted firmly and decisively, and that it had the Greek crisis under control.
This belief was triggered by the European Central Bank's purchase of €25 billion in Greek government bonds only a month earlier, in May 2010. It did this to stabilize prices for the bonds and bring calm to the markets, but the strategy only worked for a few days.
From then on, the ECB would buy more and more Greek bonds, even in 2011, and soon it was also buying Portuguese, Italian and Spanish bonds. The ECB was filling its own house, which had been created as a stronghold of euro stability, a Fort Knox of the new currency, with junk bonds. In doing so, it was ruining the credibility of the euro.
Questions about the beginnings of the euro kept resurfacing. Why did the leaders of France, Germany and nine other countries believe that Greece's way of running its economy could be compatible with other economies under the umbrella of a common currency? How is it possible that a currency was developed exclusively for good times and phases of growth, only to be dangerously in jeopardy during a crisis?
The Truck Drivers' Strike
In Greece, the plunge in the value of government bonds triggered unrest, because EU assistance was tied to austerity requirements and demands for tough reforms. The government was to shrink the public sector, which had become inflated over the decades, by one-fifth. And the markets were to be liberalized to facilitate more growth.
As a truck driver, Antonis Dimitriadis belongs to a group known as the "kleista epaggelmata," which consists of about 70 closed professions, a curiosity of Greek labor law, including attorneys, notaries, architects and taxi drivers. The members of these professions had been protesting since the reforms began, because they were losing their privileges. Until then, their rules had not been set by the market but by the state.
Dimitriadis was one of those who demonstrated in the summer of 2010 against what they believed were unreasonable government austerity measures. Trucking companies nationwide went on strike, shutting everything down. For eight days, filling stations were unable to get gasoline, while supermarkets quickly ran out of fresh products. Tens of thousands of tourists were stranded, flights were delayed and ships were unable to leave port.
There are 33,500 licenses in Greece for independent truckers like Dimitriadis. They were issued under the country's military junta in the early 1970s, but no new licenses were added after that, even though the Greek economy is now four times as large as it was at the time.
A trucking license became something of a guaranteed livelihood and even a retirement plan. When truckers retired, they would sell their licenses to the highest bidders, and licenses for large tanker trucks were being sold for up to €350,000. But now, under the debt regime dictated by Brussels and Washington, the licenses were to be made available to anyone starting in 2014, which of course caused the value of truck licenses to plunge. Today Dimitriadis's license is worth only about €12,000-15,000.
He received the license, which guarantees him his profession, as a gift from his father in 1993, for whom he had worked since he was 13. He cleaned the truck, filled the gas tank and accompanied his father throughout Greece, just as his 11-year-old son Manolis does today -- as if it were a law of nature. Of course, Dimitriadis took care of his father after he had given him the keys to this truck, if only in gratitude for the truck license, and he would expect the same from his own son.
Family is everything in Greece, a country of pre-modern, almost archaic labor structures that have been cemented into law in the form of an elaborate system of rules and regulations. As a result, the family-owned business has remained the DNA of the Greek economy. Of Greece's working population of 4.4 million, roughly 1.5 million people work for the government, while another 1.5 million are employed in small businesses with between one and nine employees, or are self-employed. And these people were now being expected to accept, in the space of a few weeks, changes to a system that had developed over decades. An economy dominated by guilds and family owned businesses was to be converted into a market economy that satisfied the requirements of politicians in Brussels and Berlin.
A Country on the Verge of a Nervous Breakdown
The truck drivers' strike did immense damage to Greece's image around the world. Until the summer of 2010, the Greek crisis had remained a relatively abstract phenomenon for the global public, one that was analyzed primarily in the business sections of newspapers. But now there were images the media could use, images that portrayed a country on the verge of a nervous breakdown, images of irate tourists, empty shelves and barricaded streets, and of soldiers driving truckloads of kerosene, gasoline and diesel around the country. The images depicted a country that was no longer functioning and was unlikely to become functional again in the foreseeable future.
They also depicted a society deeply suspicious of its own government. With tax revenues of less than 30 percent of economic output, Greece has the second-lowest tax rate of all euro-zone countries. The Foundation for Economic and Industrial Research (IOBE) in Athens estimates annual black-market sales at €59 billion -- a quarter of the official economy.
Outsiders may be shaking their heads about all of this, about the Greeks and their stubbornness and backwardness, about their way of doing business in general, which is alien to the economic systems in Central and Northern Europe. But they should be even more taken aback by Europe's politicians and its movers and shakers, and the years they spent doggedly looking the other way, repressing and denying the realities of the Greek economy.
The architects of the euro and their successors have lost the Maastricht Treaty bet. They have jeopardized an agreement made by 12 countries in the hope that the markets wouldn't notice how fragile their shiny new currency really is. And what the founders of the euro left in the way of loopholes in the original treaty -- which was aimed at providing a stable foundation for the common currency -- their successors have used in the course of 10 years to make the euro even more vulnerable.
In defiance of all rules, the euro countries have almost doubled their combined national debt since 1997. It has grown by close to €2 trillion, or 30 percent, in the last three years alone. Without the costs incurred as a result of the financial crisis, perhaps it would have taken longer for the bet to turn sour, but it would have done so nonetheless. The euro had too many design defects, the European political class was too weak to correct them, and Europeans themselves were too disinterested in the entire massive project.
A Dangerously Unstable Network
The four main promises of the euro, as put forth in the Maastricht Treaty, were all broken: government debt was not limited, but in fact doubled, with only five of the 17 euro countries still falling below the debt ceiling of 60-percent of gross domestic product permitted in the agreement's Growth and Stability Pact; budget deficits were not capped, and only four countries are now below the norm; the ban on bailouts was violated; and the European Central Bank, no longer independent, has turned into a bad bank for the bonds of ailing governments.
It isn't just a matter of political failure, which would have been as inconsequential as any broken election promise. In fact, it is a matter of the failures of two generations of political leaders, which have resulted in Europe now being blanketed in a dangerously unstable network of countries, their central banks, the ECB, the banks and investors.
The nations of the euro zone are in debt to the tune of €8 trillion, while banks hold European government bonds at a face value of €1 trillion on their books. The central banks of Greece, Italy, Portugal and Spain owe Germany's Bundesbank €348 billion. The ECB has purchased €150 billion in government bonds, and the banks, fearing loan defaults, would rather park up to €150 billion with the ECB than lend money.
The sum of all credit default swaps for Greece is unknown, as is the identity of the banks that hold them, which makes their risks incalculable. Large European banks have so many bonds of vulnerable countries on their books that, according to the IMF, they would need €200 billion in additional capital to pull through in the event of large-scale defaults. This has already prompted the rating agencies to downgrade some of the banks.
The Euro Is a House without Keepers
This highly explosive network of mutual dependencies makes the euro unstable in times of crisis. But it becomes vulnerable and truly dangerous as a result of a unique feature that distinguishes it from the dollar, the yuan and all other currencies: The euro is a house without keepers, a currency without political protection, without a uniform fiscal policy, and without the ability to forcefully defend itself against speculative attacks.
For a monetary union to function, the economies of its member states cannot drift too far apart, because it lacks the usual balancing mechanism, the exchange rate. Normally a country depreciates its currency when its economy falters. This makes its goods cheaper on the world market, allowing it to increase exports and thereby reduce its deficits. But this doesn't work in a monetary union. If one country doesn't manage its economy effectively, the common currency acts as a manacle.
If Greece were a state in a United States of Europe with a common fiscal and economic policy, it would be just as protected as the city-state of Bremen, also deeply in debt, is by the Federal Republic of Germany. But because there is no common European fiscal policy, Greece, as the weakest country in the European Union -- and despite the fact that it only contributes three percent to the total economic output of the euro countries -- becomes a systemic threat for 16 countries and 320 million Europeans. And the euro, intended as a means of protecting Europe against the imponderables of globalization, becomes the most dangerous currency in the world.
Act IV: The Future of the Euro (2011 to ?)
Why Jacques Delors, one of the founding fathers of the Europe , still believes in the common currency. Why economist Kenneth Rogoff feels that his nightmare scenario is realistic. And why Mohammed El-Erian, CEO of the world's largest bond trader, says that he isn't making any bets on the demise of the euro.
What will happen to Europe in the coming weeks and months has much to do with Greece, but it has also long been detached from the drama in Athens. In fact, it is the continuation of the financial tragedy that began in New York in 2007. According to American economist Kenneth Rogoff, what began in New York was not a normal recession, albeit somewhat more severe than usual, but a "great contraction" of the sort that happens only once every 75 years in global economic history. This circumstance, says Rogoff, has not been recognized to this day. In his view, this is why Europe's crisis, which began as a crisis of confidence, turned into a debt and liquidity crisis and finally led to multiple solvency crises, is not ending.
"The current policy is to act as if a liquidity crisis could be overcome," says Rogoff, "and as if all it took were to hand out enough loans to jump-start growth once. But it's the wrong diagnosis. We have a solvency crisis, and we have European countries and regions that are fundamentally bankrupt. No loan in the world, no matter how big, will save Greece, nor will it save Portugal and probably not Ireland, either, and Italy is also very worrisome."
Band-Aids Where Surgery Is Needed?
If this conclusion is correct, it means that the new European Financial Stability Fund (EFSF), established for ailing euro countries, is pointless. It means that the ECB's new policy of financing the national debts of countries will fail. It also means that Europe's leaders, as they rush from one crisis meeting to the next, are merely handing out Band-Aids where surgery of the inner organs of the Union would be necessary. "The goal now should be to trim debt," says Rogoff, "declare bankruptcy and start over again." According to Rogoff, Greece is so insolvent that it will only have a future if 50 to 75 percent of its government debt is written off, and the situation in Ireland and Portugal isn't all that different.
If strong medication isn't administered to Europe now, says El-Erian, notwithstanding its adverse side effects, the infection will soon reach the heart and the brain: France and Germany.
Either way, says Rogoff, the euro project is at a crossroads. The European partners must either enter into a forced marriage, a shotgun marriage, or the union will break apart sooner or later. "And, of course, it's questionable whether the people of Europe are willing to enter into such an unromantic marriage."
The Germans, says Rogoff, play a critical role. And if they want to save Greece, they should take a sober look at the situation.
They should look to Italy, says Rogoff, where the northern part of the country has been paying the bills for southern Italy for 90 years. And they should ask themselves whether they are prepared to pay Greece's bills for the next 90 years.
'A Risk Bordering on Madness'?
"That's what is involved when we talk about a transfer union. It's certainly possible. Germany is probably strong enough to pay all the bills, presumably to the tune of 150 percent of its own economic output, and the markets would somehow play along. Germany would then be the super-European, and everyone would love Germany. But, to be honest, for the Germans it would be a risk bordering on madness."
When politicians ask him for advice these days, Rogoff suggests starting with a debt haircut as quickly as possible, but even this solution would be very costly. To avoid simply pushing the affected countries over the brink, Europe -- and Germany in particular -- would have to find a way to deal with the bankrupt states.
Rogoff could imagine the Europeans guaranteeing the debts of a country's central government, but nothing more than that. In the case of Ireland, this would mean that no guarantees would be assumed for the banks. And in the case of Spain, it would mean that the immense debts of its cities and towns, such as Barcelona's, would remain Spain's problem. And finally, in that of Greece, it would mean that only the government's most critical expenses would be assumed, but nothing more.
It would mean that Europe would enter a very difficult period. "That's the problem with big crises," says Rogoff. "In the end, they create many more losers than winners."
While this is the scenario Rogoff, an American expert on financial crises, paints, European politicians like Jacques Delors stand by their vision of a great Europe. Delors, the founding father of modern Europe, cannot imagine that the euro zone, by and large, will break apart. "It would be too expensive, and I think that no one wants to take this risk." Europe, says Delors, is a moral obligation, something that today's politicians have apparently forgotten. "They run around like disorganized firefighters, and they still believe that they can put out all the fires." But what is really necessary, says Delors, is a strong central government in Brussels that coordinates the efforts, as well as new, robust institutions.
Do Only Two Possibilities Remain for Saving Euro?
The proposals to solve the euro crisis are manifold -- reducing debt with or without withdrawal from the euro zone, a European finance minister or even a European economic government -- but they have become little more than an expression of the cluelessness of economists and politicians. There is no precedent for this crisis, nor is there a recipe that could be applied to resolve it. Europe's politicians have maneuvered themselves and their people into an unparalleled situation. It scares some of them more than it scares their voters, because politicians already know what voters don't even suspect yet.
In the end, only two possibilities will remain: a transfer union, in which the strong countries pay for the weak; or a smaller monetary union, a core Europe of sorts, that would consist of only relatively comparable economies.
A transfer and liability union requires new political institutions, and individual countries would have to confer a significant portion of their powers on Brussels. Some politicians are warming up to this idea as they consider an economic government or even a United States of Europe, but without explaining exactly what this means.
The second path is the more likely one. It will not be easier, and it might not be any less costly, either. First a firewall would have to be erected between the countries that are in fact insolvent and do not stand a chance of ever repaying their debts, like Greece, and others that have only a short-term liquidity problem. Then the banks would have to be provided with government funds, so that the financial system does not collapse when banks are forced to write off some of the government bonds on their balance sheets. Finally, the countries exiting the euro zone would require continued support, because Europe cannot simply look on as countries like Greece descend into chaos.
'That Doesn't Look Not Dangerous'
Horst Reichenbach will still be needed in either case. In his first tour through the offices of Athens cabinet ministers, the director of the EU Task Force is embarking on a battle against 10 years of mismanagement, 100 years of slowness and the pride of 3,000 years of history. Reichenbach is a mathematician, an economist and a technocrat with decades of experience in the Brussels bureaucracy, and generally a well-tempered man with an aura of extremely professional and esthetic austerity. He is an envoy from another time zone, an envoy from the future.
While waiting for the elevator, Reichenbach says that he feels "extremely welcome" wherever he goes. He attributes this to the fact that he is, after all, the "good guy" in this game, whereas the representatives of the so-called troika, consisting of the European Commission, the IMF and the ECB, who are there to monitor compliance with requirements, are "regarded less favorably" in Greece.
When he drives through Athens, what he sees looks like a dynamic European city through the tinted windows of his dark-blue Renault Espace, the Task Force's official vehicle. Traffic is light now that 15,000 striking taxi drivers have disappeared from the streets of Athens.
He has to slow down at one point, where the other side of the road is blocked. Reichenbach slowly maneuvers his Renault past a burning car in front of the US Embassy. He says, "oops!" and looks out the window, but then he concludes: "That doesn't look not dangerous."