JORGE RODRIGUES SIMAO

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?