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Leaders Failing to Rescue Euro Meet Over Missed Operatic Haircut

Angela Merkel, Germany's chancellor. Photographer: Jock Fistick/Bloomberg
Angela Merkel, Germany's chancellor. Photographer: Jock Fistick/Bloomberg

Dec. 22 (Bloomberg) -- On the evening of Oct. 19, as Claudio Abbado conducted the overture to Rossini’s “The Barber of Seville” at Frankfurt’s Old Opera House, members of Europe’s policy elite were in a backroom discussing haircuts.

Officials led by German Chancellor Angela Merkel and French President Nicolas Sarkozy, fighting their region’s debt crisis, were debating whether to persuade investors to take bigger losses, known as haircuts, on Greek bonds. The talks were so ad hoc that the operatic setting was a retirement party for European Central Bank President Jean-Claude Trichet.

The issue of putting bondholders on the hook plagued policy makers and financial markets for more than a year as Greece slid toward default. While private investors eventually agreed to a 50 percent write-off on the face value of their Greek bonds, European Union leaders this month in Brussels scrapped a plan to make haircuts mandatory in future restructurings. That threat had spooked bondholders into avoiding the debt of other distressed European countries.

The idea of requiring private-investor losses under the terms of a permanent rescue fund set to come into being next year “had a very negative effect on debt markets,” EU President Herman Van Rompuy told reporters just after 5 a.m. on Dec. 9 following an all-night meeting at the Justus Lipsius building, named for a 16th-century Flemish Stoic philosopher who advocated centralized government.

Fifteen Summits

That reversal acknowledged just one of the mistakes Europe’s leaders made in the past two years of a debt crisis that now threatens the euro, the currency used by 17 nations. Fifteen summits in two years have produced five plans that failed to keep a Greek budget deficit from turning into the biggest risk for the global financial system since the 2008 collapse of Lehman Brothers Holdings Inc.

As 2012 nears, the likelihood of government-debt downgrades and defaults is rising, and the region may be entering its second recession in three years, with unemployment in the euro area at 10.3 percent, the highest since the currency began in 1999. There’s talk for the first time that some of the nations using the euro may drop out as leaders try to correct mistakes made by its founding fathers.

‘Too Late’

“Europe acted too late and often too little,” said Liaquat Ahamed, author of the 2009 Pulitzer Prize-winning book, “Lords of Finance: The Bankers Who Broke the World,” which argued that central bankers’ loyalty to the gold standard helped trigger the Great Depression. “The lords of finance this time are as much politicians as central bankers.”

The chorus of critics includes Nobel-laureate economists Paul Krugman and Joseph Stiglitz, policy makers such as U.S. Treasury Secretary Timothy F. Geithner and investors including Mohamed El-Erian, chief executive officer of Newport Beach, California-based Pacific Investment Management Co., which runs the world’s largest bond fund.

Officials repeatedly underestimated the source and risks of Greece’s fiscal defects, as well as how much money it would take to prevent investors from punishing other cash-strapped countries by dumping their bonds. As a condition for aid and to win the support of financial markets, they demanded spending cuts and tax increases, stunting economic growth. They put national interest ahead of the common good and ideology over pragmatism, while incurring self-inflicted wounds which cost them the trust of bondholders.

Berlusconi, Papandreou

As leaders failed to deliver a fix, seven heads of government lost their jobs, including Italy’s Silvio Berlusconi and Greece’s George Papandreou. Falling prices of European sovereign debt led to the failure of MF Global Holdings Ltd., the New York-based futures brokerage, and Franco-Belgian Dexia SA, once the world’s largest municipal lender.

The crisis helped wipe out more than 310 billion euros ($405 billion) of market value for the European financial industry this year, about a third of the total, based on data compiled by Bloomberg. Greece, Portugal and Ireland are shut out of debt markets, and borrowing costs are surging for Italy. They’ve climbed even for Germany.

The cocktail of austerity and uncertainty comes with a hangover. European consumer confidence dropped this month to its lowest level in more than two years, and manufacturing and services output contracted for a fourth month. Citigroup Inc. predicts a recession in which the economy shrinks 1.2 percent next year and 0.2 percent in 2013, while the Organization for Economic Cooperation and Development last month warned that the region poses “serious downside risks” to global growth.

“Every key actor contributed to the problems we are now seeing,” says Thomas Mayer, chief economist at Frankfurt-based Deutsche Bank AG, who warned in early 2010 against using “ad hoc interventions” to manage Greece’s insolvency.

‘Futile Precaution’

All of the principal figures were in Frankfurt on Oct. 19 as Bologna’s Orchestra Mozart played the overture to Gioachino Rossini’s opera, subtitled “The Futile Precaution,” whose plot features bribes, tricks and characters not who they claim to be. The work, hooted off the stage when first performed in Rome, was based on a play written in 1775 on the eve of the American Revolution, a period of economic and social unrest.

Sarkozy left his wife, Carla Bruni-Sarkozy, in labor in Paris to be at Merkel’s side. Trichet’s nominated successor, Mario Draghi, was there, as was Christine Lagarde, the International Monetary Fund managing director, who until June served as France’s finance minister. European Commission President Jose Barroso and Luxembourg Prime Minister Jean-Claude Juncker, chairman of a panel of finance chiefs, also participated in the talks.

Merkel, Sarkozy

This group, which would give itself the name Groupe de Francfort, “made the biggest policy mistakes” over the past two years, said Lutz Roehmeyer, a fund manager who helps oversee more than $15 billion at Landesbank Berlin Investment in Germany’s capital. “The fate of the euro lies in their hands.”

Merkel, 57, a physicist born in the former East Germany, has emerged as the group’s most powerful member. It was she who initially insisted on forcing bond investors to take write-offs. She has disdained short-term financial bailouts. Instead, she has made it her top priority to remake Europe as what she calls a “stability union” by demanding structural changes and budget rules that would transform weak economies into prudent, productive versions of her country.

While eager to be aligned with Germany, the 56-year-old Sarkozy was less rigid, characterizing Europe as a “family” that must stick by its weakest member and “avert the drama of a Greek default.” The position wasn’t entirely altruistic: French banks have more to lose than Germany’s if Greece goes bankrupt, and France’s top credit rating is in greater jeopardy.

Trichet’s Tears

Trichet, who turned 69 this week, was entering the final days of an eight-year term running the ECB, the capstone of three decades spent building and then managing the euro. He had often urged governments to intensify their crisis-fighting, coming close to tears on a number of occasions as he watched them bicker, according to one ECB official who spoke on the condition of anonymity.

Memories of how markets reacted following the collapse of Lehman Brothers and his role in restructuring emerging-market debts during the 1980s left him wary of the prospect of Greece defaulting or investors being required to accept losses. He wasn’t immune to criticism, as when overseeing interest-rate increases in 2008 and again this year when expansion sputtered.

Deauville Deal

European policy makers say privately that the biggest error was the one reversed two weeks ago: forcing investors to incur losses if a government can’t repay its debt. So-called private-sector involvement was foreseen in the first version of a treaty signed July 11 establishing the European Stability Mechanism, a 500 billion-euro fund to be rolled out next July.

Ten days later, leaders negotiated a 21 percent write-off in net present value of Greek debt -- declaring that treatment “exceptional and unique” -- only to revise the terms to 50 percent of face value in October.

The idea of requiring investors to pay took hold in October 2010 when Merkel persuaded Sarkozy to support it at a meeting in the French resort of Deauville. Merkel wanted to cool the outrage of German voters turning against her party after the country provided the biggest share of loans for Greece and guarantees for a regional bailout fund. Her approach to profligate nations reflected Germany’s aversion to debt and inflation, dating to the 1920s, when government deficits and hyperinflation helped pave the way for the rise of Adolf Hitler.

‘What Happens?’

As Trichet warned, her plan frightened investors into avoiding the bonds of other countries for fear the securities were no longer safe. The 10-year bond yields of Portugal and Ireland soon surged to unsustainable levels, above 7 percent, and both would also require bailouts.

While it was “almost impossible from a political perspective not to demand the involvement of investors,” the decision to do so “led to great uncertainty” in markets, said Josef Ackermann, CEO of Deutsche Bank, Germany’s largest bank.

Ackermann, 63, became the de facto spokesman for the banking industry as chairman of the Washington-based Institute of International Finance, which has represented bondholders in talks on the restructuring of Greek debt. Details of the deal are still being negotiated.

“If you talk to investors around the world, they ask, ‘What happens in the next country?’” he said Dec. 15 in Berlin.

Budget Hole

While scaring investors may have been a costly mistake, the first error may have come in the weeks after Greece’s budget woes came to light in October 2009, former French President Valery Giscard d’Estaing said in an interview.

Soon after he became Greece’s prime minister that month, Papandreou found a 20 billion-euro hole in the budget. The discovery that Greece’s true deficit was four times the EU limit was “beyond anyone’s imagination,” George Papaconstantinou, then Greece’s new finance minister, said this month in an interview with Bloomberg Television’s Francine Lacqua.

Each day, he said, he would ask ministry accountants, “Is this all?” and be told “yes,” and the next day someone would say “there is also this.”

Merkel told investors not to “overrate” the matter because deficits were rife globally. She and counterparts erred in assuming Greece would eventually repay its debt, said Giscard D’Estaing, who was president of France from 1974 to 1981.

Avoiding Default

One reason for trying to avoid a default was Trichet’s fear of what he called a “credit event,” akin to what followed the fall of Lehman Brothers. The risk would be that issuers of credit-default swaps on Greek debt, insurance contracts against a failure to redeem bonds, would have to pay off swap holders. Investors would then increase bets against other fiscally weak governments, such as Italy, destroying their ability to fund themselves. Banks worldwide might then be forced to retrench and cut risk, starving markets of liquidity.

Even without the triggering event Trichet wanted to avoid, contagion flared as investors turned against other issuers of sovereign debt that might follow Greece toward default. Policy makers didn’t help as they clashed at every step over how much to spend and on what, whether the IMF should play a role and whether the ECB should be more aggressive in helping.

It took seven months after Greece acknowledged its budget weakness for leaders to deliver an initial rescue package of loans totaling 110 billion euros. Merkel, Sarkozy and other EU leaders could never agree on a big enough bailout fund to halt the crisis, said Jacques Cailloux, chief European economist at Royal Bank of Scotland Group Plc in London.

“The policy response should have been scaled to the size of the euro area and focused on countries like Italy,” Cailloux said. “This is a systemic crisis.”

‘Catastrophic Risk’

U.S. officials shared that beef. In September, Geithner warned of “cascading default, bank runs and catastrophic risk” if Europe failed to build a big enough firewall. He has jetted to the continent five times since August to press his case.

The amount spent on aid rose from the original 110 billion euros for Greece to 256 billion euros as Portugal and Ireland joined in seeking bailouts over the next 12 months. A regional rescue fund created to channel aid and mark a show of strength to investors started with the spending power of about 250 billion euros and the ability to make loans to distressed states. Now it can spend 440 billion euros and carry out bond-buying and bank recapitalizations.

At one point, leaders were trying to increase bailout funds to 1 trillion euros through borrowing, though now they’re eying a smaller amount. Even 1 trillion euros would be less than half as much as needed to insulate larger economies such as Spain and Italy, Cailloux said. Italy alone owes about 1.9 trillion euros.

Greek Pain

Politics tied the hands of leaders, who worried they would lose voter support by tapping their coffers too much or putting their countries’ credit ratings at risk. The bailout fund, known as the European Financial Stability Facility, often needed the backing of legislatures, which led to sparring and delay.

“They’ve all played to their voters,” said Jim O’Neill, chairman of Goldman Sachs Group Inc.’s money-management unit in London.

Countries in need of aid had to sign up for pain. Greece was forced to agree to cut its debt to 120 percent of gross domestic product by 2020 from 162 percent this year. Doing so requires tax increases, spending cuts, privatizations and the agreement to write off 50 percent of the nominal value of debt in the hands of private investors.

‘Suicide Pact’

The result has been unemployment of 17.5 percent and the prospect of a fifth year of recession. IMF estimates show the country’s economy will be 12 percent smaller in 2013 than before the crisis.

Greece’s debt outlook has worsened with the shrinking. In November 2010, the European Commission estimated borrowings would total 156 percent of GDP in 2012. Last month it revised that to 198 percent if the debt swap doesn’t take place.

Stiglitz, a professor of economics at Columbia University in New York, called Europe’s austerity cure a “suicide pact.” The debt was largely a result of the banking and financial turmoil that started in 2007, he said in an interview. He said implementing deflationary policies now will make it even less likely that debts will be paid off and suggested that European governments establish a “solidarity fund” to spur growth.

The counterargument is that fighting debt with debt is a recipe for disaster.

“Debt is like a drug,” said Michael Meister, a vice chairman of Merkel’s Christian Democratic Union-led caucus in parliament, in November. “First you have some fun with it, but at some point you’re so hooked that you need a withdrawal treatment to get off it.”

Ultimatum in Cannes

In Greece, the tightening fiscal straitjacket led to a cascade of protests including general strikes and violent confrontations with police. As political attacks escalated in parliament, Papandreou surprised Merkel and Sarkozy Oct. 31 by proposing to put the bailout terms before his voters.

Outraged, the German and French leaders summoned him to the French seaside city of Cannes for a dressing-down. They said they would suspend aid and declared that such a ballot would be a poll on Greece’s membership in the euro.

In response, Papandreou shelved the referendum and resigned. Joachim Fels, chief economist at Morgan Stanley in London, wrote in a Nov. 6 note to clients that the strategy of Merkel and Sarkozy may have opened a “Pandora’s Box” for investors because it raised the possibility the euro area may splinter, something previously considered “taboo in European political circles.”

‘Worst Players’

Trichet wasn’t averse to joining the political leaders in tightening policy. In April and July, the ECB raised interest rates for the first time since 2008, citing the need to meet its mandate of delivering price stability. Critics said Trichet was ignoring the economic threat of the crisis. As recession indicators flashed red, his successor, Draghi, began reversing the increases in his first week as president in November.

“The worst players, as far as I’m concerned, in terms of giving bad advice and brushing aside problems, are not the people demonstrating in the streets of Athens, it’s the people at the European Central Bank,” said Krugman, a Princeton University economics professor, in an October interview.

Paul De Grauwe, a professor at the Catholic University of Leuven in Belgium, faults the ECB for not buying more bonds under a program it began last year with purchases of Greek, Portuguese and Irish debt and extended to securities of Italy and Spain in August 2011. Stepping up purchases would help reduce bond yields and allow governments to keep borrowing as they rally their economies, he said.

‘Economic Liability’

ECB officials including Draghi, and with the backing of Merkel, say it isn’t their job to rescue governments. Buying more bonds would burden the ECB’s balance sheet and lessen pressure on fiscal policy makers to retrench. They also say it would undermine their price-stability mandate. Even the limited buying has antagonized some policy makers, with Germans Juergen Stark and Axel Weber resigning in protest.

“The ECB has been inconsistent in saying it hates buying bonds, therefore giving a signal that you shouldn’t trust them,” De Grauwe said.

The central bank has instead focused on helping banks to lend, yesterday awarding them 489 billion euros for three years, the most ever in a single operation.

To Martin Feldstein, a professor of economics at Harvard University, the euro was an accident waiting to happen because it united disparate economies under the same exchange and interest rates, without political ties. He warned in 1998 that it would prove an “economic liability.”

Governments added to the strains. No country has ever been fined for violating the bloc’s fiscal rules, and in 2005 Germany and France led a push to dilute them.

Ratings Cuts

Now Standard & Poor’s warns that Germany, France and 13 other euro nations risk having their credit ratings cut. Investors put a 95 percent chance on Greece defaulting within five years, while the cost of insuring Italian government debt more than doubled since the start of the year to a record 595 basis points Nov. 15. A basis point is a hundredth of a percent.

The euro this month fell to its lowest level against the dollar since January. More stress may be on the way as governments have to repay at least 1.1 trillion euros of debt next year.

Pimco’s El-Erian sees a more than 1-in-3 chance the euro zone will break apart and trigger financial turmoil similar to that which rocked the world economy in 2008.

“It’s now a crisis for the euro zone as a whole,” he said this week in an interview with Bloomberg. “The contamination has been allowed to travel from the outer core all the way in and threaten the inner core.”

‘Repeating Mistakes’

As he was declaring private-sector involvement dead on Dec. 9, Van Rompuy outlined a leaders’ agreement for a German-inspired “fiscal compact” to impose more budget discipline.

Elevating to constitutional level many of the budget rules negotiated in the 1990s and stiffened this month, governments will vow to almost eliminate structural deficits and devise automatic mechanisms to ensure cuts are made. Officials say they won’t come up with final language for the agreement before March. A “‘comprehensive solution’ to the current crisis is not on offer,” Fitch Ratings said.

“The ECB is the key player now,” said Harvard University historian Niall Ferguson, in an interview last week with Bloomberg Television. Draghi and the ECB’s ability to print money are all that stand “between the euro and a 1931-, 1932-style depression.”

Ahamed, the “Lords of Finance” author, sees parallels between the 1920s and what is happening now. Then, maintaining the gold standard limited policy makers’ ability to maneuver just as the single currency does today, he said. As the Depression gathered force in the 1930s, leaders focused on “drawing blood from the patient” through tighter monetary and budget policies, he said.

“Why are we repeating mistakes?” he asked.

To contact the reporters on this story: Simon Kennedy in London at; Aaron Kirchfeld in Frankfurt at

To contact the editors responsible for this story: John Fraher at; Edward Evans at

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