A time of debt

‘Well, my message, Glenn, is that PI[I]GS are us … [W]e very quickly could find ourselves in a similar situation to Greece.’1 These were the words of historian Niall Ferguson, then at Harvard, on Glenn Beck’s Fox News TV show on February 11, 2010. The ‘we’ Ferguson invoked were the citizens and taxpayers of the United States. The PIIGS were the eurozone problem cases – Portugal, Ireland, Italy, Greece and Spain. Beck and his guests regaled their audience with scenes of disorder, strikes, riots in the streets, cars burning. As Greece demonstrated, once markets lost confidence there was no easy way out. As Ferguson put it in drastic terms: ‘You either have to default on a large part of the debt or you have to inflate it away. There really aren’t many other options open to our country that has debts this size. And none of these processes is really much fun.’ If interest rates spiked it could happen in the United States within the year. As Ferguson explained: ‘[T]he lesson of what’s going on in Europe today and what happened to Russia 20 years ago is that collapse can sneak up on you and strike very sudden [sic] indeed.’ Given this prospect, Ferguson hailed the populist backlash that was going on in America against big government. That was a healthy sign. But it needed something else: ‘[U]ntil there’s a political leader that has the courage to spell out to Americans, ‘We need to do this, we need to reform our system, root and branch,’ then I’m afraid we’re going to slide downhill in the direction not just of European economics but of Latin American economics.’

Ferguson was the Ivy League academic. Beck was one of the most excitable drummer boys of American conservatism. But fear of debt and its potentially disastrous implications was everywhere in 2010. It had been there before the crisis, in the Rubinite calls for consolidation and in the campaign for a debt brake in Germany. It was now massively amplified by the shock of 2008– 2009. This dealt the most serious blow to government finances that any of the major developed countries had suffered since World War II. The fate of Greece in 2010 seemed to spell out what lay in store for any state that slid over the edge into insolvency. Warnings ranged from outrageous rants and scaremongering from the likes of Beck to ultrarespectable academic research, most notably by two former IMF economists, Carmen Reinhart and Kenneth Rogoff.

Following their surprise bestseller This Time Is Different: Eight Centuries of Financial Folly, in January 2010 Reinhart and Rogoff launched a research paper with the title ‘Growth in a Time of Debt.’2This purported to show that as public debts passed the threshold of 90 percent of GDP, economic growth slowed down sharply. It was a slippery slope that ended in a cliff. Excessive debt weighed on growth, which made the debt even less sustainable, further slowing growth. To avoid this fate, it was crucial to take action sooner rather than later. On closer inspection, Reinhart and Rogoff’s analysis turned out to be riddled with errors. Once their Excel spreadsheet was properly edited, there was no sharp discontinuity at the 90 percent mark and the case for emergency action was far weaker than they made out.3 But in early 2010 their arguments ruled the roost. In the Financial Times they opined: ‘[T]he sooner politicians reconcile themselves to accepting adjustment, the lower the risks of truly paralysing debt problems … Although most governments still enjoy strong access to financial markets at very low interest rates, market discipline can come without warning.’ Once bond markets realized the full measure of the ‘fiscal tsunami’ unleashed by the banking crisis, their judgment would be merciless. ‘Countries that have not laid the groundwork for adjustment will regret it.’4 No one was safe. As Rogoff told Germany’s rightwing Welt am Sonntag, a newspaper that hardly needed encouragement: ‘Germany’s public finances are not on a sustainable path … There will come a time when Germany will have its own Greece problem … [I]t won’t be as bad as in Greece, but it will be painful.’5

As commentators as knowledgeable as Ferguson, Reinhart and Rogoff must have been aware, the market discipline on display in the eurozone had not ‘come without warning.’ The ECB and the German government were deliberately courting the bond vigilantes who swarmed over Greece. If they wanted to ease the pressure, all the ECB needed to do was what the Fed, the Bank of England or the Bank of Japan did as a matter of course – buy Greek bonds. But the ECB had no intention of doing that, not, at least, until the very last minute. The ECB meant to send a message: Austerity or else! They must have been delighted by the global reaction. The year 2010 would become a turning point in the recovery. Using Greece as its exemplum, an alliance of convenience among right-wing fearmongers, conservative political entrepreneurs and centrist fiscal hawks shifted the political balance.

Though unemployment remained high, though output was limping back, stimulus was abandoned. Earlier and more sharply than in any other recession in recent history, the fiscal screw was turned. On both sides of the Atlantic the result was to stunt the recovery.

I

The most remarkable instance of austerity contagion was the UK. The hotly contested election that would bring an end to the long reign of New Labour concluded on May 6, 2010, the same day that banks burned in Athens and the flash crash sent US financial markets plunging. Fiscal politics were key to both the election and the coalition negotiations that followed. Britain had been among those hardest hit by 2007– 2008. Though the Bank of England, unlike the ECB, never let there be any question of official support for UK Treasury debt, and though the UK maintained its credit rating, sterling plummeted against the dollar and the euro. As long as the Bank of England stabilized the bond market, it was not an immediate cause for concern. But it made Governor Mervyn King into a pivotal figure and, as he had demonstrated in the spring of 2009 ahead of the G20 meeting in London, he was not afraid to bring his influence to bear.6

Photo source: Wiki commons

On December 21, 2009, ‘shadow’ Chancellor George Osborne opened the electoral campaign for the opposition Tory party by claiming that unless Britain put together a credible program of fiscal consolidation, it would soon go the way of Greece. ‘By testing the patience of international investors,’ Osborne declared, ‘Labour are playing with economic fire.’ Countries that wished to retain a AAA rating did ‘not have the luxury of waiting for the recovery to be secured before announcing credible fiscal consolidation plans.’7 Osborne bolstered his case with quotes from analysts at Paribas, Deutsche and Barclays. Bill Gross, the star fund manager at bond market giant PIMCO, chimed in to tell the Financial Times that he had now placed UK bonds in the category of ‘must avoid.’ In his characteristically flamboyant style, Gross declared that UK public debt was ‘resting on a bed of nitroglycerine’ and should be placed in a ‘ring of fire’ that included not just the UK, Greece and Ireland, but Spain, France, Italy, Japan and the United States.8 On February 14, 2010, twenty senior economists, including Ken Rogoff, wrote to the Sunday Times repeating Osborne’s charge that the Labour government was not doing enough to bring the budget under control.9 They were answered by a letter to the Financial Times from a much longer and no less distinguished list who opposed the call for fiscal retrenchment as premature and pointed out the irony that ‘[i]n urging a faster pace of deficit reduction to reassure the financial markets, the signatories of the Sunday Times letter implicitly accept as binding the views of the same financial markets whose mistakes precipitated the crisis in the first place!’10

The result of the May 6 election was a defeat for Labour, but the conservatives failed to win a majority and were left needing the support of the Liberal Democrats. The coalition negotiations became a high-stakes struggle over the future of fiscal policy.11 ‘The deficit,’ wrote David Laws, a Liberal negotiator, ‘was the spectre which loomed over our talks.’12 The conservatives made spending cuts the central issue of the negotiations. And the Tory debt hawks knew that they could count on both the Treasury and the Bank of England. On May 12, 2010, Mervyn King instructed the new government that ‘[t]he most important thing now is … to deal with the challenge of the fiscal deficit … I think we’ve seen in the last two weeks, particularly, but in the case of Greece, over the last three months, that it doesn’t make sense to run the risk of an adverse market reaction.’13

In what was dubbed an “emergency budget” in June 2010, Osborne slashed spending and raised VAT. The aim was to calm markets by committing to close the deficit by 2015.14 The argument in 2010 was ‘necessity.’ But, as Neil Irwin later commented: ‘ Britain … was embarking on something that has rarely been attempted … cutting spending and raising taxes in a preemptive strike against the risk of a future debt crisis.’15 As Paul Krugman remarked from New York: ‘It’s one thing to be intimidated by bond market vigilantes. It’s another to be intimidated by the fear that bond market vigilantes might show up one of these days.’16 As the squeeze continued, other motives revealed themselves. Shrinking the state, it turned out, was an aim in itself. The ultimate goal, as David Cameron would put it in his speech to the Lord Mayor’s Banquet three years later, was ‘something more profound’: to make the state ‘ leaner … not just now, but permanently.’17

By 2015 Chancellor Osborne would claim to have slashed £98 billion in annual spending from the UK budget. From a maximum of 6.44 million public sector employees in September 2009, the UK public sector workforce would be reduced to 5.43 million in July 2016.18 One million jobs were cut, privatized or outsourced. It was a reduction larger than that imposed by the Thatcher or Major governments of the 1980s and 1990s. Translated to the US public sector payroll, it would be the equivalent of the elimination of 3.3 million positions. Because pension and health spending were ringfenced, the pain was concentrated above all in local government. As the minister in charge roundly declared: ‘[L]ocal government is a massive part of public expenditure. It has lived for years on unsustainable growth, unsustainable public finance … People blame the bankers, but I think big government is just as much to blame as the big banks.’19 Between 2010 and 2016 spending by local councils on everything from elderly day-care centers to bus services, public parks and library facilities fell by more than a third. Britain became a darker, dirtier, more dangerous and less civilized place. Hundreds of thousands of people who were barely coping on disability and unemployment benefits were tipped into true desperation.20 According to the OECD, only Greece, Ireland and Spain were put through worse contractions than those inflicted on the UK.21

The reason why American liberals followed the politics of the UK so closely was not just their partisanship for the defeated Gordon Brown. They feared that events in Britain in 2010 might foreshadow a similar turn at home. Nor did the pressure come only from alarmist experts and the alternate reality of Fox News. It came from inside the Obama administration. As early as February 2009 the president had hosted a Fiscal Responsibility Summit at the White House. A year later, the administration was under pressure from Democratic Party centrists anxious about their fiscal credentials. The administration needed their support in raising the ceiling that limits debt issuance by the federal government.22 To the horror of Keynesian commentators, on January 27, 2010, in Obama’s second State of the Union address, it was deficit reduction, not jobs, that took priority.23 Obama promised that as of 2011, all nonmilitary discretionary spending would be frozen at its current levels. ‘[F]amilies across the country are tightening their belts and making tough decisions,’ Obama declared. ‘The federal government should do the same.’24 It was the simplistic householder analogy that drove economists to despair.25 And it was fully in tune with the talk of ‘fiscal responsibility’ that now dominated Washington. As one conservative commentator remarked, ‘[I]f the arguments in the coming years are between spending freezes and spending cuts, then we’ve already won.’26

On February 18, 2010, by executive order, the president appointed the National Commission on Fiscal Responsibility and Reform, also known as the Simpson-Bowles Commission. It was to make recommendations designed to achieve primary budget balance by 2015. Simpson-Bowles would not report until December, after the congressional midterms. In the meantime, damaging divisions opened within the Obama administration over the fiscal issue.27 Hawks like Orszag were pushing for tax hikes even for those earning below $250,000. This would violate a basic Obama campaign pledge, and it was bitterly resisted on political grounds by Emanuel as chief of staff, but also on economic grounds by Larry Summers. Meanwhile, the alternative to debt alarmism was spelled out most cogently by Ben Bernanke, who had recently been reappointed as Fed chair. Bernanke did not deny the scale of the deficits or the serious implications in the long run of a much larger debt burden. But he cautioned against drastic austerity efforts. America’s nascent economic recovery might not withstand a sharp fiscal shock. The crucial thing was to separate the short and medium term. Continued short-term stimulus should be accompanied by a realistic plan as to how to end deficits in the medium term.228 The combination would provide both an immediate prop to the economy and a comforting lift to investor confidence.

It was not enough for budget hawks like Peter Orszag, who left the administration in the summer of 2010.29 The judgment of the electorate on Obama’s first two years would be even more devastating. With unemployment stuck just shy of 10 percent, four out of five Americans rated the economic situation as bad or fairly bad. The Tea Party was rallying conservative nationalist opinion against the Washington elite.30 Even among Democrats, a plurality attributed the bailouts of 2008 to their own side.31 They were wrong about the president, but given who had supported the measure in Congress, the association was not entirely far-fetched. On November 2 the angry electorate handed a historic victory to the Republicans. The GOP gained sixty-three seats in the House of Representatives, the largest swing since 1948. It was a shift that would redefine American politics.

Desperate not to allow the recovery to grind to a halt, the Obama administration worked feverishly to pass a second round of stimulus in the lame duck session of the old Congress. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of December 2010 provided, by some estimates, a demand boost of as much as $858 billion.32 But it was a measure of their political predicament that the stimulus now consisted entirely of tax cuts, including the prolongation of the grossly inequitable giveaways for top income earners inherited from the Bush era. Two years into eight years in office, it would be the last major economic policy bill that the Obama administration would pass. In the New Year, with the new Republican Congress, they would be on the defensive. Because they included modest increases on the revenue side, the centrist recommendations of the Simpson-Bowles committee were dead on arrival, even though they were heavily slanted toward cuts in entitlements. Led by Eric Cantor, the forceful House majority leader, the so-called ‘Young Gun’ Republicans would countenance no tax increases.33 Their target was immediate spending cuts of $100 billion, which, when concentrated in discretionary spending, would cause havoc across a range of federal programs, including food safety, disaster relief and air traffic control. By ‘starving the beast,’ they would lift the curse of big government and revive the American dream.

II

Both the United States and the UK had suffered severe fiscal damage from the financial crisis. It was not, therefore, surprising that they faced calls for retrenchment. Were there other economies that might take up the slack? Apart from Japan and the emerging market economies, the obvious candidate to serve as a global counterweight was Germany. As Angela Merkel admitted in the summer of 2010, ‘[O]ther EU members, and the US administration, have urged Germany to spend more to maintain the current economic recovery, and reduce its export surplus.’34 But that was not how Germany saw its role. The crisis, so the prevalent German interpretation went, was a result of excessive debt. What the world needed to guide its recovery was for Germany not to act as an expansionary counterweight but to lead the way in offering a model of austerity.

Given the prevailing mood, it was easy enough to make the case. Germany’s deficit was running at 50 billion euros per annum. Its debt had surged beyond 80 percent of GDP. The Reinhart and Rogoff meme had reached Europe. Finance Minister Schäuble invoked the menacing 90 percent threshold to argue for the need for immediate countermeasures.35 Announcing the largest budget cuts in the history of the Federal Republic, on Monday, June 7, Chancellor Merkel declared that restoring Germany’s budget balance would constitute a ‘unique show of strength … Germany as the largest economy has a duty to set a good example.’3637 In 2011, 11.2 billion euros ($13.4 billion) were to be cut, and a total of 80 billion euros by 2014. In Germany too this required choices to be made about the future shape of the state. Tellingly, the heaviest cuts proposed by the Merkel government fell on the defense ministry, which was asked to cut by 25 percent by 2014. The strength of the Bundeswehr was to be sliced and conscription to be phased out. For Berlin it was more important to achieve the 3 percent deficit rule specified by the eurozone’s Stability and Growth Pact than it was to honor its commitment to NATO to spend at least 2 percent of GDP on defense.38

At the G20 in Toronto in June 2010 the scene was set for another round in the transatlantic argument over fiscal policy. Ahead of the meeting Obama published an open letter calling for fiscal consolidation to be staggered so as to avoid jeopardizing recovery.39 Schäuble took to the pages of the Financial Times to defend his country’s distinctive long-term approach to economic policy against US short-termism. He championed the debt brake as a stability anchor for Europe.40 He had the backing of Prime Minister Cameron as well as that of the Canadian hosts. At the insistence of the Obama administration the final text of the G20 communiqué.

referred to the need to sequence fiscal consolidation so that ‘the momentum of private sector recovery’ was not jeopardized.41 But this was trumped by demands for fiscal consolidation.42 After the worst economic crisis since the 1930s, at a time when, according to the OECD, 47 million people were unemployed across the rich world, and the total figure for underemployed and discouraged workers was closer to 80 million, the members of the G20 committed themselves to simultaneously halving their deficits over the next three years.43 It was the householder fallacy expanded to the global scale. It was a recipe for an agonizingly protracted and incomplete recovery.

For Germany even that was not enough. The lesson that Berlin drew from the Greek crisis was that the eurozone’s Stability and Growth Pact had failed. Germany, or rather the Red-Green coalition that had ruled Germany back in 2003, had to accept a measure of responsibility. Now, with Merkel and Schäuble at the helm, Berlin would take the lead in rededicating the eurozone to self-discipline. This was vital not only to restore economic health. It was essential for the politics of the eurozone. The Greek crisis had shown that Europe’s governments would have to work together. Federalists like Schäuble still insisted that the ultimate answer to the crisis would be ‘more Europe.’ But for that to be acceptable to the taxpayers of Northern Europe, they had to be reassured that everyone was playing by the same rules.

As the crisis in the eurozone gathered in intensity and Germany’s pivotal role became ever more pronounced, the rhetoric became more heated. Protesters waved placards showing Merkel’s face graffitied with a Hitler mustache. This was not only offensive and grotesquely unfair. It also represented a fundamental misunderstanding of Germany’s position. When it was accused of imperialism, the German political class could honestly reply that it did not harbor ambitions for continental domination. But Berlin did have a vision of economic and fiscal discipline, which had to be generally accepted before Germany would consent to any further steps toward integration.44

For reasons of global competitiveness it was essential that government spending and debt be brought under control. Europe’s demographic pressures made the case only more urgent. As for labor markets and unemployment, the rest of Europe had to learn the lessons of Germany’s Hartz IV reforms. When Keynesians worried about domestic demand, the German answer was exports. An aging continent should be exporting to the world and building up a nest egg of financial claims on the fast-growing emerging markets. On this, Merkel’s new coalition with her probusiness FDP partners was clearer than ever. Germany had passed a constitutional amendment in the form of the debt brake. If Germany was to agree to pool financial liabilities with the rest of the eurozone, it must insist on nothing less from its partners. Prosperous as they were and as much as they benefited from European integration, taxpayers and voters in the CDU heartlands would simply not accept the transformation of the EU into a continental ‘transfer union.’ It was only if the rest of Europe could guarantee conformity to a common set of rules that Berlin could contemplate pooling sovereignty. The problem was that those rules had to be decided, upheld and imposed. And that is where things got uncomfortable.

Over the summer of 2010, rival plans for a new regime of European economic governance were being prepared by teams working separately for President Barroso of the EU Commission and Herman Van Rompuy, the first permanent head of the European Council, a position created by the Lisbon Treaty and designed to reinforce the intergovernmental character of EU decision making.45 Berlin’s ultimate goal was to have constitutional debt brake provisions like the one it had passed in 2009 written into law for all the eurozone members. Those deviating from the rules would be subject to an automatic system of sanctions, including the suspension of voting rights. For those in real financial trouble the sanctions would be even more severe. As Trichet put it, ‘[W]hen you activate a support mechanism, a country loses de jure or de facto its fiscal autonomy.’46 France, for its part, resisted automatic sanctions. Not surprisingly, smaller countries that had reason to fear that the rules might be applied more strictly to them opposed any talk of the suspension of voting rights.

These were weighty issues for Europe’s future. But how did they relate to the short-term question of financial stabilization? By the summer it was already clear that the fix devised to contain the Greek crisis in May 2010 was not sustainable. The worst fears of the more pessimistic IMF analysts were rapidly being confirmed. Not only was the PASOK government slow to push through the changes the troika demanded, but when it did, the results were counterproductive. In a classic Keynesian downward spiral, demand fell and unemployment surged further, reducing incomes. In 2010 Greek GDP would fall by 4.5 percent. Worse would follow in 2011.47 The tax revenues flowing to Athens, which even at the best of times were hardly ample, slowed to a trickle as wages, profits and consumer spending contracted.

The May 2010 program had been premised on the assumption that Greece would be able to return to capital markets within two years. But with the deficit expanding and its debt burden rising, there was little chance of that. By the end of August 2010 the yield spread of the Greek ten-year bond relative to Bunds had surged to 937 points, higher than it had been even at the height of the spring crisis.48 And yet in the face of failure, the troika remained committed to holding Greece to the May 2010 program.

If there was any justification for the protracted torture of Greece, it was the fear that an immediate debt restructuring would unleash contagion to other sovereign debtors across the eurozone and destabilize Europe’s banks, thus causing a far wider crisis. So the immediate priority for European economic policy ought to have been to use the time bought by extend-and-pretend to strengthen the resilience of the eurozone financial system and the health of the banks. If one were to follow the American example, the obvious next step was to conduct a stress test to estimate likely losses, and then to carry out an energetic recapitalization with either public or private funds.

Both in 2009 and 2010 the Europeans conducted stress tests of a sort. The 2010 exercise went further than that in 2009 in naming individual banks. But it too was a farce. The results published on July 23, 2010, proclaimed that of ninety-one leading European banks, only seven would see their primary Tier 1 capital reduced to dangerous levels by a sovereign bond crisis.49 In total the Committee of European Banking Supervisors estimated that Europe’s banks needed to raise no more than 3.5 billion euros in new capital. But, as was pointed out by skeptical analysts, this optimistic result depended on assuming that the vast majority of the sovereign debt held by banks, had zero risk of default, or was fully protected by the EU’s financial stability facility.50 According to the reckoning of the OECD, on less rosy assumptions the potential loss to Europe’s banks from a peripheral bond crisis was not the 26.4 billion euros allowed for by the official results, but 165 billion euros. These losses would be concentrated in the national banking systems of the vulnerable countries – Greece, Ireland, Portugal and Spain. They would suffer catastrophic damage. If the crisis were to spread to Spain or Italy, that would put both the German and the French banking systems in jeopardy. As always, the most serious risks were concentrated in the balance sheets of a few dangerous banks. Dexia and Fortis were at the top of the list, as was Germany’s troubled Hypo Real Estate. According to the OECD, Hypo’s capitalization was so inadequate that a sovereign debt crisis in any one of Italy, Spain, Ireland or Greece would put its survival in question.

The European institutions did not have the authority to intervene in national banking policy. The funds for recapitalization that had been created in 2008–2009 were spotty and facultative rather than mandatory in their application.51 National governments were too complacent and unwilling to disturb the comfortable status quo. Instead, Europe engaged in a double pretense. The troika went on pretending that Greek debt was sustainable, if only Athens adopted enough austerity. This was not true, as was becoming evident month by month: Greece was simply being driven into the ground.

Meanwhile, the stress tests purported to show that Europe’s banks were robust, which they clearly were not. Indeed, their weakness ought to have been the best argument for refusing to risk Greek restructuring. This, however, was not an argument that the ECB could make out loud, for fear of triggering panic. Furthermore, it would have necessitated serious action on the recapitalization front, which both the banks and the national governments resisted. Caught in this double bind, the troika was reduced to pretending that all was well on every front. Meanwhile, in Greece unemployment rose from a low of 8 percent in the summer of 2008 to more than 12 percent in 2010. For young people it was already more than 30 percent.

If the Greeks were the victims of extend-and-pretend, who were the beneficiaries? Billions of euros from the first tranche of the May 2010 program were disbursed to Athens, which in turn paid them to its creditors.

Those who were lucky enough to hold debt expiring in 2010 or 2011 were paid on time and in full. Those banks that decided to cut their losses and sell out could find buyers among the hedge funds who picked up debt for as little as 36 cents on the euro, gambling that things could only get better and that in the worst case they would get some cut of a final settlement.52 French and Dutch banks seem to have been most active in breaching the informal embargo on Greek bond sales. French bank holdings of Greek debt fell between March and December 2010 from $27 billion to $15 billion, Dutch from $22.9 billion to $7.7 billion.53 But the flight out of Greek bonds did not extend to the entire periphery.

As they sold off Greek and Irish bonds, Europe’s banks chased yield by rotating their money into Spanish and Italian bonds.54 In general one might have expected European banks with an interest in their own survival and prosperity to be energetically recapitalizing and reorienting their businesses for a future beyond the crisis. But there was little sign of that. Whereas America’s big banks operated under the discipline of annual ‘capital plans’ and were required to retain whatever profit they didn’t distribute as bonuses so as to rebuild reserves, Europe’s banks were free to do as they saw fit. In a desperate effort to keep their shareholders happy, they paid out what little profit they earned in dividends in the hope that at some point in the future they would be able to raise new capital.55 But that moment was not now.

III

In the Greek case the question of restructuring debt and forcing the banks to recognize losses had been kept off the agenda. But Ireland forced it back into play. Astonishingly, in the summer of 2010 all of Ireland’s banks were passed as fit by the European stress tests, even Anglo Irish Bank, the most notorious basket case of 2008. At that point Irish bank borrowing from special ECB facilities already came to 60 billion euros and the entire Irish banking system was only weeks away from a ‘funding cliff,’ when the government guarantee issued in September 2008 would expire and they would lose all access to funding markets. Thereafter they would be entirely dependent on the Irish central bank and the ECB. On September 30 the Irish government announced that, given its obligation to backstop the banks, in 2010 Ireland’s public borrowing requirement would surge from 14 percent to a jaw-dropping 32 percent of GDP. This would take Ireland’s public debt from a modest 25 percent of GDP in 2007 to 98.6 percent in 2010. The Irish government, once a paragon of austere public finance, was forced to withdraw from the bond market.56

If Ireland were to continue to honor the entire debt burden of its banks, owed in large part to foreign investors, the impact would be harrowing. Since the onset of the crisis in 2008, Irish incomes had been subject to emergency levies, young people’s job-seeker allowances had been slashed, health benefits for those over seventy were means-tested, public sector pay was cut between 5 and 10 percent, welfare recipients saw cuts of 4 percent and child benefits were reduced.57 The bank bailout costs announced in September implied further cuts and tax increases. Informally, with the assistance of the IMF, Dublin began exploring its options.58 A vocal faction within the IMF had never reconciled themselves to their retreat over Greek debt restructuring. Ireland presented an opportunity to bail in the investors who had profited from Ireland’s financial boom. If only the creditors of the most troubled Anglo Irish Bank took a haircut, the savings were estimated at 2.4 billion euros. If investors in all four of the protected banks were haircut, the budgetary relief might amount to as much as 12.5 billion euros. In relation to total tax revenue of 32 billion euros, these were huge savings. The position of the ECB was well known by this point. It would fight restructuring to the last ditch. But what would be the position of the rest of the eurozone? German public opinion was running ever hotter against any further eurozone programs that did not require the banks and their investors to contribute.59

On October 18, 2010, Sarkozy and Merkel were hosting President Medvedev of Russia at the Norman seaside resort town of Deauville. Somewhat to the alarm of Washington, the announced agenda of their meeting was to discuss future areas of cooperation for foreign policy, notably in the Middle East.60 The news from Deauville would make headlines. But it was not the Atlantic alliance that was at stake. It was the eurozone. Without consulting with their eurozone partners, the ECB or the United States, Merkel and Sarkozy – soon to be dubbed ‘Merkozy’ – hammered out a new agenda. It consisted of a blend of French and German ideas. The Stability and Growth Pact first agreed in 1997 would be reinforced with German-style constitutional debt brake rules. But the French got Germany to agree that when it came to disciplinary measures there must be an element of political discretion.

Sanctions would be triggered only by a qualified majority vote in cases where governments ran deficits greater than 3 percent of GDP or debts in excess of 60 percent of GDP. Sanctions would be tough – up to and including deprivation of voting rights. But discipline was not all. There would also be an institutionalized version of the European Financial Stability Facility, which would be put on a solid legal footing by 2013 at the latest, by way of treaty change. It would provide emergency loans to any eurozone member in trouble. But there would be no repeat of the Greek deal. Merkel and Sarkozy agreed that as of 2013, in any future crisis, creditors would be bailed in. It would not just be taxpayers who put up new funds. Haircutting the creditors would help to bring debts down. It was equitable. And it would serve a useful disciplining function. Creditors would take their responsibilities more seriously if they knew that they had skin in the game. The package was announced without forewarning in a press release late in the afternoon of October 18, 2010.

To say that Deauville came as a shock would be an understatement. France and Germany had acted alone. It smacked of the old days, of the Europe of the Six, not the new Europe of the post– cold war era. Not only had they acted alone but they had addressed what everyone knew was the hot-button issue of the crisis – PSI and debt restructuring – unilaterally and without preparing either the markets or their partners. For Trichet it was a disaster. The unspeakable contingency of restructuring had been blurted out in public. When the news of Merkel and Sarkozy’s deal reached Luxembourg, where the finance ministers were meeting, the president of the ECB was incandescent. ‘You’re going to destroy the euro,’ Trichet shouted across the conference table at the French delegation. Ten days later Trichet confronted Sarkozy face-to-face. ‘You don’t realize how serious the situation is,’ he belabored the French president, only for Sarkozy to snap back: ‘Maybe you’re talking to bankers … We are responsible to citizens.’61 Trichet might have prioritized confidence in financial markets, but Merkel and Sarkozy had to consider the indignation of European voters. In the Bundestag Merkel knew that majorities for her European policy would be fragile, at best, if haircuts were not part of the deal.62 As Mario Draghi, Trichet’s successor, would later acknowledge, talk of PSI might be premature from the point of view of the markets, but ‘to be fair again, one has to address another side of this. The lack of fiscal discipline by certain countries was perceived by other countries [i.e., Germany] as a breach of the trust that should underlie the euro. And so PSI was a political answer given with a view to regaining the trust of these countries’ citizens.’63

How much damage did the Deauville announcement really cause? Advocates of extend-and-pretend would insist forever after that it was Merkel and Sarkozy who tipped Ireland over the edge, that Trichet was right, that this was Europe’s ‘Lehman moment’: an unforced, politically motivated error. But, as in the case of Lehman, political and technical judgments were mingled. Given its gigantic budget deficit and the expiry of the 2008 guarantee for its banks, Ireland was heading into rough waters in any case, with or without Deauville. Spreads on Irish government debt were already surging before Merkel and Sarkozy’s surprise announcement. Deauville did not help. But it did not cause a market panic. The markets were already reckoning with the risk of a bail-in.64 The main impact of Deauville was to harden the attitude of the ECB. Trichet was determined that Dublin should not use Merkel and Sarkozy’s announcement as cover to burn the banks’ bondholders. Instead, Ireland must accept a program like that imposed on Greece. And, as in Greece, with Irish banks wholly dependent for their day-to-day survival on ECB funding, Trichet had the whip hand.65

Dublin did not surrender without a fight. To find itself pushed into the financial emergency ward alongside Greece was a humiliating shock. So the ECB applied main force. On November 12 the ECB Governing Council threatened to withdraw support from the Irish banking system while leaking to the media that Ireland was about to apply for a bailout. On November 18 the Irish central bank chairman, Patrick Honohan, fresh from an ECB meeting in Frankfurt, contacted Irish broadcaster RT. to say that a national bailout was only days away.66 On November 19 Trichet spelled out to the Irish prime minister in a confidential letter the conditions under which the ECB would be willing to extend its assistance to the Irish banks.67 Dublin must immediately apply for aid and submit to the instructions of the troika. It must agree to an urgent program of further fiscal consolidation, structural reforms and financial sector reorganization. The banks must be fully recapitalized and the repayment of the ECB’s short-term financing for the Irish banking system must be fully guaranteed.

Despite the exorbitant quality of the ECB’s demands, on November 21 Dublin had no option but to comply. The Irish Times responded with a remarkable editorial that captured the mood of national humiliation. It was emblazoned with a line from Yeats’s elegy to romantic Irish nationalism, ‘September 1913’ – ‘Was it for this?’ Was it for this, the paper asked, that Irish nationalists had fought their centuries-long struggle: ‘a bailout from the German chancellor with a few shillings of sympathy from the British chancellor on the side. There is the shame of it all. Having obtained our political independence from Britain to be the masters of our own affairs, we have now surrendered our sovereignty to the European Commission, the European Central Bank, and the International Monetary Fund.’ But rather than lapsing into self-pity, the Irish Times went on: ‘The true ignominy of our current situation is not that our sovereignty has been taken away from us, it is that we ourselves have squandered it. Let us not seek to assuage our sense of shame in the comforting illusion that powerful nations in Europe are conspiring to become our masters. We are, after all, no great prize for any would-be overlord now. No rational European would willingly take o the task of cleaning up the mess we have made. It is the incompetence of the governments we ourselves elected that has so deeply compromised our capacity to make our own decisions.’68

For all its brilliance, not the least remarkable thing about this editorial is where it put the blame. ‘The governments we ourselves elected’ bore the historic guilt, not Ireland’s bankers, investors and their business partners across Europe and the wider world, not financial experts, economists and regulators. The loss of political sovereignty was no doubt painful. But who would really pay the price for ‘cleaning up the mess’? Would it be voters and taxpayers, or those who had profited from inflating the credit bubble?

In the Greek case, at least, the debts were public. In Ireland taxpayers were being asked to pay for huge losses incurred by deeply irresponsible banks and their investors all over Europe. On December 7 Dublin announced a budget with a new round of 6 billion euros in cuts, half of what would have been saved if the bank bondholders had been haircut across the board. Instead taxes were raised on low-paid workers. Child-care allowances were cut and college fees were increased. Benefits for the unemployed, caregivers and the disabled were slashed.

Setting aside the gross inequity of the troika’s demands, was it even plausible that Ireland posed risks of contagion comparable to Lehman? As Martin Sandbu of the Financial Times put it with rare force: ‘Lehman was a global bank.’ Its business ‘was at the heart of the world’s financial plumbing.’

Not rescuing it proved to be a disaster. The Irish banks, by contrast, were ‘a small racket in Europe’s financial periphery, busily and exuberantly losing … investors’ money in the time-honoured way of lending more for houses than they were worth.’ Nothing ‘systemic’ depended on their creditors being repaid in full.69 Of course there was some risk of spillovers. But if French and German banks suffered collateral damage, that was because they had participated so enthusiastically and profitably in the Irish boom.

Given that responsibility was so widely spread, was it reasonable to impose the entire cost of containing the fallout on Ireland’s taxpayers alone? As Ajai Chopra of the IMF later remarked: ‘Yes, there would have been spillovers. But … the ECB could have stepped in … That’s what a central bank is for, to deal with these sorts of spillovers.’70

But that was not the kind of central bank the ECB thought itself to be. On November 26 its representatives in Dublin made clear that if haircutting was involved, there would be no bailout. A day later the IMF team in Dublin received direct instructions from Washington to drop any further efforts to enroll the banks. The finance ministers of the G7 had let Dominique Strauss-Kahn know that none of them welcomed talk of haircuts, and this was particularly true of the United States. As Tim Geithner later put it:

‘I was on the Cape [Cod] for Thanksgiving, and I remember doing a G7 call … in my little hotel room … I said, “If you guys do that [haircuts], all you will do is accelerate the run from Europe … [U]ntil you have the ability to in effect protect or guarantee the rest of Europe from the ensuing contagion, this is just [a] metaphor for our fall of ’08.”’71 With the IMF heretics silenced, the Irish were left with no alternative. Prime Minister Lenihan admitted resignedly: ‘I can’t go against the whole of the G7.’ For Ireland to haircut unilaterally would be ‘politically, internationally, politically inconceivable.’72 On November 28 Ireland agreed to accept 85 billion euros in emergency loans: 63.5 billion euros from the troika; the rest came in the form of bilateral support from other EU members, notably the UK, whose own financial markets had contributed so much to the debacle.

Another deal was sewed up. Debts would be honored. The population of Ireland paid the price. A ‘Lehman moment’ was avoided. But the result was not to restore confidence to the markets. The European financial crisis could not be contained by transferring the costs to taxpayers on a nation-by-nation basis. The resulting bailouts preserved the form of stability, but were not credible in their substance. In two surges, first in the spring and then in the fall of 2010, spreads on European bank credit default swaps – the price of insurance against default on bank bonds – surged above those charged to American banks. The first trigger was Greece, the second was Ireland. Europe’s financial crisis was simply too big and too interconnected to be handled on a national basis. The losses needed either to be pushed down to the investors all across Europe who had profited from the banks’ unsustainable business models or to be raised to the level of a coordinated European bailout. Extend-and-pretend on a national basis merely turned banking crises into fiscal crises, which widened uncertainty while deflecting attention from the real issue.

IV

In their defense, legalists at the ECB would argue that the central bank’s mandate gave it only one objective, price stability. They could derive from that an obligation to maintain the functioning of Europe’s financial markets and Europe’s banks. And Trichet would thus justify his interference in Greek and Irish affairs and more to come. What the ECB did not have was a mandate to concern itself with the economic welfare of the eurozone or its member states in any broader sense. It was a willfully simplistic and conservative interpretation.73 It was ruinous for the eurozone. The crisis would begin to be overcome only when the ECB began to step beyond it.

The Fed never took such a narrow view. It had a mandate both to preserve price stability and to maximize employment. This was a legacy bequeathed by the more broad-gauge economic policy debate of the 1970s. But it was anchored deep in the Fed’s organizational DNA by the memory of the Great Depression. The deflationary misery of the 1930s was the defining event in the Fed’s history. That was the history that Bernanke had pledged not to repeat. In 2010 the United States had survived the worst of its crisis. But it was far from fully recovered. The housing market was still in shock. The percentage of outstanding mortgages in foreclosure proceedings was heading toward a grim record over the winter of 2010– 2011 at 4.64 percent – more than 2 million homes. Since early in 2010 Bernanke had been sounding the alarm about an excessive tightening of fiscal policy. On the afternoon of November 3, the day after the dramatic midterm congressional elections, the Fed announced its response. After an intense internal debate, the Federal Open Market Committee resolved to begin purchasing securities at the rate of $75 billion per month for the next eight months. QE2 had arrived.

How exactly quantitative easing works remains a subject of controversy.74 Large-scale purchasing of mainly short-term bonds drives up bond prices and thus reduces yields. Reduced short-term rates may help to lever down long-term rates and thus to stimulate investment. But that depends on there being businesses willing to invest, which cannot be taken for granted at a time of crisis. The most direct effect of QE comes via financial markets. As the central bank hoovers up bonds, it drives down yields, forcing asset managers to go in search of yields in other classes of assets.

Switching out of bonds into stocks inflates the stock market, increasing the wealth of those with stock portfolios, tending to make them more willing to both invest and consume. This, to say the least, is an uncertain and indirect method of stimulating the economy. By boosting the wealth of already wealthy households, it is predestined to increase inequality. Low-income households have no way of participating in capital gains.

QE was never anything other than an emergency expedient adopted by the Fed in light of the fiscal policy logjam in Congress. But the Fed itself was not insulated from the polarization of American politics.75 The FOMC vote on QE2 was split three ways. A vocal minority argued that the stimulus should have been much larger. The markets had already priced in a QE2 announcement at $75 billion. To have a substantial impact the Fed needed to deliver a surprise. Bernanke demurred. He did not want to stray too far beyond the sense of ‘normality’ because to do so might in fact stoke a mood of anxiety and thus be counterproductive.76 As Bernanke put it at the meeting to critics on the board: ‘There is no safe thing to do … I’d like to frame our decision today as a very conservative, middle-road approach, namely, we recognize that doing nothing carries serious risks of further disinflation and of a failure of the recovery to meet escape velocity.’77 On the FOMC there were also two votes objecting to QE2 not on the grounds that it was inadequate but because it was too expansionary.

Beyond the Fed’s walls the reactions were more intemperate. In the superheated political climate of the Republican election triumph of November 2010, what hogged the headlines was the news that the Fed was embarking on a plan to ‘print’ tens of billions of dollars every month. On the part of the conspiratorial right wing, Bernanke’s intervention reinforced the conviction that dark forces were at work. Glenn Beck warned his millions of Republican viewers on Fox that they should not be deceived by their congressional victory; the actual reins of power were held by liberal inflationists. What threatened America was a hyperinflationary ‘Weimar moment.’78 Meanwhile, a prominent list of conservative intellectuals, including – once again – historian Niall Ferguson and Amity Schlaes of the Council on Foreign Relations, joined Sarah Palin in calling on the Fed to ‘cease and desist.’79 Significantly, they pointed out that ‘[t]he Fed’s purchase program has also met broad opposition from other central banks’ across the world. This was no exaggeration. After eighteen months of wrangling at the G20 over fiscal policy, QE2 produced an open rift over monetary policy.

This was predictable, but it was not necessary. The two agenda-setting innovations of October and November of 2010 – the Merkozy PSI agenda of Deauville and Bernanke’s QE2 – could have been complementary. As Chopra of the IMF had laid out, the ideal accompaniment for aggressive debt restructuring in Ireland would have been an ECB bond-purchasing program designed to insulate the other fragile members of the eurozone from the fallout. The push for PSI and bond market intervention were both responses to the inadequacy of the course embarked upon in Greece in May 2010. But in the eurozone the two never joined hands. Instead, rather than seeing QE as the necessary accompaniment to a more sustainable resolution of the eurozone debt crisis, Berlin’s conservatives led the international front against monetary experiments.

The Fed announced QE2 only days before President Obama and his team departed for the latest G20 summit, this time in Seoul. There they met unprecedented criticism. In the words of one of the US Treasury officials who ran the gauntlet, Seoul was a ‘shitshow.’ The Brazilians, as the putative leaders of the left wing of the emerging markets, inveighed against the risks of hot money and accused Bernanke of a beggar-thy-neighbor devaluation of the dollar. They warned of a ‘currency war.’80 For the Chinese, the Fed’s action was a sign that ‘[t]he United States does not recognize … its obligation to stabilize capital markets,’ as Zhu Guangyao, China’s vice finance minister, put it. ‘Nor does it take into consideration the impact of this excessive fluidity on the financial markets of emerging countries.’81 Wolfgang Schäuble went furthest. Once more America had revealed itself as an agent of global economic disorder. First it had created the fiasco of Lehman. Then it had championed stimulus. Now the Fed was monetizing public debt. As the G20 convened, the German finance minister denounced American economic policy as ‘clueless’ and as likely to ‘increase the insecurity of the world economy.’82 The Fed’s policies made ‘a reasonable balance between industrial and developing countries more difficult and they undermine the credibility of the US in finance policymaking.’ Whereas Germany had stuck with its model of export success that did not need ‘exchange rate tricks,’ the ‘American growth model’ was, according to Schäuble, ‘in a deep crisis. The Americans have lived for too long on credit, overblown their financial sector and neglected their industrial base.’83

The Americans did not go down without a fight. Tim Geithner countered that the real source of imbalances in the world economy was not US monetary policy but the mercantilist trade policies of China and Germany. The Fed was not deliberately depreciating the dollar. It was targeting domestic conditions, not the exchange rate.84 If others wanted to prevent their currencies from appreciating, all they had to do was to match the Fed’s low interest rate policy with an expansion of their own. What the critics dubbed a ‘currency war’ could thus have been turned into a comprehensive program of monetary expansion, countering the slide into a double-dip recession not just in the United States but in Europe as well. If they didn’t choose to join the stimulus, then all they had to do was to allow their currencies to appreciate, which, as Washington had been preaching since the early 2000s, would restore balance naturally. It was Germany’s export dependence and China’s determination to peg its currency that put the United States in charge. If they wanted to free ride on American aggregate demand, they should at least have the grace to do so quietly. If there were grievances, Geithner suggested, why not agree to allow the IMF to resume the project begun before the crisis, of monitoring and overseeing international imbalances, not only America’s deficit, but China’s and Germany’s surpluses as well.85 But that was a nonstarter. Germany would never admit that its trade surplus was anything other than a reward for its competitiveness and productive virtue. The back-and-forth had the effect only of producing a dizzying moment of unreality. While tens of millions were without work and the European welfare state was hollowed out at the behest of the troika, Fox News terrorized its viewers with images of Ben Bernanke as a sorcerer’s apprentice unleashing Weimar-style hyperinflation and Germany’s finance minister denounced a proposal by the US Treasury secretary as reminiscent of the bad old days of Soviet-style ‘economic planning.’86

While Berlin denounced QE as a source of instability, Europe’s banks took a very different view. For every billion dollars’ worth of securities the Fed purchased, it credited an account with a corresponding amount of dollars. But who was it that held those dollar accounts with the Fed and thus ‘funded’ QE? As the Fed’s statistics show, it was not America’s banks that took advantage of QE to unload large portfolios of bonds or to hold cash, though some American pension funds and mutual funds did sell bonds to the Fed. The banks most actively involved in QE2 were not American but European, running down their US securities portfolios and building up Fed cash balances.87 From November 2010 there is a near one-for-one identity between the expansion of the Federal Reserve balance sheet and the expansion of dollar cash balances held by non-US banks with the Fed. This would suggest that, far from the Fed increasing the ‘insecurity of the world economy,’ it was, in effect, acting as the world’s piggybank. As the eurozone stumbled back toward crisis, Europe’s banks abandoned the standstill agreement of May 2010. They shifted money out of Europe, shrank their US operations, deleveraged their balance sheets and built up a huge pile of cash.

Thanks to QE2 they held that liquidity reserve not with the ECB but with the ultimate guarantor of the global financial system, the Fed. It was not a recipe for economic expansion. But in the absence of any solution to the eurozone crisis, it did at least promise a cushion of stability.

This is an extract from Adam Tooze’s book Crashed, London: Allen Lane 2018. An Estonian translation was published in the Jan-Feb 2019 issue of the journal Vikerkaar and is available online here.