········ A ················ t a closed-door meeting in Washington on 14 April, Europe's effort to contain its debt crisis began to unravel.
Inside the French ambassa- dor's 19-bedroom mansion, fi- nance ministers and central bankers from the world's largest economies heard Dominique Strauss-Kahn, then-head of the International Monetary Fund (IMF), deliver an ultimatum.
Greece, the country that trig- gered the euro-zone debt crisis, would need a much bigger bail- out than planned, Strauss-Kahn said. Unless Europe coughed up extra cash, the IMF, which a year earlier had agreed to share the burden with European countries, wouldn't release any more aid for Athens.
The warning prompted a split among the euro zone's repre- sentatives over who should pay to save Greece from the biggest sovereign bankruptcy in histo- ry. European taxpayers alone?
Or should the banks that had lent Greece too much during the global credit bubble also suffer?
The IMF didn't mind how Eu- rope proceeded, as long as there was clarity by summer.
“We need a decision,“ said Mr.
Strauss-Kahn.
It was to be Europe's fateful spring. A Wall Street Journal in- vestigation, based on more than two dozen interviews with euro zone policy makers, re- vealed how the currency union floundered in indecision--fail- ing to address either the imme- diate concerns of investors or the fundamental weaknesses undermining the euro. The consequence was that a crisis in a few small economies turned into a threat to the sur- vival of Europe's common cur- rency and a menace to the global economy.
In April, after a year of drama and bailouts, the euro zone seemed to have contained the immediate crisis to Greece and other small countries. Crucially, euro zone economies such as Spain and Italy had avoided the panicked flight of capital. They were still able to borrow money at affordable rates in the bond market.
But by July, the rift among euro zone leaders over who should bear the burden of Greece's debt had prompted in- vestors to shun all financially fragile euro nations. Like a wild- fire, the spreading uncertainty threatened to engulf the whole of Europe's indebted south, to outstrip the resources of its richer north and to burn down the symbol of Europe's dream of unity, its single currency.
Now, as the bloc's leaders rush to forge a closer political union, the lesson of that period looms large. Investor trust in public debt is part of the foun- dation on which all nation- states depend. And in Europe's common currency--a unique experiment with the livelihoods of 330 million people--nations will win or lose that trust to- gether.
The dispute at the Washing- ton meeting divided two of the Continent's grand old men, both of them born in 1942 and both among the fathers of the euro. Wolfgang Schäuble, Ger- many's ascetic and irascible fi- nance minister, understood the IMF's ultimatum. The euro zone would have to draw up a second bailout package for Greece by summer, just a year after a loan deal for 110 billion, or $140 billion.
But this time, Schäuble said, “We cannot just buy out the pri- vate investors“ with taxpayer money. That would reward reckless lending, he said, and it would never get through an in- creasingly impatient German parliament. Greece's bondhold- ers would be required to lend more money, Schäuble pro- posed, rather than take pay- ment for their bonds at maturi- ty.
Jean-Claude Trichet, the ur- bane French head of the Euro- pean Central Bank (ECB), warned against forcing bond- holders to put in more money, which would effectively delay repayment. “This is not a good way to go in a monetary union,“ Trichet said. “Investors would avoid all euro-area bonds.“
Trichet, in the twilight of a 36-year career as a finance offi- cial, feared that if Greece didn't honour its bond debts on time, the implicit trust that kept cred- it flowing to many weak euro zone governments would shat- ter. More countries and their banks would lose access to cap- ital markets, in a chain reaction with incalculable consequenc- es. The April meeting ended in- conclusively.
Meanwhile, the cost for fixing Greece was rising. The Athens government's budget deficit was stuck at a stubbornly high level.
Italian and Spanish borrow- ing costs were still affordable and stable. The yield on Spain's 10-year bonds hovered around 5.3%; on Italy's, around 4.6%.
The debate over making bondholders contribute to the new funding package for Greece--known as private-sec- tor involvement, or PSI--divid- ed euro zone countries.
Germany had allies. In the Netherlands and Finland, new governments had promised vot- ers they wouldn't pay for prob- lems in less-frugal Mediterra- nean countries. Breaking those promises would risk rebellions in parliament.
But France joined the ECB in resisting burden-sharing by bondholders. France's banks had lent more heavily than Ger- many's to Greece and other in- debted euro nations, and France fretted about a Lehman Brothers-style banking-system meltdown. Italian officials also feared that a precedent for loss- es in Greece would scare inves- tors away from Italy's bonds.
Three weeks after the Wash- ington gathering, on Friday, 6 May, panic erupted. German news weekly Der Spiegel report- ed that Greece was thinking of leaving the euro zone, with pol- icy makers heading to a secret meeting that night in Luxem- bourg. The report was half- right. There was a meeting, but Greece was staying put.
Inside a country chateau, top euro zone officials told Greece's finance minister they expected deeper austerity and faster re- forms in return for a new aid package.
Then Schäuble said he want- ed to discuss how bondholder burden-sharing would work.
The usually smooth-mannered Mr. Trichet lost his patience. “I want to put my position on the record,“ he said: “I don't agree with private-sector involve- ment, so I won't take part in a discussion about the practicali- ties.“ He stormed out.
Trichet's assent was vital. If the ECB were to stop accepting Greek bonds as collateral for its lending to banks on the grounds that the bonds were in default, then Greece's banks, which were stuffed full of their government's bonds, would quickly run out of cash and col- lapse. That would radically drive up the cost of a rescue.
In Greece, a new wave of mass strikes and demonstra- tions was starting. Protesters, angry about Europe's imposi- tion of extra spending cuts and tax hikes, clashed with police in front of the Athens parliament in the biggest and most violent protests in a year.
Spanish and Italian bond prices remained stable. But Eu- rope was at a dangerous im- passe over Greece.
Many euro zone governments hoped Mr. Strauss-Kahn could find a way to relax the IMF's summer deadline. The IMF chief was due to discuss the matter with German Chancellor Angela Merkel in Berlin on 15 May, and with euro zone fi- nance ministers in Brussels the next day.
Strauss-Kahn couldn't at- tend. Police in New York pulled him off his Paris-bound flight and charged him with sexually assaulting a hotel chamber- maid. (The charges were later dropped, and prosecutors said they doubted the maid's reli- ability.) An aide phoned Merkel at her central-Berlin home that Saturday and told her the news. The astonished chancellor re- sponded with a German idiom that translates roughly as: “You couldn't make this up.“
The IMF sent a lower-ranking official to Brussels in his place who had no latitude to deviate from the IMF's deadline.
In Athens, meanwhile, a tent city of the “Indignant“ protest movement--a groundswell of anger at the country's impover- ishment--sprang up outside parliament. Spain's bond pric- es began to wobble as investors worried that other countries might also face debt restructur- ing. On 1 June, Schäuble's dep- uty, Jörg Asmussen, presented a German plan at a meeting of finance officials in Vienna, at the Hofburg palace of the for- mer Habsburg emperors. It in- volved pressuring Greece's bondholders to swap their Greek debt for new IOUs that would come due far in the fu- ture. That would cut the amount of European taxpayer funding Greece would need.
After a meal in a palace ban- quet hall, the officials quar- relled into the wee hours.
For the ECB, Trichet's deputy Vitor Constâncio, of Portugal, denounced the German plan as “dangerous.“ Credit-rating agencies would declare Greece to be in default on some of its debts--a so-called selective de- fault. In that case, Constâncio warned, the ECB would refuse to accept Greek government bonds as collateral, dealing a death blow to Greek banks.
France, Italy and Spain all sup- ported Constâncio.
Germany's Asmussen shot back with a threat of his own.
Europe needed Germany's money to fund a new pro- gramme of Greek loans. “With- out private-sector involve- ment,“ he said, “there will be no program.“
Greece was descending into chaos. Embattled premier George Papandreou's slender majority in parliament was fray- ing. On 15 June, a swelling demonstration in Athens's central square veered out of control.
Alone in his office, Papan- dreou phoned the parliamenta- ry opposition leader and of- fered to make way for a nation- al-unity government. Talks broke down, and the Greek government limped on badly wounded.
Even Merkel had some doubts about her finance minis- try's hard-line insistence that Greece's bondholders take a loss. On 17 June, she discussed a softer plan with French Presi- dent Nicolas Sarkozy: a gentle- man's agreement under which Greek bonds would be hon- oured but the bondholders would volunteer to buy new ones.
Schäuble pushed back. The veteran conservative politician was Berlin's biggest supporter of the European dream, but he was also the keeper of Ger- many's purse. He was deter- mined to make banks share the burden with German taxpayers, and he didn't trust them to keep a gentleman's agreement.
When finance ministers met again on 20 June, Schäuble pushed harder. Greece's bond- holders should be told not merely to accept a delay in re- payment, he said, but also to forgive some Greek debt--a so- called haircut.
As Greece's economy moved toward free fall, its debts were soaring beyond the country's ability to pay, the Germans and their northern allies argued.
Trichet and the southern coun- tries resisted. Talks dragged on for hours. The ministers knew they couldn't leave without some agreement.
They tried to please everyone: Greece would get more aid.
Bondholder losses would be substantial, to placate the Ger- mans, Dutch and Finns. But as the ECB insisted, they would avoid pushing Greece into se- lective default.
Investors knew you couldn't have it both ways. As the threat of a Greek debt restructuring sank in, Southern Europe's bond markets grew volatile.
Spain's 10-year bond yield rose above 5.6%. Italy's reached 4.9%.
Greece's parliament debated the extra austerity measures that Europe demanded. Central Athens erupted in violent pro- tests. Anarchist youths tore up chunks of paving stone and threw them at riot police, who fired back with tear gas and stun grenades. Café parasols burned.
Europe hadn't resolved how to keep Greece afloat. The IMF--whose demand for a deci- sion had set off the whole argu- ment--softened its ultimatum.
IMF officials said they were sat- isfied that Europe would sort out some kind of new bailout, and wired Greece its summer aid payment on 8 July. It wasn't enough to calm markets.
Spain's bond yield hit 6.3%. Ita- ly's rose to over 5.8%. Such bor- rowing costs, if sustained, would make it hard for both countries to rein in their debts.
The selloff in bond markets forced leaders to call an emer- gency summit for 21 July.
Determined not to let the summit pass without an agree- ment, Merkel invited the French president, who objected to the German push for bond- holder losses, to Berlin. The pair and their advisers met for dinner in the German chancel- lery the night before the meet- ing. Few of them had time to touch the duck breast and vege- tables on their plates as they searched for a compromise. Fi- nally, Sarkozy said he would ac- cept the private-sector involve- ment--if Merkel dropped her resistance to giving the eurozone bailout fund broad new powers to buy debt of weak countries directly and move to protect such countries as Spain and Italy from bond-market contagion. Merkel agreed.
One more person needed to sign off. Merkel phoned Trichet at his Frankfurt office. He took the last Lufthansa flight to Ber- lin and arrived at the chancel- lery around 10 pm.
Reluctantly, Trichet gave his OK. But he set conditions. Gov- ernments would have to insure Greek bonds against default so that the ECB could continue to accept them as collateral. And they would have to make plain that no other euro country but Greece would have its debts re- structured.
The trio's deal was both com- plicated and vague. Their staffs had little time to flesh out de- tails before the next day's sum- mit in Brussels. As leaders trick- led into the European Union's boxy headquarters, Merkel faced a challenge to placate the euro zone's south, which thought private-sector involve- ment was dangerous, and its north, which thought it didn't go far enough. When the lead- ers assembled at the sprawling summit table, Merkel admitted that the specter of bondholder losses was causing market un- rest. But, she said, some Greek debt relief was essential. With- out it, the bailout's tough aus- terity conditions--made tough- er by Greece's missing its bud- get goals--would be seen as un- bearable.
“If Greece had met its pro- gram parameters in April,“ she snapped, “that would have helped.“
All 17 euro nations had to agree to private-sector involve- ment. But presented with a cal- culation that the plan would re- duce Greece's debt by only about 19 billion out of more than 350 billion total, Dutch Prime Minister Mark Rutte balked. If it's only 19 billion, he said, “I'm out. I need more.“
Finnish premier Jyrki Katain- en also complained. His parlia- ment wanted collateral in ex- change for more Finnish lend- ing to Greece. “No collateral, no agreement from me,“ he said.
Sarkozy was peeved. “All our parliaments can cause prob- lems,“ he said.
Then it was Slovakia's turn.
Prime Minister Iveta Radi ová was fighting to keep her coali- tion together over aid for Greece--a richer country than her own. Adding more powers to the bailout fund “would be suicide,“ she said.
Greece's Papandreou plead- ed for help. “If we can't solve even Greece, we won't be seen as being able to solve anything else,“ he said. Hours later, the leaders had a communiqué. To appease the holdouts, it left key points broad and noncommit- tal, offering the possibility of collateral to Finland and de- scribing the complex bond- holder deal in a few strokes, vague language that would re- turn to haunt the bloc.
Officials struggled to explain the new Greek bailout and the bondholder losses. Amid the confusion, Rutte dispensed muddled numbers. Bank ana- lysts put out flawed reports.
Investor confidence faltered as it became clear that Europe's compromise achieved the worst of all worlds. Greece would be pushed into a historic de- fault--the first time in nearly 60 years that a developed, Western country wouldn't honor its debts. But the default was so small that Greece was still left with a crushing debt burden.
And then official Europe went on vacation: Merkel to the Ital- ian Alps, Sarkozy to the French Riviera.
Bondholders didn't. They went on a rampage.
