"Longacre Square, New York." Soon to be renamed Times Square after the recently completed New York Times tower seen here.
(Revisiting The Limits to Complexity)
A little more than a year ago I wrote an article generally sketching out The Limits to Complexity that our global society faced back then and continues to face now. The speed at which some of these limits have materialized for the average consumer, business, investor, employee, taxpayer, politician and central banker in the developed world, while expected by many, has still been nothing short of flabbergasting.
Before revisiting the complex "solutions" formulated by governments and central banks to address the problem of over-complexity, we should briefly recap what has happened over the last decade and a half, more or less.
During and after the implosion of the "tech bubble" and the brief financial recession of the late 1990s, major banks and corporations around the world realized they needed a new "asset" which could be leveraged by consumers and businesses to support aggregate demand and, therefore, their revenues and profits.
With the help of aggressive fiscal policy, new government statutes (i.e. "Community Reinvestment Act"), the repeal of pesky "firewalls" ("Gramm-Leach-Bliley Act" repealing the "Glass-Steagall Act") and accommodating (low-interest) monetary policy, private banks pushed unfathomable amounts of debts onto people and businesses who could not afford them by any stretch of the collective imagination.
These same banks were also allowed to securitize many of the underlying loans, sell them off to various institutional investors and market derivative instruments to those clients who wished to gain exposure to the global sub-prime mortgage bonanza. When the greatest financial ponzi scheme known to man eventually collapsed in 2007-08 and it was clear that the global economy faced an imminent depression, governments worldwide decided to "respond".
What this response amounted to was an attempt to maintain economic and financial complexity by adding on layer after layer of ever-more complex structures, and suspending/manipulating any measure of reality that was in the least bit accurate.
Those layers, in part, took the form of unprecedented fiscal and monetary policy, which funneled trillions worth of taxpayer-guaranteed funds to banks that were deemed too complex too fail. So how did this big dose of complexity fare after the flames died down and the smoke cleared? Focusing on the U.S., here's what I wrote last year about Obama's $820B "American Reinvestment Recovery Act" (ARRA):
The Limits to Complexity"The [ARRA] allocated about $820 billion to various local governments and companies in an effort to create jobs. What they don’t tell you about the ARRA is how much of that money, as a matter of necessity, is wasted in bureaucratic institutions that distribute and keep track of the money as it is funneled down to economic actors. Much of the money also goes to funding extremely misguided projects, such as tax credits for homebuyers that incentivized the construction of new homes when there is already a year’s worth of excess supply.
Sometimes the money goes to fund the repair of roads that don’t even need any repair, as I have personally witnessed in my own community. New estimates have made clear that it is unlikely more than 1 million jobs were created by the ARRA stimulus, which amounts to $820,000 per job, some of which were not even productive for the general economy."
Despite the [misleading] BLS unemployment rate falling to 9.1% in 2011 (signifying more people who have given up looking for work), the employment situation has significantly deteriorated since last year. On Friday, the non-farm payroll numbers came in at +103K for the month of September, with about 40K of that coming from Verizon workers who ended their strike. The more accurate U-6 unemployment measure increased to 16.5%, its highest since December of 2010. Zero Hedge has calculated that at least ~261K jobs must be created every single month for the next five years for the unemployment rate to return to pre-2008 levels, and this number has been consistently increasing every time it performs the calculation. 
The number for August was revised upwards from ZERO jobs created to 54K, which is still an overall dismal print. Manufacturing jobs declined by 13K in the month of September, while average duration of unemployment hit an all time high of 40.5 weeks. . Initial claims have continued to hover around 400k per week for at least the last six months (and have been consistently revised upwards), which essentially implies no jobs are being created. .
According to the non-farm payroll report for August 20111, ZERO jobs were created in that month, with the employment numbers for June and July both being revised downwards for a total reduction of about -60,000. An additional 600,000 people from last year were working part-time "for economic reasons" and were "marginally attached" to the labor force. . Initial claims are still hovering around 400k per week for at least the last six months (consistently revised upwards), which essentially means no jobs are being created. .
It is quite clear, then, that Obama's stimulus did very little to spur job growth, and now he is facing an even bigger limit to complexity - a dearth of political capital to pass any new "jobs bills" through Congress. On the monetary front, policy mainly took the form of slashing the federal funds rate to near zero and launching asset purchase programs which targeted more than $2 trillion in mortgage-backed securities and Treasury notes/bonds over the last two years. As the principal on the MBS was paid down, that money was reinvested back into Treasuries (and now more MBS) to maintain the value of securities on the Fed's balance sheet.
The Limits to Complexity"The above policies serve to keep a floor on mortgage rates and finance our government’s deficits at low interest (what used to be stealth monetization is now just monetization), while also providing cash to banks with the alleged hope that they will lend it out into the economy, where consumers and businesses will spend/invest the loaned money. Out there in the real world, no such lending has happened, as the banks are sitting on $1+ trillion in cash and the Fed is caught in a liquidity trap.
[..] Private markets are currently saturated with debt and therefore very few people want to borrow money, and very few lenders want to make loans at affordable rates since debtors can barely pay back what they owe now. As mentioned before, interest rates have bottomed out and there is minimal economic activity to show for it. The velocity of money in the economy has collapsed, and the Fed’s policies merely transfer large sums of taxpayer money to major banks that use it to blow more speculative bubbles in stocks, bonds, commodities, and derivative bets on the price movements of those assets."
Since the time that was written, we have seen numerous destructive consequences derived from this monetary policy. The speculative bubbles mentioned above have led to soaring inflation in the Middle East, which, in turn, has been partly responsible for the ensuing sociopolitical unrest and violence. At the same time, global markets are largely back to the same valuations they were at a year ago when QE2 was implemented.
Banks are now sitting on at least $600 billion of additional cash (excess reserves deposited at the Fed). . Back then, I also mentioned that "equity outflows from institutional investing firms have continued for months unabated and have totaled over $50 billion year-to-date". Well, let's go ahead and make that a four-fold increase to $200 billion in the last two years. .
And since the Fall of 2010 is so out of style and the Fed does not currently have enough credibility to launch a similar asset purchase program, it has decided to merely shift the duration of Treasuries on its portfolio (swapping $400 billion in short-term bills/notes for $400 billion in longer-term bonds).
This "twist" operation has done absolutely nothing to spark appetite for risk and is actually perceived as being net negative for financial markets, since long-term rates will compress and the yield curve will be flattened even further, thereby limiting the ability of banks to generate profits from interest spreads. Another limit to complexity, perhaps?
Ben Bernanke has consistently punted the responsibility for supporting "confidence" in markets and the economy to the Administration and Congress in recent months, and they consistently prove to us that they are both politically and financially unable and unwilling to do anything meaningful for neither one nor the other.
Central authorities in the West have exhausted almost all of their tools for supporting financial markets, except for increasingly short-term liquidity measures. In addition, the policies they have enacted in the comfort of 2010 are now coming back to haunt them, as the publicly-sponsored complexity has made the system even more inflexible than it was before.
This layered complexity also took the form of Western governments placing an item misleadingly known as "financial reform" on their political agendas. In the U.S., "financial reform" amounted to federal politicians attempting to somehow regulate systemic financial stability into existence by creating a few new government agencies or sub-agency departments, which possessed a few more monitoring and enforcement mechanisms, and A LOT more bureaucracy.
These agencies were essentially tasked with monitoring "systemic developments" in the financial sector whenever they felt up to the task. I wrote the following about this issue soon after the Dodd-Frank bill had been passed into law:
The Limits to Complexity"[..] and the "finreg" bill failed to break up the TBTF banks, audit the Fed or create transparency for risky derivative products. More importantly, these new top-down regulations have the inherent feature of creating unintended consequences in our complex society, despite the alleged best intentions of their creators, and can even make the targeted problem worse.
The financial reform bill created new restrictions on "angel investors" which will inadvertently stymie the creation/expansion of small businesses, while the behemoth investment banks will continue to exploit financial markets by hiring teams of lawyers to easily bypass the new regulations that affect them (as they are currently doing with the "Volcker Rule") or by simply buying off the regulators."
Fast forward to today and we can clearly see that not a single soul on Earth, let alone those moving the markets, believe the Dodd-Frank Bill did anything to mitigate systemic risk or even make sure it could be adequately identified before developing into another full-blown crisis (which has already begun). And then, of course, we have the unintended consequences of complexity.
One major unintended consequence of the Dodd-Frank Bill that has recently asserted itself stems from the "Durbin Amendment" (introduced by Congressman Dick Durbin-D-Ill). What analysts are now labeling the "Durbin Tax" provides us with the quintessential example of diminishing returns to complexity. Forbes Magazine reports:
Bank of America Debit Card Fees Slammed as "Durbin Tax"The law applies to those big banks – the ones over $10 billion in assets – and was ostensibly passed as an effort to increase competition. It was supposed to be pro-consumer.
But here’s the kicker: the Amendment gave the Federal Reserve the power to regulate debit card interchange fees and other bits of banking admin, which they’ve done. Over the summer, the Fed released the final rule on the matter. The combination of fees, restrictions and caps is thought to cost banks subject to the amendment nearly $14 billion annually.
The banks could try to recoup this money from somewhere else – like merchants. But merchants now have the ability to shop around a bit more and of course, they could refuse to accept cards altogether. It was quicker, cheaper and easier for banks to go straight to the customer.
Forbes Magazine is simply a shill for the big banksters, but the underlying point remains true. When politicians attempt to regulate "financial consumer protection" into existence by layering on increasingly complex regulations, they are bound to create unintended situations such as this one. They are also bound to not even recognize that these consequences have occurred. That is why Congressman Durbin can create legislation that has forced banks to impose fees on their customers, and then stand on the floor of Congress a little over one year later and tell those same customers to "get the heck out of" Bank of America, because it had the nerve to impose a debit card usage fee!
It's not just Bank of America either, but Citigroup, Wells Fargo and JP Morgan who are also proposing to institute debit card usage fees on their customers. For the time being, people will put up with this extortion because they see no other convenient places to park their cash or ways to make their purchases and pay their bills.
Rest assured, though, that these measures are a sign of desperation by the major banks, and will eventually lead to much fewer commercial transactions by consumers, which will dampen economic growth and decimate the profit margins of banks even further. Of course, the limits to complexity are not only present in the U.S. financial system, but the entire global economy, as Europe, China, Japan, Canada, Australia and many other "emerging economies" can attest to.
Just last year, many of these regions were being hailed by mainstream analysts as survivors of the "Great Recession" and the future drivers of global economic growth. Now, their FIRE sectors are imploding and they are all following the U.S. and Europe down the swirling contours of the collective toilet bowl.
The financial topic du jour is, and has been for many months now, the critical situation in the EMU. At this point, there is very little need to even point out the limits to the EMU’s complexity. One clear example, though, is the most recent discussions about the size and nature of the European Financial Stability Fund (EFSF).
It was only a few weeks ago that the European leaders were discussing possibilities of expanding and/or "leveraging" the fund to adequately backstop the public financing needs of Italy and Spain, and prevent contagion from a Greek default. Today, some pundits and politicians are discussing whether the fund should instead be used to directly recapitalize Euro-area banks that are struggling to stay solvent. Stephen Castle reports for the New York Times:
Europe Calls for Infusion of Capital for BanksIf Europe did adopt a regionwide approach to recapitalizing the banks, the question is whether that money would come from the bailout fund agreed to in July, which must still be voted on by a handful of member nations. If adopted, as expected, that bailout fund — the European Financial Stability Facility — would gain an effective lending capacity of 440 billion euros ($595.4 billion).
That might be enough to provide the necessary capital cushion to the region’s banks. But it would leave little cash to lend to any national governments that might require aid to protect themselves from a Greek contagion. Spain and Italy are seen most vulnerable on that count.
Needless to say, there is bitter political disagreement on both of those issues and it is looking very unlikely that either will be done anytime soon, when the countries and banks need it the most to survive in their current form. . Financially speaking, it is simply impossible for France and Germany to backstop the entire Euro periphery OR major Euro-area banks, let alone both of them.
That fact becomes even more poignant when we consider another brutal limit to complexity in the form of France being downgraded by ratings agencies if it decides to bail out all of these other institutions. That would place enormous pressures on its own sovereign financing situation and effectively make it a non-factor in the bailout mechanisms.
Stephen Castle once more:
"France’s caution over recapitalization illustrates how each potential solution to the euro zone crisis tends to become entangled in member nations’ domestic politics. A downgrade of France’s debt rating would be damaging to the French president, Nicolas Sarkozy, ahead of presidential elections next year.
The problem is that if you recapitalize the banks, then you have a problem with sovereign debt," said one European official not authorized to speak publicly. "That is Paris’s big issue."
Sarkozy and Merkel are hashing it today (Sunday) to see if they can agree on just how badly the Western taxpayers will be shafted yet again. Paris has suggested to use the very recently expanded "stabilization fund", created to backstop sovereign bonds, and redirect much of it towards recapitalizing banks directly. Berlin has said so far that this is a ridiculous proposal and the fund is only to be used as a "last resort" for the banks. . Although Dexia, the Belgian bank that scored highest on the EU "stress test" earlier in the year and was the first to implode, has once again reminded us that the banks' first resort is the same as their second resort and every other resort up until their last resort: taxpayer-funded bailouts.
The problem for the panhandling elites is that these bailouts are not as simple and as much of a given as they used to be, which was evident in the decision over whether to bail out Dexia and to what extent. The bailout issue was finally “resolved” today as France and Belgium agreed to nationalize 100% of Dexia’s operations, which is 100% against the interests of Belgian and French taxpayers. The plan must still be submitted to Dexia’s Board of Directors, who are sure to approve of any public bailout they can get their greedy hands on. Reuters reports:
France, Belgium, Luxembourg agree Dexia Rescue"The burden of bailing out Dexia led ratings agency Moody's to warn Belgium late on Friday that its Aa1 government bond ratings may fall.
The negotiations to dismantle Dexia, which has global credit risk exposure of $700 billion -- more than twice Greece's GDP -- are being watched closely for signs that Europe might be capable of decisive action to resolve its banking crisis. "I am convinced that it is possible ... by tomorrow morning to have an agreement in which Belgium resolves the issue without pushing up the debt level of our country too high," Leterme told Belgian television before the talks began on Sunday.”
It’s not that Belgium may be downgraded, but that it will be downgraded if the deal goes through, and France’s ratings may come under some pressure as well. No matter what happens, Dexia is just the first of many European banks to pass the faux “stress tests” with flying colors and subsequently implode within months, including major French banks. When those banks reach the edge of bankruptcy and need a public bailout, there is no way France will come out of that with their AAA bond rating intact, and a French downgrade will feed into the need for even more bailouts. Since the implosion of Bear Stearns and Lehman Brothers nearly three years ago, nothing has changed. The limits to complexity have been stretched out a bit, but now they are well poised to snap back even harder.
It turns out that everyone who participated in the mainstream dialogue had bought into the narrative of a global economic "recovery" and had conditioned their policies and attitudes accordingly. Now, they are all left reeling from the strict, unflinching evolution of complex systems. The subject of "bailing out banks", which was too taboo to even discuss last year, is now priority #1 on the policy agenda in Europe (and will soon be in the U.S.), but there is simply not enough political or financial capital left to do the job.
Soon, the global financial system will be forced to revisit the limits to complexity, just as we have done today, and this time it will not be so easy for our leaders to avoid their implications.
Ilargi: Here's a global map of Occupy groups, as well as info on the one closest to you. There are now groups in 1200 cities(!). See here for more. You can also set up your own group there.
I have a lot of sympathy for the Occupy movement, but at the same time I fear for it. Seeing the faces of both Michael Moore and Glenn Beck (not to mention Nancy Bleeping Pelosi: she supports you, you're cooked) pop up in the same places will do that for me. All sorts of people attempting to ride the Occupy wave for personal gain and purposes is a huge risk. As is infiltration.
As I wrote earlier this week in Occupy This: Mark the Banks to Market, I think that in many instances, demanding that politicians mark all bank assets to market before any kind of financial support is given to banks, is one of the best, if not the best, period, goal to aim for.
Protesting bankers' greed is useless; bankers can only do what the political systems lets them, and as long as the system allows them to feed their greed, they will. So what protests should be targeted at is to change the political side of the equation. If the movement fails to understand this, it is destined for complete and utter failure. And that would be a bitter shame. It would also be exactly what those people want whom the movement agitates against. Be careful out there, guys!
The map for all Occupy groups and meetings in the world:
And the one nearest your location:
Ilargi: Update: I see a headline float by just now from the Telegraph that about perfectly grasps the "nonsenseness" of Nicolas Sarkozy's claim that he's sure the euro crisis will be over before the end of the month.
Nicolas Sarkozy and Angela Merkel set a date to save Europe
Sarkozy really said it. Why these people say such things, and what they are thinking, G-d only knows. What's he going to say on November 1 when everyone can see there's no such thing as the crisis being over? Who's he going to blame for it? And besides, if you know how to solve the crisis, there's no time like the present, right?!
Fitch Predicts Half of All US Prime Mortgages Will be Underwater
The sputtering U.S. housing market will result in more prime borrowers being pushed further underwater on their mortgages, according to Fitch Ratings in a new report. Recent analysis by Fitch shows that more than 30 percent of all prime borrowers in private-label securitizations are currently in a negative equity position on their mortgages.
"With home prices likely to decline another 10 percent, roughly half of prime borrowers will wind up underwater on their mortgage," said Managing Director Grant Bailey. Fitch also found over 12 percent of all prime borrowers are seriously delinquent on their mortgages. "Prime mortgage default rates will stay elevated as home prices fall further and unemployment remains high," said Bailey.
The combination of declining equity, rising delinquencies, growing payment shock risk and the application of Fitch's updated criteria led to further negative rating actions on prime residential mortgage-backed securities (RMBS) transactions in Fitch's latest ratings review. While Fitch either affirmed or upgraded 58 percent of prime RMBS ratings, 42 percent of prime RMBS ratings, primarily those already rated 'B' or below, were downgraded further by Fitch. Further, approximately 97 percent of investment-grade classes that Fitch downgraded were already on Rating Watch Negative prior to the rating revision.
Fitch has cited borrower equity as the pre-eminent driver of mortgage default performance in its new rating model. The number of underwater borrowers is likely to increase over time. With this latest rating review now complete, however, the application of Fitch's new criteria should result in greater rating stability going forward.
IMF advisor says we face a Worldwide Banking Meltdown
"If they can not address [the financial crisis] in a credible way I believe within perhaps 2 to 3 weeks we will have a meltdown in sovereign debt which will produce a meltdown across the European banking system.
We are not just talking about a relatively small Belgian bank, we are talking about the largest banks in the world, the largest banks in Germany, the largest banks in France, that will spread to the United Kingdom, it will spread everywhere because the global financial system is so interconnected. All those banks are counterparties to every significant bank in the United States, and in Britain, and in Japan, and around the world.
This would be a crisis that would be in my view more serious than the crisis in 2008.... What we don't know the state of credit default swaps held by banks against sovereign debt and against European banks, nor do we know the state of CDS held by British banks, nor are we certain of how certain the exposure of British banks is to the Ireland sovereign debt problems."
France, Belgium and Luxembourg agree Dexia deal
France, Belgium and Luxembourg said on Sunday that they had reached a deal to dismantle troubled bank Dexia, the first victim of the eurozone debt crisis. In a joint statement, the three countries said, "The proposed solution, which is the result of intensive consultations between all involved parties, will be submitted to the Dexia board, whose responsibility it is to approve the plan."
French and Belgian prime ministers, Francois Fillon and Yves Leterme, held a lunch-time meeting to finalise the deal to dismantle the bank, which also had to be rescued in 2008 at the start of the global financial crisis. Leterme said he hoped that Dexia's board of directors which met at 2pm BST would rapidly approve the deal. He said a final solution to the Dexia crisis "depends on the board", Belga news agency reported.
France and Belgium, Dexia shareholders after the 2008 bailout, needed to agree on the sale price of Dexia shares, including in its Belgian retail banking arm Dexia Bank Belgium that Brussels wants to buy. They also needed to agree on the guarantees backing up a so-called "bad bank" that will remain after Dexia's dismantling to hold high-risk assets.
After the Dexia board meeting key members of Leterme's cabinet were to convene later Sunday to give their blessing to the deal of which no details were immediately known. The three governments involved, who are keen to finalise a deal before stock markets open on Monday, said they were working together to "search for a solution that will secure Dexia's future".
The NYSE Euronext stock exchange suspended trading in Dexia shares on Thursday following a request of the Belgian market regulator, FSMA. Trading in the stock was halted during a session in which it had fallen 17.24pc to €0.85 per share.
The bank's woes were to figure highly during a summit by the leaders of France and Germany, the eurozone's top economies, in Berlin where Chancellor Angela Merkel and President Nicolas Sarkozy will try to find common ground on a plan to recapitalise banks amid rampant fears of a credit crunch.
France and Belgium, who were forced last week to step in and rescue Dexia, are in disagreement over the price for Dexia Bank Belgium, which the Belgian state now wants to buy, according to media reports. Credit ratings agency Moody's also warned on Friday that Belgium could be downgraded over its support for Dexia.
Moody’s places Belgium’s Aa1 ratings on review for possible downgrade
Moody’s Investors Service is placing Belgium’s Aa1 ratings on review for possible downgrade, as the country appears to be on the verge of paying a significant amount of money to prop up the French-Belgian Dexia bank.
In a statement late Friday, the ratings agency said the review was prompted by the increase in long-term funding risks for euro area countries with high levels of public debt, the risk that the debt will increase because of poor economic growth, and "the uncertainty around the impact on the already pressured balance sheet of the government of additional bank support measures which are likely to be needed."
After Dexia’s shares tanked this week amid fears it could go bankrupt, the French and Belgian governments stepped in and guaranteed its financing and deposits.
Fitch downgrades Italian and Spanish debt ratings
by Nicole Winfield - AP
The Fitch agency downgraded its sovereign credit rating for Italy and Spain today and said its long-term outlook for both countries was negative, citing high debt and poor prospects for growth.
Separately, Fitch also said it was keeping Portugal's debt rating on watch for a possible downgrade, with a decision due by the end of the year. Portugal was the third and latest eurozone country to receive an international bailout package after Greece and Ireland. Fellow ratings agency Moody's warned on Friday night that it has put Belgium on watch for a possible downgrade.
The reports are a blow to Europe's hopes of containing the debt crisis that has already seen three countries bailed out. Italy and Spain have the eurozone's third- and fourth-largest economies and are widely considered too expensive to rescue. Fitch downgraded Italy's creditworthiness from AA- to A+, citing high public debt, low growth and the "politically technical and complex" solution necessary to fix Italy's financial ills and earn back the trust of investors.
While saying Italy's recent austerity measures improved its standing, "the initially hesitant response by the Italian government to the spread of contagion has also eroded market confidence in its capacity to effectively navigate Italy through the Eurozone crisis," Fitch said.
The move came after Moody's Investors Service on Tuesday downgraded Italy's bond ratings to A2 with a negative outlook from Aa2. On September 19, Standard & Poor's cut Italy's long- and short-term sovereign credit ratings one notch, though its rating is still five steps above junk status. Despite the downgrade, Fitch said Italy's sovereign credit profile remains "relatively strong" and that its budget position compares favorably to other European countries.
Also Friday, Fitch cut Spain's sovereign debt rating by two notches to AA- from AA+, citing increased risks from the eurozone financial crisis as well as high debt in regional governments and weakening growth prospects. Like Italy, Fitch kept a negative outlook on Spain, but said it expected the country to remain solvent. It says that debt reduction efforts will weigh on growth and keep unemployment high. Spain currently has the eurozone's highest jobless rate at over 20pc.
It said more reforms will be necessary to make Spain's economy more competitive, particularly in the labor market, and that another €30 billion (£25.9 billion) may be needed to recapitalize the country's weaker banks. Banks across Europe are under pressure in markets because of investor fears that they could take heavy losses on government debt they own.
The agency said the debt crisis - which has seen financial markets drop severely on worries that some governments, particularly Greece, will be unable to repay all their borrowings - will take time to fix.
'The Greatest Threat to Europe Is the Bailout Fund'
by Maria Marquart - Spiegel
Only two countries, Malta and Slovakia, have yet to ratify the expansion of the euro bailout fund. Its fate may be in the hands of a minor Slovak party headed by Richard Sulik. In an interview, the politician explains why he hopes the fund will fail and what he sees as the only way to save the euro.
SPIEGEL ONLINE: Mr. Sulik, do you want to go down in European Union history as the man who destroyed the euro?
Richard Sulik : No. Where did you get that idea?
SPIEGEL ONLINE: Slovakia has yet to approve the expansion of the euro backstop fund, the European Financial Stability Facility (EFSF), because your Freedom and Solidarity (SaS) party is blocking the reform. If a majority of Slovak parliamentarians don't support the EFSF expansion, it could ultimately mean the end of the common currency.
Sulik: The opposite is actually the case. The greatest threat to the euro is the bailout fund itself.
SPIEGEL ONLINE: How so?
Sulik: It's an attempt to use fresh debt to solve the debt crisis. That will never work. But, for me, the main issue is protecting the money of Slovak taxpayers. We're supposed to contribute the largest share of the bailout fund measured in terms of economic strength. That's unacceptable.
SPIEGEL ONLINE: That sounds almost nationalist. But, at the same time, you've had what might be considered an ideal European career. When you were 12, you came to Germany and attended school and university here. After the Cold War ended, you returned home to help build up your homeland. Do you care nothing about European solidarity?
Sulik: If we now choose to follow our own path, the solidarity of the others will also crumble. And that would be for the best. Once that happens, we would finally stop with all this debt nonsense. Continuously taking on more debts hurts the euro. Every country has to help itself. That's very easy; one just has to make it happen.
SPIEGEL ONLINE: Slovakia's parliament is scheduled to vote on the bailout fund expansion on Oct. 11. How do you predict the vote will turn out?
Sulik: It's still open. The ruling coalition is composed of four parties. My party will vote "no"; the other three coalition parties intend to say "yes." What the opposition says is decisive.
SPIEGEL ONLINE: The Social Democrats have offered your coalition partners to support the reform in return for new elections. Do you think the coalition is in danger of collapse?
Sulik: I don't see any reason why it would.
SPIEGEL ONLINE: What will you do should the EFSF reform pass despite your opposition?
Sulik: For Slovakia, it would be best not to join the bailout fund. Our membership in the euro zone, after all, was not conditional on us becoming members of strange associations like the EFSF, which damage the currency.
SPIEGEL ONLINE: If the euro only causes problems, why doesn't Slovakia's government just pull the country out of the euro zone?
Sulik: I don't see the euro as the problem. It's a good project. Everyone involved can benefit from it -- but only if they stick to the ground rules. And that's exactly what we're demanding.
SPIEGEL ONLINE: Which ground rules should we be following?
Sulik: We have to observe three points: First, we have to strictly adhere to the existing rules, such as not being liable for others' debts, just as it's spelled out in Article 125 of the Lisbon Treaty. Second, we have to let Greece go bankrupt and have the banks involved in the debt-restructuring. The creditors will have to relinquish 50 to perhaps 70 percent of their claims. So far, the agreements on that have been a joke. Third, we have to be adamant about cost-cutting and manage budgets in a responsible way.
SPIEGEL ONLINE: Many experts fear that a conflagration would break out across Europe should Greece go bankrupt and that the crisis will spill over into other countries, including Portugal, Spain and Italy.
Sulik: Politicians can't allow themselves to be pressured by the financial markets. Just because equity prices fall and the euro loses value against the dollar is no reason for giving in to panic.
SPIEGEL ONLINE: But do you really believe that politicians can calm the financial markets by stubbornly sticking to their principles?
Sulik: Let's just ignore the markets. It's ridiculous how politicians orient themselves based on whether stock prices rise or fall a few percentage points.
SPIEGEL ONLINE: You're not afraid that a Greek insolvency could mark the beginning of the crisis instead of the end?
Sulik: No. There's not going to be a domino effect along the lines of "first Greece, then Portugal and finally Italy." Just because one country goes broke doesn't mean the other ones automatically will.
SPIEGEL ONLINE: Nevertheless, banks could run into significant problems should they be forced to write down billions in sovereign bond holdings.
Sulik: So what? They took on too much risk. That one might go broke as a consequence of bad decisions is just part of the market economy. Of course, states have to protect the savings of their populations. But that's much cheaper than bailing banks out. And that, in turn, is much cheaper than bailing entire states out.
SPIEGEL ONLINE: Does one of your reasons for not wanting to help Greece have to do with the fact that Slovakia itself is one of the poorest countries in the EU?
Sulík: A few years back, we survived an economic crisis. With great effort and tough reforms, we put it behind us. Today, Slovakia has the lowest average salaries in the euro zone. How am I supposed to explain to people that they are going to have to pay a higher value-added tax (VAT) so that Greeks can get pensions three times as high as the ones in Slovakia?
SPIEGEL ONLINE: What can the Greeks learn from the reforms carried out in Slovakia?
Sulik: They have to make cuts in the state apparatus. The Slovaks could also give them a few good ideas about the tax system. We have a flat tax when it comes to income taxes. Our tax system is simple and clear.
SPIEGEL ONLINE: One last time: Do you honestly believe the euro has any future at all?
Sulík: I believe the euro has a future. But only if the rules are followed.
Slovaks May Hold Key to Euro Debt Bailout
by Nicholas Kulish - New York Times
In a television advertisement for the popular Slovak beer Zlaty Bazant, a grinning man with a paunch stands on a sunny beach, nodding his head as the narrator says, "To want to borrow from everyone, that is Greek." The ad then cuts to a skinny man, standing in a field, who shakes his head. "To not want to lend to anyone," the narrator says, "that is Slovak."
The commercial has touched a nerve here in the second-poorest country in the euro currency zone, where the average worker earns just over $1,000 a month. The prospect of guaranteeing the debt of richer but more spendthrift countries like Greece, Portugal and even Italy has led to public outrage. So much so that tiny Slovakia now threatens to derail a collective European bailout fund to shore up the euro, which requires the approval of all 17 countries that use the currency.
Once among the most enthusiastic new members of the European Union, and an early adopter of the euro in Eastern Europe, Slovakia is proud of its strong growth and eager to leave behind its reputation as the "other half" of Czechoslovakia. But it has also become a stark example of the love-hate relationship that many residents of the Continent have begun to feel toward a united Europe.
Adopting the euro required hard sacrifices here that stand in sharp contrast to reports of overspending and mismanagement in Greece. The worries about the union’s future are all too real in smaller, poorer countries like Slovakia, which has about 5.5 million people, and is being asked to contribute $10 billion in debt guarantees to a $590 billion euro zone stability fund.
Not far from the new malls and hotels along the River Danube is Trhovisko Mileticova, a market dating from Communist times, where pensioners search for bargains among the barrels of pickled vegetables and cheap synthetic blouses from Asia. "It’s tough to get by with euros," said Zuzana Kerakova, 64, who sells grapes at the market to supplement the combined 600 euros — about $804 — that she and her husband receive from a government pension every month.
Like many here on a recent morning, Ms. Kerakova said there always seemed to be enough money to help banks and foreign states but never people like her. On the other hand, she said: "The European Union has been good to us. We live more freely, move more freely." Asked whether to side with Europe or refuse to help with the bailout fund, she said quietly, "Neviem," Slovak for "I don’t know." "Neviem," she repeated, shaking her head. "Neviem."
The future of the euro could well be decided next week in the Slovak Parliament, which meets in a modern building that is too small to hold offices for all its members and their staff because it was originally designed to hold only occasional sessions of Czechoslovakia’s Federal Assembly, which usually met in Prague. The Parliament building overlooks not only the Danube but also the former frontier of the Iron Curtain, which cut off Bratislava from Vienna, less than an hour’s drive upriver and the cold war gateway to the free world.
The expansion of the bailout fund is in danger because the free-market Freedom and Solidarity Party, just one member of the four-party governing coalition, has held out against it. "I am not the savior of the world," Richard Sulik, who is both the party’s leader and the speaker of Parliament, said in a recent interview here. "I was elected to defend the interests of Slovak voters."
The opposition Smer-Social Democracy party could bridge the gap, but its leader, the leftist former Premier Robert Fico, hopes to bring down the government and win new elections, paving the way for his return to power, and is holding out for the coalition to crack.
The situation in Slovakia illustrates how ambitious young politicians, outspoken populists and struggling small parties can hinder collective action — or even derail it. Even if a compromise is found here, as it was in Finland, by the time agreement is reached among all 17 countries, investors will have long since moved on to a new batch of fears.
The vote over the expansion of the bailout fund, the European Financial Stability Facility, and its powers, is only one step. "The E.F.S.F. is not the end of the story. We will need to have other solutions," said Slovakia’s finance minister, Ivan Miklos. "This is the dilemma. Everyone agrees that we need more flexibility."
Slovakia’s relationship with the European Union runs far deeper than a single debt crisis or bailout. In the 18 years since independence, few countries have experienced such unusual twists of fate and fortune. From the "black hole in the heart of Europe," as Madeleine K. Albright described the backward, isolated state in 1997, the country transformed itself into a neoliberal champion of the flat tax.
With automobile factories springing up across the country, it earned the nickname the Detroit of Europe. It is also called the Tatra Tiger, a name derived from a local mountain range, because of its rapid growth, including the 10.5 percent economic growth rate it reported in 2007, just a decade after Ms. Albright’s dire pronouncement.
But perhaps Slovakia’s greatest sense of accomplishment came from beating its former partners, the Czechs; its former rulers, the Hungarians; and its larger neighbor, Poland, into joining the euro currency zone. Many Slovaks are reluctant to be the stumbling block for the euro’s rescue after all the European Union has done for them.
"Thanks to joining the European Union and the prospect of joining the euro zone, investors were more likely to show interest here," said Mayor Vladimir Butko of Trnava, a city about 35 miles east of the capital where a car factory produces Citroens and Peugeots.
The European Union helped to pay for improvements to the rail link to Bratislava, Mr. Butko said, and for a highway bypass. But he ranked the psychological benefits of European Union membership even higher than the economic ones. "When you can now sit in your car and go to Munich, and the same money in your pocket here can pay for a beer there, and you don’t have to stop at the borders," said Mr. Butko, 56, "this is a very strong experience for people over 45."
It is an experience that makes far less of an impression on the younger generation. Sebastian Petic, 18, a law student in Trnava who was spending a sunny afternoon on a bench in the town square with his Lenovo laptop, repeated a popular joke. "For 500 euro, you can adopt a Greek. He will sleep late, drink coffee, have lunch and take a siesta," Mr. Petic said, "so that you can work."
He opposed increasing the bailout fund, saying that debt would only snowball. "I was quite positive about the advent of the euro," Mr. Petic said. "Now, I’m not so sure."
17 Countries, but Even More Unknowns: What Investors Don’t Know About Europe
by Gretchen Morgenson - New York Times
"The direct exposure of the U.S. financial system to the countries under the most pressure in Europe is very modest."
That’s what Timothy F. Geithner, the Treasury secretary, told Congress last week, trying to allay concerns that American banks might be hurt by the escalating crisis in Europe. Investors have heard such assurances before, and they have learned to take them with a barrel of salt. Remember how the subprime crisis was going to be "contained"?
As the situation in Europe deteriorates, our own financial institutions are coming under growing scrutiny from investors. American banks have made loans to European ones. Some have also written credit insurance on the debt of European institutions and troubled nations like Greece. So if a default were to occur, some banks here would be on the hook.
Last week, officials at Morgan Stanley worked overtime trying to calm investors about the bank’s exposure to Europe. The company had $39 billion in exposure to French banks at the end of last year, not counting hedges and collateral. (Some analysts argue that the amount today is far lower, and at the end of the week, Morgan Stanley appeared to have relieved investor fears.)
Whatever the case, American banks have been writing more credit insurance lately. As of the end of June, some 34 federally insured commercial banks had sold a total of $7.5 trillion of credit protection, on a notional basis, according to the Comptroller of the Currency. That was up 2.3 percent from the end of March. To be sure, these figures represent the total amount of insurance written and do not reflect other offsetting trades that bring down these banks’ actual exposure significantly.
For investors, the challenges in trying to assess the true exposures are real. Many of the risks in these institutions are maddeningly hard to plumb, and open to a range of interpretations. The fact is, investors must deal with significant gaps in the data when trying to analyze a bank’s exposure to credit default swaps. Even the people who set accounting rules disagree on how these risks should be documented in company financial statements.
A recent report by the Bank for International Settlements noted: "Valuations for many products will differ across institutions, especially for complex derivatives which may not trade on a regular basis. In such cases, two counterparties may submit differing valuations for valid reasons." Investors, therefore, have to trust that the institutions are being appropriately rigorous.
To compute the fair value of derivatives contracts, financial institutions estimate the present value of the future cash flows associated with the contract. On this part, everyone agrees. But there are two subsequent steps in the valuation exercise that can produce wide variations on an identical exposure. First is the manner in which an institution offsets its winning and losing derivatives trades to come up with a so-called net exposure.
Accounting rule makers disagree about the right way to approach this process. Standard setters in the United States allow an institution to survey all the contracts it has with a trading partner and compute exposure as the difference between winning trades and losing ones.
International standard setters have taken a different view. They have concluded that investors are better served by knowing the gross figures of all of an institution’s trades, both the profitable ones and the money losers. Those favoring this approach say it gives investors more information and greater insight into the risks on the books, like how concentrated the bank’s bets are.
A recent report from the Bank for International Settlements illustrates how different the exposures can be, depending on which approach is used. Posing three hypothetical examples, the report noted that while the gross values of various derivatives totaled $41, the same trades dropped to $17 after netting, as is allowed in the United States.
The second area where investors must rely on institutions to do the right thing involves the collateral that has been supplied to secure derivatives contracts. Banks reduce their exposure to a possible loss by the amount of collateral they have collected from a trading partner. But is the collateral solid? Is the bank valuing it properly? Can it be located quickly? This, again, is a gray area.
The B.I.S., in its most recent quarterly review, highlighted these challenges. It said that gleaning information about collateral was difficult, and that arriving at a proper valuation was, too.
Further problems arise when it comes time to pay off a bet in a bankruptcy and close out one of these trades. At such a moment, liquidating collateral can put pressure on other positions carried by an institution, the B.I.S. noted. It is unclear whether institutions’ portfolio and collateral valuations reflect this reality.
Some investors who have been worrying about potential losses associated with European banks may have taken comfort in the results of financial stress tests conducted earlier this year by the Committee of European Banking Supervisors. Of the 91 top European banks tested — accounting for 65 percent of bank assets — only seven failed the toughest measures.
But, as an August report by Dun & Bradstreet pointed out, these tests were not as stringent as they might have been. They only assessed the risks posed by deteriorating assets in banks’ trading accounts. The tests did not measure those assets carried in the so-called held-to-maturity accounts.
"In order to give a more adequate picture of European financial sector risk beyond the short term," Dun & Bradstreet said, "we believe the hold-to-maturity bonds should have been included in the stress tests." There is clearly a great deal that investors do not know about exposures to Europe, notwithstanding the assurances from Mr. Geithner and others.
Three years ago, investors were ignorant of the risks in faulty mortgage securities. If we’ve learned anything from that episode, it’s that what you don’t know can, in fact, hurt you.
Bailouts or Bankruptcies?: Europe Begins Working on Plan B for the Euro
by Stefan Kaiser - Spiegel
How should the euro zone solve its currency crisis? European capitals are currently preparing to inject fresh capital into their banks with some economists arguing that saving financial institutions would be cheaper than propping up entire countries.
How much longer will the euro zone be patient with Greece? A growing number of politicians and economic experts are criticizing the rescue packages for the overly indebted nation and are instead demanding that Greece be allowed to slide into insolvency. Paris and Berlin continue to hold back. But, to be on the safe side, they are already preparing their domestic banks for a possible Greek default.
On Tuesday, European Union finance ministers discussed plans to provide state capital to shore up Europe's major banks. And during its regularly scheduled interest rate meeting on Thursday, the European Central Bank (ECB) committed significant sums of money to come to the aid of financial institutions. ECB President Jean-Claude Trichet warned European governments to ensure that their banks were sufficiently capitalized.
In Germany, Chancellor Angela Merkel of the conservative Christian Democratic Union (CDU) has been clear in her support of this position. On Wednesday, together with European Commission President Jose Manuel Barroso, she announced her preparedness to support a bank bailout. Following a meeting of the heads of the most important international economics and financial institutions, the chancellor reiterated her position on Thursday, saying that if banks urgently need money, the European states should "not delay" in providing financial aid. That, she said, would be "intelligently invested money."
Crisis Returns to Banks
Behind this week's string of announcements are growing concerns that the European debt crisis is spreading and could soon threaten to engulf major banks, many of which still hold a good deal of Greek government bonds and even more Spanish and Italian securities on their books. Many banks would likely be unable to withstand a national insolvency inside the euro zone. They would be forced to write off billions, and some could face bankruptcy themselves as a result. Trust has diminished to such a degree in recent weeks that interbank lending has dried up, creating a credit crunch not seen in Europe since the 2008 collapse of Lehman Brothers.
More than anything, though, the threat of a Greek bankruptcy has risen significantly. The Greek economy has collapsed, and the country has once again failed to meet its austerity targets. Patience is now dwindling among the other euro-zone member states that have been stepping up to rescue the country.
Voices calling for an orderly insolvency in Greece are growing. Within the euro zone, this position is most pronounced in Slovakia. But there are also critics within the German government, a group led by Philipp Rösler, the head of the business-friendly Free Democratic Party (FDP), the junior partner in Merkel's coalition. The faction of supporters of insolvency is also growing among economists.
Thomas Straubhaar, director of the influential Hamburg Institute of International Economics, for example, has stated that a system needs to be created that would permit a euro-zone country to go through bankruptcy proceedings. The problem, however, is that so far no one has been able to say how, exactly, an orderly insolvency would proceed.
The consequences could be disastrous for banks. Private financial institutions only recently agreed to write off 21 percent of the value of the Greek government bonds they possess. In the event of an actual insolvency, the losses would be significantly higher -- with many experts predicting banks would have to write off half of their entire Greek bond holdings.
German financial institutions would likely survive a Greek collapse. Data from the recently published stress test indicated that the country's biggest banks -- Deutsche Bank and Commerzbank -- still held Greek securities valuing a total of €1.7 billion and €3 billion, respectively, at the end of 2010. But the banks have already written off a large share of those holdings as losses. Deutsche Bank has stated that the current volume of its Greece portfolio is around €900 million and that all of its Greek securities have already been written down to their current market value.
Saving Banks Cheaper than Rescuing States
"A debt haircut for Greece might be uncomfortable for German banks, but they could cope with it," said Dieter Hein, a banking analyst at independent research institute Fairesearch. The outstanding volume, he said, is no longer high enough to endanger the two banks.
Unfortunately, the problems stretch well beyond two German banks. A Greek insolvency would hit French banks harder and would be catastrophic for financial institutions in Greece. The largest Greek bank, the National Bank of Greece, held close to €19 billion in Greek government bonds on its books at the end of 2010. If forced to write off 50 percent of those securities, the bank's equity capital would vanish in its entirety.
The second problem is potentially even graver. What happens if the pressure created by a Greek insolvency further increases the pressure on other highly indebted nations -- such as Portugal, Spain or Italy -- and drives them to bankruptcy? Under that scenario, there's a good possibility the contagion would become unsustainable for German banks, too. The state would have to infuse them with fresh money in order to rescue the financial institutions from ruin, just as the German government did with Commerzbank following the Lehman Brothers collapse. Only this time around, even more banks would have to be rescued using state funds -- in almost every country in Europe.
European Banks Would Lose €250 Billion in Own Capital
Even so, that might ultimately wind up being cheaper for taxpayers than the ongoing support of indebted states. That, at least, is the belief of German economists Harald Hau and Bernd Lucke, who have calculated a comprehensive scenario for what a wave of bankruptcies in Europe's banks could mean. Under the scenario, Greece and Portugal would undertake a debt haircut of 50 percent, with Italy, Spain and Ireland each eliminating 25 percent of their outstanding debt.
Under the scenario, European banks would lose more than €250 billion in equity capital, which would have to be replaced by government infusions. In Germany, around €20 billion in government money would be needed to shore up the banks. Deutsche Bank would require €3.7 billion and Commerzbank around €6 billion. Together, the euro-zone economies would also have to cover the losses at financial institutions in the countries that went bust -- a figure the economists estimate to be at around €180 billion. As Europe's largest and most solvent country, Germany would have to foot a large portion of that bill.
Sharing the Burden
But the economists still believe it would be cheaper to provide banks with fresh capital than to continue providing ongoing rescue packages for overly indebted countries. In addition, since governments would be given shares of the banks in exchange for the aid, taxpayers would not be left alone to carry the costs of the crisis.
"If the recapitalization is executed at market prices -- in other words, based on the current share price -- then the losses from the expected debt haircut will be carried by the old shareholders," said Hau, who teaches economics and finance at the University of Geneva and at the Swiss Finance Institute. "Initially it would cost taxpayers nothing because they would be given valuable company holdings in exchange."
There would, of course, be one exception: If a bank's losses became so high that they drained their capital entirely, then taxpayers would first have to replenish their equity capital. "Then there would be an actual loss, and there's no way around that," Hau said.
By Hau's calculations, that would apply to only one bank in Germany -- Hypo Real Estate, which he estimates would require around €500 million in capital. Losses of around €30 billion would be expected in the banks in the worst-hit crisis countries.
Hau is convinced that this path is the best one to take. "The bailout package merely protracts the solution to the crisis, but a debt haircut would at least be the beginning of a solution." He also believes his proposal would be fairer. "With a debt haircut, around 80 percent of the costs would be carried by actors in international finance -- from private investors, funds and insurance companies," he said. "Taxpayers would be hit less hard."
As good as that may sound, considerable uncertainty remains over the side effects a debt haircut strategy might have. How long, for example, would banks continue to have to rely on state support? And would governments ever be successful in selling their shares in the banks?
Nevertheless, in the event of state bankruptcies, the euro rescue fund would still be needed because it would take time before crisis countries were able to borrow on their own again from capital markets. Until that time, they would have to be supported by the solvent euro-zone countries. That, it would appear, is unavoidable.
Europe Seems to Agree on Recapitalizing Banks — but How?
by Jack Ewing and Stephen Castle - New York Times
European leaders are finally coming around to the view that banks must be compelled to replenish their capital reserves if the euro area is ever to emerge from the debt crisis. But whether the politicians can make it happen in a convincing manner is another question — especially given that Germany and France are already divided.
Analysts are skeptical that even the richest countries will be able to agree on guidelines for a broad, coordinated effort, one impressive enough to remove all doubts about solvency in the event of a default by Greece or another sovereign debtor.
In the first signs of a split, France wants to draw on the European bailout fund, the European Financial Stability Facility, to rebuild bank capital. German leaders think national governments should take the lead. "Only if a country can’t do it on its own should the E.F.S.F. be used," Chancellor Angela Merkel said on Friday.
But the sums required to armor banks against losses on government bonds — up to 300 billion euros, or about $400 billion, by some estimates — could jeopardize France’s top-notch credit rating. That would be a big political setback for President Nicolas Sarkozy before elections next May.
These kinds of arguments are just what economists fear. A parochial approach will lead countries to try to seek advantage for their own institutions, as has often been the pattern in the past, critics say. In addition, most large European banks have extensive operations and therefore require pan-European oversight, they argue.
"You need to have a European approach, which is tremendously difficult politically," said Nicolas Véron, a senior fellow at Bruegel, a research organization in Brussels. "If it doesn’t happen, I am not very optimistic about the ability of European authorities to keep the crisis under control."
When Fitch Ratings cut Spain’s credit rating Friday by two levels, to AA- from AA+, it cited the "intensification" of the debt crisis along with slower growth and shaky regional finances, Bloomberg News reported. Fitch cited similar reasons for also downgrading Italy one level, to A+, while maintaining Portugal at BBB-, saying it would complete a review of that ranking in the fourth quarter.
Meanwhile, grave problems at the French-Belgian bank Dexia, which is on the verge of its second taxpayer-financed bailout in three years, have dashed any illusions about the health of European banks. It was only in July that Dexia breezed through an official stress test that was supposed to expose vulnerable banks.
It has become obvious that restoring the soundness of European banks is fundamental to resolving the debt crisis and removing a serious threat to the global economy. Christine Lagarde, managing director of the International Monetary Fund, has been urging a wholesale recapitalization for several months. In the United States, President Obama warned on Thursday that "the problems Europe is having right now could have a very real effect on our economy."
But no one has provided even rough details of how to compel banks to raise money on open markets if they can, and to provide government financing if they can’t. "Our experience is that if no one is talking about the details of something, it is because they do not exist," Carl Weinberg, chief economist of High Frequency Economics, wrote in a note to clients Friday. "Let us just agree that there is no plan."
Mrs. Merkel and Mr. Sarkozy are expected to discuss the issue when they meet in Berlin on Sunday, along with their finance ministers. The European Commission expects to produce its proposal for a coordinated recapitalization within a week.
Even if Dexia proves to be an isolated case, it is clear that investor confidence in the solvency of European banks is at a low ebb. European banks are reluctant to lend to one another, and United States lenders are reluctant to lend to European institutions. Banks have been unable to sell bonds to raise money.
The danger is that European banks will run short of cash to lend to businesses and consumers, amplifying a recession that may already be under way. And in a vicious cycle, the threat of recession is further undermining faith in banks. Investors know that a recession will cause a surge in bad loans, adding to the potential damage if Greece defaults on its bonds.
"The problem is not just bank capital, but first and foremost that of sovereign debt crisis intertwined with slow growth," the Institute of International Finance, a banking industry organization, wrote in its monthly assessment of global capital markets. The report noted that shares of United States banks had begun to suffer because of perceptions that they are exposed to their European peers.
On Thursday, the European Central Bank expanded its aid to banks that were having trouble raising money. It said it would allow banks to borrow as much money as they wanted for about a year at the benchmark interest rate, currently 1.5 percent. And it said it would spend 40 billion euros on a low-risk form of bank debt known as covered bonds.
But, as Jean-Claude Trichet, the departing president, warned, the central bank can provide only temporary aid. The central bank is addressing banks’ liquidity problems — their need for cash day to day. But the E.C.B. cannot fix banks’ solvency problems, the lack of adequate reserves to absorb a big hit to their holdings of government bonds or losses from nonperforming loans.
Before money market funds and other investors will start risking money on European banks again, they need to believe the banks are bulletproof.
Calculations of how much more capital banks need depend on judgments about how bad things may get. Jon Peace, a banking analyst at Nomura, counts at least 25 large publicly traded banks that would need more capital if they fully recognized losses in the value of their holdings of European government bonds. The list includes big names like Commerzbank and Deutsche Bank in Germany, UniCredit in Italy, and Société Générale and BNP Paribas in France.
In addition, there may be dozens, if not hundreds, of other undercapitalized banks that fall below the radar of analysts because they do not have publicly traded shares, like German landesbanks, or because they are too small.
Larger institutions like Deutsche Bank or UniCredit would probably be able to sell new shares. But with bank share prices depressed, it is not an opportune time for even the most credible banks to go to markets.
European leaders plan to debate the issue on Oct. 17 and 18 in Brussels. In addition, governments have asked the European Banking Authority to prepare its own estimate of bank capital needs. Finance ministers have agreed to share information on their own capacity to finance aid to banks when they meet next month.
Given the weight of opinion in the euro zone, the European Commission is likely to side with Mrs. Merkel and argue that the bailout fund should be used for bank recapitalization only as a last resort — unless Mr. Sarkozy can persuade the chancellor otherwise on Sunday.
Germany’s position puts France in a tight spot, though. French banks are some of the most exposed to troubled government debt. Relatively small increases in capital reserves are unlikely to convince the financial markets. But if France were to lose its triple-A credit rating, that would also cause problems for the bailout fund, since France is the second-largest guarantor of the rescue fund, after Germany.
"Merkel has made it clear that she doesn’t see why German taxpayers’ money should be used to rescue French banks which are in competition with her own," said an official in Brussels, who declined to be quoted by name. "France argues that it has made substantial guarantees to the fund and thinks it should be able to use it."
Hedge Funds Are Betting Against Hungary
by Landon Thomas Jr. - New York Times
French and Belgian bank stocks have crashed and the bond yields of Greece, Italy and Portugal may be peaking. Now hedge funds and bond vigilantes have begun to zero in on Hungary as the fashionable European country to bet against.
One of the first countries to get bailed out by the International Monetary Fund in the early days of the financial crisis, Hungary has undergone a severe retrenchment since then with banks, consumers and the government cutting back drastically. Now, after a brief export-driven growth spurt, Hungary, like the rest of Europe, could well be headed for a second recession.
As with Greece, Spain and Italy, the Hungarian government and its large banks have been reliant on foreign investors for their borrowing needs and, as a result, the country’s foreign currency debt burden of 110 percent of gross domestic product is one of the highest in the world.
Crucially, the government sells 50 percent of its debt to foreign investors, and as worries build over the weakening of the forint and drastic antibank measures taken by the government, the bears are betting that Hungary will suffer the same foreign investor strike that led to bailouts for Greece, Ireland and Portugal.
Which may have been why Hungary’s embattled Central Bank governor, Andras Simor — who survived a concerted attempt by the prime minister, Viktor Orban, to fire him last year — made a quick visit to London this week to take the temperature of Hungary’s jittery bond holders.
Mr. Simor is fully aware that in the current risk-averse market, investors who were eager last year to hold higher-yielding Hungarian debt may no longer be willing to do so — especially in light of the controversial actions taken by the government to tax banks and, as he puts it, to "quasi-nationalize" the pension system.
"Any policy maker who says he is not concerned would be crazy," Mr. Simor said on Thursday, referring to the recent flight to safety by emerging markets investors. "This affects countries with large amounts of debt. But I think that if investors look not at the short term but the medium term they will see that this a country that pays a reasonable rate of interest and has a reasonable budget deficit — and I think they will make the right calculation."
Investors may well be looking to the medium term — but not in the way Mr. Simor would want them.
By purchasing credit-default swaps, which have more than doubled in the last three months, and making bets that the country’s banks and bonds have further to fall, some hedge funds are taking the view that money is going to keep fleeing the country, forcing Mr. Simor to keep rates even higher to defend his currency. Since July, the forint has weakened in value against the euro to 296, from 264 — perhaps the clearest sign that investors are losing confidence in Hungary.
Hungary has also suffered from the strong Swiss franc as loans in this currency, particularly in the mortgage market, are 20 percent of G.D.P.
While Mr. Simor was critical of some of the government’s more unconventional measures, he argued that the economy was in much better shape than it was two years ago, with a target budget deficit of just 2 percent of G.D.P. for 2012.
Because Hungary is not a member of the euro zone, a crisis would not have the systemic effect of a Greek collapse. But with the resources of the International Monetary Fund now focused on greater Europe, a Hungarian rescue operation would come at a bad time — especially as relations between the fund and the current government are strained. It is also true that large banks in Italy and Austria have significant operations in Hungary
Japan's Central Bank Sounds Warning on Global Economy
by Hiroko Tabuchi - New York Times
The Japanese central bank sounded the alarm over the risks facing the world economy, even as it left its monetary policy unchanged Friday, underscoring the gravity of a global economic slowdown over which policy makers may have little control.
Also Friday, the Japanese cabinet outlined a supplemental budget of ¥12 trillion, or $155 billion, for the reconstruction of areas affected by the natural and nuclear disasters this year, the third such budget, and approved a plan to raise taxes temporarily to fund the effort.
The latest emergency budget follows about ¥6 trillion already earmarked in two supplemental budgets this year. It includes money to help relocate survivors and create a fund to revitalize the economy of Fukushima Prefecture, which has been hit hard by the nuclear crisis.
The government will raise up to ¥11.2 trillion from temporary taxes to help cover costs of rebuilding, according to the provisional tax plan. Officials have said they would also cut unnecessary government expenditures and sell state-owned assets, possibly including the government’s entire stake in Japan Tobacco.
The government has yet to work out the details of any extra spending, as well as tax increases, and must also win the approval of a divided Parliament. It aims to submit the budget to Parliament later this month, according to Kyodo News. "The uncertain outlook for the global economy and instability in financial markets are underscoring the downside risks for Japan’s economy," said Masaaki Shirakawa, the Bank of Japan governor.
The world’s advanced economies, in particular, are on the brink of a major slowdown, threatening the Japanese economy, he warned. The European debt crisis has started to cause real damage to the economies in Europe and beyond, he said.
"European financial markets remain tense, as there have been moves in money markets similar to those seen during the Lehman crisis," he said, referring to the collapse of Lehman Brothers in September 2008. "What’s different is that the credibility of government debt has become the target of market worries, and this has resulted in bigger impact."
The global economic problems have affected the Japanese economy just as it has shown signs of recovery following the hugely disruptive earthquake and tsunami in March, and the subsequent nuclear crisis. Economists say they expect figures to show that Japan emerged from recession in the third quarter, as companies restored supply chains disrupted by the disasters.
The International Monetary Fund forecasts that the Japanese economy will grow 2.3 percent in 2012, the fastest among advanced economies, thanks to Japan’s large fiscal outlays for reconstruction, in contrast with fiscal austerity measures imposed elsewhere in the world.
But prospects for a strong rebound of the country’s exports — on which Japan ultimately depends for economic growth — are looking increasingly frail. Particularly worrying has been the strong yen, which has surged as investors look for a haven in which to park their assets. The strength of the yen has hurt Japan by making its exports less competitive and eroding exporters’ overseas profits.
Still, the central bank, with interest rates already near zero and a reluctance to flood the economy with more money, has little left in its policy arsenal to bolster the Japanese economy. Its kept its key interest rate untouched at a range of zero to 0.1 percent and maintained the size of its asset-buying program.
It extended by only six months a ¥1 trillion emergency loan program for regions hit by the March disasters. Half that amount remains untapped amid a still-tepid economic recovery in disaster-affected areas.
The bank’s decision came after the European Central Bank also kept interest rates steady, though it threw a lifeline to struggling banks to ward off a credit crunch. Also Thursday, the Bank of England announced a second round of monetary easing.
Clamping Down on High-Speed Stock Trades
by Graham Bowley - New York Times
Regulators in the United States and overseas are cracking down on computerized high-speed trading that crowds today’s stock exchanges, worried that as it spreads around the globe it is making market swings worse.
The cost of these high-frequency traders, critics say, is the confidence of ordinary investors in the markets, and ultimately their belief in the fairness of the financial system. "There is something unholy about them," said Guy P. Wyser-Pratte, a prominent longtime Wall Street trader and investor. "That is what caused this tremendous volatility. They make a fortune whereas the public gets so whipsawed by this trading."
Regulators are playing catch-up. In the United States and Europe, they have recently fined traders for using computers to gain advantage over slower investors by illegally manipulating prices, and they suspect other market abuse could be going on. Regulators are also weighing new rules for high-speed trading, with an international regulatory body to make recommendations in coming weeks.
In addition, officials in Europe, Canada and the United States are considering imposing fees aimed at limiting trading volume or paying for the cost of greater oversight.
Perhaps regulators’ biggest worry is over the unknown dynamics of the computerized stock market world that the firms are part of — and the risk that at any moment it could spin out of control. Some regulators fear that the sudden market dive on May 6, 2010, when prices dropped by 700 points in minutes and recovered just as abruptly, was a warning of the potential problems to come. Just last week, the broader market fell throughout Tuesday’s session before shooting up 4 percent in the last hour, raising questions on what was really behind it.
"The flash crash was a wake-up call for the market," said Andrew Haldane, executive director of the Bank of England responsible for financial stability. "There are many questions begging."
The industry and others say that the vast majority of trading is legitimate and that its presence means many extra buyers and sellers in the markets, drastically reducing trading costs for ordinary investors.
James Overdahl, an adviser to the firms’ trade group, said that they favor policing the market to stamp out manipulation and that they support efforts to improve market stability. The traders, he said, "are as much interested in improving the quality of markets as anyone else." Some academic studies show that high-frequency trading tends to reduce price volatility on normal trading days.
And while a recent analysis by The New York Times of price changes in the Standard & Poor’s 500-stock index over the past five decades showed that big price swings are more common than they used to be, analysts ascribe this to a variety of causes — including high-speed electronic trading but also high anxiety about the European crisis and the United States economy.
"We are just beginning to catch up to the reality of, ‘Hey, we are in an electronic market, what does that mean?’ " said Adam Sussman, director of research at the Tabb Group, a markets specialist.
High-frequency trading took off in the middle of the last decade when regulatory reforms encouraged exchanges to switch from floor-based trading to electronic. As computers took over, daily turnover of stocks rose to 8 billion shares in the United States from about 6 billion in 2007, according to BATS Global Markets. The trading, done by independent firms or on special desks inside big Wall Street banks, now accounts for two of every three stock market trades in America.
Such trading has expanded into other markets, including futures markets in the United States. It has also spread to stock markets around the world where for-profit exchanges are taking steps to attract their business. When British regulators noticed strange price movements in a range of shares on the London Stock Exchange, they tracked them to a Canadian firm issuing thousands of computerized orders allegedly designed to mislead other investors.
In August, regulators fined the firm, Swift Trade, £8 million, or $13.1 million, for a technique called layering, which involves issuing and then canceling orders they never meant to carry out. The action was challenged by Swift Trade, which was dissolved last year. Susanne Bergsträsser, a German regulator leading a review of high-speed trading for the International Organization of Securities Commissions, said authorities have to be alert for "market abuse that may arise as a result of technological development." The organization will present its recommendations to G-20 finance ministers this month.
In the United States, the Financial Industry Regulatory Authority last year fined Trillium Brokerage Services, a New York firm, and some of its employees $2.3 million for layering. Even the traders’ authorized activities are coming under fire, especially their tendency to shoot off thousands of orders a second and suddenly cancel many. Long-term investors like pension funds complain that the practice makes their trading harder.
Global regulators are considering penalizing traders if they issue but then cancel a high degree of orders, or even making them keep open their orders for a minimum time before they can cancel. Long-term investors worry that some traders may be using their superior technology to detect when others are buying and selling and rush in ahead of them to take advantage of price moves. This is driving some investors who buy and sell in large blocks to move to new so-called dark pools — venues away from public exchanges. As more trading takes place in these venues, prices on exchanges have less meaning, critics say.
In the United States, the Securities and Exchange Commission has been looking into the new market structure for almost two years. In July, it approved a "large trader" rule, requiring firms that do a lot of business, including high-speed traders, to offer more information about their activities in case regulators need to trace their trades.
After the flash crash, exchanges introduced circuit breakers to halt trading after violent moves. Bart Chilton, a commissioner at the Commodity Futures Trading Commission, called for regulators to go further. He wants compulsory registration of high-frequency firms and pre-trade testing of their algorithms.
One of the most controversial actions has been the European Commission’s recent proposal for a financial transaction tax on speculators, which would hit high-frequency firms and curtail volumes. The proposed tax would apply to all trades in stocks, bonds and derivatives, and may face stiff opposition from European governments. Many such firms are based in Britain or the Netherlands, and authorities fear a loss of business.
In Canada, a top regulator is proposing higher fees on the biggest players. Last year, the country put in place a monitoring system to track the 200 million to 250 million orders its exchanges receive daily — up from 70 million a year and a half ago.
And the S.E.C. last year proposed what would be an even more high-powered monitoring system called a consolidated audit trail that would gather data on trades in real time from all United States exchanges, and be a powerful tool in helping regulators piece together events in case of another flash crash.
The monitoring "will provide regulators a critical new tool to surveil the securities markets and pursue wrongdoers, in a much more efficient and effective way than we can today," said David Shillman, associate director of the S.E.C.’s trading and markets unit.
The Ticking Euro Bomb: How a Good Idea Became a Tragedy
by Ferry Batzoglou, Manfred Ertel, Ullrich Fichtner, Hauke Goos, Ralf Hoppe, Thomas Hüetlin, Guido Mingels, Christian Reiermann, Cordt Schnibben, Christoph Schult, Thomas Schulz and Alexander Smoltczyk - Spiegel
The Greek crisis has revealed why the euro is the world's most dangerous currency. The euro was built on a foundation of debt and trickery, where economic principles were sacrificed to romantic political visions. The history of the common currency is the story of a good idea that turned into a tragedy of epic proportions.
Before Germany's Horst Reichenbach had even stepped off the plane in Athens, the Greeks knew who was coming. He had already been given various unflattering nicknames in the Greek media, including "Third Reichenbach" and "Horst Wessel" -- a reference to the Nazi activist of that name who was posthumously elevated to martyr status. The members of his 30-strong team, meanwhile, had been compared to Nazi regional leaders.
The taxi drivers at the airport were on strike, while hundreds stood in front of the parliament building, chanting their slogans. One protestor was wearing a T-shirt that read: "I don't need sex. The government fucks me every day." Within the first few hours, Horst Reichenbach realized that he had landed in a disaster area.
Reichenbach is the head of the task force the European Commission sent to Athens to provide what Brussels officials call "technical assistance" in the implementation of necessary reforms. For the Greek media, the task force is the advance guard of an invasion force, the bureaucrats that have arrived to transform beautiful Greece into a German colony.
Reichenbach describes his tasks as follows: restructure the tax system, streamline the administration, accelerate privatization, strengthen legal certainty, open up access to protected professions, restructure the energy and healthcare sector and remove structures that are hostile to investment. The effort, says Reichenbach, requires "thinking in terms of years instead of months." He was the vice-president of the European Bank for Reconstruction and Development and had planned to retire at the end of December. But then he received a call from European Commission President José Manuel Barroso, who then dispatched Reichenbach on this mission impossible.
He is a middleman between two Europes, the north and the south. The euro was intended as a currency that would help Europe grow together, but the first major euro crisis is in fact pitting the north and the south, the deutschmark economy and the lira economy, against each other. To make matters worse, there are also two different speeds in Europe, with one part of Europe moving at the high-paced speed of financial markets and banks, while the other drags along at the speed of governments and parliaments. And then there is also the Europe of two versions of the truth. One is at home in Brussels, Berlin and Paris, in the centers of power, while the other resides in the living rooms and on the streets of European cities.
As admirable as it is for Reichenbach and his 30 nation-builders to be bringing order to Athens, no amount of reorganizing can simply do away with €350 billion ($473 billion) in government debt. How to cope with this debt without ruining the European project is the most pressing question of recent weeks. After 20 years of bad decisions, spineless reforms and postponed actions, it isn't the citizens but the markets that have forced united Europe into an endgame over the euro. How can this currency have a future? Is there a risk that Greece is only the first domino in a row that could end with Germany? Is the euro zone a faulty design?
A team of SPIEGEL reporters went to Brussels, Luxembourg, Athens, Berlin and elsewhere to find answers to these questions. They have reconstructed the rise and fall of a currency that can only survive if the mistakes that were made over two decades are corrected in the next few months.
Act I: The Birth of the Euro (1991 to 2001)
Why the mistakes that would later threaten the euro were already made in the foundation phase. How Greece and other countries cheated their way into the monetary union. Why the common currency is a trillion-euro bet made by politicians against the markets -- and one that they would ultimately lose.
The bold, visionary project of creating a common currency for different countries and populations cannot be understood without reminding ourselves that the Berlin Wall came down in the late 1980s, the world still felt that World War II was a relatively recent event, and that Europe was still discussing whether Germany could pose a threat again.
Jacques Delors was the president of the European Commission for 10 years, and he was the lead author of the Maastricht Treaty, which defined the basic features of the euro. Now Delors is forced to listen to the daily criticism of how illusory his vision of a common currency was. But if he had had his way completely, he says, Europe would have been far better equipped, would have a more uniform constitution, and would be centrally governed by a Commission whose work would not be constantly undermined in the European Council, which comprises the heads of state and government.
Delors always wanted to go further than the political elite he was dealing with. At the time -- unlike today, he says -- that elite was consistently filled with dedicated Europeans, people like then-French President Francois Mitterand, then-German Chancellor Helmut Kohl, then-Dutch Prime Minister Ruud Lubbers and then-Portuguese Prime Minister Aníbal Cavaco Silva. But they too were not bold enough to integrate their countries to a degree that could count as true European coordination.
The Maastricht Treaty, which marked the establishment of the European Union when it was signed in 1992, made it all possible. It placed Europe on "three columns," the first of which was an economic column, complete with an "Economic and Monetary Union." The treaty provided the necessary legal framework, so that a common financial policy would have been conceivable, as would a coordinated fiscal and interest-rate policy. But the political will to fill out the Maastricht framework was missing.
The "United States of Europe" remained little more than a soundbite. And yet the introduction of the euro created a fait accompli that could no longer be rolled back. This European Big Bang, if you will, was to be followed by a process of evolution, during the course of which all the details were to be resolved.
Perhaps most importantly, the common currency was also a political symbol. Delors says that he always perceived Greece as being very far away, different and foreign. The country's acceptance into the euro zone happened much too early, he adds. But at the time, in the 1990s, politicians stood up in front of microphones and said that Europe was inconceivable without Athens, the "cradle of democracy." And Portugal, with its Carnation Revolution, also surely deserved to be part of the club. And the Irish, oppressed for so long by the British, had to be helped too. And who would have wanted to show Italy the door, merely because of its high unit labor costs and inflation rates?
And so, when the euro zone became a reality, elephants like Germany and France came together with mice like Portugal, Ireland and Luxembourg. Stable, prosperous countries of the north shared their common currency with shaky, underdeveloped countries of the south, mature industrialized nations joined forces with what were hardly more than developing countries. Strict Protestants mixed with sensual Catholics.
The promises of the euro were recorded in the Maastricht Treaty. It was to be a currency that would make Europe strong in a competitive globalized world; that would bring the European economies closer together; that would oblige countries to limit their debts and deficits; that would guarantee that no country would be liable for the debts of another; and that would promote political unity.
And the details? Well, they would be ironed out later.
The Greeks Jump at the Opportunity
In Greece, the euro fueled hopes of a better future. In October 1993, socialist Andreas Papandreou was reelected as prime minister. Then-Finance Minister Yiannos Papantoniou recalls today that the cabinet of Papandreou's new administration quickly became convinced that Greece's accession to the monetary union was the only chance to solve the country's financial problems.
Greece was already well over its head in debt at the time. The country's liabilities exceeded its real economic strength, with the national debt amounting to 114 percent of the gross domestic product. Athens was battling more than 14 percent inflation and the economy was shrinking.
Any economist could have recognized that the Greek economy was not competitive, and that the country, without outside impulses, seemed incapable of fundamentally changing its situation. The euro and its regime were to forcibly bring about necessary reforms, and in particular make it easier to obtain credit. Gaining accession to the euro zone became Finance Minister Papantoniou's mission.
He used every opportunity to remind people of Greece's claim. When the EU finance ministers met in Brussels in April 1997 to discuss what the new money would look like, Papantoniou proposed that the coins be embossed with both Latin and Greek letters. Then-German Finance Minister Theo Waigel curtly rejected the idea. Greece was not in a position to make demands, he said. And then, turning to Papantoniou, he added: "You are not part of this, and you will not be part of this."
When the two finance ministers spoke later on, Papantoniou proposed a bet to Waigel, namely that Greece would get the euro. Indeed, it would only take a few years for Papantoniou to win his bet. Waigel, who recently described Greece's acceptance into the euro zone as a "mortal sin" in the German newspaper Süddeutsche Zeitung, eventually became a fan of Greece, says Papantoniou. "It was Waigel who brought us into the euro," he says. "It is absolutely untrue that he was opposed to our accession to the euro."
The former Greek finance minister dismisses the charge that his country used falsified figures to cheat its way into the euro zone. "We didn't do anything differently from all the other countries," he says.
The Trickery of Euro Candidates
In his book "Herausforderung Euro" ("The Euro Challenge"), Hans Tietmeyer, the then-president of Germany's central bank, the Bundesbank, confirms that "questionable cosmetic surgery" was performed in some countries to make data on inflation rates, government debt and price trends conform to the euro zone's requirements.
Italy's government debt of 115 percent of GDP was dramatically higher than the 60 percent debt limit agreed to in the Maastricht Treaty. Belgium was also massively in violation of treaty provisions.
At the time, then-Bundesbank President Tietmeyer noted with concern that, in 1998, the Europeans, inspired by the sheer magnitude of their project, had eliminated the final test of whether enough countries even satisfied the requirements for the euro, from their roadmap for switching to the new currency. They were determined that the euro would be introduced on Jan. 1, 2002.
In a German government meeting that was supposed to make a decision on the currency, Tietmeyer raised his objections against certain euro candidates -- to no avail. In fact, the outcome of the meeting had already been determined in advance, and it had even been stated in writing.
Then-German Chancellor Helmut Kohl, a thoroughly committed European who belonged to the school of thought that there should never again be a war in Europe, wanted the historic decision. As Tietmeyer recalls, the chancellor said solemnly: "May we look back at the euro in 50 years' time as positively as we do today with the deutsche mark."
Numbers and data were constantly being thrown around at the time, in the late 1990s. The gathering of data was left up to each EU country, and Europeans trusted one another. But there was one question that hadn't been clarified: When the figures came together in Luxembourg, what would happen if Eurostat, the organization tasked with assembling the data, discovered mistakes or violations of the rules? What authority or body would implement sanctions, and at what level?
Schröder and Eichel Inherit the Euro
Germany was still preoccupied with other issues. After 16 years under Kohl, a coalition of the center-left Social Democratic Party (SPD) and the Green Party won the German national election in 1998. In Germany, it felt like the beginning of a new era, but there was little enthusiasm for the European project. For the new Chancellor Gerhard Schröder, the euro was no longer a question of war and peace. Schröder flippantly referred to the new currency as a "sickly premature baby."
But the euro was also a consistently political currency, says Eichel. Spain, Portugal and Greece were all former military dictatorships that had only found their way back to democracy in the mid-1970s. The strong connection to Europe, says Eichel, was also seen as a means of strengthening democracy.
Greece's democracy received the validation it desired in 2000, when the European Commission and the European Central Bank concluded that the country had made great strides in the previous two years. The ECB warned against Greece's high debt levels, and yet the Commission recommended that Athens be admitted to the common currency. "Greece has completed a successful convergence process after a long and difficult path," then-Finance Minister Eichel told the German parliament, the Bundestag.
Then-Greek Finance Minister Papantoniou had reached his goal, winning his bet with Theo Waigel. Greece became a member of the euro zone. But that meant that the European treaties weren't worth the paper they were printed on. Greece's public debt wasn't at 60 percent of GDP, the required maximum, but at over 100 percent. And even back then, there were already doubts about the numbers that Athens was officially reporting.
The Critics of the Euro
There were opposing voices in society, particularly in Germany, where the deutsche mark was not just a means of payment but also a psychologically important symbol of Germany's postwar reconstruction and economic miracle. The 1990s were a decade of squabbles over the euro.
In 1992, for example, 62 German professors issued a joint warning against introducing the euro. They feared that the monetary union, the way it was structured, would "expose Western Europe to strong economic fluctuations, which, in the foreseeable future, could lead to a political acid test."
In the end, the political will prevailed over the economic objections. In April 1998, the two houses of the German parliament, the Bundestag and the Bundesrat, which represents the interests of Germany's 16 states, cleared the way for the last step toward monetary union.
After that, whenever a government official spoke out against the euro, it would set off an enormous commotion throughout Europe. Hans Reckers, the president of the central bank in the German state of Hesse, learned that when he dared to voice his concerns publicly.
Reckers was a member of the Bundesbank executive board at the time. In April 2000, near the end of a speech to a handful of financial journalists in the conference room of the state central bank, he cleared his throat and said: "In my view, Greece is by no means ready for the monetary union. Its accession must be postponed by at least a year."
It took about 20 minutes for the first news agency reports to be sent, and another five minutes for prices to begin plunging on the Athens stock exchange, prompting Greece's central bank to buy up drachma to prevent it from declining in value. Eichel, the finance minister, called then-Bundesbank President Ernst Welteke, and Welteke called Reckers, who was promptly muzzled. But today Reckers claims that all 15 of the bankers on the Bundesbank executive board felt that the Greece accession was a mistake.
A mistake, some said, that could be absorbed because Greece is such a small country. A dramatic mistake, others said, warning against underestimating the power of the financial markets.
The true problems were not addressed in the wake of the Jan. 1, 2002 introduction of the euro. Despite all the declarations of intent in Maastricht, the 12 new euro countries drove up their debt by more than €600 billion in the five years of preparations for the introduction of the euro. By the end of 2002, they had a combined debt of €4.9 trillion, with Italy's debt alone amounting to €1.3 trillion.
The Skepticism of the Americans
Across the Atlantic, American economists were busy examining Europe's plans, which they felt were half-baked and "oversized," in the words of financial economist Kenneth Rogoff, a Harvard professor and adviser to US presidents and governments around the world. His office is in the Littauer Building on the edge of Harvard's manicured campus in Cambridge, Massachusetts.
When the euro became a real currency, Rogoff had just taken the position of chief economist at the International Monetary Fund (IMF), and he was teaching at Princeton when the euro began to take shape in the 1990s. He agreed with his fellow US economists' view that the euro was conceived "on too grand a scale."
Rogoff observed that a trans-Atlantic rift was developing between two groups of economists. The Americans and the Western Europeans, who usually more or less agreed on key macroeconomic issues, were suddenly arguing to the point of insult. The Europeans accused their overseas colleagues of failing to recognize the historic processes, the grand vision and Europe's great leap forward.
The Americans, dry and pragmatic, accused their European counterparts of downplaying the risks. Once again, they felt that Old Europe was being overly romantic and blind to reality. Rogoff did find some good ideas in the work of the EU and the architects of the euro. The Maastricht debt criterion, for example, remains a brilliant and valid idea to this day, says Rogoff. He is still convinced that setting an upper limit for the ratio of government debt to GDP at 60 percent proved to be a great success.
"It was something new at the time," says Rogoff. "It was a great insight." The only problem, as soon became apparent, was that the Europeans had a tendency to betray their own ideals.
The Ticking Euro Bomb - How the Euro Zone Ignored Its Own Rules
by Ferry Batzoglou, Manfred Ertel, Ullrich Fichtner, Hauke Goos, Ralf Hoppe, Thomas Hüetlin, Guido Mingels, Christian Reiermann, Cordt Schnibben, Christoph Schult, Thomas Schulz and Alexander Smoltczyk - Spiegel
After they joined the euro zone, the countries of southern Europe suddenly discovered they could borrow money at German-style rates, and any hope of sorting out their dodgy finances vanished. But it was France and Germany who set the worst example, when they broke the euro-zone rules they had forced on others.
Act II: Life With the Euro (2001 to 2008)
How the euro heated up the borrowing-fueled economies of member states. Where Greece got its billions from. How the growth miracle failed to materialize. How the Germans betrayed the rules of the EU and benefited from the euro zone.
The Europeans' new determination and palpable desire to make the historic project a success was rewarded. Banks, pension funds and major investors from around the world began to show an interest in this new Europe.
Portuguese and Irish government bonds, coupled with French economic strength and German reliability, suddenly looked like low-risk, reasonable, future-oriented investments. It was at this time that the financial industry developed its new magic tricks.
Sewage treatment plant operators in southern Germany, city governments in Spain, villages in Portugal and provincial banks in Ireland got involved with Wall Street bankers and London fund managers who promised profits by converting debt into tradable securities. And while central governments tried to cap their national budgets to comply with the Maastricht requirements, municipalities piled on debt that was not documented or recorded anywhere at the European level.
Low-interest loans were available everywhere, and it was all too easy to postpone their repayment to a distant future and refinance or even expand government spending. A loophole developed in the Maastricht Treaty. Harvard economist Kenneth Rogoff says that the rule about the maximum debt-to-GDP ratio should have been amended, and that it was wrong to establish the 60 percent limit on a purely quantitative basis without asking where the loans were actually coming from.
According to Rogoff, it would have been necessary to limit the proportion of foreign liabilities in each country's national debt. In the long run, and especially during an economic crisis, this kind of debt leads to an undesirable dependency on the vagaries of the markets.
In fact, governments borrowed excessively from foreign lenders, especially the major European banks. They accumulated what economists refer to as external debt. Deutsche Bank bought Greek bonds, Société Générale invested in Spanish bonds and pension funds from the United States and Japan bought European government bonds. The yields were not particularly high, but neither were the risks of default, or so it seemed. However, it was during this period that the monetary relationships were formed that turned Greece into a money bomb that would threaten the entire euro zone years later.
The Greeks were able to borrow at interest rates that were only slightly higher than those that the German government paid on its bonds. "The euro was a paradise of sorts," says then-Greek Finance Minister Yiannos Papantoniou.
Once they had joined the euro zone, Europe's southern countries gave up trying to sort out their finances, says Papantoniou. With a steady flow of easy money coming from the northern European countries, the Greek public sector began borrowing as if there were no tomorrow. This was only possible because the country, in becoming part of the euro zone, was also effectively borrowing Germany's credibility and credit rating.
The Greeks Establish a Debt Agency
Prior to the euro, Greece had shown little interest in the international bond market. The country was simply too small and economically too underdeveloped to play much of a role. But in 1999, the Socialist government in Athens established a "Public Debt Management Agency," naming Christoforos Sardelis as its director. Sardelis, an economist, had taught in Stockholm during Greece's military dictatorship. Now he headed a staff of two or three dozen employees.
For the first time, the Greeks tried to convince foreign investors to buy larger volumes of debt with longer maturities. The message was: Buy an attractive security from the European Union. He worked all of Europe, speaking with every fund, Sardelis recalls. Today, he is 61 and a member of the board of directors of Ethniki, Greece's largest private insurance company. "Our task was to obtain money in the best possible way," he recalls.
Greece was soon selling packages of bonds worth upwards of €5 billion at government auctions, says Sardelis. Starting in 2001, there was "enormous demand from all over Europe," as well as from Japan and Singapore, he says. Things were going so well that Sardelis was even able to lure experts away from Deutsche Bank. Greece was in vogue. In reality, the Greeks were auctioning off their own future, without even noticing. They saw joining the euro as their goal, even though it was only a beginning.
In the spring of 2003, rates on Greek bonds were only 0.09 percentage points above comparable German bonds. In plain terms, this meant that the markets at the time felt that Greece, with its economy based on olives, yogurt, shipbuilding and tourism, was just as creditworthy as highly industrialized Germany, the world's top exporter at the time. Why? Because both countries now had the same currency. And because the markets -- as Andreas Schmitz, the head of the Association of German Banks, explained in a recent interview with the German weekly newspaper Die Zeit -- never believed in the so-called "no-bailout" clause of the Maastricht Treaty, a clause that was designed to prevent euro-zone countries from being liable for the debts of other members.
According to Schmitz, the markets were confident that "in an emergency, the strong countries would support the weak ones," a view based on European politicians' lax treatment of their own rules early in the game. Those who bought Greek bonds on a large scale at the time were betting that Europe's statesmen would break their rules if a crisis came along.
Sardelis claims that he had recognized the looming problems and warned against them. Today, he describes a mood characterized by the ever-increasing "illusion that the monetary union could solve our problems." But instead of pushing for serious reforms of Greek government finances, the Greeks simply "relapsed into old mentalities." Instead of saving being promoted, obtaining "as much money as possible" was encouraged.
Germany Undermines the Treaty
In 2002, the German government had other things on its mind than examining Greece's public finances. It was having troubles of its own, with the European Commission threatening to send a warning to Berlin. Germany was expected to borrow more than had been forecast, thereby exceeding the allowed 3 percent of GDP limit for its budget deficit. The result was not, however, an example of German fiscal discipline and exemplary adherence to European rules, but a two-year battle by the Schröder administration against the slap on the wrist from Brussels.
Few within the European Commission openly criticized the loosening of the Maastricht rules. And the Germans, together with the French -- both facing the threat of an excessive debt procedure -- were too busy undermining the Maastricht Treaty. The two countries, determined not to submit to sanctions, managed to secure a majority in the EU's Council of Economic and Finance Ministers to cancel the European Commission's sanction procedure. It was a serious breach of the rules whose consequences would only become apparent later.
The German-French initiative effectively did away with the Stability and Growth Pact, which the Germans had forced their partners to sign. The consequences were fatal. If the two biggest economies in the euro zone weren't abiding by the rules, why should anyone else?
The lapse was concealed behind political jargon. The violation of the pact was covered up with false affirmations of the pact. Its provisions were not formally abolished, but they were informally softened to such an extent that, in the future, they could be twisted at any time to benefit a government in financial trouble. The process also led to a not insignificant side effect: Executive power in Europe, supposedly held by the European Commission, which is informally known as the "guardian of the treaties," was de facto transferred to the European Council, which consists of the European heads of state and government.
Instead of bundling and concentrating the efforts of the euro zone in Brussels, as intended, national interests began emerging once again in Berlin, Paris, Madrid and Rome.
The Greek Deception Is Discovered
Greece's new conservative government, elected in 2004, disclosed that its socialist predecessors had been reporting manipulated figures to Eurostat since 2000, including the numbers used to join the euro zone.
But instead of criticizing Greece, European Commission President José Manuel Barroso, a Portuguese citizen, praised the new government for its openness and congratulated it for taking such "courageous steps" to make up for the mistakes of the past. Now it was Greece's job to put its house in order by 2006, Barroso added.
But the new administration in Athens soon proved to be just as creative with its accounting as its predecessor. Defense expenditures were posted retroactively to the time of order, not payment, cleverly removing them from the current balance sheet. The bureaucracy refused to make projections about budget trends and used a purely fictitious deficit of less than 3 percent in its budget planning.
Sardelis, the director of the "debt agency," was replaced. His predecessor, like Sardelis before him, took advantage of the low rates on his country's government bonds. In 2005, Greek bonds were yielding rates only 0.16 percentage points higher than German bonds. The market was buying and the Greeks were selling. Government debt increased by 14.7 percent in 2006.
A blame game began in Brussels, where officials argued over who exactly had given incorrect or insufficient information to whom. The EU currency commissioner pointed his finger at the director general of Eurostat, who shifted the blame to the EU commissioners, who in turn criticized the European Central Bank. National governments and finance ministers joined the fray and, instead of the spirit of optimism that had prevailed around the turn of the millennium, dark skies were suddenly on the horizon for this new Europe.
To make matters worse, hopes of strong economic growth in the euro zone were dashed. Germany, in particular, was ailing, growth was minimal in Europe and unemployment figures were disconcerting. Europe became a constant topic of discussion at the International Monetary Fund (IMF) in Washington.
The IMF Warns Europe
Europe was under observation at IMF headquarters. The euro countries, after having built themselves brave new economic worlds since the late 1990s, mostly on borrowed money, were already in a deepening debt hole, which was still almost unnoticed and certainly vastly underestimated. They were like a mouse that is overjoyed to have spotted a piece of cheese in a trap, without noticing that by eating the cheese it will set off the trap.
At the time, then-IMF chief economist Rogoff's answer to the question of whether the euro zone could break apart again was simple: "Of course." Rogoff said that, in 10 years' time, some countries might not even be using the euro anymore. When he said these things, his colleagues, particularly the Europeans, always looked at him "as if I had a screw loose," he recalls.
The IMF noted a "paralysis in Europe," says Rogoff. The political union that had been promised for years as a real framework for the technical monetary union did not materialize. But the European party continued -- and as long as the music was playing, everyone wanted to dance. Everyone except the Germans, that is, who were busy introducing painful and unpopular reforms -- known as Agenda 2010 and Hartz IV -- to their labor market and welfare systems.
"What the Germans accomplished at the time is very impressive," says Rogoff. "They recognized a debt problem and the systemic weaknesses, and then they rationally went about eliminating those weaknesses." But instead of developing economic productivity, reforming their social systems and controlling costs, countries like Greece, Portugal and Italy borrowed more and more money, dragging out the maturities as long as possible so as to postpone the necessary decisions into the future.
But the critics targeted Germany instead of these countries. The Germans, they said, were pushing their European partners up against a wall. German exports to countries in the euro zone were growing by an average of 7 percent a year, while 73 percent of Germany's trade surplus came from these countries.
The Agenda 2010 reforms applied pressure on wages and helped reduce unit labor costs, so that Germany acquired even greater competitive advantages over countries like Italy and Greece. While unit labor costs were declining in Germany, they were going up in most euro-zone countries, especially Greece.
Greece's Structural Problems
The Greeks were consuming on credit, using cheap loans. They bought German machinery and cars, which helped increase Germany's gross national product, while neglecting to introduce reforms at home. No elected official was willing to trim the country's enormous bureaucracy, hardly anyone was interested in debt repayment, trade deficits or unit labor costs, and very few fought against corruption, subsidy fraud or unearned privileges. The consequences of these failings are still in full view in northern Greece today, in the region bordering Bulgaria.
Almost all of the many factories and warehouses in the industrial zone of Komotini are now shut down, and yet they look as if they were brand-new. Komotini is a prime example of why the Greek economy doesn't grow, why it is uncompetitive and why there is no progress in the country.
Most of the companies there never even opened their doors for business. In fact, the abandoned buildings are the ruins of subsidy fraud. Their developers obtained funds and low-interest loans from the government in Athens and from the EU to build the factories and warehouses, but they never intended to do any business there.
Transparency International considers Greece to be the most corrupt country in the EU. Permits and certificates can only be had in return for cash. Not everyone in Greece sees this as a problem.
Some see corruption as part of Greek culture, and they also believe that taxes are unnecessary. As a result, the government has a double revenue problem. On the one hand, the bureaucracy prevents some businesses from growing and becoming profitable. On the other hand, the businesses that do grow and realize profits find ways to pay almost no taxes at all. Every year, the Greek state misses out on an estimated €20 billion in unpaid taxes. A third of Greece's economic activity is untaxed.
Poor Ratings for Greece
In September 2008, when the Lehman bankruptcy wreaked havoc on financial markets, the Greek government believed it had been spared. Greek banks held very few of the supposedly innovative securities that Wall Street's financial wizards had devised. Nevertheless, in 2008, government debt rose to 110 percent of economic output. Greece's debt-to-GDP ratio had surpassed Italy's, and the proportion of its debt that was held by foreign investors was also significantly higher. The country of beautiful islands was in much bigger trouble than it was willing to believe.
The rating agencies, which had declared massive numbers of worthless securities to be safe investments, came under special scrutiny after the Lehman crash. After all, they were also rating entire countries and government bonds. What were their ratings worth? Had they misjudged the quality of national economies just as they had got it wrong with private companies?
For years, the world's three major rating agencies had unanimously given AAA or AA ratings to the bonds of euro-zone members. On Jan. 14, 2009, one agency, Standard & Poor's, decided to downgrade Greek government bonds to A-. It was the lowest rating among all the euro zone's then 16 members. From today's perspective, it marked the beginning of the crash. The downgrade set in motion a downward spiral that would show European leaders how fragile their euro is and how contagious conditions in a small country like Greece could be.
Marko Mrsnik, a "sovereign credit analyst" responsible for Greek government bonds at Standard & Poor's, was behind the downgrade. The native Slovenian doesn't talk to journalists, but his reports provide an indication of how he assesses the markets.
His office is in Canary Wharf in London's Docklands district, a business center with shimmering façades and coffee bars built on the ruins of the old industrial society. Lehman Brothers also had its offices there, until the end.
The purely economic criteria are readily available in the tables produced by central banks, Eurostat and the IMF. But another aspect, the politics of a country, is not something that can be figured out with a calculator. It has to do with issues such as how well an administration functions, corruption, strong unions, how rebellious a country's young people are and how strong its leader is. These are the soft -- but nonetheless important -- criteria.
Explaining the decision to downgrade the country's debt rating, Mrsnik wrote that the ongoing financial and economic crisis had amplified a fundamental loss of competitiveness in the Greek economy. After this assessment was issued, prices plunged on the Athens stock exchange and interest rates rose. The buyers of Greek government bonds, wanting to be compensating for taking on more risk, demanded a higher premium. From then on, if Greece wanted to borrow €1 billion, that is, sell bonds worth €1 billion, it had to promise to pay €2.8 million more in interest than Germany was paying. The debt burden continued to grow and grow.
Alarmed by the downgrade, the European Commission initiated another excessive deficit procedure against Greece. But it was a helpless gesture. Once again, the sanction procedure remained ineffective -- not unexpectedly, one might be tempted to say. To this day, not a single euro country has even been penalized, despite the many cases of rule violations. The euro zone's sanction mechanism is an empty threat. Besides, it was poorly conceived from the start. What good does it do to slap fines on a country that is in financial difficulties?
In October 2009, the new government of Socialist Georgios Papandreou replaced the conservative administration in Athens. After Papandreou's election win, Mrsnik wrote, in a confidential letter to Standard & Poor's customers, that in light of the repeated budgetary lapses of the various Greek governments, it remained to be seen whether the new administration had the will to implement a credible budget strategy. This sounded diplomatic, but it was pure sarcasm. Investors got the message, namely that the decline of Greek bonds from secure investments to casino chips was accelerating.
The Greek tragedy had begun.
The Ticking Euro Bomb: What Options Are Left for the Common Currency?
by Ferry Batzoglou, Manfred Ertel, Ullrich Fichtner, Hauke Goos, Ralf Hoppe, Thomas Hüetlin, Guido Mingels, Christian Reiermann, Cordt Schnibben, Christoph Schult, Thomas Schulz and Alexander Smoltczyk - Spiegel
Act III: The Euro Crisis (2010/11)
How Greece becomes a pawn in the hands of investors. How the European Central Bank goes astray. Why the world no longer makes sense to the Greeks. How the Maastricht bet goes bad.
In October 2009, Marko Mrsnik's analysts at rating agency Standard & Poor's computed that Greece's debt would increase to 125 percent of economic output in 2010. On the same day, it became more expensive to hedge Greek bonds against default. The default insurance instruments, known in market jargon as credit default swaps (CDS), were an indicator of how bad things stood for Greece. It was now costing $189,000 a year to hedge a $10-million Greek government bond against default. For major investors, it was a signal to get out of Greece.
A few people had also become nervous at the headquarters of the Pacific Investment Company (PIMCO) in Newport Beach, California, about an hour's drive south of Los Angeles.
PIMCO is by far the world's largest investor in government bonds. The company lends governments money by buying their bonds. When PIMCO stops buying a country's bonds, it's a clear sign that the country is on the verge of crisis and possibly even bankruptcy.
PIMCO controls more than $1.3 trillion (€1.05 trillion) on behalf of its customers. It is an absurd number, even in these times of superlatives, times of bailout funds and banks being supported with billions upon billions in taxpayer money. Though far from a household word, PIMCO has four times the German national budget to invest.
That's why almost all governments maintain close ties to PIMCO. They send their finance ministers, the heads of their central banks and sometimes even their national leaders to see CEO Mohamed El-Erian and convince him to buy their government bonds.
In the last few weeks of 2009, PIMCO sold all of its Greek bonds. El-Erian says the company wanted to get out before everyone else noticed that the numbers weren't adding up. The company never relies on outside assessments. Instead, it employs hordes of analysts, some of whom used to work at the International Monetary Fund, where El-Erian began his career.
The analysts spend all of their time digging through large quantities of data and the financial statements of nations, re-calculating, preparing projections and feeding numbers into computers. When they don't like what they see, PIMCO gets out.
When Greece was accepted into the euro zone, it was one more reason for PIMCO to buy Greek bonds. El-Erian says the sentiment at PIMCO was that if the Greeks were being granted membership in such an elite club, then Athens would follow the rules -- or the government would be severely sanctioned if it didn't. But that didn't happen. Instead, political concessions were made and the rules were ignored. That, El-Erian argues, is what brought the cancer into the euro zone.
So why didn't the financial markets penalize Greece earlier? Why was the same yardstick applied to Greek government bonds as to German bonds, until only a few years ago? Why did the markets continue to buy the country's bonds?
The Crash of Greek Bonds
On April 27, 2010, a country's debt was downgraded to junk status for the first time in the history of the young currency. Standard & Poor's downgraded Greece's bond rating by three notches, to BB+, putting it at the same level as Azerbaijan and Egypt, and just ahead of countries like Ecuador, El Salvador and Zimbabwe.
Mr?nik wrote that Greece's government debt had to be "restructured" -- a fancy word for bankruptcy. Restructuring involves a debt haircut, so that owners of Greek bonds might only get 30 percent of their money back, that is, lenders are only repaid a fraction of the money they lent. The markets view a downgrade as the kiss of death. At this point, anyone who was still holding Greek bonds in his portfolio was crazy -- or a charitable donor.
But the market is neither crazy nor charitable. As soon as the downgrade was announced, Greek bonds were thrown onto the market, causing their prices to plunge. If the Greek government had introduced two-year bonds into the market at that point, it would have had to promise buyers a 13-percent interest rate, up from only 6.3 percent a few days earlier. The rate for 10-year bonds climbed to above 10 percent.
This came as a shock to many European banks. After the Lehman bankruptcy, they had invested heavily in the supposedly safer government bonds, with small yields that suggested security. But now it wasn't only Greek bonds that were seen as risky; confidence was also dwindling in Portugal, Ireland, Spain and even Italy.
Fear in Europe's Financial Capitals
Fear began to spread in places like Frankfurt and London. European banks had invested more than €700 billion in government bonds from the five crisis-stricken countries. And Greek banks alone were holding €50 billion in Greek government bonds. When the government bond rating was downgraded, so were the ratings of Greek banks, as part of a chain reaction that would not stop at Greece's borders.
Government bonds also serve as collateral when banks borrow money from the European Central Bank. The bonds are a key link in monetary transactions, and when their value becomes questionable, the supply of money to economies begins to falter.
Greece was adrift in a storm of mistrust, unleashed by the rating agencies and reinforced by the financial markets. The lower the country's rating fell, the more expensive it became to refinance debts, the greater the debts became, the lower the rating went, and so on. All of this spelled a golden opportunity for foreign currency traders, hedge funds and speculators. They could bet on the decline of the euro and on the euro partners bailing out the Greeks. One of the instruments they used was the credit default swap, which the financial crisis had already spread around the globe following the Lehman bankruptcy.
Although CDSs were designed to insure against the risk of credit default, someone who holds government bonds can also use them to speculate. It's as if someone had purchased fire protection insurance for a house he didn't own. He could conceivably have a strong interest in the house actually going up in flames. Those who bought CDSs for Greek bonds without owning any bonds themselves were betting that the bonds would lose value. If that happened, they could sell the swaps later on at a higher price.
A €26 trillion gray market for CDSs had developed outside the official markets. The premium that had to be paid to hedge a Greek government bond doubled within a few weeks, and by now it was 10 times as high as the premium for a German bond.
In June 2010, Greece's credit rating was downgraded by four additional notches, due to "considerable" general economic risk. Greek government securities now had the status of junk bonds. Investors in Greece had already begun moving their money to Cyprus, Malta and Switzerland. Greece had been ejected from the family of creditworthy nations. But the effect of the downgrade was also detrimental to the entire euro project, even through Europe felt that it had reacted firmly and decisively, and that it had the Greek crisis under control.
This belief was triggered by the European Central Bank's purchase of €25 billion in Greek government bonds only a month earlier, in May 2010. It did this to stabilize prices for the bonds and bring calm to the markets, but the strategy only worked for a few days.
From then on, the ECB would buy more and more Greek bonds, even in 2011, and soon it was also buying Portuguese, Italian and Spanish bonds. The ECB was filling its own house, which had been created as a stronghold of euro stability, a Fort Knox of the new currency, with junk bonds. In doing so, it was ruining the credibility of the euro.
Questions about the beginnings of the euro kept resurfacing. Why did the leaders of France, Germany and nine other countries believe that Greece's way of running its economy could be compatible with other economies under the umbrella of a common currency? How is it possible that a currency was developed exclusively for good times and phases of growth, only to be dangerously in jeopardy during a crisis?
The Truck Drivers' Strike
In Greece, the plunge in the value of government bonds triggered unrest, because EU assistance was tied to austerity requirements and demands for tough reforms. The government was to shrink the public sector, which had become inflated over the decades, by one-fifth. And the markets were to be liberalized to facilitate more growth.
As a truck driver, Antonis Dimitriadis belongs to a group known as the "kleista epaggelmata," which consists of about 70 closed professions, a curiosity of Greek labor law, including attorneys, notaries, architects and taxi drivers. The members of these professions had been protesting since the reforms began, because they were losing their privileges. Until then, their rules had not been set by the market but by the state.
Dimitriadis was one of those who demonstrated in the summer of 2010 against what they believed were unreasonable government austerity measures. Trucking companies nationwide went on strike, shutting everything down. For eight days, filling stations were unable to get gasoline, while supermarkets quickly ran out of fresh products. Tens of thousands of tourists were stranded, flights were delayed and ships were unable to leave port.
There are 33,500 licenses in Greece for independent truckers like Dimitriadis. They were issued under the country's military junta in the early 1970s, but no new licenses were added after that, even though the Greek economy is now four times as large as it was at the time.
A trucking license became something of a guaranteed livelihood and even a retirement plan. When truckers retired, they would sell their licenses to the highest bidders, and licenses for large tanker trucks were being sold for up to €350,000. But now, under the debt regime dictated by Brussels and Washington, the licenses were to be made available to anyone starting in 2014, which of course caused the value of truck licenses to plunge. Today Dimitriadis's license is worth only about €12,000-15,000.
He received the license, which guarantees him his profession, as a gift from his father in 1993, for whom he had worked since he was 13. He cleaned the truck, filled the gas tank and accompanied his father throughout Greece, just as his 11-year-old son Manolis does today -- as if it were a law of nature. Of course, Dimitriadis took care of his father after he had given him the keys to this truck, if only in gratitude for the truck license, and he would expect the same from his own son.
Family is everything in Greece, a country of pre-modern, almost archaic labor structures that have been cemented into law in the form of an elaborate system of rules and regulations. As a result, the family-owned business has remained the DNA of the Greek economy. Of Greece's working population of 4.4 million, roughly 1.5 million people work for the government, while another 1.5 million are employed in small businesses with between one and nine employees, or are self-employed.
And these people were now being expected to accept, in the space of a few weeks, changes to a system that had developed over decades. An economy dominated by guilds and family owned businesses was to be converted into a market economy that satisfied the requirements of politicians in Brussels and Berlin.
A Country on the Verge of a Nervous Breakdown
The truck drivers' strike did immense damage to Greece's image around the world. Until the summer of 2010, the Greek crisis had remained a relatively abstract phenomenon for the global public, one that was analyzed primarily in the business sections of newspapers. But now there were images the media could use, images that portrayed a country on the verge of a nervous breakdown, images of irate tourists, empty shelves and barricaded streets, and of soldiers driving truckloads of kerosene, gasoline and diesel around the country. The images depicted a country that was no longer functioning and was unlikely to become functional again in the foreseeable future.
They also depicted a society deeply suspicious of its own government. With tax revenues of less than 30 percent of economic output, Greece has the second-lowest tax rate of all euro-zone countries. The Foundation for Economic and Industrial Research (IOBE) in Athens estimates annual black-market sales at €59 billion -- a quarter of the official economy.
Outsiders may be shaking their heads about all of this, about the Greeks and their stubbornness and backwardness, about their way of doing business in general, which is alien to the economic systems in Central and Northern Europe. But they should be even more taken aback by Europe's politicians and its movers and shakers, and the years they spent doggedly looking the other way, repressing and denying the realities of the Greek economy.
Design Defects, Political Weakness, Public Disinterest
The architects of the euro and their successors have lost the Maastricht Treaty bet. They have jeopardized an agreement made by 12 countries in the hope that the markets wouldn't notice how fragile their shiny new currency really is. And what the founders of the euro left in the way of loopholes in the original treaty -- which was aimed at providing a stable foundation for the common currency -- their successors have used in the course of 10 years to make the euro even more vulnerable.
In defiance of all rules, the euro countries have almost doubled their combined national debt since 1997. It has grown by close to €2 trillion, or 30 percent, in the last three years alone. Without the costs incurred as a result of the financial crisis, perhaps it would have taken longer for the bet to turn sour, but it would have done so nonetheless. The euro had too many design defects, the European political class was too weak to correct them, and Europeans themselves were too disinterested in the entire massive project.
A Dangerously Unstable Network
The four main promises of the euro, as put forth in the Maastricht Treaty, were all broken: government debt was not limited, but in fact doubled, with only five of the 17 euro countries still falling below the debt ceiling of 60-percent of gross domestic product permitted in the agreement's Growth and Stability Pact; budget deficits were not capped, and only four countries are now below the norm; the ban on bailouts was violated; and the European Central Bank, no longer independent, has turned into a bad bank for the bonds of ailing governments.
It isn't just a matter of political failure, which would have been as inconsequential as any broken election promise. In fact, it is a matter of the failures of two generations of political leaders, which have resulted in Europe now being blanketed in a dangerously unstable network of countries, their central banks, the ECB, the banks and investors.
The nations of the euro zone are in debt to the tune of €8 trillion, while banks hold European government bonds at a face value of €1 trillion on their books. The central banks of Greece, Italy, Portugal and Spain owe Germany's Bundesbank €348 billion. The ECB has purchased €150 billion in government bonds, and the banks, fearing loan defaults, would rather park up to €150 billion with the ECB than lend money.
The sum of all credit default swaps for Greece is unknown, as is the identity of the banks that hold them, which makes their risks incalculable. Large European banks have so many bonds of vulnerable countries on their books that, according to the IMF, they would need €200 billion in additional capital to pull through in the event of large-scale defaults. This has already prompted the rating agencies to downgrade some of the banks.
The Euro Is a House without Keepers
This highly explosive network of mutual dependencies makes the euro unstable in times of crisis. But it becomes vulnerable and truly dangerous as a result of a unique feature that distinguishes it from the dollar, the yuan and all other currencies: The euro is a house without keepers, a currency without political protection, without a uniform fiscal policy, and without the ability to forcefully defend itself against speculative attacks.
For a monetary union to function, the economies of its member states cannot drift too far apart, because it lacks the usual balancing mechanism, the exchange rate. Normally a country depreciates its currency when its economy falters. This makes its goods cheaper on the world market, allowing it to increase exports and thereby reduce its deficits. But this doesn't work in a monetary union. If one country doesn't manage its economy effectively, the common currency acts as a manacle.
If Greece were a state in a United States of Europe with a common fiscal and economic policy, it would be just as protected as the city-state of Bremen, also deeply in debt, is by the Federal Republic of Germany. But because there is no common European fiscal policy, Greece, as the weakest country in the European Union -- and despite the fact that it only contributes three percent to the total economic output of the euro countries -- becomes a systemic threat for 16 countries and 320 million Europeans. And the euro, intended as a means of protecting Europe against the imponderables of globalization, becomes the most dangerous currency in the world.
Are European Rescue Efforts Doomed to Fail?
Act IV: The Future of the Euro (2011 to ?)
Why Jacques Delors, one of the founding fathers of the Europe , still believes in the common currency. Why economist Kenneth Rogoff feels that his nightmare scenario is realistic. And why Mohammed El-Erian, CEO of the world's largest bond trader, says that he isn't making any bets on the demise of the euro.
What will happen to Europe in the coming weeks and months has much to do with Greece, but it has also long been detached from the drama in Athens. In fact, it is the continuation of the financial tragedy that began in New York in 2007. According to American economist Kenneth Rogoff, what began in New York was not a normal recession, albeit somewhat more severe than usual, but a "great contraction" of the sort that happens only once every 75 years in global economic history.
This circumstance, says Rogoff, has not been recognized to this day. In his view, this is why Europe's crisis, which began as a crisis of confidence, turned into a debt and liquidity crisis and finally led to multiple solvency crises, is not ending.
"The current policy is to act as if a liquidity crisis could be overcome," says Rogoff, "and as if all it took were to hand out enough loans to jump-start growth once. But it's the wrong diagnosis. We have a solvency crisis, and we have European countries and regions that are fundamentally bankrupt. No loan in the world, no matter how big, will save Greece, nor will it save Portugal and probably not Ireland, either, and Italy is also very worrisome."
Band-Aids Where Surgery Is Needed?
If this conclusion is correct, it means that the new European Financial Stability Fund (EFSF), established for ailing euro countries, is pointless. It means that the ECB's new policy of financing the national debts of countries will fail. It also means that Europe's leaders, as they rush from one crisis meeting to the next, are merely handing out Band-Aids where surgery of the inner organs of the Union would be necessary. "The goal now should be to trim debt," says Rogoff, "declare bankruptcy and start over again." According to Rogoff, Greece is so insolvent that it will only have a future if 50 to 75 percent of its government debt is written off, and the situation in Ireland and Portugal isn't all that different.
If strong medication isn't administered to Europe now, says El-Erian, notwithstanding its adverse side effects, the infection will soon reach the heart and the brain: France and Germany. Either way, says Rogoff, the euro project is at a crossroads. The European partners must either enter into a forced marriage, a shotgun marriage, or the union will break apart sooner or later. "And, of course, it's questionable whether the people of Europe are willing to enter into such an unromantic marriage."
The Germans, says Rogoff, play a critical role. And if they want to save Greece, they should take a sober look at the situation. They should look to Italy, says Rogoff, where the northern part of the country has been paying the bills for southern Italy for 90 years. And they should ask themselves whether they are prepared to pay Greece's bills for the next 90 years.
'A Risk Bordering on Madness'?
"That's what is involved when we talk about a transfer union. It's certainly possible. Germany is probably strong enough to pay all the bills, presumably to the tune of 150 percent of its own economic output, and the markets would somehow play along. Germany would then be the super-European, and everyone would love Germany. But, to be honest, for the Germans it would be a risk bordering on madness."
When politicians ask him for advice these days, Rogoff suggests starting with a debt haircut as quickly as possible, but even this solution would be very costly. To avoid simply pushing the affected countries over the brink, Europe -- and Germany in particular -- would have to find a way to deal with the bankrupt states.
Rogoff could imagine the Europeans guaranteeing the debts of a country's central government, but nothing more than that. In the case of Ireland, this would mean that no guarantees would be assumed for the banks. And in the case of Spain, it would mean that the immense debts of its cities and towns, such as Barcelona's, would remain Spain's problem. And finally, in that of Greece, it would mean that only the government's most critical expenses would be assumed
While this is the scenario Rogoff, an American expert on financial crises, paints, European politicians like Jacques Delors stand by their vision of a great Europe. Delors, the founding father of modern Europe, cannot imagine that the euro zone, by and large, will break apart. "It would be too expensive, and I think that no one wants to take this risk." Europe, says Delors, is a moral obligation, something that today's politicians have apparently forgotten. "They run around like disorganized firefighters, and they still believe that they can put out all the fires." But what is really necessary, says Delors, is a strong central government in Brussels that coordinates the efforts, as well as new, robust institutions.
Do Only Two Possibilities Remain for Saving Euro?
The proposals to solve the euro crisis are manifold -- reducing debt with or without withdrawal from the euro zone, a European finance minister or even a European economic government -- but they have become little more than an expression of the cluelessness of economists and politicians. There is no precedent for this crisis, nor is there a recipe that could be applied to resolve it. Europe's politicians have maneuvered themselves and their people into an unparalleled situation. It scares some of them more than it scares their voters, because politicians already know what voters don't even suspect yet.
In the end, only two possibilities will remain: a transfer union, in which the strong countries pay for the weak; or a smaller monetary union, a core Europe of sorts, that would consist of only relatively comparable economies.
A transfer and liability union requires new political institutions, and individual countries would have to confer a significant portion of their powers on Brussels. Some politicians are warming up to this idea as they consider an economic government or even a United States of Europe, but without explaining exactly what this means.
The second path is the more likely one. It will not be easier, and it might not be any less costly, either. First a firewall would have to be erected between the countries that are in fact insolvent and do not stand a chance of ever repaying their debts, like Greece, and others that have only a short-term liquidity problem. Then the banks would have to be provided with government funds, so that the financial system does not collapse when banks are forced to write off some of the government bonds on their balance sheets. Finally, the countries exiting the euro zone would require continued support, because Europe cannot simply look on as countries like Greece descend into chaos.
'That Doesn't Look Not Dangerous'
Horst Reichenbach will still be needed in either case. In his first tour through the offices of Athens cabinet ministers, the director of the EU Task Force is embarking on a battle against 10 years of mismanagement, 100 years of slowness and the pride of 3,000 years of history. Reichenbach is a mathematician, an economist and a technocrat with decades of experience in the Brussels bureaucracy, and generally a well-tempered man with an aura of extremely professional and esthetic austerity. He is an envoy from another time zone, an envoy from the future.
While waiting for the elevator, Reichenbach says that he feels "extremely welcome" wherever he goes. He attributes this to the fact that he is, after all, the "good guy" in this game, whereas the representatives of the so-called troika, consisting of the European Commission, the IMF and the ECB, who are there to monitor compliance with requirements, are "regarded less favorably" in Greece.
When he drives through Athens, what he sees looks like a dynamic European city through the tinted windows of his dark-blue Renault Espace, the Task Force's official vehicle. Traffic is light now that 15,000 striking taxi drivers have disappeared from the streets of Athens.
He has to slow down at one point, where the other side of the road is blocked. Reichenbach slowly maneuvers his Renault past a burning car in front of the US Embassy. He says, "oops!" and looks out the window, but then he concludes: "That doesn't look not dangerous."