The Ticking Euro Bomb
How the Euro Zone Ignored Its Own Rules
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. By SPIEGEL Staff.
This is Part 2 of SPIEGEL’s recent cover story on the history of the common currency. You can read Part 1 here. The remaining installment will be published in English on Friday.
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.
Part 2: 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 Mršnik, 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, Mršnik 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, Mršnik 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.
REPORTED 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
A Possible Scenario for the End of the Euro
Will the euro fall? Or will it just erode?
There are a growing number of people who have envisioned what the end of Europe’s common currency might look like. Most agree that it will be chaotic. But will it? We might actually not even notice that it has failed until it is long gone.
Recent weeks have been full of talk about the failure of Europe’s common currency. “If the euro collapses, then Europe and the idea of the European Union will fail,” said German Chancellor Angela Merkel recently. “Should the euro fail, we Germans will have the greatest disadvantages,” said Finance Minister Wolfgang Schäuble. Even former Foreign Minister Joschka Fischer has gotten into the act, warning of the “political, economic and financial” consequences a failure of the euro would trigger.
But how exactly are we going to know when the common currency has reached its end? What exactly does it mean when we say a “failure of the euro?” And is it possible that the currency may have already failed a long time ago?
Conflicts of Interest
German economists say that, when it comes to a collapse of the currency union, there are two possible scenarios:
In the first scenario, the euro would remain a hard currency and there would be no extensive transfer payments among euro-zone countries. In the coming years, some uncompetitive and highly indebted countries would leave the currency union to return to weaker national currencies. The edges of the euro zone would crumble, but a hard core would remain — consisting of Germany, the Netherlands, Austria, Luxembourg and perhaps a few others.
In the second scenario, Germany and others would abandon the common currency because the euro would become a soft currency and the euro zone would develop into a transfer union, involving payments among members. That, though, would be so unpopular in countries like Germany, which had its own hard currency prior to the euro, that they would ultimately bow out.
The two scenarios are similar in that they presuppose rational decisions being made despite conflicts of interest among euro-zone nation-states.
But is that realistic? Not really.
It is likely both technically and politically impossible for the currency union to be brought to an end on the strength of a carefully considered strategy worked out by the governments involved. There is no way such a plan could be kept secret long enough — once word got out, the extreme reaction of the markets would torpedo any blueprint.
Perhaps, as one Brussels insider joked, the currency union will simply expire from exhaustion one morning. European bureaucrats, so goes the gag, will run out of energy to find yet another emergency solution for a heavily indebted member state one day and investors will take over once the markets open. A panicked withdrawal of capital would result and the euro would be history.
No matter what happens, the end of the euro — should it come to that — would be chaotic. It would be, as Fischer warned, “no longer controllable.” And politicians will do all they can to avoid such a situation.
But the failure of the euro can also be defined differently. Originally, the euro was supposed to increase prosperity in Europe, boost unity and enhance Europe’s influence in the world. Those, at least, were the goals touted when the euro was first introduced.
By that measure, however, the euro of today finds itself in a deep crisis. The growth achieved in the first years following the introduction of the common currency was achieved at the cost of skyrocketing sovereign debt and drastic imbalances among European economies. That is now coming back to haunt the euro zone. The openness and cultural rapprochement that characterized the early years of the currency union is now, with crisis at hand, evaporating. Stereotypes that long since should have disappeared, such as “lazy southern Europeans” or “fiscal Nazis,” have made a comeback.
And, as for playing a larger role in the global economy, that is mainly manifesting itself in the fear that the euro crisis has engendered in capitals as far afield as Washington and Beijing.
Like the WTO
There is, of course, still a very real possibility that the euro will be saved. The economic and political problems are certainly solvable — with a huge step toward greater European integration. But, at the moment, it is difficult to imagine European politicians embracing a kind of “United States of Europe,” just as it is hard to imagine them letting the euro crash and burn.
>> Much more realistic is a slow and agonizing degradation of the euro zone. It would be a silent failure: a slow erosion of the rules (which is already well under way), countries growing apart and a corrosion of the institutions holding it together.
It has happened before, for example to the World Trade Organization. Just a few years ago, the Doha round of trade talks, aimed at further liberalizing global trade, threatened to collapse. Developing countries were demanding that rich nations cut agricultural subsidies, whereas the industrialized countries, for their part, wanted the developing world to cut import tariffs on their products.
In answer to the question as to how one would know when the talks had failed, WTO head Pascal Lamy laughed before saying: Diplomats are good at making things sound good. But they can’t make fools out of people.
That was four years ago. Since then, the negotiations have made no significant progress. But nobody has declared them to have failed.