1. Defending a symbol - Euro is here to stay

In the first few years after its 1999 debut, the euro symbolised what the euro area member states had achieved together. Citizens could work, shop, and save across borders without having to convert their money into francs and marks. Enterprises could do business across all countries that used the euro without experiencing any exchange rate risk, and capital markets benefited from a larger pool of securities denominated in the same currency. Over time, markets began to trade euro area sovereign bonds more interchangeably.

Ten years later, global financial turmoil caused tremors that would shake the new currency to its core. By 2010, the crisis that erupted in the United States (US) had triggered a sovereign debt crisis in Europe. Investors began to wonder if the groundbreaking common currency could withstand the rising debts and troubled banks that were plaguing several of its countries and threatening the rest. As doubts spread, conservative bond investors grew increasingly nervous and pressed ever lower the prices at which they were willing to buy the sovereign debt of some euro countries. This forced up the interest rates on that debt to levels that crippled national budgets.

To meet this challenge, the euro area erected a firewall. Beginning with the European Financial Stability Facility (EFSF) and continuing with its permanent successor, the European Stability Mechanism (ESM), the countries that joined forces to build the euro made it clear that they would stand together.

This collective action meant that during the worst of the crisis, the EFSF and ESM were able to tap financial markets to provide rescue funding to five of the euro area’s 19 member states. Because of this steady access to affordable financing amid the broader market turmoil, those five countries were able to undertake the reforms they needed to compete and thrive in the global economy. Moreover, thanks to the innovative way the firewalls were structured, the rescue programmes were financed with minimal risk and virtually no direct cost to taxpayers elsewhere in the currency union.

For Jean-Claude Juncker, who during the first years of the crisis was premier of Luxembourg and also led the finance ministers of the Eurogroup, the currency area has emerged stronger than ever. The euro was under serious threat when the sovereign debt crisis reached its peak in 2011 and 2012. At that moment, various doomsayers predicted the end of the single currency. ‘They were proven wrong,’ said Juncker, now president of the European Commission. ‘The euro is here to stay.’

Historically, as part of the European Union’s (EU’s) founding treaties, fiscal policies were left up to each individual Member State. The euro area had adopted budget guidelines, known as the stability and growth pact, to try to keep all of its member states on the same page when it came to borrowing and spending. But those agreements had not held up in times of economic struggle. Germany and France had led a push in 2003 to avoid sanctions for their own higher deficits^[1], and in their shadow it was easy for other countries to postpone the fiscal day of reckoning. As long as bond yields stayed uniformly low across the region, there had been no pressing need to address the flouting of the budget rules.

Everything was made worse by the crisis that hit the world in 2007 and 2008 after convulsions in the US financial system. Governments worldwide were under huge pressure as the worst recession since the 1930s shrank tax revenues and boosted welfare spending. The Group of 20 and the EU decided collectively to undertake expansionary fiscal actions in response. The subprime mortgage crisis, in which lenders around the globe took on too much exposure to risky US housing loans, also exposed huge flaws in the banking system. Countries were forced further into the red by providing recapitalisation to troubled banks. As a result, government balance sheets deteriorated and nervous investors looked for weaknesses. This pattern would repeat itself throughout the five years when the euro crisis was at its most threatening.

In 2009, the market’s unfettered confidence abruptly evaporated after Greece elected a new government that came face to face with far higher budget deficits than had been reported. For too long, markets had ignored growing disparities in the economic fundamentals of euro area countries. When the true level of the Greek debt and deficit was revealed, investors overreacted in the opposite direction, withdrawing capital by selling off debt not only from Greece but also from countries across the region.

Some countries, such as Ireland, had independently run into trouble because of a bursting real estate bubble and subsequent difficulties in the banking sector. Others, such as Portugal, were in 2009 already up against the limits of what they could sustainably borrow following worsening current account imbalances. Throughout the currency area, the onslaught of uncertainty radiated from Greece to nearly every euro country active in the sovereign debt markets.

In the euro area’s first years, the economic success of its strongest nations had spread throughout Europe. Now the trend was running the other way. Countries that had been seen as healthy lost the benefit of the doubt, while those that were facing challenges saw their tribulations increase almost overnight. This cycle of contagion, as trouble spread from one hotspot to another, meant the euro area was at risk of losing the longstanding ability of all its members to raise money on financial markets. The implications ranged from higher borrowing rates to a possible total loss of market access that would leave governments unable to raise funds.

For example, after Greece’s deficits came to light, new questions arose about Ireland, whose government had promised to guarantee^[2] all bank debts in a bid to head off what had previously appeared to be a self-contained financial shock.

Difficulties in one country showed up in another as the crisis got worse. In January 2012, the credit-rating agency Standard & Poor’s highlighted the extent of the damage by downgrading nine euro area countries, including two countries previously AAA rated: France and Austria^[3].

The euro area was vulnerable to these kinds of shocks because of the way its member states had bound themselves together. Often a financial crisis is followed by large currency movements, driven by the markets when investors perceive a risk of investing in a country’s currency, or driven by a decision by governments to devalue their currency. For euro area countries, this was not possible to do on a country-by-country basis.

Once Europe’s greatest symbol of post-World War II unity, the common currency was under threat. In the years to come, the euro area would repeatedly be called upon to prove its mettle.

There was no mechanism to help distressed countries within the currency union before the global crisis hit. As conditions deteriorated, investors began to ask what would happen if governments ran out of money and couldn’t borrow more. What if Greece defaulted on its debts, and what if that in turn shut other countries out of financial markets so that they, too, would default? They feared Greece’s exit from the euro – Grexit – and the financial turmoil that could force others out. This pressure spread across the entire region.

Policymakers across Europe fretted about how to stop the shockwaves from Greece, in order to avoid fracturing the euro area. But the contagion was already taking root.

‘The fear of hanging sharpens a person’s mind,’ said Thomas Wieser, who throughout the crisis was chairman of the Eurogroup Working Group and the Economic and Financial Committee, the two most important economic committees of the euro area and the EU. In the Eurogroup Working Group, the euro area’s finance ministry deputies’ group, Wieser steered the detailed financial planning for the country programme rescues until he retired in January 2018. He put the euro’s problem succinctly: ‘When the Greek crisis struck, we had no instrument to tackle it – and specifically the contagion that concerned us all at the time.’

The common currency area was at a crossroads: would its leaders provide a safety net to defend the euro, or would they allow it to splinter into pieces? They had to find the will to act. ‘It had become apparent that we needed something to stabilise the euro,’ Wolfgang Schäuble, Germany’s former finance minister, said. ‘We had to take consistent and resolute action to shore up the euro area’s financial stability.’

Euro area leaders sought assistance from the international financial system’s lender of last resort, the International Monetary Fund (IMF), but never depended upon it entirely. Because of the unique interconnections at the heart of monetary union, the euro area needed its own backstop alongside the IMF’s global prowess. Moreover, the IMF’s lending capacity would not have allowed it to provide all the money needed by those euro area countries that lost market access over the course of the crisis.

‘We needed to create our own European funds,’ said Klaus Regling, the EFSF’s chief executive and the ESM’s inaugural, and to date only, managing director.

At the height of the crisis, Europe’s politics were divided among countries that needed aid, those that might, and those that did not think they ever would. The founding treaties of the EU barred the assumption of a country’s debts by another country or by the EU, and there were no tools immediately available for providing a helping hand on the scale needed.

Against this backdrop, the euro area moved to tackle the financial crisis in a stepwise fashion. At every stage, member states pushed the boundaries of what was then politically possible, so that each move would be stronger than its precursor. The firewall that emerged would be a fundamentally European solution.

In 2010, the first initiative was a bilateral loan programme for Greece, collectively managed by the Commission and named the Greek Loan Facility^[4].

‘To avoid contagion to other members of the currency union, we quickly needed to come up with a convincing approach that could also be implemented in the short term,’ Schäuble said. ‘We knew that these solutions were only temporary and that we needed to work on creating a permanent crisis mechanism, which is where the ESM eventually came in.’

The first breakthrough came during a fateful weekend in May 2010, when the euro area worked round the clock to put together a crisis response to keep the monetary union together. Directed by European leaders, and backed by ECB, the European Commission, and the IMF, euro area finance ministers strove to find a solution that would calm financial markets: a fund able to borrow on global capital markets in order to lend to nations that could no longer borrow on their own.

The stakes were enormous, remembered Christine Lagarde, who was then France’s finance minister and would later become IMF managing director. ‘If we could not reach agreement, there would be no firewall and the crisis would spread to the point where the euro was under threat.’

That weekend gave birth to the temporary EFSF, which in turn was a bridge to the permanent ESM in terms of concept and politics. The interim fund, which became fully operational in August 2010 and issued its first bond in January 2011, had an immediate ability to tap financial markets at affordable rates, replacing the stopgap system of bilateral loans that had failed to contain the contagion. In just seven months, the EFSF went from a sketch on paper to a fully fledged, top-rated issuer in capital markets.

The EFSF was backed by guarantees provided by its Members. At the time, that system was what made it attractive because it was a way around writing an upfront cheque, Wieser said.

The EFSF was also designed to be temporary, and initially its aid loans were priced at a steep premium to typical market rates for stable countries. When a euro area rescue fund had first been floated, sceptics had sought to limit its availability so it wouldn’t be over-relied upon. Euro area member states were understandably reluctant to provide funds to other countries for a lengthy period. At the same time, the fund proved essential in fighting back against euro area contagion. The EFSF’s success set the stage for its permanent successor, as the euro area became more comfortable with new ways of working together to help a country get back on its feet.

As a permanent institution backed by a buffer of paid-in capital, the ESM took things to a new level when it began operations in October 2012. It offered a sturdier financing framework than the EFSF, which allowed it to respond faster to countries in need. The ESM, set up outside the EU treaties, has not only mobilised large amounts of money in markets, but it has also been a source of technical and practical advice to euro area member states in times of deep financial strain.

‘The EFSF, and later the ESM, were crucial tools for dealing with the sovereign debt crisis in the euro area,’ said Mario Draghi, president of the European Central Bank (ECB) since November 2011.

Operating with a single staff and office since the ESM’s 2012 inception, the two funds stood for action during a time when some feared the bloc that had taken so long to build could be ripped apart overnight.

Timothy Geithner, former US Treasury secretary, said the crisis worsened in part because of ‘an external perception that Europe was not willing to put the resources’ into the type of policy response that was needed. The evolution of the ESM, along with parallel moves towards euro area banking union and stronger financial regulation, helped put these global fears to rest.

Moving to a permanent euro area institution was of ‘paramount importance’, Alfred Camilleri, permanent secretary for budget and finance in the Maltese finance ministry, said. ‘There was a very strong suspicion that contagion would escalate, and that a number of other countries – especially those that were significantly more vulnerable – would be hit,’ he said. ‘Policy is often formulated and implemented in response to particular situations. The euro area is still a work in progress. These two institutions were created in response to, and in the context of, a crisis.’

Overall, the two firewall funds were called on to assist first Ireland, and then Portugal, Greece, Spain, and Cyprus. In every case, the euro area made clear that its assistance would come in the form of loans, not grants, and that countries would be required to strengthen their economies in return through macroeconomic, structural, and financial sector reforms, referred to as ‘conditionality’. That meant reining in debt, opening up internal markets, and taking action to regain competitiveness. Each loan came conditional upon specific reform requirements, including timetables for their enactment.

‘We don’t make any disbursements without conditionality. One can argue what is the best conditionality, but it’s always tough,’ Regling said.

Regling was Juncker’s choice to lead the firewall from the beginning. The then-chief of the Eurogroup sought to tap into Regling’s experience at the German finance ministry, the IMF, and the Commission, as well as in the private sector. After such a career tour, with both policy experience and technical expertise, Regling was primed to shepherd a new institution at the intersection of governments and markets. His expertise was an essential part of the push to avoid the ‘grave danger’ posed by the euro area’s struggles and the threat of a worsening worldwide crisis, said Mitsuhiro Furusawa, former vice minister at the Japanese finance ministry and now deputy managing director at the IMF.

‘No one had any doubt when he was chosen to lead the EFSF and the ESM,’ Furusawa said. ‘He was a faithful advocate of a strong euro area, and he has a lot of credibility in the international financial community.’

The euro’s firewall funds were set up in Luxembourg, well regarded for its corporate statutes and recognised as a financial centre. Already home to EU institutions such as the European Investment Bank (EIB) and the Court of Justice of the European Union, the Grand Duchy welcomed the EFSF and provided its start-up funds and its first – and, for one month, sole – director, Georges Heinrich. Then treasurer-general at Luxembourg’s finance ministry, he said there was never any question whether or not Luxembourg would lend its support to its peers as the crisis erupted.

In short order, the firewalls went from being bond market unknowns to reliable and extensive issuers of euro-denominated securities, and in 2017 the ESM completed its first non-euro bond sale in dollars. With issuance ranging from short-term bills to very long-term bonds, the rescue funds have together proven their ability to work with investors and programme countries to ensure that there is always ready market access for the euro region.

The ESM’s solid capital structure is the lynchpin of this financial security. The ESM holds over €80 billion in paid-in capital – far more than any other international financial institution – and has the possibility of calling up an additional €624 billion from its Members, the euro area member states. Building this capital base was a huge achievement for the currency union, where there has always been strong political resistance to creating a common borrowing authority that would have joint liability for all funds raised.

In October 2017, the ESM marked its fifth anniversary. From the outset, Regling sought to create an institution that emulated the best qualities of its many influences, without becoming hidebound to a single tradition. The staff of the firewall was drawn not only from the familiar hunting grounds of central banks, finance ministries, and international institutions, but also from private sector investment banks and technology companies. With a total workforce now of under 200, the ESM has consciously created lean and flexible structures, while also translating that culture into a public service mission befitting an international financial institution.

‘We didn’t have any template to look at. Everything we’re doing here we had to build from scratch,’ said Cosimo Pacciani, the ESM’s chief risk officer.

Up until 2015, the ESM was a true start-up. This is no longer the case, said Jeroen Dijsselbloem, former Dutch finance minister, who was Eurogroup president and chairman of the ESM Board of Governors through the later part of the crisis. ‘With its upgraded risk framework, its robust internal controls, its early warning system, its programme evaluation, and its staffing, the ESM is now a fully mature institution,’ he said.

One by one, the five countries that received aid have exited their rescue programmes and returned to affordable market access. Each remains in close contact with the ESM through the firewall’s early warning system, so that any future financial difficulties can be identified and addressed early on. Most recently, in August 2018, Greece exited its ESM programme, after far-reaching macroeconomic, financial, and structural reforms.

There are three major lessons to be learned from the euro’s trials, said the IMF’s Lagarde. First, it is crucial to move quickly – both in raising the alarm and in providing a remedy – to identify when trouble is brewing and get started on solutions early on. Second, the countries that are in the toughest spots need to take political ownership of the reforms necessary to get their economies back on track. Third, it’s critical to have the right data – the case of Greece in particular shows that, when economic statistics aren’t accurate, the fallout can be devastating^[5]. The ESM’s arrival is emblematic of the euro area’s advances in these areas, and of its commitment to combat future crises and sustain its single currency.

With the ESM, the euro has emerged strengthened from what could have been its undoing. Question marks about the euro area’s willingness and ability to act have been put to rest. This book is a reflection of that journey, of the lessons learned along the way, and of Europe’s historic show of solidarity during a time of great crisis.