2. Lurching towards crisis: a ‘very fragile’ world

When the euro area made its historic decision to create a common firewall, it had been buffeted by two major crises, each of which had been building for years. First, Europe was sent reeling by the US subprime mortgage debacle and the shockwaves caused by the collapse of the investment bank Lehman Brothers in 2008. This fed into a second crisis, when the euro area was forced to deal with its heavy sovereign debt load as well as real estate bubbles in some member states, amid unprecedented turmoil in the markets.

Alarm bells started ringing in the euro area as soon as the subprime mortgage market storm began to brew in the US, said Vítor Gaspar, former Portuguese finance minister and now head of the IMF’s fiscal affairs department. From 2007 to 2010, Gaspar led the European Commission’s in-house economic policy think tank, the Bureau of European Policy Advisers.

‘When the global financial crisis started in the summer of 2007, my main concern was: what if the turmoil in financial markets, given the fragility of some financial institutions, migrates to the sovereign?’ Gaspar said. ‘My perception at the time was that Europe did not have the institutional infrastructure to manage this. It was a vague fear at that point, but it became increasingly more pressing.’

Fallout from the subprime collapse spread quickly across the Atlantic. The US investment bank Bear Stearns liquidated two of its hedge funds on 31 July 2007, and in early August the French bank BNP Paribas halted redemptions on three investment funds. In September, the Bank of England stepped in to support Northern Rock^[1], the UK’s fifth-largest mortgage lender. By February 2008, Northern Rock had to be nationalised, and in March the US moved to shore up Bear Stearns with a bridge loan and helped it merge with JPMorgan Chase.

In the following months, the flames of the US crisis would rise to new heights. The mortgage giants Fannie Mae and Freddie Mac ran into trouble and were nationalised in September 2008. A week later, Lehman Brothers filed for bankruptcy. Its failure was a calculated move to let market forces act in place of taxpayer bailouts, but the explosive strength of the market reaction caught policymakers off guard in the US and around the world. The US had to backpedal immediately, offering government support to the insurance giant AIG, and then to a large swathe of its biggest financial institutions via the Troubled Asset Relief Program^[2].

A series of crises tumbled over one another even before the troubles in Greece erupted, prompting Europe’s sovereign debt problems, according to Wieser, former chairman of the Eurogroup Working Group. ‘Lehman did not lead to the Greek crisis; Lehman led to a succession of five or six crises before it morphed into the Greek crisis.’

The euro area faced its own challenges. Because countries shared an exchange rate and a central banking system, those that had lost competitiveness couldn’t devalue their currencies, and economic conditions were more likely to deteriorate. The most direct way authorities in a monetary union can respond to growing imbalances between countries is to cut wages, salaries, and pensions, in what is known as an ‘internal devaluation’. Understandably, this isn’t popular with voters.

‘We can blame the US for the first crisis. That’s where it was triggered. But the second crisis was our own problem,’ said Regling, ESM Managing Director. ‘Problems accumulated for more than a decade, with countries losing competitiveness because they increased their wages and salaries too quickly, more than productivity gains allowed. Some ran overly large fiscal deficits so their debt was too high, while others experienced huge real estate bubbles.’

When times were good, euro area member states had little incentive to curb bubbles that were propelling growth because of the generous borrowing conditions enjoyed by every country in the bloc.

‘The euro, in a way, allowed these imbalances to get bigger than they would have become otherwise,’ Regling said. ‘The view that was out there was that financing would always be automatic, whatever the current account situation.’

For years, banks had invested heavily in euro area government bonds because the perceived risk of sovereign default was low. When investors began to question this logic, large exposures to sovereign debt already tied banks and governments together – and the bank-sovereign link was set to tighten further. Not only could banks founder by investing too heavily in sovereign debt, but governments suffered if they had to rescue struggling banks. During the boom years, banks across the euro area offered easy credit to homebuyers and business owners, only to later discover those loans might not be repaid.

As September drew to a close, the Benelux bank Fortis was seeking taxpayer help, soon followed by Dexia, Royal Bank of Scotland, HBOS, and Lloyds TSB. The costs of handling multiple banking emergencies would add to an already difficult fiscal and economic environment for many European countries. Towards the end of 2008, the euro area entered a deep recession^[3] that would last for five consecutive quarters.

In Ireland, the banking sector was headed towards systemic collapse. In addition to low interest rates and a roaring real estate market, Ireland had experimented with banking oversight changes that didn’t keep close enough tabs on what the banks were up to. The supervisors not only failed to rein the banks in soon enough; they also didn’t have sufficient information to act.

The day after Fortis sought aid, Ireland announced a blanket two-year guarantee for its banks in the hope of reassuring investors that the banks would not default. But the gambit would not succeed. The Irish government later forced fresh capital into two of its biggest banks and nationalised a third. The moves illustrated the challenge of trying to protect both the economy and financial stability. Ireland would become the first euro area country to succumb to the bank-sovereign doom loop: the cross-contamination between bank balance sheets and government finances would push the euro area to its limits.

On the one hand, Ireland set a dangerous precedent by merging its bank debts with its national finances. On the other, the country was under tremendous pressure to protect senior investors in bank debt, who in Europe had historically been shielded from losses. At a summit held in October 2008, euro area leaders pledged to consider coordinated guarantees of senior bank debt for up to five years as part of a ‘concerted European action plan’ in response to the crisis^[4].

Regling, at the time a consultant in the private sector, and the economist Max Watson, a former senior staff member at the IMF and the Commission, were tasked with assessing the Irish banking crisis in its aftermath. ‘In euro area members, fiscal and prudential policies must take into account, and seek to mitigate, a mismatch between monetary conditions and the national business cycle,’ they wrote in A preliminary report on the sources of Ireland’s banking crisis^[5]. This was particularly important during the transition to the common currency, as several countries shifted from their traditionally higher interest rate levels to the lower rates prevailing in the euro area. Lacking proper oversight, banks faced a huge temptation to make far too many risky loans.

Regling and Watson’s advice to Ireland held for the euro area in general, and underscored the importance of healthy banks to a healthy economy. Banking difficulties would be a central component of every assistance package the euro area considered, taking centre stage in Spain and Cyprus and playing significant roles in Portugal and Greece. As a remedy, Regling and Watson called for the kind of coordinated banking supervision that would later emerge in the shape of the Single Supervisory Mechanism^[6], 2014’s breakthrough in the euro area’s move to banking union.

Although problems such as weak banks, high government debt, and inefficient labour markets were visible in 2008, the former ECB President Jean-Claude Trichet said that they were not yet appreciated: ‘It was absolutely clear that many countries had no understanding of the loss of competitiveness incurred by a large number of countries during the first decade of Economic and Monetary Union,’ he said.

While the euro area grappled with how to help members in trouble, a financial storm was hitting countries in central and eastern Europe. Banks with large exposures to this region came under significant market pressure, and, to prevent them fleeing these economies en masse, the ‘Vienna Initiative’^[7] was assembled in 2009 by a consortium of the Commission, the European Bank for Reconstruction and Development, the IMF, and the World Bank. These institutions worked together to coordinate crisis management proposals and to encourage parent banks to recapitalise their subsidiaries in eastern Europe, as well as to facilitate talks between debtors and creditors on how to navigate cross-border banking difficulties.

Latvia provided a foreshadowing of the troubles to come. In December 2008, it secured a €1.68 billion aid package from the IMF to help it through its economic and financial crisis^[8]. However, to avoid disrupting its path to monetary union, Latvia chose to maintain the fixed exchange rate of the lats to the euro. The resulting downward pressures on wages and pensions were followed by protests and, in early 2009, the collapse of the government^[9].

From there, the turmoil continued to spread. To Gaspar, who was monitoring developments from his analytical post at the Commission, the euro crisis seemed fundamentally different from previous regional flare-ups in Europe and elsewhere because of its focus on sovereign market access instead of currency fluctuations. ‘I didn’t see the development in financial markets and the sovereign debt crisis as analogous to an exchange rate crisis,’ he said. ‘I saw it instead as a crisis that affected the credit standing of sovereigns, in particular sovereigns that were perceived as fragile. So the issue was not only that of sustainability, but also the standing of sovereigns in the market.’

Credit-rating agencies, which should have been monitoring bank lending practices and sovereign debt risks, failed to do so. ‘In the run-up to the financial crisis, we now know, they were over-optimistic with their ratings, but once the crisis hit, their ratings went into a very fast downward spiral’,^[10] the European Parliament said in a 2016 report on how the credit assessment firms performed before and during the crisis.

As the crisis built, markets targeted more countries, said Schäuble, former German finance minister. ‘At first, the pressure from the markets was limited to Greece. But it soon became clear that there was a risk of contagion.’

Maria Luís Albuquerque was watching the bond markets from her post at the time in the Portuguese debt management office. Albuquerque, who later became the country’s finance minister, said: ‘Leading up to the crisis, we saw that spreads on sovereigns were really crushed to a minimum, which was not consistent with the fundamental differences between different economies.’ Portuguese 10-year government bond yields were close to Germany’s, and in early 2005 even dipped marginally below, because investors were lumping together the risk of euro area countries. Later on, the trend would go the other way and spreads would widen to dangerous levels.

As the crisis heated up, investors pulled back, eventually preferring just one euro area country over the others. An initial ‘flight to security’ drove investors into a range of safer assets, namely sovereign debt, which later evolved into ‘a flight to Germany’, Albuquerque said. ‘They were basically the only ones that could really attract money because investors were so craving safety.’

At the same time, the risk to global markets was mounting. Geithner, former US Treasury secretary, said: ‘The world was very fragile at that point. I was deeply concerned with the risk that this would get out of control and the contagion would spread – it would have adverse implications for us, not just in Europe.’

The Commission began to lay the groundwork for a collective solution, without knowing where it would lead. In December 2009, planning began on a potential rescue package for Greece, whose fiscal deficit kept getting revised upwards – ‘it exploded three times in three months,’ said Olli Rehn, former European commissioner for economic and monetary affairs and the euro. These aid preparations continued through the Christmas break and into January. Instead of the planned 3.7% deficit for 2009, Eurostat put the fiscal deficit at 13.6% in its April 2010 report^[11], making one further final upward revision to 15.4% that November^[12].

In February, the new Commission took office, headed by José Manuel Barroso in his second term as president, with Rehn taking up his new economic commissioner post^[13]. ‘From that moment on, the Commission started to persuade Germany and France and then the other countries, especially the AAA ones, to agree on a stability fund. We didn’t know exactly what form it should take, or could take,’ Rehn said.

It was now evident that several countries were facing serious banking, macroeconomic, and/or market access issues – but how to deal with them was far from clear. Before Europe could move ahead to control the damage, it would need to agree on what kind of joint action made political sense. Some countries felt too strong a backstop would create ‘moral hazard’ and discourage countries from confronting their problems and taking necessary action. At the same time, others feared that asking private investors in sovereign debt to shoulder losses could destabilise the European bond market. Finding a balance between curbing contagion and encouraging reforms would be the euro area’s central challenge over the coming years.