27/12/2010
By Charles Forelle, David Gauthier-Villars, Brian Blackstone and David Enrich
DEAUVILLE, France—On Oct. 18, Angela Merkel and Nicolas Sarkozy took a sunset stroll on the beach of this chic casino resort. Five months earlier, Europe had committed more than $100 billion to rescue Greece. Now the Continent's debt crisis was moving on to Ireland, and the German leader worried Berlin would have to foot the bill for this and future bailouts.
"Angela, I'm going to help you," the French president said, before they set out for the boardwalk. The air chilled, so Mr. Sarkozy ordered an aide to fetch Ms. Merkel's coat. The lights of the palatial casino flickered in the distance.
The two leaders had a risky plan: The Deauville pact, sealed that evening, called for investors holding bonds in insolvent euro-zone nations to shoulder losses on them, starting in 2013. That would instill discipline in profligate countries, but also implied that a Western European nation might default on its debts. That hadn't happened in half a century, and the mere suggestion would shake markets, Mr. Sarkozy's own advisers had warned.
It also risked enraging the European Central Bank. For months, ECB President Jean-Claude Trichet, 68, had tried to rebuild investors' shattered confidence in the euro zone he had spent his career shaping. The central bank was almost single-handedly keeping Ireland and its tattered banks afloat. That task would be made more onerous by Ms. Merkel and Mr. Sarkozy's pact, which risked undermining the currency union itself.
This Wall Street Journal account—based on dozens of interviews with European officials—shows how the Deauville deal set off a chain of events that ultimately has led the leaders of the 16-nation euro zone to stumble into an even closer union.
As markets swooned in the wake of the pact, the ECB came down hard on Ireland. It threatened to cut off emergency lending to Dublin, and leaned heavily on the Irish central bank chief to pressure his nation to accept a bailout that would stanch the crisis, the Journal account reveals.
The agreement had the unforeseen effect of forcing Europe to take steps toward increased economic and political cooperation. In the past few weeks, European governments have created a permanent bailout fund to deal with crisis-hit countries. They have also debated raising money collectively through common European bonds, which could create a bond market akin to that for U.S. Treasurys.
Since the European community was established in 1957, its leaders have labored to forge an economic union that could compete on the global stage and, more important, ensure the Continent never plunged back into the world wars of the 20th century. Their crowning achievement was the creation of a common currency in 1999.
Ever since, economists have warned that monetary union, without a parallel authority to regulate taxes and spending, was destined to fail because there was no way to enforce the fiscal discipline essential to a currency's health. Now, as Europe's year of crisis grinds to a close, the Continent's leaders are contemplating what many long resisted: a United States of Europe.
"The crisis has shown that the process of European nation-building is necessary," says Italian Economy Minister Giulio Tremonti. "It will take time, but it's not possible to set the clock back."
The changes are far from the "quantum leap" in tightening the bloc's fiscal rules that Mr. Trichet urged governments to make earlier this year, to be sure. And governments could lapse back into complacency if markets calm down. Their resolve is likely to be tested amid rising concerns over the soundness of two more countries in the euro zone: Portugal and Spain.
After bailing out Greece in May, EU leaders tried to end the debt crisis by creating a trillion-dollar rescue fund to reassure markets that Europe could take care of its own. For a time, the plan worked.
Over the summer, the euro strengthened against the dollar. In July and August, Mr. Trichet urged governments to cut their deficits more forcefully and punish violators of the zone's deficit rules. But as the markets settled, the will to reform weakened. By the fall, a storm was forming over Ireland.
Greece's crisis stemmed from its public finances. Ireland was a casualty of its banks. They had lent to property developers in a real-estate bubble unmatched in Western Europe. After it burst in 2007, investors stopped trusting Irish banks. In a gamble that would come back to haunt it, Dublin had guaranteed in 2008 it would make depositors and investors whole if the banks failed. As bank losses grew, the government had to pump billions of euros to keep them afloat.
By summer, Ireland was in a vicious cycle: The more the banks lost, the more money Dublin had to give them, putting greater strain on state finances. The more state finances were stretched, the less trustworthy was Ireland's guarantee of the banks' obligations. The ECB, which provides financing for the euro-zone's commercial banks, stepped in, giving Irish banks quick loans in return for collateral.
By summer's end, the ECB had lent Irish banks €60 billion—more than a third of Ireland's annual economic output. In August and September, spooked depositors and investors pulled their money, and the banks grew even more desperate for cash.
Beyond the banks, Mr. Trichet was worried about the Irish government itself. Since May, the ECB had been buying the bonds of troubled euro-zone countries, so it held a lot of Irish government debt. ECB officials nudged Dublin to make bigger budget cuts. At a meeting of finance ministers on Sept. 7 in Brussels, Mr. Trichet told Irish finance minister Brian Lenihan that he had "fiscal appetite"—that is, he was hungry to see Ireland improve its finances.
Ireland's fate was on the line, but the 51-year-old Mr. Lenihan was waging a personal battle as well. Stricken with pancreatic cancer, he was undergoing rounds of chemotherapy and seemed increasingly despondent, friends say. He doubted that anything he did to improve Ireland's finances would satisfy bond markets.
While Mr. Lenihan cast about for ways to slim Ireland's budget, the crisis worsened. By Sept. 24, Irish banks' borrowings from the ECB had reached €83 billion. Frantic, Irish banks turned to a little-used emergency lending program run by national central banks, which are effectively appendages of the ECB. Ireland's central bank doled out €7 billion to Irish banks this way, accepting low-quality collateral. For example, Anglo Irish Bank offered a government IOU as collateral, thus converting a promise into instant cash.
"Financial gymnastics," one Irish banker called it.
On Sept. 30, Mr. Lenihan announced that Ireland would funnel billions more taxpayer cash into the banks. He promised a new deficit-cutting plan.
When Mr. Lenihan got on a conference call with hundreds of investors to sell the plan the next day, he was drowned out by a deluge of derision. Callers heckled him and shouted, "Short Ireland!"
Mr. Lenihan denied European officials were pushing Ireland to take the EU's emergency bailout funds. "We will paddle our own canoe," he said.
The Irish banks kept sliding. By mid-October, the ECB and euro-zone governments knew they had a second bailout candidate.
That put German Chancellor Merkel in a tight spot. The 56-year-old trained physicist, known for her tough negotiating style and cool demeanor, faced mounting pressure at home to limit how much Germans would spend to save their neighbors. As Europe's largest economy, Germany had borne the largest share of the Greek rescue. The chancellor now wanted fines on countries with excessive deficits to be automatic, rather than subject to a vote by fellow euro governments—a practice that had, she believed, let deficit sinners escape punishment.
To make any forceful change in EU rules, Ms. Merkel knew she needed France on board. Among the euro's 16 members, only Finland and the Netherlands supported her. The ECB also was pushing for automatic penalties. France led the majority that rejected automatic sanctions. It wanted to keep any penalties under the control of national leaders.
On Oct. 18, finance ministers met in Luxembourg to try to resolve the impasse. Only two—the French and German officials—knew the real deal was being brokered miles away, in Deauville.
When Ms. Merkel arrived at the Hotel Royal, Mr. Sarkozy embraced the German chancellor and led her into a small salon with views of the English Channel. France's hyperkinetic 55-year-old president relished the global spotlight. At home, though, protests against his plan to raise the retirement age were peaking, and strikers had crimped the nation's gasoline supply. The two leaders knew that the European project risked failure unless they overcame their longstanding differences on how to resolve the crisis.
Ms. Merkel immediately made one thing clear: Germany could not accept an extension beyond 2013 of the trillion-dollar safety net Europe had created after Greece's bailout, as some euro-zone countries were requesting.
Ms. Merkel proposed a compromise. Germany would drop its demand for automatic sanctions, but in exchange, the chancellor wanted France to support an idea her advisers had worked on for months: In the future, if a euro-zone country needed a bailout, its bondholders would have to accept a reduction on what they were owed, known as a "haircut."
Mr. Sarkozy knew Ms. Merkel was in a fix at home. If he rejected the haircuts, Germany might refuse even temporary help for ailing states.
"The question was: What happens if the Germans turn their back on Europe?" a French official said. "Nobody wanted to go there."
The Deauville pact struck by Ms. Merkel and Mr. Sarkozy hit Luxembourg like a bomb. Jörg Asmussen, Germany's deputy finance minister, printed out an email just after 5 p.m. outlining the proposal and passed it around to finance ministers. Not only had France and Germany decided that private creditors would have to worry about losing their money, but they had also cut a deal behind everyone's back.
"You're going to destroy the euro," Mr. Trichet shouted, in French, to the French delegation, according to people present.
Euro-zone government bonds had long been considered one of the world's safest investments: There was thought to be little risk a member state would default. But now, European leaders were about to enshrine in their laws the possibility of just such a default. That, the ECB knew, risked undercutting the bond market on which members of the monetary union depended.
When Europe's leaders gathered for a pre-summit dinner 10 days later, Mr. Trichet was still angry.
"You don't realize how serious the situation is," he told Mr. Sarkozy.
"Maybe you're talking to bankers," Mr. Sarkozy snapped back. "We are responsible to citizens."
Despite the fracas Mr. Sarkozy and Ms. Merkel had caused, other countries caved to the zone's two dominant powers. In a move toward fiscal unity, EU leaders agreed to authorize a permanent rescue fund and impose losses on creditors in some cases.
Markets revolted. Investors dumped the bonds of Ireland and other weak euro-zone countries, accelerating a sell-off that started after the Deauville meeting. Shut out of debt markets, Ireland faced the prospect of default.
Mr. Trichet was furious: The governments had shattered investor confidence, leaving the ECB to clean up the mess.
Dublin wasn't doing enough to save itself. It had made significant 2010 budget cuts. Yet ECB officials felt that unless Ireland promised impressive cuts for 2011 and beyond, markets would keep worrying—forcing the ECB to keep lending to Irish banks. In their view, a euro-zone bailout of Ireland would give Dublin enough cash to fix the banking sector without going bust itself.
On Nov. 9, Olli Rehn, the European Union's economy commissioner, relayed a stern warning from Mr. Trichet to Irish politicians. "The degree of exposure of the ECB to the Irish banks is unsustainable," Mr. Rehn told a group of officials over coffee and croissants at the EU's Dublin office.
The politicians were shaken. Mr. Trichet had been propping up Ireland's banks for months with emergency loans. Translated from banker-speak, the warning was clear: Mr. Trichet was threatening to cut Ireland off.
Over the next two weeks, the ECB played hardball. Behind closed doors, it threatened to shut off cash it was providing the banks, and scotched a plan to salvage the weakest lender, Anglo Irish Bank.
Irish officials insisted publicly that a bailout wasn't on the table: Political leaders feared a voter backlash at the loss of sovereignty a bailout would entail. But on Sunday, Nov. 14, Mr. Lenihan quietly dispatched a team to Brussels to hold preliminary talks in case a rescue was needed.
Two days later, euro-zone finance ministers gathered in Brussels. They urged Mr. Lenihan to accept the money and stop the market panic from spreading. "You have to do it tonight," Mr. Trichet told Mr. Lenihan.
Ireland still tried to resist. Then, on Nov. 18, at their monthly meeting on the 36th floor of the ECB headquarters, Europe's central bankers delivered an ultimatum to their Irish counterpart, Patrick Honohan: The ECB would disallow use of the Irish central bank's emergency loan program unless Ireland took the bailout.
That weekend, Ireland formally asked for the money.
In the days that followed, the ECB lobbied hard behind the scenes to water down the Deauville pact, arguing that it would lock Europe's weakest governments out of capital markets.
On Nov. 28, finance ministers approved a €67.5 billion rescue deal for Ireland. They also presented the details of the permanent bailout fund first unveiled a month earlier.
But Ms. Merkel, frightened by the uncertainty that her deal with Mr. Sarkozy had unleashed, agreed to a partial compromise. Instead of taking the hard line envisioned by the Deauville pact, the leaders agreed to restrict the use of haircuts: In most circumstances a country unable to borrow from bond markets would simply get a bailout. Only if the country were formally deemed insolvent by all other euro-zone members would bondholders face losses.
Still, the impact of the permanent bailout fund was undeniable: All the euro-zone countries now will become partly responsible for their free-spending brethren. That could prod the countries to head off fiscal irresponsibility by involving themselves more deeply in each other's tax and spending policies.
The agreements had left a loose end: Portugal. Lisbon is widely seen as next in line for a bailout, because of its gaping budget deficit and chronically weak economic growth.
Several participants at the Nov. 28 finance ministers' meeting pushed Lisbon to apply for aid, say people familiar with the matter, but the Portuguese finance minister refused. He has said repeatedly that his country doesn't need outside help.
Market fears about Portugal and neighboring Spain continue to haunt Europe's leaders. This month, the bonds of Italy and Belgium—two indebted countries previously spared from panic—have come under selling pressure. There are signs this pressure is pushing governments to venture further toward a united Europe.
The finance ministers of Italy and Luxembourg this month proposed raising money for European countries collectively, through common European bonds. France and Germany are still opposed to such E-bonds, but others in Europe are willing to discuss them.
Next year, the debate over Europe's future will continue. The pull of national sovereignty will face the push of coordination. If a closer union fails, some European leaders argue, the euro could unravel with dire consequences.
"The euro is our common destiny, and Europe is our common future," Ms. Merkel told the German parliament this month.
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