By James G. Neuger and Simon Kennedy
June 8 (Bloomberg) -- Jean-Claude Trichet used a simple chart to convince European leaders the euro was in grave danger.
It was Friday, May 7. Spanish, Greek, Portuguese and Irish government bonds were plunging, sending shudders through world markets and fueling speculation Europe’s 11-year-old monetary union could collapse. The European Central Bank’s president traveled to an emergency Brussels summit of heads of government armed with graphs to dramatize how bad things were.
“My main message for the governments was: Some of you have behaved very improperly and have created an element of vulnerability for your own country, and by way of consequence for Europe,” Trichet recalls. “Now the situation calls for taking up responsibilities.”
By 3:15 a.m. the following Monday, Europe knew the price of that responsibility: an unprecedented 750 billion-euro ($900 billion) aid package to prevent a debt spiral, backed by a credibility-testing pledge from the ECB to purchase the bonds of distressed governments, all to keep the $11 trillion, 16-nation economic and monetary experiment afloat.
Guiding the euro’s fate from the 35th floor of the ECB’s headquarters in downtown Frankfurt, Trichet says he’s never known “calm waters” and is “used to crisis.”
Yet the turmoil casting a shadow over the last 17 months of his eight-year term is unlike anything he has faced before. Throughout his career he has battled crises, ranging from the oil-price surge when he was a French presidential aide in the 1970s, to the euro’s birth pangs and his acquittal in 2003 on decade-old charges of helping Credit Lyonnais SA cover up losses. As ECB chief he then had to confront the global credit crunch and recession.
Now, investors are questioning the survival of the euro itself, along with the tight-money orthodoxy that Trichet has promoted as a central banker. As the 67-year old Frenchman nears retirement from the ECB in October 2011, he is having to rework parts of the German-inspired policy rulebook underpinning the euro in a bid to save the currency he helped create.
“If you cross a typhoon, the manual doesn’t help,” says Tommaso Padoa-Schioppa, 69, who served seven years on the ECB’s Executive Board and now chairs the European unit of Washington- based financial-services consulting firm Promontory Financial Group. “Trichet has had the ability to understand that the decisions during this crisis could not be exclusively based on the manuals written for ordinary times.”
One Size Fits All
The euro has slumped 19 percent against the dollar in the past six months as the fiscal crisis that started in Greece made money managers wary that some debt-swamped nations might default, or even revert to old currencies to devalue their way to salvation.
With investors selling sovereign paper from Athens to Dublin and buying safer German bonds, yield spreads ballooned in the first week of May, rendering the ECB’s one-size-fits-all monetary policy ineffective and threatening to tear the currency union apart.
So Trichet made the biggest gamble of his career, agreeing to buy government debt to halt the surge in yields in the hope politicians will respond by fixing their budgets, allowing the ECB to return to fighting inflation.
The risk is that profligate nations will renege on the deal, expecting stronger euro-area neighbors such as Germany and France to save them just as they rescued Greece.
Critics say the ECB has abandoned a founding principle not to bail out cash-strapped governments and may be left having to buy more debt, which could ultimately undermine its primary price-stability mandate.
“The last months of Trichet’s presidency are going to be among the most difficult of his time,” says Laurent Bilke, a former ECB economist who is now with Nomura International Plc in London. “The ECB more and more will have to arbitrage between a financial stability role and price stability.”
A rare communications misstep by Trichet contributed to the worsening crisis at the start of May. Speaking in Lisbon on May 6, he told reporters that the purchase of government bonds wasn’t even discussed by ECB officials during their meeting that day.
His perceived ambivalence shook European markets and briefly helped drive the Dow Jones Industrial Average down almost 1,000 points.
Within 24 hours, ECB aides were talking to the region’s primary dealers, and Trichet was at the center of emergency consultations with EU leaders throughout the weekend to get a rescue package in place before Asian markets opened.
Adding controversy to the bond move is the vocal opposition of Bundesbank President Axel Weber, a leading candidate to succeed Trichet next year, who said the policy creates “significant” risks.
Another German dissenter is Helmut Schlesinger, who ran the Bundesbank from 1991 to 1993 and raised its benchmark discount rate to a record high of 8.75 percent in 1992 to choke off the inflationary consequences of German reunification.
“Confidence in the system of European central banks is at stake,” says Schlesinger, 85. “The most important thing would be to keep the purchases of government debt to a minimum and stop them as soon as possible.”
Trichet defended his actions in four interviews with German print and broadcast media in the space of a week. The ECB is dealing with “the most difficult situation since the Second World War, perhaps even since the First World War,” he told Spiegel magazine in an article published May 15. The ECB prodded governments into acting, not the other way around, and the bond purchases will be offset to ensure they have no inflationary impact, he said.
Trichet’s supporters say the program shows his ability to set aside dogma in pursuit of a higher goal.
“The ECB was flexible in its approach and willing to act very strongly when a clear crisis was building up,” says Marie Diron, who spent five years in the ECB’s economics department and is now at Oxford Economics Ltd. “What it was trying to do was restore normality in government bond markets and not lose sight of its price stability mandate or bailing out a country.”
As of June 4, the ECB had bought 40.5 billion euros of bonds.
“He has shown a lot of sang-froid and rigor and pragmatism in managing the crisis,” says Jean Arthuis, a French senator who worked alongside Trichet as finance minister from 1995 to 1997.
Trichet learned his trade during the 1970s and early 1980s, when the U.S. Federal Reserve, under Paul Volcker, and the Bundesbank led the world in taming price pressures generated by oil shocks.
Their success in proving the mettle of independent central banks with a mission to fight inflation led the European Union to insist that all would-be euro users make their monetary authorities free of government control. It also ensured that the blueprint for the euro was the deutsche mark.
As head of the French Treasury from 1987 to 1993 and governor of the French central bank from 1993 to 2003, Trichet extolled the German mantra of low inflation and budget discipline to France’s elite, earning him a reputation as the Bundesbank’s representative in Paris.
Trichet “was able to resist political pressure coming particularly from his own government,” says Lamberto Dini, 79, a former Italian prime minister who knows Trichet from European exchange-rate negotiations in the 1980s. “When he was criticized because monetary policy was too strict and France wanted to ease up, he did not.”
Political haggling put the French civil servant -- trained first as a mining engineer, then in politics and economics before attending the Ecole Nationale d’Administration, the finishing school for the French leadership -- in charge of Europe’s money.
France acquiesced to the demands of Germany and the central banking community to let Wim Duisenberg of the Netherlands become the ECB’s first president at a summit in 1998, on condition he step down before the end of his term to make way for Trichet.
The deal set a precedent for political meddling with a central bank that, under the euro treaty, would not “seek or take instructions” from European or national leaders.
From the start, the ECB had to defend its turf, with Duisenberg saying in 2001 that “I hear, but I do not listen” to politicians’ pleas for lower interest rates.
Without the Dutchman’s gruffness, the courtly Trichet resisted similar pressure after taking over in 2003, deflecting calls from German Chancellor Gerhard Schroeder among others for easier credit.
The result is a price-stability record that surpasses even the Bundesbank’s. Inflation in the euro region has averaged 1.98 percent since the ECB took control on Jan. 1, 1999, in line with its self-set target of “below but close to 2 percent.”
The ECB’s standing is now in jeopardy. Trichet’s detractors argue the decision to buy bonds breaches a rule that the central bank doesn’t rescue governments, undermining the independence it needs to breed confidence in the euro. They also say that the ECB risks stoking inflation by increasing the money supply.
To David Mackie, chief European economist at JPMorgan Chase & Co. in London, the danger is that a lack of follow-through from governments will leave the ECB exposed.
ECB in Danger
“If governments don’t deliver on the fiscal side, will the ECB get sucked into buying more and more amounts of outstanding debt?” asks Mackie, who predicts the central bank won’t raise interest rates on Trichet’s watch again. “The ECB has got itself into a situation where it’s in danger.”
It’s also far from certain that the asset purchases will work. By June 2, Spanish and Italian yield premiums over German bonds had exceeded pre-intervention levels. The Spanish spread was at 203 basis points yesterday, 39 basis points above its May 7 level. The Italian spread was 177 basis points and Portugal’s 264 basis points.
That may require the ECB to do even more to ease market strains. Policy makers next meet on June 10 in Frankfurt.
David Owen, chief European financial economist at Jefferies Group Inc. in London, says he would not be surprised if the ECB stopped sterilizing its bond purchases at some point, meaning it would effectively be printing new money.
Trichet’s success will partly be decided by governments’ ability to overcome sluggish economic growth and cut their deficits. Even with the ECB’s record-low interest rate of 1 percent and emergency liquidity measures for banks, the Paris- based Organization for Economic Cooperation and Development forecasts euro-region growth will be 1.2 percent this year, barely a third that of the U.S. The bloc has lagged the U.S. in seven of the euro’s 11 years.
The currency’s recent slide leaves it at $1.20, roughly in the middle of its historic trading range. It debuted at $1.17 in January 1999, troughed at 83 cents in October 2000 and peaked at $1.60 in July 2008. Economists at BNP Paribas SA and Capital Economics Ltd. are among those predicting it will return to parity with the dollar.
Amid accusations the euro now looks more like the Greek drachma than the German mark, Trichet blames governments for what went wrong. Greece’s budget deficit was 13.6 percent of output last year, Ireland’s shortfall was 14.3 percent and Spain’s 11.2 percent. Germany’s deficit was 3.3 percent.
Trichet “had a lot of reasons to consider himself as playing a part in the euro’s story and he has a stake in its success,” says Eric Chaney, a former French Finance Ministry official and now chief economist at AXA Group in Paris. “That’s why he came to take such tough decisions like buying government bonds. It’s a big bet on the political will of the governments and the oppositions who may win elections.”
For now, governments are pledging to tighten their belts and the likes of Greece and Spain are introducing austerity packages. Trichet’s demand for a “quantum leap” in economic management may also be heeded, with finance ministers vowing on May 21 to stiffen sanctions on high-deficit countries.
Yet the history of the euro is littered with examples of governments casting aside central bankers’ appeals for fiscal prudence, from France raiding France Telecom SA’s pension fund in 1996 to Greece fudging its budget data to qualify for the currency in 2001.
“It’s definitely the biggest challenge of Trichet’s professional life,” says Joachim Fels, co-chief economist at Morgan Stanley in London. “This is his chance to save his legacy.”
Trichet himself is optimistic, noting that Europe often progresses through crisis.
“You must be inflexible on your long-term compass,” he says. “My long-term compass as a central banker is price stability. My life compass has been the deepening of European unity based upon reconciliation and a profound friendship to the service of prosperity and peace. This historical endeavor, which started 60 years ago and was reinforced by the fall of the Soviet Union, goes on.”