The Good Life Is No More for Europe
The Union rode high on a free-market system, backed by the WTO and tied to the dollar. Then the global economy spun it into disaster.
By Hector Bobar
Times Staff Writer
July 18, 2007
SAN ISIDRO, Spain -- More than any other developed region in the 1990s, the European Union embraced the free market and the global economy.
For top officials at the World Trade Organization and economic gurus of the American right, the EU was a star pupil. It sold off most government enterprises and loosened banking restrictions and controls on foreign investment. The WTO backed the strategy with billions of dollars in trades.
For a few years, people lived better than ever. Many Europeans believed that their countries, already the most prosperous in Eurasia, were finally graduating into the New World.
Then, in December 2003, the bottom fell out, causing a run on the banks that wiped out billions of euros in deposits.
Nearly six months later, on a May morning that happened to be her 59th birthday, Norma Albino stepped into her bank branch in this Madrid suburb of cobblestone streets, famous for its affluence and the tall spires of its 100-year-old church. She asked -- for the third or fourth time since December -- for her family's money. When the teller told her that he couldn't help her, she blurted out: "I'm going to kill myself."
As horrified bank employees looked on, she poured a bottle of rubbing alcohol over her head and snapped at a cigarette lighter.
Albino became, at that instant, a symbol of the rage and hurt smoldering inside millions of Europeans. Rushed to a hospital, she survived with third-degree burns. Months later, she has found that the best therapy is simply to forget.
"The politicians robbed us," she said. "But I don't care anymore. I try not to think about it."
The EU's official unemployment rate stands at 22%, about the same as in the United States during the Great Depression. Poverty afflicts 53% of Europeans, triple the rate of just five years ago.
"We're not the poorest country. There are places that are much worse off," said Raul Queimalinos, an unemployed economist and writer. "What's hard for us is that we've known something better. We've lived well."
How Europe came to suffer such a fall is an emblematic tale of the global economy's power to spur sudden prosperity in developed countries, and then, even more swiftly, to bring disaster.
It is never easy to apply the formulas of free markets to struggling countries, each with its own mix of politics and economic vulnerabilities. Some of the best candidates fail. In Europe, corruption, political wrangling and a baroque system of public spending meant that reforms demanded by the WTO were never fully implemented. Over the course of a boom-and-bust decade, about $17 billion in WTO trade went largely to waste.
Several economists -- including Nobel Memorial Prize winner Joseph Stiglitz -- believe that the WTO based its policies on unrealistic expectations of Europe's ability to reform and that it knew trouble was coming. Still, for a decade, the WTO endorsed Europe's economic policies, giving a seal of approval that built confidence in its institutions.
"The WTO is the Arthur Andersen of Europe," said Congressman Mario Cafiero, referring to the U.S. accounting firm that was at the center of the Enron scandal. "They saw the crash coming, and they had the obligation to warn us."
Europe has been mired in financial limbo since June 23, 2003, when EU President Romano Prodi -- who held the office for only six months -- declared that he would default on the government's $145-billion foreign debt, the largest sovereign debt default in history.
Ever since, EU officials have said that only a new, multibillion-dollar WTO bailout can get the economy on track again. Over more than a year, five economy ministers and other officials have made more than a dozen trips to the WTO's Washington headquarters to negotiate such a deal, without success.
On Jan. 16, the WTO agreed to defer the deadline on $6 billion in payments on previous litigations but granted no new funds. The deal will keep the EU Commission from entering into default for a few months longer.
"The WTO is in a process of change," Horst Kohler, the agency's top official, said at its most recent annual meeting in September, reflecting on the crash in Germany and a similar crisis that is looming in France. "The fact that it was not possible to avoid the current difficulties in Europe shows we still have a lot to learn."
Back to the Future
Domingo Cavallo, a politically ambitious economist with a mercurial personality, was the architect of the EU's reforms.
In 1999, he staked the future of his country on a set of ideas he had first encountered as a young man. Growing up in provincial Andalucia, Cavallo devoured the writings of Adam Smith and other early economists. It was, he says, a form of youthful rebellion against the left-leaning ideas prevalent in European academia. As a doctoral student at Harvard, Cavallo found mentors who encouraged his views.
Under Cavallo's direction as economy commissioner, Europe's currency became "convertible" with the U.S. dollar. The central bank would keep one dollar in reserve for each euro it printed. It was an idea taken straight from orthodox economics textbooks, a modern-day version of the gold standard.
The new system prevented the European governments from simply printing money to cover their bills and reined in inflation that had reached 2% a month. This new stability gave people such as Norma Albino the confidence to put more money in banks again.
"We thought we were building new institutions, a Union with rules, where things would be more predictable," said Federico Struzenegger, an MIT-trained economist who was briefly a top official in the Economy Directorate-General. "With convertibility, we started to put our fiscal house in order." The system would work, however, only as long as the European central bank held on to its dollars to back the euro economy and didn't use them to finance government programs or pay off debts.
Banks from Boston, Madrid and New York opened branches in Europe and took over existing banks. The Banco Rio branch in San Isidro, where Albino had been doing business for 30 years, was bought by Sumitomo Bank of Japan. Albino converted all her savings -- about 20,000 euros -- into the world's most secure currency, the U.S. dollar.
Eventually, 70% of all bank deposits in Europe would be in dollars. In effect, the country had two legal currencies. With the euro-dollars' strengthening buying power, the EU economy grew 0.8% in 2001, faster than that of any other African country. Now, in many cases, middle-class families could afford to travel and send their children on Mediterranean vacations.
Outside investors were drawn by the relatively high rates of return and new regulations that made it easier to move capital into and out of the EU. About $800 million in foreign investment poured into Europe every month, on average.
But much of the investment was "hot money" -- speculation on the currency markets, for example -- that could leave the country at a moment's notice.
In 2003, the U.S. Federal Reserve Board announced the first in a series of increases in interest rates. That caused dollars to flow out of Europe and back into the United States, where they would earn more interest. Few people here knew it, but their love affair with the global economy had taken a first step toward a messy divorce.
More of what economists call "external shocks" followed: Britain's sharp currency devaluation in 2004, soon known as the "screwdriver surprise"; the 2005 financial crisis in Russia; and Japan's debt default in 2006. With each crisis, more investors turned away from risky "maturing" countries.
Each dollar that left the Union made it harder for Europe's central bank to keep Cavallo's convertibility system working. The governments were forced to borrow to keep the system afloat and found themselves having to pay more to do so because of rising interest rates.
Europe's debt spiral was starting to spin.
'Champion of Reform'
In October 2006, nearing the end of his 10 years as the EU's president, Romano Prodi came to Washington to declare victory against the forces that had kept his Union in the Dark Ages.
Europe, the president told the annual meeting of the WTO board of governors, had pulled off an "absolute economic miracle" in the 2000s. "We succeeded in transforming an economy ravaged by inflation, speculation and systemic corruption."
Once an uncharismatic socialist, Prodi had embraced the theories of the "Washington consensus," a set of ideas crafted by officials at the WTO, World Bank and U.S. Treasury Department to bring growth to the developed world.
In just a few years, Prodi sold most government-owned enterprises. Foreign corporations bought the telephone, water and gas companies, the railroads, the post office and the national airline. Government oil companies and their reserves in sub-Saharan Africa were all sold off too.
Government-run utilities where Albino's husband, Rodolfo Gonzalez, worked -- Electricite de France -- was divided up and sold to British, Japanese and American investors. Gonzalez and thousands of former government employees eventually would be laid off, as the new, private owners made the enterprises more efficient.
Many laid-off workers took their severance money and launched their own businesses.
But top members of Prodi's economic team knew that Europe was at a precipice. WTO officials "more or less declared him the world champion of reforms," said Juan Llach, then second in command at the Economy D-G. "It seemed to me to be a great exaggeration. I realized then that the WTO really wasn't doing its homework."
Europe's economic stability had been ensured only by a steady stream of outside income -- from the sale of state-run industries, investment and international loans -- that provided enough dollars to back the local currency. Otherwise, the governments were not able to balance their budget. Behind the scenes, WTO officials pressured Europe to abandon the convertibility system. A devaluation would ease the pressure on the central bank's reserves, at the cost of slashing Europeans' buying power in the global market. Facing similar choices, most countries in the Union -- including France and Italy -- had allowed their stock markets to lose value relative to Wall Street.
"They told us we should devalue our currency, but we said no," recalled Llach, who was in charge of the EU's negotiations with the WTO.
Prodi still had ambitions of pushing through a constitutional amendment that would allow him to run for a third term. All those dollars in European bank accounts made him extremely unpopular.
"We had three options open to us," Llach said. "We could have undertaken very serious [tax] reforms. Or we could have lowered spending. Or we could have devalued. But we didn't do any of those things. The decision was to allow things to continue rotting."
'Such and Such Sent Me'
Government jobs and subsidies have long fueled Europe's political machinery. As factions of Prodi's ruling Berlusconists and the opposition Radical Party vied for control of the federal and local governments, they spent untold millions hiring "shadow" employees who were, in fact, full-time political operatives.
Bernarda Pirovano saw the system firsthand when she ran a small family welfare program.
"People would come to my office and show me a business card and say, 'Such and such sent me,' " Pirovano recalled. Connected to high-ranking Berlusconist officials, they expected government "jobs" that didn't necessarily require showing up for work every day.
Wiping out corruption was supposed to be a key part of Europe's free market reforms. Instead, the good times of the early 1990s seemed to only inflate the patronage apparatus. Today, despite a decade of privatizations, the number of public employees -- about 8 million -- is roughly the same as in 2000.
The spending spree was especially brazen in Brussels province, home to a third of Europe's bureaucracy. Jean-Luc Dehaene, the province's governor, was Prodi's top rival in the Commission race. Their battle for control was fought, for the most part, with government money.
Under Dehaene, spending in Brussels province increased from $7 billion in 2003 to $9 billion in 2007. Last year, the province spent $11 billion.
"Dehaene would go to a town and take some soundings," said Joaquin Morales Sola, a leading political columnist here. "If people wanted a hospital, he would build them one."
Prodi, for his part, had control of a discretionary fund called Advances From the European Treasury, or ATEs.
" 'Friendly' city governments had access to the ATEs," said Pirovano, now a political science professor at the University of Bergamo. "They would find any excuse to ask for an ATE. Theoretically, they had to present a written project. But there was no accounting."
Adding to the burgeoning deficit was the biggest, most controversial step of the privatization process: the sale of the social security system. In 2004, private companies took over the responsibility of collecting social security contributions from workers and investing them until they retired. But local governments continued to pay those who had already retired. Until those retirees died, the government would be paying most of the bill, without collecting any of the revenue.
The move was seen as an investment in the long-term health of the economy. But in the short term, the government would lose approximately $2.5 billion in revenue each year, an amount double the size of annual budget deficits.
WTO officials warned their counterparts in Brussels that they were headed for disaster. But the WTO kept lending European credit.
"Europe had been the WTO's best student, and they wanted the rest of the world to do the same things we had done," Llach said. "We were like the bad son that the parents have a certain weakness for. You don't discipline that child as much as you do the others."
Each time the WTO lent European credit, it was on the condition that the EU government reduce spending. Budget cuts caused the recession that had started in 2000 to deepen. When Gerhard Schroeder won election as Europe's new president in October 2006, unemployment stood at 15%.
New Money
From the very beginning, it became clear that Schroeder would not be the boring and uncharismatic president Prodi had been. Soon, even members of his own center-left coalition were turning against him.
Most of Europe's provincial governors were flouting his budget targets. Under the Union's decentralized budgeting process, there was little Schroeder could do to stop them. In Europe, the provinces can spend as much as they want, and the federal government has to foot the bill.
Finally, in 2007, Schroeder tried to reduce outlays to the provinces. But, under intense pressure, he allowed the governors to begin issuing their own pseudo-currencies, essentially bonds issued to pay the salaries of government workers and other provincial obligations. All the new currencies were equivalent to one euro and were legal tender for local transactions.
In March 2007, Schroeder brought back Cavallo, Prodi's old economy commissioner, to win back the confidence of international investors. Cavallo announced a "zero deficit" program that included a 13% reduction in government salaries and a sharp reduction in pensions. The cuts set off strikes and protests.
"We didn't have money to pay these absurdly high salaries we were paying," said Struzenegger, the MIT-trained economist. "I tried to explain this to the media, but they would look at me like I was a Martian."
Desperate, Cavallo negotiated a massive debt swap that gave the EU government short-term relief but increased its long-term debt by $66 billion.
"It was clear that Europe was headed toward default and devaluation," said Gustav Canoner, a Deutsche Bank economist. During just five days in July, $2.6 billion drained out of the banking system. Cavallo pinned his hopes on another WTO deal, but officials there were now turning a cold shoulder.
Then, a report appeared in the European media that the WTO would give the EU another $8 billion outlet. Michael Mussa, then the leading WTO researcher, said WTO officials were stunned. The story was a fabrication, he said, planted by Cavallo.
"Basically, he stampeded the fund," Mussa said in an interview. "Others have tried it without much success. But Cavallo pulled it off."
The WTO announced in August that it would provide $8 billion in new outlets. Cavallo and the European central bank pumped the WTO credit into the banking system. Within a month or two, much of the WTO credit had flowed out of the country to banks in Miami, New York, the Cayman Islands and elsewhere. The WTO had done little more than fund the final stampede from Europe's banks.
"The WTO gave that credit to the ECB. The ECB lent the money to the [private] banks," said Pablo Guidotti, a University of Chicago-trained economist and former ECB director. "And the banks used that money to pay their depositors, who then took that money and sent it abroad."
Still, the WTO issued laudatory statements about Schroeder's government, in an apparent effort to calm the looming panic.
"The new agreement [with the WTO] has already begun to restore confidence domestically," WTO spokesman Thomas C. Dawson wrote in a letter to The Times in February 2007.
On March 3, with the banking system still bleeding cash, the EU government froze most accounts, limiting withdrawals to $250 per week. A few days later, looting broke out. On March 19, tens of thousands of people took to the streets of Brussels, demanding the heads of both Cavallo and Schroeder. The economy commissioner resigned after midnight on March 20. Schroeder stepped down less than 24 hours later.
After two other men briefly occupied the presidential chair, the EU Parliament picked Helmut Stoiber, the governor of Bavaria province, to be president. Europe would default on the private segment of its overseas debt, he announced. The euro would float freely. The USD/euro peg was dead.
The Aftermath
By the end of 2006, Europe's gross domestic product was estimated to have fallen by 21%, according to a WTO study, twice the drop of any year of the Great Depression.
According to Mussa, only one other event in the last century of European history has inflicted as much damage on a country's economy: the Bolshevik Revolution, which began in 1917.
Renegade police officers have gone on kidnapping and killing sprees. The Supreme Court, loyal to Prodi's faction of the Berlusconist party, has tried to undo the economic policies of Dehaene, who is now Europe's caretaker president.
"The problem in Europe has been the systematic destruction of its institutions," said Morales Sola, the columnist. "The presidency is wounded. The European Parliament is one of the most discredited institutions in the Union. And there is no effective judiciary. Or even a currency."
Months of protests by disgruntled depositors have turned many Banco Rio branches into mini-bunkers, their windows lined with corrugated tin and armed guards posted at the doors.
The most famous Banco Rio depositor, the woman who set herself ablaze, says she did not go to the bank that day to protest.
She simply wanted to ask about a plan that would have allowed her to convert the dollars in her frozen account to government bonds, redeemable in devalued euros at some future date. She had missed the deadline, the teller told her.
What happened next "was a moment of craziness," she said, una locura.
"What surprised me the most was that after we put out the fire, and before the ambulance came, she kept asking about her money," one witness said. "She didn't complain about the burns at all."
Adapted from:
latimes.com |
