Jitters in the Euro Zone

Some tricky maneuvering lies ahead as the European Central Bank tries to avert a revived euro-zone crisis.

W riting for Capital Matters last week, Desmond Lachman had a few not altogether flattering things to say about the European Central Bank (ECB) and its belated response to rising inflation in the euro zone.

Christine Lagarde’s ECB never fails to disappoint. Faced with the highest euro-zone inflation rate since its 1999 founding, the ECB’s policy response fell miserably short of what was needed in the circumstances.

This may be disappointing, but it is hardly a surprise. Lagarde, a second-rate politician turned fourth-rate central banker, was never likely to rise to the challenge posed by the current inflationary surge.

Then again, Lagarde was a second-rate politician but not a fourth-rate one. She must have known that tackling inflation would raise some awkward political issues, not least when it came to Italy, a country in which politics, finance, and the future of the euro zone are inextricably and unhealthily intertwined. This may have led her to delay taking action even after the point at which it became obvious that inflation could not just be wished away. Perhaps cowardice was to blame, or maybe, like Mr. Micawber, she was hoping that something would turn up.

Lachman:

Italy’s public debt-to-GDP ratio [has] skyrocketed to more than 150 percent, its highest level on record. . . . Italy is the euro zone’s third-largest economy and around ten times the size of the Greek economy. This makes Italy too big to be allowed to fail if the euro is to survive in its present form. However, it also might make Italy too big for the rest of the euro zone’s members to keep bailing it out.

Up until now, despite its poor public finances, Italy has been kept afloat by the ECB’s massive bond-buying program. Under that program, the ECB bought around EUR 250 billion in Italian government bonds, or more than the Italian government’s net borrowing needs. Now that the ECB is scheduled to stop its bond-buying, markets are already questioning how the Italian government will finance its massive borrowing needs.

In other words, if the ECB stops buying Italian bonds, who will step in to fill the gap?

Lachman argues that, “given the size of the Italian government’s borrowing needs, markets would likely need to see concrete ECB steps in the form of new programs to back up its claim that it will do whatever it takes to keep the euro together.”

True enough, but beneath that mild-sounding word “programs” lurks a legal problem — in theory anyway.

Writing a day or so later for Bloomberg, Richard Cookson took up the story:

At one point this week, Italian bond yields were more than eight times what they had been at their lowest last year. On the warpath against what it calls “fragmentation,” the ECB said that because of lasting vulnerabilities from the Covid pandemic and to ensure smooth transmission of monetary policy, it would “temporarily” apply “flexibility” to the reinvestments of its vast portfolio of bonds when they mature. Translation: These will be directed at weaker rather than stronger borrowers. 

Fragmentation is a term devised to make the reasonable seem frightening. It refers to a supposedly unacceptable widening of the spread between, say, Italian and German bonds, a spread that reflects the fact that, with the ending of the ECB’s QE, investors are looking at Italy and Germany and pricing in the reality that, absent external assistance for Italy, when it comes to the two countries’ ability to service their government debt, they are very different places.

The euro zone is a currency union but not a fiscal union. The failure to supplement the former with the latter goes a long way to explain the instability (or the fear of instability) that has so often plagued this unhappy monetary experiment. And the key reason for that failure was, as so often with the EU project, that the top-down drive for yet more integration was at odds with what voters in the union’s member states actually wanted. A currency union was at the very edge of the politically possible, but the fiscal union (or even partial fiscal union) that might have made it function more smoothly would have been a step too far, for reasons that included the reluctance on the part of some countries to accept the shared financial burdens that such a regime would entail. Similar concerns were also behind the provision that there would be no bailouts (how did that work out?). This was designed both to reassure the thrifty that they would not be picking up the tab for the improvident and, more generally, to encourage fiscal responsibility on the part of the currency union’s members. Such thinking also played a part in the prohibition on ECB financing of borrowing by euro-zone nations.

So, some tricky maneuvering lies ahead as the ECB tries to find a way to support Italy while remaining (if only nominally) in compliance with its obligations, even if, after over a decade of euro-zone crisis management, these can sometimes appear to have been reduced to little more than politely murmured suggestions. If precedent is anything to go by (and it is), the central bank is unlikely to find it too difficult to satisfy the European Court of Justice that its eventual solution passes muster. The ECJ is a profoundly political court. Its mission, above all, is to remove obstacles standing in the way of an “ever closer union” — a more federal EU.

The German constitutional court has, however, rather more respect for the law than the ECJ. In Cookson’s view this is why the ECB is describing its current strategy as “temporary.” It will do so, he maintains, “until it has, in effect, established another way to collude with peripheral countries riding roughshod over debt and budget laws: its ‘anti-fragmentation tool.’”

Cookson adds:

Although there are no details yet about what this instrument might be, don’t be surprised if it is not an instrument in any meaningful sense but an off-balance-sheet fund, backstopped by the ECB but with the appearance of being self-funding, that has a specific mandate to keep spreads from exceeding certain levels or rising too quickly. That it would be an altogether more opaque way of supporting weaker creditors from stronger ones like Germany is, of course, entirely the point. That doesn’t make it any more legal. 

Indeed.

But, but . . . the EU is a “rules-based” institution.

Then again, flash back to this Reuters story from late 2010:

The Greek and Irish bailouts and the creation of a temporary European rescue fund had been “major transgressions” of the treaty.

“We violated all the rules because we wanted to close ranks and really rescue the euro zone,” [the French finance minister] was quoted as saying.

“The Treaty of Lisbon was very straight-forward. No bailout.” 

And who was this French finance minister?

Why, it was Christine Lagarde.