Eurozone Divergences Are Back

Monetary-policy tightening is coming to Europe. Following in the footsteps of the US Federal Reserve and others, the European Central Bank has announced that it will discontinue its asset-purchase program and raise interest rates this month, in a bid to rein in inflation. But, unless the authorities address the differential effect this has on member states’ financial conditions, the eurozone will experience both a recession and a financial crisis
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Anticipating this monetary-policy shift, the eurozone safe yield curve, as measured by overnight index swaps, has been moving up since December, suggesting that financial conditions are becoming significantly tighter. Meanwhile, sovereign spreads have widened, with the risk premium on Italian ten-year bonds more than 250 basis points higher than for German bunds in early June, though the spread has since narrowed somewhat in response to ECB signals that it will take action.

The eurozone has been here before. During both the debt crisis that began in 2009 and the COVID-19 pandemic, economic stress triggered a flight to safety (that is, to the German bund) by investors – especially foreign investors – and a resurgence of home bias in sovereign-bond purchases. The result was financial-market fragmentation along geographical lines. Although the origin of the stress was different, the consequences for the sovereign market were similar.

The implication is clear: the effects of the ECB’s monetary tightening will not be evenly distributed – and could jeopardize financial stability in some countries. To mitigate this and ensure that the ECB’s actions align with its price-stability mandate in all eurozone economies, targeted asset purchases – amid overall tightening – are vital. Fortunately, the eurozone has already laid the operational, legal, and political groundwork for the kind of flexible asset-purchase program that is needed.

It has been a long journey. In 2012, the ECB announced the “outright monetary transactions” program, under which it could purchase weaker eurozone countries’ government bonds, in exchange for compliance with the rules of the European Stability Mechanism.

OMT was never activated, but its mere announcement calmed markets, because the program avoided the fatal flaws of its predecessor, the Securities Markets Program, which was quantitatively capped, gave the ECB preferred creditor status, and lacked strong political support. Moreover, by including conditionality, OMT addressed northern European countries’ concern that attempting to squeeze the spreads of fiscally fragile countries would constitute a form of monetary financing and thus encourage moral hazard.

But while the announcement of OMT brought a normalization in sovereign-bond markets, the ECB’s late response to the debt crisis came at a cost: a long period of below-target inflation (that is, below 2%). So, in 2015, the ECB joined other central banks in introducing quantitative easing, with the distribution of its sovereign-asset purchases determined according to countries’ GDP. Together with other tools, QE enabled the ECB to control the level and slope of the safe yield curve.

The next step in the evolution of eurozone asset-purchase programs came in 2020, when the COVID-19 crisis spurred the implementation of the Pandemic Emergency Purchase Program (PEPP), which enabled the ECB to target purchases at the economies under the most pressure, thereby containing sovereign and corporate spreads. But the program – always meant to be a temporary response to exceptional circumstances – was discontinued in March.

Today, the eurozone is facing exceptional circumstances yet again – this time, in the form of supply-chain disruptions and energy-price spikes. This merits the implementation of a new asset-purchase program aimed at limiting sovereign spreads as the ECB pursues monetary tightening.

The revival of the OMT program is not the answer. For one thing, the eurozone is facing Europe-wide inflation driven by supply-side factors, not by idiosyncratic fiscal conditions. Nor can current circumstances be characterized as a classic case of a self-fulfilling liquidity crisis. Rather, financial markets’ functioning is being distorted in a federation with common money and national debts. In this context, a conditional program would be a hard sell, to say the least. In fact, it would probably spur a new wave of anti-euro sentiment and a political crisis.

In any case, conditional asset purchases under the OMT program come with a stigma and involve difficult negotiations with multiple institutions. What the ECB needs today is an agile monetary-policy instrument that can be implemented quickly – an instrument much like the PEPP.

This new instrument should be flexible and open-ended. Using its knowledge of monetary-policy transmission channels and responding to new information as it arises, the ECB should adjust its purchases in line with the price-stability objective. Crucially, purchases should be based on an evaluation of risk premia (although avoiding quantitative targeting), rather than on GDP. Sterilization mechanisms should ensure that the change in the monetary base is consistent with price stabilization.

To be sure, such a program would be controversial, as it would amount to engineering risk-sharing through the monetary union’s balance sheet, effectively creating a eurozone safe asset. But that is exactly what is needed to address the eurozone’s fragmentation problem. If the series of crises the eurozone has faced has taught us anything, it is that some degree of risk-pooling is a prerequisite for stability.

Of course, monetary policy alone cannot address countries’ persistent underperformance, let alone poor fiscal management. On this front, the surveillance tools that the European Commission is developing in the context of the Next Generation EU pandemic recovery fund can help, by enabling better monitoring of reform implementation. Such safeguards will ensure that countries benefiting from the purchases comply with the EU’s fiscal framework. If necessary, eurozone balance-sheet risks can be managed through the recapitalization of national central banks and clear dividend distribution rules.

Nonetheless, the ECB has a critical role to play in mitigating the pressures eurozone economies face today. Fortunately, unlike in 2012, the ECB can deploy a variety of instruments to shift the risk-free curve up and increase its slope, while ensuring effective monetary-policy transmission by avoiding excessive divergences in eurozone economies’ performance. One of those instruments must be a new, highly flexible asset-purchase program to be implemented following the EU treaties’ principles of proportionality, not monetary financing.

Lucrezia Reichlin, a former director of research at the European Central Bank, is Professor of Economics at the London Business School and a trustee of the International Financial Reporting Standards Foundation

© Project Syndicate 1995-2022 

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