By Andrew Stuttaford
Wednesday, June 22, 2022
Writing 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.
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