Eurozone divergences are back

By Lucrezia Reichlin/London

Monetary policy tightening is coming to Europe. Following in the footsteps of the US Federal Reserve and others, the European Central Bank (ECB) has announced that it will end its asset purchase program and raise interest rates this month, in the purpose of containing inflation. But unless authorities address the differential effect this is having on member states’ financial conditions, the eurozone will experience both a recession and a financial crisis.
Anticipating this change in monetary policy, the eurozone safe yield curve, as measured by overnight index swaps, has risen since December, suggesting that financial conditions are tightening considerably. Meanwhile, sovereign spreads have widened, with the risk premium on Italian ten-year bonds more than 250 basis points higher than on German bunds in early June, although the spread has narrowed somewhat since then. in response to signals from the ECB that it will act.
The euro zone has already passed through here. During the debt crisis that began in 2009 and the Covid-19 pandemic, economic stress triggered a flight to safety (i.e. to the German Bund) from investors – especially foreign investors – and a resurgence of the national bias in sovereign bond purchases. This has resulted in a geographical fragmentation of financial markets. 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 the financial stability of some countries. To mitigate this and ensure that the ECB’s actions are aligned with its price stability mandate in all eurozone economies, targeted asset purchases – against a backdrop of general tightening – are essential. Fortunately, the Eurozone has already laid the operational, legal and political foundations for the kind of flexible asset purchase program we need.
It’s been a long trip. In 2012, the ECB announced the “direct monetary transactions” program, under which it could buy government bonds from the weakest countries in the euro zone, in exchange for complying with the rules of the European Stability Mechanism.
The OMT was never activated, but its mere announcement calmed the markets, as the program avoided the fatal flaws of its predecessor, the Securities Markets Programme, which was quantitatively capped, gave the ECB preferred creditor status and lacked strong political support. Moreover, by including conditionality, the UNWTO responded to the concern of Northern European countries that attempting to reduce the gaps of fiscally fragile countries would constitute a form of monetary financing and thus encourage risk. moral.
But while the OMT announcement led to 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 (c i.e. less than 2%). Thus, in 2015, the ECB joined other central banks in the introduction of quantitative easing, the distribution of its purchases of sovereign assets being determined according to the GDP of the countries. Combined with other tools, QE allowed the ECB to control the level and slope of the yield curve.
The next step in the evolution of euro area 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 on the economies most under pressure, thus containing sovereign and corporate spreads. But the program – still meant to be a temporary response to exceptional circumstances – was halted in March.
Today, the Eurozone is once again facing exceptional circumstances, this time in the form of supply chain disruptions and spikes in energy prices. This justifies the implementation of a new asset purchase program aimed at limiting sovereign spreads as the ECB continues its monetary tightening.
Relaunching the OMT program is not the answer. On the one hand, the Eurozone faces Europe-wide inflation fueled by supply-side factors, not idiosyncratic fiscal conditions. Nor can the current circumstances be characterized as a classic case of a self-fulfilling liquidity crisis. On the contrary, the functioning of the financial markets is distorted in a federation with a common currency and national debts. In this context, a conditional program would be a tough sell, to say the least. In fact, it would likely spur a new wave of anti-euro sentiment and political crisis.
In any case, conditional asset purchases under the OMT program are stigmatized and involve difficult negotiations with several institutions. What the ECB needs today is an agile monetary policy instrument that can be implemented quickly – an instrument similar to the PEPP.
This new instrument should be flexible and scalable. Drawing on its knowledge of monetary policy transmission channels and reacting to new information as it emerges, the ECB should adjust its purchases in line with the price stability objective. Basically, purchases should be based on an assessment of risk premia (while avoiding quantitative targeting), rather than GDP. Sterilization mechanisms should ensure that the change in the monetary base is compatible with price stabilization.
Admittedly, such a program would be controversial, as it would amount to risk-sharing engineering through the monetary union balance sheet, thereby creating a eurozone safe asset. But that is exactly what is needed to solve the problem of euro zone fragmentation. 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 remedy the persistent underperformance of countries, let alone fiscal mismanagement. On this front, the surveillance tools that the European Commission is developing in the framework of the European Next Generation fund for pandemic recovery can be useful, by allowing better monitoring of the implementation of reforms. These guarantees will ensure that the countries benefiting from the purchases respect the EU budgetary framework. If necessary, euro area balance sheet risks can be managed through the recapitalization of national central banks and clear rules for the distribution of dividends.
Nevertheless, the ECB has a vital role to play in alleviating the pressures that Eurozone economies are facing 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 an efficient transmission of monetary policy by avoiding excessive divergences in the performance of developing economies. the euro zone. One of these instruments must be a new highly flexible asset purchase program to be implemented in accordance with the proportionality principles of the EU treaties, not monetary financing. — Project syndicate

* Lucrezia Reichlin, former director of research at the European Central Bank, is professor of economics at the London Business School and administrator of the International Financial Reporting Standards Foundation.

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