For better or worse, the future of the euro will probably be decided this year.
In an attempt to generate inflation, central banks have cut short-term interest rates to zero or even below for the past 20 years and have expanded their balance sheets to previously unimaginable levels. The European Central Bank has been particularly aggressive. Euro deposit rates are -0.5% and the ECB’s balance sheet is loaded with 8.5 trillion euros ($9.66 trillion) of government debt, four times more than at the start of 2015.
Where the ECB has differed from other central banks is in its other, generally unstated, objective: keeping the euro project on track by preventing the yields on government bonds issued by its weakest members from rising sharply. Apparently, this makes the euro far less stable.
The ECB cannot ignore that crazily low short- and long-term rates would have caused inflation to rise, when previously there was none. The recent inflationary surge has silenced this idea. Inflation rose by 5% in December compared with the previous year, Eurostat announced on 7 January, the highest level in the history of the euro. Strangely, the ECB has continued to maintain that this jump is temporary. Given the current extreme monetary policy settings, the ECB’s intransigence can only be understood if one recognises that in recent years the central bank has not been independent in any meaningful sense. It is now firmly under the control of government borrowers, in particular the weakest ones within the euro zone.
Thus becoming, in turn, weaker.
The euro has been on a downward trend since it peaked against the dollar in 2008
In recent months, the creditor countries of the euro zone, generally in northern Europe, have become increasingly explicit that the current policy cannot continue, both because they are worried about domestic inflation and because they are tired of subsidising more dissolute countries. The agreement reached at the end of last year provided that balance-sheet expansion would end and that the ECB would set out explicit criteria for raising short-term rates. First, the inflation index excluding food and energy should be trending downwards. Second, the ECB’s inflation forecasts for the current year and the following one should be 2% or more. At the end of December, the central bank announced that, while forecasting inflation of 3.2% this year, the rate would miraculously fall to 1.8% in the following two years.
Authoritative ECB members openly question these forecasts, including the influential Isabel Schnabel, the German representative on the Governing Council. On 8 January she said that the transition to a greener economy could probably mean a fall in energy prices, as assumed by the forecasts of the ECB’s research department under the dove Philip Lane. If prices were to stay where they are, however, the ECB’s inflation forecasts would essentially have to be revised upwards. This pressure opens the door to rate rises, perhaps even before the end of this year.
In the meantime, that screeching sound you hear is the ECB slamming on the brakes of balance-sheet expansion. Broadly speaking, the ECB currently has three programmes: a long-standing asset purchase programme (APP), the pandemic emergency purchase programme (PEPP) and a third scheme to encourage banks to lend to the real economy, targeted at longer-term refinancing operations, known as TLTRO. The PEPP was launched in early 2020 to prevent inflation expectations from falling, the ECB said.
Under this programme, which is due to end in March, the ECB has purchased around 1.5 trillion euros of bonds. At its peak last year, the ECB’s combined bond purchases under the APP and the PEPP were 100 billion euros a month. Although purchases under the APP will be slightly increased to help offset the end of the PEPP, the ECB’s direct purchases will fall to 20 billion euros a month by the end of the year. Given that inflation has been so persistently high relative to its target and that short-term rates are still so negative, the ECB could even end the APP as early as October.
Then there is the TLTRO, which allowed banks to fund themselves at up to half a percentage point below the ECB’s deposit rate, currently -0.5%. Those loans were supposed to be used to lend to the real economy, but the conditions under which banks could borrow at very low rates were easy to meet. Although some institutions simply used this programme to reduce their overall funding mix, there is no doubt that others used the money to buy government bonds, including the riskier ones. Even though we do not know how much, the amount is probably high given that there are around 2.4 trillion euros of TLTRO loans outstanding. Those favourable conditions run out on 1.2 trillion euros of loans in June and, unless the terms are extended – and there is no reason to do so – we may soon find out how much was used to buy riskier bonds. All else being equal, the ECB’s balance sheet will probably shrink by more than 1 trillion euros in June, as its indirect support for the bond markets diminishes.
What will happen? The main reason the ECB has preferred to end these programmes is that many members of its council are afraid of what will happen to bond yields, in particular those of the weakest members of the euro zone. The central bank has said that it will step in if yield spreads widen in unjustifiable ways. With what, though? And what does unjustifiable mean? The greatest concern is Italy, both for its size (it has one of the largest government bond markets in the world) and for its debt dynamics. Under the rickety stability and growth pact, euro countries are required to try to limit their debt to 60% of GDP. All members have seen their ratios rise sharply in the past two years, but this year Italy’s will have risen to about 155% of GDP, an increase of 50 percentage points since 2007. Italian banks, moreover, depend heavily on the TLTRO programme for their funding, so banks are reluctant to lend. Such is the ineffectiveness of successive Italian governments that politicians have done nothing to reform the financial system or anything else.
With the ECB short of tools to calm the markets, a likely crisis this year appears inevitable. Most countries, in particular debtor countries (including France), have sought to dismantle the rules designed to protect their creditor counterparts. Should the countries of northern Europe say enough, an enormous credit risk would arise, against which investors are woefully under-protected. As the ECB steps away from the market, and this will become all too obvious when yield spreads for the riskiest borrowers widen, the situation will become dramatically clear to everyone.
There are essentially three ways in which this could be resolved. The first is for Italy to default. Since much of its debt is held domestically, this would essentially mean the government imposing losses on its own citizens. A rather problematic scenario. The second is for Italy to leave the euro. From an Italian point of view, this would have the advantage of imposing losses on creditor countries such as Germany through the outstanding balances in the Target 2 “settlement” system.
This option would make Brexit look like child’s play.
These likely scenarios have given rise to the idea of some sort of mutualisation of existing debts, transferring them from the ECB to a dedicated debt management agency, with the promise of doing better in the future. The former ECB president and current Italian prime minister Mario Draghi and Emmanuel Macron, the incumbent French president, who is running in the spring elections, signed a joint letter shortly before Christmas, implicitly calling for the transfer of all euro-zone public debt since 2007 to such an agency.
Germany, of course, would be strongly opposed to any such move. So would the eastern European countries that have spent years cutting their debts in order to join the euro.
For the euro to survive, however, some kind of compromise will be needed. The problem is that the creditor countries are unlikely to compromise until the potential situation is serious enough. And the potential situation, I suspect, would involve Italy, which is threatening to leave the euro.
Source: https://www.bloomberg.com/opinion/articles/2022-01-11/the-euro-is-facing-a-make-or-break-year
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