The European Central Bank’s transmission of monetary policy works against convergence in the eurozone

As the European Central Bank (ECB) prepares to launch a critical new tool to tackle the threat of fragmentation of the eurozone’s financial markets, governments in our opinion still seem to be sitting on the sidelines. That is a mistake. It is pushing the central bank into murky political territory, risking its credibility and may result in another lost decade marked by under-investment, stagnation and growing economic divergence between member states.

The ECB’s bond-buying mechanism to be outlined today aims to address the gap between the yields on German and other government bonds in the eurozone. Such spreads can cause an uneven transmission of monetary policy. Assame for instance that the ECB raises rates by 0.25 percentage points and that this causes the spreads between German and Italian government bonds to increase from 1.5 to 2 points. Since government bonds act as benchmarks for credit pricing, high spreads would lead to a tighter monetary policy stance for Italian borrowers.

With spreads unaddressed, conducting monetary policy would lead to inflationary outcomes in Germany and deflationary ones in Italy. This is undesirable from a monetary policy perspective and works against convergence in the eurozone. Now switch perspective to fiscal policy. Here, ECB bond purchases have in our opinion two effects: one is secure access to credit for the respective governments and, two, a lower than otherwise cost borrowing. The latter has a direct impact on compliance with European fiscal rules: lower interest payments mean more space under the 3% deficit limit.

The current institutional set-up thus muddies the waters: to pursue its mandate, the ECB must address spreads. But addressing spreads has fiscal consequences. In particular, in addressing spreads, the ECB effectively decides which member states benefit from the privilege of sovereign borrowing, under what conditions and at which price. That is a deeply political issue, on which a technocratic, non-elected body is ill-suited to pronounce.

The ECB in our opinion can only make choices within this ambiguous architecture; and while some are worse than others, none is good. Governments on the other hand could unmuddy things – and in our opinion should. It is they who are deferring deeply political issues around sovereign debt to the ECB. It is they who should decide which country has sound government finances with a collective judgment.

Where member state governments decide a country runs sound fiscal policy, the ECB could pursue its mandate without stepping into fiscal territory. Where they decide it has not, it is clear who made that judgment and why, and who is accountable for its consequences. In this case, spreads could in our opinion only be addressed through the Outright Monetary Transactions program that was launched during the 2012 debt crisis. This involves the ECB buying a country’s sovereign debt in the secondary markets – as long as that country has agreed to a rescue package from the European Stability Mechanism and tough reform requirements.

Addressing spreads is in governments’ self-interest: the higher spreads are, the more difficult it will be to marry the goal of reducing debt ratios with sustaining high levels of investment. Rising interest payments leave less money for public investment. Increasing financing costs reduce the number of profitable private investments. Hence governments should have no interest in maintaining spreads – except as disciplining devices addressing specific misbehavior, a function they could in our opinion still serve if the use of the fragmentation tool were conditional on sound government finances. A criterion that governments could use to assess fiscal policy could be the primary balance – the difference between the amount of revenue a government collects and the amount it spends excluding financing costs. By definition, the primary balance is not influenced by monetary policy. Thus, a country could, for instance, get its peers’ stamp of approval if it runs a primary balance likely leading to debt reduction. Governments have been keen to emphasize the flexibility of the stability and Growth Pact as an asset. Flexibility is supposed to ensure that countries are not tied up in an overly restrictive corset of fiscal rules unfit for their respective circumstances. That sounds good in theory. Yet, in practice, strategic ambiguity on the side of fiscal policy makers implies that the ECB is left with political choices – one it did not have to take if governments played their proper part.

The combination of a brewing, giant stagflationary shock from weaponized Russian natural gas and a political crisis in Italy is in our opinion as close to a perfect storm as can be imagined for the ECB. Draghi’s exit spells trouble for Italy and Europe at a time of acute economic challenges. The latest sell-off in Italian debt intensified following confirmation of Draghi’s resignation last month, with the yield on Rome’s 10-year government bond jumping as much as 0.27 percentage points to almost 3.7%. Those moves took the gap between Italian and German benchmark yields as wide as 2.38 percentage points last month.

By giving itself the power to buy unlimited amounts of the bonds of any “euro” country it judges to be suffering from an increase in its borrowing costs beyond the level justified by economic fundamentals, the ECB has in our opinion addressed a key vulnerability haunting eurozone policymakers ever since a debt-crisis nearly ripped the single currency apart a decade ago. As there are very few limits on the scale of these purchases one thing at the ECB seems not to have changed:

“Whatever it takes”.

All 19 eurozone countries will automatically be eligible for the instrument, as long as they have not fallen foul at the EU’s fiscal rules and are meeting the conditions attached to the EU’s recovery fund. The ECB will also consider if a country’s “trajectory of public debt is sustainable” and it has “sound and sustainable macroeconomic policies”. The ECB claimed last month that any bond purchases under the scheme would not bloat its close to 9 trillion euro balance sheet, but it in our opinion was vague about how this could be done. We at Calvin • Farel have difficulties imagining how this could possibly be done.

For Italy, like Cincinnatus in ancient times, Mario Draghi was called upon to be the savior of Italy at a moment of national peril during the pandemic almost 18 months ago. As Prime Minister, he, too, rose to the occasion. But his reward is to lose the reins of power just when new, even greater emergencies are in our opinion are unfolding in Italy and around Europe in fiscal and monetary policy.