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Five expensive words from the European Central Bank

Just five words helped the need to spend Euro 750 billion and reopened old rows about whether the Euro area can properly share risks and approach common interest rates.

by
John Redwood

19.03.2020

Earlier this month, Christine Lagarde told the world the European Central Bank is "not here to close spreads". By this, she meant the European Central Bank (ECB) did not think it had to buy up Greek or Italian bonds to prevent those countries paying more for their borrowing than Germany. It has always been an important part of the EU's monetary union that each country is responsible for its own debts. The Central Bank sets a common short rate of interest for Euros, but each member state pays what the market thinks reflects the risk of loss from its creditworthiness when it borrowing. The Treaty prevents the ECB directly financing member states' governments with the aim of forcing them to accept strong discipline over spending, taxing and borrowing. Fiscally strong Germany and the other Nordic countries have no wish to allow Italy or Greece or any other country to borrow large sums and spend them by taking advantage of the better creditworthiness of the strong states.

Italian, Greek and other peripheral bonds sold off sharply as Lagarde's remarks were published. She tried to row back and gave a clarification in an interview. We were told, "The ECB is fully committed to avoid any fragmentation in a difficult moment for the Euro area". It did not clear away all the fears and confirmed that the Head of the Euro thought it had troubles ahead.  On 18th March, after an emergency meeting, the Bank announced a massive expansion of its Quantitative Easing (QE) programme to buy up government bonds and commercial paper. It expressly included Greece in the list, as it was the most distressed of the government bond markets. The Bank was also said to be considering raising the limits on how much it could buy off any individual country's bonds. These limits had been imposed to avoid allegations that the ECB was in fact helping finance stretched countries at advantageous rates. There was already a German court case on this pending based on past practice. The addition to QE amounts to Euro 750bn, to be spent over the balance of this year.

Five words had helped create the need to spend Euro 750 billion. They had also reopened old rows about whether the Euro area can properly share risks and approach common interest rates, or whether the strong Treaty disciplines can remain in place and force Greece, Italy and the other high borrowers to cut their budgets and reduce their outstanding debts. The ban on the ECB  financing a government was not the only shibboleth of the Treaty to come under pressure in this latest crisis. The prohibition on Member states from borrowing more than 3% in any year, and the requirement to gradually cut state debt as a percentage of GDP where it is above 60%  are also both being tested. The EU has written to Italy allowing a small increase in its annual borrowing this year given the current circumstances. The EU has also said one-off costs of fighting the virus will be excluded from all the calculations of debt controls.  It looks as if a lot of member states are going to need various flexibilities as the coming recession bloats their deficits from a sharp fall in revenues and a  big increase in cyclical expenditures.

The EU state aid rule is also undergoing a big revamp. It looks as if spending to prop up business temporarily undermined by the lockdowns will be permitted. So too is the open borders rule. There has always been a healthy flexibility over open access. In the early days of the virus attack the EU sought to draw a clear distinction between the EU's external borders, where they favoured tough restrictions on movements from outside the area, and the internal borders where they wished to preserve freedom of movement. Now the EU accepts movement restrictions may be necessary on EU internal frontiers.

The new leaders of the EU, Mrs Von der Leyen and Mrs Lagarde, began their tenures looking nervously at how they could allow some fiscal stimulus within Treaty rules for a  Euro area economy that was stalling.  Now they need to flex the rules greatly to tackle a looming recession and deal with the revived issue of how to finance the heavily indebted southern countries without German taxpayers feeling they are being made to pay.  There remains more risk in  Euro assets than in other leading currencies backed by sovereign governments with their own state-owned Central banks. When the ECB buys Italian state debt Italy still owes the ECB, and it has to pay the interest and capital back. When the US or Japanese Central Banks buy up their national state bonds, the state owes the money to a bank they own and can direct. It is a very different situation. It is not easy for Mrs Lagarde to put all her five words back, even after spending Euro750 bn to do so.

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