This week, the Board of the European Central Bank (ECB) is having a further strategic discussion with a view to coming to some conclusions on the future conduct of its money policy.
It is widely thought they will abandon the current target of keeping inflation below, but close to, 2%. The hawks would accept a symmetrical 2% inflation target. The doves want the US model of a 2% target with words to treat this as an average, allowing higher inflation for some time given the long history of undershooting.
It is taking a long time to reach conclusions on what seems a pretty simple matter because underlying this target is the whole philosophy and approach of the European Union (EU) and the ECB to government finances in the Eurozone.
The Germans, aided by other surplus nations such as the Netherlands and Austria, takes a strict and legalistic view of the Treaties. Article 123 clearly bans the EU from lending money to local and national governments and other public-sector bodies – and bans the direct purchase of “debt instruments” from member states and their related bodies.
Article 310 rules out the EU borrowing for its own expenditure, stating baldly: “The revenue and expenditure shown in the budget shall be in balance”. The austerity group are worried that the EU recovery borrowing takes them into new territory – where the EU can borrow at the expense of their taxpayers, and worry that the ECB’s asset purchase programme is effectively financing spendthrift member states without, perhaps, technically infringing the rules.
The dovish states – led by Italy, Spain, Portugal and Greece – have high state and public-sector debts and are benefitting from the way ECB purchases of their debt keeps their borrowing rates lower than they otherwise would be.
They are also proportionately larger beneficiaries of the common EU spending of EU borrowed money. They therefore wish to see the EU budget expand further with more borrowing and argue that the public debt-purchase programmes should continue to keep their interest rates closer to German rates.
Armin Laschet, the frontrunner to become the next German Chancellor, is a committed European – but he believes the EU should accept German financial discipline. He is no fan of the EU becoming a transfer union, sending more German taxpayer cash to subsidise the south. If you want a laxer inflation target, you should get more bond buying.
The aggressive buying of bonds in the secondary market over the last year has taken the ECB’s total holdings to more than €3 trillion. In 2020, the ECB bought the equivalent of most of the amount of new debt issued by the member states. The ECB is meant to buy debt in proportion to the so-called capital key, or percentage of the share capital each Euro member holds. Italy’s share is 13.8% and Spain’s 9.7% – but these figures were exceeded last year as a special measure for the pandemic. Given the large issue programmes of the southern states, it means the ECB is becoming a very large holder of this debt.
This makes the Germans apprehensive
It is not the same as the Fed or the Bank of Japan buying up larger quantities of US or Japanese debt. As these central banks are 100% owned by the states concerned, there is no debt service or repayment problem. If rates go up it is true the government owes the central bank more interest, but the government can take the money back as a dividend or payment from the central bank, which it owns.
Similarly, if it needs to repay the debt it can then reclaim the money from the central bank. Italy and Spain are in a very different position. They owe interest to the ECB where they are small minority shareholders. They cannot reclaim the interest or the capital – they need to repay their debts. That is why Germany is right to ask how easy will it be for them to afford the interest and repayments going forward, as Germany does not want a lot of bad debts at the ECB which might fall to the richer states to write off.
Christine Lagarde, ECB President, will want a compromise – but one that leans in the dovish direction. Some relaxation of the inflation target looks inevitable after this long review, and this will allow some further build-up of southern debt in the ECB portfolio.
The Germans will probably be given reassurances that this is still a temporary measure for the pandemic and will hope it ends next March. With a French election then in full swing, they may find the ECB has a continuing appetite to buy-up bonds, whilst assuring everyone they are not really financing excessive spending by overindebted countries.
To rub salt into the German wounds, it looks as if Germany will have higher inflation than most in the zone this year, a phenomenon it’s government hates thanks to its history of hyperinflation a century ago. Investors need to remember the stresses and strains within Euro-area public finances, which are different to those in unitary states.
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