The euro zone is currently struggling with two massive problems: inflation and an impending sovereign debt crisis. Fighting both is proving difficult – especially for the ECB.
Is the Eurozone on the way to a new sovereign debt crisis? In indebted Italy, the cost of a ten-year bond is 1.9 percentage points higher than in Germany and has almost doubled compared to early 2021. Borrowing costs have also risen sharply in Spain, Portugal and even France – spreads were even wider before the European Central Bank promised a turnaround on June 15-16.
Similar to the nightmare times of 2012, the central bank is working on a bond-buying plan to save weak countries from default. In line with Mario Draghi’s pledge to “do whatever it takes” to save the eurozone, ECB President Christine Lagarde warned on June 20 that anyone who doubted the central bank’s determination would be “making a serious mistake”.
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The reassurances from the ECB should avert a crisis for the time being. However, there is no question that relying solely on the central bank to assume debt for eurozone governments will make monetary union unsustainable in the long term.
Europe has spent $2 trillion to stabilize its economy during the pandemic. Today it is more indebted than it was a decade ago. Italy, the EU’s third largest economy, has a massive net debt of almost 140% of gross domestic product. At the beginning of the last euro crisis in 2010, this value was still 108%. The French balance sheet is as questionable as the Italian one after the global financial crisis. This year, high inflation promises some relief. But if the ECB raises interest rates to curb inflation, the cost of remaining debt will also increase.
High interest rates only have an impact on government budgets over time: Italy’s outstanding debts have an average remaining term of almost eight years. This gives the ECB the time it needs to avert a crisis in which higher borrowing costs make fears of a default inevitable. As a rule, the central bank walks a fine line between preventing defaults and creating incentive systems for countries willing to spend to borrow at their expense. As in 2010, it will seek to contain spreads. However, this help could possibly not be given entirely without consideration.
In addition, the ECB faces a huge new problem: It must find a way to fight inflation while supporting indebted countries. For most of the 2010s and early in the pandemic, the central bank could partially justify buying Italian or Portuguese bonds on the grounds of meaningful economic stimulus. Inflation rates hovered below their two percent target. Today, on the other hand, it is cooling the economy by raising interest rates, so it has to justify any intervention in the bond market solely with the fight against financial fragmentation. There is therefore no incentive effect.
To accomplish the impossible, the ECB could “sterilize” the effect of asset purchases on the banking system by using other tools to absorb the money that its purchases bring in. However, such a measure is only a partial solution. Higher spreads for weaker borrowers are among the inevitable consequences of monetary policy – their suppression therefore dampens the impact of rate hikes. Small as the stimulus may be, its mere existence in times of excessive inflation makes bond purchases more difficult to defend in court when supporters of tight monetary policy challenge their legitimacy – and they inevitably will.
The main risk is insufficient hedging of vulnerable economies through spread containment. Investors expect the ECB to hike interest rates to 2% by the end of the year. Even rock-solid Germany, which by definition pays zero interest, now has to factor in 1.8% on a 10-year bond. Less than a year ago it was -0.5%. A further rise in interest rates would leave Italy on the brink, even if spreads could be held at their current levels. Because the country can probably no longer cope with a return of more than 4%. From this point on, the goals of price stability and the rescue of indebted countries became difficult to reconcile.
A rise in interest rates would put the euro area in a dangerous imbalance. Security can only be achieved through fiscal and financial integration that relieves the ECB. This includes breaking the “vicious circle” between indebted sovereigns and the local banks that hold the debt – a project that has already made some headway. Even if Italian banks could withstand a country default, European politicians would not consider throwing a €2 trillion bond market to the wolves. The contradiction between monetary union and fiscal separation would therefore remain unresolved.
This can only be remedied by higher joint expenditures by the euro countries. The €750 billion Next Generation fund, launched during the pandemic and financed through joint bonds, is already disbursing money, which should ease the pressure on national budgets. The more spending is centralized, the easier it will be for indebted states to generate the surpluses that could become necessary for debt sustainability as interest rates rise. Many in Europe will not like the resulting transfers from north to south. But monetary union has so many flaws that the alternatives – instability and inflation – might look all the worse.
The article first appeared in The Economist under the title “How fighting inflation could imperil the euro zone” and was translated by Cornelia Zink.
The original of this article “Fighting inflation and helping debt-ridden countries: How the ECB is doing the impossible” comes from The Economist.
