June 20, 2018
By Steven Kelly
Over the past nine years, the European Central Bank has pinned its inefficacy on its independence and its legal inability to get involved in the politics of fiscal matters. Yet, right now, Italian bonds are being buffeted by financial markets as the country seeks a political way forward following the recent elections. That the domestic political conversation is now being driven by the possibility of “Italexit” (or Quitaly) shows that the failure of the ECB to do its job stabilizing money and financial markets is inherently political and likely more political than not. This creates a self-fulfilling cycle that introduces “redenomination risk”—exit from the Eurozone—into government borrowing and brings the country closer to the brink.
Indeed, this same dynamic is what set off the Eurozone’s “double-dip” recession after the Great Financial Crisis. As the revelations about the dire state of the Greek economy prompted a joint statement in October 2010 from Germany’s and France’s executives that sovereign debt default was on the table, the ECB’s impotence was on full display:
Yet as the U.S. was dealing with debt ceiling brinkmanship that eventually led to a sovereign credit downgrade, U.S. Treasury yields actually fell as investors sought safety—de facto guaranteed by the Federal Reserve. This allowed the political debate to play out on its own volition, instead of being forced into an unideal (by democratic political process standards) outcome based on an impending financial market collapse. Similar downgrades in Europe have the reverse effect as they signal that the ECB may soon be unwilling to accept that particular Eurozone government’s debt as collateral in its lending operations.
What’s to be done? The ECB must change the way it operates in order to more closely align with the way the Federal Reserve conducts itself. While there are benefits to conducting normal interest rate policy directly via loans to banks (for instance, reduced stigma surrounding use of the central bank), the ECB should add direct action in government paper markets, as the Fed does via U.S. Treasuries.
This will bring several benefits. Firstly, it will solve the Eurozone’s safe asset problem. This will prevent the “doom loop” in which fiscal issues cause a banking panic that increases contingent fiscal costs, leading to a crisis that becomes self-fulfilling. By adding central bank support to sovereign assets, the pre-crisis information-insensitivity of euro area government debt will be restored. While some worry this will encourage fiscal profligacy, such is a political matter falling under the European Commission’s fiscal rules; it is not the purview of appropriate monetary policy. A system in which all interest rates are aligned will almost surely be more immune to accusations of “monetary financing” by the central bank than one in which each member has a different rate.
The Eurozone as a group of countries is also infamously unbefitting of a monetary union. Note the chart below showing that countries that start with “M” would function better under one currency than those of the euro area. That said, this problem is only exacerbated by the current market dynamic in which the countries doing the worst economically end up with the highest interest rates and vice versa. Were the ECB to directly make rates uniform across the currency union, this problem would be alleviated to some extent.
By aligning sovereign debt rates with policy rates, the ECB will also encourage more real lending during crisis times by removing the incentive to bet on sovereign debt. That is, banks facing falling capital levels may be incentivized to borrow from the central bank to gamble their way out of insolvency by betting on the risky government paper and capture that interest rate spread—while also making themselves more politically indispensable (and the sovereign-bank look more pervasive) in the process. By narrowing this gap, not only is the sovereign-bank doom loop calmed, but lending incentives become more aligned with the goals of maximizing output and restoring economic health.
By expanding its operational capacity—which it could do at its own discretion—to include a credible, direct commitment to the functioning of sovereign markets (a public good), the ECB will drastically improve economic (and political) outcomes in the Eurozone. By preventing a disjointing of interest rates, the ECB will finally be able to deliver on the single monetary policy for which it is responsible.
Steven Kelly is a Capital Management Analyst at American Family Insurance and alumnus of the University of Wisconsin-Madison. The views expressed herein are his alone and not necessarily those of his employer.