In late July 2012, in the colonnaded splendour of a London West End mansion, Mario Draghi, president of the European Central Bank, told a pre-Olympic Games UK government investment conference: ‘Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.’ Eight years later, at another time of strain for economic and monetary union, there is much speculation of another ‘Draghi moment’.
Some believe that the ECB, now under the helm of Christine Lagarde, former International Monetary Fund managing director (in the audience for Draghi’s unrehearsed Olympian address), will again redeem a currency Draghi quixotically described then as ‘a mystery of nature.’ Draghi’s much-feted euro salvage, a feat of non-elected technocrats rescuing politicians, lasted until the coronavirus outbreak. Action to quell EMU unrest this time will have to come openly from democratically elected governments. This will be the focus of a 23 April European Union summit that could result in a €1tn recovery fund backed by the EU budget. The fund will be financed massively by international bond issues, in a controversial division of roles by the European Investment Bank and the European Commission that spells intense capital market competition for EU ‘safe assets’.
The ECB will not be the main player, for 10 reasons.
1. Disruption is too big for the ECB to handle
The sole European Union organisation that can speedily muster finance to counter massive dislocation, the ECB may play a supporting role in a further pandemic crisis-alleviation package that EU leaders hope to agree on 23 April. But since Draghi’s 2012 success in helping overcome EMU’s last sovereign debt upheavals, the ECB faces stronger counterforces as well as greater constraints on its own powers.
Governments, not a central bank painfully impeded by EMU’s lack of political and fiscal unity, will need to shoulder responsibility for healing divisions. A 9 April Eurogroup finance ministers meeting agreed simply to sidestep disagreement on issuing fully mutualised bonds jointly backed by all EU member governments to help countries in distress. The task for the EU leaders on 23 April, as French President Emmanuel Macron warned last week, is to come up with sufficiently strong action, while falling short of fully mutualised bonds, to prevent EMU from starting to unravel. The ECB can provide a backstop but cannot take over the main task of assuring the currency bloc’s survival.
2. Governments have less room for transferring ‘save euro’ burden
German Chancellor Angela Merkel, fearing a lack of parliamentary support for taxpayer funding of debtor countries, almost immediately threw her weight, in a joint declaration with French President François Hollande, behind Draghi’s improvised London statement. The ECB, as a legally independent entity supposed to operate outside politics, took up the strain, with staff working behind-the-scenes to devise a scheme in September 2012 called ‘outright monetary transactions’. The central bank would buy unlimited volumes of weaker EMU governments’ bonds, provided they agreed economic conditions for loans from the European Stability Mechanism, Europe’s bail-out fund, probably involving, too, the International Monetary Fund.
The OMT was a hastily engineered sleight of hand – brilliantly effective because it was never used. It was neither monetary nor outright nor did it lead to any transactions. It succeeded in defusing EMU’s life-threatening risk of sharply widening ‘spreads’ between German, Spanish and Italian bonds. The ECB is still purchasing large quantities of bonds, but has become greatly more subject to political influence over the past eight years. And it’s much more heavily constrained than its counterparties in the US, UK or Japan. The OMT option no longer looks available.
3. German and Italian positions have become more polarised
Years of arguments with the EU over debt, immigration and now the pandemic, exacerbated by separate wrangling over Greek debt and austerity that culminated in 2015, have greatly increased euroscepticism in Italy, bringing populist parties into or close to the Rome government. This has so far ruled out Italian acceptance of even minimally conditional ESM loans, viewed by many in Italy as a tool for German power play.
This culminated in Prime Minister Giuseppe Conte’s Easter rejection of an ESM credit, eliminating OMT deployment as an effective backstop. Opinion in Germany has become more hostile, shown by the rise of the anti-euro, anti-immigrant Alternative for Germany (formed in 2013), now the third biggest party in the Bundestag and the official opposition to Merkel’s Christian Democrat-Social Democrat coalition.
More recent relief comes from Germans’ much greater leaning to help Italy compared with Greece, together with Merkel’s sure-footed pandemic management, the AfD’s latest poor opinion poll showing, improved diplomacy from Olaf Scholz, Germany’s finance minister, and good technical co-operation between Rome and Berlin ministries. All this strengthens Merkel in German parliamentary deliberations.
4. Lagarde is not Draghi
The new ECB chief, a former French finance minister, is far more adept than her aloof and sharp-tongued predecessor at working with counterparties to produce desired results. She is celebrated for her ‘social competence’; as a result, she lacks Draghi’s mystique. From her eight years heading the IMF, all the European finance ministers know instinctively her basic intention is to put them under pressure to produce political as well as financial solutions. Draghi’s initially perplexing, go-it-alone 2012 statement – not discussed in advance with the ECB governing council, and resulting in many frosty exchanges with Jens Weidmann, the Bundesbank president – is not her style.
Since taking over from Draghi on 1 November, she has battled to produce a consensus linking different factions on the ECB’s disparate 25-member council. Exasperating others on the council and executive board, Draghi conferred semi-exclusively with a tight circle of senior ECB staff. Lagarde canvasses opinions far more widely. Accompanying relatively restrained monetary steps to allay the economic impact, Lagarde said on 12 March that the ECB ‘is not here to close the spreads [for German and Italian yields]’. This was part of an effort coordinated with the council to help prompt EU-level fiscal action. Up to now, that stratagem – ‘a game of chicken with governments’, according to one insider – has not succeeded.
5. The ECB faces its own limits
Brusquer than even some rigorous council members wished (who would have preferred her to advocate the OMT), Lagarde’s 12 March remarks backfired, forcing her into an unusual clarifying statement. Her bluntness sparked public criticism from Macron, and drove Italian spreads to near-panic levels of 3.2 percentage points – though still well below 4.5 to 5 points in 2012. Spurred by international financial dislocation and similar action by other leading central banks, the ECB changed tack dramatically, increasing on 18 March its additional €120bn bond-buying with an emergency ‘temporary’ €750bn package. Lagarde proclaimed: ‘There are no limits to our commitment to the euro.’ On 25 March the ECB further calmed markets by declaring it was removing or loosening nearly all previous limits on asset purchases. However, a German constitutional court ruling on 5 May, on a previous anti-asset purchase lawsuit, could bring significant legal difficulties for Bundesbank participation in the new programme. Spreads between German and Italian bond yields have steadily widened to 2.5 percentage points. Even if emergency purchases continue with Bundesbank participation, at the present buying rate the ECB will exhaust its purchase allocation by October-November – prompting nerve-jangling squabbles about next steps.
6. Signs of intra-EMU financial strain are growing
Reflecting higher bond purchases, particularly of Italian government bonds by the Banca d’Italia, the Target-2 intra-euro area balances – credits and debits linking national central banks, broadly indicating underlying stress – have started to rise again. Bundesbank advances to euro central banks rose sharply to €935bn at end-March from €822bn at end-February. This is well above €751bn in August 2012 at the peak of previous anxieties over so-called redenomination risks. Italy’s debits under the system rose in March to €492bn from €385bn. Matching an increase in Target-2 balances has been a build-up of some weaker countries’ private holdings of foreign assets, with Italian residents’ holdings of foreign securities (much of which is held through Italy-sourced investment funds) rising roughly €300bn in the past five years, according to Banca d’Italia figures. These foreign holdings are one of the reasons why Italy’s overall foreign assets roughly balance its foreign liabilities (a net figure of minus 1.7% of GDP at end-2019), in contrast to France and Spain, which have large net liabilities. The balance sheet strength brought by these private foreign assets helps explain why Rome officials believe Italian bond spreads should theoretically be no more than one percentage point – but they also underline how Italian residents would profit from any EMU break-up by repatriating foreign assets after any redenomination.
7. Germany is no longer the most stringent EU member state
ECB manoeuvres, even if backed by France and Germany as in 2012, no longer have the same chance of winning EU political consensus. Discord over the Union’s finances has significantly worsened in the past eight years. The departure of the UK, one of the strictest backers of budgetary rigour, was one of the reasons why Denmark, Estonia, Finland, Ireland, Latvia, Lithuania, the Netherlands and Sweden formed the ‘new Hanseatic League’ in February 2018 to pool views on EMU (Demark and Sweden are non-members but are legally enjoined eventually to adhere) and prevent undue concessions to debtor countries. The so-called frugal four – Austria, Denmark, Sweden and the Netherlands – are resisting calls for increasing the EU’s 2021-27 multiannual financial framework. New EMU members Estonia (2011), Latvia (2014) and Lithuania (2015) – all committed to Bundesbank-style orthodoxy – have strengthened the hand of ECB council conservatives. Long-running feuding has intensified over whether the euro area should have a unified interest rate for loans on mutualised ‘Union paper’. Nine euro members – Belgium, France, Italy, Luxembourg, Spain, Portugal, Greece, Slovenia and Ireland (Ireland is the only one also part of the Hansa group) – on 25 March proposed ‘corona bonds’ as a common way of carrying out joint finance using a long-touted unified ‘safe asset’. The north-south divide has never been so visible.
8. The ECB could play important secondary role in recovery fund
Ursula von der Leyen, European Commission president, has promised ‘a huge investment initiative.’ The 9 April Eurogroup meeting discussed setting up the recovery fund to provide money through the EU budget – ‘temporary, targeted and commensurate with the extraordinary costs’. The centrepiece of ‘innovative’ financing, though not quite matching corona bonds, is a plan to leverage money from the European budget guaranteed by member states (including some funds left over from last year as well as some unused capacity from the investment plan set up under the pre-von der Leyen Commission). This could be used to anticipate Commission and EIB borrowing on international markets. The plan could build on the existing ‘InvestEU’ programme. The borrowing vehicle would be Triple A-rated but would not be a fully mutualised instrument. If all existing and planned programmes, including guarantees, are combined, this could add up to a total €2tn-3tn in EU funding, in line with optimistic von der Leyen assertions. The ECB would be requested (although it cannot be instructed) to buy some of these new bond issues as part of its emergency programme.
9. The key EMU threat comes with EU recovery
The disparities and the dangers will be still greater than after the 2008-09 financial crisis. Germany will be the first in the euro area to recover because it is better equipped financially, economically, medically and organisationally. German companies will exploit their competitive strength to make major inroads on southern European markets and further afield. Debt divergences will widen. In 2008-09, Italy’s public debt rose to 117% of GDP from 106%, Germany’s increased to 73% from 66%. In 2020-21, Italy’s debt is expected to exceed 160%, up from 135%, while Germany’s will increase to 80% from 60%. The much bigger differential than 10 years ago is bound to affect spreads. The KfW state development bank, at the apex of Germany’s corporate rescue system, will profit not just from own-name cheap finance, but also from the German government borrowing an extra €100bn this year directly for the KfW at sub-zero interest rates. Under new flexible ECB arrangements, the Bundesbank is directly funding a large share of much-increased extra German government borrowing, by purchasing additional short-term negative-rate Berlin debt, comprising 75% of Germany’s overall €200bn-plus borrowing.
10. Geopolitics are moving against Europe
A decade ago, as storm clouds gathered over the euro, the US administration under President Barack Obama took a strong interest in shoring up EMU. He termed the currency’s travails a prime source of global economic risk, with wide-ranging implications for America’s financial and business interests. In 2020, with unilateralist Donald Trump in the White House, the US displays no such attention. A single currency assailed by doubt and indecision is just one facet of worldwide distress. The problems of the No 2 reserve currency strengthen America’s ‘exorbitant privilege’, where it uses dollar supremacy to import capital to finance budget and payment deficits. Acrimony is worsening between the US and China over the pandemic’s causes and outcomes. Europe, or at least parts of it, could suffer from a post-crisis reordering of trade, investment and economic structures, with the world carved into blocs dominated by the two economic superpowers. EU leaders on 23 April badly need a breakthrough. Deadlocked by disparities too deep to resolve with more ECB ‘whatever it takes’, Europe knows failure would leave it alone with its troubles – the worst of outcomes.
David Marsh is Chairman of OMFIF.