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Analysis
Italian plan and European political expediency

Italian plan and European political expediency

ECB bond proposals ‘would cause dislocation’ 

by Gabriel Stein

Wed 19 Aug 2015

Italian proposals on transforming the European Central Bank’s monetary operations, published by OMFIF last week, would cause severe dislocation in the European economy. If enacted, the Italian plan would bring about the ECB’s subjugation to political expediency, the rupture of consensus between northern and southern euro states, a sharp decline in the euro’s external value and a potential economic collapse.

Suggestions on 14 August by economists Marcello Minenna and Edoardo Reviglio for reducing euro area government yield spreads could have been headed ‘an Italian dream’. Minenna and Reviglio, of Bocconi University and LUISS Guido Carli respectively, suggest that the ECB should eliminate bond spreads by implementing an ‘anti-spread shield resembling the Outright Monetary Transactions announced in September 2012, but without the strong policy conditions that have limited its effectiveness’. In other words, the ECB should announce unconditional open-ended purchases of government bonds to eliminate the gap between the bond yields of Germany and other European countries.

Yield spreads exist because different borrowers have different creditworthiness. Italy pays a higher interest rate on its debt than Germany because investors do not trust the Italian government as much as they trust the German government, and because Italian debt metrics are worse than their German counterparts. 

Make no mistake. The yield compression Minenna and Reviglio favour is realisable. The ECB can print as much money as it wants, but because markets would know there is a guaranteed buyer at, say, a 2% yield ‒ and so would have a one-way bet ‒ the ECB would end up buying all euro bonds in existence, as well as future issuance. That would massively swell the stock of euro area money ‒ on my estimate, by at least 70% ‒ causing a surge in inflation. 

Once the ECB bought all the bonds issued by the 19 euro governments, it could set yields where it liked. Why stop at parity for Italian and German yields? Why not set (by immutable decree) Italian yields at 500 basis points below German yields? If parity with German yields is a good thing, surely this would be even better.

The Italian authors want a new policy on inflation. They write, ‘At the same time, the ECB would need to tailor its policies to the more ambitious goal of achieving a 2% inflation rate, not just as a euro area average, but as an actual level in all countries, regardless of the size of their government debts.’

The reader may well ask, if in all countries, why not in all regions and cities? This is divorced from reality. Attempting to force 2% inflation everywhere would involve not just identical price rises for all goods and services, but freezing every single person’s or company’s consumption patterns exactly where they are to ensure no shortages or surpluses that could alter relative prices. This would necessitate a minutely planned and regulated economy. Further, it takes no account of prices of goods set on world markets – whether oil or any other import.

Incidentally, it would also put paid to any idea of convergence in the euro area. Convergence involves poor countries growing faster than richer countries in order to catch up with them, ultimately having faster inflation than richer countries during the catch-up period. The authors wish Italy (and others) were on an equal footing with Germany, but the drawback would be that both countries could end up resembling a badly run developing country.

Gabriel Stein is Director, Asset Management Services, at Oxford Economics and a member of the OMFIF Advisory Board

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