Euro crisis II has started. The good news is that we have been here before, so we have learnt some lessons, the bad news is the that the underlying challenge is far greater: Italy – the likely epicentre of this crisis – has a far higher debt to GDP ratio; and the Eurozone has an inflation problem. The latter is the crux of the matter. The first Euro crisis was of the ECB’s making because the threat of deflation was a clear and present danger in 2009 and 2010, and quantitative easing – which Trichet rejected – was not just the means to collapse spreads, it was a mandate requirement. It eventually took a sustained fall in inflation below target and Mario Draghi’s ‘whatever it takes’ to bring back a semblance of normality.
But markets never priced in a return of spreads to the pre-GFC level. The Greek default left a permanent mark: there would forever be a credit risk in Eurozone sovereign debt. A semi-sustainable equilibrium has persisted for the best part of a decade. Mario Draghi’s legacy is not just ‘whatever it takes’ and QE, but equally important is his ‘law of conditional safety’. The crux of the financial tension at the heart of the Eurozone is not in fact one-size-fits all monetary policy, it is the absence of a risk-free asset. Do not forget that there was a failed bund auction and a rapid widening of German CDS spreads in the crescendo of crisis I.
The eurozone has no ‘default-risk free’ asset because sovereign debt is issued by member states and money is created by a supranational entity, the ECB. In extremis, the US government can print dollars and secure deposits or its own debt. No government in the Eurozone can. It is that simple. Eurozone member states are not dependent on the kindness of strangers, like developing countries issuing dollar debts, they are dependent on the kindness of the ECB – which has unlimited power in this domain. That is why the safety of sovereign debt can only ever be conditional in the eurozone. Conditional on the ECB believing that it is mandate-consistent for it to underwrite member state debt. And that is precisely why an inflation problem is the basis for a sovereign debt crisis.
Conditional support for Eurozone sovereign debt has come from two sources over the last decade, quantitative easing – printing money to buy sovereign bonds – which was a response to persistently below target inflation, and QE eligibility, which Mario Draghi made conditional on fiscal compliance. Draghi squared one impossible circle – how could the ECB underwrite sovereign risk without eliminating the budget constraint and running the risk of fiscal free-riding? Italian populists – game for both – faced the threat of losing QE eligibility and the consequences of rising spreads and financial panic. This was always high stakes, but worked.
The problem now is much greater. I will not go through the arguments around the Eurozone’s inflation, but what is clear is that the ECB perceives the risk of inflation expectations rising and threatening its mandate, so it has no option but to tighten. Market participants are rarely particularly insightful, but at the aggregate they can have good instincts. The rapid rise in Italian yields and the collapse in the price of Italian banking stocks this week is the first warning shot. Frankfurt: we have a problem.
What is to be done? At the moment, we are on course for a full scale run on Eurozone sovereigns. The fiscal arithmetic becomes self-fulfilling. While Italy’s soveriegn debt stands at around 150% of GDP, yields on BTPs are everything. The yield on 10-year BTPs has already risen from 0.5% in September last year to nearly 4% on Friday. If these levels are sustained, the consequences for fiscal policy become untenable. Markets are likely to push them far higher. Italy quickly becomes a default risk, despite heroic efforts by Italy to cope with macro shocks, run large primary surpluses, and extend the term structure of its debt.
Fortunately, European economists have not wasted the last decade with their heads in the sand. There are some brilliant proposals for institutional reform, which make possible the creation of a risk-free asset in the Eurozone, without opening the door to debt mutualisation or free-riding (see this, from Massimo Amato and others). The Eurogroup of Finance ministers should be instructing the Commission to draw up proposals along these lines. The political battle is likely enormous, however. Any viable solution, hands huge fiscal power away from member states to an new European debt agency.
It is always the role of the ECB. It determines the fate of nations. How can it address the risk of a sovereign run and at the same time tighten monetary policy? I can see no alternative to some form of direct spread-targeting. There are many ways this could be done without a complete loss of market pricing. A reference rate could be derived from a weighted-basket of the highest rated Eurozone sovereigns – from the core and Northern Europe. Spread levels for Italy, Spain, Portugal, and Greece could then be derived from, for example the five-year average spread, or another market-based measure, such as the CDS spread for equivalent credit ratings.
A policy along these lines seems unavoidable, or there is a high probability that sovereign runs ensue. But there are risks. The policy is not illegal. All these countries have market access, so the ECB is not financing fiscal activity. It is ensuring the monetary transmission mechanism is effective and balanced. There is political risk around the determination of the spread. Exiting any form of asset-price target is alway tortuous for central banks. But perhaps the main risk is that the ECB becomes the market-maker of one of the world’s largest bond markets, BTPs. This is a risk worth taking. The alternative is too grim to contemplate. Suffice it to say that there are elections in Italy next year. Given that Europe has a war on its border, and a brutal supply-side shock, populists and nationalists need neutering, not encouragement.