When the history of the euro currency’s rise and decline in popularity is written, the month of June 2022 will be viewed as decisive. In June, the ECB committed to two conflicting policy courses. On the one hand, at its meeting on June 8th and 9th, the ECB changed its interest rate outlook (so called forward guidance) away from continued negative interest rates to postulate interest rate increases, possibly as early as July. Market actors, who prior to this were scared of betting against the ECB, interpreted this announcement as an indicator of a relaxation in the volume of the ECB’s member state public debt purchasing activity, and spreads between Germany’s 10-year bonds and those of Italy quickly widened to 253 basis points, from its recent narrowest measure of 135 in January.
By June 15th the ECB was deeply worried and announced that it was designing a new market tool, termed an ‘anti-fragmentation’ device, with the aim of returning spread differentials to a range deemed acceptable by the ECB. At the time of publication, we still await details of the design of this instrument, however its mere announcement provoked divergent political statements. Francois Villeroy de Galhau, Governor of the Banque de France, chose to echo former ECB President Draghi’s words of ten years ago in saying that the design of the anti-fragmentation tool must send a message that there are “no limits” to the ECB’s efforts. Germany’s ECB Board Member, Isabel Schnabel, whilst diplomatically reiterating the “no limit” message, emphasised the importance of tackling inflation and questioned the need for any new, elaborate piece of financial engineering.
The ECB’s Forward Guidance, in Chess Parlance a Blunder
A careful reading of the words of M de Galhau compared with those of Ms Schnabel reveals opposite policy views. France has consistently pleaded the case of the heavily indebted southern member states, demanding that the ECB continue to support their economies by buying bonds to suppress market borrowing costs. Germany has consistently questioned the legality of direct member state financial support and more recently urged the ECB to focus on inflation, in other words to allow interest rates to rise.
The ECB cannot have it both ways. Even acknowledging its phenomenal powers to control member state debt prices and keep borrowing costs down it cannot both continue to do this and address inflation. In chess parlance, the ‘forward guidance’ announcement of June 9th was a blunder, and the ECB’s credibility has been damaged by it.
The ECB’s internal discussions since June 15 have been widely leaked. Its hopes of juggling with these two objectives rest on turning the clock back ten years when OMT (Outright Monetary Transactions) were first announced. Of course, in 2012 nothing actually happened; the mere announcement was enough to quell market disturbance. But now the plan is to offer to deploy actual OMT support to Italy. The difficulty is that OMT support requires the beneficiary to agree to join a European Stabilisation Mechanism programme. Given that a month has elapsed since the emergence of this plan, and that Prime Minister Draghi has tendered his resignation, it is probably safe to assume that Italy’s government has failed to agree to accept the plan on fears of conceding too much sovereignty.
This leaves the ECB only one option; OMT without conditions. The widely respected, London based, Official Monetary and Financial Institutions Forum (OMFIF) have considered this possibility:
This would simply move the site of contention from the national parliaments of the recipients to the political theatre of the euro area. Many euro area countries would look askance at no strings attached cash handouts that, although they would compress spreads, are likely to stoke inflation and weaken the euro.
But surely unconditional OMT would be too much for Germany, Netherlands and Finland. Not only are leading German policymakers such as Ms Schnabel increasingly vocal, but the important role of Germany’s Constitutional Court (GCC) should also be remembered. Readers will remember that a little over two years ago the ECB accepted the authority of the Karlsruhe court, which had been asked to opine whether the most long-established quantitative easing mechanism – the Asset Purchase Programme (APP) – represented an unlawful extension of the ECB’s powers under EU treaties which of course were incorporated into German Law at their inception.
The GCC’s then ruling was that the ECB should demonstrate compliance with specific APP programme rules, one of which specified that bonds of member must only be purchased in volumes pro rata to each member state’s shareholding in the ECB, expressed as ‘share of the capital key’. The rule was of course necessary to gain universal support for APP to start; it allayed concerns that richer member states could otherwise be indirectly financing weaker member states. The ECB accepted the GCC’s decision and its response, early in 2020, was duly accepted by the court.
However, within a year the point arose again. The ECB’s Pandemic Emergency Purchase Programme (PEPP), established in the summer of 2020, softened this APP rule; under PEPP the capital key was no longer a hard rule, now merely a guideline. Again, the GCC was asked to opine as to the constitutional legality, again it rejected the complaint. Is the GCC politically biased in favour of supporting the ECB? Possibly. But surely an anti-fragmentation, unlimited OMT bail out of Italy which on its face totally ignored the ECB’s capital key would be a step too far for the Karlsruhe court. For reasons, therefore, both of policy and of constitutional legality we doubt that the ECB will be able to implement an unlimited purchase programme.
These recent events herald, we believe, a new phase in the European sovereign debt crisis. We disagree with mainstream media journalists who seem to believe that the resilience of the euro, which has seen it survive problem after problem, will ensure that it emerges from this new crisis in decent shape. Our view is that the rarely mentioned sub story – very weak and perhaps insolvent banks – will likely influence actions by individual member states. This banking fragility is well understood and is the main reason why banking union has never happened.
Since the inception of asset purchases in 2015 the ECB has succeeded in maintaining control by keeping interest rates low, masking banking fragility. For so long as inflation remained low, politicians skeptical of the ECB’s tolerance of zombie banks were able to get re-elected and thus turned a blind eye. Now that the inflation genie is out of the bottle, now that the ECB has blundered so badly and has few options, the cosy consensus is starting to fracture and politicians at member state level are openly starting to question ECB policy.
It is possible that one or more member states will take matters into their own hands. Germany has now repatriated onto home soil most or even all of its gold previously stored abroad. Poland (not a Eurozone member) has done likewise. Smaller member states are believed to be aligning themselves with stronger countries such as Germany, and discussions about optimal currency areas are doubtless commencing.