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The ECB’s High-Wire Act -Breaking



Geoffrey Smith – Central banking is always a tricky business. Institutions must tread carefully, knowing that one slip can quickly cause disaster. 

According to market reaction after Thursday’s press conference Christine Lagarde, European Central Bank president could have believed that the catastrophe had already occurred. Since Thursday’s press conference, the euro has fallen by 3 cents to the dollar. Bond spreads in the currency union have increased sharply. This is a subtle but still worrying echo of 2012’s euro crisis. 

It seemed that markets were not impressed by the ECB’s refusal to increase interest rates more quickly at a time where the single currency is experiencing a loss of purchasing power unlike ever before. However, markets were equally scared about what even a slight rise in interest rate would mean for countries like Italy or Greece’s debt sustainability. 

The truth is that it’s difficult to think of a more effective way to resolve the tension between these two problems. To have stuck with the bank’s previous guidance of only two 25 basis point increases in the deposit rate by September would have invited accusations of complacency, after consumer inflation leaped to 8.5% in May, overshooting expectations as it did in the U.S.  To promise a 50-basis point increase immediately, however, would have been to risk letting go of the bond market’s genie. This could have triggered the same self-inforcing panic which drove the 2011 and 2012 crisis. 

Some feel that 2012 cannot be compared.

“Nothing that is happening now has any resemblance to the 2011/2 debt crisis,” Robin Brooks, an economist with the Washington-based International Institute for Finance,  said via Twitter (NYSE:) over the weekend, “People confuse rising yields with crisis. Now we are determining what yields exist without quantitative easing. That’s all.”

While it is true that the yields on the Italian and Greek bonds are not at their highest levels ten years ago (in absolute terms) or in relation to the German 10-year bond, which has been the region’s safest benchmark asset, it’s also true that the Italian and Greek yields have dropped significantly. Since the beginning of this decade, both the Eurozone (and the European Union) have steadily and slowly expanded the common financial safety network. It was the absence of which many people believed – wrongly, it turned out – that the single currency would fail to survive the first crisis. 

However, many Eurozone citizens cannot afford higher interest rates. For most of its existence, the Eurozone’s economy hasn’t grown quickly enough to support the current debt load. Although sovereign debt was already very high before Covid-19 it has become a huge overhang in public debt. Each rise in the market interest rate will cause governments to redirect more resources towards servicing this debt and less toward productive investments in schools, infrastructure, or health. 

Three decades ago, the Maastricht Treaty that laid out the foundation for monetary union stated that no country would ever have a debt burden greater than 60% of its GDP. This was in order to ensure that the nation could eventually share a currency like the Netherlands and Germany. A debt ratio today of 112% is even more than that of France, who has always been in good health for the euro. Italy has a debt ratio of 150% and Greece, a ratio of 193%. This debt makes the economy more vulnerable to changes in interest rates. 

This means the ECB will be more likely to eliminate excess demand in the system by increasing rates only a few times than the Federal Reserve, which, for instance, might do. Overheating is not the problem of the Eurozone. Problems that the Eurozone cannot control are Russia’s conflict with Ukraine and China’s inability with Covid-19. Both of these issues have already caused a slowdown in German manufacturing which is traditionally the region’s main growth driver. Inflation could remain high for longer unless these two factors are addressed. 

The tightrope walker has no other options. It is important to focus on the task at hand and not to be distracted by other distractions. We can only hope.