Learning from past failures of the ECB to contain market panics on sovereign bonds, the ECB should stand ready to provide liquidity support to Italy’s new government.
The political crisis in Italy has brought the Eurozone crisis back to the table. The prospect of having a eurosceptic government led by the coalition between Five Star movement and the League has provoked a yield increase on the Italian sovereign debt, with yields on the 10 year bond reaching 3.3%, a level we had not seen since 2014.
With a high level of public debt, the third biggest European economy is in a very weak position. Italian sovereign bonds are only 2 grades above the eligibility rule of the ECB. Were credit agencies to downgrade Italian bonds below that threshold, the whole Italian debt would be made ineligible for quantitative easing purchases, and in turn, the Italian banking system would face massive liquidity problem. It’s easy to see what could go wrong.
The Eurozone has been there before. Market panics over Greece, Ireland and other southern countries in 2010 happened for very similar reasons: self-fulfilling panics by financial markets over the credibility of specific countries to sustain their debts and/or remain in the Eurozone.
Unfair punishment
Many among the EU’s establishment are quite openly embracing the view that the current market pressure is a good thing. For example, Commissioner Oettinger said “Developments in Italy’s markets, bonds and economy will become so far-reaching that it might become a signal to voters after all to not vote for populists on the right and left.”
So their thinking goes, markets will discipline voters how to behave, and ensure the new populist government paddles back on their ambitious social and fiscal policies such as the citizen’s income.
However, this narrative is equally as harmful and poisonous as the ones of those threatening to leave the euro. The Greek experience shows that market pressures did not persuade the Greeks to reject Syriza’s anti-austerity approach. Europe’s inaction against market pressures will soon enough be denounced by Eurosceptics and fuel their narrative. They will play the victim.
In the meantime, Italian taxpayers will pay the price. As President Mattarella said, “The rising spread, day after day, increases our public debt and reduces Government spending on new social initiatives.” If the current trend persists, Italy will pay 1% basis point more for borrowing than Spain, and 2% more than Germany.
Yes, both the Five Star Movement and The League have very ambivalent intentions about Italy’s future membership of the euro. Their policies are likely to increase the budget deficit and they are unlikely to follow the path of “structural reforms” recommended by the European Commission semester after semester. For sure, the coming months will be challenging for European leaders.
Yet Italy should be given a fair chance. The new finance minister, Giovanni Tria, is not known to be against the euro, and all the measures proposed in the coalition agreement yet remain to be passed into legislation – a process which will take months. The EU should refrain from playing hard ball in this situation.
Market pressures are not unavoidable fatalities
Market panics in 2010 were only contained when Europe reacted by creating the European Stability Mechanism (ESM), and later it was the European Central Bank who successfully put an end to the crisis in 2012 – when its president Mario Draghi pledged to “do whatever it takes to save the euro.” Draghi’s spectacular statement was quickly followed by the establishment of the Outright Monetary Transactions programme (OMT), a new monetary instrument whereby the ECB could provide unlimited liquidity to any member state of the euro. Although OMT was never used, its existence alone reassured markets over the fact that the ECB would intervene in the future.
Unjustified market pressures are not an unavoidable phenomenon. With OMT, Europe has a powerful instrument available to contain them. If market pressures remain, it will soon be the time to use it.
However, the current rules of OMT are inapplicable in practice because it can only be used under strict conditions; specifically, “an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme.” This means that in order to get financial support, Italy would have to commit to a controversial austerity programme – needless to say, that’s something that a eurosceptic government is unlikely to agree with.
This deadlock could potentially lead to a damaging escalation. For sure, there will be a temptation by the EU leaders and the ECB to play hard ball until the Italian government blinks. After all, the EU will always have the upper hand because the ECB can create new money while governments have to borrow from financial markets.
Fortunately, a simple tweak to the OMT rules could help us avoid any harmful deadlock. As proposed by a Bruegel report a few months ago, OMT and ESM rules should be reformed in order to allow for more flexible and swift activation of OMT in cases of liquidity crises. Gregory Claeys, the author of the report, explains:
Concerning ‘pure’ liquidity crises in which the ESM is essentially used as a political validation device for the ECB’s OMT programme, there is no need to couple this decision with an adjustment programme. Linking a monetary policy measure to the implementation of economic reforms is highly problematic because a country might have to accept a loss of sovereignty and be forced to implement policies to access an OMT programme solely because of a problem of multiple equilibria for which it might bear little responsibility. This would put the ECB in the business of prescribing (micro-)economic policies, for which it has no remit.
Along the same lines, we think the European CounciI (which includes all EU head of States) should allow the ECB to activate OMT with no condition, for a time-limited period, with the objective of simply ensuring that Italy can keep borrowing at similar rate than other Eurozone countries. This is a helping hand, but no free money.
For sure, such assistance will raise eyebrows in Germany. To protect the ECB’s legitimacy, it is key that such decision shall be approved by the Council, for the sake of preventing another major financial crisis and the integrity of the EU.
To ensure its own ability to intervene, the European Central Bank must preemptively request such a change of the OMT rule to the EU Council. Subsequently, it should reaffirm publicly its ability to activate OMT, including through primary market purchases or even direct credit lines. If Draghi’s words are once again powerful enough, this should be enough to shield Italy from markets’ unjustified attacks without injecting one additional euro.
Constraining the budgetary capacity of the new Italian government even before it has the chance to draft its next budget is not the kind of punishment that is going to help defeat euroscepticism. Rather, it might provide the final demonstration for what anti-euro nationalists forces have been saying for a long time: the Euro is not a currency union worth remaining in.
Italy already has enough problems to deal with. For the sake of Italy and Europe, EU leaders’ best response is to show a caring hand. The League and Five Star Movement might be the EU’s enemy, but we should keep treating the whole Italian population as our friends.
Credit Picture: CC Dmitry Dzhus