The dangers for the eurozone are very real

The author is an honorary professor at the Stern School of Business, NYU and chief economist at the Atlas Capital Team

The rifts in the eurozone are re-emerging. In response to the sharp increase in government bond yield spreads in Italy and other countries, the European Central Bank held an extraordinary meeting on Wednesday. Its board decided to work on designing a new mechanism to tackle the “risk of fragmentation” or the idea that the effect of monetary policy on the 19 nations in the eurozone could vary widely, with potentially destabilizing consequences.

The dangers are real. Italian long-term yields have risen from below 1% at the beginning of the year to over 4% in recent days. But the risk of fragmentation is not the only serious problem for the ECB. Inflation in the eurozone has also risen more than 8 per cent in recent months. This is at a similar level as in the US, but unlike the Federal Reserve, the ECB plans to wait until next month to start raising interest rates. This lag behind the Fed and other central banks is due to various reasons. Labor and commodity markets in the euro area are weaker than in the United States, as the recovery of the area from Covid-19 is slower.

Supply shocks, including rising energy and other commodity prices after Russia’s invasion of Ukraine, are a bigger factor than excessive aggregate demand inflation in the euro area. Wage growth is more modest than in the United States, and core inflation is slower.

Supply shocks, which reduce growth and raise inflation, put all central banks in a dilemma. To prevent inflation expectations from spiraling out of control, they need to normalize monetary policy sooner and faster. But that risks hitting the economy hard with a recession and rising unemployment. If, on the other hand, banks also care about economic growth and jobs – even for ECB right, despite its single mandate for price stability – they can return to normal more slowly and risk diverting inflation from its expectations.

The United States and the United Kingdom are currently at serious risk of a hard landing as the Fed and the Bank of England aggressively tighten interest rates. But that risk is at least as great and probably greater in the eurozone than in the United States. Recovery from Covid is more anemic in the region. It is more exposed to energy shocks than the long war in Ukraine. And given that it relies on exports to China, it is also more vulnerable to a slowdown in Chinese growth stemming from Beijing’s policy of zero Covid.

In addition, the weakening of the euro, which stems from the difference in monetary policies between the ECB and the Fed, is inflationary. The increase in borrowing costs on the periphery of the euro area is greater. Some promising indicators, such as data on German production, signal that the area may be heading for a recession even before the ECB starts raising interest rates. All this is happening while the ECB’s hawks, who want to raise interest rates faster and faster, are gaining supremacy on the board.

The eurozone suffers from weak growth and job creation potential. A hard landing would not only exacerbate these problems, but would increase market concerns about debt sustainability or the risk of fragmentation. The “loophole of doom” between indebted governments and banks holding this debt, a feature remembered by many in the eurozone crisis a decade ago, will return to focus.

Designing a new facility to deal with the risk of fragmentation is easier said than done. The ECB’s doctrine states that potentially unrestricted purchases of certain government bonds are acceptable only if the widening of yield spreads is driven by unjustified market dynamics. When the driving factor is bad policies, not bad luck, purchases of ECB bonds must come with fixed conditions. This is how the mechanism for direct money transactions was designed in 2012, but no government asked for it because no one wanted to accept the politically difficult conditions. However, in order to pass a legal inspection, each new facility will have to include something in this sense.

The recent expansion of Italian and other spreads is not just due to irrational panic among investors. Italy has low potential growth, large fiscal deficits and huge, possibly unsustainable government debt, which rose during the pandemic. Debt service costs are now rising steadily as the ECB withdraws its over-commodity policies. The risk of a “snare of fate” is higher in Italy than in the rest of the eurozone.

Next year, Italy’s elections could form a right-wing coalition, dominated by parties skeptical about the euro and the EU. Virtually any new ECB tool designed to bail out Italian bonds may come with conditions unacceptable to the country’s new leaders – and to all other eurozone countries under pressure.

Before the ECB meeting this week, a member of the Executive Board Said Isabel Schnabel that the bank’s willingness to deal with the risk of fragmentation has no “limits”. This echoed the statement of former ECB President Mario Draghi, changing the game “whatever is necessary” from 2012. But Schnabel also hinted at the need for political conditions when it comes to offering support. Given the current volatility of financial markets, it can be expected that they will further test the ECB’s ability to protect its monetary union by supporting fragile eurozone countries.

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