What the European Central Bank taketh, it giveth back. That’s the message from Wednesday’s emergency meeting of the eurozone’s monetary policy makers, who have decided they’re not so single-mindedly focused on controlling inflation after all. Instead they’ll try to save Italy’s government from itself.
Witness a new subsidy the ECB concocted this week for bonds issued by fiscally rickety euro members. The central bank has wound down net bond purchases under its two quantitative-easing programs. But it won’t allow bonds to start running off its balance sheet at least until late 2024. In the meantime, the ECB announced Wednesday, it will divert maturing principal to new bonds issued by governments experiencing a run-up in yields.
Rome will be one of the main beneficiaries. The ECB effectively is promising to buy Italian bonds in excess of the ECB’s normal portfolio allocation rather than reinvesting the principal from maturing Dutch or German bonds in new Dutch or German issues.
This is meant to solve the problem of “fragmentation risk.” As the ECB has scaled back quantitative easing, the central bank is no longer the only net buyer of sovereign debt for many eurozone governments. As a true bond market revives in Europe, investors are demanding higher returns on the bonds of governments like Italy’s whose borrowing stands at about 150% of GDP. The spread between the yield on the German 10-year bund, the eurozone’s safest asset, and Italy’s benchmark 10-year bond increased to 2.4% as of Tuesday evening, close to a two-year high.
Rather than viewing this as a healthy market signal, the ECB perceives a threat to eurozone stability. And Wednesday’s announcement had the desired effect. The Italian spread declined to 2.13% after the ECB announcement and stayed around that level Thursday.
That doesn’t change the fact that this is a mistake by President
and the ECB. As the eurozone emerges from the pandemic and grapples with accelerating inflation, slowing economic growth, a war in Ukraine and other ills, accurate price signals are more important than ever. The eurozone won’t have them for the foreseeable future.
The new program may also discourage the ECB from running off its asset portfolios sooner now that it has a new use for the maturing principal—even if quantitative tightening proves necessary to fulfill the ECB’s primary responsibility of price stability.
No one anywhere has authorized the ECB to subsidize some nations’ debt but not others. Suppressing yields for vulnerable euro countries was an unspoken goal of ECB asset purchases, but Ms. Lagarde and her predecessor
conceded this could only be done indirectly by buying every government’s bonds in proportion to the size of its economy. That credit subsidy was contentious enough in fiscally prudent countries such as Germany. A more direct subsidy could lead to political “fragmentation” that’s worse than the yield fragmentation Ms. Lagarde is trying to fix.
Ms. Lagarde will make that political problem worse if she persists, as she promised Wednesday, in creating an entirely new mechanism to suppress the yields of spendthrift eurozone governments. This is meant to prevent the currency bloc from splitting apart in an economic mess triggered by a debt crisis. But don’t underestimate the political costs of these policies.
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