The ECB needs a formidable tool against fragmentation

Joachim Nagel, the head of Germany’s Bundesbank, is sabotaging European Central Bank President Christine Lagarde’s plans for a global backstop to prevent yields in peripheral European countries from soaring. In a scathing address this week, he argued that it is “virtually impossible” to determine whether a widened gap above German benchmarks is warranted, setting the stage for another brutal fight between policymakers that risks to trigger a summer of discontent in the bond market. . As soaring inflation ends the era of negative rates and quantitative easing in the euro zone, a glaring hole in the bloc’s defenses has been exposed. When Italian 10-year borrowing costs soared above 4% in mid-June, the ECB was forced to hold an emergency meeting to appease markets. His promise to “accelerate the completion of the design of a new anti-fragmentation instrument” worked as a stopgap; Nagel’s speech, however, suggests that nothing is settled yet. His hardline approach risks leaving economically weaker eurozone countries, including Italy and Greece, at the mercy of bond traders if markets begin to doubt the ECB’s commitment to countering any flare-ups. sovereign financing costs. It’s a back-to-the-future moment that makes Lagarde’s already difficult task of balancing the interests of the 19 countries using the euro all the more difficult. The euro is seriously unimpressed, weakening to a 20-year low against the dollar and close to parity.

For now, the bond market is more optimistic. Italian yields are around a percentage point lower since the ECB’s emergency meeting, but this echoes declines in German and US yields over the same period. There is no room for complacency.

The challenge facing policymakers is not to let the financing costs of the most indebted members of the euro spiral into unsustainable territory. How high is too high? Italy’s central bank governor Ignacio Visco said in mid-June that the spread between Italy’s and Germany’s 10-year debt should be less than 150 basis points based on economic fundamentals – and certainly shouldn’t. not exceed 200 basis points.

The outline of a so-called anti-fragmentation tool, which will be called Transmission Protection Mechanism, is expected to be unveiled at the next ECB Governing Council on July 21. the threat of too high Italian or Greek yields seems hopeless. As I wrote last month, a strong enough backstop never needs to be used. The best example is the Outright Monetary Transactions program that former ECB President Mario Draghi announced in 2012 to tame violent spikes in peripheral country bond yields, which has not been triggered to date.

François Villeroy De Galhau, head of the French central bank, remains optimistic, declaring to Les Echos that “it is likely that the mere existence of this instrument allowing rapid and massive intervention in case of need is sufficient, without it being necessary to activate it”. The scope of the program will be decisive; as Olivier Blanchard, the former chief economist of the International Monetary Fund, said on Twitter on Wednesday, size matters.

For the head of the German central bank, questioning the concept of yield caps is truly unnecessary. The history of the ECB is dotted with challenges before the German Constitutional Court, and even resignations of members of the Bundesbank. The illegality of cross-subsidies remains a stumbling block, with wealthier states in northern Europe reluctant to bail out their heavily indebted southern neighbors. This is an inherent flaw in the construction of the euro, an economic and monetary union without intertwined fiscal or banking pacts.

It won’t reassure Germany that French Finance Minister Bruno Le Maire said in an interview with the Financial Times this week that EU debt rules are “outdated” and should be overhauled. Former Italian Prime Minister Enrico Letta warned earlier this week of the need for euro unity. “The response must be common,” he said. “The risk is that leaders turn a blind eye until it’s too late.”

It’s bad enough that the central bank left it so late to deal with the risk of fragmentation. If Nagel gets what he wants, the program could end up neutered and ineffective. So far, the ECB has been slow to deploy already existing flexibility, reinvesting its existing portfolio as bonds mature so that, for example, proceeds from a redeemed German bond can be spent on Italian debt. For the Pandemic Emergency Purchase Program, that equates to about 10 billion euros ($10.4 billion) a month, well below its regular monthly purchases of 40 billion euros earlier. this year, though expanding it to the full asset purchase program would increase that firepower. Yet if market stress arises when redemption funds are insufficient to stem the tide, bond traders will smell the blood.

The irony for Germany and other hawkish members of the ECB is that the faster bond markets integrate, the less credible the bond support mechanism proves, the less scope there will be for raising interest rates. . To successfully rein in consumer prices after years of free stimulus, the ECB must raise borrowing costs, but it cannot do so if eurozone unity is at stake. against inflation, or tinker while Rome burns? Your call, Germany.

The ECB needs a formidable tool against fragmentation

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