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Can the ECB prevent a second euro crisis?

The writer is a fund manager at M&G and author of ‘Supercharge Me: Net Zero Faster’

The emergency meeting of the European Central Bank last Wednesday was a remarkable event. It could be the first time that a central bank faced with the onset of a crisis has acted early and quickly.

Concerns about structural stability at the heart of the European government bond market have never been allayed. Despite the strength of the “whatever it takes” promise by then-ECB president Mario Draghi a decade ago, and extensive bond-buying programs, markets have consistently priced a credit risk premium into some countries’ sovereign debt.

The European government bond market is unique. Debt is issued by member states, but money is created by a supranational entity, the ECB. The power to print money is the foundation of creating risk-free benchmark assets in a financial system. Without the support of the ECB, the eurozone has no such asset.

But the ECB’s support for the government bond market has always depended on consistency with its mandate of price stability. It was the threat of deflation in 2012, and during the pandemic, that gave the ECB all the clarity to provide the boundless support needed to stop a panic.

Inflation in Europe is a game-changer, and the markets know this. This time, the epicenter is Italy – Europe’s largest government bond market – not Greece. Italy’s debt-to-gross domestic product ratio is much higher than in 2010, almost 150 percent. When debt levels are significantly higher than GDP, changes in government debt interest rates dominate the fiscal arithmetic. The yield on 10-year Italian bonds (BTPs) rose from 0.5 percent in September last year to 4 percent last week. No estimate of trend growth in Italy is close to 4 percent.

If the ECB had not called an emergency meeting and sent the markets a warning shot, yields could have reached 5 or 6 percent in weeks, if not days. The ECB has now bought itself time and by acting relatively early and quickly, the central bank has at least broken the psychology that selling BTPs is a one-way street.

But the detail of any serious intervention has been put off and there is an element of can-kicking. ECB staff have been tasked with drawing up plans to avoid ‘fragmentation’.

Contrary to the pattern of the past 15 years, politics seems less of an obstacle. There are good reasons. Europe has a war on its borders, there will be Italian elections next year and Draghi, now prime minister, is likely to leave the podium. Populists and nationalists have not disappeared. It is our collective responsibility to silence them rather than encourage them. That must be the line taken by ECB President Christine Lagarde, and all the evidence from other board members’ public statements suggests there is sufficient agreement on the need to avoid another crisis.

Simply put, the task is to narrow the spreads on bonds of the most vulnerable countries to the point of fiscal sustainability. Whatever measures are introduced they will not be presented as such, as it exposes the ECB to accusations of institutional overshoot, but we must be clear that this must be the goal.

The technical challenges should not be underestimated. There is now no alternative I see to targeting state spreads directly. This cannot be achieved through a broader program of quantitative easing of asset purchases, as the background is a tightening of monetary policy. Nor can it be achieved by adjusting flows on the ECB’s portfolio of assets purchased under its pandemic emergency purchase program.

Sovereign spread targeting by a central bank has never been done before. The main thrust of a program involves creating a reference basket of “safe” European government bonds from core eurozone countries, such as Germany, and determining an acceptable spread for each market. The ECB would then commit to enforce a cap on these spreads. In principle, the actual numbers do not need to be made explicit. Markets will derive the point of intolerance from intervention.

We need to be clear about the risks. Ultimately, the ECB becomes the market maker for BTPs or other bonds. Liquidity may disappear. How will Italy issue debt in the primary market, and at what price? Can the arrangements be played by market parties? What will the ECB look like?

None of these risks is insurmountable. They are also worth taking. The alternative does not tolerate contemplation. The ECB will have to come up with answers in the coming weeks or the markets will draw their own conclusions.

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