The second European debt crisis has begun, and far sooner than expected. On the 9th of June the European Central Bank (ECB) governing council announced that it would raise interest rates from -0,5% to -0,25% in July. This rate hike is to be followed by another hike in September (to 0%, supposedly) and further increases are expected. On the 14th of June, I wrote an article making two key points:
- The proposed interest rate increase will not be enough to curtail inflation.
- Regardless of point one, it remains to be seen if the ECB will raise rates to 0% and beyond.
The very next day, on the 15th of June, the ECB council met for an emergency meeting. The interest rate on Italian ten year debt, at 3,4% before the rate hike announcement, quickly rose to a high of 4,3% on June 14th. In the same period the interest on ten year German Bunds rose from 1,6% to 1,9%. With those differential increases the spread between German and Italian rates widened to the highest level since the start of the pandemic. To counteract the rising spread the ECB announced two solutions. First it will reinvest the proceeds of the PEPP program and second it will develop a, as of yet not finalized, ‘anti-fragmentation tool’. The announcement seems to have calmed markets as Italian debt returned to a more manageable 3,7% at the time of writing.
So why is the spread a problem? According to Dutch central bank president Klaas Knot, the spread causes problems both for countries with high interest rates, such as Italy, as well as for those with lower interest rates, such as Germany. Obviously, the higher interest rates cause a problem for the Italian government in financing their deficit. Moreover, as investors move to the safe haven of the German Bund, the German market is flooded with more money, exacerbating the inflation problem. During the time of ultra-low rates, all bond yields (interest rates) were pulled in the direction of zero. With higher interest rates also come higher spreads: investors simply have more faith in Germany than in Italy when it comes to paying back debt. It makes sense as the Italian national debt is 150% of GDP, while in Germany the debt is a far smaller 60%.
The spread is a market mechanism, that rewards good behavior and punishes bad behavior. The signal the market is sending is that the Italian government needs to balance its budget. The fact that the Italian government is no longer able to borrow at low rates is not a side-effect of the rate hike, but a feature. The only way the ECB can reduce monetary expansion is if governments as well as the private sector are incentivized to reduce borrowing. The only appropriate word for a policy that seeks to tackle inflation while retaining ease of borrowing is paradox.
While we are talking about limiting the expansion of money, how do we go one step further and decrease the money supply? While money is created whenever a loan is taken out, it is similarly destroyed when loans are paid off. A financial institution pays money to the central bank and does not receive money in return: the supply of euros has dwindled; well, not anymore apparently. The ECB is free to ‘reinvest’ all the money that is paid back on loans issued under the flag of the Pandemic Emergency Purchasing Programme (PEPP). What’s more, it is free to do so in any direction it desires, for instance by buying Italian bonds while directing the Germans to the private market. It is hereby incentivizing deficit spending, while punishing a prudent fiscal policy. The ECB tends to the weeds while pulling out the flowers. I first thought this ‘reinvestment policy’ was a further acceleration in expansionary policy, but it was part of PEPP from the start. Although the E stands for ’emergency’ any PEPP funds are there forever, a permanent expansion of the euro supply.
If these existing policies are not enough to maintain low spreads, perhaps the new tool will help to prevent ‘fragmentation’. The full details of this tool have not been disclosed yet, but it will allow the ECB to decelerate monetary expansion at different speeds for different member states. This of course immediately begs the question: why are we in the same currency then? What is the ECB defending? Does the euro mean a joint monetary policy, or is it nothing but a logo?
For now the emergency meeting of the ECB has worked: spreads have returned to a more manageable level. It seems far-fetched that the governing council would not have expected diverging rates, the ’emergency’ was probably planned all along. And in this sense, perhaps the emergency meeting was not a reversal of policy at all. Perhaps the ECB is just trying to buy time while it raises rates and confronts Europe with a fait accompli. Be that as it may, any deceleration, even the small one proposed last week, immediately puts the sovereign debt of Italy and other members at risk. At the same time the runaway train of inflation will keep forging ahead for the foreseeable future, entailing great risks for governments, businesses and households alike: welcome to the second European debt crisis.