- Key EU actors were able to overcome internal resistance and deliver meaningful measures that calmed financial markets, allaying concerns that discord among member states would heighten as the COVID-19 crisis unfolded.
- Debate about the legality of the monetary and fiscal policies introduced to revive the eurozone economy will continue to simmer, highlighting the risk of future conflicts.
- The outlook for eurozone economies remains stark, and deflation remains a key risk.
- Short-term fixes might have enhanced cohesiveness within the EU for now, but fundamental issues remain.
Life’s three certainties: death, taxes, and European crises
Christopher Bullock was the first recorded author of the famous aphorism, “Tis impossible to be sure of anything but death and taxes” in 1716, although he was followed by the more poetic Danial Defoe, who in the more prophetically titled The Political History of the Devil noted that “things as certain as death and taxes can be more firmly believed,” before it was most famously attributed to Benjamin Franklin who said, “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” ¹
To this famous couplet, we can add a third certainty: eurozone crises. They’ve become as regular as clockwork and the eurozone’s politicians past masters at the economic art of satisficing—a portmanteau of satisfy and suffice first made famous by Nobel Prize winner Herbert Simon—which, in this context, involves doing the minimum necessary to maintain unity, but never achieving the maximum necessary to avoid the next crisis. Indeed, in each iteration of the European crisis, the tail risk of a breakup remains very low; however, over time, the cumulative probability of default inevitably rises as the contradictions of the dysfunctional single currency resurface.
However, few market participants believe that a breakup of the European Union (EU) will ever come to pass in their lifetime because of the learned behavior of the last two decades. In our view, the risk of a breakup is greater than the consensus expects, but it remains a tail risk.
Indeed, the European Central Bank (ECB) and European politicians appear to have had a good crisis—they appear to have learned the lessons from the great financial crisis and moved quickly to achieve the minimum. The central bank has adapted its policy mandate to compress peripheral sovereign spreads as essential to the monetary transmission mechanism.² By now, financial markets know not to fight the central bank, and its various liquidity programs will likely achieve the goal of driving these spreads back below levels that prevailed prior to the start of the pandemic.
ECB: bending rules to deliver “whatever it takes”
The ECB remains the main propagator of the “whatever it takes” narrative. The central bank expanded its Pandemic Emergency Purchase Program (PEPP) by an additional €600 billion to €1.35 trillion and extended its operation by a further six months to June 2021, bringing its potential asset purchases in 2020 and 2021 to €1.95 trillion.³ This magnificent sum also includes €480 billion from its regular Public Sector Purchase Program, at a pace of €20 billion a month, plus a “kicker” of €120 billion to be used in 2020.²
More than three-quarters of these purchases will be used to purchase government bonds, which will more than cover the current financing needs of the eurozone governments. We believe that the lowered GDP and inflation forecasts can—and will—be used as justification to extend the various asset purchase programs this autumn and next spring, when European governments are expected to seek additional measures to speed up their recoveries from this terrible pandemic.
In our view, there are three justifications for this aggressive monetary easing—first, to guard against deflationary risks. The ECB lowered its growth forecasts and now expects real GDP in the euro area to decline by 8.7% in 2020 before recovering by 5.2% in 2021, and by a further 3.3% in 2022.⁴ These forecasts are based on a one-time COVID-19 outbreak and are therefore vulnerable to the downside risks of a second wave of the pandemic, and even a third. Likewise, inflation forecasts were lowered to 0.3% for 2020 and presumed to recover only gradually to 0.8% in 2021, and 1.3% in 2022. The central bank expects core inflation to remain below 1.0% in 2022—a sign of how worried it is about deflation.⁴ For context, this is less than half the symmetrical 2.0% inflation target that the ECB is expected to adopt at the end of the year.
This leads us to the second justification, which entails making sure that the massive increase in government issuance doesn’t lead to a rise in interest rates, which crowds out private sector investment. This means providing forward guidance indicating that rates will remain low, augmented by the central bank’s asset purchases, which provides effective yield curve control.
The third justification is more controversial, and the central bank has made the compression of peripheral spreads⁵ an important component of the monetary transmission mechanism. Indeed, in justifying the expansion of the PEPP program, the central bank noted that monetary conditions were still too tight in large part because these spreads were still wider than where they were at the start of the pandemic. PEPP is supposed to be temporary, but in politics, there’s nothing so permanent as “a temporary program,” and given the EU’s inbuilt propensity to crises, we wonder if this balance sheet expansion will ever be unwound. Nevertheless, the ostensibly temporary nature of the program has allowed the ECB to depart from its capital key and prior issuer limits. These departures have been modest so far, but we expect these deviations to grow over time.
"The ECB remains the main propagator of the “whatever it takes” narrative."
In addition to its various asset purchase programs, the ECB is also supporting the economy by providing tremendous liquidity to the European banking system. Its recently adjusted pandemic targeted longer-term refinancing operations (or TLTRO III), which allows banks to borrow from the central bank at interest rates as low as -1%, provided €1.3 trillion in additional liquidity for banks ostensibly to lend to the private sector. In practice, however, this will likely lead to a significant leakage into the government bond market as banks use those funds to purchase European government bonds, reinforcing the symbiosis between governments and banks.
In our view, there are two longer-term problems with the ECB’s approach to pandemic funding. First, the relaxation of capital key requirements and issuer limits will be challenged in the German constitutional court.⁶ Adherence to these conditions enabled the court to accept that the central bank’s quantitative easing (QE) program—which ran between 2015 and 2018, and was reintroduced in late 2019—didn’t contravene the legal prohibition on monetary financing. However, the court still ruled that the ECB had acted ultra vires—beyond its legal authority—because its decisions hadn’t been “proportionate,” and demanded an explanation within three months or it’d prohibit the Bundesbank from participating in the ECB’s QE programs. We don’t believe that this will happen, but the ECB’s initial response, which stressed its independence and implied that it’s answerable only to the European Court of Justice, highlights the risk of future conflicts.⁷
A flexible approach to interpreting rigid rules
The central bank isn’t the only EU institution accused of acting ultra vires. The European Commission’s €750 billion pandemic recovery fund, which consists of €390 billion of grants and €360 billion of loans, finally received backing from 27 EU leaders on July 21 after four days of intense negotiations.⁸ While the proposal still needs to be ratified by the European Parliament, it’s important to note that a couple of precedents have been set.
The first is the plan for the EU to borrow under its own credit, and second, to provide grants rather than loans to member states. In particular, Article 310 of the Treaty of the Functioning of the European Union has until recently been understood to prohibit the EU from borrowing. However, the European Commission has circumvented this pesky provision by invoking Article 311, which states that “the Union will provide itself with the means necessary to attain its objectives and carry through its policies.” It’s difficult not to view it as the Commission’s version of Mario Draghi’s famous “whatever it takes” speech. We expect this fund to be passed with only minor changes—the frugal nations could do no less amid a pandemic.
That said, we think the size of the fund is too small and will need to be increased next year. When the dust has settled, it’ll likely become obvious that amid the tempestuous posturing and emergency EU meetings, nothing has been done to solve rising legacy debt among EU members. In our view, it’ll be nigh on impossible to reimpose austerity after the pandemic and further crises are inevitable, even if the short-term issues have been alleviated by bending the treaties.
New treaties, we believe, are required.
1 “Daniel Defoe- The history of the Devil: ancient and modern in two parts with a description of the Devil’s dwelling,” rcseng.ac.uk, August 23, 2019. 2 This is defined by the European Central Bank as “the process through which monetary policy decisions affect the economy in general and the price level in particular.” 3 Bloomberg, as of June 22, 2020. 4 “Eurosystem staff macroeconomic projections for the euro area, June 2020,” ecb.europa.eu, June 4, 2020. 5 Peripheral spreads refer to the yield differential between 10-year German bond and yields on the 10-year bond of European countries such as Spain, Greece, Portugal, Ireland, and Italy—countries whose yields rose sharply during the European crisis 10 years ago. 6 “ECB Targeted by German Far-Right Party Over Coronavirus Response,” bnnbloomberg.ca, June 18, 2020. 7 “ECB takes note of German Federal Constitutional Court ruling and remains fully committed to its mandate,” ecb.europa.eu, May 5, 2020. 8 “EU recovery fund: how the plan will work,” Financial Times, July 21, 2020 .
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