The Eurozone continues to stumble on, held together by the vast bond-buying program of the ECB, which has saved several Member States from insolvency over the last several years. While all the talk at present has been about what to do about the punitive and unworkable fiscal rules in a post-pandemic (when will that be?) period, when the emergency waivers of the Excessive Deficit Mechanism procedures are withdrawn, the reality is that under the current architecture, the only thing that keeps the currency union intact is the ECB acting outside of the legal structures set down by the treaties. Yes, I know full well that the elites have massaged the public into believing that there is no breach of the no bailout clauses, but the reality is different. The ECB is (indirectly) funding Member State fiscal deficits through its massive asset purchasing programs, the two relevant ones being the PSPP and the PEPP. And ever since they introduced the Securities Market Program (SMP) in May 2010 they have been providing funding to Member States to allow them to run fiscal deficits while maintaining low bond yields. With the Pandemic Emergency Purchase Programme (PEPP) scheduled to end in March 2022, the fears are growing that Italy will be the first Member State to succumb to the bond markets – the yields on debt will rise because the investors appreciate the credit risk and will know they cannot offload as much debt onto the ECB in the secondary markets. The fact that these fears are becoming more widespread should tell you that the role of the ECB is exactly what I say it is rather than the ‘maintaining order in investment markets’ spin that the ECB runs as the smokescreen.
The ECB is now approaching a crisis situation.
With the inflation rate (currently at 4.9 per cent per annum) well above its definition of price stability (2 per cent) it is being pressured to abandon its various bond purchasing programs.
This is based on the mainstream argument that the liquidity pumped into the reserve accounts of banks via the various bond-buying programs is inflationary – the so-called ‘printing money’ myth.
The ECB is full of economists who believe that sort of fiction.
To some extent the ECB has reduced pressure on itself to act by adopting a symmetric approach to their price stability target.
The US Federal Reserve led the way in this respect in August 2020 when it effectively abandoned the NAIRU-forward looking approach to monetary policy setting and instead said it would tolerate temporary deviations in inflation from its price stability target as long as the unemployment rate was still falling.
They had reprioritised policy to target the irreducible minimum unemployment rate instead of using unemployment to discipline price pressures that they
‘expected’ to occur, even if the pressures were not evident in the data.
That was a massive shift in thinking by the central bank and represented a rejection of the mainstream NAIRU approach that has dominated policy setting for 3 or more decades.
So the ECB can always say the current inflation is transitory (an assessment that I agree with) and that they will continue to support the real economy.
Their dilemma is, of course, that they know full well, even if a host of mainstream economists like to deny it, that their bond-purchasing programs are the only thing standing between several Member States remaining solvent and having to declare bankruptcy.
Remember the 19 Member States in the monetary union, effectively use a foreign currency having surrendered their sovereignty when they entered the eurozone at the turn of the century (for some and later for others).
That means that they have to rely on taxation revenue to spend in euros and if they want to spend more than that tax revenue, then they have to convince the bond markets to loan them euros.
The bond markets know each Member State has credit risk, which means the governments can run out of euros if they cannot get them from the markets.
And as deficits rise to deal with the pandemic, that risk rises and the bond markets demand higher yields on the loans they extend to the governments to offset the rising risk of default.
At some point the yields would get too high and the government would not be able to continue without some sort of default.
Enter the ECB.
They can ensure the bond markets keep extending loans to the Member States by making it clear they will purchase the debt once bought by the private investors.
The private investors thus know they can tender for the debt, onsell it to the ECB for a capital gain and so the fiscal deficits of the Member States continue to receive the euros they need.
So the dilemma for the ECB is that they cannot really abandon these bond-buying programs no matter how much pressure they are under.
And the programs have been massive funding most of the increase in fiscal deficits since the beginning of the pandemic.
If the ECB abandons the programs, then several Member States – such as Italy – will immediately face insolvency and/or the need to invoke harsh austerity.
It is an ugly prospect.
PSPP and PEPP update
On March 18, 2020, the ECB press release – ECB announces €750 billion Pandemic Emergency Purchase Programme (PEPP) – announced an extra public and private bond buying program.
The following graph shows the 10-year government bond spreads against the German bund (percentage points) since the beginning of 2020 up until December 22, 2021 and explains the timing of the ECB’s announcement.
A localised peak in the spreads occurred on March 18, 2020 (for Greece) and March 17, 2020 (for the other nations shown).
Just like during the GFC, the ECB responded to the rising spreads, which would have been catastrophic for the Member Nations in question had they been allowed to be driven by the private bond markets, by increasing its purchases of government bonds.
The PEPP differered from the existing Public Sector Purchasing Program (PSPP), in that, it included Greece for the first time, and so the spread on the Greek 10-year bond quickly followed the downward path of the other Member States.
It also differed because it allowed the ECB to break with the stricter rules governming the PSPP, in particular that the bonds purchased from any country had to be in proportion (with ceilings) to the so-called capital key (the Member State contributions to total ECB capital)
But I think this graph makes it clear that the ECB was able to quickly manipulate the yield spreads.
These spreads are managed by the ECB through its bond-buying programs as I have explained many times before.
How does it do that?
By purchasing large quantities of government debt in the secondary bond market (which is where open trading of these assets occurs after the primary issue has finished), the ECB boosts demand for the assets, which drives up their prices.
The yields are inverse to the price of the bonds and so the increased demand pushed down yields.
To understand this, imagine there is a 10-year bond worth $100 that was issued with a coupon (yield) of 10 per cent. That financial asset requires the government to pay $10 per year for 10 years and then redeem the bond for $100 at the end of the 10-year period.
These sorts of bonds are called fixed income assets because the $10 per year doesn’t change with the current interest rates.
But imagine that the bond price is driven up to say $110 in the secondary trading, then an annual return of $10 will imply a lower yield than before.
When the bond was worth $100, the fixed annual income of $10 was a yield of 10 per cent. Now, the $10 flow each year is yielding less in relation to the current bond price of $110.
You can also see that the ECB has also managed the spreads in according with the pre-crisis relativities, which is what Isabel Schnabel referred to as their assessment of the “different fundamentals” – largely, credit risk.
The ECB now has several asset buying programs in place.
The long-standing public sector purchase programme (PSPP) (began on March 9, 2015) buys up various government bonds in the Euro area.
The ECB say that:
Since December 2018 government bonds and recognised agencies make up around 90% of the total Eurosystem portfolio, while securities issued by international organisations and multilateral development banks account for around 10%. These proportions will continue to guide the net purchases.
As at May 22, 2020, the ECB had purchased 2,216,852 million euros worth of bonds under the PSPP. The can loan some of these assets back to the markets “to support liquidty and collateral availability”, which is the way they get around the Treaty no bail-out clauses.
The reality is that the ECB is funding significant proportions of Euro Member State fiscal deficits and without these programs, several countries would have already gone broke.
In their – Public sector purchase programme (PSPP) – Questions & Answers (updated April 2, 2020) – we learn that from November 1, 2019, the ECB committed to monthly bond purchases under its Asset Purchase Program (APP), which includes the PSPP, to the value of “€20 billion.”
The ECB provides a time series of the – Cumulative purchase breakdowns under the PSP.
The following graph shows the entire history of the program since March 2015 up until November 2021.
You can see they had to go hard in March 2020 as the bond markets started to demand higher yields. Once the ECB had controlled the spreads, they were able to maintain a lower level of purchases under this program.
They introduced the PEPP on top of the existing PSPP in March 2020.
The problem with the PSPP was that the ECB could not hold more than a certain proportion of each Member States debt and that those limits would have been exceeded in this crisis given its scale.
They could have just abandoned those voluntary limits but that would have forced them to make admissions about what they were actually doing, even though it was clear for all to see.
So, instead, they they chose to create a new, more flexible program called the – Pandemic emergency purchase programme (PEPP).
The ECB explained the difference between the PSPP and the PEPP programs in this document (April 2, 2020) – Pandemic emergency purchase programme (PEPP) Questions & Answers.
Purchases began on March 26, 2020.
To the end of November 2021, the ECB has purchased a cumulative total of 1,548,231 million euros worth of government bonds.
Italy facing renewed crisis
The pandemic has not been kind to Italy.
To support households and firms, the Italian deficits have risen as has its public debt to GDP ratio (from 134.8 per cent in 2019 to around 155 per cent in 2021).
Last year, the deficit was 9.5 per cent of GDP, which is the highest level since the early 1990s, when the recession had a massive negative impact on the Italian economy.
We expect, based on Italian government estimates that the deficit in 2021 will rise to 11.8 per cent of GDP.
Earlier in 2021, it has estimated the deficit would be just 8.8 per cent, but, such has been the deterioration in the situation, that the fiscal support had to be increased.
The Italian government has been able to fund those deficits largely because of the PSPP and PEPP conducted by the ECB.
If the ECB was to taper and subsequently abandon the PEPP in March 2022, as it has suggested then Italy would face rising yields and eventually not be able to fund its deficits.
That prospect would intersect with an economy that was struggling to recover from the pandemic, and, was already stagnating.
Italy is not Greece.
The European Commission could eviscerate Greece because it is small relative to the overall EU economy.
Not so Italy.
If austerity was imposed on Italy to reduce the deficit (as bond yields rose) and/or Italy considered defaulting on its debt then the whole monetary union would be threatened.
The EU cannot afford to let Italy stumble.
The ECB knows this and so any talk of the PEPP being abandoned is dangerous because of the functional role it plays in maintaining Member State solvency.
Some people are calling this a ‘doom loop’.
I have consistently made this point.
The inherent architecture of the money union predicates it to crisis.
The ECB has to ‘break the law’ for the union to survive.
Fiddling around the edges of the fiscal rules will not cut it.
The problem is the euro!
The dysfunctional architecture of the Eurozone continues to amaze.
It also puts the ECB in a bind.
I don’t expect it will withdraw its bond-buying programs any time soon irrespective of the course of inflation.
It simply cannot unless it wants to send a few Member States broke and take the political consequences.
What a crazy system!
That is enough for today!
(c) Copyright 2021 William Mitchell. All Rights Reserved.