The European Central Bank’s fragile German truce
A recent German Constitutional Court ruling has threatened to upend the Euro. It has done so by claiming that the European Central Bank (ECB) had acted beyond its legal authority by engaging in large scale government bond purchases.
The German court also has done so by threatening to prohibit the German central bank, the ECB’s largest member central bank, from participating in future ECB bond purchase programs. That is unless the ECB soon provides the court with a satisfactory explanation that it has not exceeded its legal authority.
Now that the ECB seems to be finding a way to mollify the German court, by agreeing to provide frequent explanations of its actions to the German parliament, Europeans can breathe a sigh of relief that a European sovereign debt crisis will be avoided this summer. But they would be deluding themselves to think that the ECB has found a way to permanently avert another European sovereign debt crisis, especially considering the dire economic situation of countries such as Italy and Spain in the wake of the coronavirus pandemic.
A basic challenge for the ECB is that Italy will need massive ECB support on a continuous basis if it is to avoid defaulting on its government debt. It will also need massive ECB support if it is to avoid having a full-blown domestic banking crisis. This makes it all too likely that at some point the German public’s patience will run out for having the ECB bail Italy out indefinitely through the backdoor.
On joining the Euro in 1999, the German government insisted that the ECB’s founding treaty included a clause that explicitly precluded it from engaging in the monetary financing of a member country’s budget deficit. The ECB’s recent actions to bailout Italy is validating the German public’s worst nightmare that the ECB would somehow find a way around this clause and effectively put Germany on the hook for Italy’s profligate spending.
A basic problem for the ECB is that the coronavirus-induced collapse of the Italian economy will render that country’s public debt unsustainable, and it also will likely precipitate a domestic banking crisis. It will do so as the big hole in the government’s budget caused by as much as a 13 percent drop in its economy in 2020 will cause Italy’s public debt-to-GDP ratio to skyrocket to 160 percent by year end. It will also do so as the unprecedented weakness in the Italian economy will cause a spike in its banks’ non-performing loans.
Over the past two months, domestic and foreign bondholders have shunned the Italian bond market as they have become increasingly concerned about the un-sustainability of the country’s public finances. The only thing that has been keeping Italy afloat has been the ECB, which has been buying Italian bonds in the secondary market in an amount equivalent to the Italian government’s gross financing needs.
The ECB could be on the hook for a staggering amount of money if bondholders continue to shun Italian government bonds. Presently, the Italian government is running an annual budget deficit of some EUR 250 billion and is having to roll over some EUR 300 billion of its maturing bonds each year. This implies that over a two-year period, the ECB might have to buy more than EUR 1 trillion in Italian government bonds in addition to the substantial support that it might have to offer to the Italian banking system.
It seems fanciful to think that there will not be a German political backlash against ECB bond buying on such a large scale in support of an individual member country. It would also seem fanciful to think that there will not be further legal challenges in the German courts to what now looks like outright ECB monetary financing of the Italian government budget deficit, which would be in flagrant violation of Article 123 of the Treaty of Lisbon.
This makes it likely that within a year or so we will have another round of the Eurozone sovereign debt crisis. One has to hope that European and global economic policymakers take advantage of the ECB’s reprieve in its battle with the German Constitutional Court to prepare for another European sovereign debt storm.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.