The European monetary system has changed fundamentally in the past few years, as the central bank moved into new territory in buying debt and issuing bonds, writes Dr Stefan Legge.
In 2019, a research paper in the journal Nature Human Behaviour empirically showed that many events that will one day be viewed as historic attract little attention at the time. It appears that this is true for the European monetary system as well.
When the concept of a common European currency gained traction in the 1990s, the central idea was to unite a continent that for centuries had been torn apart by war. The euro was part of a long-term European peace project. And it did unite in the beginning: the spreads between bonds from Italy, or other Mediterranean countries, and those from Germany, came down to zero.
Bright start
After its launch in 1999, the common currency enjoyed about a decade of calm. Then things changed dramatically. The global financial crisis and the European debt crisis exposed the currency’s weak spot: each member state was effectively indebted in a foreign currency. That is different from other parts of the world. No one would expect, for example, Japan or the US to default, because they could always print any amount needed. There is a risk of inflation and currency devaluation, but no risk of default.
The euro area was notably different: Italy, Greece or Spain could actually default. This insolvency risk raised spreads on government bonds. Things cooled down only when then European Central Bank (ECB) president Mario Draghi announced to do “whatever it takes” to preserve the euro. With the European System of Central Banks (ESCB) effectively being able to buy unlimited amounts of bonds, there was no further risk of default. The so-called Outright Monetary Transactions (OMT) scheme never needed to be utilised. Its sheer existence calmed down investors. The OMT framework came, however, with strict conditionality to discipline euro member governments.
But then came Covid-19, and the euro system changed fundamentally. For the first time in its history, all member states ran a public deficit in excess of 3% of gross domestic product (GDP). The risk of public default was back in the news. It was inflamed when Christine Lagarde, current head of the ECB, said in March 2020: “We are not here to close spreads.”
In response to the surging interest rates on Italian debt, Ms Lagarde quickly changed her position. In fact, one could argue that the ECB had adopted a “new mandate” to reduce interest rate spreads. This became official in the summer of 2022 with the introduction of the anti-fragmentation tool named the Transmission Protection Instrument (TPI).
A new era
Is this just more of the same or a new direction? There is no doubt that the European monetary system has changed fundamentally.
First, the ECB now distorts relative prices. The new TPI enables the central bank to buy debt whenever “a deterioration in financing conditions [is] not warranted by country-specific fundamentals”. This implies that the central bank buys bonds selectively, unlike in the past when the ESCB bought bonds proportional to how much weight each euro member brought to the common currency. The latest data indicate that the ECB has sold maturing German and French bonds, and used the freed-up funds to purchase Italian and Spanish debt.
Second, the strict conditionality was dropped during the Covid-19 crisis. Under the Pandemic Emergency Purchase Programme (PEPP), the ESCB bought about €1.7tn of bonds, equivalent to 14% of the euro area GDP. All the public borrowing during the pandemic was financed by the printing press, with few conditions attached. And purchases in the TPI “are not restricted ex ante”. This resembles a blank cheque to buy public debt.
Third, the EU now issues its own debt through the €750bn NextGenerationEU scheme. After a decade of debate, the Eurobonds are here. To keep interest rates low, European institutions tap into Germany’s credibility.
The broader public has barely noticed these fundamental shifts because other topics dominated the news. Additionally, there is a sense of there being no alternative. The ECB, having lost much of its credibility, faces a Catch-22 situation: if it stopped buying bonds, there would be the risk of another European debt crisis; yet, if it continues buying bonds, public deficits and inflation remain at elevated levels.
Playwright Arthur Miller said: “An era can be said to end when its basic illusions are exhausted.” The common European currency has reached that point. It is very different from what it was before 2020. And while few in the media reported it, financial markets recognised the fundamental change. The euro has started to depreciate severely against the US dollar and the Swiss franc.
Dr Stefan Legge is lecturer and economist at the University of St Gallen.
