Opinion: The European Central Bank is running out of ammunition to fight another debt crisis

Almost exactly a decade ago, Mario Draghi, then president of the European Central Bank, promised to do “whatever it takes” to save the euro from destruction. At the time, Greece was on the verge of stumbling – or being pushed – out of the eurozone; Italy, the region’s third-largest economy, was so deep in debt that it also seemed like a candidate to leave.

Today, Mr. Draghi is prime minister of a heavily indebted Italy, just when another eurozone crisis may be imminent. Inflation in Italy and the rest of the Eurozone has reached painful levels, sovereign debt yields are rising, economies are in reverse and war in Ukraine – on European soil! – threatens to destabilize the entire region economically and politically.

Except this time he can do next to nothing to prevent another euro calamity in Italy or the European Union. This work will fall to his successor at the ECB, Christine Lagarde, the former boss of the International Monetary Fund.

And guess what? The ECB is running out of ammunition to fight the next crisis. Mistakes have already been made, the biggest of which was abandoning quantitative easing (QE), which is due to end in July, instead of extending it.

QE is a central bank’s massive purchase of government debt and other financial assets, such as high-quality corporate bonds, on the open market to increase the money supply, lower interest rates, and encourage investment and lending. Mr. Draghi seriously introduced QE in 2015 to help keep interest rates at or below zero and stimulate the economy.

It has mostly worked, even if it has worsened income inequality, since it is the wealthy who own financial assets and play in the real estate and stock markets. Since then, the ECB has spent around 6.5 trillion euros on its lavish QE program. It has become the main weapon in Mr. Draghi’s battle to keep the euro, and the eurozone itself, intact and growing.

At the time, the lack of inflation (the ECB’s inflation target is 2% or so) or the potential for outright deflation was one of the big issues. Today it is the opposite. Eurozone inflation was 5.8% in February, the month Russia invaded Ukraine. In May, the rate reached a record high of 8.1%, compared to 7.4% in April.

The culprits are soaring food and energy prices.

Crude oil of the Brent variety has risen by nearly two-thirds over the past year, with most of the increase occurring since the start of the war. Usually the cure for high energy prices is high energy prices. But huge demand for oil as economies recover from the pandemic, coupled with Russian oil embargoes, suggests prices will remain high, unlike in 2007 and 2008, when an oil slump came soon after. prices hit a record high of $147 a barrel. .

Food prices also show few signs of falling, largely due to Russia’s blockade in the Black Sea that prevents Ukrainian wheat, corn and fertilizer exports. Ukraine accounted for 10% of global wheat exports in 2021. By May, those exports were down two-thirds from a year earlier, according to the country’s agriculture agency. In March, the United Nations Food Price Index hit a record high; it has only slightly declined since then.

Prices started to rise before the war started, and only now are central banks getting in on the action. This week, the US Federal Reserve raised its key rate by three-quarters of a percentage point, the biggest increase since 1994, and the ECB is expected to raise rates for the first time since 2011.

Soaring interest rates have already rekindled fears of another debt crisis like the one a decade ago that almost ripped the eurozone apart. Basket case eurozone countries were kept afloat by QE and other unconventional rescue techniques, such as Outright Monetary Transactions (OMTs), which saw the ECB buy the sovereign debt of risky countries .

Italy – the perennial problem child of the eurozone due to its relatively weak economy and crushing debt – is already showing signs of strain.

Italy’s problems are compounded by the need to refinance almost 500 billion euros of global debt, equivalent to 150% of GDP, this year and in 2023. Last Tuesday, fears that it could be unable to sustain debt as borrowing costs rise pushed its 10-year bond yield to an eight-year high of 4.06% (the yield ended Monday at 3.7%). The spread between Italian bonds and German benchmark bonds widened to more than two percentage points.

How will the ECB prevent another debt crisis with rising rates? It must find ways to suppress the borrowing costs of weak eurozone countries to avoid “fragmentation”, loosely defined as an excessive rise in those countries’ bond yields due to investor fears that they will exit the bond market. ‘euro.

Asset purchases are the ECB’s most powerful tool to moderate or reduce borrowing costs. But the bank ends the QE program. Once gone, it will be difficult to revive it, especially since Northern European countries never fully supported QE or OMT, which they saw as ways to reward Mediterranean countries for their dismal economic and fiscal behavior.

QE didn’t have to be killed. It could have operated at low levels and revived fully in case another full-scale debt crisis erupted in the usual suspect countries – Italy, Greece, Spain and Portugal. The ECB can just fend for itself as it usually does. But that may require a bazooka, as was the case during the last financial crisis, if rising borrowing costs threaten to cripple weak countries. The problem is, he doesn’t really have any now that QE is AWOL.

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