Covid-19 is showing cracks in the Eurozone, can the ECB solve the Covid-19 economic downturn without making the cracks worse?
By Avi Gupta
Covid-19 has taken a major detrimental toll on the world economy with over a 2% decline in global GDP. With such an economic shock, governments and central banks have taken steps to cauterize the bleeding. The European Central Bank (ECB) has been charged with the protection of the second largest economy and one of the most important currencies on the global scale. Although the ECB faces similar challenges to its counterparts in the US, Japan and other locations, the ECB also faces a new set of problems from its underlying systemic problems: Reliance on Price Stability, Diverse economies in the EU, and Issues from the Treaty.
The ECB started off its response to Covid-19 on a bad foot with ECB President Christine Lagarde stating that the central bank was “not here to close spreads” between government bond yields. This simply means that the ECB would not reduce the cost of borrowing for countries by buying their bonds – raising the price and reducing the bond yield which is the cost to repay bonds. This situation sent Italian Bond yields up and led to a 17% loss on the Milan Stock Exchange. Lagarde’s comments underlined her belief that “there are other tools and other actors to deal with [raising cost of borrowing] issues,” supporting the fact that European Countries should be using coordinated fiscal policy to reduce the economic shock from Covid-19. Although what is presumably her personal opinion, Lagarde walked back her comments stating that “I am fully committed to avoid any fragmentation in a difficult moment for the euro area. High spreads due to the coronavirus impair the transmission of monetary policy.”
Lagarde committed the ECB to its equivalent of “Whatever It Takes” that was used during the 2012 Eurozone debt crisis. She created an emergency purchasing program valued at over 1.5 trillion dollars to lower government bond yields and increase lending by buying liabilities of banks and companies in the EU. The ECB also has maintained low interest rates, taken a haircut on what assets can be considered as collateral for banks, reduced the required reserves held by banks, and conducted other expansionary monetary policies. With all these actions, the ECB has attempted to stimulate the economy. Yet, without a vaccine for Covid-19, the ECB is expected to protect the EU economy for an extended period of time, and the dam is starting to show cracks.
There are two problems that are not inherent with Coronavirus, but rather intrinsic with the ECB and the EU’s structure. Firstly, the ECB is currently holding the deposit interest rate at -0.50%. It is questionable how much lower that interest rate can go, which reduces the ECB’s ability to change the deposit rate for expansionary monetary policy. Secondly, there are concerns of certain European nation’s Debt to GDP ratio. The Eurozone has set the target for the Debt to GDP ratio not to exceed 60%, but few countries follow the target, and even fewer will be below the target with the massive uptick in government fiscal spending to fight against Covid-19. This questions the stability and solvency of certain countries, while also increasing the risk of permanent damage to the Euro through countries leaving the Eurozone and a possible collapse of the currency.
With the rise in mounting debt, new solutions have been proposed to better stabilize the Eurozone. One solution is to borrow debt as the Eurozone, creating a new class of government bonds. Such debt is highly controversial as certain members of the Eurozone see it as a front to their national sovereignty, while also having financially better off countries indirectly pay for the financially worse off countries. While this in theory seems politically infeasible, interestingly, Germany and France have proposed a similar plan. The plan would see the EU issue over $550 billion dollars equivalent in debt to give as grants to the hardest hit areas of the EU. The idea is applauded by many, including Former President of the Jean-Claude Juncker as a unifying policy that will bring the EU closer together politically, socially and economically. Opponents of the plan, including Austria, Denmark and Sweden, argue that these grants should instead be loans.
Overall, the ECB faces a difficult predicament. Its problems are not only financial, but at the heart of the issue is the extent of national sovereignty being overruled by a Supranational Organization. The ECB is only a point of contention in a much larger debate. That being said, the ECB is expected to succeed or risk further limitations on the ECB’s powers. The stakes for the ECB are high. A successful response to Coronavirus can change the market’s trust in the ECB, and possibly change the EU’s perception of it. The ECB had a rough start, but found its footing and created a respectable economic response. The question now is how long can the ECB maintain its strong economic response as underlining weaknesses in certain EU countries are threatening the whole EU’s economic future. □
- Image source
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