Capital market interest rates, including interest rates on government bonds, have risen sharply since the end of last year. Investors want to be compensated for the expected inflation and are already pricing in the tightening of monetary policy.
With the rising interest rates, the interest rate differentials within the euro zone have also increased. Interest rates have risen more sharply, particularly in countries with higher government debt ratios and potentially worse growth prospects.
For example, while in Germany the yields on ten-year government bonds rose from -0.33 percent to 1.75 percent between the beginning of December 2021 and June 21, 2022, the yields on Italian bonds rose from 1.02 percent to 4 percent, 27 percent. The yield differential has therefore increased by 1.17 percent within a short space of time.
In recent years, the ECB has bought more bonds than have been newly issued by the euro zone countries; as a result, it has indirectly financed the substantial new government borrowing. Since the ECB will no longer buy additional bonds on a large scale, there is considerable uncertainty about the interest rates at which private investors will be willing to buy the government bonds.
The required interest level, including the risk premiums, must first be formed on the capital market. The fact that highly indebted countries are facing increasing interest rate differentials is partly due to the fact that the ECB has so far used a more or less fixed key for its purchase decisions, while private investors are selective and demand higher interest rates for greater credit risks.
In view of this development, the ECB has announced that it will introduce a new purchase program aimed at limiting interest rate differentials between member states’ bonds. To this end, the ECB wants to buy bonds from individual countries in the currency union. Apparently she has already started making the first purchases.
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To the extent that fighting inflation requires not to further increase overall bond holdings, the purchases could be designed in such a way that the ECB’s portfolio is restructured. Expiring German or Dutch bonds could be replaced by Italian ones, for example. However, it cannot be ruled out that the portfolio of government bonds will be further increased overall, contrary to what is currently planned.
The ECB is thus deviating from the principle that government bond purchases are generally made according to the capital key in order to avoid undesirable fiscal redistribution effects and to protect the independence of monetary policy.
The ECB’s argument for its new purchase program is problematic
The ECB justifies its initiative with two arguments. Firstly, especially in times of sharp rises in interest rates, risk premiums on the capital market can rise above the levels justified by fundamental data. Pessimism among investors or speculation could drive up interest rates to such an extent that a country’s solvency would be jeopardized even though the country would be solvent if investor expectations were positive and interest rates were correspondingly low.
In this case, bond purchases could ensure that the low interest rates and positive expectations prevail in the market. However, this argument is problematic in two respects: On the one hand, in practice it is hardly possible to determine properly which interest rate spreads are justified from a fundamental point of view.
On the other hand, this is not primarily a monetary policy task, but a fiscal policy task, because the aim is to secure the financing of the national budgets of individual countries on appropriate terms.
Secondly, the ECB therefore takes the position that if interest rate differentials rise sharply, the transmission process will be disrupted, meaning that monetary policy in the countries concerned will not have the intended effect. In order to ensure that the transmission works, the rise in yields must be stopped.
Aid from the ECB for individual countries should be linked to conditions
During the years of the euro crisis, the ECB had already announced with the OMT program that it would buy government bonds from countries in financial difficulties and thus deviate from the capital key. The reasoning was similar.
The European Court of Justice and the Federal Constitutional Court have found the OMT program to be lawful. Nevertheless, economists and lawyers still disagree today as to whether this is monetary policy or fiscal policy, i.e. whether the OMT program is covered by the mandate of the ECB.
When the OMT program was introduced, however, it was undisputed that conditionality was required. There is a risk that a country will be supported by the central bank despite unsustainable public finances or that its debt will continue to increase due to the aid.
In order to limit this risk, the ECB has planned that countries that are supported are subject to economic and financial policy conditionality as part of an ESM bailout fund programme.
The then central bank president Mario Draghi explained why this conditionality is indispensable. He explained that ECB support would otherwise undermine incentives for sound fiscal policies, that conditionality protects the ECB’s independence and that it helps the government of the country in question to implement the necessary reforms.
Shielding countries from the market and from political commitments is toxic for monetary union
Against this background, it is unacceptable that the ECB now wants to support individual countries with government bond purchases, but that the conditionality of an ESM program should not be required. It is not clear why the ECB introduces a new instrument here instead of referring to the OMT program.
It is claimed that applying for an ESM program is viewed as politically unacceptable or even toxic, especially in larger countries in the euro zone such as Italy. This overlooks the fact that the ECB’s financial support for individual countries in the euro zone without effective conditionality has the disadvantages mentioned and explained by Mario Draghi.
It is true that applying for help from the ESM and the associated agreement on conditionality represent hurdles. Conditionality requires countries requesting aid to take responsibility for implementing reforms.
Shielding these countries from both market forces and political commitments will in turn have a toxic effect on the stability of the European Monetary Union.
The authors:
Lars Peter Feld is Professor of Economic Policy at the University of Freiburg and Head of the Walter Eucken Institute.
Clemens Fuest is President of the Ifo Institute.
Volker Wieland is Executive Director of the Institute for Monetary and Financial Stability at the Goethe University in Frankfurt.
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