EMU stability rests too much on the shoulders of the ECB
Interest rate differentials between eurozone government bonds are melting like snow in the sun. This was also the case after the start of EMU, when the financial markets had a blind belief in economic convergence. As a result, interest rate differentials virtually disappeared in the mid-2000s. However, there were also other periods. During the financial crisis, markets considered the political pledges to ensure EMU stability to be insufficient, with rising interest rate differentials bringing EMU to the brink of implosion. The current extremely low spreads are mainly due to the ECB’s ‘whatever it takes’ promise. In the long run, however, this decisive role of the ECB may not be sustainable.
Recently, the intra-EMU interest rate differentials with Germany have again crumbled (Figure 1). As there is no possibility of currency devaluations within the currency union, these interest rate differentials mainly reflect the assessment of the credit risk by the financial markets. The decline is remarkable, as the public debt to GDP ratio has barely improved in many euro area countries almost a decade after the start of the European debt crisis. Moreover, the period of a relatively favourable economic environment seems to be over. A slowdown in growth accompanied by a fall in the unemployment rate will reduce government tax revenue and increase social security expenditure). As a result, budget deficits increase and weigh on the sustainability of public finances. Nevertheless, intra-EMU interest rate differentials with Germany are decreasing...
Figure 1 - Intra-EMU sovereign spreads in different phases (10 year yield spreads versus Germany, in %-points)
New gold standard
At the start of EMU in 1999, the Member States found themselves in a new situation. With the advent of the euro, public debts were no longer denominated in their own currency, but in euro. Since monetary policy for the euro area was entrusted to the ECB, the national central banks lost the possibility, at least in theory, of financing the national public debts by means of money creation. The debts of the euro zone countries are now actually denominated in ‘foreign currency’, in the sense that national authorities have no control anymore of money creation. By using a single currency (the euro) that they do not control themselves, the euro countries ended up in a form of the ‘gold standard’, with all the economic consequences that such a system entails. In particular, exchange rate devaluations are no longer available to restore e.g. current account imbalances between Member States. The European experience during the debt crisis has clearly illustrated this: deficit countries must pursue restrictive and disinflationary policies, while surplus countries’ policies must be expansive and reflationary according to the ‘rules of the game’. Part of the reason for the moderate European growth and the (too) low inflation lies in the refusal of the surplus countries (in particular Germany) to abide by the rules of the new ‘gold standard’ (see also the KBC Economic Opinion of 7 May 2019).
Market expectations versus Treaty
The evolution of interest rate differentials within the currency union took place in three major phases. Each of these phases is characterised by a specific relationship between what the financial markets expect and the institutional framework.
The Maastricht Treaty explicitly stipulated that governments of euro countries were not liable for the debts of other Member States and would therefore not intervene in the event of an imminent default (the ‘no-bailout’ clause). This clause was adopted particularly at the request of Germany, which feared that otherwise the EMU would lead to an uncontrollable transfer union. Nevertheless, at the end of the 1990s, the risk premium of future Member States fell sharply and disappeared like snow in the sun when the final stage of EMU began in 1999. Despite the no-bailout clause, financial markets were fully convinced of economic convergence and ignored the risk of country-specific shocks.
The second phase started with the financial crisis in 2008 and continued with the European debt crisis. The relationship between market expectations and the institutional framework was reversed. Institutional changes were made to promote the financial stability of the euro area. The financial assistance started with bilateral government loans and continued with the establishment of the temporary European Financial Stability Facility (EFSF), which later became the permanent European Stability Mechanism (ESM). The ‘no-bailout’ clause was therefore severely watered down. Despite this new institutional reality, financial markets became suspicious. Once again there was a discrepancy between the market expectations and intstitutions. The main concern was whether first of all political considerations might prevent the EFSF/ESM from being deployed in a determined and timely fashion and second, even if such constraints were overcome, whether these mechanisms would have sufficient financial ‘firepower’, in particular if a large EMU Member State was at risk of default. As a result, many intra-EMU interest rate differentials increased so much that this market expectation threatened to become a self-fulfilling prophecy. Institutional progress alone has clearly not been sufficient to overcome the debt crisis.
The debt crisis prompted preliminary steps towards creating a European banking union. At the height of the crisis in the summer of 2012, this delivered the necessary political support for the ‘whatever it takes’ promise of ECB President Draghi. The Outright Monetary Transactions (OMT) played a decisive role in this respect. The ECB promises to buy, if necessary, unlimited amounts of government bonds from a Member State, if its financial condition threatens the EMU.
Since, in theory, the ECB has unlimited ‘firepower’ in euros, this promise was credible to the markets. As a result, interest rate differentials continued to fall sharply in this third phase. The ECB has achieved this without having to spend one single euro so far in an OMT-intervention. For the first time since the start of EMU, market expectations moved into line with the policy framework. The downward trend in interest rate differentials was reinforced from 2015 onwards by the large-scale asset purchase programme (APP), which will resume after a short break in November 2019.
The current extremely low interest rate differentials in the euro area are therefore largely due to the ECB. The low spreads can be rationally explained by the credibility of the ECB’s policies. In the long run, however, this decisive role of the ECB in determining sovereign credit risk premia may not be sustainable.