FRANKFURT — In spending its way out of the current economic crisis, Europe may be setting itself up for the next one.
Brussels is ready to tell governments to keep spending generously. The problem, some economists warn, is that free-spending states might find it hard to find anyone to finance them once the European Central Bank unwinds its massive bond-buying program — which could hit the bloc’s most indebted countries, like Italy, especially hard.
The European Union put its fiscal rules, known as the Stability and Growth Pact, on ice early in the pandemic to allow for massive fiscal stimulus. With economic output now bouncing back and expected to return to pre-crisis levels by the end of this year, the bloc’s fiscal rules will be formally reinstated in 2023. But the widespread expectation is that Brussels has no plans to get serious about mounting debt levels.
As POLITICO reported last week, the Commission will tell governments early next year it’s ready to bend the fiscal rules even after they come back into force. The Commission could issue a similar policy communication in 2024 if it’s needed to finalize a set of reforms to the rules negotiators are hashing out. Any such announcement will be greeted with sighs of relief in Southern European capitals.
To be sure, even the most indebted member states, Greece and Italy, currently pay less interest on their ten-year bonds than the United States. Yields are at rock-bottom despite the fact that the debt-to-GDP ratio in Italy now tops 150 percent, and is more than 200 percent for Greece.
But some economists see these low bond yields as misleading, as they mask the risk that borrowing costs for peripheral member states could surge once the ECB phases out asset purchases. This camp includes analysts at the Institute of International Finance, which played a key role in negotiating the restructuring of Greek debt in 2012.
The institute now sees low rates as a function of central bank asset purchases, not ample fiscal space — particularly in the eurozone’s periphery, where the central bank bought up the entire debt issuance in 2020.
The assumption that low yields suggest governments can spend more is a “great fiscal illusion,” said IIF chief economist Robin Brooks. “There was no private sector demand for Italian debt issuance during COVID-19. All issuance was absorbed by the ECB’s purchases.”
“So clearly we can’t say that Italy’s 10-year yield is a signal that fiscal space is abundant,” he added. “It isn’t.”
While nobody contests the data, other economists such as UniCredit’s Erik Nielsen question the rationale for assessing fiscal latitude while ignoring external conditions. These conditions, at least for now, include an ECB that’s committed to keeping policy extremely easy.
The Italian question
After years of austerity, European leaders are adamant they don’t want to undermine the recovery by withdrawing fiscal support too early. Even if the eurozone’s debt pile — seen topping 100 percent of GDP this year — is considerably worse than it was in 2010, it’s not an immediate concern given the low cost of servicing debt, according to the European Commission and many governments.
And most economists, including Brooks, still see a need for pump priming.
“Aggressive fiscal spending is still warranted, despite there being limited space,” Brooks said. A pullback of fiscal stimulus would further dampen growth, which would be especially tough for countries like Italy, which has stagnated over the past 20 years.
Instead, what this means is that Europe’s fate hinges on the ECB continuing to hoover up debt for years to come. Nothing spooks eurozone leaders at the moment more than prospects of an Italian debt crisis. The country is deemed too big to both fail and rescue.
It became all too apparent how vulnerable Italy would be if the ECB scaled back bond-buying during the central bank’s last policy meeting. Investors immediately dumped Italian debt, pushing 10-year yields up to their highest in 15 months amid speculation that the ECB would tighten policy. The spread — that is, the premium over ultra-safe German bonds, reflecting how risky the market considers the asset — rose to its highest level in over a year.
The spike abated along with rate hike speculations, leaving spreads well below the 2.8 percent hit in March last year, before the ECB launched its crises program, let alone the 5 percent spreads during the eurozone debt crisis. But it served as a reminder of how quickly investor sentiment can turn.
“I don’t see any enthusiasm among private investors for Italian bonds or Greek bonds,” said Brooks.
“So if the ECB tapers, there starts to be a funding problem,” he added, referring to the policy of dialing back bond purchases. “That’s why on these tapering rumors [in October], Italian yields rose so quickly.”
For now, “there’s still a sense that the ECB will do its part to keep the spreads narrow,” said Societé Generale economist Anatoli Annenkov. “However, the ECB can only act so long as inflation is under control. If we get a real inflationary scenario, it’s really going to be a big test for the ECB, and whether they will tighten as much as they should.”
“I expect they will take their treaty mandate seriously and do whatever they can,” he added. “The problem is that they might run the economy into a recession or create massive financial instability.”
And that’s the catch for policymakers. Eurozone inflation surged to 4.1 percent in October, significantly exceeding the ECB’s 2 percent target, but that hasn’t shaken the position of ECB President Christine Lagarde. She continues to argue that high inflation pressures will be transitory and stresses that with inflation expected to drop below the target again over the next two years, no policy response is warranted.
Looking to December
Lagarde is set to offer insights on the Governing Council’s commitment to stick to a narrow inflation-fighting mandate when she reveals the ECB’s plans for conducting asset purchases after the end of the pandemic emergency purchase program, or PEPP. She has signaled the ECB will decide in December to end PEPP purchases in March, and it may even be ready to share details of its longer-term plans on its broader bond-buy program at the time.
For now, most policymakers agree that ending PEPP purchases needs to be flanked with dialing up other bond purchases — at least temporarily —under the ECB’s other program, the pre-pandemic asset purchase program (APP), to avoid a sudden shock.
There’s also a camp that would like to allow the APP to temporarily buy more bonds from single countries in case spreads start spiraling. The ECB’s regular purchases are now done according to the size of the country’s economy, and include caps on how much of a country’s debt it can hold.
Such a move would be highly controversial, as the European Court of Justice has pointed to these criteria as safeguards that prevent quantitative easing from constituting monetary financing — which is illegal. Still, a return to the old rules without any new provision allowing the ECB for more targeted buying in case inflation does gather pace could spell trouble ahead.
In short, allowing national governments more room to spend their way out of the crisis might be the only available option for Brussels. But in the end, they don’t have enough money on their own to save countries in distress. That means chances are that governments’ fiscal flexibility will hinge on Frankfurt rather than Brussels.
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