Austerity programs imposed on PIIGS countries have failed. Italy’s weak economy faces “Japanification” – slow growth and an aging population bring intractable deflation and stagnation- and its sovereign debt levels are unsustainably high. Everything suggests the EU’s third largest economy – moving very slowly with reforms – will not be able to lower its debt/GDP ratio by growing enough to meet EU debt/GDP targets.
The risk of a new EU crisis is rising because:
- European banks’ wariness to lend money to all but the most creditworthy borrowers has lead to a liquidity crunch that hinders the ECB’s ability to support PIIGS bond prices without outright debt monetization. Current ECB easing steps are unlikely to ease liquidity enough to combat deflation in the coming months.
- A combination of persistent deflation and deteriorating GDPs will lead to a raise of nominal debt/GDP levels of peripheral EU nations.
- Bond market calm may not last long if the ECB does not commit to a scheme of large scale sovereign bond buying. A collapse in confidence in peripheral bonds would lead to a repeat of prior EU sovereign and bank debt crises.
The ECB needs to overcome its previous mistakes:
- Since last year, core inflation has remained stable. Inflation has however never stopped being an obssession for European policymakers.
- Too long a decision-making process greatly damaged the EU’s economy, for the ECB should have embarked on large asset purchases and cut interest rates to zero earlier on in the financial crisis.
- Outright monetary transactions surely helped bringing down bond prices but ended all willingness to further resolve the crisis.
The ECB thus needs to be granted unlimited power to create all the Euros it needs to buy member state bonds and become a true buyer of last resort. The ECB buy bonds – and nowadays maintain their prices low – through Outright monetary transactions (secondary market purchases). It sells other bonds it owns to financial institutions – now not as eager to buy sovereign bonds as before, and thus does not print money as it keeps the money supply unchanged.
“European style” QE or outright debt monetization are currently prohibited per the Maastricht treaty, forbidding the ECB from funding member states’ debt by printing money to fund sovereign debt. It is however unlikely that Italy can convince Germany, and other nations that would fund the ECB’s bond buying, that Italy could ever repay the ECB. The Bank’s mandate includes maintaining price stability. The latter, combined with Draghi’s intention to do “whatever it takes” to preserve the Euro – that last year halted the spike in several countries’ borrowing costs, could perhaps provide the needed excuse. If funding nations are willing to ease on inflation rates – let’s not forget Germany is suffering from deflationary pressures – and fund massive ECB purchases of peripheral nation bonds that are unlikely to be repaid, that is. Greece and Portugal may not have economies big enough to threaten the whole system. Italy clearly does.