By Reza Moghadam
LONDON – The European Central Bank’s €750 billion ($818 billion) Pandemic Emergency Purchase Program (PEPP) was hailed at its inception in March as the “big bazooka,” bringing welcome relief to bond markets in so-called peripheral eurozone countries such as Italy, Spain, Portugal, and Greece. But the ECB must strengthen the program to make it truly effective.
The ECB’s PEPP purchases are unlike its regular, across-the-board asset purchases, which seek to provide general monetary stimulus. Whereas those operations are based on each country’s share of the ECB’s capital (or “capital key”), PEPP’s purpose is to fix a market malfunction by targeting purchases at countries under the greatest pressure.
The new program, which investors expect the ECB to enlarge, has succeeded in capping interest-rate spreads between core and peripheral eurozone member states. But spreads remain elevated and investors are jittery, especially given the likelihood that the COVID-19 crisis will increase Italy’s public debt to 150-160% of GDP for the foreseeable future. There is no good way to finesse that shock.
To be sure, PEPP’s ability to target asset purchases, and without imposing policy conditions on the beneficiaries, makes it a more potent weapon than the outright monetary transactions scheme introduced by then-ECB President Mario Draghi at the height of the 2012 euro crisis.
But, by itself, PEPP does not allay the debt-sustainability concerns created by COVID-19, because of two program restrictions. First, there is a presumption that the bonds bought under the scheme will be held only temporarily – an impression reinforced by the German Federal Constitutional Court’s recent ruling against the ECB in connection with the separate Public Sector Purchase Program (PSPP). And, second, the capital key is to remain a “guiding principle” of PEPP over time.
To see how these strictures weaken PEPP’s effectiveness, consider what happens when a sovereign bond is bought under the program. At the instruction of the ECB’s Governing Council, national central banks undertake 80% of the purchases, and quickly return any interest they receive to governments as a profit transfer. The bonds then become effectively costless, and thus not a concern in terms of debt sustainability. But this is so only for as long as the ECB holds on to the debt.
If periphery bond spreads are to fall on a lasting basis, then these countries’ additional debt resulting from the COVID-19 crisis – estimated at some €500 billion in 2020-21 – must be rendered effectively costless. The ECB could ensure this by committing to hold this debt for a sufficiently long time, say, 20 years or more. In addition, PEPP’s reference to the capital key should be dropped in order to remove any suggestion that the ECB would sell peripheral members’ bonds first if it decided to reduce its portfolio.
The economic benefit of reducing core-periphery bond spreads, and thus holding the eurozone together, outweighs three potential concerns regarding PEPP. For starters, it is feared that large ECB bond purchases could lead to high inflation. This concern seems overdone at a time when deflation is the greater risk.
Second, there is a fear of “fiscal dominance,” whereby the ECB becomes timid about raising interest rates in the future, lest balance-sheet losses require it to be recapitalized by governments, thus compromising its independence. But it seems a stretch to imagine that a few countries on the eurozone’s periphery could challenge the ECB’s independence, which is enshrined in the Treaty on the Functioning of the European Union.
Finally, there is the perennial fear of moral hazard – that bailouts encourage fiscal irresponsibility. This is surely misplaced: Italy’s current problems reflect its higher starting level of debt, which its eurozone partners have long accepted, and its larger fiscal response to the current crisis, which all agree is appropriate.
A long-lasting deviation from the capital key is also legally defensible. PEPP is not a monetary measure, but rather aims to overcome an obstacle to the transmission of monetary policy to all eurozone member states – namely, the high spreads induced by the pandemic’s varying effect on their public-debt levels. If COVID-19’s impact on eurozone bond markets is asymmetric and long-lasting, then the response must be as well. Any wider and unintended monetary effects from PEPP can be sterilized, or undone, through higher interest rates or sales of non-periphery bonds.
To be sure, none of this obviates the need for a common European fiscal response. Although the nascent European recovery fund is an important step forward in that regard, it remains to be seen whether it could provide a sufficiently large stimulus for the hardest-hit countries. Moreover, such a fund would do little to reduce the additional debt resulting from the crisis, and, in any case, is intended for the later recovery phase.
For now, PEPP is the only game in town for ensuring that the eurozone survives the COVID-19 crisis intact. Far from being cowed by the recent German constitutional court decision, the ECB should strengthen its bazooka to prevent the pandemic from causing even more damage.
Reza Moghadam, Chief Economic Adviser at Morgan Stanley, is a former director of the International Monetary Fund’s European Department.
Copyright: Project Syndicate, 2020.