Erik Jones / Apr 2020
I am an American – an outsider – not a European. I have been studying and living in Europe for a while; I wrote my doctoral dissertation on Dutch politics; I spend more time now looking at politics in Italy. Alongside that political interest, I have spent much of the past thirty years looking at European monetary integration. Europe has taught me a lot, but there are still many things I find confusing. Top of the list right now is that the governments of the euro area would rather accept a higher shared risk in the ECB than they would face if they agreed to share risks through an institution specifically designed to raise credit in the markets. This strange choice about how to share risks matters because the risks the European face have never been greater.
The debate about the sharing (or ‘mutualisation’) of sovereign debt is not wholly controversial. The technical parts are well accepted. The first step is to create an institution to borrow money on the markets. Every participating government would contribute some capital to that institution, so that market participants will have confidence that the debt will be repaid. And every government agrees to make sure that the debt will be repaid, even if that means dipping into the capital and topping it up as necessary. If there are losses, every government will contribute to making the creditors whole again. That is how the risks are shared.
There is another principle everyone agrees on: the government that spends the money should also be the government that repays the money. The controversy is about how the money is spent and how it is repaid. Politicians disagree on what counts as a legitimate use of the funds – and particularly whether the funds can be used to repay already existing debts – and what governments should have to do to gain access to the funds in the first place. Some politicians want to place restrictions on how the money can be used and controls on those governments that borrow from the fund; others would like to see fewer restrictions on use and no controls on the states that borrow.
The ECB as Risk Sharing
This controversy has brought the Eurogroup to an impasse. As a result, national governments have to raise their own debt. This creates disparities across countries. Some governments can borrow more cheaply; others have to pay a higher rate of interest. In turn, those disparities both reflect and raise the risk that not all governments will be able to get the credit they need to respond to the current crisis or pay back the credit they get.
This impasse is expected to last until conditions worsen sufficiently to convince one set of politicians to agree to unrestricted access to common funds or another set of politicians to accept that they will have to access the funds they need with some restrictions and controls in place. In the meantime, those countries that share the euro as a common currency are content to let the European Central Bank (ECB) take much of the stress out of sovereign debt markets and to equalize – at least partly – the relative borrowing costs that governments face.
With luck, or so the presumption runs, the ECB will be able to stabilize the markets long enough for the crisis to pass and the two sets of governments to agree to disagree over the merits of ‘mutualising’ their access to credit markets.
This is the part that I find confusing. The way the ECB stabilizes sovereign debt markets is by purchasing existing sovereign debt and by accepting that debt as collateral in lending money to banks. The ECB also buys a range of other credit instruments from international organizations and private companies. More recently it has started to accept debt as collateral that is not even traded. This means that the ECB accepts the risk that some of this debt will not be repaid. It also accepts the risk that the price of the debt will rise or fall in the markets. It even accepts the risk that the debt will be worth less when it matures than the price at which it is purchased.
Two things stand out when we think about the ECB as a risk-sharing device. First, one of the big points of controversy in the mutualisation of sovereign debt is that the money should not be used to cover existing debts, meaning those incurred before the coronavirus crisis; for the ECB, dealing in legacy debt is par for the course. Second, the ECB faces a market-pricing risk that a common debt agency does not have to worry about. Once the debt is sold by the agency that issues it, the price that agency receives for the debt is fixed and any risk from price movements is borne by the investors who make the purchases. When the ECB purchases that debt, it is on the hook both for the possibility that the price will fall either in the market or as the bond matures. (On that point, you would be amazed at how much money some central banks in the euro area have lost on debt they bought at prices that were above what the bonds were worth when their governments redeemed them.)
Of course, the ECB can cover any losses on its asset portfolio because it also benefits from the upside on the investments it makes and because it has capital that was paid in by the governments of those countries that have adopted the euro. But the bottom line is that any risks on the ECB’s portfolio are shared across countries. This is not true for every part of what the ECB does to stabilize the markets: the governments decided not to share the risks associated with their asset purchases, for example. This is why I refer to national central banks having lost money in the previous paragraph rather than talking about the ECB as a whole. Nevertheless, it is true for much of the ECB’s balance sheet, which means that at least some of the risks associated with stabilizing the access of national governments are mutualised (even though that access itself is not).
What I find even stranger about this arrangement is that it could go horribly wrong if somehow one or more governments lose access to financial markets. When countries lose access to financial markets, they no longer qualify for ECB purchases – including those last-minute purchases that ECB President Mario Draghi promised in his famous ‘whatever it takes’ speech during the last crisis. Moreover, the ECB promises that it will behave like any other creditor when it purchases assets in the market. That means the ECB will have to accept losses from any restructuring. The odds of that restructuring may be low, but they are certainly higher than the odds that a government would fail to repay any money that it borrowed through some mutualised debt arrangement.
When you add these two things together it becomes clear that relying on the ECB involves not only higher routine risks associated with the purchase or holding of debt instruments but also higher catastrophic risks associated with the possibility that one or more of the debtors to which it is exposed will default. Again, just to underscore the point, the governments of the euro area would rather accept a higher mutualised risk in the ECB than they would face if they agreed to mutualise risks through an institution specifically designed to raise credit in the markets.
The Problem with Hoping for the Best
That trade off makes sense only given that the ECB’s balance sheet is large enough that it can prevent individual governments from getting into so much trouble in financial markets that it has no choice but to default. This is certainly the expectation, at least for so long as Europe remains in this crisis. As that happens, though, it is worth remembering that the ECB is mutualising ever more risk as a result of its actions – because a bigger ECB balance sheet means more risk for the ECB to manage on behalf of the euro area as a whole.
The question then is how the ECB will manage its balance sheet after the crisis has passed. That is a difficult question because any decisions the ECB makes will have real-time implications for government finances, financial market stability, and price inflation. It is also a difficult question because the ECB was never designed to make decisions that impact explicitly on government finances. The ECB’s mandate is to maintain price stability; it only recently accepted responsibility for financial market supervision.
The decisions that the ECB has to make with regard to government finances cover a range of issues like when it is supposed to intervene to stabilize relative borrowing costs; which assets it can purchase or accept as collateral, which are too risky, and when it is alright to make an exception; what maturities it should purchase and in which context; how long it should hold assets on its balance sheet; and what it should do with the principal of its investments as they mature. The ECB also has to decide what proportions it should purchase both across jurisdictions and across categories, how much it can purchase of any issue or from any issuer, when it is justified to relax any restrictions it sets on its own policies, and when it is safe to make those restrictions binding again.
The ECB can certainly make these decisions. The institution does not lack in technical competence. But remember that it also has to balance interests related to government financing, financial market stability, and macroeconomic performance. The trade-offs it faces will be controversial and the implications will create winners and losers across the single currency. Just think about the time the ECB pulled its waiver on the credit rating requirements for the use of Greek sovereign debt as collateral in February 2015. You can bet that former Greek Finance Minister Yanis Varoufakis remembers.
There are a number of people in Ireland who have strong recollections of what the rest of us might consider very technical central banking decisions as well. So does Italy’s Matteo Salvini. As we have seen since the last crisis, the ECB’s decisions attract political attention from national governments, political parties, and even the general public. I know everyone is focused now on the corona virus; only just a few months ago the debate sucking the oxygen from the room was about populism and democratic dysfunction.
Reliance on the ECB as the main response to the current crisis not only mutualises more risk related to sovereign finances across those countries that have adopted the euro than a special-purpose debt issuing agency would, but it also implicates the most important institution for managing the single currency in political controversies that it is ill-equipped to navigate. Nevertheless, the politicians in the Eurogroup would prefer to go down that route than find some political agreement among themselves that would involve the mutualisation of less risk from sovereign borrowing and would inspire more confidence in the euro as a multinational currency.
Politics is Politics, but Europe is Creative
Of course, I understand that there are good political reasons for politicians from different countries to disagree. Having spent my professional life studying European politics, I find that political constraint unsurprising. What I do not understand, however, is that that European politicians would imagine that the real world problems they face will go away, that they can be tackled individually, on a country-by-country basis, or that they can be bottled up in institutions that are not designed to resolve political tensions (and indeed are meant to be held away from politics).
The risks Europeans face are already ‘mutualised’ in the sense that what happens to any one part of Europe will have an impact on any other as well. The challenge now is to find some way to build institutions to manage that risk in the most efficient and sustainable way Europeans can imagine. The history of European integration is a testament to the ingenuity of Europeans in rising to that kind of challenge. To borrow a phrase from one of my fellow Americans, Europeans share risk across countries better than any other people on the planet.
The single currency and the European Central Bank are both illustrations of the kind of unprecedented steps that Europeans are willing to take under the right circumstances and despite considerable domestic political controversy. That Europe’s politicians would choose to jeopardize those institutions at this time of extreme need by loading them with unnecessary risks or responsibilities they were never designed to manage is very hard for me – as an outsider – to understand. They may get through the current crisis, but only at the expense of their ability to manage the ones they will face in the future.