Almost exactly a decade ago, Mario Draghi, then the president of the European Central Bank, promised to do “whatever it takes” to save the euro from destruction. At the time, Greece was on the verge of stumbling – or being frogmarched – out of the euro zone; Italy, the region’s third-largest economy, was so mired in debt that it, too, seemed a candidate for departure.
Today, Mr. Draghi is Prime Minister of highly indebted Italy, just as a fresh euro-zone crisis may be around the corner. Inflation in Italy and the rest of the euro zone has reached painful levels, sovereign debt yields are rising, economies are going into reverse and the war in Ukraine – on European soil! – threatens to destabilize the whole region economically and politically.
Except this time, there is virtually nothing he can do to prevent another euro calamity in Italy or the European Union. That job will go to his successor at the ECB, Christine Lagarde, the former boss of the International Monetary Fund.
And guess what? The ECB is running out of ammunition to fight the next crisis. Mistakes have already been made, the biggest of which was ditching quantitative easing (QE), which is to end in July, instead of extending it.
QE is a central bank’s mass purchase of government debt and other financial assets, such as high-quality corporate bonds, in the open market to increase the money supply, bring down interest rates and encourage investment and lending. Mr. Draghi introduced QE in earnest in 2015 to help keep interest rates at or below zero and juice the economy.
It mostly worked, even if it aggravated income inequality, since it is the wealthy who own financial assets and play the housing and stock markets. Since then, the ECB has spent about €6.5-trillion on its lavish QE program. It became the prime weapon in Mr. Draghi’s battle to keep the euro, and the euro zone itself, intact and growing.
Back then, a lack of inflation (the ECB’s inflation goal is 2 per cent or close to it) or the potential for outright deflation was one of the big problems. Today, it is the opposite. Euro-zone inflation was 5.8 per cent in February, the month Russia invaded Ukraine. In May, the rate hit a record high of 8.1 per cent, up from 7.4 per cent in April.
The culprits are soaring food and energy costs.
Crude oil of the Brent variety is up by almost two-thirds in the past year, with most of the increase coming since the war began. Usually, the cure for high energy prices is high energy prices. But the enormous demand for oil as economies recover from the pandemic, coupled with the embargoes on Russian oil, suggests that prices will remain high, unlike in 2007 and 2008, when an oil collapse came not long after prices hit a record US$147 a barrel.
Food prices also show little sign of tumbling, in good part because of the Russian blockade in the Black Sea preventing exports of Ukrainian wheat, corn and fertilizer. Ukraine accounted for 10 per cent of global wheat exports in 2021. In May, those exports were down by two-thirds over the previous year, according to the country’s agriculture agency. In March, the United Nations’ food-price index reached a record high; it is down only slightly since then.
Prices began climbing before the war started, and it is only now that central banks are getting into the game. This week, the U.S. Federal Reserve hiked its key interest rate by three-quarters of a percentage point, the biggest increase since 1994, and the ECB is set to boost rates for the first time since 2011.
Surging interest rates have already revived fears of another debt crisis such as the one a decade ago that almost shattered the euro zone. Basket-case euro-zone countries were kept afloat by QE and other unconventional rescue techniques, such as outright monetary transactions (OMT), which saw the ECB buy the sovereign debt of risky countries.
Italy – the euro zone’s perennial problem child because of its relatively weak economy and crushing debt load – is already showing signs of strain.
Italy’s problems are compounded by the need to refinance almost €500-billion of overall debt, equivalent to 150 per cent of GDP, this year and in 2023. Last Tuesday, fears that it will not be able to sustain its debt as borrowing costs rise pushed up the yield on its 10-year bonds to 4.06 per cent, an eight-year high (the yield finished Monday at 3.7 per cent). The spread between Italian bonds and benchmark German bonds has widened to more than two percentage points.
How will the ECB prevent another debt crisis as rates rise? It has to find ways to suppress the borrowing costs of weak euro-zone countries to prevent “fragmentation,” loosely defined as an excessive rise in those countries bond yields because of investor fears that they will drop out of the euro.
Asset purchases are the ECB’s most powerful tool to moderate or reduce borrowing costs. But the bank is ending the QE program. Once it disappears, it will be hard to revive, all the more so since Northern European countries were never fully supportive of QE or OMT, which they considered ways of rewarding Mediterranean countries for shabby economic and fiscal behaviour.
QE did not have to be killed. It could have operated at low levels and fully revived in case another full-blown debt crisis erupted in the usual suspect countries – Italy, Greece, Spain and Portugal. The ECB may simply muddle through as it usually does. But it may require a bazooka, as it did in the last financial crisis, if rising borrowing costs threaten to cripple weak countries. Trouble is, it doesn’t really have one now that QE is AWOL.