A few years ago, the Eurozone witnessed its most acute “stress test” since the euro became the official currency of a bloc of 11 European countries, gradually extended to include 19 nations as of May 2020. It was an asymmetric chock with its epicentre in Greece, testing the resistance of the Eurozone “weakest links” which were dubbed by financial investors with the infamous PIIGS acronym – standing for Portugal, Italy, Ireland, Greece and Spain. Given the complex and somewhat shaky institutional undertakings of the Eurozone at the time, and given the intricate linkages between sovereign entities and financial institutions all across the area, there was a real threat that the entire Economic and Monetary scaffolding put in place in the early 2Ks could collapse, with unimaginable consequences.
Comparing the growth of GDP per capita in constant prices between the Eurozone and the United States over the period starting from 2011, the impact of the sovereign debt crisis is striking. The lost output per capita stemming from that crisis exhibits an almost permanent character, as can be seen from the chart below. That major chock now seems to be dwarfed in scale and scope by the potential consequences of the Great Lockdown, as the Covid-19 induced economic and financial crisis came to be the named by the IMF.
In retrospect, the swift reaction of the ECB in the wake of the sovereign debt crisis managed to prevent the potential collapse of the Eurozone and to contain its fragmentation … for some time. This reaction will forever be associated with Mario Draghi’s momentous “Whatever it takes” sentence, pronounced during a speech held in London in July 2012. A week after that speech, the ECB announced a programme to buy potentially unlimited amounts of individual Eurozone countries distressed bonds, known as Outright Monetary Transactions. As a matter of fact, this programme was never actioned as it came with heavy strings attached, most notably the need to request a loan from the European Stability Mechanism and to be submitted to Greek-style conditionalities. But its mere existence was enough to calm the nerves of the markets and to thwart speculative attacks against the PIIGS countries.
It should be remembered that the ECB could assume its task of preserving the stability of the Eurozone because there was a strong policy momentum within the Member states – most importantly within Germany, France and Italy – and within the other European institutions – most notably the European Commission – in order to reform and to strengthen the functioning of the Eurozone, as part of a broad refurbishing of the EU’s Economic and Monetary Union compact.
Aside from this “nuclear monetary weapon” that the OMT programme epitomised at that time, the ECB initiated in mid-2014 an extensive new Asset Purchase Programme (APP) targeting government bonds. The ECB initiated much later a large scale asset purchase program than the FED, which started buying government related and corporate assets on a massive scale as early as end of 2008, in the immediate aftermath of the Lehman Brothers collapse. The APP programme was presented as a complementary tool extending the range of non-conventional monetary policy instruments that the Frankfurt-based institution had already deployed since 2008. But in fact, it was the result of a profound cultural revolution, faced with much resistance both inside and outside this young monetary institution.
As from the ECB website
The ECB’sAsset Purchase Programme (APP) is part of a package of non-standard monetary policy measures that also includes targeted longer-term refinancing operations, and which was initiated in mid-2014 to support the monetary policy transmission mechanism and provide the amount of policy accommodation needed to ensure price stability.
The APP consists of the following :
- corporate sector purchase programme (CSPP)
- public sector purchase programme (PSPP)
- asset-backed securities purchase programme (ABSPP)
- third covered bond purchase programme (CBPP3)
Its most important component is, by far, the PSPP, as can be seen from the chart below. All in all the outstanding volume of assets purchased by the ECB as part of the APP, which was suspended in December 2018 before being restarted in November 2019, now represents almost a quarter of the Eurozone’s total GDP.
This quote from the ECB’s website summarises well the timeline, scope and scale of the APP:
Between October 2014 and December 2018 the Eurosystem conducted net purchases of securities under one or more of the asset purchase programmes. During the net asset purchase phase, monthly purchase pace averaged:
- €60 billion from March 2015 to March 2016
- €80 billion from April 2016 to March 2017
- €60 billion from April 2017 to December 2017
- €30 billion from January 2018 to September 2018
- €15 billion from October 2018 to December 2018
Between January 2019 and October 2019, the Eurosystem fully reinvested the principal payments from maturing securities held in the APP portfolios. The Governing Council aimed to maintain the size of its cumulative net purchases under each constituent programme of the APP at their respective levels as at the end of December 2018.
On 12 September 2019 the ECB Governing Council decided that “net purchases will be restarted under the Governing Council’s asset purchase programme (APP) at a monthly pace of €20 billion as from 1 November 2019. The Governing Council expects them to run for as long as necessary to reinforce the accommodative impact of its policy rates, and to end shortly before it starts raising the key ECB interest rates.”
This massive asset purchase programme has kept government bond rates closely knit across the Eurozone’s 19 sovereign issuers. Generally speaking, it boosted financial assets prices across the board and allowed the Eurozone banking sector to recover from the combined effect of the Global financial crisis and the Eurozone sovereign debt crisis. The effectiveness of a government bond purchase programme increases all the more that the central bank holds a larger share of given securities outstanding stock – let’s say of Italian sovereign bonds for example. Indeed, as former ECB Executive Board member Benoît Coeuré stated in a speech given in 2018, when the Central bank holds more assets in proportion of their total outstanding stock, the prices of these assets react more swiftly to additional purchase announcements. This is the “bang for a buck effect” or stock effect.
As a matter of fact, this effect also holds in the opposite direction, which could make it even trickier for the Central bank to withdraw its support to governments and to reduce its balance sheet by offloading to the markets some of its outstanding stock of assets. This “ratchet effect” was experienced at times when the ECB announced that it will suspend its asset purchase programme, triggering markets fears of a disorderly unwinding of these long-standing “buy and hold” positions.
In the long run, there is potentially a real risk that the purchase of government bonds might create and addiction to Central Bank intervention – much like drug-addicts need increasingly higher doses of opioids just to keep them running – and that the ECB might end up holding a disproportionate stock of a single Eurozone country’s debt – let’s say of Italy. In this case, the ECB might become hostage to its own past policies and might not be able to change the course of its policy in due time to counter emerging inflationary trends, the containment thereof being its core mandate. In this case, the Central Bank will find itself locked into a “fiscal dominance” situation, associated with large-scale monetisation of government debt. This is the main rational behind the limits put on a Central Bank’s detention of government debt. However, in the case of the ECB, fiscal dominance applies more accurately at the Eurozone consolidated level, not at the single country level. Hence, the risk of fiscal dominance is exaggerated when it comes down to supporting individual countries … up to a certain point.
It could be argued that the effect of the ECB’s purchase programme on the real economy was much less effective than its effect on asset prices, as it did not manage to increase significantly the volume of medium and long term loans distributed by financial institutions to households and non financial corporations, despite incredibly favorable monetary and financial conditions prevailing since it initiated the APP in March 2015. To be honest this issue is highly debatable and goes well beyond the primary objective of an assets purchase programme, especially in a Eurozone context in which banks account for the lion’s share of the total financial intermediation between savings and investments, as opposed to a more markets-based system – such as the one prevailing n the United States where capital markets account for two thirds of the financing provided to the real economy.
In addition, the ECB is not the only player in town and the demand for loans is not only related to the availability of supply but also to a whole range of demand-related economic and psychological factors, over which the ECB has almost no control. In any case, it shows the limits of the ECB’s monetary “canon powder” when it comes to supporting the real economy in a quantitative easing environment. However, this is not proper to the ECB. The Bank of Japan for example has a much longer experience in quantitative easing policies and the limits of its intervention over the last two decades have been well documented. In the case of Japan, some of the limits on its early QE policies were related to the zero bound constraint on interest rates. This constraint has been lifted ever since negative rates came to be considered as a valuable monetary policy tool, but this another debate.
In any case, the response of the ECB to the Covid-19 induced crisis was expected with great anxiety from the markets and policymakers across the Eurozone and beyond. This response comes on top of the broad array of unconventional monetary policy tools that were implemented since 2008. First, it entails providing additional liquidity backstops to the Eurozone’s banks – through the so-called PELTROs (Pandemic Emergency LTROs) – to insure that there would be sufficient liquidity within the Eurozone banking system in order to help it sail through this unprecedented crisis. Second, the ECB announced on March 12 that it will increase its net purchases of government bonds and corporate bonds through its existing APP programme, to the tune of EUR 120 bn, of which it has already purchased EUR 51 bn in March and potentially a larger amount in April. Third, and most importantly, the ECB devised a new asset purchase programme to the tune of EUR 750 bn, that is specifically intended to cope with the economic and financial impact of the pandemic, the so-called PEPP (Pandemic Emergency Purchase Programme).
As can be read on the ECB’s website :
The PEPP is a temporary asset purchase programme of private and public sector securities, which has an overall envelope of €750 billion. All asset categories eligible under the existing asset purchase programme (APP) are also eligible under the new programme. Under the PEPP, a waiver of the eligibility requirements will be granted for securities issued by the Greek Government. In addition, non-financial commercial paper is now eligible for purchases both under the PEPP and the corporate sector purchase programme (CSPP). The residual maturity of public sector securities eligible for purchase under the PEPP ranges from 70 days up to 30 years and 364 days.
As for the purchase of government bonds, this new programme will respect the general allocation rules set for the PSPP, which forces the ECB to respect a “capital key” related to the share of capital held by each of the 19 Eurozone national central banks (the updated capital subscription and its split across the national central banks can be looked upon here). This has disappointed some government officials and market pundits who were pushing the Central Bank to abandon altogether its strict allocation rule – which had already been heavily criticised in 2014-2015 when the original APP programme was announced – and to move the PEPP in the direction of OMT, by allowing the ECB to purchase unlimited amounts of distressed government securities.
As can be seen from the quote below – excerpted from the PEPP announcement -, and as can be grasped from other communications made by the ECB’s President, Christine Lagarde, as well as by other ECB Governing Council Members and Senior officers since the PEPP programme has been announced, the Bank tried to dispel doubts over the PEPP’s efficiency, claiming that it would retain all the required flexibility. In layman language this means that the ECB could front-load purchases of distressed securities if needed – and that it was in any case prepared to increase its support and to do “whatever it takes”, once again, to salvage the Eurozone. Peter Lane, the ECB’s Chief Economist and former Governor of the Central Bank of Ireland, who is arguably the most prominent intellectual figure in charge of ECB’s policy design and technical implementation – or at least the most visible figure thereof – has repeatedly said that the limits preventing the ECB of holding more than a third of any single country’s debt will not apply to the PEPP.
For the purchases of public sector securities under the PEPP, the benchmark allocation across jurisdictions will be the capital key of the national central banks. At the same time, purchases will be conducted in a flexible manner. This allows for fluctuations in the distribution of purchase flows over time, across asset classes and among jurisdictions.
One way to solve the inherent contradiction between the “whatever it takes stance” and the rules that constrain ECB’s action would be for the Central bank to purchase a pool of euro-bonds issued by the European Commission or by the European Stability Mechanism (ESM). This would allow it to simultaneously mitigate the counterparty risk and the legal constraints associated with the purchase of securities issued by individual countries. This explains why from the onset of the crisis the ECB has been supporting this course of action, and why it has been repeatedly pressing EU Member states to assume collectively their fiscal responsibilities (cf. the last paragraphs of this interview by ECB EXCO member Isabel Schnabel to the Greek newspaper To Vima).
Preliminary figures disclosed on the ECB’s website show that over the March-April period, the ECB has already deployed around EUR 100 bn out of the PEPP’s fresh monetary powder. This means that at the current pace of purchas the EUR 750 bn will be extinguished by the end of the year, which is the minimal timeframe set for this programme. The detailed composition of the assets purchased as part of the PEPP’s programme have not been disclosed so far, but it is highly probable that the first assets purchases included mostly Italian, Spanish, Portuguese and Greek bonds.
Obviously, given the heavy financing needs of the Eurozone member states over the forthcoming months, and given the long lasting impact of the coronavirus crisis on the region’s economy, eventually the amount of the original EUR 750 bn PEPP will have to be doubled or tripled. But even in this case, the aforementioned legal limits and the positive feedback loop effects that might hinder the Central bank’s monetary policy credibility going forward will limit the effectiveness of such a magnified asset purchase programme.
Therefore, a Pandemic OMT – POMT – might well be the most appropriate solution in the current context – and perhaps the only one that is available, especially if discussions around a common Eurozone fiscal package fail to produce meaningful results – in order to support individual Eurozone member countries, while preserving the overall financial stability of the Eurozone and the autonomy and credibility of the ECB. This will require a relaxation of some of the most stringent conditions associated with this instrument, first and foremost the reference to an existing ESM programme to action it. The comparison with nuclear deterrence warrants that this would be akin to moving from nuclear deterrence to preventive nuclear strikes. This goes against the basic tenets of orthodox thinking and will require to move well beyond the consensus needed to create the original OMT. But, once again and even more so now than before, exceptional times command exceptional solutions and unorthodox thinking.