A notable ECB ‘dialogue paper’ last month on QT in the eurozone said the institution should “think more carefully” about the risks of draining reserves too quickly and triggering bank runs. “The ECB should be extremely careful about QT’s interaction with unwinding its TLTROs,” it said.
The paper leaves no doubt that “political and legal” motives guide the process, not economic ones. The ECB wants to clean up its balance sheet and fight the (valid) perception that it has become a fiscal agent for Club Med governments. It is done to placate the German constitutional court and to prevent a Eurosceptic tantrum in Northern Europe.
A number of things could trigger a new crisis in the Eurozone. A crash in commercial real estate is one. A bigger and less understood danger is laid out in the International Monetary Fund’s Stability Report: What happens if the Bank of Japan scraps its policy of low interest rates on bonds, as the new governor is keen to do? The move could lead to a massive and sudden repatriation of Japanese funds, undoing the world’s largest carry trade overnight.
The Japanese have accumulated $5 trillion in foreign portfolio assets, mostly debt, and much of it in Europe. Their share of each bond market is: Ireland (15 percent), the Netherlands (11 percent), France (7 percent), Belgium and the UK (5 percent), Spain and Italy (4 percent), and Germany (3 percent).
The eurozone never solved its fundamental problems. It never completed the banking union needed to break the doom circle of banks and sovereigns dragging each other down into a self-fueled crisis. Germany and Italy could not agree on the terms, even when Mario Draghi was Italy’s prime minister. A compromise is almost hopeless with a hard-right coalition in Rome.
The northern creditor states have never signed a fiscal union, the sine qua non for a viable monetary union in the long term. There was a one-off burst of corporate bond issuance during the pandemic, but Emmanuel Macron’s hopes of turning this into a proto-EU treasury have been dashed by Berlin. Germany refuses to share its credit card with France and Italy.
“Fiscal integration is a super tough nut to crack in Europe because it is intrinsically linked to national sovereignty and democracy,” says Jeromin Zettelmeyer, director of the Bruegel think tank in Brussels.
“For a moment we thought it was some kind of ‘Hamilton moment’, but it clearly wasn’t a permanent game-changer. As a result, we will probably never reach the minimum economic structure needed to provide stability and prosperity to the euro,” he said at a forum on the euro.
“Is it better than monetary independence, essentially the path the UK took? It’s not entirely clear,” said Prof. Zettelmeyer, who asked what would happen in the Eurozone if one country went wild with something like Trussonomics.
The episode was embarrassing for Britain, but was quickly corrected with little lasting damage. “British political and economic institutions have absorbed the shock. Now think of something like this in the Eurozone, with a populist right-wing in France, for example, trying to pull Liz Truss. The consequences would be disastrous,” he said.
The ECB has a limited margin of error. It has already been overtightened twice in its short history. It raised rates into the recession in 2008 and again in 2011, both times turning a bad situation into something much worse.
One lost decade is bad enough. Two would defy fate.
