Last week’s press conference to announce the European Central Bank’s monetary policy responses to the coronavirus crisis was dramatic for a few reasons, one being that the bank’s new president Christine Lagarde said: “We are not here to close spreads.”
What she was referring to was the spread between the yields on different EU member state government bonds. The yield is the gap between the face value of a government bond – just like an IOU – and the value it will trade for in the market. A promise by a sovereign to pay €100 in a year’s time for a government bond that sells at €95 euros, for instance, has a yield of 5 per cent. People working in finance refer to the gap between one yield and another as “the spread”.
These comments immediately caused yields on Italian government bonds to spike upwards. This was because markets started to factor in a higher risk that while investors are holding Italian government bonds, the government defaults and refuses to, or is unable to, pay all of the face value back.
Lagarde subsequently rode back on these comments, issuing a tersely worded “clarification” and telling reporters that the ECB was “fully committed to avoid any fragmentation” in bond markets.
The comments were an unfortunate echo of former ECB president Mario Draghi’s declaration that he would do “whatever it takes” to save the euro in 2012. Economic commentators joked that the ECB had gone from “whatever it takes” to “whatever”.
Lagarde’s clumsy words were a reminder of two things: one, how important central bank communication can be, especially if inept, and two, how the coronavirus health crisis has morphed into a financial one that could be existential for the eurozone and other governments.
In her remarks Lagarde had already paid homage to “whatever it takes”, telling reporters: “I would hope that I never have to do whatever it takes”, implying that she would do this if necessary, but hoped that it would not be.
It is no exaggeration to say that Draghi’s comments became an iconic moment in the short history of the ECB, resolving the 2008 financial crisis that threatened to terminate the euro and, of course, itself. The speech in which those words were delivered announced that the ECB would conduct “outright monetary transactions” (OMTs as they were later referred to), which were purchases of short-term government bonds financed by the creation of new, electronic ECB reserves (the modern equivalent of printing money) in whatever quantity needed. This was on the condition that the troubled member state in question submitted to a programme of fiscal rescue and correction supervised by a new European Stability Mechanism.
The speech shrank the gaps that had opened up between the most troubled eurozone government bonds – particularly those of Italy – and the rest. And it is testament to the effectiveness of that regime that spreads widened after Lagarde seemed to cast doubt on the policy.
On the face of it, “‘whatever it takes” looks like a bluff, but one that worked. The ECB committed to buying unlimited quantities of short-term government bonds that would, if the bluff was called, prove worthless, because the sovereigns issuing them would not have funds to repay the IOUs (because they could not service their existing debt). The calculation was that markets would view the bonds as worth something, because there was always the ECB to sell them to.
But the ECB was, and is, constrained in its ability to withstand financial losses, ultimately by what its owners – member state governments – are prepared to sanction. Unlimited losses could never have been credibly sanctioned by the ECB’s stakeholders because those losses would not have the consent of their electorates. So in this sense, “whatever it takes” was a gamble and a bluff.
Bluff or not, its success required everyone to believe that the ECB was unambiguously committed, which is why Lagarde’s statement that “we are not here to close spreads” was so damaging. It would be far more accurate to say that, in fact, “we are here to close spreads”.
The episode shows how a public health crisis has become a financial one. During the eurozone crisis, the spreads were the manifestation of a so-called “doom loop” between banks and the governments that stood behind them. The doom loop is when banks’ health comes into question because their loans and investments start to go bad and depositors start to withdraw their funds in a panic. This puts financial stress on the governments, who are pushed into standing behind bank deposits to present a full run on the bank; and then the run on the bank worsens because the government’s deposit guarantees are worthless, and so on.
This doom loop occurred not just in Italy, but also famously Greece, Ireland and elsewhere. In Ireland, banks lent injudiciously in the commercial property market, financing much of it from borrowing abroad. As the crisis broke, the value of commercial property prices plunged, and depositors and others lending to banks took fright. The Irish government felt it had to issue a 100 per cent guarantee over Irish deposits, and financial markets judged that the government could not afford it and they could no longer fund themselves.
In the eurozone, the doom loop had (and has) an added accelerator, the worry that the member state in question will be forced to exit the euro and start issuing its own currency again and, in doing so, redominate outstanding debt in this new unit of dubious value.
In 2008-9 the trigger of the financial crisis was… financial. Uncertainty about who was exposed to what losses from the initially moderate defaults on US subprime mortgages (mortgages extended to low-income groups with hard-to-verify credit histories). This time the trigger is coronavirus. This, and the necessary eurozone policy response, has put pressure on businesses and individuals, whose custom and income are dropping. This then causes a reassessment of the state of bank loans and banks’ wider health. This then causes worries about governments’ ability to support their banks at a time when tax revenue is falling and spending on benefits and counter-virus measures is rising.
I doubt that Lagarde’s fumble is going to prove fatal to the ECB and its “whatever it takes” policy. The policy-making board is more than just its president. We know that there are prominent sceptics. But it could not have survived until now without majority support.
The fiscal philosophy of major stakeholders also seems to have changed. Witness the abandonment of austerian fiscal policy last week by the German government, and indications from the European Commission that the Stability and Growth Pact, which regulates the deficits and debt of eurozone governments, is to be relaxed so that public spending can be directed at fighting the crisis.
It also helps that the non-risk component of the compensation that markets ask of governments when they lend to them is incredibly low, with interest rates right out to very long horizons at around zero.