Long before becoming Italian Prime Minister, Mario Draghi declared that the euro was “like a bumblebee”. In 2012, the then president of the European Central Bank called it “a mystery of nature. . . it should not steal but on the contrary it does”. The economic union is still only half complete, maintained by political will and political creativity. This week, his successors in Frankfurt unveiled their latest improvisation – an improvisation that will really matter to whoever succeeds Draghi as Italian prime minister.
One of the challenges for the Eurozone is to conduct monetary policy in a region where financial conditions vary widely. What happens when investors worry about the sustainability of a government’s debt? This concern can push up local interest rates and can actually mean that the central bank loses the ability to set monetary policy in that country. It’s a bigger problem when rates are higher – and the ECB raised rates this week, by half a percentage point, for the first time in more than a decade.
This concern is why the ECB on Thursday unveiled the so-called “transmission protection instrument”, which gives the central bank discretion to buy the government debt of eurozone countries where “deteriorating financing conditions [are] not justified by the fundamentals specific to each country”. In short, if the ECB thinks investors are panicking, it will step in to buy debt and thus put a floor under bond prices.
Italy, where Draghi resigned as prime minister this week, is not the only problem, but it is the most pressing; its 10-year borrowing costs this week stood 2.3 percentage points above those of Germany, near a recent three-year high. Italy’s debt amounts to around 150% of GDP.
It is worth being clear about what all of this means. The shape of the Eurozone debt market is going to be constrained by the ECB, which will limit the difference in borrowing costs between nations. But for states that stand to benefit, this process will also create new dynamics, in part because of the terms of the program.
States whose debt buys out the ECB will have to comply with EU budgetary rules, have a sustainable debt trajectory and ensure that they respect all the commitments they have made in order to access European funds post -pandemics.
This will be of particular importance for Italy. Draghi’s government had negotiated to receive around 200 billion euros from the EU’s post-pandemic recovery fund – and, in return, to make Italy more competitive and business-friendly. In short, Rome was pressured by the rest of the bloc to push through painful reforms. Draghi said on Wednesday that to receive the next tranche of cash – worth 19 billion euros – Italy had 55 separate targets to meet by the end of the year. These reforms must be supported to avoid future crises by making Italy grow.
It is unclear who will form the new government after the next elections, which have been called for September. But the Draghi government, which lasted 17 months, may have put in significant safeguards for everything that follows, because there is a high price in EU funds to walk away from its program. And by linking access to the TPI to the pursuit of these reforms, the ECB has further strengthened the incentives for the next government not to deviate from it – at the risk of risking a massive sale of Italian debt.
But the instrument does not concern Italian politics. This is primarily to ensure that eurozone bond markets are in line with ECB policy as it raises rates to deal with ongoing price shocks. The pressure will mount as European states bear the costs of this inflationary slowdown. Expect more improvisation to keep the bumblebee in the air.
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