Bond villains: The European Central Bank’s new strategy

If the ECB is disciplined in its use of the recently announced Transmission Protection Instrument, this could turn out to be exactly what Europe needs

ECB Director Lagarde at the ECB Forum on Central Banking in June 2022

On 21 July, the European Central Bank (ECB) raised interest rates for the first time since 2011 and introduced the Transmission Protection Instrument (TPI), which allows it to buy member states’ bonds under certain conditions. The move was a reminder that the ECB is fighting record inflation of 8.6 per cent in the euro zone. The European Union now needs to do everything it can to avoid a repeat of the disputes over monetary policy that divided northern and southern member states in the past.

The EU went through some difficult years during the European debt crisis. Many member states – especially, but not exclusively, those in southern Europe – saw their public debt rise unsustainably after governments bailed out the banking sector. This led to a rise in interest rates for financing the resulting debt and in capital flight to relative safe havens in northern Europe, especially Germany. A combination of the European Commission, the International Monetary Fund, and the ECB oversaw emergency packages that required some member states to enact drastic fiscal reforms. Germany, with the euro zone’s largest economy and as the biggest creditor of the emergency packages, pushed for these austerity policies.

While such measures brought down public debt, they also had severe side effects. In Greece, austerity measures led to violent street protests; in both Greece and Spain, the unemployment rate peaked at more than 25 per cent. And this was only part of the story, given that youth unemployment was likely twice as high and there were many personal tragedies that did not register in public accounts, such as an increase in suicides.

There could hardly be a worse moment to risk reigniting intra-European disputes

In all, the debt crisis was disastrous for European unity. Germany’s stance on austerity frequently prompted comparisons with its Nazi-era policies. The domestic political turmoil caused by the crisis led to abrupt changes of government in eight euro zone member states between 2011 and 2012 alone. Eventually, the ECB announced a programme designed to stabilise interest rates by buying government bonds under certain conditions. Although then-chancellor Angela Merkel defended the programme, the president of the German central bank vetoed it in the ECB’s Governing Council. German lawmakers subsequently challenged the legality of the programme in the German Constitutional Court. They feared that the programme could amount to cross-border burden sharing and would leave member states with little incentive to enforce austerity measures.

Of course, the EU faces a different situation today. Yet there could hardly be a worse moment to risk reigniting intra-European disputes, given that the EU is in the midst of a severe energy crisis, showing signs of stagflation (persistently high inflation combined with insufficient growth), and experiencing an existential security crisis that it can only overcome if it remains unified. To make matters worse, France’s president now lacks a parliamentary majority to support his policies, Germany is contending with a particularly severe energy crisis, and Italy’s centre-right parties have just forced former ECB president Mario Draghi to resign as prime minister.

Against this background, the ECB is trying to maintain European unity with a strategy that could initially seem to be an attempt to have it both ways: raising interest rates to drive down inflation and financing indebted countries by buying their bonds. However, if the ECB implements its strategy precisely, this could turn out to be exactly what Europe needs.

The institution has positioned itself at the forefront of a new approach to European unity. Under the TPI, the Governing Council will decide whether to intervene by buying the public or private debt of a given member state on a country-by-country basis, according to criteria based on what it calls “sound and sustainable fiscal and macroeconomic policies”. The mere announcement of the instrument should discourage market actors from betting heavily against the more indebted members of the euro zone, such as Italy, when inflation remains high and energy costs continue to rise.

Nevertheless, the TPI presents a challenge to the ECB’s credibility. Last week, when a journalist asked ECB President Christine Lagarde whether the new instrument could be applied to Italy – where Draghi had just resigned – she was eager to emphasise that it was not designed for any specific country. Yet indebted member states that are concerned about rising bond yields might be tempted to test the bank’s commitment to its own criteria. Accordingly, the ECB will need to show discipline in its use of the instrument and resist the political pressure that it will soon come under. If it does so, this could strengthen the euro zone and the EU more broadly. If not, the institution will lose some of its credibility. This could dampen the ECB’s power to calm markets, but also undermine its standing with member states.

There is also the issue of the old north-south divide over the legality of the ECB’s policy instruments – in this case, whether the TPI is a prohibited form of government financing. The best way to use the instrument is to not use it, but to send a strong signal to the markets by having it ready. The ECB will only succeed in this if it is not caught up in debates over the legality of the TPI.

The ECB’s mandate specifies that it should support the “general economic policies in the Union with a view to contributing to the achievement of [its] objectives”. These objectives include protecting EU citizens and promoting solidarity between member states. The ECB can work to achieve them without becoming a political institution. And, as shown by the current debate within the EU about a gas-saving plan, this solidarity is already coming under strain – with Germany now asking the countries hit hardest by the debt crisis to make sacrifices on its behalf.

Europeans will need a unified response if they are to stand a chance of addressing the economic challenges they face. They cannot afford to repeat past mistakes by reverting to the traditional north-south divide over monetary policy.

The European Council on Foreign Relations does not take collective positions. ECFR publications only represent the views of their individual authors.


ECFR Alumni · Programme Coordinator, European Power programme

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