The European Central Bank, or ECB, is set to raise its key rate for the first time in 11 years and take the first step towards breaking out of negative territory. The bank said it intended to raise the current rate from -0.5% to -0.25% on Thursday. And, with a further rise, it aims to reach 0% by September.
The purpose of these negative interest rates has been to encourage more lending by commercial banks by charging them to hold their reserves with the central bank, but with inflation raging at over 8.5%. in the euro zone, the ECB decided that such a stimulus was not necessary. no longer necessary. The era of easy money seems to be coming to an end.
But the bank faces a dilemma in its fight against inflation, and that dilemma stems from debt.
“The ECB is between a rock and a hard place,” said Stefan Legge, lecturer in economics at the University of St. Gallen in Switzerland. “It has to fight inflation – that’s its mandate – but debt levels across the eurozone are too high for some countries to afford higher interest rates.”
In Greece, for example, public debt exceeded 190% of GDP, while the figure for Italy – the third largest economy in the euro zone – is around 150%.
“The fear is back that Italy or Greece or some other country won’t be able to afford higher levels of interest and could eventually go bankrupt,” Legge said.
These fears have pushed up the bond yields of the euro zone’s most indebted governments and made it harder for them to borrow and service their debt – a problem compounded by joining the euro.
Without their own currencies, weaker economies are unable to devalue their way out of trouble. Lorenzo Codogno, a former chief economist at Italy’s Treasury Department and now a visiting professor at the London School of Economics, said it was reminiscent of the debt crisis that nearly blew up the euro a decade ago.
“It may be a slightly different type of crisis, but it could develop again, given that the eurozone is still a fragile construct. The whole system is still quite fragile. He could be under pressure again,” Codogno said, adding that recent political unrest in Italy had made matters worse.
Since the debt crisis, the ECB has eased investor concerns by buying large amounts of bonds issued by weaker governments, mainly in the southern euro zone; it is now sitting on around $5 trillion. This kept bond yields low and prevented them from deviating from the yields prevailing in the stronger economies.
“This has been very important in maintaining the stability of the monetary union and preventing the weaker member states of the eurozone from suffering even more than they have during the pandemic,” observed Sarah Fowler, analyst in International Economics at Oxford Analytica.
But the bank stopped those regular purchases this month because they were seen as fueling inflation, and that left the bank in a dilemma.
“Ultimately, it is difficult to see how the ECB will emerge from this cycle of only widening divergences between northern and southern member states and the constant risk that a debt crisis will not be so remote,” Fowler said.
The bank promised to unveil a plan on Thursday to avoid further divergence, or fragmentation, and avert another crisis. It appears that this may involve the targeted resumption of some bond purchases – a procedure which, along with the expected rise in interest rates, has been described as putting the foot on the accelerator and the brake at the same time.
“The ECB is in a more difficult position than the US Fed,” Fowler said. “As a result, investors have much less confidence in the ECB’s plans.”
Investors demonstrated this when the euro plunged to a 20-year low against the US dollar this month. However, none of the economists we consulted for this article believed that the euro’s problems would be terminal.
“I think it will be less severe this time around,” said Jessica Hinds of consultancy Capital Economics. “The fundamental imbalances between the different Member States are much less significant than they used to be. I think there will be less of an existential threat than in 2009 and 2010.”
Lorenzo Codogno highlighted the fact that European commercial banks are in much better shape than ten years ago, with a lower level of non-performing loans. While he acknowledged that many threats weigh on the stability of the euro zone, he does not think that its survival is in doubt.
“I don’t believe there is a significant risk that the monetary union will collapse,” he said. The consequences of a departure for the Member States could be appalling. In the case of Italy, he said, that would prove “extremely disruptive”.
But perhaps the most powerful force holding the currency bloc together is not economic, but political.
“From an economic point of view, this whole euro zone never made much sense,” said Stefan Legge. “But it wasn’t an economic project; it was a political project. It was a political symbol. He says: ‘We have a common currency.’
But the cost of that symbol, he said, could be decidedly economic: higher inflation and a weaker currency than most northern member states – especially Germany – would prefer.
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