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Podcast: Oliver Wünsch on a solution to eurozone fragmentation risks

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The European Central Bank (ECB) has played a crucial role in safeguarding stability within sovereign bond markets during the pandemic. However, its continued support is not a permanent solution for the region’s more chronic issues.

A common fiscal authority would be more sustainable, but it requires a single political authority with powers to decide on taxes, expenditure, and debt management, says Oliver Wünsch, a partner at Oliver Wyman.

That is a transfer of sovereignty most European electorates seem unwilling to accept now, he tells Central Banking.  

However, eurozone officials and governments cannot escape the side-effects of having a monetary union without a fiscal one. The ECB has provided stability buying government bonds in the secondary market through both the Asset Purchase Programme (APP) and the Pandemic Emergency Purchase Programme (PEPP).

But in order to avoid monetary financing, and to reassure markets it is implementing a unitary monetary policy, these purchases are limited by the capital key rule. The rule establishes limits on ECB purchases per country, according to their populations and GDP.

“If it were necessary for the ECB to intervene, it is fair to say the leeway they have is actually quite limited because weaker eurozone countries depend on ECB support,” says Wünsch, who was also the International Monetary Fund mission chief for Greece and Cyprus as part of the troika during the 2008 financial crisis.

“The spreads in the periphery have substantially widened, it shows that markets are watching. And the fiscal space the periphery has is very limited,” he says.

The PEPP partially circumvented limitations on ECB bond purchases. “In addition to bringing more volume, the PEPP included public sector securities at the short end of the maturity ladder, and it also included a waiver for Greece, which right now is below investment grade and, therefore, excluded from the APP,” says Wünsch.

However, ECB president Christine Lagarde signaled in October that PEPP purchases will expire in March 2022. This could resume market pressures at a time when weaker countries have much higher debt levels than before the pandemic.

Against this backdrop, the question is whether the ECB finds a way to target its purchases in a way that does not overstimulate stronger economies, which could boost inflation higher. In November inflation rose year on year by 4.9%, way over the ECB’s 2% target.

The central bank has a single potential tool that would allow it to offer targeted support: outright monetary transactions (OMT). This offers unlimited support in sovereign debt markets, but it can only be implemented in countries that have accepted a macroeconomic adjustment programme with the European Stability Mechanism (ESM).

But even if this problem were solved, “weaker jurisdictions do not just have high public debt levels, they suffer from a severe lack of competitiveness”, Wünsch points out.

An alternative, freeing the ECB from having to stabilise markets, would be to have a central fiscal authority transferring funds to eurozone weaker economies. However, “a fiscal union requires a strong fiscal governance, and this come with costs for everybody”, says the former IMF official.

This would require a political decision-making body, for instance a parliament that is responsible for deciding entirely on the budget, at a time when electorates do not seem inclined to cede more power to supranational bodies.

“That means tax revenues, expenditures and debt. And you need to have this decision-making power concentrated in one single body,” adds Wünsch. 

Index

0:00 Introduction

1:35 North-South inflation divide

3:20 Limits to ECB purchase programmes

6:30 Lack of competitiveness in weaker economies

7:38 A common fiscal solution?

8:45 Transfer of sovereignty

10:46 Reform of the Stability and Growth Pact

11:45 Adequate political leadership?

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