Europe's flawed debate on fiscal rules
1. Europe's debate on fiscal rules is flawed, as de facto spread management - and resulting low yields - make it seem like highly indebted periphery countries have fiscal space, when they do not. A major overhaul of this debate is needed.
1. Europe's debate on fiscal rules is flawed, as de facto spread management - and resulting low yields - make it seem like highly indebted periphery countries have fiscal space, when they do not. A major overhaul of this debate is needed.
2. Periphery spreads are low. Much of this is due to de facto spread management. We have a natural experiment to show this. In March 2020, President Lagarde said: "ECB isn't here to close spreads." Spreads immediately shot up. There's been de facto spread management ever since.
3. One way to see how pervasive spread management is in the case of Italy is to look at July 2022, when Draghi's government unexpectedly collapsed. A big negative surprise, but Italy's spread narrowed, even as Bund yields were rising. This is highly "anomalous" price action...
4. Another way to see this is to look at ECB net buying of government bonds vs net new issuance of debt. There's a high correlation of these two series for Italy (lhs), much higher than for Spain (rhs). It looks like - indirectly - the ECB is absorbing much of Italy's issuance...
5. ECB involvement on spreads has an inadvertent side effect: it makes the debate over fiscal rules lopsided. German calls for debt reduction get an almost universal negative reaction, when - given the inflation scare we are living through - they are more timely than ever.
6. So the current debate over fiscal rules is happening in a kind of "parallel universe" where there's an illusion of fiscal space for highly indebted countries. That illusion must end for a balanced debate, which means ECB needs to scale back its role in periphery debt markets.
7. So what needs to happen? As precondition for renegotiating Europe's fiscal rules, politicians in northern Europe should ask for full price discovery. If there is fiscal space, yields will stay low as the ECB scales back purchases. If there isn't fiscal space, yields will rise.
8. Only once periphery yields are a market price can a fair debate of Europe's fiscal rules be had. In this setting, much more prominence will be given to debt reduction. If there's important spending needs, like defense or climate change, there's plenty of private wealth to tax.
9. The ECB in all this is a force for good. The reality is that it has been put in an impossible situation by the lack of progress on fiscal union in Europe. But for a fair debate on steps to fiscal union to take place, northern Europe should ask the ECB to now take a step back.
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