A television broadcast showing Christine Lagarde, president of the European Central Bank, is pictured during a trading session at Frankfurt’s stock exchange on March 12. Photo: Reuters
by David Brown
by David Brown

As the coronavirus takes its toll, here’s what the European Central Bank must do to save the euro zone economy

  • The ECB missed an opportunity to walk in step with the US and Britain and cut interest rates last week
  • In addition to pumping liquidity into the market, the bank must shore up high-risk bond markets and ban speculative short-selling
It doesn’t take much to expose the flaws in the euro zone economy but the coronavirus epidemic has already ripped asunder any hope of getting back to sounder growth for a long time. Europe is clearly heading into recession as the pandemic takes a heavy toll on consumer demand, business activity and financial market confidence.
We are heading into uncharted territory with the national lockdowns in Italy and Spain foreshadowing bigger trouble ahead for Europe’s largest economies, Germany and France, with plenty of negative spillover likely for the rest of the region. Just how deep the recession descends depends upon how effectively Europe’s policymakers respond. Judging by the official response so far, it’s no surprise markets are panicking.

Europe’s bond and credit markets are definitely showing the strain. It’s not so much that Germany’s yield curve has turned negative on safe-haven and flight-to-quality flows, but that bond spreads for riskier markets have started to surge.

The bellwether 10-year spread of Italian government bonds over equivalent German yields has exploded out to 2.34 per cent in recent days as investors have fled for cover. Talk about Italy’s “doom loop” has resurfaced again, with deepening recession risk, the fragility of the Italian banking sector and the potential threat of future credit default combining to put the wind up the markets. It hasn’t helped that the European Central Bank seems to be turning its back on the bond market’s plight.

In a shocking display of official insouciance last week, ECB president Christine Lagarde suggested it was not the central bank’s job to close down bond spreads for highly indebted euro zone countries.

Lagarde may be forgiven for her inexperience but it’s a major departure from her predecessor Mario Draghi, who famously declared during the European debt crisis in 2012 that the ECB would do whatever it takes to protect the euro zone from collapse.
Leaving interest rates unchanged at last week’s ECB meeting was a mistake too, a wasted opportunity to unite with the US and Britain to cut the global cost of borrowing in a relatively coordinated move. It sets a dangerous precedent for bond market spreads, not just for Italy but for other high-risk assets as well.

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The coronavirus crisis is such an unprecedented event it’s hard to say how bad the downturn could be in the coming months. At the worst point of the global financial crash, European growth sank as low as -5.7 per cent in the first quarter of 2009, but was less extreme during the 2010-2013 European debt crisis with a -1.2 per cent low-point for growth in early-2013.

By that stage, the European economy was beginning to respond to the actions of negative interest rates and the big bond-buy-backs under the ECB’s quantitative easing programme. The damage limitation of extreme policy measures was beginning to show positive results.
A person wearing a protective face mask walks down a virtually deserted Via Roma in Turin, Italy, on March 12, the third day of an unprecedented lockdown across all of Italy, imposed to slow the outbreak of coronavirus. Photo: Reuters

Europe can do it again, but it needs to follow a series of bold steps. Firstly, the ECB needs to release a new flood of cheaper money, cutting interest rates again, while stepping up more quantitative easing with extra term lending injections into the markets.

Secondly, Europe must suspend the Stability Pact and bring fiscal austerity to an end with a raft of deficit-spending reflation.

Thirdly, the ECB must initiate direct intervention in support of high-risk bond markets like Italy.

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Fourthly, it needs to ban speculative short-selling, which exploits the coronavirus crisis. These are exceptional times requiring special preventive measures.

Europe’s policymakers can rise above the crisis. But it needs to build bridges with the rest of the world, especially the US and China, working together to end the mayhem. It’s not just down to finding a cure for Covid-19, but limiting the economic damage which follows.

David Brown is chief executive of New View Economics

This article appeared in the South China Morning Post print edition as: Four steps ECB needs to take to limit future economic damage