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Desmond Lachman: The European Central Bank Is Stuck Between a Rock and a Hard Place



Europe faces an even worse economic predicament than the United States. Spare a thought for Christine Lagarde, the president of the European Central Bank (ECB). She now finds herself in a worse monetary-policy predicament than Jerome Powell, her counterpart at the Federal Reserve.

Like Powell, Lagarde is having to pursue a hawkish monetary policy to contain the highest inflation since the euro was launched while simultaneously managing banking-sector difficulties that need low interest rates for their resolution. However, unlike Powell, she has an additional major problem. Lagarde has to raise interest rates at a time when governments in the euro zone's economic periphery are more indebted today than they were at the time of the 2010 euro zone sovereign-debt crisis. This more hawkish interest-rate policy, coupled with a shift to quantitative tightening, now risks triggering another round of the euro zone debt crisis.

If the Fed was asleep at the wheel when inflation pressures were building in 2021, so too was the ECB. Whereas the Fed began its aggressive interest-rate-hiking cycle in March 2022, it took the ECB till July 2022 to move away from its long-standing negative-interest-rate policy. By then it was too late to prevent a surge in euro zone inflation to an all-time high: Headline inflation exceeded 10 percent. Even excluding volatile food and energy prices, European inflation reached almost 6 percent.

Unlike the Fed, which has a dual price-stability and employment mandate, the ECB has a single price-stability mandate. This has left the ECB with little option but to slam on the monetary policy brakes to get the inflation genie back into the bottle. It has done so by raising interest rates at the fastest pace in the ECB's history and by shifting from a policy of massive quantitative easing to one of quantitative tightening at the pace of 15 billion euros a month.

One of the ECB's problems in having to raise interest rates aggressively to contain inflation is that such a course risks exacerbating the cracks that are now emerging in the European banking system. This is especially the case today: A shotgun marriage had to be arranged between Credit Suisse and UBS; Deutsche Bank, another major player in Europe's banking system, is under pressure as investors wonder which is the next domino to fall in a world of higher interest rates; and markets are now remembering that banks in the euro zone's periphery own very large amounts of their countries' government bonds.

Indeed, if current trends continue, then another round of euro zone sovereign-debt crisis, where investors lose faith in the government's ability to repay its debt, could be just around the corner. The risk of this occurring has been exacerbated by the ECB's recent shift from a policy of buying very large amounts of European government bonds to one of selling such bonds. This is especially true for Italy, where until recently the ECB had been buying Italian government bonds equivalent to that government's net borrowing needs.

Also underlining the risk of another round of the euro zone debt crisis is the fact that Italy and Spain's public debt in relation to the size of their economies is considerably higher today than it was at the time of the 2010 euro zone debt crisis. Higher interest rates will make those countries' debt problems that much worse. This has to be of concern since, stuck within a euro straitjacket, those countries are unable to address their debt problems with fiscal austerity for fear of deepening their economic recessions.

All of this makes it difficult to understand why the ECB's latest policy meeting – at a time when cracks were already evident in the banking system – Lagarde and her colleagues chose to continue an aggressive interest-rate-hiking cycle.

In 2019, when Madame Lagarde became president of the ECB, she said that it was not the ECB's job to be overly concerned about Italian government bond yields. She did so only to provoke a large sell-off in Italian government bonds. Having learned little from that experience, Lagarde may now be inviting another round of the Italian debt crisis with her newfound monetary-policy religion.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging-market economic strategist at Salomon Smith Barney.


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Posted: March 29, 2023 Wednesday 06:30 AM