By Stefan Gerlach, Chief Economist at EFG Bank in Zurich and served as Deputy Governor of the Central Bank of Ireland in 2011-2015. Originally published at TheMarket.ch
The European Central Bank (ECB) is becoming more sure-footed. The recently announced Transmission Protection Instrument (TPI) is a case in point. The TPI is yet another useful tool to combat the risk of a break-up of the euro area.
Some argue that it is unnecessary since the ECB already has a program of Outright Monetary Transactions (OMT) that allows it to support government bond markets. But to use the OMT, a government must first ask for an ESM program (European Stability Mechanism). Such a program is likely to involve IMF-designed austerity measures. Requesting such a program will be seen as admission of failure by voters and risks causing political turbulence.
Considerable Risks of a Spill-Over
Governments are therefore hesitant to apply for one. Instead, they may gamble that they can live through a period of high bond yields on their own. But high bond yields in one country will be transmitted across the euro area, slowing growth and complicating fiscal policy elsewhere. We see that already now. High bond yields in Italy, where public debt has continued to grow on autopilot, push up bond yields elsewhere in the euro area periphery, even though some countries have made progress with fiscal policy before the pandemic.
The need for the TPI arises precisely because access to the OMT is not automatic and the likelihood that governments will therefore postpone asking for help, which is costly for the rest of the euro are. The TPI, which comes with fewer conditions and is more likely to be used, therefore makes sense.
Unfortunately, the way it has been motivated does not. The ECB says that the TPI is intended to ensure that the monetary transmission mechanism is equally strong throughout the euro area. But the strength of the transmission mechanism varies naturally between euro area economies given their economic and financial structures. This has not caused concerns in the past.
Is the TPI Intended to Manage the Transition Mechanism?
For instance, monetary policy is more powerful in economies where households generally own their own housing and mortgage borrowing is common. It is more potent in countries where corporate leverage is high. It is particularly effective if borrowing costs are highly sensitive to the ECB’s policy rate because lending rates are floating or fixed only for short periods of time.
And since interest rate changes impact on the exchange rate of the euro, they are transmitted more strongly in economies where a disproportionately large fraction of trade is with economies outside the euro area.
Many commentators are therefore unpersuaded by the ECB’s assertions that the TPI is intended to manage the transmission mechanism, and instead see it as a means to keep the euro area together.
The TPI is not in Conflict with Price Stability
The ECB has a secondary mandate to support the "general economic policies of the EU" provided that doing so does not clash with its price stability objective. This provides legal backing to the TPI.
The treaty says that the euro is the currency of the EU. It does not spell out a legal route for a country to leave, so participation is intended to be permanent. The maintenance of the membership of the euro area is thus EU policy. Since the TPI allows the ECB to deal with the surge in inflation by raising interest rates more aggressively than otherwise, it does not conflict with price stability but rather supports it.
The TPI is a good idea. But the ECB should own up to what it is doing. A central bank must not mislead the public. It should say clearly that the TPI is intended to safeguard the euro area and that it is compatible with the treaty underpinning the single currency. Doing so is also good policy – the mere existence of another powerful tool to deal with break-up risk will make it less likely that it will have to be used.