MacroPolis

Italy’s political crisis and incoming government brings the European Central Bank back to making unpleasant choices as it tries to balance market risks with charting a path out of never-ending stimulus and crisis response measures. Mario Draghi has to preserve Euro-stability without appearing to intervene in Rome’s volatile politics. Will he manage? The Bank’s response to the Greek crisis offers some insight on how things may turn out for Italy. The following argues that Italy in 2018 may come to mirror Greece in 2015.

Before the latest Italian debacle, Greece had been the weakest link of the Eurozone since its debt crisis erupted in 2010. Having lost access to money markets, Greece was forced to negotiate successive bailout agreements. Within this unfortunate story, 2015 is a particularly notable year, as the task of rescuing the country came to rest significantly on the shoulders of the ECB, earning the central bank (depending on who you ask) the aura of hero or villain. The key decision to stop accepting Greek bonds as collateral for central bank borrowing and the squeeze on Emergency Liquidity Assistance (ELA) to the Greek banking sector created an arguably inevitable, but still hugely problematic, economic contraction, and it was Draghi’s call.

A key question is whether the ECB could have addressed Greece’s funding needs outside the Troika support mechanism? Theoretically, Greece could continue to finance itself via the ECB even in the absence of organised creditor support, while still lacking market access. The way this could work would be via selling state bonds to commercial banks, which then deposit those bonds as collateral with the ECB in order to access the cash needed to pay for these same bonds. This circular form of financing is possible and affordable as the interest charged by the ECB is much lower than any available commercial rate.

The ECB blocked this route however and pressured Greece, Ireland, and Portugal each to seek bilateral rescue loans and European Financial Stability Facility (EFSF)/ European Stability Mechanism (ESM) funds rather than use their banks and ECB credits to finance their deficits. The ECB took the position that the liquidity needs of banks (specifically those that did not have sufficient collateral) would need to be satisfied through the relevant national central bank, by means of ELA. Greek banks therefore could no longer deposit state bonds as collateral for borrowing from the ECB, they could only deposit them with the Bank of Greece (BoG) (which accepted lower rated paper), but whose credit supply capability was limited by the amount set by the ECB as the ceiling for ELA.

What in fact happened through 2015 is that the ECB tried to keep the Greek banking system running, but on a low gear, via carefully rationing ELA. This was politically controversial at the time, due to the lack of transparency of ECB decision making and augmented by a lack of consistency and the lack of clarity about the rules governing the operation of ELAs. Did it work out in the end? The answer to this question depends on whether one is more interested in a stable and strong Euro, or the effects of a prolonged recession in the country in question.

Let us put the question differently. Were ECB decisions technically coherent, but politically unwise? The ECB has given to many the impression of going about systematically shutting down funding avenues for the Greek government by first dis-allowing state bonds from being submitted as collateral for bank borrowing and then keeping ELA under a short leash. This has been widely condemned as being politically motivated, aiming to put pressure on Tsipras’ government to cave to the demands of the Eurogroup, leaving Troika bailouts as the only adequate source of government funding. But, what else could they, or should they have done? Allowing back door financing would defeat the prohibition against state financing (Art 123 TFEU). Allowing misuse of ELA in a bankrupt banking system would threaten the coherence of Target 2. Pleasing the Greeks would upset the Germans. In the end the ECB did ‘whatever it takes’ bringing its powers to the wire. They are now one judgment away from breaching the Treaties as they currently stand. The question becomes: will Draghi cross the line for his compatriots?

To summarise, what have we learnt from ECB interventions in Greece during the crisis years? When things went wrong for the Eurozone, as the financial crisis morphed into a sovereign debt crisis, the ECB did what it could, but without exposing itself too much for the sake of any particular crisis-afflicted Eurozone member. The ECB pulled away from Greece when the country failed to meet its bailout obligations and then systematically tried to decouple from the Greek problem, without however doing anything drastic enough to split the Euro. The implication for Italy is clear. Draghi will not bail out Italy if that means endangering the Euro. If Italian banks find themselves in a liquidity crunch and the state cannot borrow from the markets, one should not assume that the ECB will fill the gap. Keep your eyes on those spreads, this ride is about the get bumpy.

*Dr Ioannis Glinavos is a senior lecturer at the University of Westminster