21 July 2022

LSE: Assessing the ECB’s new Transmission Protection Mechanism

The European Central Bank is set to unveil a new tool, the Transmission Protection Mechanism, which it hopes will protect states in the eurozone from escalating borrowing costs. Anthony Bartzokas, Renato Giacon and Corrado Macchiarelli argue there should be close coordination with the EU’s RRF.

In the wake of deteriorating capital market trends, rising energy and food prices, and the war in Ukraine, policymakers in the eurozone face a difficult balancing act of trying to regain monetary and fiscal space without stifling Europe’s fragile economic recovery from the Covid-19 pandemic.

For fiscal policy, in particular, there is a growing consensus that policy should remain neutral – or even slightly contractionary – in the short term to aid efforts by the European Central Bank to tame the war’s inflationary pressures. At the same time, it is necessary to deliver targeted and temporary support to households most affected by the squeeze in real incomes.

The ECB has recently entered a tightening cycle following – with some delay – other major central banks, including the Bank of England and the US Federal Reserve. It is now pivoting toward more aggressive rate hikes in anticipation of higher inflation, and it is widely expected to begin normalising rates between July and September.

In addition, one important element of the ECB response to the war in Ukraine (which builds partly on its response to the Covid-19 pandemic) has been to give itself extra flexibility and discretion in buying eurozone sovereign bonds to help combat the widening of sovereign spreads and negative second round effects in the real economy, particularly in Italy. It has done so through the development of a new anti-fragmentation tool, the Transmission Protection Mechanism.

Yet, this new tool is problematic for two reasons. First, monetary policy is not designed to deal with regional differences; rather it should aim to meet a target for inflation over the eurozone economy as a whole. It then follows that – if we are prepared to accept that the eurozone is an ‘optimal currency area’ in the first place – ECB policy should not be redefined to meet intra eurozone regional macroeconomic differences.

Second, providing even more uncapped fiscal insurance via the European Central Bank will likely lead to even more moral hazard for individual governments. This issue leads us to the question of what role monetary-fiscal policy coordination should have in the eurozone. We have explored this in NIESR’s forthcoming Global Economic Outlook.

At the peak of the eurozone crisis in 2012, the ECB also unveiled a new tool, Open Market Transactions (OMTs), where the ECB agreed to buy a country’s sovereign debt as long as that country’s government agreed to strict conditionality. However, the conditionality attached to the programme, i.e., the need to negotiate a programme of reforms with the European Stability Mechanism (ESM), proved sufficiently onerous and politically difficult to prevent any member state from requesting it....

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