The Eurozone economy registered near-zero growth in the final months of 2019, which went unnoticed in Ireland, where things have gotten better these last few years. Aside from the sluggish performance, there are two hangover problems in continental Europe, weaknesses that should have been repaired after the financial crisis. The banking system remains fragile, with bad debts, not all acknowledged, lingering on the balance sheets of big lenders across the continent and a continuing failure to reform the architecture of the common currency to turn it into a full monetary union.

The Italian economy is contracting sharply

These problems combine most dramatically in Italy, where decades of political failure have seen the state debt drift ever upwards relative to economic output, undercapitalised banks are allowed to survive unbothered by reform and over-invested in Italian government debt and all against the backdrop of an economy that has delivered no serious economic growth since the 1990s.

Sod’s Law has ordained that the European country hit hardest by the coronavirus has turned out to be Italy, where the capacity to handle the damage is least. The Italian economy is contracting sharply, the budget will go heavily into deficit and the bond market is paying attention, since Italy has more debt outstanding than any other economy in Europe.

ECB uncertainty

There has been a blow-out these last few weeks in the differential between Italian and German interest rates – Italy pays a premium, and the premium gets bigger the more nervous investors become about the country’s ability to finance itself.

In recent years, the heavily indebted Eurozone countries – including Ireland and Italy – have enjoyed much lower interest rates on government bonds, which has made budget management easier. In Ireland’s case, this has partly reflected better economic performance, but both countries have been beneficiaries of the European Central Bank’s willingness to buy the government bonds of Eurozone members.

Large spreads between the benchmark German bonds and those of the more indebted members bring the durability of the common currency area into question – the interest rates they had to pay back in 2010 forced Greece, Ireland and Portugal to withdraw from selling debt altogether and into Troika lending programmes with European institutions and the IMF. There was explicit talk of the Eurozone breaking up and weaker members being ejected. Greece defaulted on its sovereign debt.

This policy has not been popular with some of the northern European countries

Support for the bond market by the ECB was part of the remedy. This policy has not been popular with some of the northern European countries, notably Germany, and the ECB had begun to scale back on these purchases until economic weaknesses emerged in 2019. The appearance of ?COVID-19 means that the Eurozone economy is declining, government budgets are heading for big deficits and the bond market has been spooked. Italy’s interest rate penalty began to widen a couple of weeks ago and in these circumstances, the ECB needed to say and do the right thing. Instead, Christine Lagarde, the new ECB president, screwed up rather badly at a press briefing in Frankfurt last week.

“I don’t think anybody should expect any central bank to be the line of first response,” she remarked, apparently unaware that this is precisely what the markets had been conditioned to expect from ECB interventions in earlier years.

Lagarde sought to amend the situation later, but the damage was done

When the integrity of the common currency was threatened back in July 2012, her predecessor Mario Draghi, when asked what the ECB would do if faced with the same threat, answered “whatever it takes”, and had to do very little as a result. Lagarde sought to amend the situation later, but the damage was done and the Italian bond market bombed out. Lagarde was French finance minister during the previous crisis and later became managing director of the IMF, so cannot plead unfamiliarity with the perils of press conferences and central banking.

Recession

The Eurozone governments will be running much looser budget policies than they intended because of the COVID-19 recession, which is already under way. The imperative, in the absence of any cohesive budget strategy at European level, is that the ECB should push its mandate to the limit to keep the Eurozone intact and I have no doubt that Lagarde understands this.

The trouble for Ireland is that the road from Lagarde’s gaffe last week to a rational ECB response could be drawn out

There will be more bond-buying in due course, unless the German political class really wants the Eurozone to fracture.

The trouble for Ireland is that the road from Lagarde’s gaffe last week to a rational ECB response could be drawn out, with Irish bonds coming under pressure and a failure to cement the progress in the public finances into a decisive re-classification of Ireland into the northern club of committed Eurozone adherents.

The option to get the budget decisively into surplus through the recent recovery and the outstanding debt on a downward trajectory was available. It was eschewed in the pursuit of plaudits from a grateful electorate. That worked out well.