Safe and Risky Sovereigns in the Euro Area Capital Market: Financial Drivers of Fiscal Policies in Germany and Italy

Abstract

This article extends the literature on the varieties of capitalism within the Economic and Monetary Union of Europe with an analysis of the financial drivers of fiscal policies in creditor and debtor countries from the euro crisis up to the coronavirus pandemic, with an application to Germany and Italy. Market perceptions of sovereign creditworthiness, as grounded in national political economies, cause a persistent segmentation of the euro area capital market between peer countries regarded as safe or risky. As a consequence, cross-border capital flows have an asymmetric effect on the public and private finances of creditor and debtor countries, adding to the asymmetric impact from their economic growth models. These financial asymmetries interact with public opinion and are in turn endogenous drivers of political choices for or against fiscal discipline and of political preferences for a stable domestic investor base of public debt. A common safe asset for the eurozone is necessary to mitigate the asymmetric systemic risks from volatile capital flows and establish a symmetric financial driver of steady output growth, fiscal soundness, and financial stability. This common mechanism for endogenous stabilisation would help to sustain euro area capital market integration and support the long-term viability of the euro.

ACKNOWLEDGEMENTS

The views expressed in this article are those of the author and should not be reported as representing the views of UNU-CRIS. Comments and suggestions from Ton Notermans and Simona Piattoni as well as from two anonymous reviewers are gratefully acknowledged.

DISCLOSURE STATEMENT

No potential conflict of interest was reported by the author.

ABOUT THE AUTHOR

Ad van Riet is Associate Research Fellow at the United Nations University Institute on Comparative Regional Integration Studies (UNU-CRIS), Bruges, Belgium. He studied Economics at the Erasmus University Rotterdam and holds a PhD from Tilburg University in the Netherlands. He started his career with De Nederlandsche Bank in mid-1987, joined the European Monetary Institute in end-1994 and the European Central Bank (ECB) in mid-1998. At the ECB, he held several management positions in the Directorate General Economics and he was Senior Adviser in the Directorate Monetary Policy and Secretary of the ECB Occasional Paper Series until end-2018.

Notes

1 The word ‘sovereign’ in this context stands for the (central or federal) government of a country that enters the capital market to issue ‘sovereign’ bonds (the equivalent of treasury bonds).

2 The ESM is the euro area’s rescue fund, which was established in 2012 to provide conditional financial assistance to member countries that are confronted with or threatened by severe financing problems that could endanger financial stability of the euro area as a whole.

3 See the article “Euro-Area Reform Plan Held Hostage by Italy-Germany Clash”, Bloomberg, Dec. 5, 2019.

4 A risk-free or safe asset typically refers to a marketable financial instrument that is expected to provide low credit risk, high market liquidity, and a stable nominal payoff. Additional relevant factors are inflation risk and exchange rate risk.

5 Since 2012, the effective interest rate advantage of Germany vis-à-vis Italy has been about 1.3 percentage points. For a public debt ratio of 60 per cent of GDP, Germany thus enjoyed lower annual interest payments in the order of 0.8 per cent of GDP.

6 Although most German policymakers see the record-large current account surplus (which peaked at 8.5 per cent of GDP in 2015-16) as evidence of a successful economic growth model, their export-centred growth strategy could backfire in a more protectionist international environment (Jacoby 2020).

7 De Grauwe and Ji (2018) ascribe this view to the ‘German School’.

8 See the online article “Merkel and Sarkozy Plan ‘True Economic Government’”, Spiegel International, Aug. 16, 2011.

9 See the online article “Italy plans ‘golden rule’ to limit budget deficits”, EurActiv, Sept. 7, 2011.

10 See, for example, the online articles “Italy’s coalition agreement explained”, Politico, May 18, 2018, and “Italy on collision course with EU over budget deficit”, EurActiv, Sept. 4, 2018.

11 The current account of the balance of payments of Italy moved into surplus in 2013 and remained positive, signalling a greater reliance on domestic savings. Alongside, the net international investment position became less negative and approached a balance by the end of 2019.

12 See the online article “Italy’s 5 Stars and League draft coalition deal leaked”, Politico, May 16, 2018.

13 See the online article “Italy Wants ECB to Cancel Pandemic Debt, Conte’s Top Aide Says”, Bloomberg, Nov. 26, 2020.

14 See the online article “Italy says German banking union plans will harm eurozone banks”, Financial Times, Nov. 7, 2019.

15 See Franco-German Declaration, “Statement for the France-Germany-Russia Summit”, Deauville, Oct. 18, 2010.

16 See the online article “Italy Takes Issue With the ESM”, South EU Summit magazine, Dec. 4, 2019.

17 Acharya and Steffen (2017) argue that the envisaged Capital Markets Union for Europe, which aims to mobilise cross-border private sector capital flows, is only sustainable when a fully-fledged Banking Union and Fiscal Union restore the status of national sovereign bonds as risk-free assets. Otherwise, the burden of capital market integration and stabilisation will fall on the ECB.

18 German Chancellor Angela Merkel vowed that there would be “No Euro Bonds as long as I live”. See Spiegel International, June 27, 2012.

19 See the online article “Calls for Corona Bonds Met with Familiar ‘Nein’”, Spiegel International, March 27, 2020.

20 See French Ministry for Europe and Foreign Affairs, “French-German Initiative for the European Recovery from the Coronavirus Crisis”, May 18, 2020, and the online article “Merkel’s milestone moment”, Politico, May 19, 2020.