Christine Lagarde Can't Solve the Covid-19 Crisis

(Bloomberg Opinion) -- Christine Lagarde spooked markets seven weeks ago by saying that the European Central Bank wasn't there to close the spread in yields between government bonds of euro area countries. On Thursday, the ECB president did everything she could to convince markets of the opposite.

In a tense press conference, Lagarde chose to read from a script to avoid any communication mishaps. The message was simple: Whatever happens during the Covid-19 epidemic, the central bank will adjust its financial instruments to make sure that governments can keep funding themselves at reasonable rates and banks can keep pumping credit into the real economy. The debt market took heart and most government bonds rallied on the day.

This time, the ECB chose to act only in relation to the banking system. It improved the terms on its existing rounds of cheap loans to banks (known as targeted longer-term refinancing operations, or TLTROs), cutting the funding rate by 25 basis points to as low as -1%. And it launched a new accompanying scheme to be used to address the pandemic (PELTROs), which will lend money at as little as -0.25%. The money provided by these schemes isn't meant to stay at the banks, Lagarde said; it's for “financing the real economy.” It remains to be seen how well this mechanism will work.

Her messaging on ECB asset purchases was possibly even more significant. Since the start of the crisis, the central bank has increased the size of its Quantitative Easing program, and launched an additional, pandemic-related bond-buying program, worth 750 billion euros ($820 billion). Lagarde didn't make any changes to these schemes on Thursday, but she stressed she was ready to use the flexibility within the pandemic asset-purchase program to increase its size, expand its duration and broaden its composition. The ECB hinted it would be willing to consider buying junk bonds, after starting to buy Greek debt. The hope is that this will comfort the markets, which were rattled by Fitch Ratings' decision this week to downgrade Italy to BBB-, one notch above junk status.

The central bank is right to do all it can to support the monetary union. On Thursday, fresh data showed the euro zone economy shrunk by 3.8% in the first quarter when compared with the previous three months. The central bank forecasts gross domestic product in the bloc could shrink by as much as 12% in 2020. Moreover, yearly inflation fell to 0.4% in April. The ECB has a mandate to keep inflation “below but close to 2%,” so there's a compelling case for keeping monetary policy as loose as possible.

Unfortunately, while the ECB can try to stop outright deflation and prevent a sovereign debt crisis, it's in no position to deliver a sustained economic recovery. Take Thursday's extra steps to encourage lending: Banks may still decide to be conservative because of the fear that investors will question the strength of their balance sheets if they lend too freely to struggling businesses and individuals. Bank managers know they cannot afford to accumulate too many non-performing loans on their books or they will be in trouble once the crisis is over.

There's another problem. The ECB is doing a good job of keeping borrowing costs low for weaker euro-area economies by buying their debt and thereby protecting their bond yields. That helps create fiscal space for much-needed spending. But governments such as Italy and Spain will still be very mindful of the risk that investors might lose confidence in their ability to service their spiraling debts — if not now, then maybe in the future. That will limit their confidence in spending enough to support companies and individuals.

The European Union wants to create a “Recovery Fund” to help the neediest nations, but there's no agreement yet over whether this will take the form of grants, or merely loans. If it's the latter, as Germany and other fiscally conservative countries would prefer, there will still be grave doubts about whether the southern European nations will be able to cope with their massive post-coronavirus debts.

The situation might get even more difficult next week, when Germany's Constitutional Court decides on the legitimacy of the ECB's original asset-purchase scheme. The judges could rule that QE infringes on the ability of the German parliament to oversee public spending. Such a decision would be yet another reminder that, for all its extraordinary power, the central bank is only a part of the euro zone's multifaceted institutional structure. Lagarde is telling investors to trust her. The real question is for how long they can ignore everything else.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ferdinando Giugliano writes columns on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.