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(Bad) Arguments Against Debt Monetization

November 21, 2011 Leave a comment Go to comments

I think it is useful to list, and assess, the main arguments advanced against an enhanced role of the ECB as a lender/buyer of last resort. I can think of four of them: credibility, inflation, irrelevance, ineffectiveness.


The first and most common is that the no-bail-out clause prevents the ECB from acting as LOLR, and that breaching the Treaty provisions would make the ECB action non credible. Mario Draghi insisted on the issue of credibility in a recent speech, reasserting the main focus on inflation that should guide the ECB.  This argument can be easily dismissed: What harms more credibility, an ECB stubbornly following a wrong rule and contributing to the eurogeddon, as Krugman calls it? Or effective action to defuse the debt crisis, even at the price of going against Treaty provisions? Furthermore, if a rule is wrong, the right and credible  thing to do is to change it, however difficult this may be. Giving constitutional strength to the rules governing monetary (and fiscal) policy was a mistake that, among many others I pointed out well before the crisis in a paper written with Jean-Paul Fitoussi in 2004:

[The EMU] setup is no accident. It reflects the neo-liberal doctrine that prevailed in the early 1990s according to which the areas of competition and macroeconomic policies have to be been largely as substitutes, with the former being superior in terms of efficiency[…] No surprise then that macroeconomic policy  in the European institutional setting is not at the centre of the stage; furthermore, it is in the hands of technical bodies like the ECB or even worse constrained within the limits of  inflexible rules like the Stability pact. This crystallization of a particular doctrine within economic institutions is a peculiar feature of today’s Europe, and is unprecedented on such a scale. (p. 2, emphasis added)

Besides, even constitutions, especially ineffective ones, may be changed. European countries proved capable of quickly implementing the Treaty changes necessary to introduce the EFSF. Thus, (wrong) Treaty provisions would (and should) not be an alibi for not putting in place a lender/buyer  of last resort for the EMU zone.

A second argument is that debt monetization would be inflationary, and it is hard to see how this could be taken seriously, while our economies are well installed into a liquidity trap, and heading into a double dip. Expectations of higher inflation should today be a policy objective, not a fear. The related claim that the euro would depreciate is also at odds with a situation in which, among other things because of ECB inaction, EMU zone financial markets are increasingly perceived as risky and unattractive by international investors. The strength of the dollar or of the pound does not depend on central bank action against inflation, but rather on perceived safety of government bonds, and medium term growth prospects.

A third, less commonly advocated, argument is that debt monetization is in fact only an apparent solution, because a treasury liability is simply transformed into a central bank liability, and therefore there would be no change at  the government consolidated level.  This argument would be sound only if money and treasury bonds were perfect substitutes, which of course they are not. In the Treatise on Money (1930!) Keynes had already explicitly stated this:

When . . . what was merely a debt has become money proper, it has changed its character and should no longer be reckoned as a debt, since it is the essence of a debt to be enforceable in terms of something other than itself. To regard representative money . . . as being still a debt will suggest false analogies [with private debt]’ (Keynes, Treatise on Money V 1 , Collected Writings (5), p. 6)

In fact, the Government is not a debtor (nor a creditor) like the others, because it has the power (sovereignty) to decide what to accept from the private sector to pay for tax liabilities:

Government money is different, because it is “redeemable by the mechanism of taxation” (Innes 1914, p. 15): “[I]t is the tax which imparts to the obligation its ‘value’…. A dollar of money is a dollar, not because of the material of which it is made, but because of the dollar of tax which is imposed to redeem it.” (Innes 1914, p. 152) In other words, what “stands behind” the state’s currency is the state’s obligation to accept it in payment of taxes. We can call this sovereign power—the power to impose taxes and to issue that which is accepted in payment of  taxes. (R. Wray, “Keynes’s Approach To Money: An Assessment After 70 Years” The Levy Economics Institute Working Paper  # 438, 2006, p. 15)

Thus, debt monetization transforms it into a liability that is universally accepted, and as such changes its nature. There has been debate as of whether it  ” should no longer be reckoned as a debt” as Keynes said. But it is certainly not of the same nature as treasury bonds, and hence it is by definition more sustainable.

Finally, the fourth and most puzzling objection to debt monetization is that the ECB already massively intervened in secondary markets, but was ineffective in stopping speculation. This criticism neglects a major objective of the lender of last resort, which is precisely of preventing speculation from happening in the first place, simply because of its availability. The very fact of stating that unlimited purchases of public debt would be carried out, if necessary,  anchors expectations, defusing speculation and hence making actual intervention unnecessary. The strategy chosen by the ECB has actually been the opposite: massive purchases, coupled with a communication strategy emphasizing that this intervention would be limited in size and in time. In his first press conference as president of the ECB, Mario Draghi explicitly stated that

The Securities Markets Programme (SMP) always has had, and was meant to have – as it has been stated since the very beginning – three characteristics. First of all, it is temporary. Second, it is limited in its amount and, third, it is justified on the basis of restoring the functioning of monetary policy transmission channels. So we should keep this in mind because this in a sense answers all the questions that one might have. The relationship with conditionality should be viewed from this perspective. We want our monetary policy to function. And I think that is where the main justification for the SMP lies.

The ECB has therefore managed to pick the worst equilibrium: it needs to actually buy large amounts of sovereign debt (for a total of almost €200 bn, mostly Italian and Spanish),  while it is ineffective in contrasting speculation and yield increases. The contrast with the British case makes the point very clearly, as speculation is deterred by the role of LOLR played by the Bank of England, which therefore ends intervening less than the ECB.

 

I am still looking for a fifth, and more convincing argument against debt monetization…

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  1. November 24, 2011 at 6:33 pm

    Perhaps the first objection deserves greater support. The ECB lacks the legal competence to act as a lender of last resort. The benefits awaiting overwhelming and immediate action by the ECB may well be substantial. The immediate cost of such action, relative to the probably benefit, seems small. The long term costs, however, may be substantial.

    The ECB could well do what is necessary and ignore its institutional constraints. In the long-run, however, such a strategy may prove miscalculated. If the ECB refuses to cross treaty-drawn lines, then they will force the politicians to rework treaties in a way that grants the ECB the competence to address not only the present crisis, and that also institutionally prepares the ECB to orchestrate orderly responses to future crises. The benefit of such preparedness, I think, probably outweighs the current cost to the ECB of letting the politicians and their voters squirm for a little while longer.

    As Rahm Emanuel once said, “never let a good crisis go to waste.”

  1. June 14, 2012 at 10:29 pm
  2. September 7, 2012 at 4:56 pm

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