Markets and Debt Monetization
Countries like the United States, Japan or the United Kingdom can finance their debt at zero or negative real interest rates. This in spite of debt levels higher than those of the euro area, and growth forecasts that are not necessarily better. Meanwhile, the eurozone peripheral countries have to deal on a daily basis with the mood of markets, and to pay interests on debt at the limit of sustainability.
The reasons for this state of affairs are clear, and have been repeatedly mentioned. Eurozone countries are forced to borrow in a currency that they do not issue: the euro is in effect a foreign currency. To quote Paul de Grauwe,
In a nutshell the difference in the nature of sovereign debt between members and non-members of a monetary union boils down to the following. Members of a monetary union issue debt in a currency over which they have no control. It follows that financial markets acquire the power to force default on these countries. This is not the case in countries that are no part of a monetary union, and have kept control over the currency in which they issue debt. These countries cannot easily be forced into default by financial markets.
In other words, peripheral eurozone countries are in the same situation of Latin America in the eighties: they are forced to pay high risk premia to markets fearing the risk of default, induced by the vicious circle austerity-recession-debt burden.
The solution of this eurozone “structural problem” also seems rather consensual, at least among non ideologically biased economists: As long as eurozone countries continue to borrow in the equivalent of a foreign currency, they will be subject to market risk, that no EFSF-ESM-you-pick-the-acronym fund would have enough resources to eliminate. The only possibility to stop speculative attacks is to transform the euro in the domestic currency of eurozone countries, i.e. to endow the ECB with the prerogatives that all the central banks of sovereign countries have, namely that to use its possibility to issue money to guarantee the debt of member countries. If markets were certain that the ECB stands ready to monetize government debt that they are unwilling to subscribe, the risk of default would be immediately reduced to zero; the rates of solvent countries would then drop in a few hours to the levels that we observe in the U.S. or the UK, with obvious positive effects on the long-term sustainability of public finances.
This does not mean that debt monetization would be costless. Significant increases in money supply could, when economic activity resumes, be inflationary. But on the one hand we can have confidence in the ECB’s capacity to absorb excess liquidity when necessary; and on the other hand, the possibility of future inflation seems a very minor problem, if compared with the clear and present danger of implosion for the euro area.
But if the problem is clear, and on the solution we observe growing consensus, why don’t we do it? Besides the objections I already discussed a while ago, the dissenting voices on debt monetization are based on a formal argument, and a substantive one. Let’s consider the latter first: a central bank that had the ability to monetize the public debt of member states would lose independence and credibility. However, it seems wrong to assume that the only way to guarantee the independence of the ECB is to limit its capacity to act. I find it difficult to understand how an expansion of the prerogatives of the ECB may limit its independence, unless one had no confidence in the institution, nor in persons who embody it. The ECB has shown in the past to be able to fulfill its mandate without bending to external pressure. Why then, the mere possibility (not the obligation) of buying government securities should mean that the ECB will do it every time a government or the European Council asked it to do so?
As for the formal objection, it goes as follows: the treaties forbid the purchase of government bonds by the ECB, and the time it would take to put in place treaty revisions is not compatible with the urgency of the crisis. It seems to me that this objection should be rejected on two grounds: First, an institutional improvement, if it is such, should be implemented regardless of the situation. At worst, if it comes too late for the current crisis, the reform would be helpful for the future. Moreover, and more importantly, one should keep in mind that we are dealing with markets and expectations: it would be sufficient that the next European Council meeting on June 28 committed to speedily reform the treaties in order to allow the purchase of government bonds by the ECB, while at the same time solemnly declaring that during the transition it would not object to to unlimited purchases on secondary markets (already permitted). This would introduce a de facto guarantee of eurozone government debt, that while waiting for the de iure treaty changes, would be more than enough to ease market tensions.
Let me underline, in conclusion, that giving the ECB the opportunity to buy debt of eurozone countries, paradoxically, could lead to a less active role for our central bank. The mere existence of a guarantee on sovereign debt would be enough to change market expectations and to make sovereign debt appealing. The ECB could then withdraw from the front line, and retrieve its role of simple regulator of the eurozone macroeconomic activity. I had already made the point, but it does not harm to repeat it…