This blog was established, initially, for the purposes of proposing solutions to the euro crisis; and in particular to propagate our Modest Proposal for Resolving the Euro Crisis. Two and a half years later, the eurozone is crashing and burning, while European politicians are steadfastly refusing to adopt a systemic solution. Those of us who understand the true human costs of the euro’s demise are doing our best to inspire our leaders to act. To adopt any rational solution that might work. Today I am pleased to host another such proposal, authored by Marshall Auerback – a regular guest of this blog.
When the euro was launched, leading German politicians used to argue, with evident relish, that monetary union would eventually require political union. The Greek crisis was precisely the sort of event that was expected to force the pace. But, faced with a defining crisis, Ms Merkel’s government is avoiding airy talk of political union – preferring instead to force harsh economic medicine down the throats of the reluctant Greeks.
Ironically, the very ideals which underpinned the creation of the euro – notably the elimination of the “German problem” once and for all and the corresponding threat to any more wars on European soil – are now being exacerbated by the very institutional structures which arose from these ideals. The immediate problem is that we have a monetary union (common currency) without a fiscal union. It works fine when everyone is expanding, but when recessionary pressures set in, the contradiction makes it impossible to shape harmonious EU wide counter-cyclical fiscal and monetary polices. (Another related problem is that the EU expanded far too rapidly, especially in recent years.)
But the increasing tensions now manifest in the current financial crisis paints a picture of a continent increasingly marked by divergence with old historical enmities re-emerging. This suggests that the creation of a supra-national fiscal entity, however institutionally elegant it might appear, is probably unworkable in the current economic climate (especially given that it would likely represent nothing more than a “United States of Germany” with a European accent).
But dissolution of the euro zone appears equally unlikely and potential heralding even great economic instability. Enter the European Central Bank: With little fanfare, the ECB has been responding to the EMU’s solvency mess by conducting large-scale bond purchases in the secondary market (which, unlike direct purchases of government debt, is not contrary to the Treaty of Maastricht rules) for the debt of the EMU nations.
But there is a better and more transparent way: The proposal is for the ECB to create and then distribute trillions of euros annually to the national governments on a per capita basis. The per capita criteria means that it is neither a targeted bailout nor a reward for bad behavior. In fact, as the largest economy, Germany would get the largest distribution of euros from the ECB. This distribution would immediately adjust national government debt ratios downward, which eases credit fears without triggering additional national government spending. This serves to dramatically ease credit tensions and thereby foster normal functioning of the credit markets for the national government debt issues.
The trillions of euros distribution would not add to aggregate demand or inflation, as member nation spending and tax policy are in any case restricted by the Maastricht criteria. The SGP should be upheld in order to prevent the ‘race to the bottom’ whereby the most fiscally profligate derive the largest benefits. Furthermore, making this distribution an annual event greatly enhances enforcement of EU rules, as the penalty for non-compliance can be the withholding of annual payments. This is vastly more effective than the current arrangement of fines and penalties for non-compliance, which have proven themselves unenforceable as a practical matter.
There are no operational obstacles to the crediting of the accounts of the national governments by the ECB. What would likely be required is approval by the finance ministers. In theory, there should be no reason why any would object, as this proposal, which will enhance the SGP, serves to both reduce national debt levels of all member nations and at the same time tighten the control of the European Union over national government finances.
Additionally, it’s not inflationary, as it mere substitutes national bonds with reserves in the banking system and building banking reserves is not inflationary. This is confirmed by no less an authority than the BIS. So an essential part of the argument is the build-up of bank reserves is inflationary.
The BIS authors write (http://www.bis.org/publ/work292.pdf?noframes=1):
The proposition that highlights the inflationary consequences of financing via bank reserves is closely related to the first. If bank reserves do not contribute to additional lending and are close substitutes for short-term government debt, it is hard to see what the origin of the additional inflationary effects could be. The impact on aggregate demand, and hence inflation, would be very similar regardless of how the central bank chooses to fund balance sheet policy. For example, it is not clear how inflationary pressures could be more pronounced in a banking system that keeps its liquid assets in the form of overnight deposits at the central bank compared to one that holds one-week central bank or treasury bills.
The same would apply to concerns about the “monetisation” of government debt, whereby the central bank purchases government bonds either in the primary or secondary market. Here the issue is whether the financing of government expenditures through the creation of bank reserves, quite apart from the boost to aggregate demand associated with expansionary fiscal policy, would lead to inflation or not.
First, one can see that while the BIS authors understand the operations of the banking system they are not operating within a classic modern monetary theory paradigm. The use of terminology such as “financing medium” tells you that. The use of this terminology, while conventional among bankers such as this, is highly misleading. The central bank does not “finance” government spending by creating bank reserves. Bank reserves are created by public spending which, as we discussed above, present the central bank with some choices depending on its monetary policy stance. The monetary operations conducted by the central bank are not “financing” operations but rather they are correctly understood to be liquidity management operations.
Further, the idea that the central bank can monetise public spending and maintain a positive interest rate target (and pay a support rate below the policy rate) is impossible. If the central bank tried doing this, the competition in the interbank market as banks tried to shed their excess reserves would lead to the central bank losing control of its policy rate. It would have to sell public debt to drain the excess reserves or increase the support rate on excess reserves to the policy rate. You will not get an understanding of this sort of reasoning in any mainstream macroeconomics textbook or research article.
Second, it is easy to show that an expansion of bank reserves will not increase bank lending. The idea that it would is based on the flawed understanding that banks need reserves before they will lend. Categorically, they do not. Mainstream macroeconomics textbooks are completely wrong in that regard.
In this context, it is essential to understand that the analysis of inflation is related to the state of aggregate demand relative to productive capacity. Credit growth manifests as increased spending. In itself that is not inflationary. Nominal spending growth will stimulate real responses from firms – increased output and employment – if they have available productive capacity. Firms will be reluctant to respond to increased demand for their goods and services by increasing prices because it is expensive to do so (catalogues have to be revised etc) and they want to retain market share and fear that their competitors would not follow suit.
So generalised inflation (as opposed to price bubbles in specific asset classes) is unlikely to become an issue while there is available productive capacity. Even at times of high demand, firms typically have some spare capacity so that they can meet demand spikes. It is only when the economy has been running at high pressure for a substantial period of time that inflationary pressures become evident and government policy to restrain demand are required (including government spending cutbacks, tax rises etc).
Further, spending growth can push the expansion of productive capacity ahead of the nominal demand growth. Investment by firms in productive capacity is an example as is government spending on productive infrastructure (including human capital development). So not all spending closes the gap between nominal spending growth and available productive capacity.
What about the legal issues? Questions have indeed been raised both about the ECB’s ultimate solvency and the legal constraints which govern its mandate. To deal with the solvency issue first: has anyone bothered to ask themselves what the concept of solvency means for a central bank that creates its own money? Wilhem Buiter has addressed this point many times, but if one takes the 30 seconds required to ponder this question, surely we can understand that the concept of solvency is totally and thoroughly irrelevant to a central bank with a sovereign currency (i.e. not convertible on demand into a fixed quantity of other currencies or a commodity).
The ECB and others who resist its involvement in the salvation of the common currency continue to think and act as if it is a central bank operating under a gold standard. That is insane, and certifiably so.
In regard to the legal requirements:
- The ECB does not have a statutory minimum capital requirement.
- It transfers profits to national governments but in times of losses is can only request a capital injection should its capital be depleted.
- The European Council (which is representative of elected governments) is not compelled to accede to this request.
- Hence, the ECB is a perfect balance sheet to warehouse risk since its losses need not become fiscal transfer as it can rebuild its profits via seigniorage over a number of yrs. In that sense, its role is analogous to that of the Swiss National Bank effectively warehoused its Swiss banks’ bad paper during the height of the crisis in 2008.
Of course, the ECB would HATE this and the risk is that its losses would limit its willingness to maintain its bond buying program. But it remains the only game in town. The bond buying is precisely what gives them leverage and, paradoxically, preserves the quality of its balance sheet, since the purchases themselves ensure that the distressed bonds of countries such as Greece do not lose value because the ECB prevents them from defaulting. In fact, the ECB effectively uses the income of the Greeks (and others) to rebuild its capital base. The minute the EFSF is introduced, along with the notion of haircuts, the ECB loses its leverage and the credit risk contagion shifts to the core countries of the EU, which WILL threaten their AAA ratings.
It also means this whole issue of banking recapitalisation is a big red herring. In reality, banks don’t really need recapitalisation. What most depositors care about is being able to get their deposit money out of their bank, so whether they are solvent or not is not their primary concern. Arguably, all of the US banks were insolvent in 1982, but the FDIC guarantees worked to stabilise the system.
Bank capital is always available at a price. The ‘market process’ is for net interest margins to widen to the point where earnings attract capital. Except this all assumes credit worthiness isn’t an issue.
The problem with current policy is that it is turning both the public and private sector into a ‘credit event’ which will make it extremely difficult for the borrowers to switch lenders.
In the current environment you have a solvency crisis which is feeding into the banking system because a large proportion of their assets are euro denominated government bonds. Going down the path of “voluntary” hair cuts and forced recapitalization will simply set off a massive debt deflation spiral. We will see bank’s fire selling assets left and right – management will not issue equity at these miserably low price to book values. Which in turn will depress economic activity even further, widen the very public deficits which are so exorcising the Eurozone’s policy making elite, and bring us back to Square One. Already the guns are being turned on Italy, now that Greece is on the threshold of being “solved”.
It also helps with their problem of enforcing the growth and stability pact which, whatever one thinks of the questionable economics underlying it, was the only way that the concept of the euro could have been sold politically in Germany.
Politically one suspects that the Germans might ultimately find the revenue sharing proposal more palatable on a number of grounds. Arguably, the revenue sharing proposal would enhance the SGP and thereby help to entrench Germany’s “stability” culture in the euro zone. Furthermore, as noted above, it does not violate the “no bailout” rule (in fact, Germany is the biggest recipient of the funds if it’s done on a per capita basis). Even if you said the money credited to the national central banks could only be used to retire existing public debt (which is the only way you could sell it politically in Germany), you would deal effectively with the national solvency issue.
Think of it like a rights issue for a heavily indebted company: Company X has a debt to equity ratio of 200% and the markets won’t fund it because of perceived solvency concerns. Somehow, said Company X launches a 1 for 1 rights issue and gets the debt to equity down to 100%. Market concerns about bankruptcy are alleviated and the capital markets open up to the company again. Likewise if you do the revenue sharing. You don’t solve the problem of aggregate demand, but you reduce the solvency concerns and reopen the capital markets to the euro zone countries again.
And the other way you sell it to the German public is that (as Wolfgang Munchau of the FT has rightly argued), it makes the SGP more credible and enforceable because now you are providing a mechanism to ensure compliance. Rather than fining a miscreant company (try getting an EU official to go to Athens to collect a fine today for violating the SGP; he’d be lucky to get out alive), you withhold funds.
Credit the national central bank accounts to a sufficient degree to bring the ratios down to, say, 60% levels required by the SGP and then enforce it rigorously. Yes, there is no economic logic to the SGP, but it’s the only way you’d ever get the Germans to agree to this proposal and, in any case, a 3% deficit in a normalised economic environment does give you some growth. You could still cut off the “profligates” such as Greece if you thought they weren’t complying or enforcing desired “structural reforms”, but eliminate the contagion risk by continuing to credit other countries (and let’s be honest: other than the die-hard Hellenist romantics, nobody in the euro zone could care less what happens to Greece except insofar as it creates contagion threats for other members of the euro zone).
To repeat: the revenue sharing proposal would be non-inflationary. What’s inflationary with regard to monetary and fiscal policy is actual spending. These distributions would not alter the annual actual government spending and taxing as demanded by the austerity measures and ongoing growth and stability pact. They simply address the solvency issue, which has effectively cut the PIIGS off from market funding (because the markets believe they are insolvent).
Under the proposal, member nations remain bound to their current spending and taxing imperatives. Bonds get retired and replaced with reserves, which we know does not lead to inflation either because reserves aren’t lent out.
The problem with the European Financial Stability Fund (EFSF( solution is that the EFSF only has a limited life and the German Constitutional Court decision means that you cannot replace it with a permanent mechanism, such as the proposed ESM
And the EFSF is a dishonest fig leaf, since all of the money ultimately comes from the ECB anyway, as the sole creator of euros. The ECB is probably ill-suited to conduct quasi-fiscal operations over the longer term, but it’s the only game in town now. Everybody now recognizes that fact. At least the operations under the revenue sharing proposal are conducted with a clear set of consistent rules, rather than the discretionary, non-transparent manner in which the ECB is conducting its bond buying operations right now. It’s an effective interim mechanism (which won’t violate the German Constitutional Court), but provides the euro zone time to develop a fully fledged fiscal union with debt issuance power, which is ultimately what is required.
Yes, this idea seems radical, but two years ago, so too did the idea of buying sovereign debt in the secondary markets by the ECB. During the panic of May 2010, the ECB bought €16.5 billion the first week, €10 billion the second, and €8.5 billion, €6.50 billion, €4 billion, and €4 billion for each successive week, ending with €1 billion for its last real week of activity on 9 July 2010 for a total of €54.5 billion seven weeks of operation.
Since the week of 4 August, it purchased €22 billion the first week, followed by €14.3 billion, €6.6 billion, €13.3 billion, €13.9 billion and €9.8 billion last week for a total of nearly €80 billion in six weeks. This represents about €13.3 billion per week, i.e. over 71% higher than the weekly purchases begun in May 2010, as Erwan Mahe, the author of “Thaler’s Corner, has recently highlighted in his research.
Longer term, you clearly will need a fiscal union of sorts.
Let, us consider the case of a federal country, such as Canada, for a moment. Imagine that the two largest Canadian provinces, Ontario and Quebec, were independent countries. If this were the case, their debt burdens would consist of their existing debts plus their respective shares of the federal debt (about 23% for Quebec and about 40% for Ontario). Their capacity to repay those debts would be determined by their respective tax bases – i.e. each province’s nominal GDP.
How would those debt burdens look? Answer: probably not very good. In fact, as the Canadian brokerage house Brockhouse Cooper has pointed out,
Ontario and Quebec would each be more indebted than Spain (albeit slightly less than Portugal). This reflects the significant social spending responsibilities of the Canadian provinces, which are responsible for healthcare and education – the two largest government expenditure items in Canada. Naturally, these spending commitments are funded via fiscal deficits and debt issuance.
Quebec and Ontario are also somewhat similar to Spain and Portugal in that they do not control the currency in which they issue debt (the Canadian dollar, controlled by the Bank of Canada – a central bank that is, in turn, controlled by the federal government). So, given the poor fiscal fundamentals and inability to print money, surely bonds issued by Ontario and Quebec should trade in line with bonds issued by Spain and Portugal? Wrong – yields on 10-year Ontario and Quebec bonds are significantly lower than yields on Spanish or Portuguese bonds.”
So, why are Canadian provinces getting away with high debt loads and the inability to print money? Because of fiscal federalism and the pooling of risk within the Canadian monetary union. There is an implicit understanding that the federal government will rescue any Canadian province that runs into trouble in the bond market, which provides a strong indication that the monetary union is also complemented by a robust fiscal union.
If Europe did opt for this solution, the creditworthiness of each country would be aggregated into that of the broader Eurozone. This would be credit-positive for the entire region, since the overall debt burden of the Eurozone is not much higher than that of the United Kingdom or the United States. The joint-and-several guarantee, coupled with robust fiscal rules, would make Eurobonds more or less similar to the bonds issued by the most creditworthy entities within Europe.
But that’s a multi-year project. In the meantime, you need a credible plan to address the immediate market concerns of growing national insolvency perceptions in the euro zone (which are gradually spreading to the core). The ECB has to be the entity that leads this effort, much as it hates the idea and much as the Germans likely despise it. That’s the real story behind the Stark resignation and the public fury now featuring so prominently in the German press and parliament.
It is indeed politically problematic that the policy of revenue sharing is being left in the hands of a bunch of politically unelected bureaucrats in Frankfurt, but the reality is that the ECB is now the sole institutions standing between the system collapsing or muddling through. There is no fiscal counterpoint.
And maintaining the SGP eliminates the “free rider” problem, since it will preclude rewarding the biggest spenders – who will issue the most government bonds, which can then be bought by the ECB in the secondary market. Maintaining the SGP means that the ECB can eliminate this moral hazard problem simply by indicating to miscreant countries that it will refuse to buy their debt in the secondary markets if it does not continue to adhere to “responsible” fiscal policy. By embracing this quasi-fiscal role, the ECB in effect becomes the “United States of Europe” until a genuine fiscal authority is formed. The ‘distributions’ the ECB will make will be via buying enough national government debt in the secondary markets to keep the national governments solvent and able to fund their deficits, at least in the short term markets.
The reality, then, is that the ECB has become the political arbiter for fiscal decisions made by each of the euro zone national governments. If the ECB determines that any member nation is not complying to their liking, they will start threatening to stop buying their debt, thereby isolating them from the ECB credit umbrella, while allowing the remaining nations to remain solvent. And soon the bureaucrats who run the ECB will realise that the non-sterlisation of the bonds doesn’t create inflationary pressures and they will keep doing it, as they will find it to be a very powerful tool to keep national government spending plans which they don’t like in check. ECB spending on anything is not (operationally) revenue constrained as the member nations are, so this policy is nominally sustainable, even if fundamentally undemocratic.
Spending restrictions can be enforced more credibly (and thereby secure the tacit backing of Germany). If too restrictive, this will result in lower growth, and maybe even negative growth, but the solvency issue is gone as long as this policy is followed. With the ECB in effect backstopping the bonds of the national governments, it facilitates the latter’s ability to secure funding again in the market place via renewed bond issuance at lower rates of interest and this might well help to create a new growth dynamic in Europe.