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26 May 2021

SUERF's Boonstra: How to prevent a too restrictive fiscal policy in Europe?

Public debt acquired by the Eurosystem has lost its significance. The central bank can keep this part of the public debt on its balance forever. Therefore, it would be wrong to base future fiscal policy on debt ratios without taking this into account.

Such a mistake could be prevented by either cancelling this part of the public debt or correcting the public debt ratios of EMU member states. Technically, this is not a problem. The caveat, however, is that such a move could bring moral hazard, which may undermine future fiscal discipline. This moral hazard should be prevented. Only then can be avoided that future fiscal policies in EMU will become too restrictive.

Introduction: not all public debt is relevant

The moment that a central bank starts to buy public debt issued by its own government, this debt loses its significance (De Grauwe, 2021). The reason is simple. A central bank is usually owned by its government. The moment the central bank becomes the owner of its government’s debt, the latter will pay interest payments and redemption to the central bank. This will add to its profits, which usually are distributed to its most important shareholder, viz. the government. As a result, this part of the public debt service becomes an intra-public sector money transfer. Which illustrates the hard fact that public debt purchased by the central bank is no longer a burden for the public budget. Of course, the implicit assumption here is that the central banks does not have the intention to resell the acquired debt to the market and, also important, reinvests the money it receives when the government redeems its debt.

This is not a new insight, it is basic undergraduate textbook stuff (Boonstra & Van Goor, 2021). Central banks have an unlimited power to create money by using the classic printing press or its modern equivalents.1 If this power is used to finance public spending, this is called monetary financing. This power has also a dangerous side, as an unlimited use of the printing press for the financing of public spending may lead to a too high inflation or, in extreme cases, hyperinflation. To be sure, hyperinflations are very rare phenomena, but some of them have resulted in serious economic and social disruptions. And most, if not all of them, began with monetary financing of public spending that ultimately ran out of hand. Which is the reason why monetary financing is explicitly forbidden van Article 123 of the Treaty on the Functioning of the European Union (TFEU).2

However, during the last years, the Eurosystem, which consists of the European Central Bank and the National central banks of the Eurozone, have bought large amounts of public debt under its programmes of Quantitative Easing (QE). The result is an enormous increase in the size of its balance sheet, which was caused by the strong growth of the entry on the asset side called ‘securities held for monetary purposes’, which is mirrored by an enormous increase in ‘liabilities to credit institutions’ on the liability side (figures 1 and 2).

Figure 1: Assets of the Eurosystem (1999 – 2020, € billion)

Figure 2:
Liabilities of the Eurosystem (1999 – 2020; € billion)
Source: ECB

The major difference between QE and straightforward monetary financing of government spending is that under QE the central bank buys existing government debt in the secondary market, while under monetary financing usually new government spending is financed by directly selling public bonds to, or taking loans from, the central bank. So defined, we can understand QE as ex-post monetary financing. An important difference is that during monetary financing, fiscal and monetary policies usually are aligned, meaning that they both are expansive at the same time. It is an extremely effective, albeit potentially dangerous (see above) way of stimulating the economy. Under QE it can happen that, while monetary policy is expansive, at the same time fiscal policy is tight. This is less effective in stimulating total demand, as Europe’s relatively slow recovery after the Great Financial Crisis (GFC) illustrates.

As a result of QE, about 30 per cent of EMU’s public debt (issued state loans) has been acquired by the eurosystem, indeed losing its fiscal relevance. It is not surprising that this led to the call to cancel this debt completely. Technically, this can be done easily by for example replacing the existing debt by a zero-coupon perpetual loan, as explained above in footnote 1. So why not?

Figure 3:
EMU member states public debt
Note: the graph should be interpreted as a rough indication. It shows the notional value of the state loans issued by the central government. Some countries have a relatively large public debt owed by lower governments levels, such as the German Länder. And of course countries can use other financial instrument for financing their public debt. The ECB intends to acquire a more or less identical percentage of the total outstanding public debt of the member states. As a result of the differences explained before, however, the percentage of debt issued by central governments acquired by the central bank varies between 29% and 51%.

In his recent SUERF Policy Brief Paul de Grauwe makes the point that as the public debt that is acquired by a central bank already has lost its monetary significance, cancelling it altogether makes no material difference. In addition, he argues that a central bank may need its portfolio of government bonds once it wants to tighten its monetary policy in the future once inflation takes off. By reselling its portfolio back to the market, it may drain liquidity (as banking reserves will decline) and push up long-term interest rates as bond prices come under downward pressure once the central bank changes its policy. Although this all is completely correct, it does not fully eliminate an important argument in favour of cancelling the debt already purchased, viz. the impact on future fiscal policy. This is especially relevant for the Eurozone. Moreover, the central bank has other options available for draining banks’ liquidity reserves. Finally, an important argument against debt cancellation is overseen: it may introduce additional moral hazard and undermine future fiscal discipline. In the following paragraphs we will briefly discuss these topics in the European context.

The European context: redefining debt ratios

Countries in the Eurozone have to meet the fiscal criteria of the Stability and Growth Pact, viz. a fiscal deficit smaller than 3% of GDP and a public debt less than 60% of GDP – or moving at a sufficient pace towards this 60% of GDP. During the corona-crisis these criteria have temporarily been suspended, at least until 2022, but sooner or later this discussion will flare up. Even apart from the rules, in the Netherlands, for example, there already was quite some discussion about the ‘debt burden that is shifted to future generations’. Very recently, the Dutch central bank warned that debt ratios are too high and future fiscal policy should certainly not be too expansive. The subtle difference between public debt that has to be repaid versus a debt that easily can be rolled-over into eternity because it is already owned by the central bank/government complex is easily lost on politicians, voters and apparently even central bankers. So far, the ECB is reinvesting the amortisation payment of the public debt in its possession by buying public debt in the markets and technically there is no reason why this could not go on forever. The real danger is of course, that Europe falls into the same trap it fell into after the GFC, viz. return to much too restrictive fiscal policies in order to meet the SGP obligations. This would be highly unproductive.

Therefore, it would be wise to either cancel this debt, or redefine the SGP-criteria. Changing the SGP could be the obvious solution, but this will be a highly political end therefore very cumbersome process. The good news, however, is that this may be solved by correcting the public debt figures for (a part of) the public debt amounts in the portfolio of the Eurosystem. Because this part of the debt, at least from a monetary point of view, has indeed become insignificant, it doesn’t make sense to base future fiscal policy on it. One could think about introducing a clause in the Treaty, which states that fiscal policy ‘temporarily’ will be based on the public debt after correction for the debt that has been acquired by the ECB.3 As an indication the Commission could decide to correct the total public debt for all member states with 25 percent.4 This may politically be an easier exercise than rewriting the SGP. Such an exercise would result in the following relevant debt figures of EMU’s member states.



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