Spain, Italy and Greece have each come under renewed market pressure in recent times. Portugal’s economic contraction is deepening. Multiple financial crises could potentially occur simultaneously, complicating economic management within the Eurozone.
It cannot but be clear to all that in many of the periphery countries public debt, which is already excessive, is set to go higher. The ‘bond’ financing of on-going (forecast) budget deficits will automatically guarantee that this is the case. The need to roll-over maturing debts, and potential private capital outflow, will also bring additional debt management stress; adding volatility and creating additional interest rate pressures.
In most periphery countries, aggregate demand is already grossly deficient, and unemployment unacceptably high. With gross general government debt as a proportion of GDP already significantly above 100 per cent, economic growth is weakening further. As the debt crisis deepens, and spreads into commercial operations and across borders, economic conditions will become even more unstable: interest rates will periodically surge higher, financial markets will suffer further crises, and periphery economies are likely to suffer deflationary tendencies as they slide deeper into depression: all of which will add further to debt burdens.
The ECB, has indicated yesterday that it will preserve the euro, operating within its mandate. Two questions immediately arise. First, how will it do so? And, second, could the ECB be more effective if the mandate were to be adjusted?
Current policy approaches
In Europe, creating new money to periodically buy-up excess periphery government bonds to lower resurgent interest rates is a purely ‘defensive’ strategy; one that could go on for a decade, or two. In attempting to stop interest rates rising excessively in this way, risky bond accumulation is increasingly destabilising the central bank balance sheet. The policy does nothing to reduce overall debt levels. And the Germans have reservations. Whether, and at what cost, the policy could be effective going forward are questions that cannot be answered with any certainty.
Once the policy interest rate is taken to its zero bound — a desirable step when demand is falling — there is little evidence that further application of ‘quantitative easing (QE) solutions’, aimed at pulling bond interest rates back below 6 or 7 per cent, could permanently address rising risk premia or sufficiently raise investment and demand. Commercial banks already have large excess reserves, housing stocks remain excessive in some countries, confidence has collapsed and the new money does not reach the unemployed, the disadvantaged, or other potential consumers generally. In terms of its likely effectiveness, it probably matters little whether the central bank itself buys the bonds or whether it provides a banking licence to the EU rescue fund to enable it to do so.
The ‘sharp fiscal austerity solution’ reduces demand, government revenues and GDP; raises the budget deficit; and increases the ‘public debt’ burden.
The ‘debt bailout/firewall/loan solutions’ potentially add new debts on top of existing debts.
The ‘Eurobond solution’ would require uncertain political compromises, and would mainly address symptoms not causes.
The ‘Euro-fiscal-funding-union solution’ would be ambitious, but cannot be quickly arranged and remains uncertain in its structure and application.
The ‘monetary union solution’ seems sensible if the Eurozone is to survive, but may not be rapidly agreed or implemented in full, and would not solve all difficulties, particularly those which might develop in the short-term.
Inflating one’s way out of the debt trap is, fortunately, not on the ECB’s agenda.
It is not obvious how, under the current political and economic architecture, the ECB can be confident that it could save the euro should a crisis develop. We, nonetheless, look forward to seeing the plan.
It is clear, however, that policy makers still need to adjust their current advice, and to get ahead of the resurgent crises. Policy needs to be repositioned to stop public debt rising at its source in the first place: rather than to continue to allow debt to surge upward, and to then seek to address it (after the event), year after year.
Jose Vinals (July 2012), is correct to conclude that ‘bold stabilization action’ is required right now. He is also correct to point to the need to strengthen the balance sheets of viable banks. After that, the solution appears to rely on ‘sweeping structural reforms’, ‘well-timed fiscal consolidation strategies’, and ‘maintaining supportive monetary and liquidity policies’. More of the same, perhaps.
Of course, structural reform policies, while fundamental for improving competitiveness and strengthening the prospects for economic growth in the future (as the IMF makes clear), cannot be expected to raise aggregate demand significantly in the short-term. Fiscal consolidation is essential over the medium to longer-terms, as public expenditures and public debt are excessive relative to GDP, but short to medium-term impacts on demand and growth may not be positive, particularly when the private sector is collapsing. It is not obvious, therefore, that current ‘fiscal austerity’ policies, or current monetary policy strategy in Europe, provide sufficient ‘stabilization’ solutions for periphery countries experiencing sharply falling demand. To preserve the euro, it will be essential to avoid catastrophe in these countries.
How to address inadequate demand and rising public debt at the same time
A strengthened monetary and fiscal policy response could, therefore, be required at some point in the near-future to address the stabilization requirements of periphery countries: that is, to simultaneously address both falling demand and rising debt. Whether policy makers believe we are now at that point is unclear, but Mr. Draghi appears to have reached the conclusion that the euro is now at risk, and that something substantial needs to be done to preserve it.
The Financial Times (July 25) reported that Belgium’s foreign minister, Didier Reynders, believes that the ECB should be participating in ‘monetary financing’ of debt, and Ewald Nowotny, head of Austria’s central bank, is reported to say that he believed there were ‘pro arguments’ for allowing the ECB to provide low-cost financing for the Eurozone’s new rescue fund. The mechanisms to deliver these outcomes are unclear under the Eurozone charter, and some are subject to constitutional challenge.
Such changes, if they were to come about, could open up a pathway to transformational policy paradigm shifts in the Eurozone. Such changes could create a chain of logic which could lead ultimately to an acceptance of the view (currently viewed as radical in Germany) that, in order to stop debt rising further, and to save the euro, new money creation could be used (in a strictly controlled manner) to finance on-going budget deficits. If a treaty (developed in vastly different circumstances) needs to be adjusted to give effect to this coordinated monetary and fiscal policy operation, in order to retain the eurozone, the sooner the better.
Since the Middle Ages new money creation has been used to finance commercial banks or governments, most often the latter (see Ugolini, 2011). There have been success and failures with both strategies; failures due to policy excesses no doubt. Abba Lerner (1943), Milton Friedman (1948, 1969), Ben Bernanke (2002, in respect of Japan) and most recently Willem Buiter and Ebrahim Rahbari (Citi, May 2012) have all recommended that new money creation could be used to finance budget deficits and to provide economic stimulus.
Abba Lerner (1943) stated that ‘When taxing, spending borrowing and lending (or repaying loans)…any excess of money outlays over money revenues, if it cannot be met out of money hoards, must be met out of printing money…’. Milton Friedman (1969) proposed ‘…a temporary tax cut, increase in transfer payments or boost to exhaustive government spending (including infrastructure investment), financed through a permanent increase in the money base.’ Buiter and Rahbari argue that this policy coordination would deliver ‘…perhaps the most effective form of stimulus currently’.
When these proposals were first advanced public debt was not the concern it is today. The case for monetisation of budget deficits is, thus, far more relevant today in periphery countries: with public debt already so high, and at unstable equilibria points, there is simply no room left for bond (new debt) financing of budget deficits, and QE has all but run its course. In the Euro-zone going forward, ‘pro-active’, rather than ‘defensive’, differentiated monetary policy action will be essential, taking account of the particular need for periphery countries to not further increase public debt. Policy makers may well need to think creatively — outside the current box and the current architecture — in order to save the euro.
Because of the requirement not to raise public debt further, it may be inappropriate for central banks to fund on-going budget deficits with new money (as proposed by Friedman, Bernanke and Buiter), as that procedure presumably requires that new government bonds be issued to the central bank in exchange for the new money. Government bonds held by the central bank are usually counted as part of ‘general government debt’, a key indicator used by credit rating agencies: credit rating agencies see that such bonds can be sold to the public at any time. If, upon further examination, this complication proves to be of concern, it could be overcome readily by, say, the Ministry of Finance creating new national currency and immediately swapping it for new euro created by the European Central Bank.
Central Banks will be creating new money in any event: the important policy question is how is that new money best deployed to raise aggregate demand and stop debt from rising in the first place? Certainly not by further QE!
In the plan for greater fiscal and monetary policy coordination sketched above, inflation cannot be of concern (Wood, 2012). Once the budget deficit is financed — and the economic stimulus delivered — in the manner recommended, the functional objective of the new money creation has been achieved. The new money can then be swapped back again, and withdrawn from the economy (and destroyed) if excess liquidity was to develop. Furthermore, a legislative cap could also be set on the scale of the policy, if that was considered necessary.
In summary, current policy seeks to periodically buy up government bonds after debt and interest rates have surged. In contrast, the proposed policy immediately stops public debt from rising at its source. This latter strategy addresses the cause of the problem directly and decisively, and, thereby, lowers the risk of financial crises and contagion. Stopping the debt from rising without creating an economic depression (via deep austerity) must represent the principal economic policy objective in periphery countries. It would be ironic indeed if, despite the best efforts of the ECB working within its mandate, the Eurozone collapsed because of a failure of governments to adjust one of their own man-made architectural provisions.
The concern about moral hazard applies as much to the current defensive strategy (buying up excess bonds after the event; that is ‘debt monetisation’) as it does to the proposed preventative strategy (that is ‘deficit monetisation’).
When the debt crisis is brought under control, monetary and fiscal policy coordination can then be re-assessed. The policy paradigm discussed above has general application whether or not individual periphery countries stay inside the Eurozone, or leave it.
Bernanke, Ben (2002), “Deflation: Making Sure ‘It’ Doesn’t Happen Here”, Remarks before the National Press Club, Washington D.C., February.
Buiter, Willem and Ebrahim Rahbari (2012), “What more can central banks do to stimulate the economy”, Global Economics View, Citi, May 9.
Fontanella-Khan, James and Wilson, James (2012), ‘Free ECB’s hand to aid states, says minister’, Financial Times, Comment, July.
Friedman, Milton (1948), “A Monetary and Fiscal Framework for Economic Stability, June. Also see Optimum Quantity of Money , Aldine Publishing Company, 1969.
Lerner, Abba (1943), “Functional Finance and the Federal Debt”, Social Research, 10, February.
Ugolini, Stefano (2011), “What future for central banking? Insights from the past’, VOX, December 11.
Vinals, Jose (2012), “Risks to Financial Stability Increase. Bold Action Needed”, EconoMonitor, July 7.
Wood, Richard (2012), “Delivering economic stimulus, addressing rising public debt and avoiding inflation, Journal of Financial Economic Policy, April.