What price to cover monetary financing of budget deficits in the euro area
There keeps growing acceptance that some type of monetary finance is necessary, if not inevitable, in light of the severe nature of the downturn in the euro area. This column argues that while a monetisation of the deficits induced by the COVID-19 crisis would eventually raise the price level in order that, after a go back to economic normalcy, inflation would rise for two years, this is a cost worth paying in order to avoid future sovereign debt crises in the euro area. Moreover, the ECB, as the utmost independent central bank on earth, will be well equipped to avoid the inflationary upsurge from becoming permanent.
The COVID-19 pandemic and the resulting Great Lockdown have caused a combined negative supply and demand shock of unprecedented intensity (Baldwin and Weder di Mauro 2020). The twin shocks risk triggering detrimental ‘domino effects’ of declining revenues, corporate bankruptcies, and mass unemployment. Governments everywhere are stepping directly into stop the dominoes from falling by using large fiscal stimulus packages, resulting in ballooning deficits and debt. We saw how these domino effects work through the 2007-2008 financial meltdown. As before, this crisis demands urgent action to place more space between your falling dominoes. We are able to think about it as ‘macroeconomic social distancing’ (De Grauwe 2020).
The ECB understands this and has announced that it stands prepared to avoid the last domino – euro area governments – from falling. It has launched a Pandemic Emergency Purchase Programme (PEPP) committing a complete of €1,350 billion (initially €750 billion, but augmented by €600 billion on 4 June 2020), targeted at buying government bonds of member states which come under financial pressure. These bond purchases, however, usually do not prevent government debt levels from increasing. As such, they could be viewed as coping with liquidity problems governments face in bond markets, however, not with foreseeable solvency problems due to unsustainable debt levels.
A robust, yet tabooed (Yashiv 2020) instrument atlanta divorce attorneys central bank’s toolkit may be the monetisation of government deficits. Among the chief virtues of monetary finance in today’s context is that it could spare governments from needing to issue new debt: if new debts were monetised, the crisis wouldn’t normally increase government debt-to-GDP ratios. For countries suffering the worst of the pandemic, the risk of a bondholder panic that could destabilise the euro area could have been taken off the equation. Several proposals have been recently put forward on how best to organise a monetisation of fiscal deficits in the euro area and beyond (Galí 2020, Kapoor and Buiter 2020, Gürkaynak and Lucas 2020). This reflects growing acceptance of the argument that some type of monetary finance is necessary, if not inevitable, in light of the severe nature of the existing downturn (Turner 2020, Wolf 2020).
However, numerous fundamental objections are generally raised against all types of monetary finance. The first objection points to risks of runaway inflation after the road of monetisation is taken. The next points to the supposed illegality of monetary finance in Europe. A third objection points to the idea that by financing government debt through money creation, the central bank merely exchanges one kind of debt for another. To the extent these concerns are rooted in deeper questions about central bank independence and governance, they are partly overlapping. In this column, we seek to handle these objections.
First objection: “Monetary finance leads to (hyper)inflation”
Before pondering the potential inflationary consequences of monetary finance in the euro area, it really is worth highlighting the considerable uncertainty in underlying inflation expectations right now (Miles and Scott 2020). In the April update of its World Economic Outlook, the IMF forecast an inflation rate of 0.23% for the euro area in 2020 and 0.98% in 2021 (IMF 2020a). Private sector forecasts vary widely, which range from -0.4% to 2.5% (Schnabel 2020). Trying to estimate the inflationary consequences of a monetisation of deficits with any precision is thus bound to be contentious. Nevertheless, many observers deem the probability of a deflationary spiral to exceed that of an inflationary outburst at the existing juncture (Blanchard 2020).
Notwithstanding these caveats, we are able to try to gain a concept of the magnitude of inflation to anticipate in the event of a monetisation of deficits. Predicated on the IMF Fiscal Monitor’s April forecast of a euro area deficit of 7.5% of GDP in 2020 and 3.6% in 2021 (IMF 2020b), which at current prices results in roughly €900 billion and €400 billion, we are able to approximate the upsurge in the euro area price level an more money creation by the ECB to the tune of €900 billion and €400 billion would bring about, everything else being equal. One simplified method of doing this is to depend on two relationships. The first one may be the relation between money base (B) and money stock (M) as expressed by the amount of money multiplier (M = mB). The next one may be the quantity theory of money (money stock × velocity of money = price level × GDP, or MV = PY). Employing both, we ask the question of how a rise in the amount of money base (B) the effect of a monetisation of budget deficits would affect the amount of money stock and result in a price increase, based on the quantity theory. 1
As established fact, the number theory represents a long-run relationship between money and prices; it isn’t necessarily an excellent predictor of yearly price changes. This is also true when the growth of the amount of money stock is relatively small, as has been the case in industrialised countries during the last 40 years. In these countries, the noise in the amount of money multiplier and velocity will overwhelm the relationship between your price level and the amount of money stock (De Grauwe and Polan 2005).
Moreover, as shown in Figure 1a, the amount of money multiplier has declined dramatically in the euro area because the start of global financial crisis. It has much related to the liquidity trap and the tendency of banks to hoard reserves. Furthermore, as Figure 1b shows, the velocity of money has tended to decline over the last decade aswell. Both of this means that a given upsurge in the money base must have a less pronounced influence on the price level. That is also clarified in Figure 2 which ultimately shows the amount of money base and M3 since 2007 (expressed as indices). We see that through the period 2015-2018 the large upsurge in the amount of money base (+150%) only had a restricted effect on M3 (+19%). Therefore, the amount of money base expansion didn’t filter through in to the real economy and into prices.
Figure 1a Money multiplier in the euro area
Figure 1b Velocity of money (M3) in the euro area
Note: We use base money and M3 to calculate the amount of money multiplier (at a monthly frequency) and GDP data and M3 to calculate velocity of money (at an annual frequency).
Source: Authors’ own calculation predicated on ECB Statistical Data Warehouse and Eurostat
Figure 2 Money base and M3 in the euro area (Dec 2007 = 100)
Source: Authors’ own calculation predicated on ECB Statistical Data Warehouse and Eurostat
As opposed to this, in countries with a brief history of large changes in the amount of money stock, the number theory has tended to be always a far better predictor of price changes (De Grauwe and Polan 2005). The question thus arises whether a rise in the amount of money base induced by monetary financing will strongly affect the amount of money stock or not. An integral difference with quantitative easing (QE) and the newer Pandemic Emergency Purchase Programme (PEPP) is that the amount of money base creation caused by a monetisation of budget deficits takes its type of ‘helicopter money’ insofar as the amount of money created by the central bank is flowing straight into the true economy via government budgets (Muellbauer 2014, 2016, Galí 2020). It could be expected that helicopter money will be transmitted differently compared to the money base created through QE, which is transmitted entirely through the financial sector, where it has either been hoarded or employed to sustain asset price inflation with little spillover in to the real economy. Thus, in the event a monetisation of budget deficits leads to a big increase in the amount of money stock, the number theory would turn into a better predictor of future price changes even in the euro area.
To estimate the potential price aftereffect of monetary finance, we first collect data from the ECB on the monetary base and broad money (M3) and calculate averages your money can buy multiplier and velocity during the last 3 years (2017-2019). We then extrapolate these data into 2021 and 2022 and add hypothetical increases in the monetary base caused by a monetization of budget deficits so as to compute the upsurge in the price level caused by the implied money stock increase. We depend on the IMF and European Commission forecasts of a solid recovery in 2021. These may grow to be too optimistic. We thus also estimate a less optimistic scenario of no growth in 2021 and a rebound in 2022 only. Hence, in the optimistic scenario, we assume a monetisation of the 2020 deficit (to the tune of €900 billion) and a go back to growth in 2021. In the pessimistic scenario, we assume the necessity for another year of monetary finance (to the tune of €400 billion) and growth to resume only in 2022.
Email address details are reported in Table 1. We find that the excess money creation caused by the monetisation of the COVID-19-induced budget deficits gets the potential to raise the purchase price level in the euro area between 20% and 36%, according to the nature of the scenario. As explained above, this estimate of the purchase price level effect assumes values your money can buy multiplier and velocity of money which will tend to be realised only in non-crisis times. Today, in light of a deflationary dynamic, both will tend to be even smaller. Consequently, the increase in the amount of money base caused by the financing of budget deficits is unlikely to have inflationary consequences in 2020. Only once the economy returns on track, which may take many years, can inflationary consequences be likely. The estimated price level increase would therefore be disseminate over many years – over just how many years exactly is difficult to learn, but a rough estimate will be a monetization of deficits gets the potential to create inflation to the tune of 4-6% for four to six 6 years from 2021 or 2022 onwards.
Table 1 Scenarios for euro area price level increase without and with monetary finance (MF)
Source: Authors’ own calculation predicated on ECB Statistical Data Warehouse, Eurostat, IMF
This computation assumes that the ECB won’t take the liquidity (money base) right out of the system after the economy has returned on track. Hence, it assumes that the monetisation of euro area deficits includes a permanent character and, by implication, permanently lowers government debt levels (in accordance with what they would have been around in the lack of monetary financing). If the ECB weren’t to get this done, our computed price level effect will be overestimated. Thus, our calculations may also be interpreted as an upper bound on the purchase price level aftereffect of a monetary financing of budget deficits. As such, they may be considered the (maximum) price to be payed for preventing a surge in government debts induced by the COVID-19 crisis. You can debate whether that is a cost worth paying. We think that it is. It’s the price we would purchase avoiding future sovereign debt crises in the euro area that could fragment, or worse, unravel it.
It is beneficial to compare our estimate of the purchase price surge following monetary shock with the purchase price surge that occurred through the 1970s because of the oil price shocks (see Table 2). In the united kingdom, Italy and Spain, the purchase price level increased by a lot more than 200% between 1973 and 1980, although it increased a lot more than 100% in France and nearly 50% in Germany over the same period. In comparison to these price surges, the potential future upsurge in the purchase price level induced by a monetary financing of euro area budget deficits through the COVID-19 crisis seems relatively subdued.
Table 2 Inflation rates and price increase (cumulative) in Germany, France, Italy, Spain, and the united kingdom, 1973-80
Source: Authors’ own calculation predicated on OECD
Second objection: “Monetary finance is illegal under EU law”
To say the (il)legality of monetary finance under European law, we must consider both primary law (i.e. the Treaties) and the ECB’s plus the Courts’ interpretation of the Treaties (established not least in the OMT and PSPP rulings of the Court of Justice of europe (ECJ) and to some degree also the German Federal Constitutional Court (Bundesverfassungsgericht)).
When it comes to primary law, the often-invoked Article 123 of the Treaty on the Functioning of europe (TFEU) is remarkably clear. It explicitly prohibits “[o]verdraft facilities or any other kind of credit facility with the ECB or with the [national] central banks” for EU institutions and member states, and also “the purchase directly from their website (…) of debt instruments”. By the same token, Article 123 will not explicitly prohibit transfers by the ECB to EU institutions, national central banks or governments, which are neither any conceivable type of credit (not least because they might not need to be repaid) nor entail any type of purchase with respect to the ECB (Kapoor and Buiter 2020). Article 123 also and expressly will not prohibit the purchase of debt instruments on secondary markets, as has been practised by the ECB since the launch of the Securities Markets Programme this year 2010, and since it continues to practise beneath the PSPP and PEPP programmes today. One method to organise monetary finance through secondary markets will be for governments to issue zero-coupon perpetual bonds to be bought and held for quite a while by the private sector before being purchased by the ECB, at its discretion (De Grauwe 2020).
This operation would, however, require the ECB to regulate its limits on asset purchases, which currently only foresee maturities as high as 30 years and 364 days. This takes us in to the realm of monetary policy design by the ECB and its own reaffirmation by the Courts. So far, the ECJ has repeatedly ruled towards the look of existing ECB policies, while emphasizing certain conditions to be met for bond purchases to be compliant with Article 123. These conditions are designed to ensure no certainty around which bonds are ordered so when, no disincentives to sound budgetary policies by the member states, no certainty around holding bonds to maturity (ECJ 2015).
In light of the wording of Article 123 and the above conditions, there is absolutely no pressing reason a priori that the ECJ would need to rule against a kind of monetisation that:
1. was created to respect the prohibition on credit facilities and direct purchases of debt instruments;
2. is justifiable with regard to the ECB’s primary objective of price stability, or the fulfilment of secondary objectives without prejudice to price stability; and
3. entails a amount of uncertainty around which purchases of perpetual bonds, if any, are undertaken so when, together with whether they are held indefinitely or not.
What provides support because of this view may be the already existing practice of rolling over public sector bonds bought beneath the PSPP (and recently also the PEPP) on the Eurosystem’s balance sheet, which – if continued in to the future – arguably amounts to a legal but implicit type of monetary finance (Blanchard and Pisani-Ferry 2020).
In addition to the ECJ, Germany’s Federal Constitutional Court has previously sought to harden the limits positioned on ECB purchase programmes, most prominently in its recent pronouncement on the PSPP (Bundesverfassungsgericht 2020). As the Court has asserted that the ECB didn’t prove the ‘proportionality’ of PSPP (and that in its view Germany and the ECJ must have challenged the ECB in this regard), it has notably not deemed the programme to maintain breach of Article 123 by itself, so long as purchases are conducted relative to the ECB’s issuer limits and capital key, and the like. If one were to take this pronouncement into consideration, then yet another feature to the three above of some type of monetary finance would presumably have to be a monetisation of deficits:
4. corresponds to the ECB’s capital key. 2
As a matter of known fact, considering that the economic shock due to COVID-19 is having a profound impact over the entire euro area, government deficits are actually on the rise in every euro area member states (a circumstance which clearly reflects “sound budgetary policy” in today’s crisis). Accordingly, member states’ projected deficits for 2020 eventually correspond closely with their national central banks’ shares in the ECB capital key, namely some 80% typically (see Table 3 below).
More fundamentally, in the “context of an overall economy entailing a threat of deflation” – as stressed repeatedly in the ECJ (2015) decision on PSPP rather than challenged by itself by the Bundesverfassungsgericht – the ECB has certain authorities to devise and utilize instruments that enable it to perform the tasks assigned to it by primary law (namely, “to keep price stability” and, without prejudice to the, to “support the overall economic policies in the Union”; Article 127(1)). In light of the severe nature of the existing shock, it really is warranted, if not imperative, for the ECB to consider all instruments at its disposal, including a monetisation of deficits which respects some or all the above conditions.
Table 3 Member state shares in projected 2020 euro area deficit versus shares in ECB capital key
Third objection: “There is absolutely no free lunch/magic money tree”
A third type of criticism against monetary finance may be the following. When the central bank monetizes budget deficits, it substitutes one kind of debt (government debt) for a fresh kind of debt (a debt of the central bank). Associated with that the majority of the money base creation nowadays takes the proper execution of bank reserves, which are remunerated by the central bank. Thus, following the monetisation of budget deficits, the federal government could have less interest-bearing debt outstanding as the central bank will need to bear an increased interest-bearing debt, by means of bank reserves. There is absolutely no free lunch nor a magic money tree (e.g. Borio et al. 2016, Banque de France 2020). This objection is situated, first, on a misconception of what money creation means; and, second, on the assumption that repaying interest on bank reserves is inevitable.
Money base created by today’s central bank isn’t debt. It isn’t a claim on the assets held by the central bank. Actually, today’s central bank can create money without buying assets, and therefore with no any assets on its balance sheet ‘backing’ the amount of money created. You don’t have to back fiat money. This contrasts with, say, corporate debt which, when the issuer of your debt fails, ultimately becomes a claim on the rest of the value of the assets of the organization. Furthermore, when issuing debt, an exclusive company promises to redeem your debt at maturity into cash, which it could or might not have. A promise by the central bank to redeem cash into cash makes no sense.
The misconception that the monetary base is a central bank’s debt has been fuelled by the actual fact that during the last 2 decades roughly, central banks have already been repaying interest on bank reserves. Because of this, central banks now utilize the interest on bank reserves as you of their favoured policy instruments. It generally does not must be so. It had been not so way back when that central banks didn’t remunerate bank reserves. In those days, central banks were equally with the capacity of controlling the interest. One potential reason why central banks pay interest on bank reserves is that they could have succumbed to the pressure of commercial banks, which disliked the actual fact that their liquid reserves weren’t remunerated. What this signifies used is that central banks in place now transfer part of their seigniorage gains (the monopoly profits of the central bank) to the banking sector, rather than turning the entire amount of seigniorage to the Treasury and therefore to the taxpayer. This practice should be reviewed. The monopoly of fabricating money was presented with to the central bank by the federal government, and the monopoly profit should arguably get back to the government.
Fourth objection: “Monetary finance is incompatible with central bank independence”
Many if not absolutely all of the above objections are rooted in deeper concerns about central bank independence and governance. For example, the potential inflationary upsurge following monetary finance depends to a big extent on if the central bank can independently avoid monetization also to tighten monetary policy conditions again when you need to (Blanchard and Pisani-Ferry 2020).
If, however, it really is indeed largely a matter of independence whether to attempt monetary finance or not, then your ECB ought to be ideally placed to credibly take part in a monetization of government deficits, considering that it’s the most ‘divorced’ central bank from national treasuries ever sold (Goodhart 1998). The ECB is often viewed as the most independent central bank on the planet, in fact it is hard to assume how any national government – or any national constitutional court, it appears – can ultimately force its hand. Independence, then, isn’t about never undertaking monetary finance, but about having the ability to choose when or you should definitely to, in light of changing economic circumstances. As the legal hurdles to enter some type of monetary finance are generally argued to be particularly saturated in the euro area (an allegation we’ve sought to dispel above), the opportunity to exit from monetary finance ought to be more credible in the euro area than somewhere else – thereby refuting a significant objection against entering to begin with.
It remains true that there surely is no such thing as a free of charge lunch, however, not in the sense that the critics of monetary finance imply. We’ve argued a monetisation of the deficits induced by the COVID-19 crisis will eventually raise the price level in order that, after a go back to economic normalcy, inflation will rise for two years. Thus, you will find a price to be payed for monetary finance. It’s the price we would purchase avoiding future sovereign debt crises in the euro area, that could fragment, or worse, unravel it. We’ve also argued a limited programme of monetary financing could possibly be designed so that it respects EU law. Finally, the ECB, as the utmost independent central bank on the globe, will be well equipped to avoid the inflationary upsurge from becoming permanent.
Baldwin, R and B Weder di Mauro (2020), Economics in enough time of COVID-19, CEPR.
Blanchard, O and Pisani-Ferry, J (2020), “Monetisation: Usually do not panic”, VoxEU.org, 10 April.
Borio, C, Disyatat, P, and Zabai, A (2016), “Helicopter money: The illusion of a free of charge lunch”, VoxEU.org, 24 May.
Court of Justice of europe (ECJ) (2018), “Judgment of the Court (Grand Chamber) (Case C‑493/17)”, 11 December.
Court of Justice of europe (ECJ) (2015), “Judgment of the Court (Grand Chamber) (Case C‑62/14)”, 16 June.
De Grauwe, P (2020), “The ECB Must Finance COVID-19 Deficits”, Project Syndicate, 18 March.
De Grauwe, P., and Polan, M., (2005), Is Inflation Always and Everywhere a Monetary Phenomenon, Scandinavian Journal of Economics.
Goodhart, C (1998), “Both concepts of money: implications for the analysis of optimal currency areas”, European Journal of Political Economy, 14: 407-432.
Gürkaynak, R and Lucas, D (2020), “Funding Pandemic relief: Monetise now”, VoxEU.org, 14 May.
Turner, A (2020), “Monetary Finance IS HERE NOW”, Project Syndicate, 20 April.
1 Another approach is always to treat the money intended to finance government deficits as a balance sheet loss for the central bank also to calculate just how much of a loss the central bank may sustain without jeopardizing its inflation target, assuming certain parameters for growth, the discount rate, and today’s value of future seigniorage revenue. For a variety of different scenarios, Buiter (2019) shows that the ECB/Eurosystem can sustain losses between €1.3 trillion and €30 trillion (and using cases infinite losses) without undermining its inflation target.