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 in to stop the dominoes from falling with the help of large fiscal stimulus packages, leading to ballooning deficits and debt. We saw how these domino effects work during the 2007-2008 financial crisis. As in the past, this crisis demands urgent action to put more space between the falling dominoes. We can think of it as ‘macroeconomic social distancing’ (De Grauwe 2020).
The ECB understands this and has announced that it stands ready to prevent the last domino – euro area governments – from falling. It has launched a Pandemic Emergency Purchase Programme (PEPP) committing a total of €1,350 billion (initially €750 billion, but augmented by €600 billion on 4 June 2020), aimed at buying government bonds of member states that come under financial pressure. These bond purchases, however, do not prevent government debt levels from increasing. As such, they can be viewed as dealing with liquidity problems governments face in bond markets, but not with foreseeable solvency problems arising from unsustainable debt levels.
A powerful, yet tabooed (Yashiv 2020) instrument in every central bank’s toolkit is the monetisation of government deficits. One of the chief virtues of monetary finance in the current context is that it would spare governments from having to issue new debt: if all new debts were monetised, the crisis would not increase government debt-to-GDP ratios. For countries suffering the worst of the pandemic, the threat of a bondholder panic that would destabilise the euro area will have been removed from the equation. Several proposals have recently been put forward on how 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 form of monetary finance is needed, if not inevitable, in light of the severity of the current downturn (Turner 2020, Wolf 2020).
However, a number of fundamental objections are commonly raised against all forms of monetary finance. The first objection points to risks of runaway inflation once the road of monetisation is taken. The second points to the supposed illegality of monetary finance in Europe. A third objection points to the notion that by financing government debt through money creation, the central bank merely exchanges one type of debt for another. To the extent that these concerns are rooted in deeper questions about central bank independence and governance, they are in part overlapping. In this column, we seek to address these objections.
First objection: “Monetary finance leads to (hyper)inflation”
Before pondering the potential inflationary consequences of monetary finance in the euro area, it is worth highlighting the considerable uncertainty in underlying inflation expectations at the moment (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, ranging 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 likelihood of a deflationary spiral to exceed that of an inflationary outburst at the current juncture (Blanchard 2020).
Notwithstanding these caveats, we can try to gain an idea of the magnitude of inflation to expect in case of a monetisation of deficits. Based 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 translates into roughly €900 billion and €400 billion, we can approximate the increase in the euro area price level that an additional money creation by the ECB to the tune of €900 billion and €400 billion would bring about, all else being equal. One simplified way of doing so is to rely on two relationships. The first one is the relation between money base (B) and money stock (M) as expressed by the money multiplier (M = mB). The second one is the quantity theory of money (money stock × velocity of money = price level × GDP, or MV = PY). Employing both, we ask the question of how an increase in the money base (B) caused by a monetisation of budget deficits would affect the money stock and lead to a price increase, in line with the quantity theory.1
As is well known, the quantity theory represents a long-run relationship between money and prices; it is not necessarily a good predictor of yearly price changes. This is especially true when the growth of the money stock is relatively small, as has been the case in industrialised countries over the last 40 years. In these countries, the noise in the money multiplier and velocity tends to overwhelm the relationship between the price level and the money stock (De Grauwe and Polan 2005).
Moreover, as shown in Figure 1a, the money multiplier has declined dramatically in the euro area since the start of the global financial crisis. This has much to do with the liquidity trap and the tendency of banks to hoard reserves. In addition, as Figure 1b shows, the velocity of money has tended to decline during the last decade as well. Both of this implies that a given increase in the money base should have a less pronounced effect on the price level. This is also made clear in Figure 2 which shows the money base and M3 since 2007 (expressed as indices). We see that during the period 2015-2018 the large increase in the money base (+150%) only had a limited impact on M3 (+19%). As a result, the money base expansion did not filter through into 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 money multiplier (at a monthly frequency) and GDP data and M3 to calculate velocity of money (at an annual frequency).
Source: Authors' own calculation based on ECB Statistical Data Warehouse and Eurostat
Figure 2 Money base and M3 in the euro area (Dec 2007 = 100)
Source: Authors' own calculation based on ECB Statistical Data Warehouse and Eurostat
In contrast to this, in countries with a history of very large changes in the money stock, the quantity theory has tended to be a much better predictor of price changes (De Grauwe and Polan 2005). The question thus arises whether an increase in the money base induced by monetary financing will strongly affect the money stock or not. A key difference with quantitative easing (QE) and the more recent Pandemic Emergency Purchase Programme (PEPP) is that the money base creation resulting from a monetisation of budget deficits constitutes a form of ‘helicopter money’ insofar as the money created by the central bank is flowing directly into the real economy via government budgets (Muellbauer 2014, 2016, Galí 2020). It can be expected that helicopter money would be transmitted differently than 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 into the real economy. Thus, in case a monetisation of budget deficits leads to a large increase in the money stock, the quantity theory would become a better predictor of future price changes even in the euro area.
To estimate the potential price effect of monetary finance, we first collect data from the ECB on the monetary base and broad money (M3) and calculate averages for the money multiplier and velocity over the last three years (2017-2019). We then extrapolate these data into 2021 and 2022 and add hypothetical increases in the monetary base resulting from a monetization of budget deficits in order to compute the increase in the price level resulting from the implied money stock increase. We rely on the IMF and European Commission forecasts of a strong recovery in 2021. These may well turn out 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 return to growth in 2021. In the pessimistic scenario, we assume the need for a second year of monetary finance (to the tune of €400 billion) and growth to resume only in 2022.
Results are reported in Table 1. We find that the extra money creation resulting from the monetisation of the COVID-19-induced budget deficits has the potential to raise the price level in the euro area between 20% and 36%, depending on the nature of the scenario. As explained above, this estimate of the price level effect assumes values for the money multiplier and velocity of money which are likely to be realised only in non-crisis times. Today, in light of a deflationary dynamic, both are likely to be even smaller. As a result, the increase in the money base resulting from the financing of budget deficits is unlikely to have inflationary consequences in 2020. Only when the economy returns to normal, which may take several years, can inflationary consequences be expected. The estimated price level increase would therefore be spread out over several years – over how many years exactly is difficult to know, but a rough estimate would be that a monetization of deficits has the potential to produce inflation to the tune of 4-6% for 4 to 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 based on ECB Statistical Data Warehouse, Eurostat, IMF
This computation assumes that the ECB will not take the liquidity (money base) out from the system once the economy has returned to normal. Hence, it assumes that the monetisation of euro area deficits has a permanent character and, by implication, permanently lowers government debt levels (relative to what they would have been in the absence of monetary financing). If the ECB were not to do this, our computed price level effect would be overestimated. Thus, our calculations can also be interpreted as an upper bound on the price level effect of a monetary financing of budget deficits. As such, they can be viewed as the (maximum) price to be paid for preventing a surge in government debts induced by the COVID-19 crisis. One can debate whether this is a price worth paying. We believe that it is. It is the price we would pay for avoiding future sovereign debt crises in the euro area which could fragment, or worse, unravel it.
It is useful to compare our estimate of the price surge following the monetary shock with the price surge that occurred during the 1970s as a result of the oil price shocks (see Table 2). In the UK, Italy and Spain, the price level increased by more than 200% between 1973 and 1980, while it increased more than 100% in France and nearly 50% in Germany over the same period. Compared to these price surges, the potential future increase in the price level induced by a monetary financing of euro area budget deficits during the COVID-19 crisis seems relatively subdued.
Table 2 Inflation rates and price increase (cumulative) in Germany, France, Italy, Spain, and the UK, 1973-80
Source: Authors' own calculation based on OECD
Second objection: “Monetary finance is illegal under EU law”
To assert the (il)legality of monetary finance under European law, we need to take into account both primary law (i.e. the Treaties) and the ECB’s as well as the Courts’ interpretation of the Treaties (established not least in the OMT and PSPP rulings of the Court of Justice of the European Union (ECJ) and to some extent also the German Federal Constitutional Court (Bundesverfassungsgericht)).
In terms of primary law, the often-invoked Article 123 of the Treaty on the Functioning of the European Union (TFEU) is remarkably clear. It explicitly prohibits “[o]verdraft facilities or any other type of credit facility with the ECB or with the [national] central banks” for EU institutions and member states, as well as “the purchase directly from them (…) of debt instruments”. By the same token, Article 123 does not explicitly prohibit transfers by the ECB to EU institutions, national central banks or governments, which are neither any conceivable form of credit (not least because they would not have to be repaid) nor entail any kind of purchase on behalf of the ECB (Kapoor and Buiter 2020). Article 123 also and expressly does not prohibit the purchase of debt instruments on secondary markets, as has been practised by the ECB ever since the launch of the Securities Markets Programme in 2010, and as it continues to practise under the PSPP and PEPP programmes today. One way to organise monetary finance through secondary markets would be for governments to issue zero-coupon perpetual bonds to be bought and held for some time by the private sector before being purchased by the ECB, at its own discretion (De Grauwe 2020).
Such an operation would, however, require the ECB to adjust its limits on asset purchases, which currently only foresee maturities of up to 30 years and 364 days. This takes us into the realm of monetary policy design by the ECB and its reaffirmation by the Courts. Thus far, the ECJ has repeatedly ruled in favour of the design of existing ECB policies, while emphasizing certain conditions to be met for bond purchases to be compliant with Article 123. These conditions are meant to ensure no certainty around which bonds are purchased and when, no disincentives to sound budgetary policies by the member states, and no certainty around holding bonds to maturity (ECJ 2015).
In light of the wording of Article 123 and the above conditions, there is no pressing reason a priori for which the ECJ would have to rule against a form of monetisation that:
1. is designed to respect the prohibition on credit facilities and direct purchases of debt instruments;
2. is justifiable in terms of the ECB’s primary objective of price stability, or the fulfilment of secondary objectives without prejudice to price stability; and
3. entails a degree of uncertainty around which purchases of perpetual bonds, if any, are undertaken and when, as well as whether these are held indefinitely or not.
What provides support for this view is the already existing practice of rolling over public sector bonds bought under the PSPP (and recently also the PEPP) on the Eurosystem’s balance sheet, which – if continued into the future – arguably amounts to a legal but implicit form of monetary finance (Blanchard and Pisani-Ferry 2020).
Apart from the ECJ, Germany’s Federal Constitutional Court has in the past sought to harden the limits placed on ECB purchase programmes, most prominently in its recent pronouncement on the PSPP (Bundesverfassungsgericht 2020). While the Court has asserted that the ECB failed to prove the ‘proportionality’ of PSPP (and that in its view Germany and the ECJ should have challenged the ECB in this regard), it has notably not deemed the programme to be in breach of Article 123 per se, as long as purchases are conducted in accordance with the ECB’s issuer limits and capital key, amongst others. If one were to take this pronouncement into account, then an additional feature to the three above of some form of monetary finance would presumably need to be that a monetisation of deficits:
4. corresponds to the ECB’s capital key.2
As a matter of fact, given that the economic shock caused by COVID-19 is having a profound impact across the entire euro area, government deficits are now on the rise in all euro area member states (a circumstance which clearly reflects “sound budgetary policy” in the current crisis). Accordingly, member states’ projected deficits for 2020 happen to correspond closely to their national central banks’ shares in the ECB capital key, namely some 80% on average (see Table 3 below).
More fundamentally, in the “context of an economic crisis entailing a risk of deflation” – as stressed repeatedly in the ECJ (2015) decision on PSPP and not challenged per se by the Bundesverfassungsgericht – the ECB does have certain authorities to devise and make use of instruments that enable it to accomplish the tasks assigned to it by primary law (namely, “to maintain price stability” and, without prejudice to this, to “support the general economic policies in the Union”; Article 127(1)). In light of the severity of the current shock, it 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 of the above conditions.
Table 3 Member state shares in projected 2020 euro area deficit versus shares in ECB capital key
Source: IMF; ECB
Third objection: “There is no free lunch/magic money tree”
A third line of criticism against monetary finance is the following. When the central bank monetizes budget deficits, it substitutes one type of debt (government debt) for a new type of debt (a debt of the central bank). The reason is that most of the money base creation these days takes the form of bank reserves, which are remunerated by the central bank. Thus, after the monetisation of budget deficits, the government will have less interest-bearing debt outstanding while the central bank will have to bear a higher interest-bearing debt, in the form of bank reserves. There is no free lunch nor a magic money tree (e.g. Borio et al. 2016, Banque de France 2020). This objection is based, first, on a misconception of what money creation means; and, second, on the assumption that paying interest on bank reserves is inevitable.
Money base created by a modern central bank is not debt. It is not a claim on any of the assets held by the central bank. In fact, a modern central bank can create money without buying assets, and thus without having any assets on its balance sheet ‘backing’ the money created. There is no need to back fiat money. This contrasts with, say, corporate debt which, when the issuer of the debt fails, ultimately becomes a claim on the residual value of the assets of the corporation. In addition, when issuing debt, a private company promises to redeem the debt at maturity into cash, which it may or may 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 fact that over the last two decades or so, central banks have been paying interest on bank reserves. As a result, central banks now use the interest rate on bank reserves as one of their favoured policy instruments. It does not have to be so. It was not so long ago that central banks did not remunerate bank reserves. At that time, central banks were equally capable of controlling the interest rate. One potential explanation for why central banks pay interest on bank reserves is that they may have succumbed to the pressure of commercial banks, which disliked the fact that their liquid reserves were not remunerated. What this means in practice is that central banks in effect now transfer part of their seigniorage gains (the monopoly profits of the central bank) to the banking sector, instead of turning the full amount of seigniorage over to the Treasury and thus to the taxpayer. This practice needs to be reviewed. The monopoly of creating money was given to the central bank by the government, and the monopoly profit should arguably go back to the government.
Fourth objection: “Monetary finance is incompatible with central bank independence”
Many if not all of the above objections are rooted in deeper concerns about central bank independence and governance. For instance, the potential inflationary upsurge following monetary finance depends to a large extent on whether the central bank is able to independently refrain from monetization and to tighten monetary policy conditions again when need be (Blanchard and Pisani-Ferry 2020).
If, however, it is indeed largely a matter of independence whether to embark on monetary finance or not, then the ECB should be ideally placed to credibly engage in a monetization of government deficits, given that it is the most ‘divorced’ central bank from national treasuries in history (Goodhart 1998). The ECB is commonly seen as the most independent central bank in the world, and it is hard to imagine how any national government – or any national constitutional court, it seems – can ultimately force its hand. Independence, then, is not about never undertaking monetary finance, but about being able to choose when or when not to, in light of changing economic circumstances. While the legal hurdles to enter into some form of monetary finance are commonly argued to be particularly high in the euro area (an allegation we have sought to dispel above), the ability to exit from monetary finance should be more credible in the euro area than anywhere else – thereby refuting a major objection against entering in the first place.
It remains true that there is no such thing as a free lunch, but not in the sense that the critics of monetary finance imply. We have argued that a monetisation of the deficits induced by the COVID-19 crisis will eventually increase the price level so that, after a return to economic normalcy, inflation will rise for a couple of years. Thus, there is a price to be paid for monetary finance. It is the price we would pay for avoiding future sovereign debt crises in the euro area, which could fragment, or worse, unravel it. We have also argued that a limited programme of monetary financing could be designed in such a way that it respects EU law. Finally, the ECB, as the most independent central bank in the world, would be well equipped to prevent the inflationary upsurge from becoming permanent.
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1 Another approach would be to treat the money created to finance government deficits as a balance sheet loss for the central bank and to calculate how much of a loss the central bank could possibly sustain without jeopardizing its inflation target, assuming certain parameters for growth, the discount rate, and the present value of future seigniorage revenue. For a range of different scenarios, Buiter (2019) suggests that the ECB/Eurosystem would be able to sustain losses between €1.3 trillion and €30 trillion (and in certain cases infinite losses) without undermining its inflation target.
2 Overcoming potentially hard constraints on issue share and issuer limits, in turn, might require avoiding issuance and purchases in the first place (e.g. by means of transfers as suggested by Kapoor and Buiter 2020).