Volume 50, November/December 2015, Number 6 · pp. 360-362
Monetary Financing, Take Two – A Reply
In the July/August issue of Intereconomics, Silke Tober criticised a proposal put forth by Andrew Watt to solve the euro crisis through the use of monetary financing of the public sector. Tober argued that there are valid reasons to keep monetary and fiscal policy separate from one another and that Watt's proposal blurred the line between the two policy areas. Watt responded to his critic, followed by this reply from Tober.
Silke Tober, Macroeconomic Policy Institute (IMK), Düsseldorf, Germany.
In the eighth year of the crisis, the euro area's economic situation is characterised by high unemployment, large output gaps, low private and public investment, as well as an inflation rate substantially short of the ECB's inflation target. Against this background, a recent article by Watt and its precursor in the independent Annual Growth Survey (iAGS) outline a scheme to increase public investment that aims to neither impact on the fiscal deficit or public debt nor involve higher taxes.1 The scheme is straightforward: the European Central Bank (ECB) promises to buy newly issued bonds from the European Investment Bank (EIB) in the magnitude of €750 billion over a period of five years. This promise allows the EIB to raise its loan volume by 175 per cent without increasing its capital or losing its triple-A rating. The money thus obtained by the EIB is transferred to the member states, which use it to raise public investment.
The "free lunch" dimension of the EIB-ECB plan – echoed in the title of "Monetary Financing in the Euro Area: A Free Lunch?"2 – is not as peripheral to the scheme as Watt makes it out to be in his reply.3 Indeed, it is an important part of the narrative. At its core lies the idea that public debt transferred to the ECB "might as well be extinguished".4 The only "cost" is higher inflation, which in the current situation "is a boon not a bug of the scheme".5 ECB-financed public investment "is not just a free lunch, it is a meal that diners are being paid to eat".6 Lack of cost is an essential element, because it underlies the claim that higher public investment in this scheme does not entail higher fiscal deficits or higher public debt.
Contrary to Watt's assertion, however, higher inflation does not represent the costs of increased public investment in this scheme. Instead, the costs are the opportunity costs that arise because non-interest-bearing EIB bonds take the place of interest-bearing debt on the balance sheets of the Eurosystem. For the ECB, faced with a longer-term low inflation outlook and subdued inflation expectations, the alternative to monetary financing is not inactivity but rather other forms of monetary expansion, such as quantitative easing. Monetary financing as proposed in Watt's scheme does not affect the amount of asset purchases by the Eurosystem but only their composition. Substituting non-interest-bearing bonds for interest-bearing bonds reduces central bank profits and thus negatively impacts on national fiscal balances. Except for possible differences in interest rates, the fiscal impact is therefore the same, regardless of whether public investment is financed by credit or by newly issued bonds monetised by the central bank.
Analogously, public debt does not disappear once transferred to the Eurosystem. It is important to bear in mind that central banks have to be able to reverse or neutralise any monetary policy operation to maintain price stability. Once the economic situation normalises, the currently high level of liquidity may not be needed anymore. To absorb excess liquidity, a central bank that monetised debt might have to issue interest-bearing debt certificates rather than being able to sell the bonds it bought while engaging in quantitative easing. Shifting debt to the Eurosystem does not make it disappear but instead reduces the central bank's net assets.
The upshot of my reasoning above is that the analysis of the costs of monetary financing is logically flawed in Watt's scheme – a flaw not shared by Pâris/Wyplosz.7 The only "benefit" of the scheme is that there is a chance that the higher public debt may be effectively hidden and therefore not subject to the stringent fiscal rules in the euro area.
Contrary to Watt's assertion, Bernanke provides no theoretical backing for Watt's scheme either.8 In his analysis of Japan, Bernanke was dealing with the problem of Ricardian equivalence, which renders fiscal policy ineffective because economic agents anticipate future tax burdens as a result of deficit spending and reduce current consumption accordingly. Bernanke's recommendation is quantitative easing, as already practiced by the ECB, combined with price level targeting and expansionary fiscal policy. In addition, Bernanke proposes measures to protect the central bank's balance sheet by transferring risk to the national ministry of finance, not the other way around as in Watt.9 Watt's scheme, on the other hand, attempts to get around the very different problem that policy makers in the euro area are not willing to increase deficit spending or change the fiscal rules they themselves legislated.
As a side issue, Watt reaffirms his view that it is compatible with the ECB's inflation target to continue expanding its balance sheet for six months after core inflation has exceeded "2.5% for three consecutive months".10 I disagree, not because of a half percentage point, but because inflation targeting requires a credible target and a central bank that acts in a forward-looking manner, adjusting its policy instruments based on its inflation forecast rather than actual inflation. If the ECB reacted only after underlying inflation was well above the target – and core inflation in this context cannot be but synonymous with underlying inflation – it would risk higher inflation expectations, which, in turn, tend to feed back into actual inflation. The medium-term perspective of the monetary strategy evoked by Watt is important because it allows for fluctuations in headline inflation, for example as a result of exogenous shocks, such as oil price hikes.11 It is not the purpose of the medium-term perspective to blur the target for underlying inflation and its role as a stability anchor. There may be good arguments for adopting a price level target as suggested by Bernanke for Japan;12 my disagreement with Watt concerns the purported compatibility of the only quantified trigger mechanism with the ECB's inflation target.
It can be frustrating to watch the ECB strenuously attempting to "push a string". The euro area needs higher aggregate expenditure, and only fiscal policy can deliver this directly. Fiscal policy has eased a bit in recent years, as convincingly analysed in other sections of iAGS and more recently in Horn et al.13 Making the case for public investment and expansionary fiscal policy may be cumbersome and it might fail. But trying to circumvent the rules by saddling the Eurosystem with non-interest-bearing, illiquid bonds and potentially weakening the ECB's ability to deliver monetary and financial stability is neither a realistic nor a viable alternative.
1 A. Watt: Quantitative easing with bite: a proposal for conditional overt monetary financing of public investment, IMK Working Paper No. 148, March 2015; and Observatoire Français des Conjonctures Economiques (OFCE), Institut für Macroökonomie und Konjunkturforschung in der Hans-Böckler-Stiftung (IMK), Economic Council of the Labour Movement (ECLM): independent Annual Growth Survey 2015, Third Report, Brussels 2014, pp. 125-129.
2 S. Tober: Monetary Financing in the Euro Area: A Free Lunch?, in: Intereconomics, Vol. 50, No. 4, pp. 214-220.
3 A. Watt: Monetary Financing: A Response to Silke Tober, in: Intereconomics, Vol. 50, No. 6, pp. 356-360.
4 OFCE et al., op. cit., p. 129.
5 Ibid., p. 127.
6 A. Watt: Quantitative easing ..., op .cit., p. 20.
7 P. Pâris, C. Wyplosz: The PADRE plan: Politically Acceptable Debt Restructuring in the Eurozone, VOX CEPR's Policy Portal, 28 January 2014.
8 B. Bernanke: Some Thoughts on Monetary Policy in Japan. Speech Before the Japan Society of Monetary Economics, Tokyo, 31 May 2003.
9 A. Watt: Quantitative easing ..., op .cit.
10 Ibid., p. 24 (emphasis added).
11 S. Tober, T. Zimmermann: Monetary Policy and Commodity Price Shocks, in: Intereconomics, Vol. 44, No. 4, 2009, p. 231-237.
12 B. Bernanke, op. cit.
13 OFCE et al., op. cit.; G.A. Horn, S. Gechert, A. Herzog-Stein, P. Hohlfeld, F. Lindner, A. Rannenberg, S. Stephan, T. Theobald, S. Tober: Im Aufschwung – Prognose der wirtschaftlichen Entwicklung 2015/2016, IMK Report No. 104, April 2015.