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The Italian budget saga – 3/3 – The role of ECB as a monetary backstop

[…Continuing from the second part:]
[full essay in pdf version here]

In the previous two parts of this essay we have seen that fiscal expansion in Italy could be justified. However, even without disagreement from the European Commission, the willingness of financial markets to finance the ensuing budget deficits seems to be putting a hard constraint to this. “Lo spread” between German and Italian government bond yields has risen sharply on the news of the draft budget, signalling that market investors now fear Italian default considerably more. Despite the ECB still keeping euro interest rates near zero, this makes servicing Italian sovereign debt much more expensive, reducing the stimulative effects through crowding out, and worsening the fiscal situation as well, potentially making default more likely in a self-fulfilling way. Even before the current Italian situation, on the surface the euro crisis seemed to be about public debt, severely limiting the ability of periphery countries to fight the recession with fiscal stimulus.

All this may not sound so surprising or unusual, but in fact, it is very much so. The eurozone should not be having a debt crisis, and fear of default should not guide its policy decisions, simply because an economy with its own fiat currency should never default. I have written about this in another post, which I really urge you to read because it is an often overlooked and ignored aspect of monetary-fiscal interactions. A country who issues debt in a currency which it can control need not have default risk because the central bank can be a buyer of last resort in the government bond market in times of stress by its unlimited ability to create money, ensuring that creditors always get back the face value of their bonds in legal tender. While this may add some inflation premium, default risk should therefore not feature in the nominal bond yield. As it is pointed out by Paul de Grauwe from the LSE, Corsetti, Dedola and coathors from the ECB, or Athanasios Orphanides, a former ECB central banker, a central bank which acts as a lender of last resort for governments is essential to rule out unsubstantiated, self-validating default concerns (“sunspots”) and multiple equilibria.

It is not just unfounded, sentiment-driven confidence crises which can be avoided though: even a significant fundamental easing in fiscal policy should be free of increasing default risk. As Corsetti and co. also explain (formalized model by Jarocinski & Mackowiak), another source of multiple equilibria is the liquidity trap, where monetary policy loses its ability to affect demand and determine inflation due to the zero-lower-bound constraint. Therefore we might need a switch to “active fiscal policy” which is not primarily focused on debt stabilisation but can take over from the central bank to provide demand stimulus in the form of permanently decreasing the present value of future primary budget surpluses. This can only be done though without violating the intertemporal government budget constraint (i.e. without defaulting), if monetary policy passively accommodates rising inflation (i.e. without raising interest rates, or even buying government bonds with freshly printed money), effectively monetizing debt by eroding its real value. At this point, I think it is useful to cite a disclaimer from my earlier post:

“Before you start screaming, this is not a hostile take-over of independent central banks by politicians, pressuring it to monetize debt. It is just a realization that no sane independent monetary authority would stand idle while its government is going bankrupt and the collapse of bond markets is bringing down the banking system. Of course, systematically irresponsible fiscal policies and money printing sooner or later would lead to runaway inflation, but this is not the case we are talking about here. It is just to [rule out multiple equilibria and stabilize demand at the liquidity trap], which also points to the fact that the prohibition of monetary financing should not be viewed as a binary choice.”

One might argue that once politicians get access to money printing, they will abuse it even when it is not warranted. But all this is in line with the Fiscal Theory of the Price Level: if policymakers are to maintain price stability, fiscal policy must contain its deficits voluntarily. If politicians keep overspending from freshly printed money, it will either lead to hyperinflation, or the central bank taking back the printing press and forcing the government to default (which it will most certainly not do). Therefore, no matter how independent our central banks are, at the end of the day price stability depends on fiscal policy being conducted by sensible politicians. In other words, there is no added value in banning monetary financing when it is actually needed. Then this allows a responsible policymaker to undertake some extra money-financed fiscal stimulus in times of a liquidity trap when it is be beneficial: in a low demand environment a bit of inflationary pressure is just what the doctor ordered. By ensuring that public debt is non-defaultable (i.e. guaranteeing that maturing bonds can be converted into currency at face value), and keeping interest rates low while the fiscal expansion lasts, the central bank can prevent rising fiscal deficits from being associated with increasing default premia, and the necessary stimulus will not be halted by financial markets (or its effect offset by crowding out).

Once you wrap your head around this argument, it becomes surprising why the euro area with unlimited capacity to print euros should be paralyzed by default-fearing debt markets, when it should be rather wielding a formidable fiscal stimulus to fight the biggest crisis since the Great Depression. The United States has a public debt-to-GDP ratio above a 105%, much larger than the eurozone’s combined 86%, and yet they could overtake a much bigger fiscal stimulus without even a slight increase in bond yields, and with no sign of the dreaded “bond vigilantes”. But even if we look at the United Kingdom (which does not have the “exorbitant privilege” of issuing a reserve currency like the US dollar), we see that much larger budget deficits and a similar debt ratio of 88% did not cause British bond yields to rise. As a consequence, the overall fiscal-monetary policy stance in these countries was much more accommodative than it was in the euro area, resulting in a much more robust recovery from the crisis.

Quantitative Easing by their respective central banks certainly helped in this, but the more crucial difference is that these countries have their own central banks, implicitly guaranteeing that their government bonds are non-defaultable. The problem with the eurozone is that the same implicit guarantee is perceived to be missing from the part of the ECB, which is one of the most serious design flaws of the single currency. In fact, the EU Treaty explicitly forbids the ECB from undertaking anything of the sort (prohibition of monetary financing and no-bailout clauses), in the spirit of German-inspired aversion to inflation and moral hazard. What this means is that euro member countries, like Italy, are like not having their own central bank, or like being indebted in a foreign currency over which they have no control (see dollar-indebted Argentina) – as if the euro was not a fiat currency with potentially unlimited supply but something akin to a modern gold standard. All of these cases mean that default risk becomes real and it can seriously constrain fiscal policy, which is exactly what we see now as Italy faces off debt markets and “lo spread”.

It is not the first time this is happening. In 2011-2012 spreads on Italian sovereign debt were around 4-5 percentage points. Apart from (potentially unfounded) default concerns this also reflected something unique to a multi-country monetary union: redenomination risk. Given that the domestic banking system holds large portions of the national government’s debt, a sovereign default would likely go hand in hand with a banking crisis, which would increase pressure to exit the euro and recapitalise banks with a newly printed national currency. It was not until ECB chief Mario Draghi’s famous 2012 “whatever it takes” speech and the introduction of the ECB’s Outright Monetary Transactions (OMT) program that the spread was normalized. Although it is most certainly a violation of the ill-advised EU Treaty (and as such, was attacked by Germany in court), it was needed to preserve the unity of the single currency, and thankfully the central bank managed to sell it under the label of “being necessary for the proper functioning of monetary transmission”. The subsequent introduction of QE in 2015 also helped to contain sovereign debt markets. But still, QE is winding down and OMT is conditional on submitting to a harsh bail-out program, and beyond Draghi’s term there are no institutional guarantees from the ECB. The effect of this uncertainty is clearly present in current Italian bond yields.

If this situation continues and the ECB does not intervene, it can have dire consequences. Italy might be forced into default by the markets. This could lead to mass bankruptcies in its banking system which holds a large portion of government debt. Normal access to ECB liquidity operations would be severed as the most common collateral used by banks, sovereign bond, would lose its value. The ECB’s lender-of-last-resort facility, Emergency Liquidity Assistance (ELA), which does not require collateral, might be approved on a case-by-case basis, but it is for liquidity purposes and is not supposed to be granted to actually insolvent banks. Moreover, the fiscal burden of the credit risk in ELA is not born by the Eurosystem as a whole, but by the Banca d’Italia and the Italian state – which would not reassure the ECB Governing Council in the case of a country in default. The banking crisis and the corresponding recession could then force the government to leave the euro and reintroduce the lira. In anticipation of redenomination into lira, capital would start rushing out of the country, basically causing a bank run and further draining liquidity from the banking system. To prevent that, capital controls might need to be imposed which would severely disrupt trade and daily life, as we have seen in Greece and Cyprus. It is another question what would happen with the already existing TARGET2 liabilities of Banca d’Italia within the Eurosystem, the value of which would be further amplified by the capital flight as euro deposits are transferred abroad (it is like running down FX reserves for a normal country). Seeing that a defaulted country is unlikely to honor them, Italy might be shut out of the TARGET2 payment system, effectively ejecting the country from the euro.  It would be, as Barry Eichengreen put it, the mother of all financial crises.

Moreover, as Orphanides points out, due to an (inapprehensible) discretionary decision taken by the ECB in 2005, collateral eligibility of sovereign bonds is not even determined by the central bank’s Governing Council, but by the credit ratings of private agencies like Standard & Poor’s. Even if the Italian government does not default, a downgrade to junk category already deprives Italian banks from accessing normal ECB liquidity operations using Italian government bonds as collateral. This can also have serious disruptive effects, potentially creating a self-fulfilling mechanism.

If all this were to happen in Italy, it would arguably mean the end of the euro. Italy is just simply “too big to fail”, which is why I would hope that one way or another, this scenario will be avoided and the ECB cannot afford to stay idle. They either intervene in the bond markets similarly to 2012, or approve a blanket ELA to Italian banks the fiscal risk of which is born by the whole Eurosystem, or Italy gets an explicit and formal intergovernmental bailout like Greece or Ireland did. In the case of Italy the required size of such a bailout would likely to be prohibitively large though. Which is why it seems that the only thing standing between us and disaster is most probably the ECB.

That is, unless the Italian government backtracks first in this game of chicken. But as I argued throughout this three-part essay, it is really not fiscal stimulus which should be on the losing side in a weak-demand eurozone and stagnating Italy, but rather the unnecessary and self-inflicted austerity bias stemming from the ill-advised design flaws of the single currency.

Sidenote: The exact institutional setup in an alternative eurozone might not entail the ECB actually buying bonds: it can also be done by a fund, or even just by unconditionally accepting them as collateral in financing operations with banks. Corsetti and co. propose a “euro area fund” which buys the (dafaultable) bonds of national governments as long as they satisfy a flexible fiscal criteria (which allows for stimulus in liquidity traps) while financing itself from issuing non-defaultable “eurobonds” which are convertible into currency at par, as guaranteed by the ECB. In an economic sense, this is no different from ECB bond purchases: the fund just acts as intermediary between national governments and the ECB. Deciding on when to buy national bonds of member states needs more direct democratic accountability than what the ECB has. Admittedly, this is a form of debt-mutualisation and fiscal risk sharing. After extreme fundamental shocks, or fundamentally irresponsible national fiscal policies sovereigns might fail to meet the fiscal criteria and they can still be forced to default in which case the euro fund will suffer capital losses, which have to be shared among other member states. Another proposal for a “Financial Stability Fund” is designed in the ADEMU project by Ábrahám, Marimon & coauthors, which is similar to the one above, but also involves limited enforcement and moral hazard constraints trying to optimally balance between risk reduction (“discipline”) and risk sharing (“solidarity”).

Of course, there are valid reasons behind the German point of view. Moral hazard concerns in a multi-country monetary union are certainly justified and not to be taken lightly. In the basic single country framework of the Fiscal Theory of the Price Level we could reasonably rely on the sensibility of fiscal policymakers not to overspend and abuse the printing press as this would have lead to suboptimally high inflation, possibly crippling hyperinflation, the cost of which is internalized by a sensible politician (if they are not sensible, then recall, there is nothing to talk about: price stability is jeopardized anyhow). In a currency union with many independent fiscal authorities, however, this cost might not be internalized, as their size to the whole union is smaller. So it could be optimal for a single government to free-ride on some easy money-financed fiscal spending, the benefits of which are enjoyed by the country alone while the costs are spread out over the whole union in the form of higher inflation and/or fiscal loss-sharing on the monetized debt through the balance sheet of the ECB. It is true that this free-riding and externality problem should be handled and avoided, and these moral hazard considerations are certainly the reason behind the EU Treaty’s no bailout clause and the strict budgetary rules of the Fiscal Compact (although, as discussed in the previous parts of this essay, the fiscal rules could allow for a bit more flexibility in a liquidity trap, without jeopardizing debt-sustainability or price stability).

However, they should not be the reason behind a ban on monetary financing. Disciplining free-rider countries and fighting moral hazard is not the job of monetary policy. Using the ECB as leverage against these countries puts in danger the proper conduct of monetary policy, the adequate functioning of a monetary union without redenomination risk, and financial stability. European politicians must find way to enforce commonly-agreed (and possibly more sensible) fiscal rules without using the central bank as a political weapon (see euro fund proposals listed above in the box). Delegating the task from the ECB to a “euro area fund”, which in turn issues non-defaultable eurobonds would not make the core of the moral hazard issue go away though. This is why they do not need to grant a free pass to member states, but instead can make access to the fund subject to conditionality. The point is that this conditionality is decided by politicians/central bankers, and not the markets. E.g. they might decide that fiscal stimulus in a liquidity trap complies with the rules, so access to the fund/central bank is granted and forced default by the markets is averted. In other cases, fiscal expansion might not comply with the rules, so the threat of default would be a real disciplining force, constraining moral hazard. A key feature is that the rules should be transparent and institutionalized, in contrast to the current ad hoc system of intergovernmental bailouts and discretionary ECB decisions.

Of course, this leads to some fiscal risk sharing through the balance sheet of the Eurosystem or the euro fund which is backed by national governments of the member states. But this minimum degree of risk sharing is unavoidable in a well-functioning monetary union, even if  fully fledged fiscal union is not a political reality with the current lack of solidarity.

 

***

In this three-part essay I have argued that hysteria about the recent Italian budget proposal is largely overblown and that some fiscal demand stimulus would not hurt Italy which is likely to have not yet recovered fully from the crisis. Myths about Italy being a fiscally irresponsible profligate country seem equally misleading. What is often overlooked though, is the responsibility of Germany which significantly contributed to the austerity bias of the eurozone by its excess savings, running current account surpluses in a liquidity trap and forcing asymmetric rebalancing burden on deficit countries. In effect, Europe imposed self-inflicted austerity and misery on itself, significantly underperforming the US, in order to avoid more risk sharing and solidarity. There are also serious flaws in the monetary design of the euro, whereby debt markets can force member states into default. The ECB should guarantee sovereign bonds as non-defaultable by standing ready as buyer of last resort. Moral hazard concerns should not be addressed through the central bank, and the unavoidable risk sharing must be accepted by Europe as the price of a well-functioning monetary union.

 

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