In the dying days of his ECB presidency, Mario Draghi threw everything he had at the deflation problem, buying time for Europe’s governments and his successor, Christine Lagarde. But, like antibiotics to which bacteria have fully adapted, his weapons no longer work. On the contrary, they inflict considerable damage on savers in Europe’s heartland, who blame the ECB for the resulting negative interest rates that eat into their savings and encourage no appreciable productive investment in the green technologies and infrastructure that Europe needs.
In his penultimate press ECB conference, Draghi warned that very little was left in the ECB’s arsenal to continue the job. He urged politicians to boost aggregate demand via higher public spending and a substantial relaxation of the EU’s absurd commitment to procyclical fiscal policies, which he rightly feared would magnify the coming recession. Future historians will write long studies on why Europe’s governments refused to coordinate a sensible fiscal policy. All the news from Berlin and from the informal, yet powerful, Eurogroup of eurozone finance ministers, confirms this: there will be no macroeconomically significant loosening of fiscal policy. The burden of confronting the next recession will fall, yet again, on the ECB.
ECB observers predict Lagarde will tinker with and extend existing practices. Quantitative easing will continue by increasing the portion of a country’s public debt the ECB may buy. And the emergency programme of providing cheap liquidity to the periphery’s banks, known as “targeted longer-term refinancing operations” (TLTRO), will become a permanent drip-feed. Continued reliance on Draghi’s weapons will probably succeed in keeping quasi-insolvent states and banks afloat. But it will do so only at the expense of deeper stagnation and uglier political tensions. More precisely, by 2025, the ECB will hold half the eurozone’s debt (public and private).
Voters and politicians in fiscally conservative central and northeastern Europe will become further disillusioned by the backhanded manner in which the dreaded mutualisation has been foisted upon them, thus fueling Euroscepticism among conservative Europeans. Meanwhile, real investment, creation of high-quality jobs and public sentiment will remain in the doldrums across Europe as both surplus and deficit countries labour under a cloud of permanent stagnation. The only beneficiaries will be right-wing populists.
The conclusion is inescapable: the ECB needs new weapons. Urgently. But what should they be? In designing them, it helps first to agree on four standards they must meet:
First, the rules for their deployment must be consistent with the ECB’s charter and so simple that discretion in using them is eliminated. The more complex any new intervention’s protocol is, the more vulnerable the ECB will be to accusations of favouritism (say, partiality toward Italian debt or German banks).
Second, to prevent the revival of damaging moral-hazard objections, the ECB’s new weapons must have an in–built mechanism for preventing free-riding by weak states and banks. Placing the disciplinary burden on market-based incentives will eliminate dependence on the authorities – whether the European Commission, the Eurogroup or some other body – for the enforcement of fiscal rules.
Third, the ECB’s new tools must fill the eurozone’s largest void: the lack of a copper-bottomed safe asset that every currency needs to stabilise the financial institutions using it. Its absence has prevented eurozone banks from shoring up their capital with a sufficient supply of high-quality assets, resulting in greater financial instability. Moreover, the euro will never become a viable alternative to the US dollar as long as no euro-denominated asset exists in which a foreign entity can safely invest euros accumulated from exporting to the eurozone.
Fourth, the ECB’s new tools must simultaneously help states and banks in the periphery overcome insolvency and alleviate the burden of negative interest rates in the surplus countries. Fortunately, an effective weapon can immediately be built to all four of these standards: ECB conversion bonds.
A sketch of their announcement follows:
“Henceforth, whenever a eurozone government bond matures, the ECB will issue a conversion bond with a face value equivalent to the Maastricht-compliant portion of the member state’s total public debt. The bond’s purpose is to service, at low interest rates that only the ECB can fetch, member states’ Maastricht-compliant public debt (up to 60% of GDP) – conditional on member states’ commitment to redeem the bond and afford it seniority over all other debts (presumably serviced at higher interest rates).”
To give a numerical example, if a member state’s debt-to-GDP ratio is 90%, the ECB conversion bond services €667 of each €1,000 of maturing state debt. The less the member state has exceeded its Maastricht debt limit, the larger the percentage of its public debt that will be serviced at the ultra-low ECB bond yields. Immediately, we see how this interest rate differential encourages discipline and eliminates the fear of moral hazard that the present quantitative easing programme has elevated to dangerous levels.
Note also that, besides minimising moral-hazard risks, the new ECB bonds meet the other three standards. Their issuance requires no discretionary powers by the ECB as it follows directly from the existing Maastricht limits.
They would provide eurozone banks with the missing safe asset they need to wean themselves off bonds issued by often-weak national governments (while creating a safe asset for foreigners to buy with their euros).
Finally, ECB conversion bonds would allow interest rates in surplus countries like Germany to rebound, because the ECB would no longer need to buy German bunds as a condition for purchasing Italian bonds. In fact, the ECB would be free of any obligation to buy anything, allowing it to consider supporting only one other bond: green bonds issued by the European Investment Bank to soak up and convert additional liquidity into the green investments Europe needs.
Technically speaking, ECB conversion bonds are the obvious replacement for the failing quantitative easing programme. Only the misplaced fear of debt mutualisation stands in their way. BM
Copyright: Project Syndicate, 2019.