The extraordinary salvo from six eminent European former central bank mandarins against the European Central Bank’s ultra-loose monetary policy earlier this month is too easily dismissed as the work of tired hawks protecting the interests of rich northern Europeans.
Their worry that behind the ECB decision to renew asset purchases “lies an intent to protect heavily indebted governments from a rise in interest rates” does, after all, have some justification.
The tide of opinion in Europe and elsewhere is moving towards the adoption of monetary financing — direct central bank financing of government debt — against a background of rising populism and a slowing global economy. This raises tricky questions, not least because the future path of the 20-year project of economic and monetary union is beset by uncertainty in the post-Brexit EU.
At a conference last month, Otmar Issing, 83, the ECB’s first chief economist and one of the authors of the critical memo, characterised the eurozone as being divided into two camps.
In one are people who feel Brexit is evidence that centralisation and bureaucratisation in the EU have gone too far and that it would be better to preserve some distance between member states. In the other are those who claim Brexit shows that integration has not gone far enough, especially in relation to fiscal transfers to address macroeconomic imbalances in the eurozone.
The new European Commission clearly falls into this latter camp, with president-elect Ursula von der Leyen championing an EU-wide unemployment insurance scheme.
Christine Lagarde, who succeeds Mario Draghi as ECB president next month, is likewise an integrationist. She favours bundling together member country bonds to create a eurozone-wide safe asset.
For Mr Issing, such transfers would be fine within a political union. But since political union is not happening, he worries that there will be attempts to carry out transfers via the backdoor by blurring responsibility for fiscal and monetary policy in ways that bypass the 1992 Maastricht treaty’s ban on monetary financing.
In their memo, Mr Issing and his fellow authors conclude that the ECB is being threatened with the end of its control over the creation of money and that central banking independence is at risk, either by law or in practice.
Direct central bank financing of government spending is a seductive policy option when, as in the eurozone, there is a problem of deficient demand. And it is all the more attractive when conventional monetary tools are losing their potency and the central bank is undershooting its inflation target.
Yet debt monetisation, in which the central bank purchases newly issued government bonds, sits uncomfortably with independent central banking since it requires explicit co-operation between fiscal and monetary authorities.
The great advantage of monetary financing is that it is more expansionary than quantitative easing — the asset buying that the big central banks have engaged in since the 2008 financial crisis — because it makes no demand on private savers. If such financing is used specifically to reduce output gaps or increase investment it need not lead to runaway inflation.
The snag is moral hazard. If governments can fund budget deficits by selling their bonds to central banks rather than private investors, it neuters the discipline of the debt market. As a result, it has frequently paved the way for hyperinflation.
This was the case in the Weimar Republic in the 1920s where, on the calculations of economists Steve Hanke and Nicholas Krus, Germany’s monthly inflation hit a peak of 29,500 per cent. In 1930s Japan the picture was more mixed. After abandoning the gold standard in 1931, finance minister Korekiyo Takahashi, a former Bank of Japan governor, pressured the central bank into directly underwriting the issue of government IOUs. The policy was initially successful in overcoming deflation. But after Takahashi was assassinated by military fanatics, the policy was extended without limit, permitting fiscal deficits to run riot and inflation to go out of control.
In more recent times monetary financing was followed by hyperinflation in Zimbabwe under Robert Mugabe and in Venezuela under Nicolás Maduro.
Yet outcomes like this are not inevitable. Russell Jones and John Llewellyn of Llewellyn Consulting point out that monetary financing can be a viable policy option if there are robust institutional checks and balances. One option would be to place the decision to pursue debt monetisation in the hands of a central bank policymaking committee, or an independent fiscal authority, or some combination of the two. Another might be to confine the action to a specific amount over a specific period.
Yet as history implies, this monetary wheeze has long been a taboo in economic policymaking for good reason. The writers of last week’s blistering memorandum on the ECB’s monetary approach may be old — but not too old to recognise a potential slippery slope when they see one.
For another view, read Jean-Claude Trichet on Mario Draghi’s critics
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