Despite the unprecedented scale of monetary intervention undertaken by the European Central Bank (ECB) in response to the Covid-19 crisis (see EUROPE 12499/1 and 12450/6), some experts are calling on the bank to do even more. A particular case in point is Nicolas Dufrêne, a senior French civil servant who specialises in monetary issues and who is also director of the Rousseau Institute. Along with other economists and politicians, this independent think tank is arguing that the 2,320 billion euros of euro area states’ government debt acquired by the ECB since 2015 should be cancelled [Interview by Damien Genicot].
Agence Europe – What are the advantages of your proposal compared to the ECB’s quantitative easing policy?
Nicolas Dufrêne – Firstly, if part of the government debt held by the ECB is cancelled, the euro area member states’ government debt-to-GDP ratios will fall instantly.
This will help them to comply with the conditions laid down in the Stability and Growth Pact which, even though it is suspended at the moment (see EUROPE 12452/1), will become a factor again at some point, and will require member states to continue pursuing policies to reduce their debts and deficits.
Secondly, more than anything else, cancelling these debts will help to revive the economy by allowing member states to reinvest equivalent amounts without increasing their debt levels.
If they were to do this, the stimulus would go directly via the member states, whereas the ECB's current quantitative easing policy directs liquidity to commercial banks via the secondary market, and not directly to the states.
However, as a recent Bank of England study [https://bit.ly/3hxQQYg ] shows, commercial banks reinvest the money in bonds or assets on the financial markets rather than in the real economy, thus contributing to the formation of financial and property bubbles.
Some experts believe that cancelling government debts is unnecessary in the current context of very low or even negative interest rates.
I don’t agree. European governments have been able to take on debt at very low or even negative rates for the last five years. But even though the rates were lower than growth rates, they have not borrowed and invested more in recent years. Quite the opposite in fact: on average, they have been reducing their debt levels.
With the coronavirus crisis, member states are now more inclined to go into debt to invest and support the economy, but the levels are still too low compared to the stated impact of the coronavirus on the economy (see EUROPE 12522/1).
As the member states are the ECB’s shareholders, in a manner of speaking, the bank pays them dividends on the interest they pay it. Cancelling part of the government debts held by the ECB would lead to the cancellation of both the interest on the debts and the dividends…
First of all, the dividends are lower than the interest, because the national central banks, which together make up the European System of Central Banks (ESCB), retain part of the dividends to pay for their own costs and fund their reserves.
Secondly, this argument ignores the principal part of the debt. It is true that member states pay interest to the ECB, which then pays the majority of it back to them. However, the member states still have to repay the principal when the security matures. If the debts were cancelled, the member states would not have to repay the principal.
What impact would your proposal have on inflation?
The twentieth-century monetarists’ view that injecting money into the economy automatically generates inflation does not really reflect economic reality, and this is even more the case in modern societies with powerful deflationary tendencies.
In the current economic situation where some production capacity is idle, an increase in the quantity of money simply leads to the mobilisation of this idle capacity.
This link between creating money and inflation also depends on how the injection of additional money is targeted. If governments direct their investments at the creation of local jobs, such as jobs linked to energy-efficient building renovation, rail transport or organic farming, there is no risk of creating too much inflation.
In addition, a slight increase in inflation in the real economy would be welcome, as inflation has been struggling to reach 1% on average in the euro area for more than a decade, while the ECB has set itself the target of close to, but below, 2% inflation.
One reason for this is that the transmission channels for monetary policy have been captured by the financial markets. Quantitative easing creates inflation, but on the financial markets and not in the real economy. And it’s not visible, because the inflation measure excludes property and the financial markets.
Isn't there a risk of loss of confidence in the currency?
The amounts of liquidity that would be injected under our proposal would be too small to constitute a genuine risk in the euro area.
The real risk to the currency is not a loss of confidence in it caused by the risk of hyperinflation. Instead, I believe the real risk at the moment is the risk of going into a deflationary spiral (falling prices, falling incomes, a proportionate increase in the debt burden, unemployment, etc.) if the stimulus plans are inadequate. Deflation is much more difficult to deal with than inflation.
Isn’t it possible that cancelling the debt in this way might create a position where the ECB goes into negative equity, thereby threatening the bank’s ability to operate?
Maintaining a balanced balance sheet is just an accounting policy that isn’t relevant when it comes to central banks that can create money. A central bank can have an unbalanced balance sheet without it having an impact on the bank itself or on governments that have no obligation to recapitalise it.
In addition, there are numerous examples of central banks that have operated with negative capital (in the Czech Republic, Chile and Israel), sometimes for several years. It is technically absurd and legally wrong to want to subject the body that creates the money to conventional accounting rules.
Some member states, particularly Germany, are strongly committed to the ECB’s independence. Doesn’t your proposal run counter to this principle, as the ECB would exceed its core mandate of stabilising inflation?
The Treaty on the Functioning of the EU (TFEU) states that, in addition to and without prejudice to the objective of price stability, the ECB must support the general economic policies in the EU.
The ECB could therefore say, in consultation with the member states, that the time has come to show ambition, without the need to call into question the articles of the TFEU relating to its independence.
More broadly, I believe that the ECB’s independence is a form of powerlessness. Its requirement to remain neutral with respect to the market deprives it of the legitimacy and the opportunity to make bold political decisions, such as favouring green investments over investments in fossil energy sources or funding the costs of public investment banks or governments directly.
Is your proposal allowed under the EU treaties?
In theory yes, as the TFEU doesn’t mention debt cancellation at any point. Protocol No 4 on the European System of Central Banks even states that the ECB could indemnify loss-making national central banks by any means it deems appropriate.
Some experts might nevertheless associate debt cancellation with monetary financing of member states, a practice that is prohibited by Article 123 TFEU. This interpretation seems to me to be wrong, however, because debt cancellation would not constitute new financing provided to member states by the ECB.
In addition, the Court of Justice of the European Union (CJEU) has approved the ECB’s OMT programme (see EUROPE 11336/18), which involved repurchasing government debt securities with a high risk of default, thereby implicitly admitting that the ECB could make losses on government debt securities it held. If it cancels some of the debts it holds, this will amount to the same thing: it will make a loss.
Even though there would certainly be challenges before the CJEU, as there have been recently with regard to quantitative easing (see EUROPE 12480/17), it seems to me that the economic, technical and legal basis exists, without any requirement to amend the treaties.
Doesn’t the decision to cancel part of the debts still require a unanimous vote by the ECB’s Governing Council?
As a general rule, Governing Council decision are taken by a simple majority of the members with voting rights and, in a few specific situations, by a qualified majority. In the event of a tie, the President has the casting vote. Theoretically, a decision of this nature does not therefore require a unanimous vote.
And, if a national central bank were to refuse to apply the decision, the ECB would have legal grounds to challenge it before the CJEU.