Is Quantitative Easing the solution for the Eurozone?
Considering Quantitative Easing (QE) to be an effective way to save the Eurozone from deflation, De Grauwe and Ji (2015) argue that a QE programme can be so structured as not to pose a risk on German taxpayers – this risk being seen as the main obstacle against active policies by the ECB. However, they seem to miss some important points.
First, they fail to recognize that there is little convincing evidence that QE has any significant effect on consumer price inflation: QE does not buy-up ordinary goods and services, and consequently it does not create consumer price inflation. QE has delivered positive effects only when it has been implemented in conjunction with decisive fiscal stimulus, since it has counteracted the interest rate rises that deficit and debt growth would have otherwise caused. Giavazzi and Tabellini (2015) note that an accompanying fiscal expansion is critical to QE’s effectiveness. Yet fiscal expansion does not appear to be an option in the Eurozone, especially in already largely indebted countries, as it would trigger offsetting effects linked to Eurozone members having issued debt in a non-sovereign currency, which would neutralize the action of QE combined with fiscal expansion.
Second, De Grauwe and Ji suggest that QE reduces the financial obligations associated with the debt purchased by the central bank. Yet they miss to specify the condition that would be necessary for such debt obligations to be “sterilized” indefinitely. Specifically, for governments and taxpayers to be effectively relieved of the associated debt and tax obligations, QE purchases must be accompanied by a “permanent debt holding” commitment clause, whereby the ECB would explicitly undertake to holding the bonds purchased permanently. In the absence of such condition, governments would continue to bear the obligations associated with the outstanding debt, and taxpayers will face the related future tax burdens. De Grauwe and Ji recognize that in the future the ECB might want to sell part of the governments bonds it has acquired back in the secondary market. If that were the case, governments would be liable for the shares of debt that would be sold to the market.
From these considerations three conclusions follow:
- QE must be accompanied by fiscal expansion for the policy action to succeed in stimulating aggregate demand and raising inflation. Yet,
- Fiscal expansion must be undertaken in a way that does not worsen the debt situation, since the latter would neutralize the impact of expansionary policy through higher interest rates and Ricardian equivalence effects. Therefore
- A combination of i. and ii. is necessary to mimic some form of Helicopter Money operation, whereby monetary and fiscal policy mutually interact, at no extra cost to the taxpayer, to ensure that new money is created and spent in the economy – which QE and fiscal expansion, in isolation, are not able to achieve.
This would pretty much amount to a “grand scheme”, for which there does not seem to be any appetite from Germany and other northern European countries. There are hints, however, that, facing a deteriorating situation, the most recalcitrant members of the ECB might be open to a hybrid approach to QE whereby national central banks would make separate purchases of their own, with the consequences of eventual public defaults falling upon the intervening national central banks.
While this “Balkanised” approach is far from ideal for a so-called monetary union, it does at least offer a chance of doing something to save crisis-hit Eurozone countries from collapse, without forcing potentially catastrophic euro exit events.
Under this “Balkanised” scenario, three options can be contemplated.
Option 1: Activating the Emergency Liquidity Assistance facility of the European System of Central Banks
A government of the Eurozone submits to its Parliament a pre-defined fast-track public-spending package or tax-reduction plan to be financed in deficit under Emergency Liquidity Assistance (ELA) facility. The corresponding deficit is set with a view to delivering a pre-determined domestic nominal-demand target. After consideration of the approved government programme, the European System of Central Banks (ESCB) endorses use of the ELA for deficit financing purposes by the central bank of the submitting member country.
The central bank communicates to the government its readiness to finance an increase in the fiscal deficit through permanent purchases of newly issued debt under the ELA facility. In other words, the central bank would buy it and commit to holding it in perpetuity, rolling over into new government debt the bonds on its balance sheet that reach maturity, and returning to the government the interests matured. Alternatively, government issues could be structured as special non-interest bearing and never-redeemable securities (Turner 2013). What matters is that, under this “permanent debt holding” commitment clause, the public debt situation of the issuing country would not be altered: the state would not take upon itself any new future obligation to repay the holder of the special securities.
Accordingly, the government would instruct its ministry of finance to issue special non-transferable government bonds to the central bank in exchange for newly issued euros under the ELA. The national central bank could also buy the bonds on the secondary market, under commitment to permanent purchases, and the government could use the resources saved on capital and interest payments to finance a public spending or tax reduction programme.
Option 2: Monetising national debts
Considering the public debts of some Eurozone countries as unsustainable, Pâris and Wyplosz (2014) have proposed that the ECB purchase and subsequently eliminate these debts through debt monetisation. In practice, the ECB would purchase the outstanding debt of a euro member in exchange for a zero-interest loan of an equal amount. The loan would stay indefinitely on the ECB books, and will never be repaid. Notice that, like in Option 1 above, the monetisation would be permanent. The counterpart of the operation would be an equal supply of euro monetary base, which would represent the cost of monetisation. This would be a one-off measure, and would have to be accompanied by strengthened fiscal rules to avoid the re-accumulation of large debts in the future. Debt monetisation would not be intended directly to support economic activity: it is a form of Helicopter Money for the public sector. Yet it would regain fiscal space to the government and grant new spending capacity to the economy. The inflation risk would be remote, according to the monetisation proponents, due to the weak economic conditions of the countries considered but, if necessary, the ECB could sterilise the money issued. While there seems to be no favour for such a measure at the euro area level, consideration could be given to scaling it down at the level of individual countries. Again, resorting to the ELA facility could be a channel to implement it at the national scale.
It should be noticed that both Options 1 and 2 above would weigh on the balance sheet of the central bank and, ultimately, on its capital. Such circumstance, however, is to be seen in the very special context of an institution that can always resort to ‘printing’ money in order to cover eventual balance-sheet losses and capital erosion. It becomes critical only when the need to create money for balance-sheet reasons conflict with the monetary policy objectives that the central bank pursues. See the important contribution by Archer e Moser-Boehm (2013). These consequences would not differ, obviously, if deficit financing were provided directly by the state treasury through the issuance of its own monetary instrument, and in the context of a consolidated public sector balance sheet.
Option 3: Issuing fiscal monies
Following a recent proposal discussed on the Italian media, the government could issue new bills called Tax Credit Certificates (TCC) by amounts necessary to gradually close the economy’s output gap, taking into consideration plausible values of the fiscal multiplier for an economy with large unutilized capacity where monetary policy operates under the zero lower bound. TCC represent government bills of exchange: the government has no obligation to reimburse them in the future. Rather, two years after issuance, they are accepted to fulfil any financial obligation towards the Italian state (taxes, public pension contributions, national health system contributions, etc.). The deferral allows for output to start recovering and generate resources to offset the shortfall of the euro-denominated tax receipts that follows when TCC start being accepted by the state for payments of taxes and other obligations. The TCC would be a form of Helicopter (quasi) Money originated by fiscal fiat.
TCC are issued free of charge to private sector enterprises and employees. Enterprises and employees receiving TCC allocations can immediately cash them into euros and use them for spending. The market will discount them like any zero-coupon two-year (default-free) government bonds. Those deciding to hold TCC will use them past the deferral date to pay taxes and obligations to the state.
Enterprises are allocated TCC based on their labour cost. TCC allocations primarily aim to reduce the fiscal wedge between gross salaries paid by the enterprises and the net salaries received by the employees. They cut enterprise tax bills and raise employees’ disposable incomes. Higher disposable incomes foster consumption, and labour cost reductions encourage employment and improve competitiveness. The trade balance reflects both the effect of lower labour costs on competitiveness and that of increased spending on imports. By partially offsetting tax-driven excess labour costs, TCC allocations help enterprises recover external competitiveness, thus balancing the effect that TCC allocations have on imports via higher demand.
Improving demand stimulates investment and revamps banking. As expectations reinvigorate, private consumption and investment bounce back, and the economy re-approaches full employment, the government reduces and finally terminates new TCC emissions while tax reductions become permanent.
A preliminary simulation exercise suggests that the Italian government could issue TCC at a 200-billion annual rate for 2015-2018, and phase out the program during 2019-2023. Assuming a fiscal multiplier effect of 1.2, conservatively spread across three years, and two alternative inflation scenarios, Italy would close the current output gap by 2017, never exceeding the Maastricht treaty 3% budget deficit limit, and steadily reducing its gross public debt/GDP ratio. Besides, a multiplier of 0.8 would be necessary for the shortfall of fiscal revenues in euro (due to TCC payments) not to cause the deficit to exceed the 3% limit. Note that, after TCC phase-out, the higher tax revenues due to GDP recovery allow for making permanent the demand support action (including the lower tax burden) initially financed with TCC.
While there is no space here to compare the relative advantages and disadvantages of the three options, it is evident that they have different institutional implications: Options 1 and 2 both require a high degree of cooperation and coordination between the monetary and fiscal authorities, whereas Option 3 largely falls within the fiscal state sovereignty of the Eurozone member countries and implies a partial recovery of monetary sovereignty by the national states issuing fiscal (quasi) monies.
Conclusion: dying from austerity?
All the above options aim to correct the biggest distortion of all, the original sin with which the European Monetary Union was created: a central bank with no regard to output and employment conditions, and a monetary union without fiscal union.
Not many might recall that, in 1998, Franco Modigliani and other world prominent economists issued a Manifesto, which was then co-signed by other leading economists, against unemployment in the European Union (Modigliani et al, 1998). As regards the then nascent European Central Bank, they strongly recommended that its role be given a broader and more constructive interpretation than just pursuing low inflation (the interpretation that eventually prevailed), and expressed their favour for a mandate that, like that for the US Federal reserve, would include at least one other objective, that of keeping unemployment under control.
In the absence of sufficient mechanisms to coordinate an appropriate policy response to crisis, the above options provide powerful tools to avoid Eurozone citizens having indefinitely to bear the consequences of those who created such an imperfect union.
Archer D, and P Moser-Boehm (2013) “Central bank finances”, BIS Papers No 71, Bank for International Settlements, April
Bossone B (2014) “Secular stagnation”, Economics Discussion Paper No 2014-47, November 19
Bossone B (2015) “The ‘safety trap’ and Eurozone secular stagnation, All About Finance, 13 January
Bossone B and R Wood (2013) ‘Overt Money Financing of Fiscal Deficits: Navigating Article 123 of the Lisbon Treaty’, EconoMonitor, July 22
De Grauwe P, and Yuemei Ji (2015), “Quantitative easing in the Eurozone: It's possible without fiscal transfers’, VoxEu, 15 January
Giavazzi F, and G Tabellini (2015) “Effective Eurozone QE: Size matters more than risk-sharing”, VoxEu, 17 January
Modigliani, F, J P Fitoussi, B Moro, D J Snower, and Rt Solow (1998), “A manifesto on unemployment in the European Union”, Quarterly review, Vol. 51, Iss. 206, 327-361
Pâris, P., and C. Wyplosz (2014), “PADRE: Politically Acceptable Debt Restructuring in the Eurozone”, Geneva Special Report on the World Economy 3, ICMB and CEPR
Turner A (2013) “Debt, Money and Mephistopheles: how do we get out of this mess’, Cass Business School Lecture, 6 February
 I wish to thank Marco Cattaneo for his useful comments on a previous version of this post.
 For an analytical comparison of unconventional monetary policies, including Helicopter Money drops, see Bossone (2014). The analysis shows that Helicopter Money as the most effective type of demand management policy tool for economies in deep recession and running large public debts. The results of the analysis are synthetically discussed in my recent post on this blog (Bossone 2015).
 The Emergency Liquidity Assistance facility gives national central banks of the Eurozone the ability to support temporarily illiquid domestic institutions and markets over and above ESCB assistance, in exceptional circumstances and on a case-by-case basis. The ELA is not a function of the ESCB, and the power to use it lies with the national central banks and does not derive from their membership in the ESCB. Although the use of the ELA by national central banks is not constrained by the rules governing European System of Central Banks operations, restrictions apply:
- Prohibition of overdraft facilities for official bodies;
- Purchasing government bonds;
- Undertaking tasks that go beyond those of a central bank (ECB 2012a).
The ELA does not require explicit approval of the ESCB, yet it may be terminated by vote if it is deemed to run counter to the ESCB’ mandate. Moreover, the same degree of independence is required for national central banks performing ELA functions as they enjoy in carrying out ESCB-related operations
 I am grateful to Stefano Sylos Labini for bringing the Manifesto to my attention.