The author is the founder of Dezernat Zukunft, a macrofinance think tank
As the European Central Bank prepares to launch a crucial new tool to combat the threat of fragmentation in the eurozone’s financial markets, governments still appear to be sitting on the sidelines.
This is a mistake. It pushes the central bank into opaque political terrain, jeopardizes its credibility and could lead to another lost decade of underinvestment, stagnation and growing economic divergence between member states.
The ECB’s bond-buying mechanism, outlined on Thursday, aims to close the gap between German and other government bond yields in the eurozone. Such spreads can lead to an uneven transmission of monetary policy.
For example, let’s assume that the ECB hikes interest rates by 0.25 percentage points, thereby increasing the spread between German and Italian government bonds from 1.5 to 2 points. With government bonds serving as a benchmark for credit prices, high spreads would lead to tighter monetary policy for Italian borrowers.
If spreads are not addressed, the conduct of monetary policy would lead to inflationary outcomes in Germany and deflationary outcomes in Italy. This is undesirable from a monetary policy point of view and counteracts the convergence in the euro zone.
Now switch to fiscal policy. For fiscal policy, ECB bond purchases have two effects: on the one hand, secure access to credit for the respective governments and, on the other hand, lower borrowing costs than usual. The latter has a direct impact on compliance with European fiscal rules: lower interest payments mean more leeway below the 3 percent -deficit limit.
So the current institutional structure is muddying the waters: in order to fulfill its mandate, the ECB needs to address spreads. But fighting spreads has fiscal ramifications. In particular, when dealing with spreads, the ECB effectively decides which member states benefit from the sovereign bond privilege, under what conditions and at what price. This is a deeply political issue on which a technocratic, unelected body is ill placed to speak.
The ECB can only make decisions within this ambiguous architecture; and while some are worse than others, none is good. Governments, on the other hand, could – and should – clean things up. They are the ones who are currently shifting deeply political questions about sovereign debt to the ECB. They should use collective judgment to decide which country has sound public finances.
If member governments decide that a country is pursuing sound fiscal policies, the ECB could pursue its mandate without encroaching on fiscal territory. If they decide they are not, it is clear who made that judgment and why, and who is responsible for the consequences.
In this case, spreads could only be addressed through the Outright Monetary Transactions program launched during the 2012 debt crisis. The ECB buys a country’s government bonds on the secondary markets – provided the country has agreed to a rescue package from the European Stability Mechanism and tough reform requirements.
Tackling spreads is in governments’ self-interest: the wider spreads, the more difficult it becomes to reconcile the goal of lowering debt ratios with sustained high levels of investment. Rising interest payments leave less money for public investment. Rising financing costs reduce the number of profitable private investments.
Therefore, governments should have no interest in maintaining spreads, except as a disciplining tool against certain misconduct, a function they could still perform if the use of the fragmentation tool depended on sound public finances.
One criterion that governments could use to judge fiscal policy could be the primary balance – the difference between the amount of revenue a government collects and the amount it spends excluding financing costs. By definition, the primary balance is not influenced by monetary policy. For example, a country could receive its peers’ seal of approval if it has a primary balance sheet that is likely to lead to deleveraging.
Governments have highlighted the flexibility of the Stability and Growth Pact as an advantage. Flexibility aims to ensure that countries are not locked into an overly restrictive set of fiscal rules that are inappropriate for their particular circumstances. That sounds good in theory. In practice, however, the strategic ambiguity on the part of fiscal officials means that the ECB is left with policy choices – choices that it would not need to make if governments were playing their proper role.
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