The tensions in the public policy debate between economists is intensifying and on show in Europe, where these sort of obvious conflicts between adherence to dogma and a recognition that ‘out-the-box’ solutions are not only possible but preferred. More of these latter thought offerings are starting to appear as more people come to understand that the mainstream dogma has become more of a security blanket for reputations rather than saying anything about reality. One such proposal emerged last week in the form of a letter to the major European newspapers signed by more than 100 economists and politicians calling for the ECB to write-off its massive public debt holdings, which currently amount to around 25 per cent of total outstanding public debt. It is a good idea but some of the framing leaves a lot to be desired. At any rate, central banks everywhere should be buying up massive amounts of government debt and hitting the keyboard with zeros and writing it off. The world would be a much better place if they did that.
Around about this time, 68 years ago (February 27, 1953), the victorious nations from the Second World War formalised the – London Agreement on German External Debts – at a meeting in London.
The agreement covered:
… Germany’s pre-war public and private indebtedness and to the German debt arising out of post-war economic assistance …
That is, the deal excluded any reparations that might have been enforced as a result of Germany’s conduct during the War.
The amounts were staggering at the time:
1. 16.1 billion marks outstanding from the First World War settlement finalised at the Treaty of Versailles, which Germany had defaulted on in the inter-War period.
2. 16.2 billion marks owed to the US government for loans made to rebuild Germany after WW2.
The London Debt Conference was held between February and August 1952 and the offer of debt forgiveness was initially rejected by the German government.
The deal cut the outstanding debts in half and tied the repayment schedule to Germany’s subsequent export revenue, which reinforced the growing export-bias that then made it difficult to achieve currency stability in Europe given the growing trade imbalances that followed between European nations.
An recent article published in the European Review of Economic History (Vol 23, No 1, February 2019) – The economic consequences of the 1953 London Debt Agreement – studied the consequences of the Agreement and found that:
1. Germany’s immediate post WW2 growth was stunning given the circumstances.
2. The “debt relief program in 1953, known as the London Debt Agreement (LDA), might have partially contributed indirectly to growth by creating a propitious economics environment as well as directly by stabilising German public finances and allowing for greater public investment”.
Remember, this was during the early Bretton Woods period where fiscal policy was constrained by the need to manage the agreed exchange rate parities.
in more recent times, it was pointed out that one of the terms of the Agreement was that Germany would honour its reparation obligations arising from WW2 to Greece and that the current German government refused to acknowledge that obligation during the GFC.
Can a central bank cancel its holdings of debt?
Answer: Yes and it should.
I have long argued that after central banks purchase government debt either in the primary issue (less frequent now) or in the secondary markets they should just type a zero against the balance and write it off.
While there is all this pretence about central bank independence, the fact is that the central bank and the treasury functions are intertwined on a daily basis and both are parts of the currency-issuing government.
So when the central bank holds government debt it is just a left-pocket/right-pocket sort of situation.
In most situations, the central bank will receive interest payments from the treasury and then remit them back to Treasury in some form (dividends, etc) by arrangement within the government.
So a rather curious accounting charade with no significance for financial markets outside of the government (once the secondary bond market transactions are made).
Mainstream economists are horrified by this suggestion claiming it would be inflationary and would unleash a lack of discipline from Treasury departments.
They clearly misunderstand that the inflation risk, inasmuch as there is any in these current circumstances, is already in the system, the moment the deficit spending is exeecuted.
The fact that the central bank buys the debt, or, indeed, that the government issues the debt in the first place to match (or in the Eurozone Member State’s case to fund) the spending beyond tax drains, doesn’t alter that inflation risk.
So what happens to the government debt held by the central bank has no impact on the inflation propensity inherent in the spending.
The only question then is whether the spending was excessive in relation to the productive capacity of the nations and it would be far fetched to conclude that it was given the state of these economies and the excess capacity that is rife.
The question then is what would happen if the central banks around the world just wrote off all their holdings of government debt?
Answer: Nothing much at all.
They can still maintain liquidity management concerns using interest rate payments on excess reserves.
If they found themselves with ‘negative capital’, who cares. They are not corporations and do not have to be ‘solvent’ in the private corporate sense.
This is like comparing a household to a treasury (given that the central bank is part of the consolidated government sector).
See these blog posts (among others):
1. The consolidated government – treasury and central bank (August 20, 2010).
2. The ECB cannot go broke – get over it (May 11, 2012).
3. The US Federal Reserve is on the brink of insolvency (not!) (November 18, 2010).
4. Better off studying the mating habits of frogs (September 14, 2011).
Should the ECB cancel its public debt holdings?
Last week over 100 economists and politicians published an ‘Open Letter’ in the leading European newspapers demanding that the ECB to cancel €2.5 trillion in debt it is holding.
That would wipe out around 25 per cent of the debt issued by EMU Member States.
The letter states in part (Source):
Citizens are discovering, some with much shock, that about 25% of the European debt is now held by their own central bank. In other words, we owe ourselves 25% of our debt and, if we are to reimburse that amount, we must find it elsewhere, either by borrowing it again to “roll the debt” instead of borrowing to invest, or by raising taxes, or by cutting spending.
Which is a statement that the EMU Member States in question do not enjoy currency sovereignty (using a foreign currency – the euro) and so are financially constrained.
Such a wedge is why a nation should never surrender their currency sovereignty.
The current proposal stated that the ECB could simply write the debt off and this would give the EMU nations renewed fiscal space to pursue a “green recovery” and “heal the severe social, cultural and economic damages undergone by our societies during the devastating covid-19 health crisis”.
I am supportive of the proposal but there are gaps in logic.
First, Brussels has already invoked the temporary emergency rules in the Treaty Annexe relating to the Stability and Growth Pact, which gives the Member States the latitude to engage in significant spending.
So there is no reason for Europe to be languishing in the state pointed out by the signatories to this proposal.
One reason they are languishing is that they have adopted the austerity mentality after years of being thrashed by the narratives and actions coming out of Brussels and they are scared stiff that the technocrats will get nasty soon and start raving on about the Excessive Deficit Mechanism procedure again.
Second, with the ECB purchasing significant proportions of the debt issued, such that bond yields are low and can stay low as long as the ECB wants, then the concerns of the proponents that the interest serving burdens will damage the prospects of recovery are somewhat exaggerated.
Sure, the ECB might turn on the Member States as it did during the GFC.
But it knows as well as anyone that insolvency is just a blink away for heavily-indebted nations in the Eurozone if bond yields rise quickly or significantly.
The ECB has to keep purchasing the debt or the monetary union will collapse.
Ironically, the Delors gang thought they could inflict their version of neoliberalism onto the Member States by producing a flawed architecture for the common currency but have produced a situation where the central bank that they thought could be bolted down is now exhibiting behaviour that is the anathema of these neoliberal pedants.
Third, none of this is to say that the proposal to cancel the debt is excellent.
The ECB, in fact, should ramp up the PEPP program to ensure it buys all the debt issued by the currency-using governments, which would maintain yields at zero levels and then simply write off the issue once purchased.
That would be the most desirable outcome.
I doubt that the politics of Europe could cope with Germany and the Frugal Four, at least being intolerant.
The Proposal thinks that their idea would be a “foundational” moment and pointed to the historical precedent made by the London Agreement (discussed above).
They think this would be an “extraordinary measure” to fit “extraordinary times.”
I agree the pandemic is an extraordinary time, but I would argue that progressives (which are represented by the proponents) should be ‘mainstreaming’ central bank debt cancellations.
It would only be ‘extraordinary’ if you think the appropriate benchmark was the mainstream taboo that central banks should not hold any public debt above the amount they might use to manage liquidity via open market operations.
I reject that benchmark.
The Modern Monetary Theory (MMT) benchmark is that the currency-issuing government has no need at all to line the pockets of bond investors by issuing corporate welfare in the form of the public debt.
In the Eurozone context, the situation is somewhat different given that the Member States surrendered currency sovereignty. So the MMT benchmark in that context would be that the ECB should just control all yields by purchasing the debt.
By avoiding the framing that a debt cancellation would be ‘extraordinary’ we can move the debate away from the neoliberal framing more quickly.
But the proponents clearly understand that:
1. “The ECB can without a doubt afford it. As many economists already recognize, even among those who oppose this solution, a central bank can operate with negative capital without difficulty.”
2. “It can even print money to compensate for these losses: this is provided for by the Protocol 4 annexed to the Treaty on the Functioning of the European Union.”
Once again framing and language here is a concern.
The way in which the ECB would restore its capital would be via some computer entries to its balance sheet. It alone can do that.
Protocol (No 4) on the statute of the European System of Central Banks and of the European Central Bank – is an annexe to the Treaty on European Union and to the Treaty on the Functioning of the European Union.
Chapter IV of the Protocol relates to the “Financial Provisions of the ESCB”.
Article 16 relates to “Banknotes” and says that “the Governing Council shall have the exclusive right to authorise the issue of euro banknotes within the Union. The ECB and the national central banks may issue such notes. The banknotes issued by the ECB and the national central banks shall be the only such notes to have the status of legal tender within the Union.”
Article 28 relates to the “Capital of the ECB”.
So in a situation that the ECB has negative capital, the Governing Council can authorise restoring that capital whenever it wants.
A commercial bank does not have that right. If its assets fail and they find they cannot cover their liabilities then they are insolvent unless they can inject more capital from private investors.
A central bank cannot become insolvent.
And remember that the euro is a fiat currency just like the US dollar or the Japanese yen, except that the governments involved use it rather than issue it.
The currency is not backed by any of value including the ECB’s assets.
It enters the eurosystem costlessly – keyboards typing numbers – and the IOU characteristic is only notional.
The ECB dealt with the question of insolvency in this Working Paper (No 392) – The Role of Central Bank Capital Revisited – way back in May 2004.
The authors noted that:
a central bank with a loss-making balance sheet structure would in this context still able to conduct its monetary policy in a responsible way, even with a negative long-term profitability outlook …
In practice, a central bank can never achieve an absolute, guaranteed institutional independence. In particular, no government can commit future governments (whether they obtain power by election, war, or revolution) not to change the central bank law or abolish its exclusive right to issue legal tender …
… central bank capital still does not seem to matter for monetary policy implementation, in essence because negative levels of capital do not represent any threat to the central bank being able to pay for whatever costs it has … Although losses may easily accumulate over a long period of time and lead to a huge negative capital, no reason emerges why this could affect the central bankís ability to control interest rates.
That should seal it.
The Proponents then ask whether this would be violating the “spirit of the treaty” and acknowledge that the ECBs conduct over many years in buying massive amounts of Member State debt has effectively already violated the prohibition on funding Member State deficits.
That is the point.
The EMU technocrats talk big on rules but violate them continually when it is convenient to maintain their positions.
I thought the most telling part of their letter was the following:
The European Union can no longer afford to be systematically impeded by its own rules. Other states in the world, such as China, Japan and the USA, are using their monetary policy tool to its full extent, i.e. in support of their fiscal policy.
The EU always impedes progress because of its rules.
Which is why Britain is lucky to be out of the mess.
And why, ultimately, the Treaties have to be scrapped and a new Europe based on intergovernmental agreements is created.
And, in doing so, the euro is scrapped and currency sovereignty restored. Then the newly sovereign states will cease being ‘Member States’ and can deal with the crises they face with the full currency capacity they lack now.
That is enough for today!
(c) Copyright 2021 William Mitchell. All Rights Reserved.