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What's wrong with monetizing debt?

Chris Dillow

Chris Dillow

There is, in principle, a straightforward solution to the euro area's debt crisis. The ECB could simply print sufficient money to buy as many bonds as necessary to drive down their yields. There is, in theory, no limit at all on how much money a central bank can create.

Equally, though, there is a powerful obstacle to this - members of the ECB's governing council are opposed to it. Jens Weidmann, a member of the council and also president of the Bundesbank has said such buying is "certainly not compatible with our mandate" which is to ensure price stability. Such opposition is not merely German fastidiousness. Mario Draghi, the Italian president of the ECB, has said of such monetization of the debt: "I don't really see that as the remit of the ECB. The remit of the ECB is price stability over the medium term."

There are three reasons for this opposition. But none of them are necessarily overwhelming.

First is the argument that such monetization is illegal; article 123 of the Lisbon Treaty prohibits the ECB from directly buying national governments' debt.

However, this article says nothing about buying in the secondary market - hence the securities market programme of bond-buying. And, says Charles Wyplosz of the Graduate Institute in Geneva, the ECB has already violated this article, when it bought Greek debt last year - so there's a precedent.

Secondly, there is the moral hazard problem. If the ECB buys government bonds, national governments will have every incentive to borrow like billi-o, knowing they needn't fear higher interest rates.

Again, Professor Wyplosz is unconvinced. Greece's experience, he says, shows that punishing delinquent governments by imposing fiscal austerity onto them does not necessarily reduce borrowing or placate debt markets. Instead, he says, the ECB can help enforce fiscal discipline after the crisis by refusing to accept the bonds of badly behaved governments as collateral against its loans to banks. And if banks know such debt won't serve as collateral, they'll be less willing to hold it and so governments would face the discipline of higher borrowing costs.

More radically, governments could agree upon a new and credible stability and growth pact, to limit national governments' borrowing after the crisis has passed.

This brings us to the third problem - that printing money is inflationary.

In our present context, though, this is not a bug of monetization but a feature. Imagine the ECB were to buy enough bonds to reduce yields a lot. What would happen?

The threat of catastrophic bank losses would fade, thus encouraging banks to lend. And companies' borrowing costs in capital markets would fall as corporate yields fall and share prices rise. Allied to a rise in business confidence, this would increase capital spending and employment. In other words, aggregate demand would rise. And unless aggregate supply is perfectly elastic - and despite 10 per cent-plus unemployment it probably isn't - prices would rise at least a little.

Some increase in inflation, then, would be the inevitable result of the pick-up in economic activity that the resolution of the debt crisis would cause.

There is, though, another sort of inflation that ECB members are worrying about - the possibility that monetary expansion would raise inflation expectations and hence actual inflation.

However, recent history suggests that inflation expectations aren't automatically linked to monetary growth. For example, in early 2010 the money stock was shrinking, and yet the forecasters surveyed by the ECB expected "normal" inflation. This suggests that a debt monetization, if it is regarded as a temporary emergency response, might not be permanently and seriously inflationary - just as the shrinking money stock wasn't seen as deflationary. This is also the lesson of the US's and UK's quantitative easing; the gilt market's inflation expectations are now quite low.

All this suggests that the ECB's opposition to debt monetization might be overcome, at least if it turns out that the only alternative to monetization is a break-up of the euro. After all, there's not much point fighting to preserve the value of a currency if this means that the currency ceases to exist.

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