The ECB's Covert Monetary Financing Is Risky Business
The European Central Bank introduced, by a large majority, a new twist to its stimulus agenda Thursday. From here on, the principal repayment on government bonds purchased under QE will be used to buy more bonds. It's hard to overstate the significance of the reinvestment provision, which ECB Board Member Yves Mersch called "the most important" element of Thursday's announcement.
ECB President Mario Draghi tried his best to have it both ways. He portrayed the move as an extension of the QE timeline, which it is. But he denied that in doing so the ECB was blessing a kind of "monetary financing," which it is also doing. That practice, forbidden under EU treaty rules, refers to the financing of government expenditure directly through money creation.
As the product of Jesuit schooling, Draghi chose his words carefully when he stated "I can exclude completely any monetary financing." The acquisition of over a trillion euros of government bonds - and an additional 360 billion euros following the new measures - is not strictly direct financing, which occurs when government spending is financed by "by an increase in the monetary base." According to the ECB, monetary financing does not occur here because the sovereign bonds, currently being bought in massive quantities by national central banks, are not bought on the primary market but on secondary markets.
But the effect is the same: It is as if close to 1.5 trillion euros of European national, regional and local bonds are being put on the central bank balance sheet for an indefinite period and retired from the market.
The argument that this doesn't constitute monetary financing ignores the fungible nature of government bonds in the securities market. If a national central bank acquires a quarter of its country's national debt, institutional market participants, which are often required to hold such bonds, will rush to buy the country's new debt issues, implicitly financing not only this year's fiscal deficit, but much more.
Further, if a national central bank states that it will keep this money invested in government bonds in the future, as has just been done by the ECB under its new Principal Reinvestment policy, the debt purchased has effectively been monetized for the foreseeable future, which is exactly what monetary financing is.
Crucially, this isn't happening at the European level, which underlines the lack of risk-sharing and trust between euro system participants, in what increasingly looks like a network of currency boards. It is national central banks that will bear most of the credit risk and keep the profit for national governments. Should the euro fall apart -- a possibility that may seem far-fetched at the moment, but was precisely the fear that prompted Draghi to make his now famous "whatever it takes" pledge -- the Bundesbank will not be carrying truck-loads of, say, Italian debt on its books. The Bank of Italy would bear any loss from a sovereign default or restructuring of the national debt it holds.
Exactly how much each national central bank already owns of its own government debt is unclear. Questioned by a reporter about German-press articles stating that the French and Italian central banks had acquired staggering amounts of debt, the ECB chief averred that the national central banks decide their own investment policies "in complete independence" and should be approached directly for details. The allocation rules for national central banks suggest the following breakdown, compiled by Bloomberg:
The effective debt retirement is against the spirit if not the letter of the ECB mandate. It is also an acknowledgement that the ECB no longer has a clear QE exit strategy, since existing money will now stay in the system much longer than the period of stimulus. That, indeed, is the point.
But is it bad policy? There is certainly an argument for saying why not retire debt this way, provided it's not inflationary. The level of sovereign debt has risen materially with the financial crisis and is unsustainable. European economies face lack of demand. It would of course be better to ring-fence the ECB's new money for investment in infrastructure and to force more profligate and indebted governments to embrace structural reforms to labor and product markets; but the political will to do that doesn't exist. Debt-financing is the last remaining arrow in the ECB quiver to stimulate demand.
The problem with this argument is one of moral hazard. Monetary financing (of this kind) may simply delay much-needed structural reforms and subsidize vote-buying spending programs that hurt economic growth. This is unlikely to be acceptable to fiscally conservative countries, such as Germany. While the new ECB stimulus program may smooth things for now, we can expect more tensions in the euro zone over time.
Indeed, these may be the "risks and spillover effects" that Bundesbank head and ECB board member Jens Weidmann has spoken of. He opposed Thursday's decision. Others in Germany have been even more blunt, referring to the ECB as a "bail-out machine."
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Jean-Michel Paul at JPaul@acheroncapital.com
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