Is OMT a bluff?

Tony Yates yesterday commented on my two recent pieces on Germany. The second issue he raises, on countercyclical fiscal policy, is I think quite easy to deal with. He may be right that there was general unhappiness with how fiscal freedoms had been abused in the past. But if so, that suggested something very similar to the SGP (i.e. rules designed to reduce debt policed by Brussels), but with an additional countercyclical element. That in particular would have applied pressure on the Irish and Spanish governments before the recession, pressure that the actual SGP notably failed to do.

His discussion of OMT (the ECB acting as a sovereign lender of last resort) suggests OMT is a bluff. The argument is that if, under the protection of OMT, the market still refused to buy a government’s debt, the ECB would be forced to buy it, and because there was the possibility of a loss for the ECB they would not do so. I think this is unlikely in practice and is certainly wrong if it is true.

OMT is not extended to any Eurozone country that gets into difficulties. The ECB has to have the right to say no, leading to almost certain immediate default. The test is whether the government is willing and able to stay solvent. The ECB also has to have the right to withdraw support if conditions change sufficiently to put its earlier judgement in question. That is a good argument for why OMT support should come with some form of conditionality, so as to give the country fair warning that support might be withdrawn.

If the ECB gets that judgement right, then there are no implications for inflation. Just as with QE, the central bank will have created money to buy assets which it will at some point sell off again. In fact the central bank makes profits, because the interest it receives from the government on that debt will exceed the interest it pays on reserves. If the ECB gets it wrong there will be costs, but they are not unlimited: they are simply the amount of debt it bought until it decided to withdraw support. The benefits that OMT provides surely outweigh the expected value of those costs, although I agree with Tony that some in countries that are never likely to require OMT may take a more narrow view. Even then there are no necessary implications for inflation, as Eurozone governments should make good the ECB’s losses.

The most worrying thing in Tony’s post is his suggestion that limits should be applied to the amount central banks outside the Eurozone should provide as a sovereign lender of last resort. Such limits can only do harm. They are based on a myth that independent central banks can stop a highly profligate government from raising inflation. It is a myth because the first thing such a government would do is abolish those limits. More generally, a government that is so profligate that future default was inevitable would have no hesitation in abolishing central bank independence. You cannot stop a government of central bank nightmares. Such limits are therefore either meaningless, or could do harm.  

The ECB as sovereign lender of last resort

Understandably the element of my talk at the Royal Irish Academy which generated most discussion was the role of the ECB. (Here is a media report, but ignore the last two paragraphs which are confused/wrong. Abstract for the talk is here. Paper will follow.) The proposition I put forward was that the ECB’s OMT programme should have been put in place in 2010, and if it had been countries outside Greece could have implemented a more efficient austerity programme (one that produced less unemployment) and might have retained market access (interest rates on government debt would have remained reasonable). [1]

There are two serious and related arguments against this view. The first is that it is unrealistic for the ECB to act as a sovereign lender of last resort because of the transfers between countries that this might lead to. (A sovereign lender of last resort is a central bank that is always willing to buy its government’s debt.) [2] The second is that in practice OMT is bound to be coupled with a requirement for austerity programmes that might have simply duplicated what was actually put into place by national governments. Both arguments speak to a real problem that remains unresolved within the Eurozone, but do not nullify the argument that things should have been done much better.

Government debt in advanced economies is regarded as a safe asset for two reasons. The first is that most governments that borrow in their own currency rarely default. The second is that an individual investor does not need to worry about market beliefs, because if the market panics and refuses to buy the government’s debt the central bank will step in (hence sovereign lender of last resort). If the central bank did not do this, the government might be forced to default because it cannot roll over its existing debt.

It makes sense for the central bank to act as a sovereign lender of last resort, because it avoids self-fulfilling market panics. Doubly so because such panics will be more likely to occur after a large recession when the social value of government borrowing is particularly high. The complication in the case of the ECB is the following. If the market panic is so great that the ECB was forced to actually buy a ‘distressed’ government’s debt (normally the threat to do so is enough), it is possible that this government might choose to default even with ECB support. If it did that, the ECB would make losses which would be born by the Eurozone as a whole (the transfer risk).

Partly for this reason, the ECB has to have the ability not to act as a sovereign lender of last resort, or withdraw support if circumstances change. If that ability exists (a point I will come back to), then the transfer risk associated with the ECB acting as a sovereign lender of last resort are tiny. It represents the kind of minimal risk that should always be offset by the trust and solidarity that comes with the territory of being in a monetary union. I suspect those that suggest otherwise are often trying to hide other motives.

A government that is receiving ECB support of this kind will naturally want to know what it has to do to maintain it, because the threat of its withdrawal is so great. It would be unreasonable to withhold that information. Does that in practice amount to nothing more than the kind of conditions that have in practice been imposed on Ireland and Portugal anyway? Absolutely not. Just as the market does not worry about the build up of debt in a recession in countries like the UK or Japan, a rational ECB would have no reason to impose fiscal consolidation at the time it would do most damage. The time a rational ECB might withdraw its support is once a recovery is complete and the government refuses to embark on fiscal consolidation.

So a sovereign lender of last resort in a monetary union must have the ability not to provide that support. In other words it has to sort Greece from Ireland. That decision is a huge one, because in effect it is a decision about whether the country will be forced to default. It is natural that the ECB wants to share that responsibility with member governments, but as we have seen with Greece member governments are hopeless at making that decision (particularly when their own banks may be compromised by any default). We have also seen that European central bankers are far from rational on issues involving government debt (compared with at least one of their anglo-saxon counterparts), so giving the decision to someone else other than the current ECB would seem like a good idea. However at present there is no institution that seems capable of doing this job.

In this post I suggested contracting out this task to the IMF, although that presumed a reduction in the political influence of European governments on that institution. I have also wondered about whether a body like the newly created network of European fiscal councils could play this role. Another possibility is to reform the ECB so that it is not subject to deficit phobia, and is more accountable. It seems to me that this is where current research and analysis should be going, rather than into schemes involving greater political union.

The existence of various alternatives here means that we should not take what has actually happened in the Eurozone as some kind of immutable political constraint beyond which economics cannot go. There is no intrinsic reason why the OMT that was introduced in September 2012 could not have been introduced in 2010. There is no intrinsic reason why any conditionality that went with that could not have been much more efficient in terms of unemployment costs. Beyond Greece, the Eurozone crisis happened because the ECB thought it could avoid undertaking one of the essential functions of a central bank. This was perhaps the most important of the many errors it has made.

[1] For a country within a monetary union which needs to reduce debt more rapidly than does the union as a whole, a gain in competitiveness relative to the rest of the union is required to offset the deflationary impact of fiscal consolidation. That ‘internal devaluation’ probably requires some increase in unemployment, but it is much more efficient to obtain that increase in competitiveness gradually.

[2] It could be argued that the Fed does not provide lender of last resort services to individual member states. But state debt is typically lower relative to GDP and income than for Eurozone governments. Before 2000, Eurozone governments were able to borrow more because they were backed by their central bank. That means that they are inevitably subject to a greater risk of suffering from a self-fulfilling market panic. The architects of the Eurozone might have initially believed that the SGP might avoid the need for a sovereign lender of last resort, but after the Great Recession they would have known otherwise.

Making the Eurozone work better: sovereign default

Given the current problems in the Eurozone, it is understandable that many non-Eurozone economists remind us that they had doubts from the beginning. That, unfortunately, is not very helpful criticism, except in so far as it tells us how these problems were originally wished away. One lesson from the Greek tragedy is that voters' faith in the Euro project can survive even under tremendous strain. [1] The Euro was always a political project, and the political reasons for it have not gone away. For the governing elite of Europe this is likely to remain the case. So going backwards is not an option.

Yet while the people and the elite both want to keep the Euro, they part company when it comes to moving to a complete fiscal and political union: a United States of Europe. As Philippe Legrain notes, ever since the French and Dutch voted No, voter attitudes to further central control have hardened - and with good reason. If what he describes as the “Monnet method” (use any crisis to increase integration) continues, and as Andrew Watt points out it is continuing in a big way, the threat to the Eurozone could become existential. European policy makers have taken far too many liberties with democracy as it is: they should not take even more. Which is why I tend to get a little impatient with economists and institutions that spend a lot of time designed schemes for further substantial integration.

So the critical issue for now is whether the way the current union is run can be improved? I see three key unresolved areas here: sovereign default, competitiveness imbalances and the ECB. I talked about how to cope better with potential competitiveness imbalances recently. This post is about default.

I agree with Philippe Legrain that we need to have more decentralised fiscal control, and less rules from the centre. As I have noted before, there now exists in the Eurozone a system that is parallel to monitoring from Brussels, based instead on national fiscal councils. Can we design a system around that which negates any need for central control?

One way of making this work would be to deny any support to any EZ government that gets into trouble with the market. When the EZ was set up, its architects worried that market discipline would be too weak for this to work, so centralised controls were also necessary (the Stability and Growth Pact). In one sense they were right: the markets started treating Greek government debt as if it was German debt. But once a crisis happened they were wrong: governments with lower deficits than the UK were regarded as riskier by the markets.

What should now be clear is that the debt of member governments of a monetary union are subject to much greater rollover risk than equivalent countries outside the union because they do not control their own currency. That problem has been dealt with (for the moment) by OMT. But you cannot have OMT without conditions. For obvious reasons OMT cannot be a blank cheque to a monetary union member to run ever higher deficits.

So OMT has to be conditional, but who should set the conditions? Who decides that a future Greece has to default, but that a future Ireland should get the OMT guarantee without the need to default? At the moment the answer is both the other Eurozone governments and the ECB decide. But Eurozone governments have shown themselves to be hopeless at this task (see actual Greece), partly because they are subject to pressure from creditors. To leave this all to the unelected, unaccountable ECB is just asking for problems, and would represent too great a strain on ECB independence.

Let’s imagine the following. The Italian government at some time in the future finds that interest rates on its debt begin to rise well above average Eurozone levels. We get into a situation where a self-fulfilling default is possible. Should the ECB supply OMT cover to end that possibility or not? What conditions should be imposed on Italy as the price for that cover?

It would be nice if we could write down some simple rules (even complex rules) that could choose between a Greece and an Ireland. Fabian Lindner discusses some possibilities here. The major problem is that a great deal depends on something that embodies a political judgement: just how large will future primary surpluses be? Italy, because of its large debt, is used to running much larger primary surpluses than other countries. How do you judge what the upper limit is?

This is why ‘leaving it to the market’ is so attractive, because you appear to be asking a huge number of people to take a bet on the answer. But that method is flawed, because with rollover risk what they are actually taking a bet on is what they think other market participants think about rollover risk. OMT removes that rollover risk.

So if the market cannot do this, and the ECB and EZ governments should not do this, who is left? Do we set up a new institution of experts to decide and set conditions? (Conditions have to be set, because actions may change after OMT is granted.)

One obvious response is that we do not need a new institution, because we already have one, and it is called the IMF. It is imperfect, with at the moment too much influence from EZ governments on its decisions, but that means reforming the IMF rather than reinventing it. This may happen as a result of the Greek debacle. Philippe Legrain suggests using the IMF in a similar role here, although as a transitional measure while a new EZ institution is set up. However it is difficult to imagine EZ governments setting up a new institution that was truly independent of political pressure from member states.

The proposal would work like this. When Italy got into difficulties, it would go to the IMF. No EZ assistance would be allowed before this. The IMF would decide what level of default (if any) was required. The IMF, and not EZ governments, would set any conditionality thought necessary to return deficits to a sustainable level. That would include a path for deficits that the country could reasonably achieve without creating unnecessary unemployment. (If the country was uncompetitive, some unemployment would be inevitable.)

If Italy agreed to those conditions, then OMT would automatically be extended by the ECB. It is quite possible that in those circumstances Italy would regain market access at reasonable rates. If it did not, the IMF (and NOT other EZ governments) should provide the finance necessary to cover transitional deficits.

I suspect this scheme would not be attractive to many Eurozone policy makers, because they would be losing influence and control. But a better way to think about it is that the Eurozone contracts out (to the IMF) the tricky business of deciding whether a government’s debt is sustainable or not. That seems to me to be a small price to pay to avoid the kind of conflict between governments that became so clear in the recent Greek ‘negotiations’.

[1] Of the countries polled here, only two had more people thinking the euro had been bad rather than good for their country: Italy and Cyprus. See also Andrew Watt here.

Alternative Eurozone histories

I missed this paper by Philippe Martin and Thomas Philippon when it came out last October, but thanks to Francesco Saraceno I have now read it. There is also a VoxEU post by the authors. It is particularly interesting for me because it undertakes analysis (using a model which is itself interesting but which would make this post too long to discuss) of a couple of alternative histories for the Eurozone which are related to two claims that I have made in the past:

1)    It is now widely accepted among macroeconomists (but not politicians or the media) that fiscal profligacy was only the major cause of subsequent problems in Greece, while elsewhere private excess was the main problem. I have argued that aggressive countercyclical fiscal policy before 2008 would have reduced subsequent problems.

2)    If the ECB’s OMT programme had been implemented in 2010, rather than September 2012, this would have substantially reduced the degree of austerity required outside Greece. As a result, these countries would have had a better recovery from the Great Recession. [2]

Put the two claims together and I would argue that the 2010-12 Eurozone crisis (rather than just a Greek crisis) need not have happened. OMT would have limited fears of contagion, allowing a quicker and more complete Greek default. There would have been no funding crisis outside Greece, and no need for the core Eurozone economies to immediately embark on austerity.

How does the paper address these arguments? In terms of fiscal policy, it imagines reaction functions for government spending and transfers that contain a (common) countercyclical element, but also a (country specific) positive drift term, in Greece, Ireland, Portugal and Spain. One counterfactual eliminates the drift. This does not exactly fit the scenario I had in mind, because I see actual policy as not being countercyclical but (Greece apart) having less drift. However the end result is the same: a counterfactual with much more fiscal tightening before the recession. An interesting result is that tighter fiscal policy could have substantially reduced the rise in interest rates spreads in Ireland and Spain. The pre-2008 employment boom would not have happened in Greece, and would have been substantially reduced in Ireland, but the impact in Spain would have been smaller but non-negligible.

It conducts another counterfactual which imagines macroprudential policies that eliminated the household leverage boom in each country. This has a significant effect in reducing the boom in Ireland and Spain. (There was no actual employment boom in Portugal.) By inference a combination of countercyclical fiscal policy with no drift, plus macroprudential policies, would have been ideal.

So claim (1) seems to hold up fairly well. Of particular interest is what would have happened to employment from 2008 under a purely countercyclical fiscal policy. In Spain it would have fallen as a result of the recession, but subsequently stabilised rather than continuing to fall as it did in reality. In Ireland employment would have fallen in the recession, but would have risen again from 2010 rather than continuing to fall. This is partly because countercyclical fiscal policy would have helped, but also because lower levels of debt going into the recession would have reduced the increase in interest rate spreads, easing monetary policy.

With a pure countercyclical fiscal policy the debt to GDP ratio in Greece would have stayed flat (because there would have been no boom), suggesting that the Greek crisis was essentially a result of fiscal profligacy. In Spain the debt to GDP ratio would have fallen to nearly 20% of GDP, rather than staying above 40% of GDP in reality. In Ireland public debt would have been largely eliminated. This indicates the substantial amount of countercyclical policy that was required to tackle what were very large domestic booms. (Fiscal policy would presumably have been less contractionary if combined with macroprudential controls.) It also tells us how foolish it was to have a Stability and Growth Pact which essentially ignored the need for such countercyclical fiscal policy.

Claim (2) is examined in its own counterfactual, which essentially eliminates the increase in interest rate spreads that occurred from 2008. The beneficial effects on all four periphery countries are substantial. This counterfactual is unrealistic for Greece, because OMT should never have been implemented for Greece - immediate default was the better and more sustainable option. However I think it is highly credible that, despite Greece, if OMT had existed in 2010 spreads in other countries would have stayed low. [1]

Francesco Saraceno draws the lesson that the real problems with the Eurozone are institutional, and I agree. The Stability and Growth Pact was misconceived (as some of us argued before the Eurozone was created), because it ignored the need for countercyclical fiscal policy. The ECB delayed acting as a sovereign lender of last resort for two years, creating a Eurozone crisis out of what should have been just a Greek problem. The conclusion I draw, unlike many economists, is that the concept of a European Monetary Union was not inherently doomed to fail. It was the way it was implemented that caused the crisis.

It would be very nice if this was all about history. Unfortunately exactly the same mistakes are continuing, with equally damaging effects. Fiscal policy continues to be pro-cyclical, meaning that we had a second Eurozone recession and no real recovery from that. Monetary policy is either perverse (2011), or 6 years too late (!) and continues to openly encourage fiscal austerity. That most policy makers in the Eurozone have still not understood past errors remains scandalous.

[1] The paper attributes this to the reduced risk of union break up. I suspect it does so because it wants to make interesting comparisons between Eurozone countries and US states. My own analysis has instead focused on the danger of a self-fulfilling funding crisis when there is no lender of last resort. That danger presumably exists for US states.

[2] An interesting question which I have not examined is whether, even if OMT had existed in 2010, it would still have been better for both Ireland and Spain to have written off some of their debt. 

Article 123.1 and the ECB

123.1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

This post will not be about the the legal interpretation of this article of the European Union Treaty. Ashok Mody does a much better job of that than I ever could, and he comes to the conclusion that the European Court of Justice (ECJ) could well decide that this Article, combined with other parts of the Treaty, makes OMT illegal. As OMT is widely credited with ending the debt funding crisis in the Eurozone, this would represent an existential threat.

The same treaty article may be crucial in deciding whether the ECB institutes a programme of Quantitative Easing (QE) to help revive the Eurozone economy. As Willem Buiter reminds us (in a paper which I discussed an earlier version of before in a different context) a combination of fiscal expansion and QE is a certain way to boost demand and raise inflation. He writes: “there always exists a combined monetary and fiscal policy action that boosts private demand—in principle without limit. Deflation, 'lowflation' and secular stagnation are therefore unnecessary.” He goes on to say that if the Eurozone Treaty prevents this policy, yet the Eurozone wants to avoid the kind of deflationary trap it is currently in, then the Treaty should be changed.

Ashok Mody’s view is nicely summarised in these two paragraphs.

“In highlighting the tensions between the TFEU and the OMT, the German Court is basically concerned that the OMT is a fiscal union by the backdoor. The ECJ could validate the current design of the OMT— locating the fiscal union in the central bank—in which case the nature of the eurozone will be fundamentally altered and the ECB will become a more political institution. Alternatively, if the ECJ were to determine that the German Court’s concerns need to be addressed by changes to the OMT—by imposing serious limits on purchases of sovereign bonds and requiring the ECB to claim seniority to private creditors—the OMT will be rendered ineffective. 

There is a third option. And that would be to agree that the OMT is needed as temporary support because an incomplete monetary union creates intolerable risks. The ECJ would ask the political actors to meet their responsibility by providing a transparent and legitimate mandate for a permanent OMT. They would do so by jointly guaranteeing the ECB against losses incurred if a particular transaction ends in a default. That guarantee may never be needed. But it would focus the minds and clarify who bears the cost. Then Europe would have taken a real step forward.”

I have a lot of sympathy for that view. I have argued that for the Eurozone to survive in something like its current form (and not to have to become a fiscal and political union), the decision about whether to implement OMT must never be automatic (default must be possible), and should be based on transparent and informed advice. However it also seems sensible that the ultimate responsibility for such a momentous decision should lie with member states and their elected representatives.

The issue I want to highlight here is the position of the ECB. At present, as I understand it, the ECB would have the right not to implement OMT, even if governments were happy with it. It also has complete authority about whether to introduce QE - member states get no say. The reasoning behind this is that the ECB’s control over inflation is absolute. As OMT could in theory compromise this control, it must be allowed a say in whether it goes ahead. Article 123 is designed to protect that control, and ensure that the ECB cannot be subject to fiscal dominance. The same mentality can explain why the ECB feels so free to tell member states what they should be doing with fiscal policy. Fiscal policy has a bearing on inflation, so the ECB has a right - indeed a duty - to speak out.

Discussion about the ECB often focuses on the difficulties it faces because its decisions may or may not lead to redistribution among member states. These difficulties would disappear, of course, if the Eurozone became a political union. However, as Ashok Mody points out, the ECJ seems content with this kind of redistribution if it is sanctioned by the democratic representatives of the member states involved. This could happen with OMT, or QE. But this cannot happen if the ECB is designed to be independent of any democratic control. If the ECB can take decisions independently of member states, and those decisions can redistribute income among member states, then the ECJ may say those decisions are illegal and cannot be made. We have a problem, because the ECB is beyond democratic control.

When economists extolled the virtues of central bank independence, did they really have this in mind? Should governments really have no say in what monetary policy’s targets should be, and what mechanisms it should or should not use to achieve them? If the monetary policy institution is completely autonomous, how do we guard against incompetence? Perhaps the perceived need to outlaw inflation using the constitution or by treaty is an attempt to solve a problem of the past, which is stopping us dealing with the problems of today.

The ECB as a Lender of Last Resort to Governments

John McHale rightly points out that in my earlier post on the European Commission’s justification for austerity, I said little about the Lender of Last Resort to governments (LOLR) issue. What I did say is that OMT should have been established much earlier, and that this might have allowed Ireland and Portugal to continue to sell government debt to the markets at tolerable interest rates, which in turn might have allowed them to implement budget consolidation at a less damaging pace. (Whether they would have taken that opportunity is another matter.)

However this begs an obvious question, which is how OMT conditionality should operate. One possibility is that the ECB imposes as least as harsh conditions as the current Troika. Alternatively the ECB passes responsibility for imposing conditions to the Troika, and the Troika continues to do what it has already done. It would be wrong to say nothing would be gained as a result. If OMT works and the governments continue to borrow from the market, then we avoid some of the toxic intergovernmental lending that is in danger of tearing the Eurozone apart. However we will still have excessive fiscal deflation.

Do we need any conditionality at all? Unfortunately we do. To offer OMT unconditionally would take us back to the pre-2007 situation, where default was not thought possible. It revitalises the arguments that gave rise to the disastrous Stability and Growth Pact and the more recent Fiscal Compact. As Charles Wyplosz and others have emphasised, it is very difficult to run any kind of system where component parts have autonomy to borrow without having the discipline of default, unless you resort to a degree of central control that is not feasible for the Eurozone.

Conditionality should not come naturally to any independent central bank. There is no significant example of a country delegating fiscal decision making to an unelected body, and even if it did so there are reasons not to use a central bank for that task. But before addressing this dilemma, we should establish what the nature of conditionality should be.

The remit of the central bank should be short run macroeconomic stabilisation and long run price stability. OMT can be justified under this remit, as I argued here, because if a country finds itself in a bad market equilibrium, this will have a negative impact on the monetary transmission mechanism and short run macroeconomic stability. Conditionality can also be justified under this remit, because a complete failure of fiscal control in one country in a union when default is not allowed will compromise monetary policy for the union as a whole. (One of my own papers with Campbell Leith looks at this in a two country case. [1]) By complete lack of fiscal control, I essentially mean that a government is insolvent at a level of interest rates consistent with normal monetary policy. [2]

In other words, all the ECB needs to worry about is whether fiscal policy is sustainable in the long run. It should have no concern about which of the many possible sustainable fiscal paths a government chooses - that is up to the national government. There is a analogy with the well established rules for central bank support of private banks. If the bank is solvent but suffering from liquidity problems, support should be unequivocal and unlimited. If the bank is insolvent, no support should be forthcoming. [3]

The problem with this analogy is that solvency for a government involves a political as well as a technical judgement. Suppose a government submits fiscal projections that are sustainable. This could involve government debt initially rising but stabilising at some high level. If it then starts falling again so much the better. There could be two things wrong with this projection. The first is technical: for example growth assumptions may be too optimistic or tax receipts given growth are too optimistic. The second is political: the plan may involve cuts in spending, or increases in taxes, that are unlikely to be realised because the political costs are too high.

No central bank should like to be in a position where it has to make these political judgements. It would like to offload the problem on someone else. The obvious someone else is the market, but that will not work because all the market tells you is that there exists a bad equilibrium, and not whether a good equilibrium exists. To use Keynes’s famous analogy, the market is judging who the market thinks is beautiful, and not who is actually beautiful. The ratings agencies seem ‘market like’, but are in effect just a bunch of people with a (perhaps informed) opinion, and a not very good track record.

Who else could the ECB delegate conditionality to? Delegating to EU heads of state would be a bad idea, for reasons that I hope are obvious. [4] Delegating to the Commission seems too close to that. A better possibility would be the IMF. The IMF certainly knows all about this issue: see this research for example. However all of these agencies have a recent track record that does not inspire confidence. An acid test is how any arrangement would have worked in the case of Greece. What should have happened, as soon as the true extent of Greece’s fiscal problems had become clear, is that whatever body the ECB had delegated its conditionality assessment to should have concluded that default was more likely than not, and therefore OMT should not have been provided.[5]  

I have an alternative suggestion, which regular readers will not find surprising. A number of Eurozone countries now have fiscal councils, whose very job is to assess the sustainability of fiscal policy. They are the obvious people to ask. Putting such an important question to the relevant national fiscal council may be politically unwise - could that council survive a decision that led to default? It would be better, for this and other reasons, for fiscal councils to act as a group in advising the ECB on the sustainability of national fiscal plans. That way expertise could be pooled, and experience shared.

Let me be quite clear what I am suggesting here. As soon as a country specific default premium began to emerge on a Eurozone member’s government debt, the ECB would ask the collective of Eurozone fiscal councils whether they thought current fiscal plans would result in a sustainable level of debt. If they did, the ECB would announce that OMT would apply to that country i.e. it would buy whatever quantity of that debt that could not be sold to the market. That decision could be reviewed annually until the default premium faded away. If the fiscal councils collective did not think current fiscal plans were realistic and sustainable, OMT would not be forthcoming. In these circumstances, there would be no bailing out by the Eurozone or IMF, and default would almost certainly follow.

The Commission plays no part in this. However, I think the Commission still has a very important role to play. The ECB, as part of the role it should have in preventing deficient aggregate demand in the Eurozone as a whole, should publicly state that because of the zero lower bound they cannot use monetary policy to fulfill this function. They should ask the Commission to coordinate fiscal actions to provide additional support to demand. In doing this, the Commission would clearly not ask that much of countries on OMT, so most of the ‘burden’ would fall on others, like Germany or the Netherlands.

Which brings me back to my previous post, and why I think what I said there was quite compatible with LOLR issues. Now some commented on that earlier post that it was not politically feasible, by which they mean Germany would not countenance it. I am sure that is right, although what has disappointed me (and others - see Kevin O’Rourke) is that the election of Hollande did not emboldened countries like France and Italy to provide any kind of counterweight to German views.

One of the advantages of being an academic is that your advice does not have to be bound by what is politically feasible. It is important that someone sets out what is best as they see it, and others can then modify it to satisfy political constraints. However the problem in this case is not so much that fiscal stimulus rather than austerity, and the ECB acting as a LOLR, are not in the German national interest. I think you could make a case that they are in fact in Germany’s long term national interest, because a well functioning Eurozone is in their interests. The problem seems more that policy makers throughout Europe have two economic blindspots. [6] Those blindspots are the fallacy of austerity at the Zero Lower Bound, and the necessity of a LOLR. What I will not do is give advice which accepts that those blindspots cannot be removed.

 

[1] See also Canzoneri, M. B., R. E. Cumby and B. T. Diba (2001), “Fiscal Discipline and Exchange Rate Systems”, Economic Journal, No. 474, pp 667-690.

[2] Using Eric Leeper’s terminology, it means the fiscal authority is active: for a discussion of the active/passive idea and its application to the ECB and OMT see here.

[3] One problem with the Bagehot dictum is contagion: if an insolvent bank is allowed to fail, this may create a liquidity (or even solvency) crisis for others. These contagion arguments have much less weight when it comes to countries in the Eurozone, once OMT has been established and the conditionality involved is clear and non-political.

[4] See, for example, Cyprus. Colm McCarthy describes it well here (HT Kevin O’Rourke)

[5] This may be a little unfair on the IMF, who almost certainly came under intense political pressure from the Eurozone to provide funds before the inevitability of default was conceded. I do not know whether this assistance, which allowed default to be delayed, was provided against the better judgement of some of those in the Fund.

[6] See a shrill Kevin O’Rourke here.

Active and Passive at the ECB

I’ve been away and busy at the IMF, so did not respond immediately to this speech from ECB Executive Board member Benoît Cœuré on the new OMT policy. In econblog terms, the speech would be described as wonkish, but I think the ideas I want to focus on are reasonably intuitive. They are worth exploring, because they illuminate the key issue of conditionality.

In a classic paper, Eric Leeper distinguished between active and passive monetary and fiscal policies, within the context of simple policy rules. The concept of an active monetary policy is by now familiar: monetary policy should ensure that real interest rates rise following an increase in inflation, so that higher real interest rates deflate demand and put downward pressure on inflation. Leeper’s use of active and passive for fiscal policy is a little counterintuitive. A passive fiscal policy is where, following an increase in debt, taxes rise or spending falls by enough to bring debt back to some target level. If neither taxes nor spending respond to excess debt, debt would gradually explode as the government borrowed to pay the interest on the extra debt. This is the extreme case of what Leeper calls an active fiscal policy.

Now you might be forgiven in thinking that the only policy combination that would bring stability to the economy was an active monetary policy (to control inflation) and a passive fiscal policy (to control debt). This would correspond to what I have called the consensus assignment. However Leeper showed that there was another: an active fiscal policy combined with a passive monetary policy. A simplified way of thinking about this is that it represents the opposite of the consensus assignment: fiscal policy determines inflation and monetary policy controls debt, because debt becomes sustainable by being reduced through inflation. This idea, which became known as the Fiscal Theory of the Price Level (FTPL)[1], is very controversial. (For once, divisions cut across ‘party’ lines, with John Cochrane and Mike Woodford both contributing to the FTPL.) However for current purposes you can think of the FTPL policy combination as being a form of fiscal dominance. You can also think of this combination as being inferior to the consensus assignment from a social welfare perspective (see this post).

So why did Cœuré invoke Leeper’s definitions of active and passive in his speech? To quote:

“central bank independence and a clear focus on price stability are necessary but not sufficient to ensure that the central bank can provide a regime of low and stable inflation under all circumstances – in the economic jargon, ensuring “monetary dominance”. Maintaining price stability also requires appropriate fiscal policy. To borrow from Leeper’s terminology, this means that an “active” monetary policy – namely a monetary policy that actively engages in the setting of its policy interest rate instrument independently and in the exclusive pursuit of its objective of price stability – must be accompanied by “passive” fiscal policy.”

Now OMT involves the ECB being prepared to buy government debt in order to force down interest rates so that fiscal policy becomes sustainable. To some that seems like fiscal dominance: monetary policy is being used in a similar way to the FTPL, in order to make debt sustainable. Cœuré wants to argue that with OMT we can get back to the consensus assignment, because OMT will allow fiscal policy to become passive again.

Now current fiscal policy in the Eurozone can hardly be described as ignoring government debt, as in the polar case of active fiscal policy outlined above. However, for fiscal policy to be passive it has to counteract the tendency for debt to explode because of debt interest payments. If interest rates are very high, because of default risk, this may require destructive and perhaps politically impossible rates of fiscal correction. In other words, default risk forces fiscal policy to be active. Although this problem is just confined to one part of the Eurozone, as Campbell Leith and I showed here, this is sufficient to force monetary policy to become passive if it wants to preserve stability.

I think this is a very clever way of describing OMT to those who believe this policy goes beyond the ECB’s remit. OMT is necessary to allow fiscal policy to become passive in countries subject to significant default risk, and therefore for monetary policy to ensure price stability. The argument, like the FTPL, is controversial: many of those who dislike the FTPL would argue that an active monetary policy is sufficient to ensure price stability. This analysis also ignores the problem of the Zero Lower Bound (ZLB) for nominal rates, which one could reasonably argue forces monetary policy to become passive.  For both reasons I did not use this argument in my post on conditionality, but without length constraints I would have.

I want to make two final points which Cœuré does not. First, a feature of passive fiscal policy at ‘normal’ (largely default risk free) levels of real interest rates is that debt correction does not have to be very rapid, and as Tanya Kirsanova and I show here, it should not be very rapid. Almost certainly the speed of debt correction currently being undertaken in periphery countries is more rapid than it needs to be to ensure a passive fiscal policy at normal interest rates. The current Eurozone fiscal rules also probably imply adjustment that is faster than necessary. As a result, no additional conditionality is required before the ECB invokes OMT. Second, this analysis ignores the problem of the ZLB, which is as acute for the Eurozone as it is elsewhere. Cœuré says that OMT is not Quantitative Easing (QE), but does not explain why the ECB is not pursuing QE. It has taken the ECB about two years too long to recognise the need for OMT – let’s hope that it does not take another two before it realises that for monetary policy to stay active in the sense described above, it also needs QE.  

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[1] The Wikipedia entry on the FTPL is poor.