The arcane notion of ‘monetary dominance’ lay behind the last eurozone crisis. Unless challenged, it could underlie another one.
How safe are eurozone government bonds? This superficially technical question is central to the future of economic and monetary union: without safe bonds, another eurozone crisis could loom right after the pandemic.
The last one erupted in 2010 because of uncertainty about the status of government bonds. Financial-market actors saw those bonds as at risk of default and demanded massively higher interest rates from many governments. These latter, unable to finance deficits, had to implement harsh austerity policies, which led to mass unemployment and nearly brought down the entire euro project.
Only when the then president of the European Central Bank, Mario Draghi, announced in July 2012 that the ECB would do everything it must to save the euro—in an emergency, buying government bonds—did the risk of a sovereign default, and thus interest-rate hikes, dissipate. This was the beginning of the end of the eurozone crisis. Many governments were able to end the disastrous austerity and the economy could finally recover.
While there were similar economic crises in the United States, the United Kingdom and Japan, there was never any doubt in those countries that the central bank would ensure the safety of government bonds. Hence they were spared a sovereign-debt crisis like that in the euro area.
Only when government bonds are sufficiently default-proof that investors don’t fear losses will they lend money to governments at low interest rates. Only then will governments be able to increase spending or cut taxes to support corporate and household incomes and thus employment.
The ECB is buying bonds even now in the coronavirus crisis, thus enabling governments to pursue a fiscal policy that stabilises employment. In May last year, however the German Constitutional Court ruled that the ECB was acting outside the European treaties with its bond purchases and that the Bundesbank should no longer participate unless the ECB could dispel doubts that it was acting ultra vires.
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Not least in light of such resistance, in March the ECB president, Christine Lagarde, had said that the central bank was not responsible for reducing interest-rate differentials, or spreads, among euro-area government bonds. In doing so, she appeared to be disposing of Draghi’s legacy. Immediately after, interest rates on Italian bonds rose—as the country faced the peak of the pandemic. To be sure, Lagarde rowed back, but spreads remained high into May 2020.
The constitution of the European Stability Mechanism (ESM) also shows how uncertain the status of government bonds remains. The ESM is designed to provide emergency loans to eurozone countries on the verge of default but states only receive the loans under certain conditions. Since if they don’t meet these conditions they will default on their debts, their bonds are still a default risk. This uncertainty is particularly problematic because financial actors can force sovereigns into default if the central bank does not ultimately guarantee the safety of government bonds.
States—as with banks and most corporations—generally do not repay their debts. To roll over maturing debt, they take on new debt. Normally, this works smoothly. But if holders of government bonds fear that a state will stop making payments in the future, they will demand higher interest rates or not roll over the debt at all. In this case, governments are threatened with default and bondholders with losses.
Expectations of a sovereign default can become self-fulfilling prophecies. If an investor believes other investors will not renew their loans for fear of default, she will be in danger of not getting her money back. This investor will consequently not roll over her loans, which will then lead to others not getting their money back. And so on.
This is how bank runs happen. For banks, though, there are two lines of defence. First, central banks usually act as lenders of last resort: against collateral, banks can borrow money from the central bank and thus satisfy a surge of demand from account holders for cash they don’t normally hold. Secondly, there is a government-regulated deposit-guarantee scheme in the euro area, under which bank deposits are guaranteed up to €100,000. These two mechanisms make deposits with banks safe investments: account holders do not have to fear losing their funds, so there is no self-fulfilling expectation of default.
But as long as there is uncertainty about whether government bonds can default, euro-area banks’ debts—their deposits—are safer than government bonds. This is precisely where Draghi and the ECB stepped in: when Draghi announced the purchase of government bonds, interest rates fell. The downward spiral of negative expectations was broken.
Those who are afraid of a government default know they can get their money from the central bank in an emergency. So they do not have to fear losses and continue to lend willingly to states at favorable conditions. At the moment, this is helping governments stabilise the economy and, above all, employment.
But if safe government bonds are so important to an economy, why have they been so unsafe in the euro area? This is largely because of the theory of ‘monetary dominance’ upon which it was founded. According to this theory, government bonds must be explicitly at risk of default, as the ‘no-bail-out’ clause of the European treaties was supposed to ensure. Euro-area governments have in effect forbidden each other to guarantee their respective debts, while the central bank is not permitted to lend directly to governments.
With monetary dominance, the highest economic-policy goal—to which others, such as full employment, are subordinated—is low inflation. For a central bank to pursue this goal consistently, the argument goes, it must be absolutely independent of politics: governments would otherwise always have an incentive to incur too much debt and then have the central bank inflate it away.
Only when government bonds are at risk of default can market discipline be ensured, it is claimed: if governments take on too much debt, lenders charge higher interest rates because of the higher risk and government’s appetite for debt decreases—lowering the risk of politically-motivated inflation in the future. This is exactly what happened in the eurozone crisis, but with devastating economic, social and political consequences.
How dangerous would it now be to ease the regime of ‘monetary dominance’ in the euro area? Would there be a threat of hyperinflation, as in Germany after the first world war?
No, as experience illustrates: at least since Draghi’s speech and the subsequent purchases of government bonds, such a strict regime of monetary dominance does not exist in reality in the euro area. But inflation has hardly risen—on the contrary, the central bank is struggling to reach its inflation target of around 2 per cent. Central banks generally are desperately trying to avoid deflation.
In the US, the UK and Japan, however, there has never been strict ‘monetary dominance’ and there has never been any question about whether government bonds are unsafe. This is because the respective central banks have always been willing to buy such bonds. Also in those countries, inflation was not an issue and is not likely to become one.
But could the high mountains of debt which states are now accumulating in the crisis force central banks to bring about inflation in the future? The ECB’s strong independence and its focus on price stability are set against that. If inflation were to rise noticeably—a rather unlikely scenario for the medium term—it could sell government bonds again and raise interest rates. In addition, there are the European fiscal rules which prevent government debt from getting out of hand (albeit they are definitely in need of reform).
In this respect, the pragmatic monetary policy being conducted by the ECB is justified. It protects sovereigns from the ravages of sovereign default risk but its independence means that it can equally counteract excessive inflation.
Yet monetary dominance remains an integral part of the European treaties. To be sure, the ECB does not directly violate it with its bond purchases, because it does not lend to sovereigns directly. It buys government bonds already outstanding in the financial markets, which it is allowed to do. But many think that the bond purchases nevertheless go against the spirit of the treaties. That is one of the reasons why the German Constitutional Court reached its decision. The court has to interpret European law, whether it makes sense or not.
Therefore, there is a real risk that a ruling by a national court which would restrict the purchase of government bonds could lead to them once again being seen as at risk of default, with the corresponding negative consequences. That is why, in the medium term, a commitment is needed from European policy-makers that European government bonds are safe. The euro area cannot afford another explosion of interest rates—with the associated austerity and economic crises.
A German version of this article was published by the Friedrich Ebert Stiftung