14 June 2013

De Grauwe & Ji: Fiscal implications of the ECB's bond-buying programme

The monetary-fiscal policy connection is under scrutiny by the German Constitutional Court in the context of the ECB's OMT bond-buying programme. This column argues that most analyses are deeply flawed by the misapplication of private company default principles to the central bank.

There is a lot of confusion about the fiscal implications of the government bond-buying programme – the OMT, or Outright Monetary Transactions – that the ECB announced last year.

• This confusion arises mainly because the principles that guide the solvency of private companies (including banks) are applied to central banks.
• The level of confusion is so high that the president of the Bundesbank turned to the German Constitutional Court arguing that the OMT programme of the ECB would make German citizens liable for paying taxes to cover potential losses made by the ECB.

In this column the authors argue that the fears that German taxpayers may have to cover losses made by the ECB are misplaced. They are based on a misunderstanding of solvency issues that central banks face. Indeed, German taxpayers are the main beneficiaries of such a bond-buying programme.

Solvency central banks versus private agents: The key difference

Private companies are said to be solvent when their equity is positive, i.e. when the value of their assets exceeds the value of their outstanding debt. The solvency of a private company can also be formulated in terms of the maximum amount of losses that a company can bear at any given time. Thus, a private company is said to be solvent when its losses do not exceed the value of its equity. Since in efficient markets the latter is equal to the present value of future profits, we arrive at the solvency constraint that says that the losses today cannot exceed the present value of expected future profits.

The problem arises when these solvency constraints are applied to central banks.

• This misapplication of private principles has led some to conclude that the loss the ECB (or any central bank) can bear should not exceed the present value of future expected seigniorage gains.
• Similarly, it is sometimes concluded that a central bank needs positive equity to remain solvent. These solvency constraints should not be applied to the central bank; central banks cannot default.

A central bank can issue any amount of money that will allow it to 'repay its creditors', i.e. the money holders. Such a 'repayment' would just amount in converting old money into new money. Contrary to private companies, the liabilities of the central bank do not constitute a claim on the assets of the central bank. The latter was the case during gold standard when the central bank promised to convert its liabilities into gold at a fixed price. Similarly in a fixed exchange-rate system, the central banks promise to convert their liabilities into foreign exchange at a fixed price.

The ECB and other modern central banks that are on a floating exchange-rate system make no such promise. As a result, the value of the central bank’s assets has no bearing for its solvency. The only promise made by the central bank in a floating exchange-rate regime is that the money will be convertible into a basket of goods and services at a (more or less) fixed price. In other words the central bank makes a promise of price stability. That’s all...

The authors' analysis suggests the following:

• Limits to a bond-buying programme depend on the nature of the economic and financial situation, i.e. the existence of a liquidity trap.
• In normal times when an increase of the money base leads to proportional increases in the money stock the limit to a bond-buying programme is tight. If the target for the increase in the money stock is 4.5 per cent (as is the case in the eurozone where a 4.5 per cent target is assumed to lead to at most 2 per cent inflation) this also means that the money base should not increase by more than 4.5 per cent per year. But then during normal times there is very little need for a bond-buying programme.
• The situation has changed dramatically since the start of the banking crisis. During the crisis period the limits to the amount of money base that can be created without triggering inflationary pressures is much higher because of the existence of a liquidity trap.

How much higher depends on the money multiplier. In De Grauwe and Ji (2013) the authors estimate the size of the multiplier during the crisis period and conclude that it has collapsed to zero. As a result, there is no limit to the size of the bond-buying programme, i.e. the ECB can buy any amount of government bonds without endangering price stability, as long as the crisis lasts.

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