What stops public debt being monetised to avoid the pain of prolonged austerity after the pandemic? An obsolete economic theory of ‘credibility’

Pompeo Della Posta

English

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6/11/2020 Public debt monetisation and the credibility of the ECB – Pompeo Della Postahttps://www.socialeurope.eu/public-debt-monetisation-and-the-credibility-of-the-ecb 1/4by Pompeo Della Posta on 28th July 2020Pompeo Della PostaWhat stops public debt being monetised to avoid the pain of prolonged austerity after thepandemic? An obsolete economic theory of ‘credibility’.In the conditions, akin to wartime, resulting from the Covid-19 pandemic,public debt is being created—and more will have to be created—to meet the exceptional  scal needs arising. Many economists, ofdi erent orientations (Blanchard and Pisani-Ferry, Giavazzi andTabellini, Galì, De Grauwe), suggest that this debt should be‘monetised’—bought up on primary markets by central banks, with thecreation of new money. This would avoid the accumulation of publicdebt and the consequent need to adopt future austerity policies for itsrepayment, hindering growth.The main objections to such direct-money  nancing of publicexpenditure in the European economic and monetary union (EMU) relate to its institutional feasibility—given the requirements of the Treaty on the Functioning of the European Union—and the negativee ects it would supposedly have on the anti-in ationary credibility of the European Central Bank.The  rst objection is, of course, rather serious—although only so long as insu cient political willprevents its resolution via treaty change, to which I shall return. To deal with the second, it is worthrecalling the evolution of the theory of ‘credibility’.Social Europepolitics, economy and employment & labourPublic debt monetisationand the credibility of theECB6/11/2020 Public debt monetisation and the credibility of the ECB – Pompeo Della Postahttps://www.socialeurope.eu/public-debt-monetisation-and-the-credibility-of-the-ecb 2/4Enter your email address here... SIGN UPMake your email inbox interesting again!"Social Europe publishes thought-provoking articles on the big political and economic issuesof our time analysed from a European viewpoint. Indispensable reading!"Polly ToynbeeColumnist for The GuardianPowered by ConvertKit‘Rational expectations’The  rst generation of credibility theory, dating back to the 1970s and 1980s—in particular thecontributions of Kydland and Prescott and Barro and Gordon—contended that central banksshould follow monetary rules rather than exercise discretion. In the latter case, it was asserted, the‘rational expectations’ of economic actors would anticipate the central bank’s ‘time inconsistency’problem, namely its purported incentive to renege on the initial promise not to run an expansionarymonetary policy and instead reduce unemployment by managing a surprise injection of money toincrease the price level—thereby reducing real wages and inducing employers to hire more workers.The expectation of in ation would, it was contended, pre-emptively become a self-ful lling prophecy,leaving no real e ect on unemployment and production, which would remain anchored to levelspresumed naturally dictated by the market. ‘Tying the hands’ of central banks by imposing strict rules onthem, then, would solve the ‘time inconsistency’ problem.This theory—however questionable its deterministic chain of argumentation—was convenient for thosebelieving in the unconditional virtues of free markets and unconcerned about unemployment in thepost-Keynesian era. It became the theoretical basis on which the ECB’s institutional architecture wasbuilt, to preserve its anti-in ationary credibility.Optimum currency areasThis conclusion con icted with the basic approach of the parallel  ow of literature on optimum currencyareas (OCA). From a di erent perspective, this also implied tying the hands of the central bank, althoughthrough participation in a  xed exchange-rate system or a monetary union, rather than by imposing6/11/2020 Public debt monetisation and the credibility of the ECB – Pompeo Della Postahttps://www.socialeurope.eu/public-debt-monetisation-and-the-credibility-of-the-ecb 3/4stringent domestic rules.More speci cally, OCA theory examined the conditions to be met for a currency or monetary union—inwhich exchange-rate and monetary independence were renounced—to be optimal. It did so by askinghow likely an asymmetric shock a ecting a country would be (Kenen’s product-diversi cation criterion),how easily it could be absorbed by automatic market mechanisms (Mundell‘s criterion on mobility and exibility of labour and capital) and how e ective the forsworn exchange-rate instrument might havebeen (McKinnon‘s criterion on the degree of openness).Credibility theory, being based until then on deterministic models, should not have been part of thisdebate, but it was wrongly credited as being the ‘new’ OCA theory  (Tavlas). In this view, since monetaryindependence produced only an in ationary bias, without any substantive bene t, giving it up by joininga currency or monetary union would always be optimal, because it would avoid running the risk ofin ation.We need your help! Please support our cause.As you may know, Social Europe is an independent publisher. We aren't backed by a largepublishing house, big advertising partners or a multi-million euro enterprise. For the longevity ofSocial Europe we depend on our loyal readers - we depend on you.Become a Social Europe MemberJustice was only done when the second generation of credibility theory took instead a stochasticapproach—recognising contingency and randomness. This led to the same conclusion as OCA theory: ifproduction is hit by an unexpected and asymmetric shock, one can no longer conclude that rules(whether a domestic or an external tying of hands) are always preferable to discretion.If the problem is uncertainty as to central-bank behaviour over time, credibility is at issue, but this is notthe problem when a stochastic shock a ects the economy and needs to be absorbed in the here andnow (Lohmann). The rules, therefore, should not be  xed, but rather state-contingent  (Svensson)and policy-makers cannot gain credibility by following policies that are not credible (Drazen and6/11/2020 Public debt monetisation and the credibility of the ECB – Pompeo Della Postahttps://www.socialeurope.eu/public-debt-monetisation-and-the-credibility-of-the-ecb 4/4Masson). How, in 1992, for example, could the Italian central bank gain credibility and an anti-in ationary reputation by following a  xed rule of exchange-rate stability that damaged the Italianeconomy?Less costlyAnd, in the current situation, how could the ECB lose its anti-in ationary credibility if it agreed to buygovernment bonds on the primary market or if it  nanced citizens directly by crediting their currentaccount—which would not entail any in ationary risk and would be less costly for the euro-areaeconomies than recourse to debt? After all, that is what the Bank of England and the Federal Reserve aredoing. In fact, the future repayment of these debts would risk jeopardising the economic-recoverycapacities of the countries in question, which would have to resort to recessionary austerity policies.During the eurozone crisis, European countries already followed restrictive  scal policies, the opposite ofwhat the United Kingdom and the United States did. It is not to these policies—which perverselyincreased the ratio of public debt to gross domestic product, due to their larger contractionary e ect onthe denominator—that we owe the end of the crisis. Rather, that came with the reassurance of the‘whatever it takes’ monetary commitment by the then ECB president, Mario Draghi.Restrictive  scal policies were implemented not because they were coherent or validated but because ofthe distrust of European countries towards one another. It was this mistrust which fostered thebelief that, without limiting  scal looseness, the associated ‘moral hazard’ would produce excessivegrowth of public debt.It seems that today we shall make a similar mistake—this time in terms of an inappropriatemonetary, rather than  scal, policy. The reason, however, is the same—mutual mistrust and the fear thatthe expectation of debt monetisation would induce irresponsible, ‘freeriding’ behaviour.Such fear is engendered by the continuing incompleteness and indeed fragmentation of economic andmonetary union. Which carries a high cost—a cost that should be su cient to foster the political willnecessary to avoid it and so to enjoy the full bene ts of EMU.

Public debt monetisation and the credibility of the ECB

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Public debt monetisation and the credibility of the ECB

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