For many years, the European Central Bank was able to print money to purchase member states’ government debt without having to worry about causing high inflation. But now that stagflationary conditions have set in, the ECB finds itself on the horns of a dilemma.
MUNICH – Until recently, the European Central Bank could simply throw money at the eurozone’s problems. But that is no longer possible in the face of inflation, so it has now developed a new “anti-fragmentation” mechanism – the Transmission Protection Instrument (TPI) – to protect highly indebted member states in the event that their borrowing costs (sovereign-bond yields) rise much higher than those of less indebted member states. Should the need arise, the ECB will swap out low-debt member states’ bonds for those of high-debt member states in its portfolio, thereby reducing the interest-rate differential between them.
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And who will decide whether there is indeed a need for such action? The ECB will – all by itself.
The TPI is problematic for many reasons, not least because interest-rate spreads are an integral part of a properly functioning capital market and federation. It is worth bearing in mind that while yield spreads refer to the nominal interest rates agreed on paper, these interest rates are not paid at all in the event of bankruptcy.
To make effective, mathematically expected interest rates the same for all countries, an efficient capital market assigns rates according to the level of country risk. If a country becomes excessively indebted, its risk of bankruptcy increases, investors demand a premium in the form of higher interest rates, and the higher rates cause the government to reduce its borrowing. The market thus automatically prevents excessive debt.
By contrast, intervening to reduce interest-rate differentials is tantamount to subsidizing highly indebted countries’ borrowing at the expense of less indebted countries, which must bear higher nominal and effective interest burdens as a result. Opposition from these countries’ taxpayers – and objections from their constitutional courts – are to be expected.
The Eurosystem is entering dangerous waters. Gone are the days when the ECB could deploy asset-purchase programs to provide freshly printed money to member states without creating withdrawal effects anywhere else. Now, if the ECB prints new money for the purpose of government financing, it will be expropriating the eurozone’s money holders through inflation; and if it applies its anti-fragmentation instrument, it will be redistributing budgetary resources between member states – a plainly political act.
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Through the succession of euro crises that followed Lehman Brothers’ collapse in 2008, financing public spending with the printing press has been the main driver of monetary expansion. Since the summer of 2008, no less than 83% – €5.3 trillion ($5.43 trillion) – of the total overhang of central bank money (relative to GDP, and over the level that had proved sufficient) came from the purchase of government securities.
For a while, these purchases allowed governments to take on more and more debt (in defiance of all the Eurosystem’s debt ceilings) without irritating investors. While that debt stimulated aggregate demand and kept unemployment in check, inflationary secondary effects from the expansion of banks’ credit supply failed to materialize, because the newly circulating money was being hoarded by banks and private individuals.
But conditions have changed. The COVID-19 pandemic has led to stagflation. Lockdowns and quarantine measures have curtailed production and caused supply problems everywhere – and these issues are far from being overcome, especially in China. Meanwhile, Russia’s war in Ukraine and other factors have created opportunistic supply shortages in the fossil-fuel sector. The result has been massive inflation, far dwarfing the effects of the 1970s oil crises.
In a stagflationary environment, government financing with the printing press no longer works, because it merely fuels inflation and social turmoil, especially among middle-class voters who justifiably fear for their savings. Under these conditions, over-indebted states and financial systems’ creditworthiness can be secured only through international fiscal aid programs financed with taxes – not debt. And yet, higher taxation also is certain to face staunch resistance among voters. The TPI can be thought of as one such program, because it leads to redistribution effects between state budgets.
The ECB is thus left with a dilemma. If it wants to continue helping hard-pressed governments by buying their bonds, it can get them the resources they need via predatory inflation at the expense of money holders, or it can get some governments the resources they need at the expense of other governments.
Either way, the free lunch offered by inflation-free money printing is over. In a context of stagflation, a Keynesian demand policy to stimulate economic activity will merely fuel inflation, for which the ECB will rightly be blamed if it keeps buying government bonds. But using the TPI would amount to redistribution between member states, leading to storms of protest and severe legal consequences.
The only other option is to do nothing, which would send capital markets into turmoil. The ECB may be facing its biggest test yet.
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