The centrality of public debt to private capital markets
In thinking about the next ten years, we must acknowledge that new times are coming, and they will lead to big changes in the capitalist system. The absolute novelty of the situation in which the COVID-19 crisis has placed the world, and even more markedly, Europe has made the financial and monetary options that have preoccupied economic debate so far, if not obsolete, at least questionable. It is a crisis that obliges us to rethink, before acting, the underlying assumptions of the last thirty years of economics, finance, and politics.
In a bold move, David Sassoli, President of the European Parliament, called for the cancellation of public debt generated to tackle the pandemic. His proposal immediately inflamed debate and pushed economists, politicians, opinion leaders and institutions into a series of positions, for and against. The ECB formally adopted a negative position, which can be summarized as follows: cancellation is technically feasible (because the ECB “cannot fail”) but is institutionally impossible (because the ECB statute prohibits it).
Rather than indulging in analysis of pro and cons of the President’s proposal, it is worth exploring the new scenario that the words of this prominent member of the European ruling class has disclosed,
Let’s than start from the role of debt in capitalism, leaving the floor to an historian, Marc Bloch:
“Delaying payments or repayments and making such delays perpetually overlap each other: this seems to be, ultimately, the great secret of the modern capitalist regime, the most exact definition of which might perhaps be «a regime that would die in the event of a simultaneous closure of all accounts»”.
We can brutally “translate” this text written in 1935 by acknowledging that capitalism is a regime characterized by debts, which formally have to be paid, but which are in fact systematically rolled over.
This applies in particular to public debts. Since the English “Financial revolution”, that’s the way it is. Central banks exist and can exert “soft power” over financial markets, only because public debts exist, and vice-versa.
Adam Tooze had no difficulty recognising this recently.
“To the horror of conservatives everywhere, the arena in which central banks perform this balancing act is the market for government debt. Government IOUs are not just obligations of the taxpayer. For the government’s creditors, they are the safe assets on which pyramids of private credit are built. This Janus-faced quality of debt creates a basic tension. Whereas conservative economists anathematize central banks swapping swap government debt for cash as the slippery slope to hyperinflation, the reality of modern market-based finance is that it is based precisely on this transaction—the exchange of bonds for cash, mediated if necessary by the central bank.”
Tooze actualises and specifies Bloch’s thesis and introduces the real underlying theme of these COVID-19 months: the growing public Eurozone debt and the methods of its financing. The issue to be faced is this: public debt is the origin of a safe asset that is capable of sustaining financial markets’ stability, which is constantly menaced by the risk of multiple equilibria, that is, equilibria not dictated by “fundamentals” but potentially distorted by expectations.
The aim of Sassoli’s proposal is to lighten the burden of European public debt. Debt which has expanded for all EU countries because of a common, global shock. The cancellation of the debts would be relegated to those originated by EU’s emergency extra-expenses.
Pending a precise definition of the rules of operation and even more of the financing of the Recovery Plan (Next Generation EU) these expenses were essentially financed by the issuance of national bonds purchased overwhelmingly by the ECB, under its PEPP (Pandemic Emergency Purchase Program).
The ECB now holds large amounts of European public debt. If rolled over at maturity, these debts are in fact subtracted from the not always rational (in Lucas’ sense) expectations of the markets, and hence lead to a substantial mitigation of volatility, and additional revenues to the States, thanks to the redistribution of seigniorage income. The clear, and for some surprising, novelty in recent months is that the “scary” increase in public debt and Europe’s debt / GDP ratio has not scared anyone at all. It has instead been accompanied by a mitigation of the yield on ‘govies’.
The objection is that all this could happen only thanks to a suspension of the rules: the expansion of debts and deficits has behind it the suspension of the stability pact, and the PEPP the suspension of the capital key rule (i.e. the obligation of the ECB to purchase government bonds in proportion to their capital in the Bank).
The problem is therefore to understand what will happen to these suspensions, given that we cannot even remotely hope that the “new normal” can be indefinite procrastination of suspensions. If there is something to procrastinate, it is not the suspension of the rules, but the payment of the debt. The procrastination of payment, if it has to be performed in such a way as to not undermine its sustainability, requires rules.
The ECB’s niet to cancellation is based on the fact the treaties do not allow it. Okay, someone will say, let’s change the treaties. Yes, I say, but in view of the “new normal” how should we change them?
How to resolve the debt crisis to finance the Green New Deal
Sassoli’s proposal can be read as an expedient to get “back to normal”. Faced with an exceptional but one-off increase in debts, the one-off solution of their cancellation could simply prepare a return to the old rules, or the old “normal”.
However, we could ask ourselves a twofold question: what Sassoli demands by cancellation cannot be obtained otherwise, without changing the Treaties? But on the other side, is a one-time increase in the debt a likely scenario? Are we not at the beginning of a new season of systematic expansion of public debt for infrastructure spending, of which the Green Deal is but the spearhead?
On the first question, the answer is positive: under the Treaties, the indefinite maintenance of public debt securities on the ECB’s balance sheet would be equivalent to its cancellation. This choice would meet various proposals made in recent months to transform public debts linked to the pandemic into perpetual debts, exactly as happened during the wars of the last century. These proposals can rely on the blessing if not of Robert Barro, certainly of David Ricardo. It is a proposal that would lead to an effective lightening of the debt burden, capable of producing expansionary effects on the real economy.
However, the perpetuation of the ECB’s PEPP would presuppose a definitive overcoming of its capital key rule, because it would imply that the ECB’s purchase decisions for securities are linked to a stability objective and not to a formal distribution rule. One could even imagine that, in order to avoid the recording of losses in the balance sheet and possible need for recapitalization, the cancellation takes the form of a transformation of the debts represented by the public securities held by the ECB into a perpetual credit of the ECB towards the States, at zero interest.
So on the second question about a new beginning, the answer has to be prudent, and hence negative. Since it is not certain that COVID-19 debt is a one-off problem, an institutionalization of the PEPP would overload the ECB with a weight that is already excessive for some, because it concentrates fiscal policy decisions in the hands of the independent monetary policy maker.
Therefore, benefits of debt relief risk being offset by the costs of cancellation. However, if the goal remains reasonable, then we must ask ourselves if there are any other means to attain it.
Let’s then propose an extra step: instead of resubscribing them, the ECB “passes” the bonds at maturity to a European Debt Agency. The Agency will provide the States with the liquidity needed to pay the national debts due by granting them perpetual loans, while financing itself on the markets by issuing common bonds with finite maturities that are indefinitely renewable. Its financial balance will be guaranteed by a systematic redefinition of the annual instalments paid for the perpetual loans based on its financing conditions on the market. These conditions will obviously also depend on the fact that the bonds of the Debt Agency will also be systematically purchased by the ECB, in view of the need to stabilize financial markets, which in turn are always happy to buy safe common bonds with a finite maturity, backed by the ECB. This removes their worries about taking on the refinancing risk of EU States.
By filtering their refinancing risk with a perpetual loan, the Agency would finance individual States based on an exclusive assessment of their “fundamental risk”. Technically speaking, the fundamental risk is what remains when distortions are removed. Politically speaking, however, this risk would be the expression of the rules of a renewed stability pact. That is, a pact that will no longer be able to impose the previous austerity logic, but which nevertheless will have to provide the a priori rules for the fiscal policies of States, to avoid any form of moral hazard and in view of their full assumption of responsibility.
There are suggestions on how to renew it. Think of Olivier Blanchard’s recent reflections on public debt and his proposal to set fiscal standards, which could allow States to make full use of their “fiscal space”, that is, their spending potential.
Last but not least, this same Agency could also finance the rollover of European public debt, which, just like national public debts, must, under capitalism, not be paid but served: that is, perpetuated through appropriate financing practices – as Bloch explained.
The markets, which have already shown their appreciation of the temporary and partial interventions of the ECB, would approve even more strongly, as they would see the supply of European safe assets enormously increased.
New times are coming, bringing radical changes to capitalism. These changes will transform the financial and monetary options that have occupied the debate so far. Above all, they will push us to seek, and hopefully to find, new solutions.