Research Topics

Monetization Fears and Europe’s Narrowing Options

With the creation of the Economic and Monetary Union and the euro, the national government debt of eurozone member-states became credit sensitive. While the potentially destabilizing impact of adverse cyclical conditions on credit-sensitive debt was seriously underestimated, the design was intentional, framed within a Friedman-Fischer-Buchanan view that “no monetization” rules provide a powerful means to discipline government behavior. While most countries follow some kind of “no monetization” rule, the one embraced by the eurozone was special, as it also prevented monetization on the secondary market for debt. This made all eurozone public debt defaultable—at least until the European Central Bank (ECB) announced the Outright Monetary Transactionsprogram, which can be seen as an enhanced rule-based approach that makes governments solvent on the condition that they balance their budgets. This has further narrowed Europe’s options for policy solutions that are conducive to job creation. An approach that would require no immediate changes in the European Union’s (EU) political structure would be for the EU to fund “net government spending in the interest of Europe” through the issue of a eurobond backed by the ECB.

A Historic Monetary Policy Pivot Point and Moment of (Relative) Clarity

Not since the Great Depression have monetary policy matters and institutions weighed so heavily in commercial, financial, and political arenas. Apart from the eurozone crisis and global monetary policy issues, for nearly two years all else has counted for little more than noise on a relative risk basis.

In major developed economies, a hypermature secular decline in interest rates is pancaking against a hard, roughly zero lower-rate bound (i.e., barring imposition of rather extreme policies such as a tax on cash holdings, which could conceivably drive rates deeply negative). Relentlessly mounting aggregate debt loads are rendering monetary- and fiscal policy–impaired governments and segments of society insolvent and struggling to escape liquidity quicksands and stubbornly low or negative growth and employment trends.

At the center of the current crisis is the European Monetary Union (EMU)—a monetary union lacking fiscal and political integration. Such partial integration limits policy alternatives relative to either full federal integration of member-states or no integration at all. As we have witnessed since spring 2008, this operationally constrained middle ground progressively magnifies economic divergence and political and social discord across member-states.

Given the scale and scope of the eurozone crisis, policy and actions taken (or not taken) by the European Central Bank (ECB) meaningfully impact markets large and small, and ripple with force through every major monetary policy domain. History, for the moment, has rendered the ECB the world’s most important monetary policy pivot point.

Since November 2011, the ECB has taken on an arguably activist liquidity-provider role relative to private banks (and, in some important measure, indirectly to sovereigns) while maintaining its long-held post as rhetorical promoter of staunch fiscal discipline relative to sovereignty-encased “peripheral” states lacking full monetary and fiscal integration. In December 2011, the ECB made clear its intention to inject massive liquidity when faced with crises of scale in future. Already demonstratively disposed toward easing due to conditions on their respective domestic fronts, other major central banks have mobilized since the third quarter of 2011. The collective global central banking policy posture has thus become more homogenized, synchronized, and directionally clear than at any time since early 2009.

The main purpose of this study is to explore the potential expansionary effect stemming from the monetization of debt. We develop a simple macroeconomic model with Keynesian features and four sectors: creditor households, debtor households, businesses, and the public sector. We show that such expansionary effect stems mainly from a reduction in the financial cost of servicing the public debt. The efficacy of the channel that allegedly operates through the compression of the risk/term premium on securities is found to be ambiguous. Finally, we show that a country that issues its own currency can avoid becoming stuck in a structural “liquidity trap,” provided its central bank is willing to monetize the debt created by a strong enough fiscal expansion.