To Eurobond or not to Eurobond?

Written by Vasilis Psarras

In the past few weeks, many articles and Facebook posts have raised the importance of issuing a Eurobond to finance the fiscal stimulus needed to tackle the Covid-19 recession. For many days EU finance ministers tried to reach an agreement on whether to issue this “popular” €1tn Eurobond and share the risk of fiscal expansion, or to remain dedicated to the “business as usual” approach. Yet common ground was found among the hawkish and dovish members of the Eurogroup by creating a €500bn rescue fund supervised by the European Stability Mechanism (ESM) and the European Investment Bank (EIB). 

 Whenever an economic crisis erupts, it has to be determined whether it is a supply side or a demand side shock. The Great Financial Crisis of 2008 and the European Debt Crisis that followed are clear examples of a demand side shock to the economy, either due to a financial crash or a government default [1]. The right policy answer to these crises would have been fiscal expansion and monetary stimulus, and in the US, policymakers decisively used all available monetary and fiscal tools to deal with the 2008 crash. On the contrary, in the Eurozone policymakers chose to enforce fiscal consolidation in the countries worst hit by the recession, disillusioned by the expansionary austerity approach [2]. In 2011, during the peak of the EU depression,  even the European Central Bank (ECB) decided to contract its monetary policy by raising interest rates twice that year. 

 The 1970s stagflation phenomenon was a clear example of a supply side shock in the economy as a result of increased oil prices. As some German economists pointed out in an open letter, in 1974 the European Economic Community decided to issue a Eurobond to deal with the economic collapse and to equally support all countries hit by stagflation [3]. Undoubtedly, the Covid-19 crisis evokes the sad memories of the 70s since, even before the complete lockdown, it has generally affected supply chains and commodities around the globe [4]. The problem is that even if the current healthcare and economic crises are compared either with stagflation or the Spanish Flu, this time is, in Carmen Reinhart’s words, truly different [5].

In early February economists projected that the output loss from Covid-19 would have mostly derived from the shrunk aggregate supply, but once the virus started spreading to more and more countries with mass lockdown decisions, aggregate demand decreased sharply as well. With no companies able to produce and with customers quarantined at home unable to consume, the 2020 recession will be even more severe than the Great Depression [6]. The major difference with the Great Depression of 1929, which Friedman and Schwartz describe as “the Great Contraction” due to the contractionary measures of the US Federal Reserve, and the Great Recession of 2008 is that the policy response of central bankers and governments was more decisive and achieved in a month what it took them three years to do in the previous recession.

 Issuing a Eurobond would be a key opportunity for governments to use these resources to finance their deficits with lower interest rates and to provide even further fiscal stimulus. Fiscal stimulus packages are widely perceived as the Keynesian policy mix needed to strengthen the economy and lead it to full employment, but the current fiscal expansion doesn’t reflect Keynes’ ideas of productive public investments or better financial regulation. The helicopter money provided by governments all over the world is much closer to Friedman’s macroeconomic solutions [7]. So, the Eurobond is a “Keynesian” excuse to use even further monetarist remedies. 

 It is almost unthinkable, even in these critical times, to believe that a deficit of around 15 percent of GDP can be considered as sustainable despite interest rates being below 100 basis points. The purpose of the €1tn Eurobond, equal to almost 8 percent of Eurozone GDP, would be to boost consumption during the lockdown when people have no source of income, and at the same time provide social benefits to those affected most. But no government has made a clear commitment to increase funding to healthcare systems in the long term, and they have mostly intended to use these deficits to promote tax cuts instead of effective public investments. It would be more important for Eurozone member states to promote an essential wealth tax to increase government revenues, which would enable them to finance public services more easily [8].

Yet Eurobond advocates have utterly forgotten the short term stabilising role of monetary policy. The ECB Governing Council in March launched its Emergency Purchase Programme with an envelope of €750bn until the end of the year, in addition to the already existing QE programme. The total value of the combined Asset Purchase Programme will be equal to €1,1bn – the same amount as the Eurobond – and considering the past decisions of the ECB, almost 90 percent of total assets purchased will be government bonds [9]. Monetising public debt is no reason to panic and it must be understood that these exact policy tools find supporters from across the spectrum of economic thinking. New Keynesian economists should agree with Blanchard and Pisani-Ferry that monetised debt shows little chance of uncontrolled inflation, but should also agree with Peter Bofinger, a Post Keynesian economist, who believes that debt monetisation is the right step towards implementing Modern Monetary Theory (MMT) [10] [11].

 Although many economists may say that MMT cannot be enforced in the Eurozone, the Outright Monetary Transaction (OMT) pledge of the ECB in 2012 paved the way for MMT in the Euro area. OMT was first described by former ECB President Mario Draghi, that in case of extremely high interest rates in one specific member state, the ECB would intervene by purchasing all of its outstanding debt. Even today, average 10-year bond yields in the Eurozone are among the lowest in the world, and even countries like Greece have a borrowing cost of around 200 basis points, clearly below the 6 or 8 percent at the beginning of the European Debt Crisis. Maybe there is still a reason why OMT has not yet been put into action while still remaining an opportunity to support the real economy if interest rates become unsustainable [12].

 Finally, there is an essential macroeconomic argument in favour of monetised debt over the Eurobond. When the fiscal authority decides to finance deficits through a politically independent Central Bank with a stable prices target, the work of the Central Bank is improved to reach this target once both fiscal and monetary authorities make it clear, even in a shadow way in the case of general government, that they both have a price stability mandate. Aggregate supply is affected by the level of nominal wages which are in turn influenced by inflation expectations. Since the ECB has taken more aggressive actions to monetise debt and has been using forward guidance, it’s easier to increase inflation expectations. Due to all these structural reforms on the labour market, nominal wages will adapt more quickly to these higher inflation expectations and consequently increase aggregate supply and eliminate the shock in the economy faster. 

The Eurobond isn’t a disastrous idea, yet without a fiscal union and with the already decisive and effective actions of the ECB, the Eurobond wouldn’t work in an optimally expansionary way and it would just increase moral hazard for the overindebted EU countries. Even in Greece, interest rates are extremely low, and the QE will decrease them even further. It is vital to understand that the current response to the crisis is neither too little nor too late and we have to let the ECB play its role as the short-term stabilising institution that helps fiscal authorities. Either way Europe has to remember what Keynes once wrote: “What a government spends the public pays for. There is no such thing as an uncovered deficit” [13].

References

[1] Benguria, Felipe and Taylor, Alan M. (2020, 3 March). “Are financial crises demand or supply shocks?”. CEPR. Retrieved from: https://voxeu.org/article/are-financial-crises-demand-or-supply-shocks

[2] Breuer, Christian. (2019). “Expansionary Austerity and Reverse Causality: A Critique of the Conventional Approach”. INET, Working Paper No. 98, June 2019

[3] New Statesman. (2020, 30 March). “To avoid economic disaster, Europe must demonstrate financial solidarity”. New Statesman. Retrieved from: https://www.newstatesman.com/world/europe/2020/03/avoid-economic-disaster-europe-must-demonstrate-financial-solidarity

[4] Rogoff, Kenneth. (2020, 2 March). “That 1970s Feeling”. Project Syndicate. Retrieved from: https://www.project-syndicate.org/commentary/next-global-recession-hits-the-supply-side-by-kenneth-rogoff-2020-03

[5] Reinhart, Carmen M. (2020, 23 March). “This Time Truly Is Different”. Project Syndicate. Retrieved from: https://www.project-syndicate.org/commentary/covid19-crisis-has-no-economic-precedent-by-carmen-reinhart-2020-03

[6] Gopinath, Gita. (2020, 14 April). “The Great Lockdown: Worst Economic Downturn Since the Great Depression”. IMF Blog. Retrieved from: https://blogs.imf.org/2020/04/14/the-great-lockdown-worst-economic-downturn-since-the-great-depression/

[7] Buiter, Willem H. (2020, 26 March). “The Helicopters Are Coming”. Project Syndicate. Retrieved from: https://www.project-syndicate.org/commentary/helicopter-money-coronavirus-response-by-willem-h-buiter-1-2020-03

[8] Landais, Camille, Saez, Emmanuel and Zucman, Gabriel. (2020, 3 April). “A progressive European wealth tax to fund the European COVID response”. CEPR. Retrieved from: https://voxeu.org/article/progressive-european-wealth-tax-fund-european-covid-response

[9] Cottarelli, Carlo. (2020, 16 April). “Don’t worry about another debt crisis”. Politico. Retrieved from: https://www.politico.eu/article/coronavirus-dont-worry-about-another-debt-crisis/

[10] Blanchard, Olivier and Pisani-Ferry, Jean. (2020, 10 April). “Monetisation: Do not panic”. CEPR. Retrieved from: https://voxeu.org/article/monetisation-do-not-panic

[11] Bofinger, Peter. (2020, 5 April). “Coronavirus crisis: now is the hour of MMT”. CEPR. Retrieved from: https://voxeu.org/content/coronavirus-crisis-now-hour-mmt

[12] Codegno, Lorenzo and Van den Noord, Paul. (2020, 5 April). “COVID-19: OMT is second-best, but still welcome”. CEPR. Retrieved from: https://voxeu.org/article/covid-19-omt-second-best-still-welcome

[13] Keynes, John Maynard. (1924). “A Tract on Monetary Reform”. Retrieved from: https://delong.typepad.com/keynes-1923-a-tract-on-monetary-reform.pdf