By Willem H. Buiter
LONDON – Since the second quarter of 2021, inflation in the United Kingdom, the United States, and the eurozone has far exceeded their central banks’ 2% target. This surge could well be explained by the unexpected severity and duration of the COVID-19 pandemic, the fallout from Russia’s war in Ukraine, and repeated errors of judgment by the Bank of England, the US Federal Reserve, and the European Central Bank.
But another possible explanation is that monetary policy has been subject to fiscal dominance or fiscal capture. In this interpretation, major central banks have engaged in aggressive low-interest-rate and asset-purchase policies to support their governments’ expansionary fiscal policies, even though they knew such policies were likely to run counter to their price-stability mandates and were not necessary to preserve financial stability.
The “fiscal capture” interpretation is particularly convincing for the ECB, which must deal with several sovereigns that are facing debt-sustainability issues. Greece, Italy, Portugal, and Spain are all fiscally fragile. And France, Belgium, and Cyprus could also face sovereign-funding problems when the next cyclical downturn hits, or when risk-free interest rates normalize from the past decade’s extraordinarily low levels, or when sovereign risk is priced more realistically.
In April 2022, headline inflation for the eurozone was 7.5%, and core inflation (excluding food and energy) was 3.5%. Yet the ECB remains very concerned with financing sovereign deficits. This was apparent in its March 24, 2022, announcement that it would continue to accept Greek government bonds as collateral until at least the end of 2024. Greek sovereign debt does not meet the ECB’s investment-grade credit requirement, but it has been purchased and held by the Euro-system (the ECB and member states’ central banks) under the Pandemic Emergency Purchase Program (PEPP) since March 2020.
In December 2021, the ECB Governing Council announced that it would discontinue net asset purchases under the PEPP at the end of March 2022. But it also decided that the maturing principal payments would be reinvested until at least the end of 2024, so that “the future roll-off of the PEPP portfolio [could] be managed to avoid interference with the appropriate monetary stance.”
Moreover, in March 2022, the Governing Council made clear that it might continue to buy and accept as collateral the debt of other governments that could fall below investment grade. The ECB “reserves the right to deviate also in the future from credit rating agencies’ ratings if warranted, in line with its discretion under the monetary policy framework, thereby avoiding mechanistic reliance on these ratings.”
All told, the Euro-system’s holdings of public-sector securities under the PEPP at the end of March 2022 amounted to more than €1.6 trillion ($1.7 trillion), or 13.4% of 2021 eurozone GDP, and cumulative net purchases of Greek sovereign debt under the PEPP were €38.5 billion (21.1% of Greece’s 2021 GDP). For Portugal, Italy, and Spain, the corresponding GDP shares of net PEPP purchases were 16.4%, 16%, and 15.7%, respectively.
The Euro-system’s Public Sector Purchase Program (PSPP) also made net purchases of investment-grade sovereign debt. From November 2019 until the end of March 2022, these totaled €503.6 billion, or 4.1% of eurozone GDP. In total, the Euro-system bought more than 120% of net eurozone sovereign debt issuances in 2020 and 2021.
Now, the ECB is said to be working on a “new instrument” to support eurozone member states confronting higher borrowing costs stemming from the ECB’s own expected future policy-rate increases. Sovereign yield spreads on risky eurozone sovereign debt are rising again – with the Italy-Germany ten-year yield spread reaching 2% on May 10, 2022 – at a time when many vulnerable sovereigns are still planning additional large net debt issuances.
I expect that either the PSPP eligibility rules will be changed to allow the purchase of sub-investment grade debt, or that a new PEPP-like facility will be created for the purpose. Either way, the ECB is the only institution with the resources and the necessary reaction speed to engage in fiscal-rescue operations. The entity specifically created to address eurozone sovereign debt issues, the European Stability Mechanism, has neither the deep pockets nor the flexibility to respond promptly and decisively to a looming sovereign funding crisis.
Indeed, as of April 2022, the total amount of loans disbursed by the ESM (and its predecessor) since 2010 was just €295 billion, or 2.4% of GDP. And Germany has just rejected a proposal by the ESM to create a new permanent aid fund worth €250 billion (about 2% of eurozone GDP).
Whenever the ECB starts raising its policy rates (which should be soon, though it will be too little, too late), I expect that it will continue its bond purchases. Most likely, these will be targeted at the high-risk sovereign debt issued by countries like Greece and Italy, though targeted purchases of corporate bonds and asset-backed securities could also be part of the “new purchase program.”
When such asset purchases occur under disorderly market conditions, they can be justified as “market maker of last resort” measures. That will likely be the case with Euro-system purchases of corporate debt, provided that these are reversed as soon as orderly market conditions are restored. But by becoming a long-term holder of a growing stock of vulnerable sovereign debt, which is not justifiable on the grounds of systemic financial stability, the Euro-system will be engaging in still more fiscal-support (and sometimes fiscal-rescue) operations.
No member-state finance minister is laying siege to the ECB’s headquarters, of course, so one could argue that this manifestation of fiscal capture is voluntary or internalized. But that does not mean it is not detrimental to the objective of price stability.
Willem H.Buiter is an adjunct professor of international and public affairs at Columbia University.