The ECB Isn’t Allowed To Directly Finance EU Governments – Who Said It Needs To?

A large part of the debate on whether or not the ECB can do quantitative easing revolves around the issue that the ECB statutes prohibit the central bank from “financing” any of the member governments directly (or, depending on what German courts say, indirectly as well). To a certain extent this policy makes sense – it avoids a lot of explicit moral hazard and essentially prevents the EU from ever getting stuck in a hyperinflationary situation where governments issue bonds to raise their spending and the central banks just acquiesces and goes on buying these bonds. Also, the Bundesbank has a price stability fetish because of something that happened over 80 years ago but for some reason they can’t seem to learn the correct lessons from. Somewhere else on this blog I have also argued that introducing Eurobonds would provide an instrument for the ECB to actually engage in straight-forward QE, even though just buying a reasonably weighted basket of national bonds would do the same trick (however, with potentially different fiscal implications). But why should buying government bonds be one of the go-to policy to try and gain traction in a liquidity trap in the first place?

Essentially what the ECB needs to do, or in fact what any central bank needs to do in order to avoid the zero lower bound, is to raise the supply of money above the demand for money. Our focus on short-term interest rates, born out of Keynesian, new-Keynesian, but also neoclassical obsession with this supposed indicator of monetary policy (often also mistaken with the price of money), of course makes this hard. The whole liquidity trap argument is based on the notion that at some point “ultra-safe” assets, i.e. government bonds, become perfect substitutes for base money. But there are plenty of other assets out there that have positive interest rates or are not bothered by interest rates at all. McCallum (.pdf) makes the point, also treated later by Svensson (.pdf), that the easiest, indeed a “fool-proof” way of avoiding the zero lower bound on nominal interest rates is to stop looking at nominal interest rates in the first place. This is of course also central to market monetarists thinking on the issue. When nominal interest rates seize to do what they’re supposed to do (which in a neo-wicksellian framework could be described as bringing the real interest rate in the economy in line with the natural interest rate that leads all markets to clear), then throw them out. If the central bank would instead start buying up foreign currency, for instance, thus depreciating the local one and pumping cold-hard cash into the economy, it would be achieving exactly what it wants to achieve (and to a certain degree does with QE): increase the amount of money in the system without having to resort to buying up assets where it strictly speaking makes no real difference whether it buys them or not.

Different to buying government bonds (which, as the liquidity trap argument goes, bear close to 0% interest), it could instead be buying any type of asset with very different nominal interest rates. For all it’s worth the assets bought this way don’t matter as long as they have a higher nominal interest rate (or people who would be willing to hold them for other reasons) than the supposedly ultra-safe asset that is used to claim that monetary policy seizes to be effective once the zero lower bound is reached. Buy gold, buy CDOs, buy other private debt obligations. All of this increases the supply of money in the system and at some point leads to an excess of money supply compared to money demand – and through what is often referred to as the hot-potato effect (people just stop wanting to hold the cash because its quantity quite simply exceeds their willingness to do so) would in turn get the economy rolling. If you want to look at it through the interest rate lens, one might argue that this policy pushes other nominal interest rates down, and given there is clearly a positive demand for those assets (otherwise no market for them would exist and their price would be zero), we can safely assume that in general this lowering of interest rates would in turn reduce the demand for them and push money elsewhere. Sure, there might be some reaching for yield, sure there might be some hoarding, but that’s always the case whenever monetary policy becomes easier, relatively speaking. Just as likely will there be market participants that deem their marginal benefit of consumption to have suddenly become higher compared to the reduced marginal utility of holding the assets that now have lower yields. If the policy works, however, of course the effect would be to raise interest rates in response to a rise in inflation expectations, which is exactly what is supposed to happen.  If you think of inflation as being a lowering in the price of money, driving up the prices of assets achieves exactly that – it lowers the price of money in relation to those assets. So if the ECB is barred from buying up government bonds in order to increase the money supply – just let it buy up something else.

EDIT: Removed wrong definition of money supply.


10 thoughts on “The ECB Isn’t Allowed To Directly Finance EU Governments – Who Said It Needs To?

  1. I agree that the ECB doesn’t have to finance EU governments — and it doesn’t under the OMT program because it says all interventions would be fully sterilized. But that wasn’t really what bothered the German constitutional court. Their concern was a little different: they held that OMT involves a transfer of resources between euro members similar to a “Finanzausgleich” for which there is no legal basis in the Eurozone. And I think they got that right.

    But second, what does OMT have to do with the liquidity trap? The way I see it, OMT is Draghi’s chosen tool to prevent self-fulfilling debt crises in the Eurozone – in effect coordinating the bond market on the low interest – low default probability equilibrium. It is essentially about keeping risk premia on government debt low. “Quantitative easing” is a tool to get inflation expectations up, which is the kind of thing you need to do in a liquidity trap to get the actual real interest rate down to the natural level (i.e. the level consistent with full employment).

    Also, M*V is your money supply? That sounds like a radically unorthodox proposition – even from my present point of view from the People’s Republic of Berkeley, California.

    • I think we agree that OMTs do nothing to boost the economy other than through their effects in preventing the self-fulling crises you mention. So no, OMTs have nothing to do with the liquidity trap, but I don’t think I ever imply they do. My post was more about the ECB buying government bonds in general, not specifically for the OMT. And if anything the main argument applies as much to the US (or any other central bank) as to the ECB – I just found that the ECB provided a more interesting angle through which to tell the story. Obviously my storytelling failed me 🙂

      I never understood the “Finanzausgleich” argument. If anything, Germans should be thrilled about it. The ECB buys bonds from peripheral countries with relatively high interest rates, these countries service this debt and the money is then redistributed according to the national equity shares each country has in the ECB. In other words, if bonds where ever actually bought, Spain would be transferring money to Germany, not the other way around. It doesn’t do much for the legal argument, but the notion that the core would “subsidize” the periphery this way is nonsense.

      You are indeed correct in pointing out that M is the money supply, that was sloppy, yet M*V (shall we call it something like the “effective money supply”? Not quite sure. In the end V is more tied to money demand in any case.) is what determines (at least from a monetarist perspective) aggregate nominal spending. Basically given that V has fallen so much (for different reasons), most of what central banks have done to M has proven fairly ineffective. That nominal spending fell had less to do with monetary policy being ineffective as it had with monetary policy not making up for the fall in V. Instead of “demand” for money something like “willingness to hold” might possibly also have been better…

      • I think you are wrong about the Finanzausgleich argument in two respects:
        1) The legal question at hand is not whether a bailout of EZ governments via the OMT program is economically desirable. The question is if there is any legal basis for it in the EU treaties or the ECB statutes. And I think the Germans are right that there isn’t any.

        2) The Finanzaugleich results from the fact that the OMT acts to reduce the interest rate at which peripheral governments can refinance themselves for the cost of making the ECB’s balance sheet more risky. Thus it decreases the liabilities of the periphery and increases the liabilities (in an ex ante sense) of the core. In this sense, there is a real transfer of resources from the core to the periphery. In effect it is the same as if the core would guarantee the debt of peripheral governments. That’s the concern here. Of course, if the periphery services their debts, there will be an ex-post transfer from the periphery to the core. But that should not be seen as a Finanzausgleich, because that transfer is merely a reward to the core for holding the risk that the periphery has created.

      • Of course the legal argument is about legal arguments. Other than that I have no comparative advantage in assessing how correct or not this is, so I really don’t know whether they have a case against the ECB or not.

        I also think the argument you are making on the Finanzausgleich makes little sense. De Grauwe for one ( makes a pretty solid case that eurozone governments (or in fact any governments) do in fact not carry the risks of the balance sheets their central banks run up. As long as the ECB retains its monopoly on creating money and inflation is not a problem, the riskiness of its balance sheet is essentially irrelevant. As he writes: “In no way can one conclude that German taxpayers, or any EZ taxpayer, would pay the bill of the Spanish default – except in the narrow sense that they would no longer be able to count on the yearly interest revenues.”

        In fact, the way I see it, the most surefire (if radical and possibly illegal) way to get out of this mess is for the ECB to buy up all spanish (or periphery) bonds, write em off, and be done with it. The only fiscal implications would be that the core would be missing out on the interest payments that the periphery would be making. Here’s another pretty interesting article with a similar view (

  2. Thanks for providing the links. I missed both of these articles.

    However, in my humble opinion, De Grauwe is just wrong. The interest income which Eurozone governments get through the ECB’s bond holdings is part of their ordinary revenue. If that stream of revenue stops or is reduced, as it would happen in case of a default on periphery bonds held by the ECB, the EZ governments would have to make up for the loss by raising taxes, slashing expenditure or borrowing more. So, as long as there is a non-negligible probability of a periphery default, the OMT program does involve a transfer of resources from core to periphery governments.

    Look, I’m not saying such a transfer is a bad thing (I believe it may be inevitable to save the euro). But I have great sympathy for the German’s demand that there ought to be a legal basis for it. The whole thing is meant to calm investors, rebuild trust, etc. I, for one, don’t think that a program that is clearly against the law can ever be a “surefire” way to resolve a debt crisis.

    • Hmm…I actually don’t think De Grauwe and you (and me, for that matter) disagree there. Of course Germany would miss out on interest payments – the larger point, however, was that Germany does not “guarantee” the loans of Spain beyond this.

      But on the other hand, the ECB was never intended to conduct monetary policy through bond purchases in the first place. What it calls “open market operations” are somewhat different from what the FED does, for instance, in that it provides liquidity directly to eurozone banks through different forms of repo operations (which the FED does as well), but that it does not buy or sell bonds. So in that sense, the ECB was never supposed to have anything resembling bonds it purchased directly on its balance sheet in the first place. Yes, it receives assets as collateral from commercial banks (which might or might not involve government bonds), but if you’re worried about that risk possibly forcing “fiscal transfers” you can shut down the ECB altogether. So it would seem to me that in general, there is no “ordinary revenue” that Germany would get from the ECB balance sheet that goes beyond the collateral put up by commercial banks (if even that, my understanding gets a bit murky as to who gets interest payments here).

      You might even say that what Germany would get in interest payments from any bond purchases in the periphery could be considered economic rent – Germany is getting paid money yet incurring essentially zero (opportunity) costs. And if Spain defaults, it would just seize to get that money – money it wouldn’t have gotten anyways under normal operations of the ECB.

      • So if you can refinance yourself at the risk-free interest rate and are invested in risk-bearing assets you consider all interest revenue from that investment economic rent? Again it seems you are taking a wildly heterodox position here…

        Your remarks on the ECB’s way of conducting policy are correct but beside the point. The point is that the German government derives income from the ECB’s operations. If the ECB’s balance sheet changes in composition by substituting low-risk assets with higher-risk assets, as it would under the OMT, that income stream becomes riskier. That is a cost to the German government. The beneficiary of the program is the Spanish government whose refinancing costs are reduced by the OMTs. Hence the transfer.

      • I’m not sure what your analogy applies to. Since the German government is not lending money directly to Spain, there is no refinancing at the risk-free interest rate and investing in risk-bearing assets at all on this end. The ECB’s (opportunity) cost of printing money, as long as inflation is no problem, is essentially 0. So the costs of OMT purchases to the ECB, but also to Germany (who is the ultimate beneficiary along with other core countries) is essentially non-existent, while the return potentially very real.

        Also, the sterilization the ECB does would seem to work differently than you describe it. It’s not as if the ECB would buy Spanish bonds and instead sell the same value of German bonds – the ECB does not even own any German bonds it can use for this purpose. What the ECB does is ensure that the money supply stays essentially the same through operations in the banking system, but what the interest-bearing part of its balance sheet is concerned OMT purchases would entail an unambiguous expansion, i.e. the core would at best get more interest payments and at worse get the same interest payments as if the ECB had done nothing.

        Other than that we might just have to agree to disagree. To a certain extent I see the potential problems with the ECB buying any government bonds at all, but the economic issues still do not convince me.

  3. I am afraid we cannot agree to disagree on a point of pure logic. Of course, our discussion is plagued by a great uncertainty exactly how the OMT should work – it has never been made clear as far as I know. But what we know is this: Under the OMT program, the ECB would buy bonds of troubled EZ governments at above-market prices. In order to leave the money supply unchanged they have to sell an equal amount of some other assets, like repos or gold or whatever. The effect of that is to substitute low-risk assets with higher-risk ones. I don’t think we disagree so far, do we? Where you and I disagree is about what this implies for the transfer of resources between EZ governments.

    Let me sum up our positions: Your view is that the transfer runs from periphery to core, because the ECB is adding higher yielding assets to its books, and they pass on that higher yield to the EZ governments. So the Germans should be happy about OMTs rather than fight it in the courts. My position is first, whatever the direction of the transfer, it is prohibited by EU law. EU citizens never voted for such a transfer. And the Germans are right to point out that legal problem. Second, the higher nominal yield of the periphery bonds must be weighed against their higher default risk. Insofar as the ECB buys bonds for a price above their true risk-adjusted value, the OMTs will result in a loss to the EZ governments. That implies a transfer from core to periphery.

    How can you win this debate? My argument rests on the proposition that the ECB will end up buying stuff above its true value. Convince me that this will not be the case and I will surrender.

    • I wrote a new post in response to the first, more general aspect of your argument. Spoiler alert: we disagree so far. Also, on a political note, if “the european voters didn’t vote for it” where a knockout criterion, I’m not sure much of the EU would pass the test. It was always a primarily top-down project. I am, however, confused by the second part of it.

      You say that OMT might involve the ECB buying bonds “above their risk-adusted”, or their “true” value. I am not sure what that even means, so maybe you can help me out. The whole problem with multiple equilibria is that there is more than one “correct” price – depending on where we are, the markets will clear either at a level we want them to clear or at a level we would rather not have them clear, yet the price is still “the right one” technically speaking. But let’s assume that, from a normative perspective, we assume the good and thus “true” equilibrium to be the one where interest rates on periphery bonds are low. Let’s assume now that the ECB buy bonds at interest rates above this level, this would, by simple arithmetic, mean that the value of those bonds is below that (by me, hopefully in adherence to your argument, normatively as “correct” defined equilibrium) level. Given the ECBs unique power to actually influence markets, it would seem to be the most safe speculative bet there is – the ECB buys bonds that are below the good equilibrium price level (and thus their interest rates above it), fully knowing that by doing so it ends up increasing the value of the bonds it is buying. It would seem that an assumption regarding what the equilibrium is we are starting from is necessary in order to argue whether or not the price at which the ECB is buying bonds is above or below “true value” – and for the more plausible case, exactly the opposite of what you describe seems to happen.

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