The radical transformation of the ECB

Students of my generation will remember what we learned about how the European Central Bank conducts monetary policy: The ECB makes one-week loans to commercial banks against top-rated collateral. This was called “Main Refinancing Operations”. The interest rate charged on these loans was known as the Main Refinancing Rate and was considered the key policy rate of the ECB, like the Fed Funds Rate in the United States. Then we learned something about Marginal Lending Facilities and Long-Term Refinancing Operations, but were told they were relatively unimportant.

This was indeed how the ECB operated – before 2009. Since then the ECB has changed its operations. It seems to me that the radical nature of this change has not been recognized enough by economists – let alone the general public.

Look at the chart below. It shows the assets held by the ECB system for purposes of monetary policy operations. The Main Refinancing Operations (the yellow area) have disappeared. In 2019 they constituted a mere 0.25% of the total monetary-policy related assets! The Long-Term Refinancing Operations (blue area) have replaced them and make up about 20% of the total now.

But the elephant in the room is the grey area that first appears in 2009 and then explodes after 2014. The ECB labels it “Securities held for monetary policy purposes”. What are those securities? Government bonds and a couple of corporate bonds as well. The ECB started to buy them with the “Securities Market Program” in 2009 and hugely expanded the purchases with the “Public Sector Purchase Program” in 2015. Last year, the ECB system held 2.6 trillion of assets in relationship with those programs. That is more than 80% of their total policy-related assets.

This means that the ECB of our old textbooks, the ECB that was envisioned by the founders of the euro, has ceased to exist. It has been replaced by an altogether different beast. The primary way in which the ECB conducts monetary policy these days consists in buying Eurozone government bonds in the open market.

This has made the ECB the single biggest lender to Eurozone governments. As I showed in my last post, 91% of all new government debt issued after 2010 is now being held by the ECB. It resembles a 3.2 trillion euro hedge fund, financed by short-term commercial bank deposits (aka “reserves”), holding a diversified portfolio of Eurozone government bonds. The equity owners of this fund are the Eurozone government themselves: they “own” the ECB, they are responsible for replenishing its equity if and when it is deemed necessary.

One implication of this radical transformation should be immediately obvious: Eurozone governments have in effect mutualized 91% of their post-2009 debt. Whenever a Eurozone government defaults on the bonds held by the ECB, the losses would be absorbed, eventually, by the other Eurozone governments.

I’m not saying that’s a bad thing or a good thing. I’m not saying it is illegal or legal. But nobody should delude themselves or others that this is not what has been happing.

Debt crises in a monetary union: the case of Indiana

As Europeans we tend to think of America as new, young, and modern, whereas in Europe everything is old and traditional. At least that’s what I thought, until I noticed this while driving around in the American Midwest:


The license plate celebrates the 200th birthday of the State of Indiana in 2016. 200 years! This means, in a sense, Indiana is older than many of the states of the European Union. In 1816, Germany was still a patchwork of small territories, loosely connected through the German Confederation – of which Austria was a part. Italy was merely a geographical description – the process of Italian unification had not even begun. Greece was just a province of the Ottoman empire. Belgium, until 1815 known as „Austrian Netherlands“, was part of the United Kingdom of the Netherlands. France did exist as a nation then, however, while the people of Indiana lived for 200 years under the same political system and only once made marginal changes to their constitution (more about this below!), the French during the same time went from the post-Napoleonic Bourbon monarchy to the Second Republic to the Second Empire, then back to the Third Republic, then to totalitarian rule under the Nazis, and finally back to Fourth and now the Fifth Republic. As far as I am aware, there is no European country which has had the same constitution for the past 200 years without interruptions or major changes – the single exception I can think of is the United Kingdom which always had the same constitution: none.

There is another striking fact about the history of Indiana. Indiana has been in a monetary union with the rest of the United States for as long as it existed. And during its early history, it has had its own debt crisis which bears a striking resemblance to the recent history of the much younger European monetary union.

When Indiana became a State in 1816, it was mostly a wilderness at the margin of civilization. The only major road in the country was the Buffalo Trace – literally a trace created by migrating bison herds. Population was only 65,000 initially, but growing fast. The government of the young state decided to take the country’s infrastructure into the 19th century. And 19th century infrastructure, they figured, was going to be canals. So, they launched a giant public investment program, called the Mammoth Internal Improvement Act, spending 10 million dollars (equivalent to 260 million current dollars, roughly 100% of GDP at the time) on canals and toll roads. The heart of the project was the Wabash & Erie Canal connecting the Great Lakes with the Ohio River. „Crossroads of America“  was the official state motto of Indiana.

To finance these projects, the governor of Indiana, a certain Noah Noble, had a plan: some money was to be raised by selling public lands, some by raising taxes, and some by borrowing from the Bank of Indiana, which was partly state-owned. The Bank of Indiana refinanced itself by issuing bonds, backed by the state, at the London exchange.

Initially, the plan looked like a big success. The construction works employed many thousands of people and provided a stimulus for the economy. Borrowing costs were low and spirits were high. But soon, problems started to appear. It turned out that the government had greatly underestimated the costs of building the canals, mostly because they failed to take into account the damage done by muskrats who burrowed through the walls of the dams. Critical voices in the State Congress regarded the canals as a total waste of money. Railroads, they argued, were the future! Nobody seemed to listen.

And then, in 1837, a financial crisis broke out. The crisis was triggered by the Bank of England which, in an attempt to curb the outflow of gold and silver reserves, raised interest rates. This had a direct impact on Indiana whose borrowing costs skyrocketed. It also had an indirect effect: since the United States was on a gold and silver standard, American banks were forced to follow the Bank of England in raising interest rates, which led to a credit crunch and a nation-wide recession. (A classic example of a monetary policy spillover effect!)

The combination of stagnant tax revenues, exploding construction costs and rising interest rates meant that State of Indiana was effectively bankrupt at the end of 1841. So they sent the head of the Bank of Indiana to London to negotiate a restructuring of the debt. The creditors agreed to a haircut of 50% of the debt. In exchange, Indiana handed over control of most of the canals and roads, many of them still unfinished. The Wabash and Erie Canal was held in trust to pay off the remaining debt. It operated until the 1870s yielding a low profit, but was soon made obsolete by – the railroads which turned out to be the key infrastructure of the 19th century.

The conclusion Indiana drew from this was that the long-run costs of government borrowing far exceed the short-run benefits. Which is why in 1851, they adopted an amendment to their constitution, forbidding the State government to get into debt (except in cases of emergency).

I’d say there is a thing or two our modern European states can learn from this story.

Sind Staatsschulden eine Belastung für unsere Kinder?

Dass Staatschulden eine Belastung für zukünftige Generationen sind, gehört zu den Dingen, die nun wirklich jedes Kind über die Volkswirtschaft weiß – neben der Tatsache, dass unbegrenztes Wirtschaftswachstum unmöglich ist, und dass eine negative Leistungsbilanz schlecht für ein Land ist.

Leider ist das, was jedes Kind über die Volkswirtschaft weiß, falsch. Die Frage ist nur wie falsch. Völlig falsch? Unter Umständen richtig, aber in der Regel falsch? Oder unter Umständen falsch aber in der Regel richtig?

Sagen wir unsere Regierung beschließt jedem österreichischen Haushalt 100 Euro zu schenken. Finanziert wird das über eine neue Anleihe mit einer Laufzeit von 30 Jahren (einer Generation). Belastet diese Staatsschuld die zukünftige Generation?

Ja sicher: Die zukünftige Generation wird höhere Steuern zahlen müssen um die Anleihe zu bedienen. Angenommen der Zinssatz beträgt r und das Bevölkerungswachstum n, dann muss jeder zukünftige österreichische Haushalt 100*(1+r)/(1+n) Euro an zusätzlichen Steuern schultern.

Unsinn: Die zukünftige Generation erbt ja auch die Anleihen, die ihre Eltern gekauft haben! Die Zusatzsteuern, die sie zahlen müssen, fließen ihnen selbst zu, weil sie die Anleihen halten. Ihre Eltern haben ihr „Geschenk“ vom Staat selbst finanziert indem sie die Anleihen gezeichnet haben. Für die zukünftige Generation entsteht überhaupt keine Belastung.

Moment mal: Da haben wir aber ein paar implizite Annahme gemacht. Wer sagt denn, dass die gesamte Anleihe an die nächste Generation weitervererbt wird? In der Realität erbt nicht jeder Haushalt was, und nicht alle Haushalte haben Nachkommen, denen sie was vererben könnten. Was, wenn die erste Generation die Staatsschulden an die nächste Generation verkauft anstatt vererbt?

Sagen wir die erste Generation hat die Anleihe als Altersvorsorge gekauft (entweder direkt oder über eine Pensionsversicherung) in der Erwartung sie im Alter wieder verkaufen zu können. Zunächst bekommt jeder Haushalt der ersten Generation 100 Euro vom Staat und zeichnet Staatsanleihen im gleichen Wert. Wenn die erste Generation in den wohlverdienten Ruhestand übergeht, verkauft jeder Althaushalt die Anleihe an einen jungen Haushalt der nächsten Generation um 100*(1+r) Euro. Nach 30 Jahren – die erste Generation ist mittlerweile tot – hebt der Staat von jedem Haushalt der zweiten Generation 100*(1+r)/(1+n) Euro an zusätzlichen Steuern ein und begleicht damit seine Schuld gegenüber dem Haushalt in derselben Höhe. Somit hat sich die erste Generation um 100 Euro bereichert – zu Lasten ihrer Kinder!

Okay, aber das ist wohl auch kein realistisches Szenario. Die Wahrheit liegt wie immer irgendwo dazwischen: Sagen wir ein Anteil s der Staatsschulden wird vererbt und der Rest verkauft. Dann beträgt die Belastung der zukünftigen Generation nur 100*(1-s)*(1+r)/(1+n) pro Haushalt.

Moment, es geht noch weiter: Wer sagt denn, dass die Anleihen nur von österreichischen Haushalten gehalten werden? Was, wenn die Staatsschulden in den Händen ausländischer Haushalte sind? Sagen wir der Anteil der von Inländern gehaltenen Staatschulden beträgt d. Dann muss jeder Haushalt der zukünftigen Generation 100*(1-d)*(1+r)/(1+n) Euro an ausländische Gläubiger zahlen. Die Last der Staatsschulden verteilt sich dann wie folgt: die erste Generation trägt 100*d*s*(1+r) Euro pro Haushalt, die zweite Generation 100*(1-d*s)*(1+r)/(1+n).

Zum Beispiel: d=1/3, s=1/2, r=10%, n=5%. Dann beträgt die Last der Staatsschulden für die erste Generation 17,5 Euro und für die zweite 87,3 Euro pro Haushalt. Gemessen in Gegenwartswerten wird somit die erste Generation zu Lasten der zweiten Generation um 83,3 Euro bereichert.

Das heißt, die populäre Doktrin, dass Staatsschulden unsere Kinder belasten, stimmt in aller Regel. Nur dann, wenn die gesamte Staatsschuld im Inland gehalten und zur Gänze an die nächste Generation vererbt statt verkauft wird, ist sie falsch.

Interest Rates and Debt Ratios

Paul Krugman links us to a fascinating new report by the BOE (.pdf) which also presents some really really long time-series data on a hotly discussed issue over the past years, but also very much relevant for some of the discussions we’re having on this forum: the ability of governments to borrow and the limits to this borrowing. Below the relationship between long-term bond yields and debt-to-GDP ratios of the UK ranging all the way back to the 1700s.

The whole issue is of course strongly related to e.g. the 90% threshold level of debt-to-GDP ratio found (or not) after which economies abruptly start dying (again, or not) in the now infamous Reinhart-Rogoff paper (.pdf). Christoph, in his last guest post, also writes that “Empirical articles show that the higher the deficits and debts are, the higher is the probability of a country to experience a “sudden stop” of capital inflows”. As he points out in the comments, causality and correlation are indeed tricky to disentangle, yet the point seems to stand that a high debt-to-gdp ratio makes a country inherently a more risky investment. I, for one, am not sure why this should be the case. There are many things that might make a country a risky investment, and also many reasons that might lead to “sudden stops” in the willingness of investors to finance a country’s deficit. But, and as counter-intuitive as this might sound, the level of debt-to-GDP simply does not seem to be one of them, as the graph above but also the eperience of e.g. Spain in the current crisis and Japan over the past couple of decades, to name just three of the most obvious examples, show. This supposedly existent causal relationship – or indeed any meaningful relation at all – between debt levels and the ability of a country to finance itself seems not only wrong but utterly destructive. Spain (and Europe in general) has many huge problems it needs to tackle, but its debt level is not one of them (Greece, of course, is a different story).

As a final note, the authors in the paper note that “Increases in the public debt ratio resulting from military spending were often associated with increased government bond yields”. The most obvious exception to that is the second world war. The authors hint that the rise of interest rates in many past episodes of war “mainly reflected fluctuations in the fortunes of war”, but could this also be interpreted as representing the difference of fiscal spending that crowds out and that which crowds in? I don’t really know much about the other historical episodes but the spending undertaken that got us out of the Great Depression clearly would be a case of the latter, explaining why interest rates fell.