The European Commission and the European Central Bank have changed the eurozone during the crisis in the way that progressive economists have demanded. National governments can now spend more money without fear of deficits or rising interest rates. All traffic lights are green. The battle for the future of the Eurozone has begun.
Dirk Ehnts is a research assistant at the Faculty of Economics of Technical University Chemnitz, Germany. He holds a PhD in economics and has worked at the Berlin School of Economics, Free University, University of Flensburg, University of Oldenburg and Bard College Berlin. He is the author of “Modern Monetary Theory and European Macroeconomics” and spokesperson of the Pufendorf-Gesellschaft für politische Ökonomie e. V.
The coronavirus has significantly reduced economic production in Germany and the Eurozone. Economic policy measures are now called for, and the national governments of the Eurozone must spend more money to achieve this. For this to work, the rules of the Eurozone must be adapted. Normally, two mechanisms limit the spending of national governments. These have to sell government bonds to banks if they want to spend more money (given constant tax revenues). So the banks have to buy government bonds – otherwise the government can no longer spend. The 3% deficit limit set by the euro group, on the other hand, is based on the results of government spending. If the deficit is above that level, politically forced expenditure cuts may be required.
Government spending in the Eurozone: a brief explanation
In a modern payment system, people and companies have accounts at banks. They are essentially based on an Excel spreadsheet which the banks modify. This is what we see when we bank online. Bank deposits are promises of cash, and therefore we trust the banks, even if our money is “only” virtual. Banks, in turn, have accounts at the national central bank. In the German case that is the Bundesbank. It can add or reduce deposits to/from the banks’ accounts, depending on the booking. Credit balances at the central bank can be exchanged by the banks for cash. Only the central bank is allowed to produce money.
When the state spends money, the central bank carries out the “transfer”. In doing so, it increases the balance of the bank where the recipient has his account. The bank in turn increases the balance of the recipient’s account. Where does the money come from? The Bundesbank has simply increased the credit balance of the receiving bank on behalf of the Federal Ministry of Finance. This is done by computer. Asking where the money comes from makes no sense.
Sales of government bonds generate a green light
In the Eurozone, the Bundesbank may only pay the federal government’s bill if there is enough money in its “central account of the federal government”. If there is enough money, the traffic light turns green and the Bundesbank increases the money of the recipient bank. If there is not enough money, it is not allowed to do so. The Federal Government’s central account is mainly replenished by tax revenues and the proceeds of sales of government bonds. When making payments on behalf of the Federal Government, the Bundesbank reduces the deposits in the Federal Government’s central account by the corresponding amount. However, this is not technically necessary – the credit balance of the receiving bank is already increased.
Since in a crisis, tax receipts collapse along with economic activity, a national government in the Eurozone would have to sell more government bonds before it can spend more money. This need not be the case. The Bank of England is currently considering whether it will simply execute all payments of the British government directly and without any ifs and buts – without selling any government bonds (here). But in the Eurozone, before government spending increases, an increase in the sale of government bonds is required. What can go wrong with this? Let’s look at the example of Italy.
Government bonds and interest rates
Could interest rates possibly rise because investors expect that Italy will not be able to pay out the government bonds at maturity? The ECB has announced a €750 billion bond purchasing program (PEPP) with an option for more (link). The former head of the ECB, Mario Draghi, was once asked at a press conference whether the ECB could run out of money (link). This is not the case. This should therefore remove any doubts investors may have about Italian solvency. They can sell their bonds to the ECB at a good price. The ECB itself wrote:
“The Governing Council will do everything necessary within its mandate. The Governing Council is fully prepared to increase the size of its asset purchase programmes and adjust their composition, by as much as necessary and for as long as needed. It will explore all options and all contingencies to support the economy through this shock.”
As Christine Lagarde has now also understood, the ECB is responsible for ensuring that the interest rates on government bonds in the Eurozone do not diverge too much (here). This is a lesson from the financial crisis: it makes no sense for countries in economic crisis to see interest rates rise (and thus stifle private investment), while the ECB can bring these interest rates down to any value at any time through the interest on government bonds. So if the prices of Italian government bonds were to fall, the ECB could buy these securities at higher prices (interest rates and bond prices have an inverse relationship) at any time and thus lower the yields again. As Mario Draghi already noted, the ECB cannot run out of money (here). So Italy can now increase spending without having to fear that interest rates on bonds and then interest rates on new bonds will rise.
Government bonds and deficits
The second problem could be that Italy can spend more money, but in return it will have to negotiate a return to austerity because of excessive deficits. But this possibility has been eliminated, as Ursula von der Leyen, as president of the EU Commission, has already said that she has activated the “general escape clause” in the Stability and Growth Pact (here). As the coronavirus crisis will lead to a collapse in tax revenues in Italy, there will certainly be very high government deficits there as well as everywhere else. Government spending will rise, due to rescue packages, unemployment insurance and other social programmes, among other things – and tax revenues will fall significantly as a result of the collapse of economic activity. But all of this is now unproblematic because the Eurozone’s3% limit has been deferred for this year.
So if the Italian economy returns to normal in 2021, we will only see a one-off high government deficit for 2020. After that, taxes will rise again in line with economic activity and government spending will also return to normal. The deficit falls to the pre-crisis level. The higher national debt has no further impact, as the ECB sets interest rates and limits the spread of Italian government bonds compared to other euro member states. We therefore maintain that the economic policy interventions of the ECB and the EU Commission to date have paved the way for increases in government spending. (Italy, with a debt level of over 60%, must adhere to a medium-term budget target of a deficit of usually 0.5%, but Italy’s public debt already amounts to about 133% of GDP).
ECB goes MMT
What does all this have to do with MMT? In my book “Geld und Kredit: Eine €-päische Perspektive” (3rd edition, 2020) I gave the following recommendation on p. 243 (English version available here):
“This [stabilizing employment in the eurozone with fiscal measures] can be done by the ECB declaring that, in case of doubt, it will buy up all the government bonds of eurozone countries. This would make national government bonds risk-free. It must then be clarified which deficit limits are reasonable in times of upswing and recession. This would leave (or re-establish) the responsibility of national governments for full employment.”
This is exactly what has happened now: deficit limits are lifted, government bonds are risk-free. This was already implied. The previous ECB President Mario Draghi said in September 2019 that the ECB should explore new ideas such as MMT (here). His successor, Christine Lagarde, remarked half a year earlier that MMT is not a miracle cure, but could help to combat deflation (here). A key insight of the MMT is that government debt and deficits are not a problem (here), as the central bank ensures that government bonds are risk-free. The ECB is now doing the same. So all lights are on green: national governments can increase their spending at will. A financing question does not arise. Failures cannot occur, so questions of liability are also irrelevant.
The battle for the euro
The real battle for the euro will follow in 2021, when, after the end of the coronavirus crisis, when the ECB and the EU Commission will want to withdraw their “emergency measures”. A withdrawal of the PEPP by the ECB would cause the interest rate premiums of some euro countries to shoot up and would trigger a euro crisis. It is hardly conceivable that this could happen. The ECB has no mandate to force countries out of the euro. The 3% deficit limit from the Stability and Growth Pact is more exciting. A higher value should be found. A European Green New Deal involving the European Investment Bank is also a good idea [here]. Other alternatives, which to me do not yet seem fully developed, are corona bonds [here] and Renaissance bonds [here].
We can be cautiously optimistic that EU Commission president von der Leyen and ECB President Lagarde – admittedly a strange duo – will go down in history as the Euro saviours of 2020. As of today, the national governments have regained their sovereignty. Now they have to prove that they can solve the problems of their citizens. If they manage to do so, it will be difficult to take the steering wheel away from them again in 2021. Once the first two teething troubles of the euro have been eradicated, we can then think about a European Finance Ministry that issues (risk-free) Eurobonds and spends – for a European Parliament converted to a more democratic Parliament – with a view to full employment, price stability and sustainable resource management. But that remains a beautiful utopia for now.