QE is fiscal policy
A new paper by Johnston and Pugh of the legal department of the University of Sheffield discusses the legality and the effectiveness of QE and its relatives, including the ECB’s OMT “whatever it takes” promise.
The background to this is the German Constitutional Court’s ruling that OMT amounts to monetary financing of government deficits and is therefore unlawful. Although the European Court of Justice is still to give its judgment in this matter – and is widely expected to dissent – the ECB is evidently doing its best to avoid outright QE, quite possibly because of questions over its legitimacy. The ECB has stated that in its opinion QE is legal, but then it said that about OMT too. The truth is that it is by no means clear that QE is legal in the Eurozone.
So the University of Sheffield’s legal eagles have had a good look at the legality of both OMT and QE with respect to the Lisbon Treaty. And they concur with the German Constitutional Court. OMT does indeed amount to monetary financing of governments. So does QE. Both are therefore illegal under Article 123 of the Lisbon Treaty.
Article 123 of the Lisbon Treaty reads thus:
1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.
2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.
The UK has a specific restriction on the applicability of Paragraph 1 to allow it to continue to use the Treasury’s existing “ways and means” overdraft facility at the Bank of England:
10. Notwithstanding Article 123 of the Treaty on the Functioning of the European Union and Article 21.1 of the Statute, the Government of the United Kingdom may maintain its ‘ways and means’ facility with the Bank of England if and so long as the United Kingdom does not adopt the euro.
But in the view of Johnston & Pugh this does not exclude the UK from the GENERAL prohibition of monetary financing of fiscal deficits in Article 123. The “ways and means” overdraft was last used in 2008 at the height of the financial crisis: that borrowing has since been repaid and the UK has no current plans to use this overdraft facility. The question is therefore whether the Bank of England’s QE programme has breached the prohibition of monetary financing to which the UK is subject as a signatory to the Lisbon Treaty. The Sheffield researchers think it has.
The reasons are not straightforward. Central bank purchases of own-government debt in the capital markets are not prohibited under the Lisbon treaty. Indeed they cannot be, because that would prohibit the main mechanism that EU central banks have historically used to control inflation, namely open market operations (sales & purchases of government debt) to maintain interest rates at a target level. This mechanism is currently in abeyance because of the presence of excess reserves in the banking system, but that does not mean it will never be used again in the future. QE also involves secondary market purchases of government debt. It is therefore easy to see QE as simply open market operations on a much larger scale. But the researchers argue that this is a misunderstanding of the nature and purpose of QE.
When government debt is purchased in a QE programme, the purpose is to control the market price of that debt. From the time that QE is announced until it is ended, the central bank effectively sets a floor on the price of government debt. This applies in both limited QE programmes, such as the Bank of England’s, and unlimited, such as those in the US, Japan and Switzerland.
Forcing governments to fund themselves in the capital markets rather than obtaining funding from the central bank is supposed to ensure fiscal discipline. If governments over-spend, the thinking goes, capital markets will push up the cost of borrowing, forcing them to cut back spending and/or raise taxes. But if the central bank sets the price of government debt and stands ready to buy it in unlimited quantities, there is no discipline on the government. It can issue as much debt as it likes in the certain knowledge that there will always be a buyer. There cannot be a “buyer’s strike” causing the price of debt to crash and yields to spike, as happened in Greece.
And this applies whether or not the central bank is actively purchasing securities. OMT has never been used – but its effect has been to force down yields on Italian and Spanish bonds, allowing their governments to maintain high debt/dgp levels without fear of default. There is no question but that the ECB did this to preserve the Euro. But it has undoubtedly also benefited the governments of those countries.
This is why the authors argue that QE is monetary financing of government deficits even though purchases are made from investors and banks, not directly from governments. QE amounts to an unlimited central bank credit facility. It is not the prohibition of government purchases that would be breached in an ECB QE programme, it is the prohibition of overdrafts and credit lines to governments.
And this raises a further issue. There has been huge debate about exactly how QE reflates the economy, though none of the explanations offered by economists and central banks have been conclusive: it has been claimed that QE influences the economy through portfolio effects (but substituting one safe asset for another doesn’t have any effect on aggregate demand), suppression of the term premium (but it’s probably very low anyway), increased liquidity in financial markets (doubtful, because QE contributes to collateral scarcity), increased bank lending (bank lending has been stagnant or falling), increased corporate investment (share buy-backs due to low borrowing costs are not investment). Most people agree that QE does support asset prices in a crisis, but its effectiveness as a long-term economic stimulus is questionable.
But the implication of Johnston & Pugh’s work is that we have fundamentally misjudged the nature of QE. It has monetary effects, yes, but it is in reality a fiscal tool. It uses the central bank’s ability to control market prices to enable governments to borrow and spend. This is why QE only works when the fiscal stance is expansionary. When the fiscal stance is contractionary – as it has been in most developed countries to varying degrees since 2010 – QE is ineffective.
Regarding QE as an enabler for fiscal expansion may explain a puzzle. Japan has by far the highest debt/gdp in the world, but it has very low borrowing costs. This can partly be explained by the fact that the Japanese are diligent savers, and much of their savings is held in the form of government debt: it could also perhaps be explained by the fact that investors are creatures of habit, retreating into traditional safe havens such as Japanese yen and JGBs when things get rough. But Japan has also been doing QE for far longer than any other country. Could the central bank’s historical willingness to intervene in markets to control the price of Japanese debt be the reason why the JGB yield remains so low despite very high debt/gdp and poor economic growth?
But QE is also highly regressive. Doing fiscal expansion by the back door in this way virtually ensures that the money created does not go where it would have the most effect – it goes to those who least need it. The biggest beneficiaries of QE programmes are the rich, the value of whose assets rises when central banks intervene in this way – not just because the price of government debt rises, but because the price of other assets rises too due to substitution effects and the “reach for yield”.
When government uses the central bank’s suppression of bond yields as an opportunity to lock in low borrowing rates for the future and fund a fiscal expansion programme, then QE can be highly effective. But when governments fail to take advantage of central bank price control, QE can only benefit the economy through monetary channels which are both morally dubious and of questionable effectiveness. And when governments use QE as a cover for ill-considered fiscal austerity, QE actually transfers wealth from the poor to the rich. The weak monetary effects of QE might offset this effect to some extent, but the idea that QE can entirely negate the harmful effects of fiscal tightening in an economic downturn is not supported by the evidence. “Monetary offset” is a very nasty joke.
Johnston & Pugh’s conclusion is damning:
In this paper, we have seen that, whilst QE can be argued to amount in substance to monetary finance, it is likely that the courts would not rule it unlawful. However, if a central bank did not offer justifications couched in monetary policy terms, there would be a much more serious risk of the intervention falling foul of Art 123 TFEU. The law’s emphasis on justifications and deference to central banks may not be surprising, but it does mean that there is scope for monetary finance so long as nobody admits that that is what is happening. It also means that arguably, monetary policy is outside the rule of law. It would be better for everybody if the debate was more open.
So QE and OMT are illegal under EU treaties, but for political reasons no-one will ever admit that. This is the reason for the entirely artificial separation of monetary and fiscal policy, the monetary justifications for QE, the pretence that central banks are independent, and the charade of “fiscal discipline”. The central bank must monetize debt, because the alternative is sovereign debt default and collapse of the currency: but if the central bank loses credibility, the currency is junk.
There is an elaborate charade whose sole objective is preserving the central bank’s credibility. When central banks are monetizing government debt, it is the electorate, not the market, that controls the fiscal authority’s propensity to borrow and spend. But if an elected government blatantly uses central bank debt monetization as an excuse for high borrowing and spending, the credibility of the central bank is toast. So everyone has to pretend that QE and its relatives don’t fund the government, and politicians and voters have to be persuaded that restricting government’s ability to borrow and spend is in their interests. The inflation monster is routinely invoked to terrify electorates into voting for austerity-minded politicians, and if that isn’t enough, then the bond vigilantes and public debt bogeymen are called in too. And it works: not only have voters across Europe apparently been convinced that fiscal austerity is necessary even when it is clearly harming their economies, they have also been convinced that elected governments can’t be trusted to manage public finances responsibly and must be restrained by unelected, unaccountable bureaucrats with their own political agendas. What an appalling erosion of democracy.
But debt monetization should not have to be a back-door exercise. In their concluding paragraphs, Johnston & Pugh call for an open debate about carefully considered outright monetization to end the disastrous austerity/debt deflation/higher debt/more austerity spiral in the Eurozone:
We have serious doubts about the efficacy of QE as a means to reflating the economy in the aftermath of a debt deflation…..Increased fiscal spending by governments would be more likely to be effective, but is currently ruled out by a belief that governments must pursue austerity in order for their countries to escape the crisis. We agree with Adair Turner that the time has come for a meaningful discussion about whether monetary finance offers a better way out of the current economic malaise, and if so, what form that monetary finance should take.
I have considerable sympathy for their argument, certainly for the depressed Eurozone periphery countries. Outright monetization is prohibited because of the fear of Weimar-style hyperinflation: but as I’ve explained before, hyperinflation is always and everywhere a consequence of political chaos and loss of trust. Provided that central bank credibility is maintained throughout, outright monetization of excessive legacy government debt burdens does not have to mean hyperinflation. There is still a need for fiscal discipline and structural reform going forward to ensure that debt, once relieved, does not build up again. But a one-off monetization of the debt burdens of the Eurozone periphery would do much to help Europe out of its seemingly endless slump.
Rethinking the monetization taboo – Adair Turner
Have central banks been breaking the law? – Telegraph