It’s fascinating when macroeconomics and finance becomes a matter of constitutional law, as is happening in Germany, where their constitutional court has ruled on the legality of outright monetary transactions, or OMTs. Their justification for ruling is that the ECB’s activities might enter the fiscal sphere, and so undermine German fiscal sovereignty, which would be contrary to the German constitution. That constitution was put in place to stop the German central banks buckling under pressure to finance German deficits, and so to avoid a repeat of the hyperinflation which undermined the Weimar Republic. With monetary policy now delegated to the ECB, this constitution has the effect of limiting the ability of the ECB to debase the euro to finance another government’s deficit. Somewhat perversely, given the original intention of the constitution’s drafters, these limits are having the effect of undermining the credibility of the (relatively young) Southern European democracies that are struggling most with fiscal problems. [Update: actually, if you think about it, the historical irony is even more unpleasant and apt, since it was the social chaos of hyperinflation in part that provided for the emergence of German National Socialism. It's now the chaos post-austerity in Greece, a direct consequence of the German anti-inflation bias, that is fuelling the support for the Golden Dawn].
The core issue is the distinction between policies that are deemed ‘monetary’ and policies that are deemed ‘fiscal’. The court ruling has a good go at making this distinction. But, perhaps unbeknownst to itself, it gets into very hot theoretical waters. ‘Monetary’ things are things that central banks should do, and which the ECB was intended to do. ‘Fiscal’ things are things that governments should do, which the ECB was set up to avoid doing. And which in the case of Germany the constitution reserves for itself.
Monetary policy – the setting of interest rates or the decision about the speed with which central bank money is created – has fiscal consequences. And the setting of what the court (and actually most of us) think of as fiscal policy – taxes and government spending – has monetary consequences. Everywhere and always.
First, the fiscal consequences of monetary policy. Positive inflation implies a certain amount of seigniorage, for one thing, which is money made by the central bank and usually repatriated (once a generous slice to pay for its own nice offices and pensions has been lopped off) to its Treasury owners. That means less money to raise through other means. [Not much less, mind, given the stately pace at which money is printed at 2 per cent inflation]. Despite the best intention of central banks, inflation targets are of course almost always missed. Inflation varies, and the interest rate tool used to control it varies, all the time, and these variations, many unforeseen and unplanned, have small but definite fiscal consequences. That same central bank interest rate ultimately determines the rate at which the government can finance itself. And the fluctuations in interest rates affect spending and revenues through the effect that they have on the state of the economy and the automatic stabilisers.
Likewise, fiscal policy has monetary consequences. Some are relatively mild and hard to detect. How fiscal tools are set affects the supply side of the economy, and therefore the inflation/output trade-off that the central bank has to confront in designing monetary policy to best meet its own mandate [which typically involves it worrying not just about inflation, but also the real economy], and so fiscal policy will bear on the path for inflation chosen by the central bank. Some effects of fiscal policy are typically latent, but can then manifest themselves in extreme ways. For example, the credibility of fiscal policy affects government financing rates, and these ultimately affect the rate at which consumers and businesses can borrow. If the government comes under extreme fiscal stress, it is possible that this spills over into monetary policy, either by causing the price level to jump to revalue outstanding nominal debt [the fiscal theory of the price level] or the government to lean on the central bank to print money so that it can repay the debt without legally defaulting.
The court ruling wants to make distinctions between monetary and fiscal policy based on the instruments used. But as we have seen, the use of one instrument usually reserved for the central bank has consequences for the instrument and objectives of the government, and vice-versa.
The constitutional court also wants to make a judgement about the ‘fiscalness’ of the ECBs actions based on its objectives. But we might presume that the objectives of the government and the central bank are highly overlapping. They are in the UK. If they are not overlapping we would judge them to be highly deficient. Price stability, for example, is not an end in itself, but something to be pursued to the point where it raises overall well-being, and not, therefore, to the point where it leads to excessive output volatility. Hence the corresponding wording in the UKs mandate, persuasively reemphasised in HMT’s 2013 review of the Bank of England mandate.
Dig into the academic literature, and you will find that ‘monetary policy’ is taken to refer to policy that has to do with the price and quantity of central bank issued liabilities; ‘fiscal policy’, by contrast, is taken to refer to policies that have to do with the price and quantity of government issued debt. Both are, in a sense, debts. One is a perpetuity not redeemable for anything other than itself. The other may or may not be a perpetuity, redeemed by a combination of real taxes and seigniorage. But usefulness of these definitions depends on behavior and is not absolute. If people chose not to use euros, the price and quantity of euros would no longer be of any consequence. It’s conceivable that people could switch to making transactions using government-issued debt, or IOUs written on such debt. [I say that, but of course many financial market based transactions are effectively done in just such a way]. In which case, both ‘monetary’ and ‘fiscal’ actions would happen inside the debt management office.
Perhaps the German constitutional court understands this, because their ruling states that if the OMT policy were interpreted ‘restrictively’, in particular, if it were made clear that the ECB would not engage in unlimited purchases of troubled sovereign bonds, the policy would not be in breach of the ECBs mandate. This comment reveals that the important thing is not whether OMTs are monetary or fiscal, but how fiscal they are. Actions by the ECB that involve small fiscal risks are ok. [After all, there are many other open-market-operation-related fiscal risks run in the normal course of business]. But any actions that involve large fiscal risks should be okayed by member state parliaments first. Such a distinction would be perfectly sensible. Though not consistent with the earlier text in the ruling that insists on trying to make an in-principle distinction.
One response to the ruling about the limited or otherwise nature of OMTs has been to say: the ECB already have limited purchases by saying that they will only buy existing short-term bonds [a fraction of total debt]. However, if there were a genuine limit on OMTs, the policy could not guarantee to defend the sovereign from fiscal implosion and thus stave off an exit from the euro. Markets would be free to rally behind some George Soros like figure just as they did when the UK were forced out of EMU in 1992. Or could rationally forecast that such a run might happen, in which case the ‘redenomination risk’ in troubled sovereign bonds would persist. And the limit itself is quite ambiguous. A sovereign headed down the road to fiscal ruin would find itself rolling all its long-term debt steadily into more and more short-term debt. So the quantity of ‘existing’ short term debt would increase exponentially, thus making room for and probably necessitating larger purchases. And finally, this is only what the ECB have said. They can say something else later, when circumstances demand it, and the German court process may be too slow to prevent them acting on any new form of words.
The same problematic distinctions in the German court ruling of course crop up in the ECBs own language, no doubt because such distinctions were forecast to carry legal force. Hence OMTs are directed at solving ‘liquidity’ problems of a troubled sovereign, facing speculative activity based on an irrational forecasts of a euro exit. As I wrote before, and others have no doubt too, the distinction between liquidity and solvency (which is fiscal, and to be avoided by the ECB) is impossible to make in practice, and controversial in theory. But ‘liquidity’ problems sound like something that should be the concern of the central bank, and that would not carry a fiscal risk once everyone catches up with the wise view of the ECB that there is no chance of a break-up.
This is not to say that legal restrictions on all the relevant parties are not important. On the contrary. It’s important that the ECB, which is not staffed by elected politicians, does a well-defined job that those who are elected have decided they are happy to delegate. However, rather than looking for Platonic pure essences of monetaryness or fiscalness to decide what the ECB can or cannot do, it would have been better to ground such legislation in specifics, based on what the best thing to do would be when certain problems arise, and who would be best-placed to do it.
Right now, ideally, it would be best to have a transparent agreement from the euro area polities that they want to save the euro no matter what, that the governments with deep pockets are prepared to back actions to save it as much as necessary, and that the ECB is the organisation best placed to do the saving, and that creating central bank money to buy troubled-sovereign bonds is a policy worth gambling on.
Instead we have the ECB bluffing to markets, with no explicit political backing for the potentially unlimited quantities of purchases of bonds that an attempt to call that bluff would imply. And the bluff is laced in language straining under contradictory forces: the need to sound audacious to markets, and the need to sound conservative to the German constitutional court and, ultimately, the German electorate.