There is a time for everything, it says in Ecclesiastes, and a season for every activity. Now is the time for the European Central Bank to loosen its monetary policy.
With a liquidity facility providing 639 billion euros ($820 billion) to banks and an interest rate at 1 percent, one could argue that the ECB’s monetary policy could hardly be looser.
The reality is different. Most of that liquidity has never left the central bank’s Frankfurt headquarters: European banks redeposited 502 billion euros at the ECB. And the real measure of monetary policy isn’t the rate at which banks borrow from the ECB, but the rate at which businesses can borrow from banks. Credit is drying up in Europe. The little credit available is very expensive. As a result, Europe is quickly drifting into a recession.
What can the ECB do?
I have never been a fan of loose monetary policy. When it was adopted by the Fed in 2002-2005, it contributed to the housing bubble and the ensuing financial crisis. Moreover, the quantitative easing pursued by the Fed in the past couple of years has been at best irrelevant and at worst dangerous. Yet, I do believe that a central bank should intervene when the fear of a sovereign default risks becoming self-fulfilling, as is the case now in Europe.
Illiquid or Insolvent
Clearly, it is very difficult to disentangle illiquidity from insolvency. No borrower will ever admit to being in default; instead, such woes will be described by debtors as a temporary liquidity problem. And all the political incentives are to classify every borrower, in particular every sovereign borrower, as illiquid, not insolvent.
The worst example of this bias is Greece. Even in 2010 it was difficult to find an economist outside of government willing to say that Greece was solvent. When you cornered them, even government officials would admit that Greece was insolvent. Still, everybody played the pretend game, including the ECB, which intervened by buying Greek debt.
Last summer, even Italy seemed on its way to default. When debt to gross domestic product ratio exceeds 100 percent, a country is at risk: Any small difference between the real interest rate and the growth rate is amplified, requiring a large adjustment in the primary surplus to prevent the debt to GDP ratio from exploding.
The combination of a decade of zero growth, an inability to maintain a primary surplus and a political stalemate put Italy at risk. The ECB was wrong to buy Italian debt in August. It only exacerbated moral hazard. As the ECB stepped in, the Berlusconi government weakened a proposed fiscal adjustment.
Since then, however, Italy has changed. Under Prime Minister Mario Monti, Italian cumulative fiscal adjustment reached 80 billion euros, or 5 percent of GDP, in three years. The long-term sustainability of debt, jeopardized by the pension liabilities, has been greatly improved by a pension reform.
Yet the credit market hardly noticed. The spread between Italian bonds and German ones is close to its record high, and Standard and Poor’s recently downgraded the Italian debt by two notches.
In Italy, people are outraged by the rating company’s decision. They experienced it as “a true slap in the face,” as the minister of labor said. They think they have done everything in their power to redress the situation, so why should they be punished? Yet, S&P isn’t to blame. It is just a referee. Any such observer looking at a country with no growth, a 120 percent debt-to-GDP ratio, and a 7 percent borrowing cost would arrive at the same conclusion: The country is on the path to default.
At this borrowing cost, even a 4.5 percent primary surplus for the next 30 years wouldn’t prevent the debt from exploding. By contrast, if the cost of debt were a more reasonable 4 percent rate, with primary surplus of 3 percent, Italian debt not only wouldn’t explode, but in 30 years it would converge to the desired level of 60 percent to GDP.
Unlike Greece in 2010 and Italy last summer, Italy today appears to be facing multiple equilibriums: If investors expect the country to default, they demand high interest rates and default is inevitable. If everyone expects the country to make it, investors will accept low rates and the country will make it.
This is the typical situation where a central bank’s intervention can help. So why doesn’t the ECB announce that as long as Italy will stay its course, the ECB will buy Italian debt to ensure the long-term rate stays below 4 percent?
One reason is that the ECB doesn’t trust Italy. It is afraid that the moment it buys enough Italian debt, the Italian government will relax its fiscal policy, imposing large losses on the ECB.
This mistrust, however, can become self-fulfilling. Fearing that their painful fiscal adjustment was in vain, Italians are starting to lobby for a looser fiscal policy. To prevent this dangerous unraveling, Italy should offer the ECB a deal:
Italy commits to maintain a 3 percent primary surplus as long as the ECB ensures the spread between Italian bonds and German bunds will be below 200 basis points (what it was until June). If Italy deviates from its promise, the rate on all the Italian debt held by the ECB will reset at the rate prevailing today and all that debt will become senior.
This agreement would achieve two goals. It would make it extremely costly for future Italian governments to deviate from the virtuous path set by Monti. It would also indemnify the ECB for potential losses from its purchases of Italian debt, freeing its board from any potential liability.
Most important, it would teach European countries that fiscal restraint pays off. Moral hazard is fought not only by punishing the profligate, but also by rewarding the virtuous. If Italians were to discover otherwise, the effect would be devastating for every country in Europe.
Read more opinion online from Bloomberg View.
To contact the writer of this article: Luigi Zingales at Luigi.Zingales@chicagobooth.edu.
To contact the editor responsible for this article: Max Berley at firstname.lastname@example.org.