Many commentators understand that Germany objects to the ECB engaging in mass purchases of Italian and Spanish government debts. However, most are rather hazy as to exactly why. Most of them write as if the German people had a semi-irrational fear of inflation, going back to the hyperinflations of the 1920s and 1940s, and fear that ECB purchases of Italian and Spanish bonds would be the thin end of a money-printing wedge that would lead inexorably to hyperinflation today.
Well, perhaps some Germans fear that. And perhaps some ought to fear that. But there are much more straightforward reasons. The key straightforward objection is not that such purchases would risk hyperinflation. It is that such purchases constitute debt pooling — German citizens becoming responsible for trillions in Spanish and Italian government debts.
Let’s see why, and in doing so, see why the European Central Bank should not (contra most of what one reads and what our Coalition government urges) serve as a lender of last resort to Eurozone governments.
First, we should observe that when economists write of central banks having a role as “lender of last resort” that actually means that central banks lend money to banks under their supervision / licensing, not that they lend money to governments. It isn’t actually an intrinsic role of the central bank to provide last resort lending to governments. Doing so used to be regarded as the short path to hyperinflation – if the markets won’t lend to the government, there’s probably a good reason, and if the government ignores that reason and resorts to the printing press instead, then it’s two thirds of the way to economic perdition.
But let’s ignore that. For in recent decades, although it has not come to be accepted that central banks should provide last resort mass lending to fund government deficits that borrowing could not, it has, instead, been seen as plausible that, under some limited circumstances, governments can fund some of their expenditure via the printing press or central banks can purchase some government bonds, provided that the effects of doing so upon the money supply (increasing it) are desired and monitored carefully. After all, that is precisely what we have done in the UK and US with our quantitative easing programmes.
But the ECB cannot undertake any equivalent of quantitative easing. Why not? Let’s focus upon central bank purchases of government bonds (like the UK’s quantitative easing). The government will either pay these bonds back, with interest, or it won’t. Let’s assume that, eventually, it does. Well, in that case there is an initial injection of extra money into the economy when the central bank buys the bonds, which is gradually drained out as the government redeems those bonds. For ease of explanation, let’s assume that this extra money injection increases inflation. (It makes no difference to what I’m explaining whether it increases inflation or prevents deflation, except that by assuming inflation I can explain things more easily.)
When the government spends money, it buys real things — people’s time, concrete for roads, medicines for hospitals, etc. That real value must come from somewhere, even when the central bank funds the government’s activities by printing money. When such money printing results in inflation, that real value to fund the government spending comes from a reduction in the real value of savings and of other assets that fall in real value because of the inflation. Sometimes economists talk about the “inflation tax”. That is apt here. When the central bank prints money to fund government bonds, effectively government spending is funded by an inflation tax.
But note something important. When we do this in Britain, there is inflation in Britain (in the sterling area) that funds government spending in Britain. Now, the individuals that suffer from the inflation tax may not be the same as the individuals that benefit from the government spending, but they are all British.
But now consider the case of the ECB. If the ECB buys Italian government bonds, things work much as I have described above. There is money printing, so the amount of euros in circulation increases, and the real value of the euro declines via inflation across the euro area. But in this case the recipients of the real value transferred are Italian. So we impose an inflation tax across the euro area which creates real value that is spent by the Italian government. This is a transfer from Germans to Italians. I’ll say it directly: ECB mass purchase of Italian bonds constitute a mechanism for imposing a real terms tax on Germans the proceeds of which are then spent in Italy.
Of course, this is only half the problem. I set aside the case in which the government didn’t pay. If the ECB purchases trillions in Italian and Spanish government bonds, then these governments defaulted, then the ECB would be insolvent — epically insolvent. Let’s set aside the fact that having your central bank go epically insolvent can ruin your entire day, and ignore the mobs running through the streets with burning brands and the diplomatic chaos, and assume that the ECB is instantly recapitalised. Who pays to recapitalise the ECB? You guessed it – the Germans.
So ECB mass purchases of Italian and Spanish debt make the Germans liable in the event that Italy or Spain defaults, and in the meantime constitutes an inflation tax transferring real value from Germany to Italy and Spain.
That is why the Germans are resistant to David Cameron’s urging that Angela Merkel agrees to ECB mass purchases of trillions of Italian and Spanish government bonds — for exactly the same reason that the British would be resistant if Angela Merkel suggested that the solution to Italy’s debt problems would be for the British to guarantee Italian and Spanish debts and at the same time to impose a special tax here, sending the proceeds to the Italian and Spanish governments. And our Prime Minister saying that we find it “difficult to understand” why the Germans are resistant to this idea is not, I suggest, the way to build credibility or camaraderie with Germany.