To get a variety of views on this issue, read this post from Bruegel . Here is my view.
We can think of the governments of Ireland or Spain facing a multiple equilibria problem when trying to sell their debt. There is a good equilibrium, where interest rates on this debt are low and fiscal policy is sustainable. There is a bad equilibrium, where interest rates are high, and because of this default is possible at some stage. Because default is possible, a high interest rate makes sense – hence the term equilibrium.
Countries with their own central bank and sustainable fiscal policy can avoid the bad equilibria, because the central bank would buy sufficient government debt to move from the bad to the good. (See this pdf by Paul De Grauwe.) The threat that they would do this means they may not need to buy anything. Anyone who speculates that interest rates will rise will lose money, so the interest rate immediately drops to the low equilibrium.
How do markets know the central bank will do this, if that central bank is independent? They might reason that independence would be taken away by the government if the central bank refused. But suppose independence was somehow guaranteed. Well, they might look at what the central bank is doing. If it is already buying government debt as part of a Quantitative Easing (QE) programme, then as long as the same conditions remain the high interest outcome would not be an equilibrium.
Suppose instead that the central bank does not have a QE programme, and announces that it will only undertake one if the country concerned agrees to sell some of its debt to other countries under certain onerous conditions, and agreement is uncertain. We are of course talking about the ECB. Now the bad equilibrium becomes a possibility again. Perhaps the country will not agree to these onerous conditions. As Kevin O’Rourke pointsout, this possibility is quite conceivable for a country like Italy. Equally, based on past experience, the lenders may only agree if there is partial default. Neither of these things needs to be inevitable, just moderately possible – after all, interest rates are high only because there is a non-negligible chance of default. The ECB also says that even if the country and its potential creditors agree, it may still choose not to buy that country’s bonds. This throws another lifeline to the existence of a bad equilibrium.
So, we have moved from a situation where the bad equilibrium does not exist, to one where it can. As the good equilibrium is clearly better than the bad one, there must be some very good reason for the ECB to impose this kind of conditionality. What could it be?
The ECB’s mandate is price stability. So without conditionality, would there be an increased risk of inflation? One concern is that printing more money to buy government debt will raise inflation. But that does not appear to be a concern in the UK and US, for two very good reasons. First, the economy is in recession, or experiencing a pretty weak recovery. Second, central bank purchases of government debt are reversible, if inflation did look like it was becoming a serious problem.
What about the danger that by buying bonds now, when there is no inflation risk, governments will be encouraged to follow imprudent fiscal policies at other times when inflation is an issue. But why would the ECB buy government bonds in that situation? Buying bonds now does not commit the ECB to do so in the future. No one thinks the Fed will be doing QE in a boom. OK, what about all those ‘structural reforms’ that might not occur if the bad equilibria disappeared? Well, quite simply, that is none of the ECB’s business. It has nothing to do with price stability. If the ECB is worrying about structural reforms, it is exceeding its mandate.
Cannot the same argument – that an issue is not germane to price stability - be used about choosing between the good and bad equilibria? No. The bad equilibrium, because it forces countries like Ireland and Spain to undertake excessiveausterity (and because it may influence the provision of private sector credit in those countries), is reducing output and will therefore eventually reduce inflation below target. The only ‘conditionality’ the ECB needs to avoid moral hazard is that intervention will take place only if the country in the bad equilibrium is suffering an unnecessarily severe recession. The ECB can decide itself whether this is the case by just looking at the data.
So, in my view, to embark on unconditional and selective QE in the current situation is within the price stability mandate of the ECB. To impose conditionality in the way it is doing is not within its mandate. Unfortunately, as Carl Whelan points out, this is not the first time the ECB has exceeded its mandate. As he also says, if the Fed or Bank of England made QE conditional on their governments undertaking certain ‘structural reforms’ or fiscal actions, there would be outrage. So why do so many people write as if it acceptable for the ECB to do this?
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