The coronavirus pandemic has paralysed Europe and poses challenges to its policymakers. It is conceivable that the substantial disruption to the economy has created a demand slump leading to below-target inflation, or even deflation (Guerrieri et al. 2020). In this scenario, measures need to be taken by the European Central Bank (ECB) to bring inflation back on target. Since the nominal interest rate (the main instrument to steer inflation) is limited through an effective lower bound (ZLB), the ECB has resorted to quantitative easing (QE) to fulfill its price stability mandate.
The current euro area paradigm is built on a separation between monetary and fiscal policy. The mandate of monetary policy is to maintain price stability. However, it is recognised that measures taken to ensure price stability also (necessarily) have other economic consequences, which are typically associated with fiscal policy. Article 123(1) of the Treaty on the Functioning of the European Union (TFEU) restricts the purchase of government bonds by the ECB. The Court of Justice of the European Union (CJEU) acknowledges that while the European System of Central Banks (ESCB) is not entitled to purchase bonds directly from public authorities and bodies of the Member States, it can do so indirectly, on secondary markets (as shown in C 493/17 paragraph 104).1
To determine which forms of purchases of government bonds are compatible with Article 123(1) TFEU, it is necessary to account for the objective pursued by that particular provision (as outlined in C-62/14 paragraph 98, and C-370/12 paragraph 133 ).2,3 The CJEU finds that the aim of Article 123 TFEU is to encourage the Member States to follow a sound budgetary policy, not allowing for the monetary financing of public deficits, and prohibiting privileged access by public authorities to the financial markets, which could lead to excessively high levels of debt or excessive Member State deficits (shown in C-62/14 paragraph 100). The issue is then whether measures taken by the ECB are predominantly motivated to ensure price stability, or whether the measures pursue, in reality, an overriding economic policy objective (or even undermine the objective of price stability). The CJEU has therefore developed safeguards which prevent circumventing the prohibition of monetary financing. The GFCC4 seems to interpret these criteria (in particular a 33% purchasing limit and asset purchases in proportions reflecting the Member States shares in the ECB´s capital) as necessary conditions (as shown in 2 BvR 859/15 paragraph 202). However, the GFCC, while concerned with the manner these criteria are applied by the CJEU, finds that a manifest violation of Article 123(1) TFEU is not ascertainable and that the safeguards still suffice to rule out a manifest circumvention of the article.
A new paradigm
These (not easily dismissible) legal issues are a result of a paradigm that largely separates monetary and fiscal policy. According to the new Heterogeneous-Agent New-Keynesian (HANK) paradigm, such a distinct separation does not exist. However, the point of departure is not that the ECB has to step in for a missing fiscal union. Instead, HANK involves a mixture of the conventional fiscal and monetary instruments in ensuring price stability. At an effective lower bound, debt-financed fiscal instruments (like tax rebates or increasing public employees’ wages more than GDP growth) stimulate nominal demand and lead to higher inflation. This relationship between inflation and fiscal spending is consistent with the experience of many high-inflation countries with high government spending, often monetised by central banks. This channel is also well understood and the TFEU was designed precisely to prevent excessive inflation through this mechanism. However, the TFEU neglects the fact that it could play a role in overcoming deflationary pressures.
According to HANK, the ECB might need the help of the treasury to fulfill its mandate effectively. In response to a forecasted deflation, the ECB has to ask the Member State treasuries for a spending increase in debt to generate inflation. It is then the treasury which does the job of maintaining price stability on behalf of the central bank. The central bank can support the treasury (e.g. through debt monetisation) as long as it abides by its mandate of price stability in doing so.
Inflation and monetisation
Whether or not inflation is generated does not depend on the actions of the ECB but on the conduct of fiscal policy. We conduct several experiments to illustrate quintessential points about the inflation consequences of a stimulus package in a ‘HANK world’.5 We assume that the model is hit simultaneously with supply and demand shocks, generating a deep and persistent recession, and significant deflation. We then simulate the effects of fiscal stimulus under two scenarios. Under one scenario, the stimulus is financed through additional government debt, which is allowed to grow, with taxes eventually raised to fully pay back the debt. In the second scenario, the debt from the fiscal stimulus is rolled over in perpetuity.
Figure 1 The effect of fiscal stimuls
Whether the additional debt used to finance the government spending is purchased by the central bank (‘is monetised’) is irrelevant for inflation. Monetisation and non-monetisation induce the same nominal demand, which is the critical variable determining the inflation rate. Further, households are indifferent between an ‘IOU’ signed by the treasury or the central bank.
What matters, however, is whether the government eventually increases taxes to pay back the debt or rolls it over in perpetuity. The full roll-over case generates substantial inflation, while inflation is substantially lower in the other extreme of full debt payback. In the first case, the nominal demand stimulus is significantly more extensive, causing prices to respond more, eventually. Increasing taxes constrains nominal demand and mutes the inflation rate accordingly. Both financing scenarios create additional inflation because the issuance of additional debt generates more demand.
The economics of Article 123(1) TFEU reassessed
A demand stimulus financed through debt monetisation appears to be a violation of Article 123 TFEU but is, in fact, accomplishing the objective of the ECB. Financing the treasury is (or could be) necessary to ensure price stability and does not fall foul of the prohibition of monetary financing in Article 123(1) TFEU.
Thus, Article 123 TFEU has less ‘bite’ under HANK than under the prevailing view. However, the ECB would have to ensure that Member States engage in expansionary fiscal policy, and do not use the asset purchases to pursue a policy of austerity. Insofar as such a cooperative approach between the ECB and the national governments can be implemented, QE is dominated by fiscal demand stimulus policies in terms of effectiveness. Only under these conditions would a HANK judge find QE not to be the most effective measure (and thus be an infringement of the principle of proportionality).
While the safeguards developed by the CJEU seem sensible in the old paradigm, they are hampering the effective attainment of the price stability mandate under the new paradigm.
A stimulus policy to fight deflation does not reduce the impetus (which the provision of Article 123(1) TFEU is intended to create) for Member States to follow a sound budgetary policy (outlined in C-62/14 paragraph 107).
According to HANK, bond purchases can be selective. A selective purchase might be more effective in satisfying the price stability mandate than a non-selective one, simply because a euro spent in one country has a larger effect on inflation than when spent in another country. Such purchases would not be intended to meet the specific financing needs of individual Member States of the euro area (shown in C-493/17 paragraph 82). A non-selective bond acquisition might be less effective and exceed what is necessary to achieve price stability, infringing on the principle of proportionality.
A temporary asset purchase programme or an exit strategy might be detrimental to overcome deflation (shown in C-493/17 paragraph 116). A ‘blackout’ period between the issue of a debt security and its purchase by the Eurosystem is not required and might be detrimental to the necessary coordination of the two entities (shown in C-493/17 paragraph 114). It would also be irrelevant whether the ESCB purchased bonds on the secondary markets or conducted a direct purchase of bonds from the public authorities and bodies of the Member States (shown in C-62/14 paragraph 107).
We are not recommending any specific actions by the ECB. We are merely discussing the new options that a HANK perspective offers. However, the obligation to declare reasons for its actions (laid down in the second paragraph of Article 296 TFEU) requires some advanced planning. The hope is that this discussion will broaden the set of tools policymakers can consider using to help the ECB meet its price stability mandate.
Guerrieri, V, G Lorenzoni, L Straub and I Werning (2020), “Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?”, National Bureau of Economic Research w26918.