The case against cancelling debt at the ECB

With eurozone governments’ responses to the coronavirus pandemic set to rack up €1.5tn of extra debt, several senior Italian officials including the prime minister’s economic adviser have suggested the European Central Bank should forgive governments the debt bought through quantitative easing. Cancelling sovereign debt the ECB has gathered or extending its maturity perpetually, they say, would free up more resources for the government to support the recovery. The idea has caused consternation in France and Germany. The ECB is right to stand firm against it.

In some circumstances relying on the central bank to fund government can be a lot better than the alternatives. Few today think the Bank of England’s interference in gilt auctions at the start of the first world war was anything other than sensible. Similarly, throughout the second world war the US Federal Reserve fixed the interest rates the US Treasury paid to borrow and bought any bonds at that price that private investors did not want.

Italy, however, faces no similar crisis today. Differences between the borrowing costs for peripheral eurozone countries and Germany have compressed since Christine Lagarde, the ECB president, said it was not her job to “close the spread” earlier this year. Now Italy pays just 1.2 percentage points more than Germany to borrow for 10 years, half the spread after Ms Lagarde’s comments in March. The disorder in government funding markets in the first stages of the coronavirus pandemic has largely been dealt with by central banks’ quantitative easing programmes.

Neither would cancelling the eurosystem’s debt holdings hand any more cash to the Italian government. The debts represent spending that has already been financed and the interest rate payments are recycled back into eurozone treasuries. For the moment, warehousing the debt on the Italian central bank’s balance sheet is not very different to cancelling it altogether.

A fiscal crisis could be prompted by the resumption of EU rules that limit government debt to 60 per cent of national income. Italy already breached that limit before the pandemic; many others will now join it. Yet such a crisis is more likely be prompted by political errors and a deliberate confrontation with northern “creditor” nations than by economics. The European Commission has been able to finesse this issue before. 

Italy could act by itself to make its debt easier to deal with over the long run, in case the ECB ever decides to sell its holdings back to the private sector and rates go up. In particular it could issue much longer dated debt to lock in the current low rate of funding, and gain more time to fix the country’s sluggish growth rate. Italy could even try to sell perpetual debt.

There may be monetary reasons to cancel government debt holdings. Many economists argue that “helicopter money” — a permanent increase in the money supply, likened by the economist Milton Friedman to central bankers dropping cash from a helicopter — will be necessary to rescue the eurozone from potential deflation. This would be most easily enacted by simply writing down the ECB’s existing holdings of government debt to zero. Any move towards this policy should come from central bankers keen to hit their inflation targets and not politicians playing with populist slogans.

Either way, there is little reason for Italian officials to bring this possibility up now. Debt markets are quiescent and the proposal could easily spook investors or northern European taxpayers. Debate over the long-term response to eurozone debt can wait until the pandemic is over.


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