Cancelling some of the debt in Europe is no longer a taboo
lunedì 7 dicembre 2020

This is the English version of an article published by Avvenire on 15th October.

In an interview released on Saturday November 15th (la Repubblica newspaper), European Parliament President David Sassoli said that the possible cancellation of the public debt that EU Member States have incurred during the pandemic is an interesting working hypothesis.

In an article published by the Italian newspaper Avvenire on 15th October 2020, I argued that, in exceptional times like the ones we are currently living in, the cancellation by the European Central Bank of the debt incurred by the Member States during the current pandemic would be a possible and desirable measure in order to avoid aggravating the burden on present and future generations, who have already been so severely affected by Covid-19.

Partial debt cancellation has not been uncommon in recent history, both in poor or emerging countries as well as in high-income economies. Carmen Reinhardt, one of the world’s leading experts on debt and fiscal policies, has recently published some research work co-authored by Christoph Trebesch which analyses 48 cases of partial debt cancellation that took place in the twentieth century, both in high-income countries between the two wars, and in poor or emerging countries after the Second World War.

This research shows how debt relief or outright partial debt write-off can have positive and significant effects not just on debt service and debt/GDP ratio but also on economic growth and even financial rating of the debtor in the years that follow. Empirical findings also indicate that more drastic forms of partial debt stock cancellation are more effective than more timid interventions (such as reduction of interest payment and debt rescheduling).

The substantial difference between the cases analysed in the Reinhardt-Trebesch research and the proposal currently under discussion in Europe is the fact that, in the case of today’s Europe, the creditor would not be a sovereign state but the European Central Bank, which currently holds a high share of Member States' public debt as a result of unconventional monetary policies that would have seemed unthinkable just a few years ago.

In order to assess the feasibility of the debt relief proposal, we need to reflect on the various effects this may generate at different levels, i.e. the impact on the ECB's budget and the consequent impact on ECB reputation on financial markets, the impact on its independence which, in turn, could have consequences in terms of the euro exchange rate. It is also essential to evaluate the possible effects on money supply and inflation, not only in relation to the debtor’s economic performance and financial condition, but also in terms of the temptation to adopt lax behaviours in the future (the phenomenon of moral hazard). These concerns could be addressed by applying progressivity and conditionality, that is debt relief mechanisms that are progressive over time and that are linked to target achievement (which is exactly the principle of the Next Recovery Fund if debt cancellation were replaced by financial resource availability).

There is another substantial difference between the current situation in Europe and the vast majority of cases of debt cancellation, which very often are the result of debtors defaulting. Indeed, should debt cancellation be approved by the ECB, the decision would not be justified by the need to urgently bail out the debtors as, despite the high levels of debt, said debt could be honoured and there are no alarm bells going off in the financial markets, mainly thanks to the protection offered by the ECB. Indeed, it would be the creditor that, unilaterally and regardless of the conditions of the counterparty, would make the decision based on the fact that the exceptional high level of debt has not been generated by lax fiscal policies.

It is also essential to analyse similar proposals and initiatives which have recently been suggested (from the ‘PADRE’ plan proposed by Wyplosz to the proposal by Giavazzi and Tabellini, who advocate the issuance of irredeemable bonds guaranteed by the ECB) and assess them, bearing in mind that the ECB has long been using unconventional policies and that the rollover (i.e. selling new securities to pay for the redemption of maturing securities) of large shares of Member States’ public debt with the repayment of interest is, in reality, a form of partial debt cancellation, although it presents some small, albeit important, peculiarities. Indeed, the ECB is entitled to revoke this policy at any time and, unlike debt write-off, it forces the debtors to have to return to the markets in order to renew the debt. If the ECB were not permanently committed to repurchasing that debt, more demand would be available and securities supply would be rebalanced in favour of the debtors.

The consequences on the ECB's budget of a partial cancellation should be assessed carefully. Asset loss should be offset by the expected future value of seigniorage (as Wyplosz has already discussed in the ‘PADRE’ plan). Some of this income would be transferred from national central banks to governments, but this wouldn’t necessarily mean that cancellation would be a mere financial in- and outflow. The seigniorage mechanism could be left untouched, and the recovery over time of the resources could be slowed down, or the share transferred to the Member States could be reduced, thereby creating a principle of co-responsibility and mitigating the risk of moral hazard.

Moreover, while it is true that, in principle, a central bank that prints money cannot go bankrupt, it is also true that the loss of reputation/confidence, which impacts upon the value of its currency, and rising inflation are two fundamental limits to the omnipotence of its actions. The ECB’s reputation, the extraordinary nature of the current situation and the market conditions in relation to inflation risk suggest that a debt cancellation experiment carried out today and linked to the unprecedented pandemic we are experiencing would not have a particularly negative impact on the weaknesses described above. Our recent past has taught us that in a world where global competition is fierce, substantial increases in money supplies result in surges in the prices of financial assets rather than in the growth of the prices of goods and services (i.e. the real economy).

On 22 October 2014, this newspaper published an appeal signed by 340 colleagues which advocated quantitative easing, Eurobonds, common fiscal policy and forms of partial debt cancellation (the ‘PADRE’ plan). Critics responded with a resounding ‘No’: “it can’t be done, it mustn’t be done and it will never be done by the EU”. It has taken a dramatic financial crisis and a pandemic to achieve the first three policies we had advocated and to initiate a discussion on the fourth. Unfortunately, as is very often the case, decisions to move forward with conviction are only ever made when we find ourselves trying to avoid walking off a cliff or when our backs are against a wall.

Translation by Angela Napoletano

Review by Marco Girardo

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