The unthinkable: “pure” monetization now is the only way out

The unthinkable: “pure” monetization now is the only way out, ( co written  with Dimitris A. Ioannou), naftemporiki.gr, English edition, Wednesday, 22 April 2020.

The way in which European authorities are trying to deal with the economic impact of Covid 19 on the Eurozone will not prove rational. Indeed, it risks to become deadlocked.

Treating all Eurozone countries as similar cases is acting in a dogmatic and rigid way. Αs a result of which their policy is in danger of having devastating consequences.

Eurozone countries that enjoy fiscal space may indeed be able to cope with the crisis through fiscal policy, that is, by issuing, collectively or alone, new debt to meet the vital needs of their citizens and the liquidity needs of their businesses in the sectors of their economy that have been forced into a holiday.

However, this is not the case with countries that do not have fiscal space. Increasing their debt today will have devastating consequences both for themselves and the eurozone as a whole at the imminent next stage.

An economy like Greece, for example, will see its debt/GDP ratio exceeding 200% after the crisis. Which will bring it into a new debt crisis process with negative consequences for both itself and the eurozone.

But even more important will be the outcome if large economies, such as Italy and Spain, become unable to service their debts that will be inflated by the policies pursued to combat the crisis.

In the first place, an insolvency crisis in the south European economies will have significant adverse effects on all those in northern Europe who hold their debt or any kind of arrears.

In particular, though, the institution that will be confronted with the most acute problem is the one that now keeps in its portfolio a growing part of the government debt of the Mediterranean countries, i.e. the European Central Bank.

What will happen when the inevitable cannot be escaped, that is, when some European countries will no longer be able to service their debt sitting in the ECB's portfolio? There are three possible developments:

The first is to call the taxpayers of the fiscally strong countries of the eurozone to cover the losses, by recapitalizing ECB. Something that is politically impossible (and, yes, unfair).

The second is for the ECB to go bankrupt, leading to the dissolution of the Eurozone and possibly the European Union itself. Something that, if it arises, it will be a pure European disaster (and absurdity).

The third option, which most likely will be chosen, is something that is now considered unthinkable: a slight amendment to the ECB's charter to allow non-performing (Covid-19 crisis related) debt to be written off, i.e. debt cancellation by “pure” monetization.

These are the three possible developments and we believe that if Europeans think logically, they can only opt for the third. 

Even then, though, this will be the culmination of a collective irrationality: in the meantime, the economies that have become insolvent will have suffered a severe economic blow with high unemployment, massive corporate bankruptcies, a deep social crisis and a long-term decline in their potential output.

In order to avoid all this, there is a much better solution that has been proposed and supported by a number of sound and reliable economists: instead of the post insolvency monetization of the debt, when the Eurozone economy will be running the risk of collapsing, the appropriate economic policy to deal with the crisis is for ECB to finance a “Covid-19 crisis fund” to prevent its evolving negative effects. With “pure” monetary financing, i.e. without creating new debt for any member–state.

This, as extreme as it may sound, may be the most modest and realistic solution, especially in comparison to the dogmatic beliefs that prevail. It will prevent the economic catastrophe of the Eurozone by allocating a much smaller amount than the ongoing consecutive panic solutions will ultimately burn.

It will do so in a way that is beneficial to the real economy: with less inflationary impact than the perennial QE rounds, but, at the same time, with less disinflationary impact upon the suffering economies than the over-indebtedness of their private and public sectors would have exerted.

It will also stop the increasing misallocation of resources caused by the asymmetry of the Eurozone’s fiscal and monetary policies.

Finally, in a democratic society of sensible citizens, the policy of tackling the Covid-19 crisis by providing non-repayable benefits to the affected sectors of the economy through the monetization of the required amounts is the only policy that does not involve moral hazard risk, since this is a policy that will be explicitly and unequivocally applied to the present idiosyncratic crisis and never again.

On the contrary, there is a moral hazard risk when every time you try to correct your previous real mistake by falling into a new one.