03.11.2015.

#QuoVadis or all that you wanted to know about the public debt/ECB active monetary policies, but were afraid to ask

I have attended a number of "international" conferences whose only claim to "internationalism" was the English language and the addresses by "wedding generals" of some nearby countries. The scale of issues discussed at such conferences is deeply regional and the maximum that can be expected is a common response by the region to global challenges, without, however, affecting global developments. I would call the Latvijas Banka's conference of 28 October international without the quotation marks: there, the discussion was among people who manage such developments. Thus the interest by foreign media is understandable: the conclusions reached at the conference received wide publicity in such international media as Bloomberg, Reuters, MNI, The Wall Street Journal etc.

Does the fact that the previous Latvijas Banka conference was dedicated to structural reforms but this year's conference to the rise in the public debt and the active monetary policy of the Eurosystem (QE)  point to a change in paradigm? No, just the opposite. At the conference this year we managed to counter several myths and concluded that neither public debt, nor the QE (euro area government bonds purchase in the amount of 60 billion euro each month) is a magic wand. At best, these are short-term painkillers that provide a breather before launching the serious treatment process (structural reforms) without touching the root cause of the problem.  Moreover, using them for too long and in too great quantities involves undesirable side-effects.  

QE drives the interest rate of government bonds downward. Thus the interest payments are not large, creating misperception  that even a high public debt is sustainable.  That could motivate governments to borrow increasingly more. Yet the period of low interest rates is not endless – sooner or later the QE will be stopped and the interest rates will go up. To prevent a rapid rise in interest payments, the central banks could try to postpone the rise in interest rates as long as possible (Niels H. Bünemann) and with a predictable result – high inflation. Even if high inflation is currently not on the agenda, it does not mean that things will stay this way forever. Who would have thought ten years ago that we would have to fight deflation?

Once the pain stops, most people abandon treatment. That makes the harsh words by the former finance minister of Slovakia Ivan Mikloš in the address of QE all the more understandable. Do governments perhaps launch structural reforms only when they have run out of money and there is no longer a moment to spare (until the next election) to delay implementing the reforms? If so, then it means that budget deficits and QE would postpone structural reforms as long as possible instead of supplementing them (by supporting total demand when it drops). As I wrote last year, it does not pay to postpone reforms: you can't avoid reforms and postponing them simply raises their costs.

It is however also easy to see the point made by the board member of the European Central Bank (ECB) Peter Praet that there may not be an alternative to implementing QE. The ECB takes care of price stability in the euro area and its duty is to use all instruments at its disposal to fight deflation. If the medium-term goal of the ECB (annual inflation slightly under 2%) has not been reached consistently and nothing will be done to reach it, confidence in the ECB will be jeopardized, endangering the stability of inflation in the long term. Structural reforms are in the hands of politicians. It is doubtful that the possibility that politicians may misread the QE signal should be sufficient grounds for the ECB not to do its work.

Ilmārs Rimšēvičs, Governor of Latvijas Banka and member of the ECB Council, agreed that everyone must do their own work. Yet under the impact of QE, with the state bond interest rates approaching zero, investors seek profit by purchasing risky assets from which they would keep their distance under other circumstances.  Moreover, is the central banks should exhaust all instruments for fighting deflation in short order (by buying "everything that moves") but with modest results, would that not mean an even greater loss of confidence in the central banks?

It is important not only to assess the side-effects of the QE medicine compared to the risks inherent in not using the QE, but also to have a clear idea of the real situation of the economy. Does today's euro area not resemble Japan twenty years ago? The slowing of economic growth in Japan of the 1990s was first considered cyclical recession, which was treated in the best traditions of Keynes -- with a budget deficit. i.e. by accumulating public debt. Kenichi Ueda, an associated professor of Tokyo University, emphasized at the conference that this measure did not help to fuel the economy, accumulating a huge government debt (currently at 250% of gross domestic product (GDP)). In time, the Japanese economists understood that what was taking place was not cyclical recession but a slowdown of the potential GDP (in part because of the aging population). An error in evaluating the actual situation of the economy burdened the country with an enormous debt.

Currently, the euro area continues along the path of accumulating government debt. Since 2011, the euro area government debt has increased by a trillion euro or   10% of GDP. I would not claim that the euro area's budget deficit did not "heat" the economy at all, but the impact was obviously less than predicted, which invites drawing parallels with the failure of heating the Japanese economy in the 1990s. At the moment, only in six euro area countries (including the three Baltic countries) the government debt is below the magic 60% of GDP set by the Maastricht criteria. It would probably not make much sense to stubbornly increase the debt burden to Japan's level only to understand that the mechanism for stimulating total demand is broken.  

What would be the critical level of the government debt that should not be exceeded so as not to impede economic growth and jeopardize investor confidence? The conference participants shared the view that there is no such critical level.  It is different for different countries and can change over time, yet one thing is perfectly clear: the poorer we are, the less we can borrow without negative consequences.  

Defaulting on the debt is not a solution. In the case of Japan, a default is not possible for political reasons: the debt is by and large an internal one and the voters will not understand a default.  Yet even in the case of defaulting on an external debt, the consequences are devastating – as a defaulting country returns to the borrowing market, the interest rate on new loans is by 2.25-4.00 percentage points higher (Luis Catao). So because of old sins, the country would have to give its creditors an entire education or healthcare budget.

As we know from the theories of Milton Friedman, pouring money from a helicopter for a long time only creates inflation, stimulating economic activity only for a short while and only in a situation of crisis. A trick question for today – why is it that the money helicopter (QE) fails to leave any substantial impact not only on economic activity but also on consumer prices? It is possible that quietly and imperceptibly money is being accumulated in a new bubble, which cannot be seen in the consumption basket, for instance, in real estate prices. It is also possible that we are finding ourselves in a period when economic theory is being rewritten.

APA: Krasnopjorovs, O. (2019, 15. sep.). #QuoVadis or all that you wanted to know about the public debt/ECB active monetary policies, but were afraid to ask . Taken from https://www.macroeconomics.lv/node/2728
MLA: Krasnopjorovs, Oļegs. "#QuoVadis or all that you wanted to know about the public debt/ECB active monetary policies, but were afraid to ask " www.macroeconomics.lv. Tīmeklis. 15.09.2019. <https://www.macroeconomics.lv/node/2728>.
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