Central Banks Cancelling Government Debt Is No Panacea
Recently, more than a hundred European economists, including such luminaries as Thomas Piketty, called for the European Central Bank to write off a chunk of government debt that it holds. The idea of central banks cancelling government bonds they have come to hold as a result of their large-scale quantitative easing has a certain superficial appeal. However, it reflects a fundamental misunderstanding of what QE is, and diverts attention from considering more fruitful ways in which monetary and fiscal policy can cooperate.
Since the global financial crisis and now in response to the Covid-19 recession, governments have accumulated a huge pile of debt and central banks, by doing QE, have come to hold a big slice of it. The central bank, while operating independently, is part of the ‘consolidated government’, so the bonds it holds sit on both sides of the latter’s balance sheet. Debt cancellation would seem to kill two birds with one stone: getting rid of a chunk of government debt, thus creating more ‘fiscal space’, and helping the central bank unwind its QE-bloated balance sheet, freeing up room for monetary policy. Were things that simple...
Such a debt cancellation, while possible operationally, would achieve very little of substance. It is easily overlooked that when the central bank acquired the government bonds it did so, dollar for dollar, euro for euro, or yen for yen, by creating reserves (deposits of banks at the central bank). QE does not change the amount of government debt obligations issued to the public; it just changes the form they take – government bonds or central bank reserves.
The government treasury and the central bank can agree to cancel all the bonds they like held between them, but that will not change how much the government as a whole ‘owes’.
It would also be more trouble than it is worth. A balance sheet has two sides, so, if a central bank were to write off some of the government bonds it holds, extinguishing them from the liability side of the treasury’s balance sheet, it would have to write down something on the liability side of its balance sheet. Nobody is suggesting that the central bank extinguish reserves when it writes off the government debt, the very reserves it created when it bought the bonds in the first place. Reserves being an asset of the banking system, this would blow a hole in banks’ balance sheets and would be tantamount to a big monetary contraction, the opposite of what debt cancellation proponents presumably have in mind.
A more natural balancing item for the central bank would be its capital account. Given that the modern central bank is part of the government (or in the ECB’s sui generis case is owned indirectly by nineteen governments), unlike a company its capital account does not have much, if any, intrinsic meaning: like government bonds held by the central bank, in effect it cancels out within the consolidated government. But the bigger the debt cancellation, the bigger the hole blown in the central bank’s capital, creating uncomfortable optics and raising concerns of the independence of the central bank being compromised. On both scores, conservative central bankers are likely to oppose such an outcome tooth and nail.
While cancelling debt may be more trouble than it is worth, the proposal does focus attention on one useful thing: the scope, in a world in which fiscal and monetary policy are both stretched thin, for central banks to loosen the fiscal constraints on governments without sacrificing their hard-won inflation-fighting credibility.
The stimulatory effect of QE is muted, but the change it effects in the form of government liability holds a key implication: central bank reserves, unlike government bonds, never have to be repaid. Let that thought linger – with the tap of a computer key, central banks have the power to take government default risk off the table.
QE largely renders moot concerns about fiscal sustainability. Governments can never issue too much debt in the sense that they may not be able to pay it back, because they never really have to pay it back.
When governments run budget deficits, they are not borrowing money; they are creating it. If they create too much, inflation will result. That’s why we need central banks to be independent, so they can head off that risk at the pass.
Central banks can pay interest on reserves, which gives them two instruments (in a Tinbergen principle sense): interest rates to control inflation and QE to give governments the necessary fiscal space to achieve their jointly held goal of full employment.
Forget about cancelling debt: independent central banks being able to do QE and pay interest on reserves opens the way for monetary and fiscal policy to work together, when needed, to get demand-deficient economies back to full employment without risking inflation being triggered. If inflation does threaten, policymakers can tighten both monetary and fiscal policy; if the fiscal authorities don’t do their bit, independent central bankers can compensate by hiking interest rates even more.
Paul Sheard is a Research Fellow at Harvard Kennedy School and formerly held chief economist positions at leading institutions in New York and Tokyo.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.