The Finnish economic policy debate received much-needed airing when well known economist in Finland, Vesa Vihriälä, proposed the partial cancellation of government debts after the coronavirus crisis. It is becoming increasingly clear that there is no socially sustainable way back to compliance with the EU’s Stability and Growth Pact through traditional means, namely financial discipline and tax increases. Therefore, there is now a lot of demand for creative ideas.
The first thing that comes to mind for economists regarding debt burden relief is inflation. The idea here is that the state can, if it wishes, accelerate inflation and wage developments through excessively expansionary fiscal policy. Higher inflation leads to higher nominal GDP growth and thus lowers the government debt-to-GDP ratio. Indeed, after the World Wars, inflating away debts was common until the late 1970s.
In the Euro area, however, inflation is not an easy measure. The European Central Bank (ECB) has not achieved even 2% inflation, even though it has already used all the usual means and significant unconventional means. Member states, in turn, are constrained not only by the prevailing mindset but also by fiscal policy rules and Euro area institutions. Inflating away the debts would therefore mean huge changes in thinking and in the institutions of the Euro area, which are difficult to imagine, at least in the short term.
Zero-interest perpetual bonds
Mr. Vesa Vihriälä is the chairman of the working group at the Ministry of Employment and the Economy and the Ministry of Finance which is assessing the economic impact of the coronavirus crisis. Vihriälä proposed that, following the coronavirus crisis, part of the debt of all Euro area member states be converted into zero-interest perpetual bonds. Thus, the debts would never have to be repaid, nor would interest be paid on them. In practice, therefore, the debts would be cancelled.
According to Vihriälä, debt ratios should be reduced by at least ten percentage points from pre-crisis levels. In other words, if, as a result of the coronavirus crisis, debt levels rise by an average of, for example, 15 percentage points, then debt should be cancelled by at least 25% of GDP in each member state. Debt cancellation would treat all member states equally, and there would be no income transfer between member states.
I think Vihriälä’s proposal is creative and constructive. However, it remains open how perpetual bonds would react to the framework set by the EU’s Stability and Growth Pact, especially to the 60% debt ratio. Although zero-interest perpetual bonds in a purely economic sense increase fiscal policy capacity, capacity may not increase in the economy politically.
If perpetual bonds are included in the rules of EU fiscal policy, it means adjusting public finances by traditional means, such as spending cuts or tax increases. In that case, one will easily drift onto a socially unsustainable path. Significant climate, infrastructure and R&D investments would now be needed, not cuts and tax increases.
For this reason, zero-interest perpetual bonds should be excluded from the regulatory framework of EU fiscal policy. Alternatively, of course, the regulatory framework can be revised, but it is likely to be a longer and more uncertain road, although in the longer term it will certainly be necessary.
In principle, a simpler way to cancel a debt would be to write off some of the Euro area member states’ government bonds that have ended up on the central bank’s balance sheet. This means that the central bank’s equity would become negative. However, the central bank cannot go bankrupt, because it is the central bank. Operating with technically negative equity is not a problem.
However, the current rules require the central bank to be recapitalized if its equity dwindles. Debt write-down means that the rules should be changed or at least interpreted creatively. Debt write-downs may therefore be a more difficult path than perpetual bonds, although in the past, in times of need, the ECB has found creativity in interpreting the rules, as shown by large government bond-buying programs.
Bilion euro emergency coins
An interesting and even more creative proposal is the minting of billion euro emergency coins. The proposal is an import from the U.S. debate , which has even submitted a bill to mint two trillion dollars coins. Even in the euro area, coin minting remains the responsibility of the member states, even though the banknotes are issued by the central bank and the electronic money by banks.
Member states cannot mint coins arbitrarily, but need permission from the ECB for the amount of coins to be issued. To ensure equal treatment, the ECB may declare that it will purchase coins from member states in the same proportion as it purchases bonds.
The € 1 billion emergency coins avoid the problems of the previous two proposals. Emergency coins do not increase government debt, and it is clear that the rules of EU fiscal policy are not driving economies towards continuous adjustment. Emergency coins also avoid the central bank having to operate with negative equity, as the coins are valued at their nominal value in the central bank’s balance sheet.
In this sense, EUR 1 billion emergency coins seems to be a competent solution to cancel government debts. In the end, however, more important than the exact implementation is that debts will be cancelled in one way or another after the coronavirus crisis in order to avoid social instability. Exceptional times require exceptional measures.
Patrizio Lainà, Chief Economist, STTK