JKH On Paul De Grauwe’s Fiscal Arithmetic

In a recent article for VOX, Paul De Grauwe and Yuemei Ji write about potential fiscal effects of a possible asset purchase program by the Eurosystem (European Central Bank and the National Central Banks in the Euro Area). In that the authors take an extreme stand suggesting that a default by a Euro Area government on bonds held by the Eurosystem doesn’t even matter.

JKH has written a fantastic critique of the VOX article by De Grauwe and Ji.

JKH says:

De Grauwe goes on to say that because bonds held by the ECB –defaulted or otherwise – are “eliminated” on consolidation, it doesn’t matter what they were valued at on the ECB balance sheet in the first place. They may as well have been valued at zero – because they have effectively been eliminated and replaced by ECB liabilities (assumed by implication to be permanently interest free).

Thus, the balance sheet implication of De Grauwe’s treatment is that some portion of future currency issued by the ECB will be “backed” on its own balance sheet by an asset of zero value – the defaulted Italian bond. The problem is that this currency would have been issued in any event according to the demand that will arise naturally from the growth of the European economy over time (notwithstanding current depressed conditions). And so ECB seigniorage will have been reduced from what it would have been had it included the effect of good interest on Italian bonds. That reduction in seigniorage due to default is a real fiscal cost, because it reduces the profit remittance of the ECB from what it would have been in the non-default counterfactual. And the fact that the reduced seigniorage gets distributed to the residual capital holders means that there has been a fiscal transfer to the defaulting sovereign from the remaining capital holders. So De Grauwe is simply wrong on this point.

Another way to look at it is by looking at the international investment position. A default by a nonresident on a claim on held by residents is a reduction in the net international investment position and a reduction in the wealth of the geographic region. (The wealth of a nation is the sum of the value of its non-financial assets plus the net international investment position). International investment position matters as a sounder position implies that there is higher potential to raise output.

De Grauwe has another article for The Economist from today. He writes:

Since Milton Friedman we have all become monetarists. In order to raise inflation it will be necessary to increase the growth rate of the money stock. This requires that the ECB increase the money base. And to achieve the latter there is only one practical instrument, ie, an open-market purchase of government bonds. There is no other way to raise inflation than through an increase in the money base and a bond-buying programme is the time-tested way to achieve this.

It is sad that Monetarism is still alive today, despite being repeatedly been shown to be incorrect. But more importantly for the current discussion about risks, De Grauwe repeats his stand again and states it more explicitly:

This confusion between accounting losses and real losses is unfortunate. It has led to long hesitation to act. It also leads to bad ideas and wrong proposals.

So losses do not even matter!

The problem with a Eurosystem asset purchase program of Euro Area government bonds is that it achieves little. It is not a coordinated Euro Area wide fiscal expansion which is badly needed. The ECB already has the OMT program which has helped government bond yields from rising and leading to a crisis, so a QE will hardly achieve much except having an impact on prices of financial market securities. QE just diverts attention from important challenges for a unified Europe. Challenges such as how to move toward the formation of a central government.

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