Approaches

Ⓔ The European Central Bank can’t do everything, governments must fully use their budgetary powers

Reader's digest

• The European Central Bank (ECB) has taken the leading role to support the eurozone economy. This raises the question whether it is appropriate and legitimate for the ECB to do so.
• Another question is whether the ECB’s actions are sufficient, and whether governments need to do more by using fiscal policies such as spending to boost the economy.
• Government’s actions are, however, limited by EU and national rules on what they can do depending on their deficit and existing levels of sovereign debt.
• Governments, like citizens, need money in order to pay for things like public welfare and infrastructure. Unlike citizens, they do this either by raising taxes or by issuing bonds which they sell to investors and banks.
• The ECB plays an important role in helping governments lend money from investors, mainly by buying governments bonds on financial markets and by imposing negative interest rates.
• With the support of the ECB backing their bonds, governments can spend more to boost their economies without the need to raise taxes.
• Governments are not like households when it comes to debt : they have the support of their central bank, so they don’t always need to reduce their debts.
• While the EU has encouraged government spending during the current health crisis, this is only a temporary solution and begs the question of whether we need a longer-term framework for ambitious fiscal spending.

Full explanation

Since the great financial crisis of 2008 and the current Covid-19 crisis, the European Central Bank (ECB) has taken the leading role to support the economy within the limits of, and arguably even beyond, its mandate. The primary reason for this is that, when crisis hits, central banks have the necessary fire power and resources to take on the risk that no else wants. While this could be seen as an honourable role for central banks, it raises several questions. First, is the ECB, as opposed to national governments, ideally placed to take on these risks? Should the ECB be the main actor to deal with  societal issues like rising inequality and unemployment? And is it legitimate for the unelected and technocratic bankers to be the only players in town?

Another question is whether the central bank’s actions are enough. Despite the ECB’s support, the European economy is not growing as much as it should, and its price stability target of below but close to 2% has been consistently missed for the past decade. The final question, then, is: should governments play more of an active role in spurring long-term growth and job creation in the eurozone?

In fact, the ECB’s monetary policies — the measures it uses to reach its objective of price stability and other economic objectives — are not the only tools available in the toolbox. Fiscal policies — taxing and spending — deployed by governments are also used. A good example of this is the arsenal of tools that governments in the eurozone have used in the wake of the Covid-19 crisis. These measures include spending on medical resources, keeping people employed, subsidising small businesses, deferring certain tax and social security payments for citizens etc. Some governments have even resorted to directly transferring money to the bank accounts of citizens.

The question of whether eurozone governments should do more to help out is partly constrained by both national and EU rules on what they can do. These rules, known as the “Maastricht rules” or “Stability and Growth pact” rules, notably impose limitations on government spending depending on their deficit and their level of existing public debt. According to these rules, eurozone governments should not have a deficit (meaning that they spend more money than they get from taxes) of higher than 3% of their Gross Domestic Product (GDP), and their total level of debt should not go beyond 60% of GDP. In practice, most Member States have repeatedly not respected them.

Governments borrows money through bonds

Governments, like citizens, need money in order to pay for things like a national healthcare system, taking care of an aging population, investment in railroads etc. Governments primarily get their money from collecting taxes from their citizens. However, when governments increase their spending, raising taxes is not always an option, partly because it’s unpopular with citizens.

Instead they borrow the money, by issuing what is called a bond, which they sell to investors like big commercial banks. The government promises to pay periodic interest payments (called coupons) to the investor, and to only repay the full amount borrowed at the end of the loan period. Investors may choose to sell these government bonds on the financial markets to other investors.

Government bonds are generally quite popular with investors: they are considered to be low-risk since the government backs them. However, governments may face problems borrowing money when their debt levels are already high. Investors are less inclined to invest in bonds issued by countries with a high level of debt because they fear that they will never see their money again. They might then charge higher interest rates to reflect the increase in risk that they are taking by buying the bond.

ECB reduces the cost of borrowing for governments

This is where the role of the ECB comes in. The ECB plays an important role in ensuring that governments continue to pay low interest rates on the bonds that they issue. In other words,  making it cheaper for governments to borrow money.  

While governments cannot borrow money directly from the ECB, the ECB can buy government bonds on the financial markets. When it does this, through its so-called quantitative easing (QE) programmes, it gives other investors the incentive to reduce their interest rates on the bond because they know that there is a demand for the bonds from a powerful institutional player. By creating this demand, the ECB effectively reduces the cost of debt for governments. Another way that QE helps governments is that the ECB also transfers the profits earned from those debts back to the national governments in the eurozone.

Another way the ECB makes it easier for governments to raise money through bonds is by setting negative interest rates. Commercial banks are obliged to keep any of their extra money as reserves with the central bank. If a commercial bank wants to keep more of its money as reserves at the central bank instead of lending out money, the negative interest rate means that they will have to pay an additional fee to "park" their money with the ECB, rather than earning an interest on it. The ECB does this to incentivize banks to make more loans during an economic downturn, to prevent banks from hoarding money without making it available to finance the economy’s needs.

Need for government spending

With the support of the ECB backing their bonds, governments currently have the capacity to boost their economies without having to raise taxes. Some people would argue, however, that even with the backing of the ECB, governments should not be indebting themselves further when debt levels are already so high.

While this is a sound argument when applied to the personal finances of a household, we have to remember that a government is not like a household. For one, a household does not have the backing of a powerful central bank like the ECB behind it. Moreover, households do not collect taxes from other households. And when a household cuts its spending by 10%, it has little effect on the wider economy. On the other hand, when governments cut spending by 10%, it has massive repercussions for employment and wages in the public sector (i.e. nurses, teachers, police officers etc) and the sectors that provide goods and services to the government (i.e. constructions workers).

During times of crisis like the one we are facing today, austerity measures, such as cutting spending and raising taxes, risk further depressing national economies and worsen the situation for millions of eurozone citizens. This argument has largely been accepted by the EU which has suspended the Maastricht rules that limit what governments can do, precisely to encourage government spending during the current health crisis. However, these rules cannot be suspended forever. It thus raises the question of a more long-term and permanent vision for governments, rather than the ECB, to take the lead on stimulating the economy.

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Start the debate

There is not much more the ECB can do to help the economy without going beyond its democratic remit. Instead, the current interventions of the ECB are an opportunity for governments to deploy ambitious budgetary spending to invest in the long-term needs of society. By generating long-term economic growth, employment and social progress in the short-term, governments will be able to pay back their debts in the medium/long-term, when their economy is at maximal capacity. Moreover, this approach could allow the ECB to achieve its inflation target more easily.

Want to dig even deeper in this debate? Click on any of the links to discover concrete ideas for the future of the ECB, or join the debate and contribute your own ideas.

→ #8 Change European Union Treaties to allow for direct financing of government spending

→ #10 Review EU fiscal rules to increase public spending

→ #11 Create a permanent eurozone federal budget to coordinate fiscal policy and stimulate the economy