Monetary policy cannot substitute for fiscal policy

The rising risk premiums for Italian government bonds are a thorn in the side of the Lega and its Deputy Head of Government, Salvini. At present, the government in Rome has to pay an upcharge of almost three percentage points compared to German Bunds when borrowing money for ten years in the financial market. Even crisis-riddled Greece currently hardly offers a higher mark-up. In this context, basking in the glory of his party’s victory in the European elections Salvini has demanded that not just Italy, but the ECB should bear the brunt of the additional refinancing costs Italy faces. Salvini has, however, hitherto not provided details on how this proposal should be implemented.

Irrespective of how Salvini might intend to implement the idea in reality, there are several reasons why it points in the wrong direction. Firstly, ever since the Eurozone was established the principle has been that government financing (by the ECB) is prohibited. The claim that the ECB is today already conducting monetary government financing is quite simply wrong and hinges on a fundamental error. The ECB’s bond purchasing programme, the PSPP, serves by definition to secure the stability of price levels within the monetary union. For this reason, its purchasing volume is limited and purchases take place according to a fixed country key. The auxiliary OMT programme, the fundamental legal validity of which has already been confirmed by the ECJ, serves the purposes of monetary policy: It is destined to avert market imbalances in the event of crisis. In the case of Italy one can hardly speak of there being market imbalance caused by a crisis. Rather, the higher premiums for government bonds reflect the greater risk as regards Italy’s ability to sustain its debts, given that the government has clearly deviated from the cost-cutting path of its predecessor. Moreover, were the ECB to purchase government bonds or even only guarantee the objective of facilitating refinancing conditions for a particular country it would quite unequivocally violate the prohibition on government financing through monetary policy. The central bank’s reputation, not to mention the external value of the Euro, could both take heavy hits.

Secondly, Salvini fails to recognise one absolutely central task of the market for government bonds, for the price has a steering function. Risk premiums are essentially nothing other than school grades for the member states’ behaviour in the field of economic and fiscal policy. At present, the market is at best giving Italy’s policy a “D”. If Rome insists on pressing ahead with its exaggerated deficit plans, then the chances that it will have to ‘re-sit’ the year increase and bond buyers will bypass Italy, meaning in an unfavourable case the country will run the risk of facing a liquidity bottleneck. If the ECB were to be at hand and cushion the rising risk premiums, then the government in Rome would no longer have an incentive to put its financial house in order. This would be disastrous in the long run, and not just for Italy, as the example of Rome could swiftly become the norm to follow. Other governments such as Spain have invested heavily in putting their state finances on a solid footing, even at the cost of social welfare cuts. What incentives would Madrid then have not to follow Italy’s example? The eventual threat would be a debt spiral that could shatter the very foundations of the Eurozone.

In the final analysis, it bears remembering that monetary and fiscal policy may be economically related, but the one can never substitute for the other. Any expectations that the ECB can offset mistakes in economic policy go nowhere. Countless examples of economic and financial crises above all in the emerging markets attest to this fact.

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