Eurozone QE clears the way for tax cuts

In a very clear analysis, Paul de Grauwe shows how QE could work in the Eurozone. National central banks, or the ECB, would buy government bonds in proportion to member states’ share of ECB capital. National governments would also receive the interest paid on their own bonds. For example, interest received on the purchase of Italian government bonds is paid to the Italian treasury. This avoids any transfer from one national taxpayer to another. In the case of a default, the treasury of the defaulting nation would forfeit this remittance – and other member states would be unaffected.

In this way, de Grauwe makes a strong case that there are no fiscal transfers from one nation to another. With one technical caveat[1] this is true: each government is paying interest to itself.

But although there are no fiscal transfers, there are potentially huge fiscal effects. Consider Italy, which is probably the major beneficiary. Italy currently has a budget deficit of around 3% of GDP. But its primary balance (i.e. the budget balance before interest payments) is close to 2% of GDP. Interest payments therefore account for approximately 5% of GDP.

Consider what happens if the ECB, or the Bank of Italy, buys 30% of Italian bonds financed by creating new bank reserves in the Eurosystem? Italy’s interest bill falls by 30%, and its budget deficit falls by 50% from 3% of GDP to 1.5% of GDP.

It follows that Eurozone QE – if sufficient in scale – has the potential to have a dramatic impact on the Eurozone, if governments offset their reduced interest payments with fiscal stimulus.

Assume that the ECB does buy 30% of Italy’s debt, should Italy be able to exploit this dramatic improvement in its fiscal health? The obvious counterargument is that governments should not assume that the reduction in their net debt that occurs due to QE is permanent, because at some point in the future the ECB will reverse QE and sell the debt back to the market.

There is some truth in this, although the evidence everywhere else is that the government bond purchases under QE look increasingly “permanent”. But the smart compromise is as follows: Because Italy is already fiscally compliant, any new remittance it receives from the ECB as a consequence of QE could be paid to the household sector in the form of tax rebates. Annually, it can pay the household sector somewhere between 0.5% and 1.5% of GDP, depending on how much QE the ECB does. This can continue until the ECB reverses QE.

This is an automatic stabiliser: QE will persist as long as demand in the Eurozone is weak. If it is reversed, presumably it is because the Eurozone is growing strongly. In which case there is no longer need for tax cuts.

Many have argued that QE is pointless in the Eurozone because bond yields are already so low. This completely misses the point. If QE is large enough it will have a major impact on budget deficits across the Eurozone. Given that most countries are currently compliant this creates space for a major fiscal stimulus. The prospects for European growth may finally be improving.

[1] The only weakness in his argument concerns reversing QE in the future. He considers the case where a) one nation has defaulted, and b) QE needs to be reversed to shrink the monetary base. De Grauwe argues that as long as the ECB has enough bonds sell back to the market it does not matter that there has been a default. However, in order to shrink the monetary base by a given amount, the ECB would have to sell back more of the solvent governments’ bonds than would have been the case had there been no defaults. In other words, the larger the default or the greater number of countries that default, the higher the interest payments of the non-defaulting member states, if QE needs to be reversed. To circumvent this problem, the ECB would be better off raising reserve requirements.