How to eliminate the debt trap

Erasmus School of Economics

As the vaccination rate rises and inflation expectations increase, the moment is approaching when the ECB will have to make a decision. Will monetary dominance be restored and ultra-loose monetary policy be shifted to a more neutral position? Or will the ECB continue to do its best to keep the borrowing costs of weak governments manageable, as is currently the perception among rating agencies and investors. In an opinion article, Ivo Arnold, Professor of Monetary Economics, explains why the latter is to be feared.

Hostage held monetary policy

According to Arnold, the ECB should be ready to wind down the sovereign debt buy-back programme and return to a more normal monetary policy with positive interest rates. ‘To dampen high inflation expectations, it is important that financial markets, companies and consumers have enough confidence in the ECB's ability to fight inflation when needed.’ However, this will not work if the ECB continues to use monetary policy to reduce interest rate differentials between the more and less creditworthy eurozone countries, as it has started to do since the crisis, Arnold argues.

According to Arnold, it is better to solve the problem with fiscal policy, for example by introducing a mechanism to dampen interest rate differentials. The pandemic buy-back programme, specially designed to buy relatively more debt from weak eurozone countries, did what it was supposed to do, namely reduce interest rate spreads. According to Arnold, this situation, in which monetary policy is held hostage by the fear of rising spreads, must be resolved. ‘An end to the buying programme will have consequences for bond markets within the euro area. Without support from the ECB, interest rate spreads will widen again. How much we don't know, but it is good to take into account an overreaction of the financial markets and the possible consequences for the European economy.’

The ISM

The flare-up of tensions in the European bond markets could lead to capital seeking a safe haven in the government bonds of the most creditworthy countries, which would mean that interest rates in the Netherlands and Germany would still remain too low. ‘Strong interest rate differences within a currency union thus lead to a situation of financial fragmentation, with monetary policy not having the same effect on interest rates and the economy throughout the currency union', Arnold writes.

A solution could be found in the ESM (European Stability Mechanism), which provides emergency loans to euro countries that get into financial difficulties. According to Arnold, the ESM could be used instead of providing emergency loans, by setting up a mechanism to cushion or settle interest rate differentials within the euro area. ‘The idea is to subsidise the rising interest costs of problem countries from the interest rate windfalls of the AAA countries in the event of market panic, when capital flees from southern to northern Europe. Ideally, such a mechanism would be activated early and automatically, for example when interest rate differentials exceed a threshold.' The aim is to break the vicious circle of the debt trap, whereby rising interest costs raise doubts about the sustainability of the national debt and further push up market interest rates. With an ISM (Interest Stabilisation Mechanism), the effect of rising market interest rates on the interest costs of countries in financial problems is broken, and the debt trap is eliminated.

Professor
More information

The full article from MeJudice, 3 June 2021, can be found here (in Dutch).