Increasing the limits of debt buying: a slippery slope

Erasmus School of Economics

The boundaries have to stay in place, says President of De Nederlandsche Bank Klaas Knot. The European Central Bank (ECB) should not be allowed to buy up larger parts of the debts of European countries. Professor Casper G. de Vries, H.J Witteveen Chair of Monetary Economics at Erasmus School of Economics explains what could happen if the European Central Bank would be allowed limitless debt buying.

Just as people can borrow money from a bank to buy a house, governments of countries can raise money on the capital market by issuing bonds. When governments issue a bond, lenders give a certain amount of money to a government in exchange for a fee. These lenders can be other countries, large investors like pension funds, or indirectly central banks like the European Central Bank. Until now, the ECB did this to a limited extent: it would buy up to one third of all bonds issued by a country, and proportionally the same amount from all eurozone countries.

Changing boundaries

Now, the European Central Bank is considering buying more than one third of the bonds of a country. This way, the central bank can help eurozone countries that are experiencing financial problems due to the coronavirus such as Italy and Spain. These countries were already in a relatively bad financial situation and are now being hit hard by the corona crisis, making it more difficult for them to find lenders who will lend them money against a rate that is not excessively high.

Veto power

Nevertheless, there is an important reason why an agreement has been made allowing the ECB to buy up a country's debt to a limited extent. ‘This agreement has been put in place in case countries experience payment problems,’ explains de Vries. If the ECB would be allowed to buy up more than a third, the bank would automatically be given veto power to decide the value of the government bonds. In this case, the bank would basically be able to finance the national debt.

Slippery slope 

Take for example Greece. A few years ago, when the country was experiencing severe financial problems, Greek bonds were declared partially worthless. In other words, a part of the amount that lenders had given, would not be paid back. For a central bank however, this is not such a big problem. A central bank could technically ‘print’ more money if necessary. But every time the European Central Bank does not pay back the loan and prints more money, the value of the money decreases. ‘This leads to hyperinflation. This is a scenario that is still very far away, but it’s a slippery slope’, says de Vries.

More information

The full item of NOS, 27 March 2020, can be found here (in Dutch).