ECB: Tapering by Twisting

QE measures implemented by central banks of most advanced economies are reaching their limits. In the euro area, the macroeconomic impact of the ECB’s quantitative easing has been disappointing. Now that taper scares have crossed the Atlantic, central banks should team up with multilateral development banks to swap government bonds away from their balance sheets and replace them with equity shares in real investment projects.

Over a few years, the size of central bank balance sheet has grown by multiples in an attempt to inflate prices and foster growth. But today, most central banks admit that they are running out of tools to achieve their mandate. More worryingly, they are aware that their massive asset purchases may create macroeconomic, financial and policy risks. A gigantic asset price bubble has built up in fixed income asset markets, and the seeds of budgetary indiscipline have been sewn.

But what does budgetary indiscipline mean nowadays? According to the “New View” of fiscal policy, fiscal expansions can also help making public debt sustainable. And at the zero lower bound, government expenditure is very effective at stimulating the economy, because its impact on GDP is not crowded-out by induced increases in interest rates. So euro area governments should not spend less, but they should spend better.

Economists usually assume that neither fiscal nor monetary policy have the ability to affect such “fundamental parameters” of the economy as the potential rate of growth or the natural rate of interest. But this may not be true in current circumstances. If spent wisely on investment expenditures such as smart infrastructure or human capital, government money can lift potential growth, raise productivity and shake-up real returns on capital. Likewise, a central bank that implements monetary policy by colossal injections of liquidity should have chances to see this money one day put at work in a productive way.

But there is a catch: by injecting money into sovereign debt markets, the ECB writes a blank check to euro area governments who can use that money as they please. Yet recent years have shown that these very governments have cut public expenditure on investment by unreasonable amounts. This bodes ill for future jobs and growth.

How can the ECB help euro area governments spend their money in a more clever way? What would happen if the ECB engaged its own “Operations Twist” by gradually substituting away from public debt instruments in order to finance directly real investment? This could be done gradually so as not to disrupt markets and avoid a taper tantrum à l’européenne. The ECB’s exposure to risks inherent to fixed income instruments would be reduced, and its exposure to long-term GDP growth increased. The duration of assets in the ECB balance sheet would be increased, and the share of liquid assets reduced. Really nothing to complain about!

Some of course will say that it is not the role of the central bank to finance infrastructure, human capital or green technologies. Others will complain that such a scheme would be utterly undemocratic. Granted, the ECB has no expertise for long term investment. Yet, other institutions have it and could perfectly pair with the ECB in the implementation of this policy. Insurance companies, pension funds, dedicated funds and multilateral development banks could channel monetary creation towards profitable real investment projects.

With a little cleaning-up to their governance, multilateral development banks would be fit to implement an ECB Operations Twist: they already catalyse private investment and correct market failures; their value added lies in the expertise of their engineers and financiers who can ascertain the relevance of investments for long-term growth; they have a policy mandate and cannot be used to serve private interests; and by definition they would channel money creation to investment spending and nothing else.

As such, central banks would ensure a sound, growth friendly, composition of fiscal expenditure. With fiscal dominance around the corner, this would please those euro area member states that legitimately worry about the dangers of monetary financed, il-spent, public debt accumulation.

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