Nationalization of the bond market - the last bastion against the government debt crisis

Among economists - particularly in France, where I am currently staying - there is an intense debate on debt repayment as a consequence of the increase in public expenditure for the needs of the coronavirus crisis. Some economists, mainly right-wing, are already calling for cuts in public spending, while others, mainly left-wing, support the idea of ​​debt cancellation. In my opinion, in both cases, this debate is based on incorrect premises.

About the Author

Christopher Dembik - French economist of Polish origin. Is a global head of macroeconomic research at a Danish investment bank Saxo Bank (a subsidiary of the Chinese company Geely serving 860 HNW customers around the world). He is also an advisor to French parliamentarians and a member of the Polish think tank CASE, which took first place in the economic think tank in Central and Eastern Europe according to a report Global Go to Think Tank Index. As a global head of macroeconomic research, he supports branches, providing analysis of global monetary policy and macroeconomic developments to institutional and HNW clients in Europe and MENA. He is a regular commentator in international media (CNBC, Reuters, FT, BFM TV, France 2, etc.) and a speaker at international events (COP22, MENA Investment Congress, Paris Global Conference, etc.).

The solution ... nationalization of bonds

In times of crisis, it is normal for governments to use fiscal policy as a weapon to fight coronavirus, protect human lives and save businesses. As with all crises so far, for economic and social reasons there is no alternative but to nationalize the debt. The ultimate goal is to prevent a larger than necessary increase in private sector debt in the short term, which could stand in the way of economic recovery and it does not matter that this means an unavoidable increase in public debt of 30%, or even 50%.

In the current situation, there are two main reasons justifying state intervention. First of all, by avoiding the accumulation of private debt, there is an increase in disposable income of households, which are necessary for recovery, and at the same time the risk of bankruptcy decreases. Secondly, almost all of the new public debt related to the coronavirus will be absorbed by central banks, and governments will literally incur no costs. This is how it will look in the eurozone: governments will pay EBC interest on coronavirus-related debt, thereby increasing its profits, which will be almost entirely redistributed between governments, providing a source of fiscal revenue. In other words, the coronavirus debt interest rate will be de facto zero.

The fundamental mistake made by those calling for budgetary consolidation or for canceling a debt is that they ignore the change in the role of central banks and the quantitative easing period, including the reinvestment strategy. Since 2007, central banks have not only focused on maintaining stable prices, but also on maintaining financial stability and supporting the state's financing needs throughout the crisis. As a consequence of significant liquidity injections through asset purchase programs (also called quantitative easing), central banks have become market makers of the sovereign bond market. In fact, they provide liquidity and set a price. It is expected that in the euro area by the end of this year the ECB will be buying monthly public and private debt with an average value of at least EUR 115 billion. The total asset purchase amount in 2020 is already EUR 1,1 trillion, exceeding the previous record of 2016 of EUR 900 billion, and next week the ECB may increase it to EUR 1,5 trillion.

Quantitative loosening indefinitely (?)

And here we go to the next point: the risk of another government debt crisis in developed countries is close to zero. We will not soon depart from expansive monetary policy. In the euro area, economic damage resulting from a pandemic and worsening inflation forecasts will force the ECB to continue or even expand quantitative easing in 2021, and potentially, and further. Given the unlimited room for maneuver and suggestions for a long-term departure from capital keys, the ECB may prevent any lasting increase in interest rates in the euro area. In addition, after years of conflict between governments and the central bank, these institutions have finally begun to work together to ensure that economic activity resumes as soon as possible. This new cooperation will undoubtedly be continued and deepened also after the pandemic. It will then be easier to deal with new challenges, in particular those related to climate change, and to ensure that the level of public debt will never become a problem again.

We see the same phenomenon in the United States. Since 2010 Federal Reserve it could buy up to 70% of treasury bonds in circulation, and it did so for almost all bond issues since the outbreak of a pandemic to counteract it in the latest quantitative easing round. Given the economic situation and long-term damage caused by the crisis, normalization of monetary policy in the near and medium term is unlikely. On the contrary. The Federal Reserve will implement a new form of unconventional monetary policy in six to twelve months, in this case the official Yield Curve Control (YCC). After the start of the economic recovery, the American central bank will most likely seek to warm up the economy, and thanks to YCC it will be possible to prevent a too rapid rise in profitability. Over the past two weeks, three Fed representatives, including vice president Richard Clarida, have hinted that serious discussions are ongoing at FOMC regarding the selection of specific government bond yields to ensure borrowing costs remain low. In 2010, during the global financial crisis, Fed representatives presented the FOMC with three YCC variants:

1. Policy signaling approach, i.e. a form of imposing maximum limits on bond yields reaching maturity in the period in which FOMC planned to keep interest rates around zero;
2. Incremental approach, i.e. preventing too rapid increase in yields at the beginning of the curve (i.e. securities with maturity up to two years). It was this variant that Clarida inclined in his last speech;
3. Long-term approach, i.e. emphasis on long-term government bond yields.

In the eurozone, the official introduction of the YCC may not be legal, it is not necessary at this time and would certainly cause considerable political dissatisfaction. However, it is clear that we have definitely entered a new era of economic history in which central banks on both sides of the Atlantic are market makers and will therefore take all necessary steps to avoid the government debt crisis. This time is really different.