The way to head off the growing crisis in the eurozone is to make greater use of the Emergency Liquidity Assistance facility. Greater cooperation between central banks and fiscal authorites, and 'overt money financing' of government debt, is the way forward

The crisis in peripheral Europe is deepening and spreading to core Europe, affecting France and now threatening Germany. Political concerns in a number of eurozone countries undermine confidence within the region.

The Cyprus blunder has added to overall nervousness. In Italy, falling productivity and falling real incomes, as well as prospects for yet more austerity to come, are further depressing the economy. Financial markets are giving the country the benefit of the doubt, in the expectation that a new government will soon be in charge. But how can the new government and eurozone countries avoid a retrenching Italy becoming a major factor for instability in the whole eurozone?

There is a need for radical action. A large pro-growth stimulus programme is necessary, especially in the countries where the economy is weaker. This would give a signal that Europe can still find the moral resources to regenerate hope amongst its growing masses of dangerously discontented citizens. Just recently, the European Commission’s Economic Sentiment Indicator decreased in both the eurozone and the EU.

So what can be done? The solution would be for eurozone members to use the Emergency Liquidity Assistance facility provided for under the statute of the European System of Central Banks to undertake what could be called ‘overt money financing’ (OMF) of government debt in order to finance tax cuts or new spending programmes.

The idea of OMF has been recently revived by a number of well-known scholars, pundits, and policymakers. It was defended in the past by many eminent and diverse economists - from John Maynard Keynes to Milton Friedman - as the most effective macroeconomic policy lever when it comes to stimulating a stagnating economy. The idea was resurrected by Ben Bernanke when he recommended Japan fight deflation through a programme of tax cuts or public spending explicitly coupled with incremental (and permanent) central bank purchases of government debt.

The money created would finance the tax cuts or the new spending programmes. If the money had gone to finance tax cuts – Bernanke argued – consumers and businesses would probably spend their tax-cut receipts, since no current or future debt-service burden would be created to imply future taxes.

Eurozone members should urgently consider undertaking OMF to achieve aggregate domestic nominal-income targets. It would be a eurozone ‘coordinated-and-decentralised’ effort to conjugate monetary and fiscal policies, tailored to country needs, with a view to preserving highly compromised regional stability and prosperity.

The Emergency Liquidity Assistance facility gives national central banks within the eurozone the ability to support temporarily illiquid domestic institutions and markets over and above European System of Central Banks assistance, in exceptional circumstances and on a case-by-case basis.

Emergency Liquidity Assistance is not a European System of Central Banks function, and the power to use it lies with the national central banks and does not derive from their membership of the European System of Central Banks. Existing legal documents make it clear that its scope, terms, and procedures need to be spelt out in national law and regulations.

Although the use of Emergency Liquidity Assistance by national central banks is not constrained by the rules governing European System of Central Banks operations, restrictions apply, such as: prohibition of overdraft facilities for official bodies; purchasing government bonds; and undertaking tasks that go beyond those of a central bank .

Emergency Liquidity Assistance does not require the explicit approval of the European System of Central Banks, yet it may be terminated by vote if it is deemed to run counter to the European System of Central Banks’ mandate. Moreover, the same degree of independence is required for national central banks performing Emergency Liquidity Assistance functions as they enjoy in carrying out European System of Central Banks-related operations.

During the financial crisis, Emergency Liquidity Assistance was used by the Bundesbank in 2008 to save Hypo Real Estate against a €42 billion guarantee by the German government, and by the National Bank of Belgium in 2009 to bail out Fortis Bank with €54 billion on the eve of its collapse. It was also used in Ireland and Greece, although for a completely different purpose than the one originally intended for the facility.

At the time, Ireland had reportedly had a constant use of the facility since 2008 with the central bank providing anything between €40 and €60 billion since 2010, and Greece had resorted to Emergency Liquidity Assistance for about €55 billion. Such constant use of the facility was not envisioned under the European System of Central Banks statute, and suggests that Emergency Liquidity Assistance has been used during the crisis as a source of additional bailout funding.

Emergency Liquidity Assistance could be used in countries facing conditions of economic recession to finance government spending programmes or tax reduction through permanent purchases of newly issued public debt.

Based on the policy precedent of the European System of Central Banks’ Outright Monetary Transactions, the European Central Bank could extend its legal interpretation of Emergency Liquidity Assistance, allowing for its use as proposed here, and ensuring coherence with the European System of Central Banks’ principles.
Under the new legal interpretation, Emergency Liquidity Assistance could be used as last-resort demand management tool to fight local recessions and preserve monetary and financial stability in the eurozone. The ECB could always sterilise any undesired effects of the additional local supplies of euros on the eurozone’s aggregate money supply.

Much as the Outright Monetary Transactions must be supported by conditionality through macroeconomic adjustment or precautionary programmes under the European Financial Stability Facility/European Stability Mechanism, Outright Monetary Transactions should require submission by national governments of fiscal stimulus programmes consistent with underlying economic conditions, to be executed under EU monitoring.

The scheme could work as follows:

A government of the eurozone submits to its parliament and the eurogroup a pre-defined fast-track public-spending package or tax-reduction plan to be financed in deficit under Emergency Liquidity Assistance.

The corresponding deficit is set with a view to delivering a pre-determined domestic nominal-demand target.

After consideration of the approved government programme, the European System of Central Banks endorses use of Emergency Liquidity Assistance for OMF purposes by the central bank of the submitting member country.

The central bank communicates to the government its readiness to finance an increase in the fiscal deficit through permanent purchases of newly issued debt under the Emergency Liquidity Assistance facility.

The government instructs its ministry of finance to issue special non-transferable government bonds to the central bank in exchange for newly issued euros under Emergency Liquidity Assistance.

The new debt could either bear interest, and the central bank would buy it and hold it in perpetuity, rolling over into new government debt the bonds on its balance sheet that reach maturity, and returning to the government the interests matured; or be structured as special non-interest bearing and never-redeemable securities.

The launch of the OMF is accompanied by a central bank’s statement indicating that its purchases of newly issued debt will be permanent, and by a communication strategy explaining that the debt financed under Emergency Liquidity Assistance will not raise sustainability issues, since it may not be redeemed or sold to the market, it does not pay interest, and does not give rise to new government liabilities.

The ECB and the eurogroup monitor the implementation of the government programme.

So would central-bank independence be in jeopardy? Whereas the OMF scheme outlined here demands a high degree of coordination between central banks and governments, it does not entail a breach of central-bank independence. In fact, as recent research indicates, central bank-government coordination is the most appropriate policy response under conditions of economic stagnation or deflation.

A technical dialogue between the two institutions will be necessary, for instance, to identify the type of deficit programme (public spending or private spending through tax cuts) with the highest expected impact on nominal demand. But this dialogue can take place in full respect of the prerogatives of each institution, with the government having the last word on the composition of the deficit programme to be financed and the central bank deliberating on the volume of OMF intervention.

Coordination should aim at leading both governments and central banks to form common views on the real needs of the economy and the desired impact of the intervention.

In such a framework, the central bank subjects itself to cooperating with the government in stimulating economic growth directly and for as long as necessary, in order to reduce economic slack and root out deflationary pressures, but retains the authority to say ‘no’ to the continuation of the operation in the event of excessive money creation.

Biagio Bossone is chairman of 'The Group of Lecce' on global governance and financial reform. A fuller version of this post first apeared on the Vox website