Resetting EMU: A One-off Package Deal for EMU’s Member States

7 November 2022 10:19

The ECB is in a unique position to fundamentally strengthen the eurozone and support the fiscal policies of its member states. But everything depends on a successful bond issuance by the ECB.

Small flags of the member states of the EU


To deal with its liquidity surplus, the European Central Bank (ECB) should issue tradeable securities, coupled with an agreement that prohibits the ECB from purchasing eurozone member states’ public debt in the future. Debt acquired by the ECB under the Public Sector Purchase Programme (PSPP) is de facto already mutualized. The ECB could transform the liquidity surplus that has resulted from its purchasing programs into new tradeable securities.

The issuance of securities by a central bank is a market-friendly instrument of open market operations, which already is used by many central banks all over the world. This would be a much smoother way for the ECB to reduce liquidity than the other option: reselling its portfolio of bonds acquired under the PSPP. A sizeable issue of ECB securities would also create a deep and liquid market for common safe assets across the Economic and Monetary Union (EMU), giving the ECB the opportunity to conduct its future open market operations exclusively in its own securities.

Moreover, the presence of a well-developed market in a European common safe asset would greatly reduce the fragmentation risk of the eurozone. The debt acquired under the PSPP could remain on the Eurosystem’s balance sheet into eternity, meaning that the relevant public debt ratios of all member states would decline substantially. To eliminate public hazard – and to make sure that this de facto bailout will never be repeated – the Treaty on the Functioning of the European Union (TFEU) should be amended to state explicitly that, in the future, the ECB is no longer allowed to purchase the public debt of any member state.

This is the package deal: Member states have to accept a much stronger EMU with more market discipline and a well-developed market in common safe assets. The bonus: a reduction of public debt ratios by approximately 25%.


The unconventional monetary policies implemented by the ECB in recent years have resulted in an enormous expansion of the Eurosystem balance sheet. On the asset side, we find a large expansion in the items ‘lending to credit institutions’ and ‘securities held for monetary purposes.’ On the liability side of the Eurosystem’s balance sheet we see a huge increase in commercial banks’ liquidity under the entry ‘liabilities to banking institutions.’ See Figures 1 and 2.

Figure 1: The balance sheet of the Eurosystem, assets, 2007-June 2022

Source: ECB data per June 30, 2022

Figure 2: The balance sheet of the Eurosystem, liabilities, 2007-June 2022

Source: ECB data per June 30, 2022

This situation is the heritage of a long period of monetary stimulus, in the context of a weak economy and a rate of inflation that was considered too low. However, since the acceleration of inflation since the second half of 2021, the ECB should find a way to tighten monetary conditions. This raises several important policy questions. The first is how the ECB should deal with the public debt acquired by the Eurosystem under the Public Sector Purchase Programme (PSPP), part of the Asset Purchase Programme (APP). The second challenge is to find the best way for the ECB to reduce bank liquidity. Finally, the ECB should find a way to deal with the increasing tensions in the eurozone, more specifically, the increasing interest differential between Italian and German government bonds.

This article will explain that the current situation offers a unique opportunity to help countries with their public debt, while strengthening the eurozone – which may reduce or even eliminate the eurozone’s fragmentation risk – and introducing more market discipline.

Question 1: How Should the ECB Deal With the Acquired Public Debt?

Once public debt is acquired by the central bank, it has lost its monetary relevance. Therefore, it does not make sense to try to reduce public debt that is already owned by the central banks and thus, ultimately, its shareholders: the governments (De Grauwe, 2021).

Essentially, the ECB has four options in dealing with purchased government debt. First, it can decide to actively sell it. As explained above, this represents an unnecessary tightening of fiscal policy. It is also expected to lead to considerable turmoil in the financial markets. Second, the ECB can passively leave the acquired debt on the Eurosystem balance sheet and let it mature gradually over time. This has essentially the same disadvantages, although market turbulence will probably be smaller. An additional disadvantage is that it will take decades before all the acquired debt has disappeared from the central bank’s balance sheet. The third option is to simply write off the purchased government debt. The resulting loss, however, would lead to the central bank having substantial negative equity. It could raise the danger of the central bank becoming dependent on funding from public finances, which could jeopardize its political independence. The fourth option, which I believe is preferable, is for the ECB to leave the debt on its balance sheet indefinitely (Boonstra, 2021). This would not lead to new inflationary pressures. Insofar as the buyback program has led to inflation, it is already incorporated in the current price level. In principle, therefore, that part of the debt does not have to be repaid. Viewed this way, this action has few practical disadvantages. Member states’ public debt ratios can be corrected for the part of their national debt purchased by the Eurosystem.

Figure 3: Public debt ratios adjusted for Eurosystem-purchased debt, 2021

Source: Calculation based on 2021 ECB data

Moral Hazard as a Disadvantage

Figure 3 shows what this action would mean for the public debt ratios of eurozone member states. It would essentially reset their public debt ratios to pre-Covid-19 levels. Technically this is easy, but the real caveat is how to prevent moral hazard. Once it is decided that member states do not have to repay a significant part of their public debt and their public debt ratios are corrected for this, the de facto result is, of course, a major bailout. This would introduce a strong element of moral hazard, which may have a negative effect on future fiscal discipline. Why should a country stick to the Stability and Growth Pact (SGP) if, when all is said and done, it is bought out by the central bank anyway? Unfortunately, the experience in recent years has shown that it is not a foregone conclusion that all member states follow the agreed fiscal policy rules. This is a serious problem that can be tackled along the following lines.

First, even after the proposed debt correction, many countries still have public debt ratios well above the 60% of GDP agreed to in the SGP. It is conceivable that only countries that comply with the SGP deficit rules are ‘rewarded’ with the conversion of part of the public debt bought up by the Eurosystem into a perpetual loan. Once a country’s fiscal policy slackens, this conversion action ceases.

Second, it must be clear in advance that the ECB will not embark again on another massive purchasing program of sovereign debt in the future. This position is only sustainable if the ECB can fall back on other forms of open market policies besides purchasing member states’ public debt. This is possible, as explained in more detail below. It must be absolutely clear that the ECB will refrain from purchasing member states’ sovereign debt in the future. This must therefore be laid down in European legislation (in the TFEU). Disciplining member states should then be left to the financial markets, as was originally intended. In the future, if an EMU member state really runs into debt problems, it can always turn to the European Stability Mechanism (ESM) or even the International Monetary Fund (IMF) for help, but not to the ECB. As said, this does require the creation of conditions in which the ECB can conduct its monetary policy without having to buy up member states’ sovereign debt.

Question 2: How To Reduce Bank Liquidity?

If the ECB wants to regain its grip on the money market, it has several options to reduce bank liquidity. First, of course, it can wind down its LTRO lending to banks. Second, it can reverse its purchasing program and start to sell securities on the market. As explained above, this option has serious negative side effects. Third, the central bank can try to decrease the degree of liquidity of the banks’ reserves by offering the banks term deposits with a longer maturity. The ECB actually did this in the past when it tried to reduce the liquidity impact of the Securities Market Programme. And, as a fourth option, the central bank may start to issue central bank securities. Like term deposits, this option would absorb liquidity. Moreover, it would avoid one of the disadvantages of the former instrument: Term deposits are not tradable, but securities are. Although holdings of central bank securities usually do not count as liquidity reserves, a bank or investor can always trade them on the open market. As a result, central bank securities reduce aggregate liquidity in the system, but individual holders can obtain liquidity by selling them to another investor. This is in contrast to term deposits, which not only reduce liquidity but also flexibility. A further side effect is, of course, that where access to the ECB’s open market operations and standing facilities is restricted to eurozone banks, ECB securities can also be bought by banks outside the eurozone, including other central banks, and by non-bank investors.

Central bank securities are not a new, untested instrument. Many central banks very actively use this instrument.[1] The Swiss central bank (SNB), for example, actively and widely issued central bank securities between 2008 and 2012 in a successful effort to neutralize the liquidity inflow that resulted from the massive capital flight into the Swiss franc during the European debt crisis (Boonstra & Van Geffen, 2022). Although some central banks limit themselves to issuing short-term securities, others issue bonds with maturities of up to 20 years. Compared to the other liquidity-reducing operations mentioned above, the issuance of central bank securities is much more effective. Using this instrument, it is possible to drain huge amounts of liquidity in a relatively short period, without much market turbulence. And in the context of the eurozone, it has one additional advantage: It would create a common safe asset, giving the European capital market an EMU-wide benchmark at last.

[1] Gray and Pongsaparn (2015) indicate that over 30% of central banks issue or have issued central bank securities. Among them are the central banks of Chile, Thailand, Korea, Sweden, Switzerland, and Japan. A thorough discussion of the topic can be found in Hardy (2020).

The European Capital Market: A Market Without a Proper Benchmark

The fragmentation of the EMU’s public bond markets is often mentioned as one of the vulnerabilities of the eurozone. Over time, there have been a series of proposals to end this situation by the ‘mutualization’ of public European debt (Boonstra, 1991; Muellbauer, 2013). Under such proposals, the public debt of individual countries is fully or partly combined by organizing a single European public debt management office and/or private entities that replace it with structured products. Moreover, there are other options to create a ‘common safe asset’ which do not require the mutualization of national public debt (Boonstra & Thomadakis, 2020). Although this discussion is far from concluded, for the time being no individual proposal can count on enough political support to become a reality. However, a main exception is the recent issuance of so-called ‘coronabonds’ as part of the NextGenerationEU initiative. This article will not dwell further on this discussion, but it should be remembered that the fragmented sovereign bond market is a structural weakness of the eurozone.[2] To understand the complexity of the environment in which the ECB operates, one can just try to imagine the US Fed conducting its open market policies in a market without Treasury Bills and operating in bonds issued by individual states. The ECB is one of the few major central banks, if not the only one, that doesn’t have a one-to-one relationship with a national sovereign.

The European debt crisis mercilessly exposed the eurozone’s weak spots. The fragmentation of public bond markets along national lines offered speculators, in the absence of a well-developed market for EMU-wide common safe assets, the opportunity to put a crowbar in the EMU, driving countries apart by increasing the spread between the financially stronger and the weaker countries. This is illustrated in Figure 4.[3]

During the years of quantitative easing, this problem was masked by the massive purchases under the APP, but for the last couple of months it has been back on the agenda.

[2] See Muellbauer (2013) for a thorough discussion of this topic.

[3] In the years before the crisis, the financially weaker countries enjoyed very low interest rates on their public debt that, in general, did not reflect the relatively poor quality of their public finances. Most of them have not used this windfall ‘gain’ since the start of the EMU to consolidate their public finances.

Figure 4: Effective yield (%) on EMU government debt, 1980-2022

Source: OECD via FRED database

The Euro as an International Currency

After the introduction of the euro on the financial markets in 1999 it immediately became the second most important currency of the world. It is a major reserve currency, investment currency, payment currency, anchor currency, vehicle currency, and trading currency. But, where many policymakers had hoped that the euro would challenge the dollar as the world’s leading currency, the euro’s importance remains relatively limited compared to its American counterpart. Since 2018, the EU has launched initiatives to further strengthen the international role of the euro (European Commission, 2018). Indeed, it would be a good idea to strengthen the euro’s international standing, if only to prevent the euro from being overshadowed by the renminbi in the course of the next decade. Here as well, however, the fragmentation of Europe’s bond markets is a major hindrance. There is no EMU-wide safe asset, so to say. Meanwhile, the demand for safe assets has only increased due to regulation. Were such an asset available, this might be a great help. China, for example, has foreign currency reserves of over USD 3,000bn. It would like to have a larger share of euro-denominated assets in its portfolio, but it is not very eager to invest in what it once described as ‘bonds issued by European provinces.’ A pan-EMU safe asset would potentially greatly improve the euro’s standing as a reserve currency. As long as there is a relatively small amount of Eurobills or -bonds available compared to the supply of US Treasuries, for example, securities issued by the ECB may play a positive role in tackling both issues mentioned here.

Central Banks Issuing Securities: How Does It Work?

The Balance of the Central Bank

Let’s begin with a look at a simplified central bank balance (see Figure 5).

Figure 5: A simplified ECB bank balance

Note: The figure concentrates on the balance sheet items that are relevant for this analysis. The rest is summarized under the label ‘other.’ The numbers between brackets in the specific items correspond with the lemmas used by the ECB in its balance sheet representation

The most important items on the liability side, at least in normal times, are the banknotes in circulation and the liabilities to credit institutions. This last item covers the money banks hold as liquidity reserves at the central bank. This reflects the role of the central bank as the creator of base money (M0), including its actions as lender of last resort. It contains the money banks hold on current accounts (under the reserve requirement), the deposit facility, and the liabilities that are the result of their repo transactions and fine-tuning operations.

The item debt certificates is zero today, although the ECB had a small amount of outstanding debt certificates on its balance sheet in the early years of its existence. This was probably a legacy of some of its founding central banks. Capital and reserves are present to cover losses.

On the asset side, the first items are the official reserves (gold and foreign exchange reserves). These are buffers to finance foreign exchange transactions. For major central banks like the ECB this item is relatively unimportant, as agents in major countries usually have access to market finance in any relevant foreign currency and, just as important, their currencies have a large degree of international acceptance. For developing countries with inconvertible currencies, this item is usually more important. There, the central bank is the ultimate guarantor of a country’s obligations in foreign currency.

The lending to eurozone credit institutions is related to the conventional, regular monetary policy operations.[4] The item securities held for monetary policy purposes reflects the financial assets required by the central bank under the unconventional interventions under the APP.

[4] This item has two sub-items: securities received as collateral under the main refinancing operations and securities received as collateral under long-term refinancing operations.

Liquidity Scarcity Versus Surplus Liquidity

Central banks prefer to operate in an environment of liquidity scarcity. In such an environment, banks are constantly in need of central bank liquidity, which the central bank can supply at will on its own conditions. The result is that the central bank has a very tight grip on both the interbank money market rate and the size of the monetary base. It also means that the growth of the balance sheet is driven by the demand for liquidity (liability-driven), while the growth of the asset side of the balance sheet follows. The moment a central bank starts to intervene in financial markets under one of the above-mentioned special programs, the asset side begins to dictate the rate of expansion of the balance sheet. In that case, the liability side follows and, if the purchasing of securities results in a strong increase of bank reserves, an oversupply of liquidity may be the result.[5] One of the consequences of such an oversupply is that the ECB has less grip on money market rates, which no longer follow the refinancing rate, but have dropped to the floor created by the deposit rate. A further consequence is that banks, in case of a strong improvement in the economic climate, have more than enough liquidity to support a strong increase in lending. Probably even too much.

[5] Therefore, the ECB originally sterilized its purchases under the SMP by conducting liquidity-absorbing operations.

Why Should a Central Bank Issue Securities?

As explained above, the most important reason why many central banks start issuing securities is to reduce or prevent surplus liquidity. The background can be quite different. Sometimes, a central bank wants to drain surplus liquidity which is the result of a massive inflow of foreign capital. If such an inflow is too large in the opinion of the central bank, it can intervene in the FX market by buying the foreign currency. On the asset side of such a central bank’s balance sheet, the amount of foreign exchange reserves increases. On the liability side we see an increase of bank liquidity. This liquidity can be drained with the issuance of central bank bills. This is what happened in Switzerland between October 2008 and June 2012, when a strong inflow of money from abroad resulted in an unwarranted increase in bank liquidity (see Figure 6).

Figure 6: The Swiss experience, 2007-2012

Source: SNB

Sometimes a central bank wants to reduce bank liquidity without selling assets. This better illustrates the ECB’s current situation. Such a central bank can issue bonds and sell them to domestic banks. All else being equal, this would not shrink the central bank’s balance sheet but it would reduce the banks’ liquidity reserves. This is offset by an identical increase in the amount of outstanding central bank bonds (substitution on the liability side of its balance sheet). In Figure 7, the upper panel reflects the balance sheet prior to the issuance of securities, the lower panel the situation after the operation.

Figure 7: Reducing banking liquidity by the issuance of central bank securities

The lower panel of Figure 7 illustrates that the asset side of the balance sheet is unchanged, while the central bank intervention only results in substitution on the liability side of the balance sheet, where deposits of commercial banks at the central bank are replaced by the newly issued central bank bonds.

The Consequences

Were the ECB to start to issue securities – so-called ‘ECB bills’ – it may have an impact on market rates. It is clear that some crowding out effects are to be expected. However, compared to the effect of actively selling its securities portfolio, this effect may be relatively limited. Mopping up bank liquidity through the issuance of ECB bills can probably be achieved in a much shorter timespan than doing the same thing by selling the securities portfolio. The positive effect is that the ECB would improve its grip on the money market sooner than in other scenarios. One may expect that if the ECB were to start issuing ECB securities, it would use short maturities as a pilot program. First, because this would be less politically sensitive. Second, because this gives the ECB better options to change or even stop the issuance of ECB bills if unforeseen negative externalities arise. Given this short maturity, certainly of the first issues of ECB securities, the ECB would retain all options available to keep market conditions in a tight grip. Moreover, the ECB could steer the process by targeting its initial issues explicitly toward banks, although other investors could acquire them on the secondary market. The enthusiasm for ECB bills, which would most likely carry a zero-risk weighting, may be substantial. The next logical step for the ECB would then be to issue securities with longer maturities, if political conditions allow it. This would allow the ECB to lock up liquidity for a longer period without having to continually roll over its tenders.

A New Tool for Open Market Policies

As said, the arrival of a new, large issuer of a AAA-rated, EMU-wide safe assets would have an impact on market conditions. ECB bills may affect the interest rates that other AAA issuers have to pay on their national public debt. They would also crowd out lower-rated public debt, such as Italian, Spanish, or Portuguese government bonds, which may have to offer higher yields. However, these distortions will probably be smaller than in a scenario in which the ECB actively reduces its holdings of public debt. Moreover, any price effect may be mitigated by the extra inflow of money from foreign investors that are attracted by the new instrument. The ECB initially should tread very cautiously, especially in the early stage when the market (and political) reaction is the most uncertain. Thus, we expect it to limit itself to short maturities when it starts its issuance program. Ideally, it should aim to issue longer bonds in the future as well in order to establish a full yield curve with benchmark issues.

Once the ECB has established a well-developed market in its own securities, it will also have a completely new instrument for its open market operations. By increasing or reducing the amount of its outstanding securities it can determine money market conditions. The important point is that, in the future, the ECB can refrain from buying or selling debt issued by member states when conducting its open market policies. This combination – the reduction of public debt and the issuance of ECB securities – opens opportunities for a package deal.

Conclusion: A Package Deal

The deal is simple. If the EMU’s member states agree that in the ECB is prohibited from buying eurozone countries’ public debt in the future, they will be rewarded by a substantial reduction of their public debt. From that moment onwards, countries that conduct irresponsible fiscal policies will have to be disciplined by financial markets. In the future, the ECB will not bail them out, although they can always turn to the ESM or even the IMF for help if necessary. Both issues necessitate a change of the Treaties of the Functioning of the European Union. The waiver of the public debt on the Eurosystem’s balance sheet means a formalization of the monetization of their public debt that is already de facto monetized, which is not allowed under Article 123 of the TFEU. But in order to strengthen the one-off character of this step it is absolutely necessary to also include in the TFEU that the ECB will never be allowed to purchase public debt issued by the member states again. This deal, which essentially resets the eurozone, would in practice mean:

  1. All member states see their public debt ratios decline by around 25%. This is an enormous bonus.
  2. The danger of eurozone fragmentation will strongly decline or even disappear once there is a full-blown market in ECB securities.
  3. Market discipline in the eurozone will be strengthened substantially once it is clear that the ECB will conduct its future open market policies in its own securities only and, crucially, under the Treaty is formally no longer allowed to purchase any public debt issued by member states.

It is essential that the prohibition on purchasing national public debt in the future is included in the TFEU. If not, the debt cancellation will just result in more moral hazard, writ large. This package deal may ultimately make the EMU future proof. But without a package deal like this, the EMU will have a long period of improvisation and muddling through ahead of it. A period during which much can go wrong, including the demise of the euro, which would be disastrous.

An earlier version of this article was previously published in the Belgian Financial Forum journal on September 1, 2022.


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