Public Financing of Public Tasks: An Unorthodox Proposal


 Introduction

Public budgets are the manifestation of governments’ commitments to their electorates in numbers. Of course, not all of a government’s agenda items need financing, but most of them do. Financing comes from tax revenues, other government revenues (user fees, sale of government property, profits from government-owned enterprises) and debt financing, usually in the form of government bonds.

Ideally, and over the long run, government revenues should be levied in amounts adequate to finance government expenditures. However, there is a long drawn-out discussion in economics whether long-gestation infrastructure expenditures need to be included in such a “balanced-budget” rule or whether their long-term contribution to growth and welfare does not warrant their financing by debt, since the fruits of these investments will also be reaped by future generations, who will have to pay for them.

The more topical discussion, at a time when public debt ratios have risen to potentially unsustainable levels in many (especially rich) countries, is how to finance annual budgets at a time when taxes and other revenues are below their medium-term trends because of the shrinking tax base as a result of recession. (I will also not touch on the point that there is an ideological bias in mainstream Western policy-making towards lowering tax rates in general, and specifically for corporate income with a view to attract (local and) foreign investment.)

The present discussion will focus on both the immediate crisis-relevant policy discussion, but also on the more long-term structural problem of how to finance public expenditures in general.

 The Background

The starting point is the fact that public budgets  need to be financed also by debt. The present mainstream obliges countries to go to (private) financial markets to finance this debt. National Banks, another possible source, in many countries and the EU are explicitly forbidden to finance public debt, either directly or indirectly. This is codified in Art 123 TEU (Treaty establishing the functioning of the European Union). This rule is motivated by the historical experience that politicians’ ability to tap National Banks’ (unlimited) financial resources has led to hyper-inflation, to the financing of populist, vote-getting white elephant projects, and has driven many countries’ economies towards  ruin. It is reinforced by Art. 125, the so-called no-bailout rule, which prohibits countries and European institutions from taking over the debt of EU member countries.

The image conveyed by this rule is that ruthless politicians, only interested in maintaining power and promoting their own interests (also financially), as exemplified bz the popular “public choice” theory, need to be reined in by a strict “non-monetization” rule. We all know many such examples. But these rotten apples should not cloud our thoughts, but should give rise to appropriate safeguards.

The intention of these prohibitions was to establish legal obligations on governments to deal effectively with their own budget problems and not to transfer part of the responsibility for solving them to other units. While this makes sense as an incentive mechanism, it has proven to be stifling in cases where real budgetary problems arose, like the taking over of private (bank) debt by governments (Ireland, Greece, Cyprus, and others).

If the respective National Bank is prevented from financing public debt, then the only recourse is to the financial markets. It needs to be mentioned here that the intermediation of bond sales by banks also provides these with a welcome income stream, thus banks’ interest in the non-monetization dogma follows.

Bond emissions via banks lead to a price-setting mechanism which is usually driven by rating agencies which assess an emitter’s riskiness. In the case of sovereign states this involves an assessment of the short-term and medium-term economic situation and future prospects of a country. This, at least in theory, follows accepted rules of risk assessment. But states do not just emit bonds to be held by banks or their customers until maturity, states also attempt to optimize their debt portfolio by refinancing old debt when conditions are good, i.e. interest rates low. Thus, the gross flow of debt financing every year surpasses the budgetary financing needs for the year in question by several times. One could ask the legitimate question, whether such optimization, which gives rise to secondary trading of government bonds, should be permitted. In the old days of the seventies, most government bonds were held by banks or savers until maturity, very little trading happened.

Banks are also interested in budgetary financing being conducted via private financial markets, i.e. banks, because until recently their own holdings of government bonds in their portfolios did not require equity capital for risk mitigation, since government bonds were deemed risk-free because of the explicit guarantees by sovereign states. This is the reason, among others, why rating agencies until 2007 assessed the risk of Eurozone member states’ bonds – from Greece to Germany – to be nearly equal. Practically no spreads (yield differential vis-à-vis German Bunds) were charged for the other Eurozone countries, with small exceptions for liquidity premia, and political events, like Austria’s FPO participation in government in 2000.

This has changed massively. When the crisis hit, spreads for 10-year bonds rose to excessive heights for Greece (spreads vis-à-vis German Bunds reached more than 900 basis points in 2010, but 3000 (!!) basis points in March 2012 , for Italy 580 basis points in November 2011, and  similar amounts for other countries) which were only now deemed to be “in trouble”. Today, at the beginning of 2013, table 1 shows some of the spreads in the Eurozone.

Table 1 Spreads of 10-year bonds vis-à-vis German Bunds

Feb. 24, 2013 (Basis Points)

Greece

940

Portugal

470

Spain

360

Ireland

215

Italy

290

France

67

Cyprus

730

Austria

34

Source: Andreas Pregesbauer, Austrian Ministry of Finance, daily report

 

There is a real question about the rationality of this rating agency behavior: until 2008 all Eurozone countries, irrespective of their growth rates, their budget performance, their involvement in the excessive deficit procedure of the European Commission, were deemed “risk-free”, and suddenly, when the crisis set in, some countries are in reality shut out from financing their debt via financial markets, because they are assessed too risky. There is a remarkable circular reasoning involved, which is far from rational: financial markets charge high spreads to e.g. Spain, which means that Spain’s costs of financing rise to heights which crowd out productive government expenditures, thus driving Spain into a recession – which again drives the high spreads, because during a recession tax revenues fall, thus servicing the debt becomes more and more difficult. In Greece’s case, about 30% of their public budget goes towards servicing the country’s debt, leaving little room to invest in future growth.

However, a more basic question arises. Given the assumption that public expenditures are not pure folly or (populist-assessed) waste of money, but rather the financial expression of the political will of the sovereign (the Parliament which in each country approves the budget), why should an important part of their financing be left to the profit-making private, irrationally behaving private financial markets, or investors – whose interest is not to promote the public good, but rather that of their investors? Why is this financing not turned over to an accountable, public institution – and thus withdrawn from the irrational behavior of private investors with different interests? If we see public expenditures as the expression of the political will of the sovereign, should not financing be also done by public institutions? After all, the largest part of expenditures is financed by tax revenues which are also decided upon by parliaments, i.e. a public body; why should the rest be turned over to private agents – who as the crisis has shown and is still showing, have been plagued by a gigantic market failure? But even beyond the present crisis: Why should this financing by entrusted to entities which have differnet, if legitimate, interest than the public good?

There have been recent attempts by National Banks to challenge this non-monetization dogma at the margin, by buying up government bonds by the ECB, the Bank of England and the Federal Reserve System. These attempts, which were occasioned by the deep crisis and the fact that the ECB was the only EU institution able to act decisively and quickly during the European crisis, were highly contested by dogmatists and have hobbled further attempts to resolve the crisis. But, in spite of these attempts, the more general discussion, whether there should be a complete system change in sovereign finance, has not been led. This is one of the big taboo issues in the lessons learned (or rather: not learned) from the crisis.

 A New Financing Scheme

The task then is to devise a system which safeguards that government debt financing by National Banks, especially the ECB, is not captured by irresponsible politicians, but evolved into a system where the over- and undershooting of yields on government bonds is laid to rest, and where sober assessments about the political and economic state of countries give them incentives towards better economic policy making.

 1. Application for ECB Funding

Each country needing ECB funding (on a credit basis) should periodically assess its financing needs and relay them to the specific ECB unit in question. Whether this is the ECB itself, or e.g. the Europan Stability Mechanism, outfitted with a bankinglicence, is immaterial for this discussion. Ideally, such a national decision should be part of the budgeting process, once the budget has been approved by the national parliament. Out of turn requests could be lodged with ECB at any time.

 2. Risk Assessment by ECB

In its recurrent economic forecasts of the Eurozone (EZ) countries, ECB could expand this examination with a view to assessing the risk situation of EZ countries relative to their ability to repay future debt to ECB (debt sustainability analysis). Whether ECB for this purpose adopts a scaling mechanism like the rating agencies, or a different system, isirrelevant. It is clear that such an assessment would widen the present ECB assessment exercise , but the IMF/World Bank approach to assessing debt sustainability could serve as an example. These “country risk assessments” should be published together with ECB economic forecasts.

ECB should not assess or opine on the specific financing request, i.e . the activity to be financed. Its assessment should be restricted to the overall economic situation, the overall budget path (in line with European Commission) and its ability-to-pay. Concretely, this would result in risk-based different interest rates, also differentiated by maturity profiles.

 3. The Mechanism

The financing request from the country would ideally come from the respective Debt Management Institution of the country with whom ECB would negotiate the specific conditions of the loan.
One model could be that the financing task is delegated from ECB to the European Stability Mechanism, the Eurozone’s crisis workout arm. ESM already has established governance structures and an established conditionality regime – which should be reviewed if sovereign financing becomes part of ESM “regular” business. It might be advisable to set up a separate financial council as part of the governance structure which advises ESM management on policy conditionality. In order to fulfill this task, ESM would also need to obtain a banking licence, in order to be able to tap ECB funds for re-financing purposes.

The government bonds which would be purchased by the ECB would not be traded, but kept in ECB/ESM portfolio until maturity, or until the government in question wants to redeem them prematurely. In this way, the respective government has stability about its interest rate, but could, if the interest rate landscape changes, redeem early or roll over after re-negotiation with ECB.

If a government is unable to repay its debt service, ECB would enter into discussion with the government’s authorities and try to re-establish debt and repayment sustainability.

ECB should be a preferred creditor, as it managed to do when a “haircut” was applied to Greece’s debt restructuring.

The major advantage of such an ECB or ESM-financed system would be that interest rates charged on government bonds would be steadier and lower than when they are driven by profit interest and the irrationalities of financial market actor behavior. Thus, government finance would be on a steadier path, but still interest rates charged would mirror the differential risk situation as assessed by a public body. It has been suggested (Bruegel Institute, Deutscher Sachverstaendigenrat) to finance only part of government expenditures by such a joint “European” mechanism, and leave the rest to private markets, in order to increase the incentive effect on governments to budget responsibly. (While I myself could foresee such a mechanism as a first step, I would prefer to “aim for the sky” and introduce a radically different scheme as described here).

 4. Dealing with Existing Debt

ECB could offer to purchase existing debt from bond holders, but could not force them to sell. Governments (EU Council) could forbid trading of existing sovereign bonds on secondary markets. This might speed up and incentivize banks to sell their government bonds at the going rate to ECB – which could then, together with the respective country, restructure the bond portfolio, in order to safeguard debt service sustainability.

 

The Message

Public finance cannot be a casino game where the interests or private investors, or their agents, rating agencies and banks, determine the costs of government debt. The developments of the last years, and especially the recent crisis have proven that this interest-laden determination of (required) bond yields does not serve the public interest. For this reason, it is proposed that the financing of public debt (apart from its major financing source, public revenues) is taken away from private financial markets and turned over to a public, and publicly accountable institution – not as a crisis resolution measure, as it is contemplated by the ECB right now / but as a systemic solution.

The institution of choice is the European Central Bank, or – acting as its agent – the European Stability Mechanism. In order to avoid free-loading behavior by Finance Ministers, this Financing Institution needs to attach risk-dependent interest rate spreads  for its loans, policy conditionality on the country applying for financing, and an “independent” governance mechanism in order to shield it from country- or interest-political interference. The statue of such a financing institution would have to be closely linked to “social welfare” enhancing objectives, and especially, to debt and debt service sustainability objectives.

If such a mechanism were to be installed, government bonds would not be traded in secondary markets, the country assessments would be carried out with a view to the medium- to long-term stability and development paths of the country in question and would introduce a high degree of rationality into the volatility and over- and undershooting frenzy of financial market actors.

This institution would be accountable to the European Parliament and would have to report to the respective committees at quarterly intervals. The European Parliament would have to devise the governing rules for the financing institution.

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