Is restrictive monetary policy doomed to ruin public finances? Not necessarily.

The European Central Bank (ECB) risks the fragmentation and collapse of the eurozone if it tightens its monetary policy by selling government bonds. That is why it should look towards restricting the money supply by increasing the capital requirements for banks, write Leonardo Becchetti and Guido Cozzi. 

Leonardo Becchetti is a professor of economics at the Tor Vergata University of Rome and Guido Cozzi is a professor of macroeconomics at the University of St. Gallen.

Central bankers got caught between the Scylla of inflation and the Charybdis of post-Covid public debt. And the Ukraine war predicts that the worst is yet to come.

The FED [Federal Reserve System], the ECB and the Bank of England are timidly raising policy rates, scared to overburden public finances. Most notably, the ECB has recently realised that its implicit unwritten mandate should include avoiding the fragmentation and collapse of the eurozone. The Southern countries are extraordinarily indebted – even though the debt is high for most EU countries – and a massive rise in interest rates may be unsustainable for taxpayers.

The risk of fragmentation of the eurozone hurts the market’s trust in the euro, leading to euro depreciation and inflation. Hence, avoiding this fragmentation falls within the ECB “price stability” mandate. Fortunately, the ECB is much more aware of this risk now.

Everyone expects that to raise interest rates, the ECB must sell the stock of public debt it detains or, at least, not continue to increase its stock of public debt holdings.

The reason for this belief is an uncritical application of introductory macroeconomics: ECB public debt purchases are paid with money and therefore increase the monetary base in the system, thus fuelling inflation. Moreover, massively selling bonds reduces their price, hence their rate of return rises. According to this simple theory and its cumulated practical applications, the central bank’s asset side of its balance sheet shall shrink to increase interest rates and avoid increasing the monetary base.

Consequently, higher interest rates bring with them the unpleasant effect of ending the era of cheap public borrowing.

Regrettably, the ongoing debate always seems to postulate that the only form of restrictive monetary policy is the sale of securities. This practice worked in decades of open market operations. But this would be devastating now, especially for the eurozone.

Furthermore, it would probably be useless if we consider that the current inflation has almost entirely been the result of the increase in energy prices generated by the Russian aggression in Ukraine and other supply-side factors. Also, the previous monetary expansion induced by ECB government debt purchases did not even bring inflation up to the 2% target.

But eurozone fragmentation is not inevitable. Central bankers can also carry out a more restrictive monetary policy without selling government bonds. Instead, they can let rates rise even as they buy more bonds to make government debt more sustainable.

To achieve this, central banks could increase the compulsory reserve of banks and tighten the prudential parameters of the Basel III accord. These actions do not operate through government debt, but they are potent tools to reduce credit and the money supply and curb aggregate demand as it would make it more expensive for banks to provide loans to the private sector.

Today, this must be the main instrument in the euro area because selling public securities would have disastrous effects on public finances and the euro’s stability.

The eurozone’s minimum reserve requirement for banks has been 1% of deposits since January 2012. It was so low that nearly everyone forgot it, along with the concept of the deposit multiplier, that we keep teaching macroeconomics students almost as a theoretical curiosity. Yet, why not increase it again?

For example, the Reserve Bank of India raised the minimum reserve requirement from 4% to 4.5% in May, withdrawing an amount of reserve money equivalent to 0.55% of total public debt from circulation. Increasing it by 10% could absorb 11% of public debt without creating any money. The ECB could try something similar, with great relief for the debt-tormented governments.

Of course, even absent any meaningful reserve requirements, banks could not create all the deposits they wanted because the several constraints introduced after the 2007-2008 financial crisis, with the Basel II and III framework, effectively replaced the old reserve requirements.

Minimum capital requirements, liquidity coverage ratio, and the net stable funding ratio are potent tools to bridle credit expansion and the economy. They provided enough elasticity to fine-tune credit expansion, which partly explains why the pre-Covid quantitative easing policies did not generate inflation despite a massive increase in the central bank’s assets.

The authorities loosened these bridles during the 2020-21 Covid crisis to give banks more flexible buffers and fuel anaemic macroeconomies. Now the time has come to rein them in to cool the economies down. However, this arsenal of policies can guarantee interest rates rises and inflation control without affecting the taxpayers.

To sum up, the increase in rates, necessary given inflation, can be disconnected from the sale of government bonds. Indeed, by raising the banks’ reserve requirement and prudential parameters, the central bank can obtain monetary tightening while maintaining or increasing public debt purchases and help governments reduce the impact of rate hikes.