Long post today – written fast
TH has been wondering whether institutional arrangements in the Euro area encouraged the European governments to run up bigger debts. So he turned to the literature and was serendipitously pointed to a nice paper by Stephen Ferris, Bernard Grofman and Stan Winer on just the topic (except it happens to be on Canada and not the Euro area).
The authors’ basic hypothesis is that the institutional arrangements that govern how a nation decides to issue more debt is important. The authors reckon is that when a government is constrained by institutions that keep its decision makers accountable, then debt will be kept to levels that are more easily sustained. For example, they argue that Canada’s Westminster style system helped to keep Canadian debt levels sustainable because, when it comes to the size of Canada’s deficit and debt, the buck stops with the Prime Minister, who in turn is held to account by the voters.
Unfortunately, Ferris et al. can’t test the Westminster hypothesis directly with their data, so they test a bunch of related hypotheses like “did the establishment of the Bank of Canada increase Canada’s debt?” The idea being that, if you have a central bank that can finance the government’s budget by printing money, then it reduces the incentive of the Department of Finance (i.e. the Treasury) to be careful about running deficits and racking up larger debts.
Interestingly, the authors find that, in Canada, this was likely the case. Debt levels were somewhat boosted by the establishment of the Bank of Canada. Even more interestingly, they find that when the mandate of the Bank was narrowed to keeping inflation low and stable, that Canada’s government debt levels fell to more sustainable levels. TH reckons they would find much the same for Australia and New Zealand.
A similar argument has been made in relation to a country’s banking systems. For example, George Fane, argues that countries with currency boards (such as Hong Kong) will have banking systems that take less risk because they know that, if they get into trouble, they won’t be able to rely on lender of last resort loans from the central bank.
All well and good except for one BIG real world experiment (economists rarely get to experiment with the real world, so we get excited when it happens in a big way). In 1999, a bunch of European governments abandoned their central banks in favour of the ECB. According to Ferris et al, the governments should have responded by implementing budgets that would bring debt levels down to more sustainable levels and banks should have taken less risk.
So what went wrong? Perhaps nothing – maybe the argument holds up. With respect to Europe’s banks, they knew that the ECB would stand ready to act as lender of last resort (LOLR) to them, even if it wasn’t willing to fund governments, so the absence of a true national central bank didn’t really change things for them. Moreover, given that regulation of banks was taken at the national level, while LOLR lending would be taken at the supra-national level, there would always be some confusion between the regulatory authorities as to who should provide regulatory guidance to the banks (i.e. should it be the national government or the ECB?). Worse, the national government bank regulators may well have recognised that, if a banking crisis happened, the cost of ECB LOLR lending would be shared over the whole of the Euro area, which would have reduced the incentive for the national regulators to regulate well.
What about euro area governments? Before the crisis, although the euro area governments clearly failed to coordinate their fiscal policies as they had planned to do (all the major players violated the Maastricht treaty) they may have believed that, if push came to shove, policies would be coordinated if they had to. That is perhaps they believed that if one country found itself having to make a substantial fiscal adjustment as Canada (and Australia and New Zealand) did in the 1990’s, the others would run expansionary policies to accommodate. This moral hazard problem could have encouraged excessive deficits.
The other possible reason, related to the above, is that the ECB is a relatively new institution and its credibility had not really had a chance to be tested. So, for the euro area as a whole, perhaps accountability was reduced by the establishment of a supra-national central bank to serve many governments that lacked institutions to promote fiscal coordination in the same way that Ferris et al think a Westminster system increases it.
Having said all that, it is interesting the Christine Lagarde recently called for the ECB to partially cover the costs of a possible Greek sovereign default. If the ECB does, then the hypothesis that weak institutional accountability arrangements tend to cause debt levels to become more unsustainable will have been validated. Maybe they have no choice anymore.