☆ ☆ « The European Central Bank could very well cancel government debt, which would have positive effects on economic activity. » Why is this highly incomplete?

We often hear, from both unreliable and reliable sources (see Patrick Artus here, for example), that the European Central Bank could very well cancel the debt of certain countries in order to reduce their debt ratios. Although often unmentioned, this proposal would effectively require the ECB to operate on a long-term basis with a significantly lower, if not negative, capital base, which is in itself a contentious issue. Explanations.

Let’s imagine that a central bank buys back $1 billion of its country’s public debt and decides to cancel it. This means that the country will no longer have to repay the $1 billion in public debt: its explicit debt to be repaid is therefore reduced. We could stop there and conclude that such an operation would reduce public debt, currently one of the number one problems in the eurozone. However, this reasoning is only partial. If the central bank cancels this €1 billion of debt, it means that the central bank itself will eventually have to forego €1 billion in budget revenue that it was initially promised. It has purchased a security guaranteeing it €1 billion that the creditor (the state) will ultimately not repay. The central bank will therefore incur a financial loss, just as a normal bank would incur a financial loss if the borrower failed to repay the loan. Like a commercial bank, the loss recorded by the central bank will ultimately be absorbed by its capital. The central bank will then find itself with €1 billion less capital.

What happens next? From a theoretical point of view, a central bank that incurs capital losses is supposed to be recapitalized by the government. Let’s apply this to the ECB: the governments that initially « gained » €1 billion will have to give up part of that €1 billion as part of the central bank’s recapitalization[1]. €1 billion minus €1 billion = €0. The debt cancellation will have had no major effect in the long term[2].

The only way debt cancellation could change anything would be if the Central Bank did not need the level of capital it has. But in that case, there is no need to go through debt cancellation: it would simply be enough to ask the Central Bank to transfer its « surplus » capital to the states[3]. Debt cancellation is therefore, theoretically speaking, nothing more than a pipe dream that addresses the problem from the wrong angle. Asking the central bank to cancel part of the debt is tantamount to asking the central bank to have less capital if we want this to have an impact on the government’s explicit debt. This therefore implicitly amounts to supporting one of two arguments: either the central bank has too much capital, or the central bank’s capital is not useful to it. The first is difficult to judge, as central bankers themselves have been grappling with the question of a central bank’s capital requirements for many years. The second is theoretically valid only in an ideal world; in practice, the need for financial independence of central banks, as well as their credibility, often depends on it.

It is on these last two arguments that the debate should therefore focus when the idea of « debt cancellation by the central bank » is proposed. By ignoring these debates, this type of proposal clearly appears idealistic, placing the emphasis in the wrong place.