Manna From Heaven and Government Debt



  • Government debt is a growing problem that needs immediate attention but gets "head in the sand" treatment from politicians.
  • The ECB is driving investment-grade bond prices in excess of principal and interest, which results in negative interest rates and is Manna from Heaven for the sellers.
  • This ultimately puts private institutions on a collision course toward not being able to fulfill their contractual obligations.


Baby Boomer entitlements, long viewed as an over-the-horizon problem, are now upon us. These unfunded liabilities are morphing from a forecast into actual debt — a process that will continue for decades — and the accumulated debt is already undermining aggregate economic performance. It’s a problem that is crying out to be addressed, and the sooner the better.

The implications of government debt accumulation have been the subject of posts on The Spellman Report and throughout the blogosphere, but the topic usually receives a “head in the sand” treatment from governments and politicians alike because the implied cure — to rescind entitlements — is a political third-rail.

If not addressed, debt default ultimately occurs, but that doesn’t seem to even arouse a response other than the hope that it occurs on someone else’s watch. (Observe the Greek debt theater being played out.)

So the question is: What fixes can governments apply now that can still sustain the economy and all the things that go with it? Certainly supply-side policy should be front and center in that discussion. Everything the government does needs to be viewed from the prism of economic growth, which provides the income to sustain debt.

Having run out of conventional solutions within a government toolbox of macroeconomic fixes, the European Central Bank (ECB) is implementing a desperate (or some might say a "creative" and "subtle") use of its money-printing ability. Sadly for Europe though, it will have unfortunate side effects.

The policy, while being labeled quantitative easing (QE), is much more than a monetary policy to create extreme low interest rates. It also has a Manna from Heaven component that can be used for multiple purposes. Allow me to explain.

Quantitative easing originated in Japan and also turned up in the U.S. as large-scale central bank bond purchases. While it seems on the surface to be Keynesian interest rate policy, its more pressing, unspoken reason was debt service containment, both for government and private debt.

Manna from Heaven is unleashed when QE, as implemented by the ECB, is taken to the next extreme level. The ECB intends to buy a large quantity of Euro investment-grade debt, including sovereign debt on secondary markets. To reach their target requires that the ECB offer a higher price to induce present owners of investment-grade debt to sell their holdings to the central bank.

Investment-grade bond purchases by the ECB have been targeted to be approximately twice the current issuance of investment-grade debt (for both private and government issuers), hence reducing the available supply of investment-grade bonds in the market. That puts financial institutions and foreign central banks in a bind given their mandates to hold bonds of this character.

Therefore, there is great competition for Euro-denominated investment-grade debt, and it becomes scarcer with each ECB purchase, driving investment-grade bond prices not just higher but in excess of the principal and all interest until maturity for most debt issues.This is the definition of negative interest rates and reveals how it comes about for market-traded debt. The premium prices paid for by new money issuance is the Manna from Heaven and generates windfall gains for the sellers.

And in the hope of not being considered too irresponsible, the ECB has put a cap on the price premium above the bonds’ total proceeds of 20 percent (which puts a floor under just how “negative” interest rates can go).

Despite the premium prices the ECB is willing to pay for investment-grade bonds, it has come to believe that there will not be sufficient availability of offered bonds on secondary markets to meet their quantity objectives. As a cover narrative, they claim their quantity goals can only be reached if they also purchase original issuance of Euro sovereign bonds at up to the 20 percent premium despite the Euro prohibition on such transactions.

Now think about what that means, as it means a lot.

First, the premium prices paid produce negative yields not only for the central bank buyer but also for pension funds, insurance companies, banks, and endowment obligations (or savers in general who invest in this market). While the central banks can “afford” negative yields, most certainly the private institutions cannot — and they are ultimately on a collision path of not being able to fulfill their contractual obligations when their investment income derived from bonds declines so dramatically. They then become future government bailouts waiting to happen that would substantially add to government debt.

Second, the ability of the central bank to pay premium prices for investment-grade bonds results in windfalls for both debt holders and debt issuers. For them it’s veritable Manna from Heaven financed via central bank printing.

Third, with the price paid being greater than all future commitments on the part of the debt issuers’ means there now becomes a large incentive to keep issuing debt, including government issuers, as they receive greater proceeds than their corresponding obligations. Or to put it another way, they are being paid to borrow.

Fourth, the Manna becomes a new free policy option for governments. Their choice becomes to use the excess cash proceeds to either retire other government debt obligations and dissolve their debt overhang or will they choose to issue yet more debt for which they are being paid? Or yet will they take the cash proceeds and lock up an amount equal to their future obligations of principal and interest and spend only the Manna? They are being given those three options by the ECB. Whatever way is chosen, it’s an incredible test of the inclinations of government to act responsibly and address the debt problem or keep on spending and borrowing.

Fifth, irrespective of governments’ use of the Manna, there is a balance sheet effect for the government whose debt is purchased by its own central bank.

As an aside, when the ECB as a policy board orders a buy of a country’s debt, it is purchased by the country’s own central bank. (Yes, the individual country central banks continue to exist even though there is an ECB. The individual country central banks are the operational banks within the Euro system, as are the 12 Federal Reserve Banks carrying out Federal Reserve policy.)

Now, if a Euro central bank purchases its own government’s debt, it defeases (annuls) that debt. A balance sheet defeasement occurs when the government and its central bank balance sheets report on a consolidated basis. The debt of the parent organization (the government) is owned by its subsidiary (its central bank) and, as a result, only net debt not owned by the subsidiary can be reported. Indeed, the U.S. now reports government debt outstanding on a net basis to mollify those concerned about government debt balances.

Sixth, the ugly government debt problem disappears (on a net basis) when central banks buy its sovereign’s debt and pays monetary premiums for it but, in its place, there is a classic fear that there will be an inflation tax. That is a real reduction in the value of fixed income assets held by the public due to inflation. This is a fear that is totally justified despite today’s weak and deflationary-prone environment, as the increase in the monetary base would be very, very large.

For example, in the U.S., if the Fed were to monetize the total outstanding $18 trillion of U. S. government debt, and with some premium paid above that amount equal to the ECB premium, the total monetary base would easily go above $20 trillion. This compares to a monetary base of $0.8 trillion at the outset of the Great Recession. That would cause a 25-fold or 2500 percent increase in the money base as compared to a cumulative 13 percent increase in real output over the same period. It might take some time to play out but this will certainly lead to inflationary devaluing of fixed income assets and currency and result in capital flight to a more stable medium of exchange.

This is no way to run a government and its finances if a country expects the world and its own citizens to hold wealth denominated in its own currency. Indeed, it is second-best policy not just due to the inflationary potential but also as a result of undermining insurers, pension funds, banks, and endowments to perform on their obligations. Furthermore, negative yields create a poverty class of retirees, of which there will be many.

But somewhere between zero defeasance and total defeasance of government debt is likely to be a better place for debt overloaded countries, giving them the option to use the proceeds to retire rather than squander the proceeds or give in to the incentives to borrow and spend even more.

Manna from Heaven, on its face, can be helpful if done on a very limited and disciplined scale, but when have we ever seen governments do that? The Manna becomes a litmus test of governments’ inclination to act responsibly and effectively, as it could either defease debt or be incentivized to add to debt.

At best it can only be a small help as compared to policies to unleash the supply-side of the economy to generate growth that will sustain the developed world’s debt problems.

Given all this, we find that the monetary sleight-of-hand to produce Manna only goes so far before producing unwelcome side effects. It’s not a replacement for containing debt within supportable limits. All in all, John Maynard Keynes did a disservice some 80 years ago to suggest otherwise.

We must conclude that the rules of propriety have changed. Many naïve among us believed that when governments borrowed, they intended to subsequently tax in order to retire debt. But at least it was thought that taxes would pay interest to service the debt. This, too, has proven to be a false premise as central banks drive interest rates to zero or negative to accommodate over-indebted governments. And now in the final assault on propriety, governments are being paid by central banks to issue yet more debt.


The views expressed are those of the author and not necessarily The University of Texas at Austin.

About The Author

Lew Spellman

Professor, Department of Finance, McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

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