Make room for fiscal action through debt conversion

Vesa Vihriälä 15 April 2020



The corona crisis is a massive supply shock turning rapidly into an equally massive demand shock.  A wide consensus exists that a large-scale fiscal expansion stemming not only from automatic stabilisers but also from discretionary measures is necessary.

The starting point for fiscal expansion is unfortunately far from ideal in the euro area because of the high level of public debt – almost 90% of GDP – prior to the crisis. More importantly, some countries have debt levels that clearly make them vulnerable to doubts over debt sustainability. Even more unfortunate is that the corona shock has hit some of these fiscally vulnerable countries hardest, notably Italy.

Coronabonds are a non-solution

The vulnerable countries – rightly – point out that the current shock is not of their making and, if European solidarity has any meaning, it should be forthcoming now.  Therefore, these countries and many economists have proposed a completely new financial instrument, Coronabonds, guaranteed by all member states by a joint and several guarantee, as a way to finance the necessary expenditures of the highly indebted countries. 

The Coronabond is a temporary version of the old Eurobond idea. That is why countries whose own public finances are in a better shape are resisting the idea. They see it as a way to start a permanent programme, which would lead to increasing mutualisation of the risks associated with the debt issued by countries pursuing imprudent fiscal policies. This has been politically impossible for many countries to accept; it is considered unfair by large parts of their populations. The argument is that while the current shock is not due to bad policies by individual countries, the fiscal vulnerability is. 

Old and new debt instruments

This unwillingness to engage in direct debt mutualisation has prompted the search for other solutions. They now involve some reallocation of EU budget towards coronavirus-related expenditures in member states. This implies modest transfers to the countries hit by the greatest healthcare problems.

But the bulk of the measures take the form of credits. This applies to the new vehicle, SURE, the €100 billion mechanism set by the EU Commission to borrow funds against the future EU budget to refinance national unemployment insurance schemes. Additional EIB funding to the private sectors is also loans.  

The decision on 9 April to use the European Stability Mechanism (ESM) belongs to the same category. It makes an ESM credit line available to finance coronavirus-related healthcare expenditures up to 2% of GDP. While this is a creative way of using the existing crisis institution for the crisis at hand, it is problematic at the same time. First, particularly when limited to healthcare expenditures, it may not help the worst affected countries sufficiently. Second, the new credit line is effectively without conditions, blurring the original idea of the ESM support, which is supposed to be a bulwark against threats of financial instability by means of strictly conditional loans. 

The essential thing is that all of these instruments add to the debt burden of the already highly indebted countries. 

In the end, it is up to the ECB

Given the limited size of the aforementioned programmes and the high debt levels of the relevant countries, the avoidance of a new debt crisis continues to depend on the ECB, as the purchaser of last resort of government debt.  

So far, the ECB has managed to be very effective in providing liquidity not only in aggregate but also with regard to limiting the spreads between different countries’ bonds. The new programmes, especially the Pandemic Emergency Purchase Programme (PEPP), serve the same twin objectives, particularly as the PEPP involves a significant degree of flexibility with regard to country composition. The new programmes also show the ECB’s ability to take swift and quantitatively decisive actions. 

The question, however, is how far the ECB can go with debt purchases, which deviate from the capital key, to assist fiscal expansion of the member states vulnerable to doubts over debt sustainability. Guaranteeing liquidity can easily drift into guaranteeing solvency, which is a deeply political issue and is certainly not part of the ECB mandate (Beck 2020).

Applying PEPP with a lot of flexibility approaches OMT but without conditionality. For the OMT, the conditionality requirement is at least in principle stringent: “A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme.” This, like the conditionality on the ESM loans themselves, is not for nothing. It exists to ensure that credits remain credits, and will not turn into unintended transfers.

Importantly, the bond purchases by the ECB, presumed to be temporary monetary policy actions, do not solve the fiscal conundrum; sovereign debt levels increase strongly, including in the highly indebted countries like Italy. While the additional burden is not overwhelming with low interest rates, things may change in the future.

A stock operation as a solution 

The need to be able to run deep deficits in the current situation directs attention to possible ways of reducing debt levels by stock operations. The first option is debt restructuring. However, subjecting particularly a large country to restructuring in the midst of a worldwide economic crisis would almost certainly lead to a massive financial crisis, the very thing one wants to avoid.

The second option is debt relief by the ECB on all countries’ debt. Converting a fraction of the sovereign debt held by the ECB (or better the European System of Central Banks, or ESCB) into perpetuity with zero coupon would ease the debt burden instantaneously.1 Monetary financing strictly speaking, yes. But how different economically from the continued holdings and rollover of large amounts of the same sovereigns’ debt at (close to) zero rates? Relative to trusting the ECB to continue to pursue extremely accommodative policies for undetermined period of time, such a conversion would make debt relief certain. This would make a significant difference in the eyes of the investors in government bonds. 

The conversion would contribute to anchoring inflation expectations at a higher level, given that undoing the associated stimulus would require active tightening measures by the ECB. This would help the ECB to achieve its inflation target at a juncture where the well-below-the-target-inflation economy is hit by an extraordinary shock. In this sense, the conversion would serve the ultimate purpose of price stability against the threat of deep deflation, even if it would bend one of the institutional constraints set to prevent a route to accelerating inflation. 

A key point is that if the conversion took place in relation to the capital key, it would not involve any direct transfers between member states, and thus would not reward imprudent behaviour any more than prudent behaviour.  The capital key-based relief would also match very well the broadly symmetric nature of the shock. 

The size of the conversion should be big enough to bring debt-to-GDP ratios to lower levels even after the increase in current deficits by at least 10 percentage points. On the other hand, the stock of the Eurosystem-held sovereign bonds, currently somewhat over €2,000 billion or some 18 % of euro area GDP, is a technical upper limit, though increasing rapidly. Any share around 20% is also well below the present value of ECB seigniorage income consistent with 2% inflation in most scenarios (Buiter 2019).This means that such a debt relief should not excessively threaten price stability even in the longer run.2

A clearer division of labour of the instruments

The proposed debt relief would allow all member states to finance the necessary fiscal measures in a normal fashion. It would not eliminate the moral argument for burden sharing by all member states of part of the shock, which has been exceptionally large for some of them. But it could reduce the size of the needed transfers to a level which would be easier to agree on, be it through the reallocation of the future EU budget contributions (Gros 2020) or otherwise.  

Should member states still have financing difficulties, the ESM and the OMT programmes with the appropriate conditionality would be the right instruments to meet such challenges. A significant reduction of the effective indebtedness of all member states might also help to expand the resources of the ESM. This would be helpful in meeting future financial stability threats and obviously benefit most the member states at greatest risk of market pressures. 

The proposed debt conversion is very close to the helicopter money proposals by Gali (2020) and Kapoor and Buiter (2020).  A difference is that here the debt relief would be a part of package that would seek to maintain a clear division of labour between programmes that involve, or are likely to involve, politically sensitive transfers between member states and liquidity provision.

A Münchausen scheme?

Why could a conversion scheme like this help alleviate the constraints of the highly indebted states? After all, the budget constraints of the states including their central banks would not change as a result; the reduction of the nominal debt service burden of the states would be exactly compensated by a reduction of seigniorage income from their respective central banks. 

What changes is inflation. As noted, the conversion would make a significant part of the current monetary expansion permanent unless undone by active policy measures. This would ultimately result in more inflation than currently on the cards, which would transfer some of the real burden from debtors to creditors. This applies to sovereign debtors as well as to private ones. And obviously, to the extent the fiscal expansion facilitated by the scheme lifts real economic activity, it would also contribute to better debt service capacity. 

Additional inflation would imply some transfers also across national borders. But unlike in a Coronabond/Eurobond scheme, there would not be any explicit commitment by governments to share other sovereigns’ credit risk now or in the future. The member states would remain responsible for their debts, supporting incentives of the governments to pursue prudent policies. These incentives could also be strengthened by making debt restructuring a more credible way of solving debt sustainability problems in the future.  A reform of ESM statutes with regard to debt sustainability requirement, stronger common action clauses and effective constraints on banks’ holdings of single sovereign debts would be ways of achieving this.

Exceptional times require exceptional measures

Effectively forgiving past debt obviously creates expectations that the same could happen again in the future. Nevertheless, this moral hazard should be weighed against what is likely to happen without such relief. 

Either fiscal expansion would fall badly short of what is needed in the highly indebted member states, or it would be financed by ever-increasing asymmetric ECB bond purchases, perhaps aided by a depletion of ESM resources before an acute financial crisis. The marginal financing – and, yes, solvency – of the vulnerable member states would become increasingly dependent on the ECB.

Both alternatives risk creating an existential crisis for the euro area and the whole EU. Not facilitating fiscal expansion in Italy and other highly indebted countries would be economically stupid and politically explosive. Increasing the dependence of these countries on the ECB (and the ESM) liquidity increases the likelihood that the liquidity support has to be recognised as solvency support for individual countries in not too distant future. What turn the events would take at that point is anybody’s guess, but it is not at all clear that the euro would survive. 

Compared with this perspective, the political and legal difficulties of the symmetric debt relief outlined should not be insurmountable. 


Beck T (2020), “The economic, political and moral case for a European fiscal policy response to Covid-19”,, 7 April.

Buiter, W (2019), Central Banks as Fiscal Players. The drivers of fiscal and monetary policy space, unpublished manuscript.

Gali, J (2020), “Helicopter money: The time is now”, Chapter 6 in R Baldwin and B Weder di Mauro (eds) (2020), Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes, a eBook, CEPR Press.

Gros, D (2020), “EU solidarity in exceptional times: Corona transfers instead of Coronabonds”,, 5 April.

Kapoor, S and W Buiter (2020), “To fight the COVID pandemic, policymakers must move fast and break taboos”,, 6 April.

Vihriälä, V and B Weder di Mauro (2014), “Orderly debt restructuring rather than permanent mutualisation the way to go”,,  2 April. 


1 This type of stock operation was discussed in a somewhat different context in Vihriälä and Weder di Mauro (2014).

2 As Estonia’s debt is less than 10% of GDP, the programme would have to involve a transfer other assets or issuing for example ECB CDs to Estonia to maintain equal treatment of all member states.



Topics:  Covid-19 EU institutions EU policies Europe's nations and regions

Tags:  COVID-19, coronavirus, ECB, debt relief

Professor of Practice, University of Helsinki, Graduate School of Economics


CEPR Policy Research