The Case for Consumption-Linked Perpetuities in the Eurozone

The real value of the euro can ultimately only be sustained through some form of fiscal support. However, this guarantee is currently implicit rather than explicit. Such a vague commitment is problematic for various reasons, not least of which being that support should arguably be provided proportionately by all eurozone member states.

It is sometimes argued that the eurozone should therefore become a full-fledged fiscal union, with significant taxing authority delegated to the EU. I believe this to be politically impossible. Moreover, as I will argue, it is not necessary anyway.

I propose a relatively simple and innovative solution for collective support of the euro, namely the issuance of consumption-linked perpetuities. These perpetuities, financed by a small and flat value-added tax (VAT) across the entire eurozone, could play a crucial role in ensuring a more predictable and stable monetary environment.

The Mechanics of Consumption-Linked Perpetuities

Consumption-linked perpetuities are a type of perpetual bond, meaning they have no maturity date and indefinitely pay a steady stream of dividends. These perpetuities would be financed by a small, flat VAT. Various institutions and individuals could hold these perpetuities, but the European Central Bank (ECB) would only be allowed to hold these perpetuities on its balance sheet, and no other types of securities. This creates a unique mechanism for stabilizing the euro. The ECB would have interest-paying reserves and physical currency as its only liabilities.

One distinctive feature of this system is that the ECB would not need to control the size of its balance sheet. Rather, the market would determine this, as individuals and institutions would be free to buy and sell perpetuities from and to the ECB at a fixed price.

Setting the Interest Rate and Perpetuity Price

1. Interest Rate on Reserves:

The ECB could set the nominal interest rate on reserves according to a fixed rule that reflects real economic activity, such as a moving average of perpetuity dividends. This would create a direct link between the ECB’s monetary policy and economic conditions in the eurozone. For example, if VAT revenues increase, signaling higher consumption and economic activity, the ECB could raise the interest rate on reserves. Conversely, if VAT revenues decline, indicating a slowdown in consumption, the ECB could lower the interest rate. If the ECB manages to set the interest rate equal to the return on perpetuities, then the value of a dollar will remain constant.

Countries like Brazil, which already have real-time VAT reporting requirements, demonstrate that it is feasible to implement such a system. Real-time or high-frequency dissemination of VAT data would allow the ECB to make timely adjustments to interest rates, ensuring that monetary policy remains responsive to current economic conditions. This rule-based approach would enhance the predictability and transparency of monetary policy, reducing uncertainty for market participants.

2. Price of Perpetuities:

The price of a perpetuity is determined by the balance sheet of the ECB. For example, if the ECB held 1 trillion perpetuities but issued €4 trillion in reserves and currency, then the price of a perpetuity would simply be €4. When the ECB pays interest, its liabilities increase, meaning that the dollar price of a perpetuity would increase (i.e., inflation), similar to a stock dilution. When the ECB receives dividends from the perpetuities (which are settled in reserves), then the value of perpetuities will drop (just as with stocks after they pay dividends). However, the value of the ECB’s assets would not be affected. So for instance, if the ECB held 1 trillion perpetuities but also €1 trillion, and had €4 trillion in liabilities, then the price of a perpetuity would be €3. In effect, the ECB is holding its own liabilities as assets, similar to treasury stock held by a corporation.

Estimating the Required VAT Rate

To determine the feasibility of this proposal, consider a back-of-the-envelope calculation using the Gordon asset pricing model, which is given by P = D/(r-g), where P is the price of the perpetuity, D is the dividend (VAT revenues), r is the real interest rate, and g is the growth rate of the dividend.

Given that the total sovereign debt in the eurozone is around €12 trillion, and the ECB’s current balance sheet is about €8 trillion, let us set a goal of issuing €8 trillion in consumption-linked perpetuities. Assume that the real interest rate minus the growth rate of consumption (r — g) is 1%.

It is straightforward to calculate that we would need to raise D = €80 billion each year, for which a VAT rate of 1% would suffice.

The transition could be implemented gradually, with governments slowly issuing more and more perpetuities. The revenues from issuing these perpetuities could (and arguably should) be used to reduce existing sovereign debts. Likewise, the ECB could gradually shift its holdings to an ever greater concentration of perpetuities. Once the ECB only holds perpetuities, it can officially switch to the pricing rule outlined above.

Additional Benefits

1. Market-Determined Monetary Policy: Allowing the ECB’s balance sheet size to be determined by the market introduces a novel form of monetary policy. The ECB would no longer need to engage in active bond purchases or sales to manage inflation or the money supply. Instead, the value of the euro would be stabilized through the demand for perpetuities, directly linked to consumption in the economy.

2. Inflation Stabilization: Since the ECB’s liabilities are interest-paying reserves, funded by VAT-linked perpetuities, there is a direct link between the central bank’s monetary policy and the real economy. This could lead to more predictable inflation outcomes, as the interest rate set by the ECB would follow a rule based on VAT revenues, which reflect real economic activity.

3. Risk Containment in Sovereign Debt: While countries would be free to issue other types of debt securities, these would be considered risky and not be eligible for purchase by the ECB. This distinction would create a clear separation between safe, consumption-linked perpetuities and riskier debt instruments, helping to contain sovereign risk and preventing contagion within the eurozone. In addition, banks would only be allowed to finance fixed value deposit accounts with ECB reserves, and no longer with sovereign debt (or any other risky asset). This would ensure that there will never be a mismatch between the value of a bank’s assets and liabilities, which can create significant financial instability, in particular, runs.

Conclusion

The introduction of consumption-linked perpetuities in the eurozone, financed by a small VAT, offers a promising solution to several of the region’s economic challenges. By stabilizing inflation, creating a market-driven monetary policy framework, and enhancing transparency, this proposal could strengthen the eurozone’s economic stability. The rule-based approach to setting the ECB’s interest rate on reserves and the price of perpetuities would tie monetary policy directly to real economic activity, leading to a more predictable and stable economic environment.