Debt monetization

Last updated

Debt monetization or monetary financing is the practice of a government borrowing money from the central bank to finance public spending instead of selling bonds to private investors or raising taxes. The central banks who buy government debt, are essentially creating new money in the process to do so. This practice is often informally and pejoratively called printing money [1] or money creation. It is prohibited in many countries, because it is considered dangerous due to the risk of creating runaway inflation.

Contents

Forms of monetary financing

Monetary financing can take various forms depending on the motivating policies and purposes. The central bank can directly purchase Government debt that would otherwise have been offered to public sector investors in the financial markets, or the government can simply be allowed to have a negative treasury balance. In either case, new money is created and government debt to private parties does not increase. [2]

Taxonomy of monetary financing
DirectIndirect or ex-post
Non-reimbursable

(permanent)

Direct monetary financing without corresponding asset on the balance-sheet Ex-post cancellation (taken from the Latin phrase for 'after the event') or conversion of public debts held by the central bank into perpetuities.
Reimbursable

(or reversible)

Purchase of sovereign bonds on primary market

Credit lines or overdrafts to the government at reduced or zero interest rate

Purchase of sovereign bonds on secondary markets (quantitative easing)

Direct forms of monetary financing

In its most direct form, monetary financing would theoretically take the form of an irreversible direct transfer of money from the central bank to the government. However, in practice monetary financing is most usually done in a way that is reversible, for example by offering costless direct credit lines or overdrafts to the government. The Bank of England can do this for example through its "ways and means" facility. [3] In these cases, a government does have a liability towards its central bank.

A second form of direct monetary financing is the purchase of government debt securities on issue (i.e. on the primary market). In this case, the central bank can in theory resell the acquired treasury bills.

Those forms of monetary financing were practised in many countries during the decades following the Second World War, for example in France [4] and Canada. [5]

Indirect forms of monetary financing

Quantitative easing as practised by the major central banks is not strictly speaking a form of monetary financing, due to the fact that these monetary stimulus policies are carried out indirectly (on the secondary market), and that these operations are reversible (the CB can resell the bonds to the private sector) and therefore not permanent as monetary financing. Moreover, the intention of the central bank is different: the QE programmes are not justified to finance governments, but to push down long rates in order to stimulate money creation through bank credit. The increase in the government deficit that these policies allow is presented as an unintended side effect. This is at least the legal view: for example the European Court of Justice has ruled that the programme does not violate the prohibition of monetary financing as laid down in the European Treaties.

However, it is often said that the frontiers are blurry between QE and monetary financing. Indeed, the economic effect of QE can be considered similar or even equivalent to monetary financing. Insofar as ECB QE effectively reduces the cost of indebtedness of Eurozone countries by lowering market rates, and as central banks pass on to governments the profits made on these public debt obligations, the benefit of QE policy is significant for governments. Some observers thus believe that the distinction between QE and monetary financing is hypocritical or at best very blurry.

Moreover, quantitative easing could become an ex-post monetisation of debt if the debt securities held by the central bank were to be cancelled or converted into perpetual debt, as is sometimes proposed. [6] According to the ECB, an ex-post debt cancellation of public debt securities held under QE would clearly constitute an illegal situation of monetary financing. [7]

Because the process implies coordination between the government and the central bank, debt monetization is seen as contrary to the doctrine of central bank independence. Most developed countries instituted this independence, "keep[ing] politicians [...] away from the printing presses", in order to avoid the possibility of the government, in order to increase its popularity or to achieve short-term political benefits, creating new money and risking the kind of runaway inflation seen in the German Weimar Republic [8] or more recently in Venezuela. [2]

In the Eurozone, Article 123 of the Lisbon Treaty explicitly prohibits the European Central Bank from financing public institutions and state governments. [9]

In the United States, The Banking Act of 1935 prohibited the central bank from directly purchasing Treasury securities, and permitted their purchase and sale only "in the open market". In 1942, during wartime, Congress amended the Banking Act's provisions to allow purchases of government debt by the federal banks, with the total amount they'd hold "not [to] exceed $5 billion." After the war, the exemption was renewed, with time limitations, until it was allowed to expire in June 1981. [10]

In Japan, where debt monetization is on paper prohibited, [11] the nation's central bank "routinely" purchases approximately 70% of state debt issued each month, [12] and owns, as of October 2018, approximately 440  trillion JP¥ or over 40% of all outstanding government bonds. [13] The central bank purchased the bonds through the banks instead of directly, and books them as temporary holding, allowing the parties involved to argue that no debt monetization actually occurred. [14]

The People's Bank of China (PBOC), is forbidden by the PBOC Law of 1995 to give overdrafts to government bodies, or buy government bonds directly from the government, or underwrite any other government debt securities. [15]

Bank Indonesia (pictured) agreed to directly purchase about US$27.4 billion of government debt in July 2020 Jakarta Indonesia Central-Bank-of-Indonesia-02.jpg
Bank Indonesia (pictured) agreed to directly purchase about US$27.4 billion of government debt in July 2020

Policy debate

Debt monetization and inflation

When government deficits are financed through debt monetization the outcome is an increase in the monetary base, shifting the aggregate-demand curve to the right leading to a rise in the price level (unless the money supply is infinitely elastic). [16] [17] When governments intentionally do this, they devalue existing stockpiles of fixed income cash flows of anyone who is holding assets based in that currency. This does not reduce the value of floating or hard assets, and has an uncertain (and potentially beneficial) impact on some equities. It benefits debtors at the expense of creditors and will result in an increase in the nominal price of real estate. This wealth transfer is clearly not a Pareto improvement but can act as a stimulus to economic growth and employment in an economy overburdened by private debt.[ citation needed ] It is in essence a "tax" and a simultaneous redistribution to debtors as the overall value of creditors' fixed income assets drop (and as the debt burden to debtors correspondingly decreases).

If the beneficiaries of this transfer are more likely to spend their gains (due to lower income and asset levels) this can stimulate demand and increase liquidity. It also decreases the value of the currency - potentially stimulating exports and decreasing imports - improving the balance of trade. Foreign owners of local currency and debt also lose money. Fixed income creditors experience decreased wealth due to a loss in spending power. This is known as "inflation tax" (or "inflationary debt relief"). Conversely, tight monetary policy which favors creditors over debtors even at the expense of reduced economic growth can also be considered a wealth transfer to holders of fixed assets from people with debt or with mostly human capital to trade (a "deflation tax").

A deficit can be the source of sustained inflation only if it is persistent rather than temporary, and if the government finances it by creating money (through monetizing the debt), rather than leaving bonds in the hands of the public. [16]

On the other hand, economists (e.g. Adair Turner, Jordi Gali, Paul de Grauwe) are in favor of monetary financing as an emergency measure. [18] [19] During an exceptional circumstances, such as the situation created by the COVID-19 pandemic, the benefits of avoiding a severe depression outweighs the need to maintain monetary discipline. [20]

In addition, the policy responses to the 2007–2009 Great Recession showed that money can be injected into economies in crisis without causing inflation. [2] Why? An economy in recession is a "deflating" enterprise. As the quantity of money in circulation declines, economic activity naturally recedes, reinforcing collapse. Economists would say that contraction is "sticky," on the downside. Thus, deflation was a far bigger threat than inflation during the pandemic. [14]

COVID-19 pandemic response

National responses to the COVID-19 pandemic include increasing public spending to support affected households and businesses. The resulting deficits are increasingly financed by debt that are eventually purchased by the central bank. The business publication Bloomberg estimates that the United States Federal Reserve will buy $3.5 trillion worth of bonds in 2020, mostly U.S. government bonds.

The Bank of England allowed an overdraft in the government account. [21]

In July 2020, Bank Indonesia agreed to purchase approximately 398 trillion rupiah (US$27.4 billion) and return all the interest to the government. In addition, the central bank would cover part of the interest payments on an additional 123.46 trillion rupiah of bonds. The central bank governor Perry Warjiyo billed the decision as a one-time policy. [22]

The economist Paul McCulley commented that despite the lack of an explicit declaration, the various policies represented the breakdown of the "church-and-state separation" between monetary and fiscal policy. [14]

Related Research Articles

<span class="mw-page-title-main">European Central Bank</span> Supranational central bank in Europe

The European Central Bank (ECB) is the prime component of the Eurosystem and the European System of Central Banks (ESCB) as well as one of seven institutions of the European Union. It is one of the world's most important central banks.

Financial capital is any economic resource measured in terms of money used by entrepreneurs and businesses to buy what they need to make their products or to provide their services to the sector of the economy upon which their operation is based. In other words, financial capital is internal retained earnings generated by the entity or funds provided by lenders to businesses in order to purchase real capital equipment or services for producing new goods or services.

<span class="mw-page-title-main">Fiscal policy</span> Use of government revenue collection and expenditure to influence a countrys economy

In economics and political science, fiscal policy is the use of government revenue collection and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variables developed in reaction to the Great Depression of the 1930s, when the previous laissez-faire approach to economic management became unworkable. Fiscal policy is based on the theories of the British economist John Maynard Keynes, whose Keynesian economics theorised that government changes in the levels of taxation and government spending influence aggregate demand and the level of economic activity. Fiscal and monetary policy are the key strategies used by a country's government and central bank to advance its economic objectives. The combination of these policies enables these authorities to target inflation and to increase employment. In modern economies, inflation is conventionally considered "healthy" in the range of 2%–3%. Additionally, it is designed to try to keep GDP growth at 2%–3% percent and the unemployment rate near the natural unemployment rate of 4%–5%. This implies that fiscal policy is used to stabilise the economy over the course of the business cycle.

<span class="mw-page-title-main">Debt</span> Obligation to pay borrowed money

Debt is an obligation that requires one party, the debtor, to pay money borrowed or otherwise withheld from another party, the creditor. Debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. In financial accounting, debt is a type of financial transaction, as distinct from equity.

<span class="mw-page-title-main">HM Treasury</span> Ministerial department of the UK Government

His Majesty's Treasury, occasionally referred to as the Exchequer, or more informally the Treasury, is a department of His Majesty's Government responsible for developing and executing the government's public finance policy and economic policy. The Treasury maintains the Online System for Central Accounting and Reporting (OSCAR), the replacement for the Combined Online Information System (COINS), which itemises departmental spending under thousands of category headings, and from which the Whole of Government Accounts (WGA) annual financial statements are produced.

<span class="mw-page-title-main">Government debt</span> Total amount of debt owed to lenders by a government/state

A country's gross government debt is the financial liabilities of the government sector. Changes in government debt over time reflect primarily borrowing due to past government deficits. A deficit occurs when a government's expenditures exceed revenues. Government debt may be owed to domestic residents, as well as to foreign residents. If owed to foreign residents, that quantity is included in the country's external debt.

In macroeconomics, an open market operation (OMO) is an activity by a central bank to give liquidity in its currency to a bank or a group of banks. The central bank can either buy or sell government bonds in the open market or, in what is now mostly the preferred solution, enter into a repo or secured lending transaction with a commercial bank: the central bank gives the money as a deposit for a defined period and synchronously takes an eligible asset as collateral.

<span class="mw-page-title-main">Money creation</span> Process by which the money supply of an economic region is increased

Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region, is increased. In most modern economies, money is created by both central banks and commercial banks. Money issued by central banks is termed reserve deposits and is only available for use by central bank accounts holders, which is generally large commercial banks and foreign central banks. Central banks can increase the quantity of reserve deposits directly, by engaging in open market operations or quantitative easing. However, the majority of the money supply used by the public for conducting transactions is created by the commercial banking system in the form of bank deposits. Bank loans issued by commercial banks expand the quantity of bank deposits.

Monetization is, broadly speaking, the process of converting something into money. The term has a broad range of uses. In banking, the term refers to the process of converting or establishing something into legal tender. While it usually refers to the coining of currency or the printing of banknotes by central banks, it may also take the form of a promissory currency. The term "monetization" may also be used informally to refer to exchanging possessions for cash or cash equivalents, including selling a security interest, charging fees for something that used to be free, or attempting to make money on goods or services that were previously unprofitable or had been considered to have the potential to earn profits. And data monetization refers to a spectrum of ways information assets can be converted into economic value.

Helicopter money is a proposed unconventional monetary policy, sometimes suggested as an alternative to quantitative easing (QE) when the economy is in a liquidity trap. Although the original idea of helicopter money describes central banks making payments directly to individuals, economists have used the term "helicopter money" to refer to a wide range of different policy ideas, including the "permanent" monetization of budget deficits – with the additional element of attempting to shock beliefs about future inflation or nominal GDP growth, in order to change expectations. A second set of policies, closer to the original description of helicopter money, and more innovative in the context of monetary history, involves the central bank making direct transfers to the private sector financed with base money, without the direct involvement of fiscal authorities. This has also been called a citizens' dividend or a distribution of future seigniorage.

Modern monetary theory or modern money theory (MMT) is a heterodox macroeconomic theory that describes currency as a public monopoly and unemployment as evidence that a currency monopolist is overly restricting the supply of the financial assets needed to pay taxes and satisfy savings desires. According to MMT, governments do not need to worry about accumulating debt since they can create new money by using fiscal policy in order to pay interest. MMT argues that the primary risk once the economy reaches full employment is inflation, which acts as the only constraint on spending. MMT also argues that inflation can be addressed by increasing taxes on everyone to reduce the spending capacity of the private sector.

“Global debt” refers to the total amount of money owed by all sectors, including governments, businesses, and households worldwide.

<span class="mw-page-title-main">Quantitative easing</span> Monetary policy tool

Quantitative easing (QE) is a monetary policy action where a central bank purchases predetermined amounts of government bonds or other financial assets in order to stimulate economic activity. Quantitative easing is a novel form of monetary policy that came into wide application after the financial crisis of 2007‍–‍2008. It is used to mitigate an economic recession when inflation is very low or negative, making standard monetary policy ineffective. Quantitative tightening (QT) does the opposite, where for monetary policy reasons, a central bank sells off some portion of its holdings of government bonds or other financial assets.

<span class="mw-page-title-main">History of Federal Open Market Committee actions</span>

This is a list of historical rate actions by the United States Federal Open Market Committee (FOMC). The FOMC controls the supply of credit to banks and the sale of treasury securities. The Federal Open Market Committee meets every two months during the fiscal year. At scheduled meetings, the FOMC meets and makes any changes it sees as necessary, notably to the federal funds rate and the discount rate. The committee may also take actions with a less firm target, such as an increasing liquidity by the sale of a set amount of Treasury bonds, or affecting the price of currencies both foreign and domestic by selling dollar reserves. Jerome Powell is the current chairperson of the Federal Reserve and the FOMC.

A sovereign default is the failure or refusal of the government of a sovereign state to pay back its debt in full when due. Cessation of due payments may either be accompanied by that government's formal declaration that it will not pay its debts (repudiation), or it may be unannounced. A credit rating agency will take into account in its gradings capital, interest, extraneous and procedural defaults, and failures to abide by the terms of bonds or other debt instruments.

Inflationism is a heterodox economic, fiscal, or monetary policy, that predicts that a substantial level of inflation is harmless, desirable or even advantageous. Similarly, inflationist economists advocate for an inflationist policy.

A distributional effect is the effect of the redistribution of the final gains and costs derived from the direct gains and cost allocations of a project. A project has a direct-profit redistribution effect and a direct-cost redistribution effect. But whether it is profit or cost, the redistribution effect can be expressed as a benefit to a group of people or department or region, and the loss to another party. In theory, the indirect profit and indirect costs can also be derived from the redistribution effect, and valued.

Sri Lanka declared the country was suspending payment on most foreign debt from April 12, 2022, kindling the Indian Ocean island's first sovereign default event and ending an unblemished record of repaying external debt despite experiencing milder currency crises in the past. By April Sri Lanka was suffering the worst monetary crisis in its history with a steeply falling rupee, high inflation and forex shortages which triggered shortfalls of fuel, power and medicine. Widespread public protests led to a political crisis. In March, the International Monetary Fund released a report saying publicly for the first time that the country's debt was unsustainable and required re-structuring. Authorities had advertised for financial and legal advisors to help negotiate with creditors shortly before the suspension was announced.

In 2009–2010, due to substantial public and private sector debt, and "the intimate sovereign-bank linkages" the eurozone crisis impacted periphery countries. This resulted in significant financial sector instability in Europe; banks' solvency risks grew, which had direct implications for their funding liquidity. The European central bank (ECB), as the monetary union's central bank, responded to the sovereign debt crisis with a series of conventional and unconventional measures, including a decrease in the key policy interest rate, and three-year long-term refinancing operation (LTRO) liquidity injections in December 2011 and February 2012, and the announcement of the outright monetary transactions (OMT) program in the summer of 2012. The ECB acted as a de facto lender-of-last-resort (LOLR) to the euro area banking system, providing banks with cash flow in exchange for collateral, as well as a buyer of last resort (BOLR), purchasing eurozone sovereign bonds. However, the ECB's policies have been criticised for their economic repercussions as well as its political agenda. 

References

  1. ↑ Mishkin, Frederic S. (2003). The Economics of Money, Banking, and Financial Markets (7th ed.). Addison Wesley. p. 643. ISBN   978-0-321-10683-4.
  2. 1 2 3 Holland, Ben (2020). "How Long-Feared 'Monetary Finance' Becomes Mainstream". Bloomberg L.P.
  3. ↑ "HM Treasury and Bank of England announce temporary extension to Ways and Means facility". www.bankofengland.co.uk. Retrieved 2021-03-27.
  4. ↑ Vincent Duchaussoy, Eric Monnet, La Banque de France et le financement direct et indirect du Trésor pendant la Première Guerre mondiale : un modèle français ?
  5. ↑ Ryan-Collins, Josh (December 2017). "Breaking the taboo: a history of monetary financing in Canada, 1930-1975". The British Journal of Sociology. 68 (4): 643–669. doi:10.1111/1468-4446.12278. ISSN   1468-4446. PMID   28783229. S2CID   22386890.
  6. ↑ "Cancel the public debt held by the ECB and 'take back control' of our destiny". www.euractiv.com. 2021-02-08. Retrieved 2021-03-27.
  7. ↑ "The simple answer is: no, we cannot do that, because the Treaties don’t allow sovereign debt cancellation. But, regardless of the legal aspects, cancelling debt would not be a good idea in general, and the debate is a digression. We are seeing that governments are able to issue a lot of debt and to do it at low interest rates in a sustainable way." https://www.ecb.europa.eu/press/inter/date/2021/html/ecb.in210131_1~650f5ce5f7.en.html
  8. ↑ Heimberger, Philipp. "Fiscal austerity and the rise of the Nazis". heimbergecon.substack.com. Retrieved 2021-03-27.
  9. ↑ "Independence". European Central Bank. 2016-04-27. Retrieved 2021-03-31.
  10. ↑ Garbade, Kenneth D. (August 2014). "Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks" (PDF). FRBNY Staff Reports no. 684. Federal Reserve Bank of New York.
  11. ↑ "Editorial: Bank of Japan's scrapping of state bond purchase ceiling carries risks". The Mainichi . 28 April 2020.
  12. ↑ Evans-Pritchard, Ambrose (10 August 2013). "Japan's Debt Has Officially Passed ¥1,000,000,000,000,000 — No Problem". The Daily Telegraph . Retrieved 8 March 2018.
  13. ↑ Gov't Bonds, Bank of Japan
  14. 1 2 3 Ben Holland; Liz McCormick; John Ainger (15 May 2020). "Pandemic Bills Are So Big That Only Money-Printing Can Pay Them". Bloomberg Businessweek .
  15. ↑ Gazette of the State Council of the People's Republic of China (in Chinese), Government of the People's Republic of China, 1 February 2004, retrieved 1 January 2022
  16. 1 2 The Economics of Money, Banking, and the Financial Markets 7ed, Mishkin
  17. ↑ The economics of the platinum coin option The Economist 9 January 2013
  18. ↑ Galí, Jordi (2020-03-17). "Helicopter money: The time is now". VoxEU.org. Retrieved 2021-03-31.
  19. ↑ Turner, Adair (2020-04-20). "Monetary Finance Is Here | by Adair Turner". Project Syndicate. Retrieved 2021-03-31.
  20. ↑ Grauwe, Paul De; Diessner, Sebastian (2020-06-18). "What price to pay for monetary financing of budget deficits in the euro area". VoxEU.org. Retrieved 2021-03-31.
  21. ↑ "Bank of England to finance UK government Covid-19 crisis spending". The Guardian. 2020-04-09. Retrieved 2021-03-31.
  22. ↑ Grace Sihombing; Tassia Sipahutar (6 July 2020). "Bank Indonesia Agrees to Buy Government Debt to Fund Budget". Bloomberg L. P.
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.