Debt monetization

Debt monetization or monetary finance is the practice of a government borrowing money from the central bank, which, in the process of buying the debt, creates new money. It is one of the practices often informally called printing money. This practice allows a government to finance its deficit without creating money directly—which is prohibited in many countries—and also without increasing debt to private parties. Generally considered dangerous because it risks creating runaway inflation, various forms of debt monetization have occurred as part of national responses to the COVID-19 pandemic and its economic impact.

Overview

When a government increases its spending, it can pay for the new spending by increasing its revenue, principally by raising taxes, or it can go into deficit—allowing the spending to exceed the revenue. The deficit can be financed by either increasing the amount of government bonds held by the public (public borrowing) or by increasing the monetary base (often informally called "printing money").[1] In developed countries, such as the United States, the government is not allowed to create new money and this power is in the hands of the central bank, but debt monetization provides ways for it to still finance new spending by new creation of money.[2][3]

Debt monetization can occur in several ways. The central bank can buy the bonds issued by the government, thereby absorbing the debt that would have otherwise been sold through the financial markets, or the government can simply be allowed to have a negative balance. In either case, new money is effectively created, and government debt to private parties does not increase.[3] Because of the newly created money, debt monetization is among various practices frequently referred to as "printing money".[2]

Policy debate

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 or more recently in Venezuela.[3] Such an outcome can also result from debt monetization, if deficit persists over a long time and money supply continues to accumulate.[2] This fear of inflation causes it to be a "longstanding taboo" among policymakers.[4]

On the other hand, there are arguments among economists for this practice as an emergency measure. 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. In addition, national responses to the 2007–2009 Great Recession showed that money can be injected into economies in crisis without causing inflation.[3] In addition, deflation is seen as a bigger threat than inflation during the pandemic.[4]

Comparison with quantitative easing
Further information: Quantitative easing

Quantitative easing (QE) is a related policy in which the central bank buys financial assets, including government bonds through the secondary markets, in order to stimulate the economy. According to the business publication Bloomberg, "the dividing lines are blurry" between QE and debt monetization. Although in theory, QE is intended to lower borrowing costs for the entire economy, in practice governments have been its main beneficiary. In addition, assets bought by the central bank as part of QE often remain in its possession rather than sold back to the markets.[3]

Restrictions and practices

In the Eurozone, Article 123 of the Lisbon Treaty explicitly prohibits the European Central Bank from financing public institutions and state governments.[5] 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.[6]

In Japan, where debt monetization is on paper prohibited,[7] the nation's central bank "routinely" purchases approximately 70% of state debt issued each month,[8] and owns, as of October 2018, approximately 440 trillion JP¥ or over 40% of all outstanding government bonds.[9] 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.[4]

Bank Indonesia (pictured) agreed to directly purchase about US$27.4 billion of government debt in July 2020

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.[4] 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.[10] 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.[4]

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. Mishkin (2003), p. 644
  3. Holland, Ben (2020). "How Long-Feared 'Monetary Finance' Becomes Mainstream". Bloomberg L.P.
  4. Ben Holland, Liz McCormick, and John Ainger (15 May 2020). "Pandemic Bills Are So Big That Only Money-Printing Can Pay Them". Bloomberg Businessweek.CS1 maint: uses authors parameter (link)
  5. Fiscal policies, ECB
  6. 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.
  7. "Editorial: Bank of Japan's scrapping of state bond purchase ceiling carries risks". The Mainichi. 28 April 2020.
  8. 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.
  9. Gov't Bonds, Bank of Japan
  10. Grace Sihombing and Tassia Sipahutar (6 July 2020). "Bank Indonesia Agrees to Buy Government Debt to Fund Budget". Bloomberg L. P.CS1 maint: uses authors parameter (link)
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