The Financial Express

Fiscal deficits and debt monetisation

| Updated: February 23, 2021 19:27:44

Fiscal deficits and debt monetisation

Governments around the world both in developed and developing countries have been responding to the Covid-19 pandemic generated economic downturns with large fiscal support programmes. These programmes allocate billions of dollars in direct payments, tax breaks, business subsidies and other relief measures. The size and scale of these programmes have led most governments to run massive budget deficits than would have been the case in normal circumstances. In general governments use two principal methods to finance their fiscal deficits-- to borrow or raise taxes. But there is a third option also available which is known as debt monetisation.

To assist governments in their financial response to the pandemic, most governments have been pursuing the third option, debt monetisation. Central banks in those countries have been purchasing large volumes of  government bonds  as a part of debt monetisation. This is a  strategy rarely used by developing countries in the past. Such a policy orientation could have wider long run implications for these countries.

Theoretically, any government that issues its own currency could continue to create its own money without limit. But there is always the fear that excessive printing of money and spending that money can lead to inflation, or even hyperinflation as happened during the Weimer Republic period in Germany before the second World War. The idea that governments either tax or borrow or a combination of the both to spend is the result of legal and institutional constraints imposed by the state. Governments around the world have delegated responsibility of money issuance to independent central banks. Such an institutional framework also enables countries to keep fiscal policy considerations separate from monetary policy.

Central banks, including Bangladesh Bank, are  responsible for implementing monetary policy. That involves to keep inflation low, stabilise the business cycle and  promote growth  to keep unemployment low. Central banks, therefore, to fulfill their mandate  are constantly engaged in  open market purchase and sales  of government bonds and other securities to ensure that the economy has enough liquidity (money available) or the cost of liquidity (interest rates) achieves certain levels and moves in the desired direction.

To achieve those monetary policy objectives, if  the central bank wants to lower interest rates, it increases money supply or creates money and uses that money to buy government bonds (government debt). As such one can argue that that the central bank is involved in monetising and demonetising over the course of a typical business cycle. But in the strictest sense of the term "monetisation",  when the central bank buys government bonds, it is not  monetising the debt issued by the government.

The term "monetisation" broadly implies the process of converting something into money. The monetisation of debt means the use of money creation as a permanent source of financing fiscal deficits, that is government spending exceeding revenues.  The financing of such extra expenses involves the purchase of government bonds by the central bank. In doing so, the central bank implicitly agrees to hold the bonds in perpetuity by rolling over government bond at maturity and also handing over interest incomes  thus earned over to the government. This is happening in most advanced economies as reflected in their Debt/ GDP ratio in countries such as the US (108 per cent), the UK  (81 per cent) and  Japan (237 per cent).

Debt monetisation can also address other problems apart from financing fiscal deficits as is happening now on a global scale. It can mitigate deflation and stimulate moderate inflation. By stimulating inflation, it can then reduce the real value of the government's outstanding debt obligations. In fact, stimulating inflation is a part of the plan.

Since the central bank creates fresh money to purchase these bonds in the open market, debt monetisation leads to an increase in total money supply. Such increased money supply exerts downward pressure on interest rates, thus stimulating consumption and investment spending, putting upward pressure on price levels (inflation).  While  interests rates over the last decade and a half have remained low, even in many countries have moved into the negative territory, there has not been any upward pressure on price levels, i.e., inflation. In fact, inflation and inflation expectations remain very low despite such low levels of interest rates.

Such incongruity between interest rates and inflation is to be understood to know how inflation is measured. Inflation is measured by the Consumer Price Index (CPI). Without going into the debate on the basket of goods and services included to measure the CPI, the  low rate of inflation can largely be explained by the fact  that increased money supply  did not cause increased velocity of money ( volume of transactions), thus did not put pressure on the price level.

The reason for low volume of transactions is  very high levels of unemployment and underemployment that have been experienced both in developed and developing countries since the Global Financial Crisis (GFC) of 2007-08.That has reduced consumption expenditures, thus  making new investment expenditures to produce goods and services not profitable. Therefore, once money reaches  the business outlets, it largely sits there and then moves to banks and from there to the stock market to make speculative gains. 

This increased supply of money would also be permanent and would remain in the economy either as cash in circulation or bank reserves. The remitted interests earned by the government can now be  spent  for free without interest charges or can borrow more. The monetisation of debt relieves the government  from budget constraints giving the government more fiscal space, especially when the government is already heavily burdened with debt. Also, when the government has access to limitless money, given that economic resources are limited, the situation  gives rise to the possibility that the government could control that limited resources thus "crowding out" the private sector.

In this context. a related policy known as Quantitative Easing (QE) needs to be distinguished. For QE the central bank  buys financial assets including government bonds from the secondary markets, i.e., banks. These assets particularly government bonds have value but bank debts on mortgage etc., are of less value. These assets bought by the central bank as part of QE often remain in its possession, rather than sold back in the market again.  The initial cost to government for this is zero. The real beneficiary of QE is the bank as all these dodgy bank assets are now owned by the government, but the bank gets the cash, therefore, it gets wealthier because this not like SWOP.

QE is ostensibly done to stimulate the economy by encouraging bank lending for investment to lower borrowing cost for the whole economy. The government could have done  so by lowering interest rates but it can not do so now as interest rates are already very, very low indeed. However, the government benefits financially by buying up its own debt and thus reducing it. By doing so, the government reduces debt interest payments as well as creates further space for further borrowing keeping the  debt level as before. This is why many do argue that the dividing line between QE and debt monetisation is quite blurred.

Furthermore, Debt monetisation and QE also have  blurred the dividing line between monetary policy and fiscal policy. In effect, monetisation of debt has created an environment which could be labeled  a "fiscal dominance regime". Therefore, the central bank, in effect, has been turned into another government organisation despite its being considered as an autonomous body to pursue its mandated policy.

Any government that issues debt in excess of what it could collect in taxes will likely pay higher interest rates. Therefore, a government fiscal policy operates within definite market constraints. As such debt monetisation can weaken the disciplining effects of  budget constraints when central banks using their power to create money  to accommodate massive deficit spending by the government, inflate the government's debt  to levels where it is not clear how or if ever it will pay  off the debt.

To assist governments around the world to respond to the Covid- 19 pandemic, central banks have been purchasing government bonds as part of a debt monetisation programme. However, high carry over debt carries significant risk, in particular for developing countries since this can make them more vulnerable to external shocks. Of particular interest is absorption of government debt from the secondary market. Critics say that such debt monetisation could trigger higher levels of inflation and weaken the value of the currency in addition to the risks of holding more substantial percentage of national debt.

 As debt monetisaton involves the roll over of debt, that can become quite difficult to do in a period of financial stress. Very high levels of government debt  can limit  the size of and effectiveness of fiscal stimulus and can slow down long-term growth prospects. However, the benefits of debt monetization of fiscal deficits would outweigh the associated costs of such an action in times of serious economic crisis as we face now, especially when inflationary consequences of such a policy is not  at all substantial as it is right now. More importantly, central banks will still continue on their price stability mandate while trying to stimulating growth to reduce unemployment.

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