While central banks doing QE have maintained some separation from directly funding government deficits through purchasing assets in secondary markets until recent weeks , this distinction is superficial at best, since largescale central bank buying has helped to enable governments to borrow at ultra-low rates. While QE programs over the past decade have led to an increase in the monetary base, they have done little to increase money supply.
This was partially due to central banks paying interest on reserves at the central bank and a reluctance of banks to lend in the period right after the global financial crisis GFC.
Importantly, where QE programs thus far have fallen short in meeting monetization criteria has been their temporary nature. For example, the Fed was careful to justify QE as a key non-conventional tool to help achieve its inflation objectives. When these targets were achieved, QE was reversed in Although there appears to be little current appetite among central banks for abandoning current policy setting objectives in favour of debt monetization, this could change down the road as pressures mount and the appeal of monetization grows.
Notably, by the time the dust settles from this crisis, several countries will be facing much larger debt burdens and fiscal deficits Chart 2 and 3. Governments will have a few options to reduce debt. They can count on inflation, debt restructuring, financial repression, higher taxes, and wealth expropriation. From a political perspective, however, the most feasible option is to allow monetization induced inflation to eat away at debt.
The remaining options can have severe political repercussions. Until now, proponents of monetization were accused of heresy. And there were reasons for that. Accepting monetization and removing legal obstacles will give money-creating power to the government. Elected governments have short-term goals that are aligned with the election cycle, so they can ask for new money and more spending at opportune times, thereby allowing inflation to get out of control.
While unelected governments are not influenced by election cycles, coercing central banks to print more money is one way they maintain power. The government would welcome lower bond yields caused by the purchase of government debt by the central bank. A depreciated currency would also improve the current account balance, which could also be used for political point-scoring.
With monetization, the government can also cut taxes or increase expenditure without having to worry about future interest liabilities. Such convenient fiscal policy, especially during peak election cycles, will inevitably benefit the incumbent government.
However, on the flip side, monetization may also exacerbate wealth inequality as it would lead to an increase in asset prices. Therefore, households already holding assets for example, equities, real estate would see their wealth increase.
Those not holding assets would see a decrease in their incomes relative to asset-holding households. This will propel the already high wealth inequality, promote populism and generate political instability. Monetization may particularly be useful when aggregate nominal demand needs to be stimulated during a recession or deflationary cycles.
Given the weak nominal GDP growth since the GFC, it may also be useful to fuel growth for certain countries outside of a crisis Chart 4. The need to stimulate nominal demand may especially be true once this crisis is over as pandemic induced scarring to the economy is likely to shift near-term nominal GDP growth downwards.
Monetization — like debt-financed fiscal deficit — can lead to an increase in aggregate nominal demand. But under monetization, the increase in government spending today, does not have to be offset by higher taxes tomorrow, as the increase in the monetary base is permanent.
Compared to negative interest rates, monetization can also stimulate aggregate nominal demand without the risk of financial instability caused by large private sector credit gaps or overleverage.
Monetization may be more effective than other measures to stimulate nominal demand. In Table 1, we compare monetization to a range of other monetary and fiscal stimulus measures, such as helicopter money, temporary QE, debt financed fiscal deficits, and a combination of the two. Importantly, moderate use of monetization may not produce hyperinflation. The larger the monetary finance operation, the higher the risk that monetization leads to hyperinflation. With the burden of monetization on their backs, central banks need to tread carefully.
Debt monetization is not for everyone, especially for countries with weak institutions or a history of government intervention in central bank decision making. This is particularly true for EMs where the church-and-state separation between central banks and governments is not as strictly enforced as in advanced economies AEs. Under political pressure, a central bank may have little choice but to monetize deficits. Such political pressure — common in EMs — prevents central banks from achieving their goals.
Therefore, several central bank mandates for example, the ECB have classified monetization as illegal. Expectations are even more central in the "New Keynesian" theories popular among academics and central-bank research staffs around the world. These theories hold that the Fed's announcement of its inflation target should by itself be enough to "coordinate expectations," and force the economy to jump to one of many possible "multiple equilibria. This line of academic theory is making its way into policy analysis.
For example, International Monetary Fund chief economist Olivier Blanchard recommended last year that the Fed induce some more inflation in order to stimulate the economy, and argued that, to do so, the Fed needed simply to announce a higher target.
This view also helps to explain the Fed's growing commitment to communicating its intentions. For example, the Fed's major "stimulative" action over the summer was its announcement that interest rates would stay low for a long time in the future; it did not make any concrete policy move. This view is in many ways reminiscent of the "wage-price spiral" thinking of the s, or even the "Whip Inflation Now" buttons that Ford-administration officials used to wear on their lapels.
If we just talk about lower inflation, lower inflation will happen. But are inflation expectations really "anchored" because everyone thinks the Fed is full of hawks who will raise rates dramatically at the first sign of inflation? Does the average person really pay any attention to Fed promises and targets, so that inflation expectations will "coordinate" toward whatever the Fed wants them to be?
Yet if neither a widespread belief in the Fed's toughness nor the "coordinating" action of the Fed's pronouncements is the key to the stable expectations we have seen for the past 20 years, what does explain them?
One plausible answer is reasonably sound fiscal policy, which is the central precondition for stable inflation. Major explosions of inflation around the world have ultimately resulted from fiscal problems, and it is hard to think of a fiscally sound country that has ever experienced a major inflation. So long as the government's fiscal house is in order, people will naturally assume that the central bank should be able to stop a small uptick in inflation.
Conversely, when the government's finances are in disarray, expectations can become "unanchored" very quickly. But this link between fiscal and monetary expectations is too often unacknowledged in our conventional inflation debates — and it's not only the Keynesians who ignore it.
For 50 years, monetarism has been the foremost alternative to Keynesianism as a means of understanding inflation. Monetarists think inflation results from too much money chasing too few goods, rather than from interest rates, demand, and the slack or tightness of markets.
Monetarists today have plenty of reason to worry, as the money supply has been ballooning. Reserves are accounts that banks hold at the Fed; they are the most important component of the money supply, and the one most directly controlled by the Fed.
The monetary base, which includes these reserves plus cash, has more than doubled in the past three years as a result of the Federal Reserve's attempts to respond to the financial crisis and recession. Monetarists fear that such increases in the quantity of money portend inflation of a similar magnitude. Get ready for inflation and higher interest rates. The unprecedented expansion of the money supply could make the '70s look benign.
We can expect rapidly rising prices and much, much higher interest rates over the next four or five years. In an interview with the Wall Street Journal earlier this year, Philadelphia Fed president Charles Plosser issued a more muted but similar warning:. We have all these excess reserves sitting in the banking system, a trillion-plus excess reserves. As long as [the excess reserves] are just sitting there, they are only the fuel for inflation, they are not actually causing inflation.
While I also worry about inflation, I do not think that the money supply is the source of the danger. In fact, the correlation between inflation and the money stock is weak, at best. The chart below plots the two most common money-supply measures since , along with changes in nominal gross domestic product.
M1 consists of cash, bank reserves, and checking accounts. M2 includes savings accounts and money-market accounts. Nominal GDP is output at current prices, which therefore includes inflation. As the chart shows, money-stock measures are not well correlated with nominal GDP; they do not forecast changes in inflation, either.
The correlation is no better than the one between unemployment and inflation. Why is the correlation between money and inflation so weak? The view that money drives inflation is fundamentally based on the assumption that the demand for money is more or less constant. But in fact, money demand varies greatly. During the recent financial crisis and recession, people and companies suddenly wanted to hold much more cash and much less of any other asset.
Thus the sharp rise in M1 and M2 seen in the chart is not best understood as showing that the Fed forced money on an unwilling public. Rather, it shows people clamoring to the Fed to exchange their risky securities for money and the Fed accommodating that demand.
Money demand rose for a second reason: Since the financial crisis, interest rates have been essentially zero, and the Fed has also started paying interest on bank reserves. But if bonds earn the same as cash, it makes sense to keep a lot of cash or a high checking-account balance, since cash offers great liquidity and no financial cost. Fears about hoards of reserves about to be unleashed on the economy miss this basic point, as do criticisms of businesses "unpatriotically" sitting on piles of cash.
Right now, holding cash makes sense. Modern monetarists know this, of course. The older view that the demand for money is constant, and so inflation inevitably follows money growth, is no longer commonly held. Rather, today's monetarists know that the huge demand for money will soon subside, and they worry about whether the Federal Reserve will be able to adjust. Laffer continues:.
Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. Laffer's worry is just that "rapid growth" in money will not cease when the "panic demand" ceases. Plosser writes similarly. Some people have questioned whether the Federal Reserve has the tools to exit from its extraordinary positions. We do. But the question for the Fed and other central bankers is not can we do it, but will we do it at the right time and at the right pace.
The Fed can instantly raise the interest rate on reserves, thereby in effect turning reserves from "cash" that pays no interest to "overnight, floating-rate government debt. Modern monetarists therefore concede that the Fed can undo monetary expansion and avoid inflation; they just worry about whether it will do so in time.
This is an important concern. But it is far removed from a belief that the astounding rise in the money supply makes an equally astounding increase in inflation simply unavoidable.
And like the Keynesians, the monetarists do not consider our deficits and debt when they think about inflation. Their formal theories, like the Keynesian ones, assume in footnotes that the government is solvent, so there is never pressure for the Fed to monetize intractable deficits.
But what if our huge debt and looming deficits mean that the fiscal backing for monetary policy is about to become unglued? You don't have to visit right-wing web sites to know that our fiscal situation is dire. About half of all federal spending is borrowed. Then, as the Baby Boomers retire, health-care entitlements and Social Security obligations balloon, and debt and deficits explode.
And the CBO is optimistic. Three factors make our situation even more dangerous than these grim numbers suggest. First, the debt-to-GDP ratio is a misleading statistic. But there is no safe debt-to-GDP ratio. There is only a "safe" ratio between a country's debt and its ability to pay off that debt. If a country has strong growth, stable expenditures, a coherent tax system, and solid expectations of future budget surpluses, it can borrow heavily.
In , everyone understood that war expenditures had been temporary, that huge deficits would end, and that the United States had the power to pay off and grow out of its debt. None of these conditions holds today. Second, official federal debt is only part of the story.
Our government has made all sorts of "off balance sheet" promises. The government clearly considers the big banks too important to fail, and will assume their debts should they get into trouble again, just as Europe is already bailing its banks out of losses on Greek bets.
State and local governments are in trouble, as are many government and private defined-benefit pensions. The federal government is unlikely to let them fail. Each of these commitments could suddenly dump massive new debts onto the federal Treasury, and could be the trigger for the kind of "run on the dollar" explained here. Third, future deficits resulting primarily from growing entitlements are at the heart of America's problem, not current debt resulting from past spending.
But even if the United States eliminated all of its outstanding debt today, we would still face terrible projections of future deficits. In a sense, this fact puts us in a worse situation than Ireland or Greece. Those countries have accumulated massive debts, but they would be in good shape Ireland or at least a stable basket case Greece if they could wipe out their current debts.
Not us. Promised Medicare, pension, and Social Security payments known as "unfunded liabilities" can be thought of as "debts" in the same way that promised coupon payments on government bonds are debts. To get a sense of the scope of this problem, we can try to translate the forecasts of deficits in our entitlement programs to a present value.
The idea that these fiscal problems could lead to a debt crisis is hardly a radical insight. As even the circumspect Congressional Budget Office warned earlier this year:.
It is possible that interest rates would rise gradually as investors' confidence declined, giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could avert a crisis. But as other countries' experiences show, it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply.
The exact point at which such a crisis might occur for the United States is unknown, in part because the ratio of federal debt to GDP is climbing into unfamiliar territory and in part because the risk of a crisis is influenced by a number of other factors, including the government's long-term budget outlook, its near-term borrowing needs, and the health of the economy.
When fiscal crises do occur, they often happen during an economic downturn, which amplifies the difficulties of adjusting fiscal policy in response. Bernanke has been echoing this warning with a degree of bluntness very unusual for a Fed chairman.
In testimony before the House Budget Committee earlier this year, he said:. The question is whether these [fiscal] adjustments will take place through a careful and deliberative process. But precisely the situation they warn about carries a significant risk of inflation amid a weakening economy — an inflation that the Fed could do little to control.
To see why, start with a basic economic question: Why does paper money have any value at all? In our economy, the basic answer is that it has value because the government accepts dollars, and only dollars, in payment of taxes. The butcher takes a dollar from his customer because he needs dollars to pay his taxes. Or perhaps he needs to pay the farmer, but the farmer takes a dollar from the butcher because he needs dollars to pay his taxes.
As Adam Smith wrote in The Wealth of Nations , "A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a certain kind, might thereby give a certain value to this paper money.
Inflation results when the government prints more dollars than the government eventually soaks up in tax payments. If that happens, people collectively try to get rid of the extra cash. We try to buy things. But there is only so much to buy, and extra cash is like a hot potato — someone must always hold it.
Therefore, in the end, we just push up prices and wages. The government can also soak up dollars by selling bonds. It does this when it wants temporarily to spend more giving out dollars than it raises in taxes soaking up dollars.
But government bonds are themselves only a promise to pay back more dollars in the future. At some point, the government must soak up extra dollars beyond what people are willing to hold to make transactions with tax revenues greater than spending — that is, by running a surplus. If not, we get inflation. If people come to believe that bonds held today will be paid off in the future by printing money rather than by running surpluses, then a large debt and looming future deficits would risk future inflation.
And this is what most observers assume. In fact, however, fears of future deficits can also cause inflation today. The key reason is that our government is now funded mostly by rolling over relatively short-term debt, not by selling long-term bonds that will come due in some future time of projected budget surpluses.
Half of all currently outstanding debt will mature in less than two and a half years, and a third will mature in under a year. As the government pays off maturing debt, the holders of that debt receive a lot of money. Normally, that money would be used to buy new debt. But if investors start to fear inflation, which will erode the returns from government bonds, they won't buy the new debt.
Instead, they will try to buy stocks, real estate, commodities, or other assets that are less sensitive to inflation. That does not provide a fiscal gain to the government, as one can see from the example of Japan. David Beckworth recently retweeted a couple of Adams making a similar point:.
While I follow convention in focusing on price inflation, NGDP growth is the more relevant variable for this sort of analysis. Would we not expect the end of the covid shock to be a be deflationary as it is the end of a negative supply shock? Yes, it should be deflationary. Which suggests to me that we have not yet reached the end of Covid.
There are still lots of supply bottlenecks. But this might also reflect policies triggered by Covid, such as enhanced unemployment insurance. I think the big misconception is on the relationship between QE and debt monetization. If reserves pay interest, then the gain to the government in buying back its debt is offset by the added cost to the government in paying IOR. Was debt monetization even effective in the 70s? Long term nominal interest rates got pretty high, too. It was only briefly effective, reducing the value of long-term T-bonds issued before the Great Inflation.
Is there a synopsis on how debt monetization happens in high inflation economies? One economics blog comment some weeks ago said that new money is not used to purchase government bonds in Argentina. Which are the big or mid-sized economies where that is the practice? Hard to say. My model predicts that wage-adjustment alone should have allowed for full recovery from the Great Recession within about 6 years.
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