Economics 6: monetary financing

by George Hatjoullis

Fiat money is simply a liability of a central bank. The CB creates money by opening an account in the name of an entity and allowing this entity to debit this account (and will even provide cash). On one side of the balance sheet is this liability but on the other side is an asset, namely the liability of the entity to the central bank. CBs do not deal with individuals but rather licensed banks. Individuals deal with banks and the ‘money’ in this case is a deposit with the bank. The bank can create a deposit simply by making a loan much like the CB does for the licensed bank. The bank deposit is money but not quite the same quality as CB money. The first £85k is equivalent to CB money in the UK because the Financial Services Compensation Scheme (FSCS) insures it against bank failure. Any amount over this is not so guaranteed and thus not quite as good as CB money (or notes in your pocket, which is the same thing). The stock of notes and deposits with licensed banks is treated as money and is acceptable in exchange for goods and services. If the CB wants to influence the amount of money in the system it adjusts the amount it is lending to licensed banks and the cost of the loan. This encourages/discourages bank lending and thus the creation of deposits. However, this process is asymmetric. It is easier to contract the stock of deposits than expand it.

The financial crisis of 2008 pushed GDP in many economies well below potential. In fact the deflation word was heard. This happened at the same time as it was widely understood that government debt levels needed to be contained. Governments everywhere were deemed to have borrowed too much of future GDP. An expansive fiscal policy ceased to be an option. Expanding bank deposits also became quite difficult because the licensed banks, for various reasons, did not want to (or could not) expand lending. So GDP remained below potential. The central banks attempted to circumvent the licensed bank problem through buying government debt (and some mortgage debt). It is unclear how successful this was and is not the issue here. GDP is growing again in these economies but it is generally accepted still to be below potential because of the behaviour of inflation and unemployment. What if GDP growth stalls before potential is reached?

The one tool left that is not being discussed is monetary financing of government expenditure. In principle this is a simple and elegant solution to the unutilised potential GDP. The CB gives the government a loan that it need never repay (alternatively it buys government debt and cancels it). The government is then able to spend by writing cheques on the central bank up to the amount of the loan, and up to the amount of the value of the unutilised GDP potential. The unrealised GDP can be realised and those that own claims on it will receive the desired monetary claims. There is no tax liability for future generations. There is a claim on future GDP though, in the form of the increased stock of monetary deposits in the hands of labour and the owners of the means of production. Why is this elegant solution not ever considered?

Monetary financing is taboo in modern economics. The reason is that the process is open to abuse. Governments that can avail themselves of this facility have tended to press the central bank to grant loans that exceed the value of the potential GDP that is not being utilised. The result is the demand for GDP then exceeds potential and the price of GDP rises. Accelerating inflation ensues. The fact that a tool can be abused does not negate its value if properly used. During a deflation (when expectations are of price falls) monetary financing is a very useful tool for halting the deflation and moving GDP back to potential. In these days of central bank independence, with mandates expressly framed in terms of inflation targets, abuse is less likely. The idea is beginning to circulate, though it is expressed as ‘debt cancellation’, but it amounts to the same process.

If one looks at central bank narratives at the moment one will find ‘forward guidance’. They are promising to keep interest rates low for as long as is necessary to get unemployment down to a target level and inflation back to a specific level (in the UK it is to keep inflation below 2.5% but in Japan and the USA it is to get inflation up to 2%). The two variables, unemployment and inflation, are being used as proxies for potential GDP ( recall the NAIRU concept). The low interest rates are meant to encourage borrowing and thus expansion of the money deposit stock. If this process does not achieve the desired end then monetary financing may become necessary. The nation state most likely to have to resort to this is Japan, which has been in a well documented deflation for many years. The Bank of Japan is presently buying government debt as part of its promise to double the money deposit stock and get inflation back to 2%. If this fails it may need to resort to simply writing off this government debt.

Monetary financing is not a panacea for all economic ills. It is a specific response that solves a specific problem. If the GDP is well below potential and deflation is an actuality or threat, and if government borrowing is no longer an option, then monetary financing is an effective and appropriate tool. Once the conditions for legitimately using it cease to exist it needs to be halted. In an inflation the central bank needs to reduce the monetary deposit stock. It need not involve the government in this except to cease to make any loans to the government. It has plenty of tools to stop banks lending. The horse cannot drink if it has no water!

To recap:

1. The central bank normally adjusts the stock of money via the banking system.

2. Quantitative easing (QE) is an attempt by central banks to influence the money deposit stock directly. It is of questionable effectiveness.

3. Monetary financing is an appropriate tool under specific conditions. It is taboo but this arises from the abuse of monetary financing. Abuse is less likely under present institutional arrangements.

4. Monetary financing provides labour and the owners of the means of production with the claims on future GDP that they require without creating a direct liability for future taxpayers and is thus an effective alternative when government borrowing from the private sector is no longer an option.