Monetization of Fiscal Deficits and COVID-19 - A Primer

Introduction

Governments around the world have introduced huge stimulus programs to combat the economic damage caused by COVID-19. These programs allocate billions of dollars in direct payments, tax breaks, business subsidies, and other relief. The size and scale of these programs have caused many governments to run much higher budget deficits than normal. But how are they going to finance these deficits? One way, which some consider anathema to the price-stability mandate of a central bank, has been thrust back into the spotlight as the crisis rages on: sovereign debt monetization.

What is monetization?

Most of the time, governments have two basic choices for financing their deficits: they can borrow (issue debt) or raise taxes. Monetization represents a third, unconventional choice that governments may consider in crises like the current one.

What is it? Simply put, monetization—also known as “money-financed fiscal programs” or “money-printing”—occurs when the government finances itself by issuing non-interest-bearing liabilities: that is, either currency in circulation or central bank reserves, if the central bank can avoid paying interest on those reserves.

Monetization can solve several problems for a government during the COVID-19 crisis. First, it can directly cover some of the costs of extraordinary recovery programs. Second, it can mitigate deflation and stimulate moderate inflation. Third, by increasing inflation, it can reduce to some extent the value of its outstanding obligations. Stimulating inflation is a necessary part of the plan. A central bank financing government spending—by purchasing government debt directly, or crediting the government the amount needed—is not monetizing that spending unless it also stimulates inflation.

The fact that most central banks now pay interest on bank reserves complicates the process of monetization.

Without interest on reserves, monetizing debt would be easier. The government would issue enough bonds to pay for its fiscal program, and the central bank would then purchase those bonds, committing to hold them in perpetuity or to roll them over forever. The government would spend the “money” that the central bank has created on any short-term stimulus, or COVID relief, that it has identified as necessary. In the short run, that money would end up at banks, as people and businesses deposit their checks from the government. But banks wouldn’t want to keep their excess reserves with the central bank, where it earned no interest. Much of the money would flow back into the economy through loans, and thereby boost aggregate demand. The stronger demand would, in turn, increase inflation, which would gradually reduce the real value of currency and reserves back to their initial levels. As a consequence, the government would end up having financed its fiscal action through base money: growth in both reserves and currency.

But, in reality, central banks do pay interest on reserves today. The interest rate they pay, even if it is small, gives banks an incentive to keep their excess reserves with the central bank. The interest payments the central bank pays on excess reserves are merely substituted for the interest payments the government pays on its debt, confounding the process of monetization described above. Nonetheless, this method of financing government debt programs works broadly similarly to the above, with a few key differences.

As in a world where banks don’t earn interest on reserves, central banks would still directly purchase and commit to roll over the debt issued by the government to initially finance the fiscal program. But it would also commit to raising prices to a high enough level that the additional demand for nominal currency is sufficient to finance the debt purchase. Essentially, this means that there would be some temporary but moderate inflation (4% annually over five years, say), which would reduce the real value of the currency stock and increase the demand for currency. As a result, seigniorage—the profit generated by the government from printing money—would be used to finance the fiscal action.

For this to work, the public must perceive the central bank’s commitment to expanding base money as credible and permanent, or else the short-run economic impact would be far less (English, Erceg, Lopez-Salido (2020), p. 3). While the central bank could instead communicate that it would only monetize a certain amount in this way, it is preferable for it to commit to raise the price level; not doing so may have unpredictable effects on inflation (English, Erceg, Lopez-Salido (2020), p. 26). Committing to a higher price level alongside expansionary fiscal policy may make it easier to convince the public that the increase is indeed permanent (see here). When modeled, a program that costs about 1 percent of GDP that is fully monetized corresponds to about a 10 percent increase in the price level (see here).

This story is different from the story that some tell about debt monetization. To some, any purchase by the central bank of government debt is monetization. But it really is not, if it is financed through (interest-bearing) reserve creation and the central bank does not intend to raise the price level. Thus, recent attempts to flood financial markets with liquidity via the purchase of government bonds (among others) is not monetization. Nor are the Federal Reserve’s purchases of large amounts of Treasury debt as part of its quantitative easing (QE) programs during both the Global Financial Crisis (GFC) and the COVID-19 crisis (see here).

One of the biggest challenges in determining whether monetization has actually occurred is that it is not immediately clear whether debt purchases by the central bank satisfy the requirements outlined above. The Bank of Japan (BOJ), for instance, has continually purchased Japanese securities proportionate to the amount of the fiscal deficit over the past 25 years, but has never explicitly stated that monetization is its intent (see here). The size of its balance sheet has only increased and it has made no major efforts to sell its bond holdings. But the BOJ financed these purchases through reserve creation; it has been unable to generate consistent inflation and spur demand for its domestic currency stock. The BOJ in 2016 did say that it would be aiming to overshoot its inflation target while keeping the rates on government debt close to zero, an important step in a seigniorage-based monetization framework. Nonetheless, it has still undershot this target and has been unable to generate the seigniorage needed to pay for fiscal actions.

Why has monetization not been more widely used?

The primary concern about engaging in monetization is the fear that it will lead to excessive and uncontrollable inflation. Since monetization is, by definition, a permanent increase in non-interest-bearing liabilities of the central bank (in this case currency), the policy should be expected to lead to some inflation. However, this increase is intended and necessary in order to generate enough seigniorage to finance the fiscal program in question. The increased inflation generated is not inherently a bad thing if it is moderate, temporary, and communicated clearly by the central bank. Uncontrolled monetization, particularly in less-developed economies, can cause currency crises in fixed exchange rate regimes and lead to excessive inflation. These crises can be exacerbated in countries with a substantial amount of foreign currency-denominated debt, as the increase in domestic currency puts pressure on the exchange rate, weakening the domestic currency and increasing the cost of their debt exponentially.

A central bank in a fixed exchange rate regime under this sort of pressure may find that conventional methods of defending its currency (by raising interest rates, for instance) would create unacceptable economic costs at home. The central bank would have to choose between providing relief at the risk of breaking the peg, or alternatively, defending the peg and allowing the economy to stagnate. In fact, “first generation” currency crisis models discuss this very issue. These models outline a hypothetical country that runs persistent budget deficits while maintaining a fixed exchange rate. Eventually the government will need to monetize its deficit, putting downward pressure on the exchange rate, and the model predicts that the peg will break (see here). Currency crises in both Mexico and Turkey in the 1990s share some of these characteristics.

This phenomenon can also occur if there is widespread circulation and usage of other currencies, as people will flock to these if the domestic currency is under pressure. The risk of excessive inflation depends on the degree of monetization and the characteristics of the economy doing it.

Governments that have access to the printing press as a form of financing may also exercise far less fiscal discipline than otherwise. Issuing debt without the expectation of repayment could lead to governments spending excessively and overheating the economy.

This concern underscores the importance of central bank independence. Adopting monetization as a regular part of a central bank's toolkit, or even setting a precedent that it is available, could gradually erode the barriers between monetary and fiscal policy, damaging the central bank’s credibility and limiting its ability to fulfill its mandate. Central bank credibility is a nebulous concept, yet it is absolutely critical when thinking about the impact that monetization can have. There appears to be a general relationship between economic development and central bank credibility, but there are a variety of factors that can affect it. The erosion of credibility could unhinge inflation expectations. A fiscally irresponsible government ultimately puts any central bank in an impossible situation. If it does not monetize the deficits, interest rates on government debt will rise, which could increase the probability of default. Eventually, the central bank will have little choice but to monetize. This phenomenon—when a central bank is forced to monetize an unsustainable, out-of control deficit to avoid negative economic outcomes—is known as fiscal dominance (see here, pp. 34-37). Thus, long-run fiscal sustainability is key in ensuring that central banks are able to fulfill their price-stability mandates and remain credible. The lack of fiscal discipline ultimately affects the independence of the central bank.

There are other issues. Monetization can circumvent the market-pricing mechanism in secondary markets by allowing the government to issue debt at lower interest rates. The Fed expressed this concern back in 1917, when the U.S. Treasury offered it $50 million in bonds at far below market rates. The cheap credit for the government also led to moral hazard concerns if the central bank commits to low interest rates along the yield curve. Excessive spending could also lead to crowding out, though this may not be an issue if the central bank doesn’t allow interest rates to rise. These are some of reasons why monetization has been generally characterized as a last-resort authority, if anything (see here).

How has monetization been used historically?

Governments have used monetization most often in the past as a mechanism for war financing. Wars are typically financed through some combination of taxation, debt financing, external financing, and monetization. Monetization is typically the easiest option, provided that central bankers are willing to cooperate. It generally is not a politically sensitive policy during wartime, and can be operationalized quickly. To finance huge wartime production needs via monetization, governments issue bonds that are then purchased directly by the central bank. The question of central bank independence does not have to arise in this case, since the incentives of the central bank and government are aligned. Below are discussions of different countries’ experiences - successful or not - when they chose to monetize. In some cases, such as the Weimar Republic or Zimbabwe, the decision to monetize resulted in rampant hyperinflation. In others, like Japan during the Great Depression, monetization proved to be an effective tool.

In the US, Section 14 of the original Federal Reserve Act allowed the Fed to directly purchase government bonds. The earliest use of this authority was in 1917 at the onset of World War I, when Treasury Secretary William McAdoo offered $50 million in 3-month notes to Federal Reserve banks (see here, p. 2). The Board of Governors was not happy, as the interest rates were below market rates, but ultimately acquiesced (see here, p. 3). After World War I, the government continued to use this authority, albeit only for cash-management purposes, until Congress prohibited it in 1935. At the time, some policymakers expressed concerns about chronic deficits, the erosion of fiscal discipline, and ballooning Federal Reserve balance sheets. Treasury questioned Congress’s decision, arguing that the Fed’s ability to make direct purchases could be crucial in times of crisis (see here, p. 5). Congress eventually accepted this argument, inserting a wartime exception in 1942 that allowed the Fed to underwrite Treasury debt. But the exception was subject to a $5 billion limit (see here, pp. 9-10). It was really just an overdraft privilege for the U.S. government to use when it was cash-poor, most notably around tax-collection dates.

The U.S. government financed World War II and the Korean War very differently. Of the major wars that the U.S. participated in after World War I—that is, after the Fed became a truly independent central bank—it only financed World War II in part through monetization, based on our definition (see here, p. 3). The Fed used the exception to help facilitate Treasury cash balances on tax collection dates during the war (see here, p. 10). Because of the exception’s limited size, however, the U.S. relied primarily on borrowing, and its debt ballooned from $51 billion in 1940 to over $260 billion in 1945 (see here and here).

In doing so, the Fed committed to pegging interest rates at low levels and offered an even lower, preferential rate for loans secured by short-term government obligations (see here). The Fed’s balance sheet grew massively in its effort to keep rates low; its holdings of government securities rose from $2.5 billion at the end of 1939 to $24.3 billion at the end of 1945. Wartime price controls and rationing temporarily mitigated the inflationary effects, but their removal after the war caused a surge in the price level, which prompted the Fed to increase reserve requirements (see here, p. 25). After World War II, the wartime exception was used sparingly until it was allowed to expire in 1981. The Korean War was financed entirely through taxation, due to high post-World War II inflation and broad public support (see here, p. 114). Nonetheless, high inflation in 1951 forced the reintroduction of wage and price controls (see here, p. 8).

Although the Fed did not monetize wartime debt during the Korean War, its independence was tested because it continued to maintain its low interest-rate peg. It attempted to raise rates throughout 1950, believing the peg to be inflationary, but was blocked by the Treasury to keep its debt-service costs manageable (see here). After a meeting between the Fed and President Truman in early 1951, the President committed the Fed, without its consent, to maintaining the peg during the Korean War, just as they had done during the two world wars. This conflict between the mandate of the Fed and needs of the Treasury ultimately resulted in the Treasury-Fed Accord, which stated that the Fed and Treasury remained committed to financing the government’s needs while minimizing outright purchases of the debt (see here).

Governments have been known to continue financing their deficits through monetization even after a war has ended. Such policies led to out-of-control hyper-inflation, with prices rising by factors of two or more per month, in Weimar Germany (1923), Austria (1922), and Poland (1924-27) after World War I.

In the case of Germany, a reduced tax base, increased debt service, unrealistic reparation demands from the victors, and the erosion of tax revenues created huge budget deficits. Germany first attempted to solve this by fixing the exchange rate to slow inflation and hence tax erosion, which worked while the Reichsbank had sufficient reserves to support it. Ultimately, the bank couldn’t defend the peg and abandoned it, which necessitated further reform. The German government passed legislation in October 1923 that created a new currency; under the legislation, the central bank could no longer purchase government debt. The government also raised taxes and reduced outlays (see here, pp. 8-16). The new currency, the Retenmark, had a limited issuance and was backed by claims on industry and agriculture. One of the most important uses of the new currency was a “once and for all allocation” to the government to help it retire its existing debt while it passed fiscal reforms (see here, p. 11). The central bank quickly got inflation and the exchange rate under control by pushing interest rates to extremely high levels, as high as 20% per day in December 1923. In 1924, a substantial reduction in reparations expectations and a large loan from the U.S. helped restore the fiscal and monetary balance.

Similarly, during and after the war, Austria increasingly funded its deficits via the printing press, which led to massive inflation and depreciation. Currency in circulation rose by nearly 1000% from the beginning to the end of the war (see here). The postwar government imposed artificially low price controls on agricultural products and enacted massive food subsidies. Excessive inflation turned into hyperinflation in 1921 and continued into 1922. Inflation in the third quarter of 1922 was at an annual rate of 130,000% (see here, p. 18). To stabilize, the government received a large foreign loan and was required to bring its budget back in line.

It took the Polish government three separate attempts to stabilize its economy from hyperinflation. Military conflict continued in Poland even after the end of World War I, and the government committed over 50 percent of its budgetary resources to defense spending (see here, p. 9). Due to a small tax base, most of these expenses were financed through the printing of Polish marks. As was the case in Germany and Austria, currency in circulation increased quickly, and depreciation followed suit. First, the government introduced austerity measures, which prompted a modest appreciation of the mark, but it did not stick to them and the inflation worsened. Second, the government raised taxes, “valorizing” them, or indexing them to gold, and issuing a new currency that was pegged to the dollar. Initially the measures appeared to work, but budgetary and economic issues forced the central bank to defend the peg, which ultimately broke. The money supply kept growing because the Treasury continued to issue small notes and mint coins, although the central bank was actively removing notes to defend the currency. Stabilization was finally achieved via a large U.S. and British loan and regulatory reforms that prevented the government from issuing treasury notes.

Generally, each of these countries had extremely high postwar deficits that were almost entirely monetized and worsened economic and political turmoil and by punitive reparations (Germany), governmental instability and incompetence (Austria), and generally poor fiscal discipline (Poland). The Reichsbank in Germany purchased any and all government debt that the private sector did not want, providing the government a seemingly bottomless well of financing (see here, p. 501). The National Bank of Austria had been granted the authority to provide credit to the state, and did so out of “fear for upheaval, social chaos, and anarchy” (see here, pp. 13-14). The Polish National Credit Bank was created during World War I by occupying Germany and functioned as a temporary bank of issue until the Bank of Poland was established. It had financed sky-high war expenditures using the printing press and continued to do so after the war due to a lack of fiscal capacity (see here, p. 10). The degree of separation between central banks and finance ministries that is commonplace today simply did not exist during this time. The central banks or banks of issue in these countries were largely subordinate to the fiscal authorities, making it impossible for them to establish credibility and manage inflation.

In each of these cases, stabilization was achieved through the dramatic reduction of budget deficits, usage or proposal of foreign loans, and pegging the exchange rate. However, solely relying on a strict peg, or even a narrow band of exchange rate targeting, is not sufficient to stabilize the economy since the peg may not be sustainable. Fiscal discipline was necessarily enforced and regulatory reforms or legal restrictions limiting governments issuing money were introduced.

In the 1990s, Turkey experienced a serious economic crisis that had roots in excessive monetization. Turkey’s economy rapidly expanded throughout the 1980s and early 90s; meanwhile, the government relied increasingly on monetization to finance huge deficits (see here, pp. 12-15). This lack of fiscal discipline, coupled with huge inflows of “hot” money from foreign investors and consistent financing conflicts with the central bank, eroded confidence and caused a currency crisis in 1994, and the economy spiraled into recession in 1999. Because of the significant dollarization of the economy, the monetary authority was unable to combat the recession because it had to raise interest rates to ward off downward pressure on the Turkish lira (see here, pp. 276-77). Ultimately, Turkey received a 3-year IMF Standby Arrangement that required the authorities to curb the excessive inflation and reform their institutions and regulations.

Perhaps the most noteworthy and most recent example of monetization-induced hyperinflation is Zimbabwe in the late 2000s. From 1980 to 1999, the country experienced modest growth, but the country’s public debt began to climb as the government spent heavily on bonuses for war veterans, involvements in other conflicts, and debt service to the IMF. The agriculturally focused country also experienced periods of heavy droughts and land reallocation at the turn of the century, depressing output dramatically (see here, pp. 4-5). Instead of financing these costs through taxation or issuing debt, the government—already managing a weak economy—heavily monetized them. By 2008, continuously monetized deficits created a deep currency depreciation that wiped out citizens’ net worth and reduced GDP per capita below its level 50 years earlier (see here, p. 5). In response, the government introduced harsh price controls, which led to rampant shortages of key goods. The U.S. dollar, which was already one of the de facto currencies in the wake of this crisis, became the primary currency.

France’s performance during and after World War I offers a more encouraging example of monetization. It depended heavily on borrowing and money growth to finance its expenditures during the war and saw its price level more than double (see here, p. 5). While the government faced considerable challenges—a large debt-to-GDP ratio, huge budget deficits, damage from the war—its economy rebounded significantly (see here, pp. 6-12). This was because the Bank of France eased monetary policy and allowed the value of the franc to fall significantly before eventually repegging it to gold at a lower level in 1926. This decision increased inflation, which reduced the debt-to-GDP ratio, and also significantly increased output over time (English, Erceg, Lopez-Salido (2020), pp. 27-28). On the other hand, the UK, which adopted a much tighter monetary stance and returned to its prewar peg to gold, saw much more sluggish growth (see here, p. 24).

France, in contrast to Germany, Austria, and Poland, did not exclusively finance its involvement in World War I through monetization. France, as a victor in the war, did not face the same fiscal imbalances that Germany and Austria did. Poland, which was partitioned by Germany, Austro-Hungary, and Russia at the start of the war, faced considerable political and economic turmoil even after the war’s conclusion (see here). The French people may have also seen the Bank of France’s change in monetary policy as credible in the face of its difficult fiscal circumstances (English, Erceg, Lopez-Salido (2020), pp. 27-29). Had France attempted to follow the U.K’s example of re-pegging earlier, it is likely that the adverse economic outcomes would have seriously damaged the government's credibility (see here, p. 32).

Japan’s performance during the Great Depression offers another encouraging example. Similar to France, its central bank and treasury cooperated in a monetary expansion, allowing it to recover quickly under the “Takahashi economic policy,” named after finance minister Korekiyo Takahashi. Japan experienced double-digit deflation in 1930 and 1931, but Takahashi promoted expansionary exchange rate, fiscal, and monetary policies starting at the end of 1931 (see here, pp. 1-4). The country first moved off the gold standard, prompting a substantial devaluation of the yen; eased monetary policy; and introduced massive fiscal stimulus. All of these measures were explicitly financed by the Bank of Japan. Consumer prices rebounded shortly thereafter and GDP per capita began recovering in 1932. This recovery can be partially attributed to the fact that the Japanese people viewed these policy changes as credible, much in the same way that the French did during their stabilization (English, Erceg, Lopez-Salido (2020), p. 29).

Takahashi, worried about the inflationary consequences of continuing to finance government expenditures in this way, pushed back against further monetization (see here, p. 373, here, p. 130). He was assassinated during a coup 1935 due to his decision to cut government - specifically military - spending. In the words of former Fed chairman and Great Depression scholar Ben Bernanke, Takahashi had “brilliantly rescued” Japan and allowed it to rebound rapidly from the Depression, even while many other nations were still suffering.

It is important to note that, in all of these examples, monetization was the primary, often the only, tool to finance profligate spending—for wars or otherwise. The governments in our modern examples—Turkey and Zimbabwe—followed similar paths. Turkey financed rapid economic expansion via monetization and saw large foreign capital inflows, leading to an increased debt burden, further monetization, and less confidence, which culminated in a currency crisis. The government of Zimbabwe faced a mixture of problems with key sectors (agriculture), spent frivolously and chose to not rely on conventional methods of financing. While external factors, such as crushing war reparation burdens in the case of Weimar Germany or a turbulent period of interwar occupation, in the case of Poland, contributed to postwar economic hardship, the consistent lack of fiscal discipline and the partial or complete subordination of the central bank to the government across all the examples were the catalysts to extremely damaging economic crises.

In contrast, the French and Japanese experiences offer more hopeful lessons. They did not have to rely exclusively on the printing press to finance expansionary monetary and fiscal policy; they had stronger, more credible central banks; and they made attempts to curtail excessive spending and depreciation after they were on the road to recovery. France re-pegged to gold at a lower level and Takahashi made the mistake of attempting to cut government spending in an attempt to rein in inflation.

Are Central Banks Monetizing Government Debt in 2020?

It’s not clear that any country is conducting monetization in response to COVID-19, based on our definition. Many central banks, including several in emerging markets, have established or reinstated asset purchases and QE programs in 2020; and debt levels are only rising, especially in developing countries. But no central bank, to our knowledge, has explicitly labeled its programs as monetization. On the contrary, several have taken measures to make clear that monetization is not part of their strategy.

One example is the Banko Sentral Ng Pilipinas (BSP) in the Philippines. The BSP purchased about $6 billion in securities from the government in March, but with the understanding that the government would repay after six months. This explicit exit target, as well as the absence of a commitment to increase the price level, suggests that the central bank, while cooperating with the fiscal authority, does not intend to monetize this spending.

In Indonesia, government debt has tripled in the fight against COVID-19. The government first issued a regulation that allowed Bank Indonesia (BI) to directly purchase newly issued government debt as a last resort. It later proposed auctioning off about $30 billion in “pandemic bonds,” most of which would be purchased by BI. But the government never issued the pandemic bonds, saying it could obtain financing through traditional auctions. BI can still participate in other auctions if needed. Foreign demand for Indonesian debt has fallen, but domestic lenders and banks, supported by BI’s liquidity measures, have increased their holdings. The finance minister predicted on June 8 that the budget deficit would rise as high as 6.34% of GDP this year. More recently, the government and BI agreed to a proposal under which BI will purchase about $40 billion in government bonds; the interest rate will be at market levels, rather than zero as originally proposed. It is likely that BI will hold on to these bonds through 2021 (see here). It is doubtful that these debts will be monetized, as BI did not issue any guidance signaling that it was committing to a higher price level following these purchases.

There has also been some discussion about monetization in China. The People’s Bank of China (PBOC) is not permitted by law to directly buy sovereign debt or provide an overdraft facility to the government. However, the country still has significant monetary and fiscal space that it could use to enact other forms of relief, without monetizing those costs.

India has kept the door to monetization open, but it has not yet acted. Like many central banks, the Reserve Bank of India (RBI) is actively purchasing government bonds. However, it is only doing so in secondary markets and for limited amounts, as direct purchases were outlawed in 2003. In the early days after India’s independence, its government could achieve monetization automatically by issuing ad-hoc treasury bills “on-tap” directly to the RBI. A series of reforms in the 1980s and 1990s set some limits on this explicit form of fiscal dominance. The government adopted a market-based pricing system for auctions of sovereign debt, phased out the usage of ad-hoc treasury bills, and completely outlawed primary market purchases of debt by the RBI (see here). Some direct government finance occurred during the GFC through the use of Special Market Operations (SMOs), which allowed certain public companies (namely in the oil sector) to sell bonds directly to the RBI to meet foreign exchange requirements. These were used sparingly, however. A former RBI governor has said that monetization is “inevitable” as calls for further stimulus continue. However, many in the government remain concerned about the potential for excessive inflation and the return of fiscal dominance (see here). India has seen a record number of COVID-19 cases recently but has not opted to reinstate lockdowns (see here). The country’s healthcare infrastructure is already strained. However, an escape clause in the law allows the central bank to purchase government debt during times of crisis. This allows the government to borrow from the RBI for temporary, cash-management needs and for the RBI to purchase government debt on primary markets during periods of significant economic stress, national emergency or war (see here, pp. 5-6) .

The Bank of England (BoE) expanded the scope of its standing overdraft facility, called the Ways and Means facility, for COVID-19-related expenditures. Historically, the facility has been used for cash-management purposes, similar to the wartime exception in the U.S. during the world wars. It was drawn on for nearly £20 billion in 2008 during the Global Financial Crisis. The BoE justified this decision by stating that the facility was necessary to support the economy and meet its inflation target. It also stated that doing so does not subordinate the BoE to the government; a member of its monetary policy committee noted that this freedom of action is what separates the BoE’s use of monetization today from the historical monetary disasters of the Weimar Republic or Zimbabwe (see here, p. 14). Despite the government ramping up debt issuance to finance COVID-19 relief, the facility has not yet been used.

The BoE’s Asset Purchase Facility has dramatically increased its purchases of government debt over the last few months as HM Treasury continues to issue more (see here and here). Despite this, BoE governor Andrew Bailey has repeatedly stated that governments should not become reliant on central banks buying their debt through extensive asset purchase programs. He said these programs have more in common with QE programs—they are crisis-focused and temporary by design. Additionally, he stated that the BoE would be looking to reduce its balance sheet before raising interest rates (see here). This is a departure from previous thinking. Bailey's predecessor, Mark Carney, argued for just the opposite after the GFC. The BoE under Carney viewed interest rates as a policy tool that could be more easily adjusted. Bailey, however, has said he does not wish for huge central bank holdings of government bonds to become the norm.

None of these examples meet our definition of monetization, although many observers have used the word to describe them. We have yet to find an example of any monetary authority that is explicitly engaging in monetization (see here, p. 63). Many central banks are purchasing government debt, including through QE programs, alongside large fiscal expansions. Those are aggressive, even unprecedented crisis-fighting measures. But they are not monetization. In none of these cases is the central bank using non-interest-bearing liabilities or seigniorage to finance the purchase of government debt. In none of these cases is the central bank committing to a higher price level.

For instance, even though the BoE has been aggressively purchasing newly issued government debt, the Bank of England says it remains confident that it will be able to continue to fulfill its mandate while increasing its involvement in the government bond market. Additionally, the BoE has not coordinated with the fiscal authorities by issuing forward guidance to raise its inflation targets, suggesting that it is not monetizing.

Do Central Banks Have the Scope to Monetize their Debt?

If central banks wanted to monetize their debt to support their COVID-19 response, would they be able to?

Based on our analysis, a country’s capacity for “safe” monetization depends on its level of economic development, the central bank’s credibility, and the current economic environment. However, there is no clear tipping point where the inflationary and governance issues discussed above suddenly occur. Countries that have persistently low inflation, credible central banks, and strong economic fundamentals could potentially monetize some of their COVID-19 spending without excessive inflation or a loss of central bank independence. These countries generally have undershot their inflation targets and have central banks that are well-equipped to handle changes in the price level. A country like Japan, which has struggled more than any other country to generate enough inflation to hit its target, might actually find it difficult to convince the public of its commitment to a higher price level.

Traditional debt financing, particularly for countries that already have high levels of debt, could still be an issue, with investors potentially questioning a sovereign’s ability to fulfill its obligations and influencing expected future default probabilities. Deficits are rising rapidly in 2020, raising questions about which natio ns will be able to reliably pay back what they owe. This creates a difficult situation for developing countries that do not have a large amount of fiscal space and are struggling to obtain external financing or issue debt. It may be tempting for such countries to monetize, as they would be more likely to do so, and to do it for longer. But their risks are also much greater. Continued monetization, as discussed above, could lead to a de-anchoring of inflation expectations and excessive inflation. Central banks in these countries may also be more susceptible to governmental influence and fiscal dominance.

Tables 1 and 2 below break these concerns down. Table 1 charts the capacity that various types of countries have to engage in “conventional” (in other words, tax-based or debt-based) financing. Table 2 charts countries' varying capacity to conduct monetization. It is clear from this rough analysis that the financing capacity is quite disparate across countries. Countries that could potentially benefit the most from monetization due to a lack of conventional financing capacity may also be most susceptible to its risks.

Table 1: Characteristics of conventional financing capacity

Level of Economic Development	Central Bank Credibility	Fiscal Capacity	Borrowing capacity	Reliance on external finance	Overall “conventional” financing capacity
High income	High	High	High	Generally low	High
Medium income / emerging market	Mixed	Mixed or low	Mixed, cyclical	Mixed or high	Mixed
Low income / developing economy	Generally low	Low	Low, cyclical	Generally High	Generally low

Source: Authors' analysis

Table 2: Characteristics of monetization capacity

Level of Economic Development	Risk of fiscal dominance	Risk of excessive inflation	Procyclicality of capital flows	Currency strength	Overall monetization capacity
High income	Low	Low	Low	High	High
Medium income / emerging market	Mixed	Mixed or low	Mixed	Mixed, cyclical	Mixed or low
Low income / developing economy	High	High	High	Generally low	Low

Source: Authors' analysis

Despite these risks, some have argued that developing countries may be able to monetize a portion of their debts, provided they have a flexible exchange rate regime and are issuing debt mostly in their local currency. Foreign ownership of local-currency government bonds in many countries has steadily increased. Investors usually have U.S. dollar-based liabilities, which increases the risk of a fire-sale of local government debt. However, their central banks are positioned to function as purchasers of last resort if this occurs.

Operationalizing monetization requires some additional thought. Using reserve creation for monetization assumes a world in which there is no interest paid on reserves, which is not the world we live in. The aid extended by a fiscal program will inevitably end up in the banking system, which will increase the amount of bank reserves at the central bank. In times of stress banks are reluctant to lend, so they are likely to keep these excess reserves at the central bank and earn interest on them (see here). The central bank, by paying for the program initially using reserves, has simply substituted interest payments that the government would pay on debt for interest paid on reserves.

Central banks could opt to pay very low, or even zero interest on the bank reserves created in this way, which would discourage banks from parking their cash, encourage lending, and ensure that the exercise is costless to both the central bank and the government. Another method involves the central bank levying an adjustable charge on banks—one on total liabilities, for instance—that would be sufficient to offset the interest paid on reserves (see here). This, however, amounts to a tax on the banking system and has its own issues. Concerns about fiscal dominance and central bank independence could potentially be alleviated by the government opening a permanent account at the central bank that would be filled only when the central bank deemed monetary financing appropriate (see here).

As for the problem of interest on reserves, a longer-run solution for central banks would be for them to gradually reduce their reserves and return to an environment where they no longer pay interest on them. However, this would be exceptionally time-consuming and require major central banks to coordinate amongst one another about how to unwind their balance sheets. Given these limitations, it would be much more effective to finance a fiscal program with reserve creation initially and seigniorage in the long run, rather than reserve creation.

There are reasons to be cautious, but as the costs of COVID-19 continue to mount, so too have the sizes of government deficits and with them, the calls for monetization. It is a powerful emergency tool, capable of providing substantial stimulus and a dramatic reduction in real interest rates if it is communicated successfully and seen as credible (see here, pp. 30-31). However, it is unclear how much monetization developing countries could safely conduct, if any.

What are some alternatives to monetization?

For developing countries for whom monetization appears difficult, debt relief may be the only alternative in the COVID-19 crisis. On April 15, the G20 announced the Debt Service Suspension Initiative (DSSI). It provided relief from sovereign debt payments to G20 members for International Development Association (IDA) countries and least developed countries (LDCs). A total of 77 countries are eligible for the DSSI, which would suspend debt service payments through the end of 2020 for participating countries. Approximately $11 billion could be freed up this way.

There are some challenges, however. Debt relief may be too small or too narrow in scope to effectively reduce massive debt stocks. Many of the DSSI-eligible countries need relief from private-sector creditors coordinating with sovereign ones for debt relief, as they owe a collective $13 billion to them through the end of the year. But negotiations with the private sector is being done on a case-by-case basis, and there are likely to be some holdouts, which could mean that countries will have to pay those creditors in full (see here). There are also a number of middle-income countries that have higher debt burdens and are expected to run much higher deficits this year. These countries also tend to rely more on private creditors, which can exacerbate holdout issues. See the following YPFS blog for more information on the DSSI.

Another alternative is financial repression. This typically takes the form of policies that allow the government to “tax” savers, such as through interest-rate caps, capital controls, and other policies. Financial repression can help a country reduce nominal interest rates, alleviating the debt service burden and ultimately reducing the debt-to-GDP ratio (see here). The U.S. used financial repression extensively after World War II, and real interest rates during this time were negative about half the time (see here). Ultimately, financial repression “played an instrumental role in reducing or liquidating the massive stocks of debt accumulated during World War II” (see here, p. 5).

As with debt relief, financial repression is not without its challenges. Enforcing low interest rates can lead to inefficient allocation of savings, and successful implementation may require a level of coordination between fiscal and monetary authorities that may call into question the independence of the central bank.

Another option is a combination of tax increases and spending cuts, or austerity. These appear to be unlikely options, as they are politically unpopular and can harm economic recovery. Spain’s efforts at fighting the virus were initially hamstrung by austerity measures they adopted in the wake of the GFC, which led to a number of shortages of equipment, doctors, and hospital beds. The government of India circulated a memorandum that stated that it would suspend the commencement of all new publicly funded programs aside from those in their approximately $260 billion pandemic response package. Ecuador announced austerity measures in May, which will result in the closure or merging of several public companies and potentially thousands of layoffs. The decision sparked massive protests across the country, similar to the reaction that occurred after the government negotiated an austerity-laden $4.2 billion agreement with the IMF in March 2019 for economic support. The IMF and Ecuadorian government cancelled this agreement in May and have begun working towards a more sustainable aid package (see here, p. 2).

Is there a difference between war financing and pandemic financing?

Much of the criticism of monetization centers around the fear that, if it is extended, it will prevent the central bank from fulfilling its price-stability mandate—through excessive inflation, loss of independence, or some combination of the two. But some forget that this type of monetary-fiscal cooperation is typically seen in times of war.

Wars typically entail dramatic but temporary increases in government spending and borrowing to adequately address the conflict. In the case of World War II, for instance, the United States ran budget deficits in excess of 27 percent of GDP (see here). The Federal Reserve relinquished some of its independence to cooperate with the U.S. government during both world wars, but it was always able to return to its mandate and retain independence once they ended.

Something to consider is that, historically, pandemics and wars have impacted economies very differently. The real “natural” rate of interest in the decades following a major pandemic is 1.5 percentage points lower about 20 years later (see here, pp. 6-7). Pandemics, which often result in massive losses of life, and thus, labor, rebalance the relative returns to labor and capital. Wars, on the other hand, cause the destruction of both portions of the capital and labor supply. The added destruction of capital during a war then has the opposite effect as a pandemic on the natural interest rate for about the same amount of time. While these differences exist, academics have suggested that the potential decline in real interest rates may not be as severe, as the deaths from COVID-19 make up a smaller proportion of the total population. Those that have lost their lives are generally older, and thus not in the labor force, and that aggressive fiscal policies, which lead to higher debt burdens, will put upward pressure on interest rates (see here, p. 15). We do not yet know the full extent of the damage caused by COVID-19, and monetization would also depress real interest rates for a time, so the potential stagnation described above may still be a concern now.

Wars often necessitate more monetary-fiscal cooperation than what convention suggests is wise, but it’s helpful to have the central bank backing the government to ensure it has everything it needs to address the conflict. The sharp but temporary increase in deficit spending during a war mirrors what countries are having to do currently to combat COVID-19. If we assume that the current crisis is temporary, as wars are, and necessitates large temporary increases in government spending to combat it, then is allowing monetary-fiscal cooperation to the degree that some of these deficits may be monetized as harmful as some argue?

Concerns about excessive and uncontrolled inflation would still remain, but could be combated with conventional tools or potentially through some form of financial repression. Some additional inflation is necessary to both counteract the deflationary nature of the COVID-19 crisis and to pay for fiscal programs, but it must be proportionate, controlled, and temporary. It is true that the independence of the central bank may be damaged, but the benefits from having the objectives of the monetary and fiscal authorities temporarily align in the face of a truly damaging crisis may outweigh the harms. We are not suggesting that monetization would produce no negative impacts, but that the similarities between the COVID-19 crisis and times of worldwide conflict, from a public financing standpoint, are strikingly similar.

Conclusions

Monetization, that is, financing government expenditures through issuance of non-interest-bearing central bank liabilities, poses real risks—potentially excessive inflation and encroachment on central bank independence. Some paint monetization as a relic of a bygone era. The onset of the COVID-19 crisis, however, has forced governments to spend heavily to combat the considerable economic and public-health impacts. As deficits continue to climb and external investors remain cautious about where to place their capital, monetization has re-entered the conversation as a potential avenue to avoid massive debt burdens that some nations, particularly those in the developing world, may face.

However, much of what many are calling monetization today is not really monetization. In particular, many central banks are conducting extensive purchases of government bonds -- but they are financing these purchases with newly created, interest-bearing reserves rather than through a temporary commitment to increase the price level. Without committing to raise prices, they aren’t creating currency demand, so they aren’t generating seigniorage—and aren't really monetizing, even though they could hold the bonds until maturity and roll them over indefinitely. The characteristics of debt securities purchased via quantitative-easing programs can make it difficult to tell if the purchases are permanent; it could be up to 30 years before some of the debt matures and needs to either be retired or rolled over. To our knowledge, no central bank during the COVID-19 crisis has explicitly stated that it is conducting monetization.

The extent to which a country is able to conduct either explicit or even “implicit” monetization depends on its level of economic development, the credibility and independence of its central bank, and the general economic environment. This makes monetization more attractive for countries that may not be able to obtain sufficient financing through debt issuance, taxation, or external finance (such as through the IMF).

However, these countries are often much more vulnerable to the inflationary and governance risks associated with the practice. A counterargument is that not fighting the crisis forcefully enough could have medium or long-run economic effects that are worse than the risk of some inflation. Central banks are well-equipped to deal with inflation, but the historical examples of excessive inflation, spurred by a loss of central bank credibility and a de-anchoring of inflation expectations, serve as a cautionary tale.

Monetization has primarily been used in the past to help finance wartime expenditures. The Fed financed deficits as high as 27% of GDP during World War II. Central banks may sacrifice some of their independence and ability to manage inflation in favor of fiscal objectives in such situations, albeit for a very limited period to avert a crisis. From a public financing standpoint, a substantial, but temporary economic shock, whether through war or disease, could be a dangerous enough emergency to demand similarly substantial and temporary cooperation between monetary and fiscal authorities. As World Bank Chief Economist Carmen Reinhart said recently: “This is a war. In a war, you worry about winning the war, and then you worry about paying for it.”