LONDON – In response to the COVID-19 pandemic, the US Federal Reserve will buy unlimited quantities of Treasury bonds, the Bank of England will purchase £200 billion ($250 billion) of gilts, and the European Central Bank up to €750 billion ($815 billion) of eurozone bonds. Almost certainly, central banks will end up providing monetary finance to fund fiscal deficits. The only question is whether they should make that explicit.
Monetary policy, on its own, is clearly impotent in today’s circumstances. Central banks have cut policy interest rates, and bond purchases are depressing long-term yields. But nobody thinks that lower interest rates will unleash higher consumer expenditure or business investment. Instead, depressed economic growth will be offset (as best possible) by increased government spending on health care, direct income support for laid-off workers, and a reduced tax take. This will inevitably result in unprecedented fiscal deficits.
In theory, funding those deficits by selling government bonds could raise bond yields, potentially offsetting the stimulative effect. But with central banks buying bonds and depressing yields, governments can borrow all they need at rock-bottom interest rates.
When the United States used that policy during World War II, the Fed’s role in facilitating debt finance was explicit: from 1942 to 1951, it committed to buying Treasury bonds in whatever quantity needed to keep bond yields flat. This time round, such explicit commitments have been avoided, but the effect is the same: central banks are making it easy to fund yawning fiscal deficits.
Whether this amounts to permanent monetary finance depends on whether the bonds are ever sold back to the private sector, with central banks’ balance sheets returning to “normal” levels. In the US after WWII, such a reversal never happened.
In their book A Monetary History of the United States, Milton Friedman and Anna Schwartz later estimated that about 15% of the war effort was financed with central-bank money rather than by taxes or with debt which was ever actually repaid. In Japan, where 25 years of large fiscal deficits have been matched by equally large purchases of government bonds by the Bank of Japan, it is also obvious that the central bank’s bond holdings will never be sold: permanent monetary finance has occurred.
So, monetary finance need not be explicit to be permanent. All asset purchases by central banks over the past decade – so-called quantitative easing (QE) – might in retrospect entail some monetary finance.
That possibility terrifies those who believe that monetary finance must eventually lead to hyperinflation. But such fears are absurd. Friedman famously said that in a deflationary depression, we should scatter dollar bills from a helicopter for people to pick up and spend. Suppose US President Donald Trump ordered just $10 million of such helicopter money: the impact on either real activity or inflation would be miniscule. But suppose he ordered $1,000 trillion: obviously, there would be hyperinflation. The impact of monetary finance depends on the scale.
Fears about the long-term impact on central-bank balance sheets and commercial-bank profitability are also misplaced. Central banks do not directly create the money held by individuals or companies in the real economy; what they create is the monetary base held as reserve assets by banks. As a result, central banks, which pay interest rates on reserves, will face an ongoing cost if they create more such money.
But central banks can create costless money by paying zero interest on some commercial-bank reserves, even while paying a positive policy rate at the margin. And while such zero-rate reserves might impose an effective tax on credit creation when economic activity revives, that could be desirable, because it would prevent the initial stimulus from being harmfully multiplied by commercial bank’s future money creation.
So, on close inspection, all apparent technical objections to monetary finance dissolve. There is no doubt that monetary finance is technically feasible and that wise fiscal and monetary authorities could choose just the “right” amount.
The crucial issue is whether politicians can be trusted to be wise. Most central bankers are skeptical, and fear that monetary finance, once openly allowed, would become excessive. Indeed, for many, the knowledge that it is possible is a dangerous forbidden fruit which must remain taboo.
They may be right: the best policy may be to provide monetary finance while denying the fact. Governments can run large fiscal deficits. Central banks can make these fundable at close to zero rates. And these operations might be reversed if future rates of economic growth and inflation are higher than currently anticipated. If not, they will become permanent. But nobody needs to acknowledge that possibility in advance.
Paradoxically, the only danger with this approach is that central banks will be too credible. If individuals or companies believe policymakers’ promise never to allow monetary finance and that all QE operations will definitely be reversed, they will expect that all the new public debt must be repaid out of future taxes. And anticipation of that burden could depress consumption and investment today.
The alternative approach is honesty – while offsetting the danger that honesty will lead to excess. Andrew Bailey, Governor of the Bank of England, argued on April 5 that explicit monetary finance is “incompatible with the pursuit of an inflation target by an independent central bank.” But former Fed Chair Ben Bernanke has shown why that is not true, proposing instead that independent central banks should determine the amount of any monetary finance while governments decide how to spend the money.
Independent central banks could make explicit decisions about optimal quantities of permanent monetary finance. But whether or not they do, a significant proportion of today’s QE operations will in retrospect have financed expanded fiscal deficits.
Adair Turner, Chair of the Energy Transitions Commission, was Chair of the UK Financial Services Authority from 2008 to 2012. His latest book is Between Debt and the Devil.