{"id":8242,"date":"2020-05-27T11:53:45","date_gmt":"2020-05-27T10:53:45","guid":{"rendered":"http:\/\/www.economicsobservatory.com\/question\/monetary-financing-it-happening-and-what-are-dangers"},"modified":"2022-09-28T12:08:33","modified_gmt":"2022-09-28T11:08:33","slug":"monetary-financing-it-happening-and-what-are-dangers","status":"publish","type":"question","link":"https:\/\/www.economicsobservatory.com\/test\/monetary-financing-it-happening-and-what-are-dangers","title":{"rendered":"\u2018Monetary financing\u2019: is it happening and what are the dangers?"},"content":{"rendered":"\n

The high costs of emergency fiscal supports and lost tax revenue in the current crisis mean that the UK government is likely to run a deficit of at least 10-15% of GDP in 2020\/21. This would be larger than the deficit following the 2008\/09 financial crisis \u2013 and any additional costs of future policies to stimulate demand are still to come.<\/p>\n\n\n\n

Such projections have led many to ask whether there are alternative ways to finance this support that might avoid a long period of fiscal adjustment after the worst of the crisis is over. For example, why can\u2019t we just print the money? Or \u2013 as it\u2019s sometimes more formally put \u2013 can\u2019t the government use direct \u2018monetary financing\u2019?<\/p>\n\n\n\n

To understand why most countries don\u2019t pursue the option of printing money, it is useful to understand how policy institutions typically split responsibilities for macroeconomic policies, as well as why that split exists.<\/p>\n\n\n\n

Who controls UK macroeconomic policy?<\/h3>\n\n\n\n

Since the 1990s, most OECD economies (including the UK) have broadly followed an approach to macroeconomic policy called \u2018the new macroeconomic consensus\u2019. In this approach, responsibility for the fiscal and monetary policies is separated between the government and the central bank.<\/p>\n\n\n\n

The government is responsible for fiscal policy, setting taxes and deciding on government spending plans, such as how much to devote to different priorities \u2013 all of which in the UK is decided by the finance ministry, HM Treasury. The central bank \u2013 in the case of the UK, the Bank of England \u2013 is given operational independence from the government with responsibility for monetary policy to achieve a government-set inflation target (inflation measures how prices are changing).<\/p>\n\n\n\n

This separation of duties has been the case in the UK since the Bank of England was granted independent control of monetary policy in 1997. The inflation target is currently 2% per year for the CPI (consumer price index).<\/p>\n\n\n\n

To control inflation, the central bank typically controls the interest rate. Although this is not an exact science, raising interest rates tends to increase the cost of borrowing funds, which in turn reduces how much households consume and how much firms invest; the lower economic activity reduces the pressure on prices to rise. Lowering rates has the opposite effect.<\/p>\n\n\n\n

Before central banks became independent, one concern was that governments would put pressure on them to provide too much monetary support to the fiscal authority and the result would be inflation running persistently higher. It was evidence published in the early 1990s that showed that central bank independence was associated with lower and less volatile inflation (Alesina and Summers<\/a>, 1993). The separation of responsibilities of the government and central bank was seen as a credible way to allow the central bank to control inflation.<\/p>\n\n\n\n

What is the evidence that too much money is inflationary?<\/h3>\n\n\n\n

Inflation is costly because it erodes the value of money: if you earn 2% more but prices go up by 5%, your earnings actually have less purchasing power \u2013 you are worse off. But higher levels of inflation are also increasingly unstable, which makes it more difficult to plan. The cost of the inflation depends on the amount of inflation.<\/p>\n\n\n\n

Inflation in the UK has been consistently less than 10% since 1982, and more recently it has been mostly below 5%. But there are examples of countries that have experienced such high rates of inflation that it is called hyperinflation. These are countries in which governments have chosen to finance their spending through monetary financing rather than raising tax revenue or borrowing to pay back in the future.<\/p>\n\n\n\n

Recent examples are Zimbabwe (2008) and Venezuela (2018). As an illustration of how out of control price increases were, inflation in Zimbabwe got so bad that prices were doubling every day on average. Under such a scenario, long-term contracts break down and shops tend to suffer from major shortages of goods to sell. Hyperinflations are extremely damaging for the economy and people\u2019s wellbeing.<\/p>\n\n\n\n

So central banks are tasked with keeping increases in prices under much greater control. The main reason is that it is generally agreed among economists that while monetary policy might boost (or suppress) economic activity in the near term, the ultimate effect of having too much monetary support is inflation. And too little monetary support can lead to deflation.<\/p>\n\n\n\n

So how does the government fund itself?<\/h3>\n\n\n\n

The main way that governments fund their spending is through tax revenue. But sometimes they choose to spend more than they are raising in tax revenue (a fiscal deficit).<\/p>\n\n\n\n

Direct monetary financing would involve the government financing its deficit by printing money \u2013 or asking the central bank to do so.<\/p>\n\n\n\n

Under the separation of responsibilities, a government with a deficit must borrow to cover its expenditure, which increases government debt. This is called bond financing because the government issues debt contracts (bonds) that promise to make certain fixed payments over the life (maturity) of the bond. Bonds are typically bought by financial investors such as asset managers, insurance companies and banks, which hold them as part of their portfolio of investment assets.<\/p>\n\n\n\n

In the UK, the Debt Management Office (DMO) works to ensure the most cost-effective financing of the government\u2019s debt obligations. Like any borrower, the government pays a return, and the DMO offers new bond contracts to investors in what is called the primary market; these debt issuances raise funds for the government.<\/p>\n\n\n\n

Once issued, there is a secondary market in which investors can buy and sell government bonds. Of course, when one investor in the secondary market sells their bond to another investor, there is no new funding given to the government (although the fixed payments from the bond will now have to be paid to the new owner of the bond.)<\/p>\n\n\n\n

Doesn\u2019t the central bank also buy these government bonds? Isn\u2019t that direct financing?<\/h3>\n\n\n\n

Central banks, like many other financial institutions, hold portfolios of assets. In general, central banks hold less risky portfolios of assets and therefore they have a relatively high proportion of government bonds (which are typically considered relatively safe investments in most countries).<\/p>\n\n\n\n

But they make these purchases independently: not directly to finance the government\u2019s borrowing needs but rather for their own operational needs. In particular, if the central bank makes a purchase of bonds, they do so in the secondary market and therefore their purchases transfer money to the seller who is not the government. Direct monetary financing would involve the central bank creating money, which is transferred either directly to the government or via outright purchases of bonds in the primary market.<\/p>\n\n\n\n

Has the Bank of England just started directly financing the government?<\/h3>\n\n\n\n

The Bank of England was originally a private bank established to be the government\u2019s bank. Despite now being operationally independent in pursuit of the inflation target, the Bank of England remains the banker to the government for wholesale banking operations. This means that the government has a number of bank accounts at the Bank of England, and the Bank of England works closely with the DMO too.<\/p>\n\n\n\n

While the government has mostly relied on the DMO\u2019s cash management operations to meet its short-term cash needs since 2000, it sometimes needs an overdraft in order to borrow short-term funds. The Bank of England continues to provide an overdraft facility to the government via what is called the \u2018Ways and Means\u2019 facility. This facility was the primary method of cash management before the DMO was created. Use of the Ways and Means is equivalent to the issuance of a short-term bond bought directly by the central bank.<\/p>\n\n\n\n

A recent announcement about this facility on 9 April 2020 attracted some media attention. It was announced that the Bank of England and HM Treasury agreed to extend the Ways and Means account usage from the normal level of around \u00a30.4 billion. Many commentators speculated that monetary financing was beginning in the UK.<\/p>\n\n\n\n

But this is not direct monetary financing in the traditional sense \u2013 and it should not lead to inflation:<\/p>\n\n\n\n