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Debt monetization

Debt monetization is the financing of government operations by the central bank. If a nation's expenditure exceeds its revenues, it incurs a government deficit which can be financed

either by the government treasury, by way of

• money it already holds (e.g. income or liquidations from a sovereign wealth fund)
• issuing new bonds

or by the central bank, through

• money it creates de novo

In the latter case, the central bank may purchase government bonds by conducting an open market purchase, i.e. by increasing the monetary base through the money creation process. If government bonds that have come due are held by the central bank, the central bank will return any funds paid to it back to the treasury. Thus, the treasury may "borrow" money without needing to repay it. This process of financing government spending is called "monetizing the debt".

Restrictions

Monetary financing used to be standard monetary policy in many countries, such as Canada or France, while in others it was and still is prohibited. In the Eurozone, Article 123 of the Lisbon Treaty explicitly prohibits the European Central Bank from financing public institutions and state governments. In Japan, the nation's central bank "routinely" purchases approximately 70% of state debt issued each month, and owns, as of Oct 2018, approximately 440 trillion JP¥ (approx. $4trillion) or over 40% of all outstanding government bonds.

In the United States, the 1913 Federal Reserve Act allowed federal banks to purchase short-term securities directly from the Treasury, in order to facilitate its cash-management operations. The Banking Act of 1935 prohibited the central bank from directly purchasing Treasury securities, and permitted their purchase and sale only "in the open market". In 1942, during wartime, Congress amended the Banking Act's provisions to allow purchases of government debt by the federal banks, with the total amount they'd hold "not [to] exceed $5 billion." After the war, the exemption was renewed, with time limitations, until it was allowed to expire in June 1981.

In most high-income countries the government assigns exclusive power to issue its national currency to a central bank, but central banks may be forbidden by law from purchasing debt directly from the government. For example, the Treaty on the Functioning of the European Union (article 123) forbids EU central banks' direct purchase of debt of EU public bodies such as national governments. Their debt purchases have to be from the secondary markets. In China, the central bank, called as the People's Bank of China (PBOC), is forbidden by the PBOC Law of 1995 to give overdrafts to government bodies, or buy government bonds directly from the government, or underwrite any other government debt securities. Monetizing debt is thus a two-step process where the government issues debt (Government bonds) to cover its spending and the central bank purchases the debt from secondary markets and perpetually rolls it over, leaving the system with an increased supply of money.

Debt monetization and inflation

When government deficits are financed through debt monetization the outcome is an increase in the monetary base, shifting the aggregate-demand curve to the right leading to a rise in the price level (unless the money supply is infinitely elastic). When governments intentionally do this, they devalue existing stockpiles of fixed income cash flows of anyone who is holding assets based in that currency. This does not reduce the value of floating or hard assets, and has an uncertain (and potentially beneficial) impact on some equities. It benefits debtors at the expense of creditors and will result in an increase in the nominal price of real estate. This wealth transfer is clearly not a Pareto improvement but can act as a stimulus to economic growth and employment in an economy overburdened by private debt. It is in essence a "tax" and a simultaneous redistribution to debtors as the overall value of creditors' fixed income assets drop (and as the debt burden to debtors correspondingly decreases). If the beneficiaries of this transfer are more likely to spend their gains (due to lower income and asset levels) this can stimulate demand and increase liquidity. It also decreases the value of the currency - potentially stimulating exports and decreasing imports - improving the balance of trade. Foreign owners of local currency and debt also lose money. Fixed income creditors experience decreased wealth due to a loss in spending power. This is known as "inflation tax" (or "inflationary debt relief"). Conversely, tight monetary policy which favors creditors over debtors even at the expense of reduced economic growth can also be considered a wealth transfer to holders of fixed assets from people with debt or with mostly human capital to trade (a "deflation tax").

A deficit can be the source of sustained inflation only if it is persistent rather than temporary, and if the government finances it by creating money (through monetizing the debt), rather than leaving bonds in the hands of the public.