Are central banks financing governments by printing money? There are numerous people that seem to assume so, and almost as many that condemn it. Central banks aren't supposed to finance governments. We almost take a completely opposite view, simply based on present and historical evidence. We say central banks aren't really monetizing public deficits, but in certain cases and to a certain extent, they should.
Central bank rationale
Central banks, like the Bank of Japan (BoJ), the Fed in the U.S., or the Bank of England (BOE) are buying up assets on a rather massive scale (although none on the scale of the little noticed central bank of Switzerland, but we'll keep that for another day). Most of these assets these central banks are buying are government bonds.
However, these central banks are not buying these bonds directly from governments: they're buying these bonds on the secondary market instead. Not good enough, according to some. SA contributor Colin Lokey argues there is little difference. What's more, at least the ECB is attaching some conditionality, whilst the Fed is giving the U.S. government a 'free ride.'
Countries in the eurozone have to sign up for rescue funds, which makes them amenable to the distinctly dubious pleasure of being subject to Troika (ECB, EU, IMF) oversight and conditionality. In the U.S., there is no such conditionality, invoking all kinds of conspiracy theorists to come out of the woodwork, like Charles Hugh Smith, who seems to argue that the real purpose is to perpetuate government spending.
First off, we might remind Hugh Smith that Bernanke was twice appointed by Bush Jr. Secondly, we could point out that the Fed is embarking on these asset buying sprees simply because interest rates are already zero and the economy is still stuck in a rut, producing way below capacity. This state of affairs is accumulating damage to the productive capacity itself, and we haven't even mentioned the millions of people that are unemployed.
And even if Hugh Smith were right, so what? The simple fact is that the private sector is deleveraging, that is, borrowing and spending less in order to repair balance sheets ravished by the financial crisis. With interest rates already zero, it should be fiscal policy that makes up for the slack.
To an extent, that happened with the bailouts and the recovery act. In the figure below, you see how, compared to other similar financial crises, employment has at least been recovering.
You might have noticed in the figure that the only country not suffering major (if any) employment loss after a financial crisis has been Japan. That is all the more remarkable, because Japan's financial crisis of the early 1990s was three times the relative size of both the U.S. in 2008 or even in the aftermath of the 1929 crash.
What set Japan apart from the other countries suffering financial crisis is their use of expansionary fiscal policy, which is simply what you should do. The private sector is deleveraging, so spending less. But spending less means saving more, so interest rates are low for the government to borrow.
The public sector should simply step in to fill the gap left by the private sector. This isn't at all about 'big government,' it's simply necessary to keep the economy from spiraling downwards. Japan managed to do just that.
U.S. policy did that as well in the aftermath of the crisis, but has been backtracking ever since, which is the simple explanation for why the recovery is so tepid. By retrenching too early (especially on the state and municipal level), the public sector has become a drag on growth.
Even the Wall Street Journal (!) argued that unemployment without government cuts would be 7.1%:
The Labor Department's establishment survey of employers - the jobs count that it bases its payroll figures on - shows that the government has been steadily shedding workers since the crisis struck, with 586,000 fewer jobs than in December 2008. ... But the survey of households that the unemployment rate is based on suggests the government job cuts have been much, much worse.
So, with fiscal policy prematurely retrenching and interest rates already zero, the Fed has a simple choice. Should they do nothing, and keep the present status quo with millions of unemployed and an economy slowly accumulating structural damage as it keeps on producing way below capacity? On top of that, run the risk of the economy deteriorating again? Or try something else, like the stuff they're doing now?
We find it difficult to fathom why, in the face of mass unemployment and clear, present and manifest problems and fiscal policy stuck, there are that many people arguing that the Fed should do nothing. In fact, some even argue that they should raise rates and let the slump run its course.
Some also argue that instead of making up for the lack of private sector demand, the public sector should actually embark on austerity. When the private sector is deleveraging, this is the most dangerous thing that can happen, as the slump in private sector will be compounded by that of the public sector, creating a vicious downward debt-deflationary spiral, like the one that is ravishing Spain at the moment.
It's what the UK tried to do in the aftermath of WWI. We'll have to quote The Economist at considerable length here to illustrate:
Britain emerged from the first world war with debt at 140% of GDP and prices more than double their pre-war level, but it was determined to pay off its debt and return the pound to its pre-war value against gold. This required excruciatingly tight fiscal and monetary policy. The primary budget balance (which excludes interest) rose to a surplus of 7% of GDP. The Bank of England raised interest rates to 7%, and deflation meant that real interest rates were even higher. The results were awful: output was lower in 1928 than in 1918. And the debt ratio actually rose, to 170% of GDP in 1930 and 190% in 1933, as high real rates and declining output wiped out the benefits of a primary surplus.
Take note. Not even the public debt declined. It actually increased significantly as a percentage of GDP, as the latter sank (and falling prices did the rest).
Milder versions of this happened when countries with deleveraging private sectors embarked on austerity prematurely, like Japan 1997 or the U.S. in 1937. Not a good idea.
Now, about that deficit funding by central banks. People worrying about this (or even being outraged about it) should answer the following question: if central banks stopped engaging in these bond buying programs, interest rates would shoot up, right? Well, that at least is what people like Niall Ferguson predicted as far away back as 2009 (see here for a riposte by the author under attack from Ferguson).
The simple truth is that QE hasn't made much of a difference to bond yields, and it's not that hard to understand why. A private sector that is deleveraging is saving more. Basically, the aftermath of a financial crisis is one which generates its own savings. Add to these the high savings in many Asian countries, and you have a world savings glut.
The only countries where bond yields have gone up are those peripheral eurozone countries, because savings can leave the country. This differs from the situation in a country issuing its own currency.
Sellers of bonds in the latter also sell the currency, devaluing it until buyers step in. The buyer of the currency will usually buy assets in the country as well; money doesn't really leave the country, an extremely important difference.
Money does leave the eurozone periphery though, increasing bond yields (and wrecking bank balance sheets). Which is why we have argued for quite some time that the eurozone is the only area where QE can have a real impact. Even the mere announcement of it has brought peripheral rates down quite dramatically, a way bigger effect than in the U.S., UK, or Japan.
- Factoid 1: QE hasn't had much effect on bond yields, apart from the peripheral eurozone, but this is a consequence of the euro itself. Since QE hasn't had much influence on bond yields, it isn't proper deficit funding.
But this isn't all. While some are fearful of central bank deficit funding because it 'perpetuates' public spending, others argue it is 'money printing,' and hence inflationary. Once again, this flies in the face of a few simple facts. There isn't much inflation, nor money printing. Monetary aggregates are pretty well behaved.
In the eurozone periphery, these have even been shrinking for a while (due to the capital flows).
- Factoid 2: All that QE hasn't led to much money printing nor inflation.
Despite years of dire predictions, it's actually no mystery. Once again, we say, the private sector is deleveraging. That means, borrowing less, spending less, saving more. In the euro area as a whole, consumer credit has actually been shrinking quite a bit.
Private sector deleveraging hasn't been completely offset by higher public spending and borrowing anywhere, except perhaps in Japan (see below). Which is why we have a savings glut, and global overcapacity, and massive unemployment. It's very, very difficult to create accelerating inflation under these circumstances.
What's more, that same Economist article quoted at length above also mentions an IMF study into 26 episodes since 1875 when public debt exceeded 100% of GDP, to determine how those ratios got back down. We're afraid we have to quote at some length again:
Growth, spending cuts and tax increases did their bit, but the make-or-break factor was monetary policy. Low or falling nominal interest rates and inflation were crucial to reducing the debt-to-GDP ratio. When interest rates were high and deflation rife, consolidation failed. This is mildly positive news for America and Britain, whose central banks are determined to keep monetary policy easy as austerity bites. But it suggests a bleak future for countries locked into the monetary straitjacket of the euro, in the absence of easier monetary policy by the European Central Bank.
We'll part with a quick note on Japan. We already mentioned that despite the mother of all financial crises in the early 1990s, Japan has been experiencing no big recession due to expansionary fiscal policy.
In Japan, we would actually welcome direct BoJ purchases of government debt, that is, direct monetary financing, and/or retiring a substantial amount of the outstanding public debt. The reason is very simple. Japan's debt/GDP ratio is in excess of 200% of GDP.
From the quote above, you'll instantly realize that other means would convict Japan to decades of fiscal consolidation, with possibly brutal consequences for growth (read the quote about the UK's post WWI experience again if you are in doubt about this).
The main risk of monetizing public debt is inflation. But Japan has actually experienced deflation for over a decade. It's about time they took more radical measures, and kill two birds with one stone, getting rid of deflation and a substantial fraction of public debt. What's more, given the alternatives, we strongly believe this is going to happen anyway.
It would make Japan a remarkable example. First, they suffered no real economic crisis and nothing approaching anything like mass unemployment in the aftermath of what was the mother of all financial crisis, by embarking on massive fiscal expansion to counteract private sector deleveraging. If they can extract themselves from deflation and a good deal of the resulting public debt, it would be an even more remarkable story. The jury is still out on the latter, though.
Yes, rather unorthodox, we agree. But let's not forget what economic policy is for. It's to create the maximum welfare for the maximum number of people, not to satisfy some abstract principles that perform well only in textbooks.