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The Monetization of Fiscal Deficits: What is it Exactly?

Summary:
Biagio BossoneIn many countries, governments are responding to the economic consequences of the Covid19 pandemic with exceptionally large fiscal support programs, while central banks, on their side, are conducting similarly large purchases of government securities.As a result, many people, including renowned scholars, talk wrongly about fiscal deficits being monetized and draw wrong conclusions about possible their economic and financial policy effects. In the following, I will try to correct the misperceptions and the ensuing confusion as well as the wrong implications that derive from the concept of monetization as commonly discussed. What is monetization of the fiscal deficits?Central banks are in the business of governing monetary policy and, as part of their typical modus operandi,

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Biagio Bossone

In many countries, governments are responding to the economic consequences of the Covid19 pandemic with exceptionally large fiscal support programs, while central banks, on their side, are conducting similarly large purchases of government securities.

As a result, many people, including renowned scholars, talk wrongly about fiscal deficits being monetized and draw wrong conclusions about possible their economic and financial policy effects.

In the following, I will try to correct the misperceptions and the ensuing confusion as well as the wrong implications that derive from the concept of monetization as commonly discussed.

What is monetization of the fiscal deficits?

Central banks are in the business of governing monetary policy and, as part of their typical modus operandi, they constantly engage in buying and selling government bonds and other securities, to make sure the economy has enough (but not too much) liquidity or that the cost of liquidity achieves certain levels or changes in some desired directions. Yet, when central banks buy government bonds, that doesn’t mean they are monetizing the debt issued by governments.

The monetization of fiscal deficits – that is, budget expenses in excess of revenues – involves the financing of such extra expenses with money, instead of debt to be repaid at some future dates. It is a form of "non-debt financing". Thus, monetization of fiscal deficits can occur only through one of two modalities:

  • First, the sovereign (government) prints its own money and finances its expenses. In practice, the same happens as the fiscal deficit is financed with newly created money issued by the central bank and transferred to the state treasury without future repayment obligations: the money issued by the central bank is either credited to the account of treasury or treasury is allowed an overdraft facility. Debt would obviously originate if treasury were to borrow the money from the central bank; yet, this would not constitute true monetization of the deficits, but simply a temporary support to treasury cash needs.
  • According to an alternative (and more convoluted) modality, fiscal deficits are monetized as the government issues bonds in the primary market and the central bank purchases an equivalent amount of government bonds from the secondary market. Importantly, however, and this is commonly the forgotten part, for this modality to replicate the same effects of the first, the central bank must commit to the following actions: i) hold the purchased bonds in perpetuity, ii) roll over all the purchased bonds that reach maturity, and iii) return to government the interests earned on the purchased bonds (Turner, 2013).

Noncompliance with such commitments would invalidate monetization and practically reverse it. The second modality would no longer be equivalent to the first and should not be referred to as "monetization." Doing so has consequences that I discuss below.

In the first modality, government excess expenses (i.e., deficits) are monetized immediately, directly and permanently (Andolfatto and Li, 2013), there is no new debt creation, and the government’s budget constraint remains unaltered. In the second modality, fiscal deficit monetization is indirect: thanks to the above three central bank commitments, the purchased debt is de facto removed from the government’s set of future obligations. This relieves the government’s budget constraint and allows government to finance an equivalent level of deficit with new debt issuances and yet without changing its total indebtedness (provided that the new issues do not exceed the debt retired through monetization).

In principle, the monetized debt could be written off de iure and removed from the government’s set of future financial obligations since, in force of the above central bank commitments, the central bank would never redeem the monetized debt for or other forms of value at any point in future time. Yet, this would reflect negatively on the central bank’s capital (albeit with no direct financial consequences for the central bank itself).[1] Thus, the monetized debt remains as a fictitious asset in the central bank’s balance sheet and, correspondingly, it remains as a fictitious liability in the fiscal budget, since the government is no longer under any actual obligation to repay it in future.

Thus, monetization properly implemented (meaning, in accordance with the modalities discussed above) relieves the government’s budget constraint permanently, thereby preserving the government’s fiscal space or giving government greater fiscal space, especially when the public sector is already burdened with heavy debt.

It should be noted, incidentally, that the condition of "permanence" of the budget constraint relief (relative to the portion of monetized debt) does not require – as is often erroneously believed – that once issued, the currency can no longer be withdrawn from the system through subsequent monetary policy operations. It only requires that any liquidity drainage operations are not carried out by reselling the securities originally purchased to initiate the monetization: those securities are unavailable and should be so considered. Therefore, any drainage operations will have to be carried out with other instruments (I will return to this point further on).

For the reasons discussed, if implemented correctly, monetization should lead to consider public debt statistics net of the share of monetized debt – another very critical element that is commonly forgotten when discussing about this topic. If monetization happens, then net (not gross) public debt should be used as the only sensible definition of public debt for fiscal policy decisions or for discussions on budget rules and financial stability. Once monetized, debt simply ceases to exist and debt sustainability analyses should disregard it, focusing instead only on the actual financial obligations of the public sector.

This point seems goes unnoticed in the recent communication on this topic from one of the members of the Bank of England’s Monetary Policy Committee (Vlieghe, 2020), since even under the recent decision of the Bank of England to finance UK Treasury (if markets turn sour during Covid19), the financing would still be in the form of loan advances.

One should cautiously consider that monetization can weaken the disciplining effect of a hard budget constraint.[2] Yet, the benefits of the monetization of fiscal deficits would outweigh the associated costs in the event of serious economic emergencies (such as the one we are going through) and when its potential inflationary consequences are unsubstantial (as is the case today).

Monetization wrongly understood

To my knowledge, no major central bank in the world is currently involved in monetizing fiscal deficits the way it is described above. No central bank of advanced countries is purchasing bonds from government or bondholders and formally committing to the actions referred above at the same time. Central banks are intervening in the markets, purchasing huge amounts of government debt, and likely the markets and their publics expect them to behave responsibly, that is, stocking the purchased bonds for a long time, rolling them over as they mature, and returning bond interest income to government. This is happening in the US, UK and Japan, where the massive central bank purchases have brought the respective yield curve structures down to zero.

Yet, as discussed, this is not the same as monetizing the fiscal deficits and the effects of central bank purchases will be equivalent to monetization only to the extent that central banks are expected to behave responsibly and actually do so.Should this not happen, the effects could be significantly different.

To show this, I take the example of the Eurozone and my own country, Italy, whose public sector is heavily indebted and where currently the economy needs to spend enormous amounts of public money in order to avert collapse from Covid19. Italy’s government is bound to further increase its public sector indebtedness, similarly to many other member countries of the euro area. Coming into assistance, the European Central Bank (ECB) has launched a new temporary asset purchase program of private and public sector debt instruments. Loosely speaking, since the program aims to prevent financial market speculation from unorderly affecting interest rate spreads, and thereby counter the risks to the area’s monetary policy transmission mechanism, one could conclude that the ECB is actually monetizing new government debt issues.

However, this is not the case. Whatever Italian government bonds the ECB purchases from the secondary market, these bonds remain in the calculation of Italy’s gross public debt, and Italy will be expected to honor their repayment any time the ECB will decide to sell them back to the market. While the ECB is unlikely to do so any time soon, Italy will be subject to (heavy) fiscal adjustment requirements under the EU rules (including to reduce its excessive debt) as the emergency will be over, and these requirements will be commensurate to the country’s gross public debt, not its net debt (as would be the case under monetization). Thus, there is no benefit that Italy stands to gain from the ECB intervention in terms of permanent relief of its public budget that monetization would deliver. Furthermore, it is uncertain for how long more the ECB will continue its purchases program and for what additional amounts.

Finally, to the extent that the ECB does not monetize the fiscal deficits, new issuances of debt will add to Italy’s already large gross public debt, and to the cost of servicing it, and will expose the economy to market speculative attacks that would not arise under monetization. The ECB’s intervention will at best secure less efficient results than what monetization would accomplish by keeping country debts unchanged until the national economies recover.

Dispelling confusing messages

The incorrect understanding of monetization is also responsible for generating confusing messages and for leading to wrong implications on its possible use. For instance, Olivier Blanchard and Jean Pisany-Ferri have recently argued that monetization at zero interest rates simply replaces a zero-interest rate asset (called debt) with another one (called money), and leaves public debt dynamics unchanged. But that conclusion does not take into account that monetization does indeed change the debt dynamics, as I discussed above.

The same authors – who also erroneously take monetization necessarily to imply a fiscal dominance regime – have argued that monetization in the Eurozone (with one central bank, many national treasuries, and different rates for different sovereign bonds) would affect the distribution of risk across countries. Their argument is that, from the standpoint of the consolidated government of the euro area (that is, putting together all the treasuries and the ECB), monetization would generate an internal transfer of risk from the holders of securities issued by the high debt countries to the shareholders of the ECB (the national governments), but would have no implications for the total debt held by the public.

In fact, this would not be the case. The monetized debt (correctly understood and implemented) would reduce the total debt held by the public and create new fiscal space that governments could exploit without changing their total indebtedness. Also, it would not expose ECB shareholders to any additional risk: monetized debt would cease to be debt and thus carry no default risk for the ECB. As to the illiquidity of its fictitious assets, the ECB may avail itself of an ample range of other instruments if it needs to mop up liquidity from the economy in the future, including, inter alia, its existing portfolio of safe securities, changes in reserve requirements and rate of remuneration, and the issuance of central bank bills.

Furthermore, the cross-country transfers generated by the interest paid on the bonds purchased by the ECB and returned to its shareholders (governments) would depend only on the debt newly issued by each member government and eventually monetized by the ECB, and would not depend on the total stock of the national public debts outstanding. Thus, if anything, for each euro of monetized debt, transfers would occur from the countries paying higher interest to those paying lower interest.

Conclusion

Understanding what we mean when we talk about monetizing the fiscal deficits is important both for reasons of theoretical rigor and consistency and for allowing to draw correct implications of the use of such a critical instrument of macroeconomic policy. Hopefully, the modalities described in this post provide sufficient clarification as to what monetization is, and is not, and identify the exclusive conditions under which fiscal deficits are truly monetized.

A correct understanding of monetization would be important, for instance, in the case of the Eurozone and its efforts to fight the economic consequences of Covid19. An incorrect interpretation of the concept leads to wrong implications with regard to how the monetization of country fiscal deficits could support economic recovery in the area during and after the virus crisis.

References

Andolfatto, D., and L. Li (2013), Is the Fed Monetizing Government Debt?, Federal Reserve Bank of St. Louis Economic Synopses, 2013, No. 5.

Archer, D., and P. Moser-Boehm (2013), Central bank finances, BIS Papers No 71, Bank for International Settelements, April.

Blanchard, O., and J. Pisani-Ferry, Monetisation do not panic, Vox, 10 April 2020.

Bossone, B. (2019), The portfolio theory of inflation and policy (in)effectiveness, Economics 13 (2019-33): 1–25.

Bossone, B. (2020), Global Finance and the effectiveness of macro-policies, World Economics, 21.1, June edition, forthcoming.

Bossone. B., M. Costa, A. Cuccia, e G. Valenza (2018), Accounting Meets Economics: Towards an 'Accounting View' of Money, d/SEAS Working Paper No. 18-5, 22 ottobre.

Turner. A. (2013), Debt, Money, and Mephistopheles: How Do We Get Out of This Mess?, Group of Thirty, Occasional Paper No. 87, Washington, D.C, May.

Vlieghe, G. (2020), Monetary policy and the Bank of England’s balance sheet, speech given by Gertjan Vlieghe, External Member of the Monetary Policy Committee, Bank of England, 23 April.


[1] As regards the impact of monetary policy operations on central bank finances, see Archer and Moser-Boehm (2013). As regards the concept of central bank capital in relation to the features of the money they issue, see Bossone et al. (2018).

[2] See, for instance, my recent work Bossone (2019, 2020).

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