⚠️Automatic translation pending review by an economist.
On September 17, 2020, BSI Economics organized a meeting to discuss the monetization of public debt. How can we define monetization? Are we really seeing monetization? Is it a temporary or lasting phenomenon, and what are the associated risks? To answer these questions, the panel brought together a chief economist from a private bank, a manager from a strategy firm, and a university professor specializing in monetary policy.
The subject warrants a methodical approach, identifying the dangers and the situations in which they arise:
- The majority of central banks (CBs) increased their net asset purchases in 2020. But the big news concerns emerging economies. We are now seeing countries such as Indonesia, Poland, Thailand, Chile, and Costa Rica buying back assets despite still positive key interest rates. Some market players are concerned about the risk of excessive inflation, particularly in Eastern Europe. (See this Allianz reporton the issue)
- The term « quantitative easing » is often used by central banks (particularly in emerging countries) to refer to different types of policies. A distinction must be made between (i) « pure » quantitative easing, where the central bank buys assets to lower long-term rates for the purpose of economic stimulus (and where the Treasury does not particularly change its debt issuance), (ii) episodes of monetization currently observed in certain countries, where the central bank acts in a context of significant budgetary spending and either prevents risk premiums from rising or simply provides direct financing to its government. The latter often takes the form of asset purchases on the primary market (Bank Indonesia) or loans to the government (BoE).
- Type ii) monetization (see above) involves a risk of loss of credibility for the central bank and its currency. Direct monetary financing of government spending is often a first step towards hyperinflation. This is certainly one of the reasons why the term « quantitative easing » is often used in the communications of central banks in emerging countries. The rare central bank to have communicated on the subject of monetary financing is the Bank of England, but its statement contained six references to the terms « temporary » and « short-term, » clearly demonstrating its desire to reassure economic actors. Repeated direct monetary financing could lead to a loss of confidence in the currency and a currency or inflation crisis.
- What matters for debt is the sustainability of the financing trajectory over the long term (academics say that the intertemporal budget constraint must be respected). If lending investors judge that the financing strategy is becoming unsustainable, they avoid lending and dispose of the debt, as they anticipate that they will not be repaid. The same applies to money issuance (the academic work of Reis, Sims, and Cochrane was mentioned). If the financing trajectory (through money) is not sustainable, investors may become concerned and dispose of a country’s currency.
(2nd speaker) In the financial markets, the risk of developed central banks losing their independence does not seem to be a major concern:
- The risk of a rate shock must be ruled out. Thus, as in March in the eurozone, central banks are increasing their asset purchase programs, expanding them or making them unlimited in order to contain any marginal pressure on interest rates. Such a policy of helping to finance budget deficits, which allows for a faster rebound in global activity, is necessary. Investors will be paying close attention to how central banks support governments in managing public spending.
- Inflationary risk seems unlikely at this stage for advanced economies. The US experience in the 1940s shows that inflation only picked up again seven years after monetization. The Fed’s current asset purchase policies are unlikely to lead to significant inflation in the current environment. One explanation raised during the discussions concerns the concentration of financial assets in the hands of a small number of wealthier individuals who invest the amounts rather than consuming them because they have already reached their maximum spending level. This would break the link between rising financial asset prices and inflation, particularly the rise in prices for consumer goods.
