Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 16 April 2024

Could governments finance deficits by creating money?


MMTers often say that financing government spending less taxes by issuing government debt is a policy choice, because they could instead create reserves (electronic money) at commercial banks. Of course only governments that have their own currency can do this, so this option is not available to Eurozone governments for example. If governments could finance deficits by creating money/reserves, would they want to do so?

The textbook answer (see here for example) is that monetary financing is inflationary, which is why most governments delegate reserve creation to independent central banks. This is not because of any crude monetarism: in mainstream macro the idea that there is a predictable and causal link between money creation and inflation died many decades ago, and today is believed by only a few. Instead the textbook story relies on the idea that governments creating money would undermine the ability of central banks to control the short term interest rate. Money financing would force interest rates to zero, and that would be inflationary.

However textbooks are nearly always out of date, and this explanation for why money financing would be inflationary became largely irrelevant when central banks started paying interest on reserves. Reserves are like electronic money held by commercial banks, the quantity of which is controlled by central banks. Today central banks control short term interest rates by paying that interest rate on reserves. As a result, it is possible to create large amounts of money/reserves without this ending in higher inflation.

We know this because of Quantitative Easing (QE), where central banks created large amounts of reserves in order to buy government debt. When they did this after the Global Financial Crisis (GFC) we didn’t get hyperinflation! The idea that recent inflation is a result of the new QE that took place during the pandemic is just silly. What recent experience shows us is that it is perfectly possible for central banks to control inflation even when there is a lot of money/reserves in the system.

So if central banks can create large quantities of money but still control inflation, why cannot governments finance their deficits by creating money? If interest is paid on that money/reserves, and it is clear that central banks have complete control over setting that interest rate, there is no reason to believe that money financing deficits rather than financing deficits by issuing bonds would be inflationary. This is what MMT means when it says bond financing is a policy choice.

Indeed we could go further and say that QE has been equivalent to the money financing of current and past deficits. The fact that this has happened because central banks wanted to put downward pressure on long term interest rates rather than governments choosing to money finance is just about motive. In practice we have ended up in much the same place as if governments since some past date had financed their deficits by creating reserves.

Of course none of this would matter if governments had no reason to be interested in money financing deficits. The obvious reason why they might be is if this form of financing was cheaper than selling debt to the bond market. Creating money/reserves incurs a cost equal to whatever the central bank sets the short interest rate to. Issuing debt could incur much the same cost if that debt was very short term. However governments have the option, which they normally take, of selling longer term debt. That may or may not be immediately cheaper than creating money/reserves, because long term interest rates may be above or below short rates. After the GFC short rates were below long rates, so money financing would have been cheaper and QE made a profit. Currently long rates are below short rates so bond financing would be cheaper at the moment. However over the long term whether the option of borrowing long is cheaper for governments remains questionable. Ellison and Scott found that the UK, which tends to borrow long, would have been better off if it had borrowed short.

The situation becomes much clearer if central banks only pay interest on reserves at the margin, rather than paying interest on all reserves. This would allow central banks to continue to control short term interest rates, but also to pay substantially less interest on the total stock of reserves. I discussed this possibility in detail here, in the context of reducing current losses from QE. An additional reason to pay interest only on some rather than all reserves is that there is no obvious reason why commercial banks should receive large sums of money for reserves when rates are high and virtually nothing when rates are low

If interest was only paid on marginal reserves, then it does clearly become attractive from a public finance point of view to finance deficits by creating money/reserves rather than issuing debt. So why are governments not exploring this possibility? I could equally well ask why mainstream economists are not talking more about this possibility. Maybe I’m missing something obvious here. If so please let me know.

One possible argument that I think doesn’t hold water is that cheaper financing of deficits would encourage governments to be fiscally profligate. The main deterrent to fiscal profligacy when there is an independent central bank is high interest rates, not high debt interest payments.

I want to end by making two additional points. The first is about markets and default. Money financing may appear attractive to those who believe that debt finance constrains government fiscal decisions. The idea is that bond markets could suddenly stop lending governments money, and this inhibits politicians from optimal fiscal policy choices. If politicians think this way they are mistaken, because as I have explained elsewhere the bond market is highly unlikely to stop lending the government money, and if it ever did the central bank would act as a last resort buyer of government debt. This is what happened as the pandemic hit, and after Truss’s infamous fiscal event. [1]

Because governments can create money they never need to worry about being forced to default as a result of a bond market strike. In addition governments having a magic money tree means that bondholders can always get paid interest and their money back. The only formal default [2] that bond markets need to worry about is when governments choose it, because the political cost of servicing government debt becomes too high. We are way away from such levels today, so the following paragraph is strictly of academic interest only.

If a government with an independent central bank that had financed all of its past deficits through money/reserve creation chose to default, how could it do so? Unlike government debt, reserves don’t have to be paid back at a set date. The only sense in which such a government could default is to instruct its central bank to no longer pay interest on reserves, which means that the central bank is no longer independent and loses control of inflation. In contrast, defaulting on government debt is possible while maintaining an independent central bank, and therefore maintaining control of inflation.

My second point is about safe assets. Because governments of advanced economies who issue debt in their own currency hardly ever choose to default, the debt they issue is far safer than any debt the private sector creates. [3] Such debt is invaluable to the financial sector. It allows pension funds greater certainty that they can pay future pensions, for example. This is a very good reason why governments should continue to issue at least some debt. Does that mean governments should always finance deficits using debt? No, because governments can issue debt to buy assets (through a sovereign wealth fund for example) rather than fund deficits.

[1] Politicians may worry about the impact of fiscal decisions on how the central bank sets interest rates, but it is absolutely right that they should.

[2] Bond markets do need to worry about inflation, which is sometimes considered as a form of default, but that gets reflected in interest rates through the actions of independent central banks and arbitrage.

[3] It can be disastrous when the private sector thinks they have created safe assets when in reality they haven’t, as we found out in the GFC.

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