In the BoE’s case, the irony is that the latest announcement
came just a few days after the new Governor wrote a column in the FT making it clear that the BoE is not and will not be engaged in monetary financing.
Andrew Bailey emphasised that “the UK’s
institutional safeguards rule out this approach … [and] the MPC remains in full
control” of the policy instruments designed to increase the central bank
balance sheet. Simply put, if the BoE buys financial assets this is purely in
line with the BoE’s inflation remit. But the element that is often overlooked
is that the remit
is “to maintain price stability; and
subject to that, to support the economic policy” of the government, where
the government’s policy objectives include a “credible fiscal policy, returning the public finances to health, while
providing the flexibility to support the economy.” The BoE’s policy remit
is about far more than simply controlling inflation – whatever it says in
public.
But what is monetary deficit financing and why is it so
“bad”? In simple terms, it amounts to central banks creating money to pay off
the government’s creditors. The conventional argument is that it results in
excessive liquidity creation that eventually results in higher inflation (too
much money chasing too few goods). The textbook example of such a policy is the
action of the Weimar government in Germany following World War I which chose to
inflate away its debt by printing money but which instead resulted in the great
hyperinflation of 1923. Admittedly it was successful as a debt reduction
strategy but disastrous in terms of its other economic side effects. A century
on from this experience, Germany remains scarred by the memory and was
instrumental in writing the provision into the Maastricht Treaty that prohibits
monetary deficit financing in the euro zone. More recently, it was practiced by
Zimbabwe and the policy was only stopped when the currency became so devalued
that the government was reputedly unable to pay for the ink required to print
more banknotes.
It is thus generally accepted that allowing governments to
control the monetary printing press is a bad idea for it may encourage them to
over-expand the money supply. The conventional narrative is that allowing
central banks to enjoy a degree of autonomy over monetary policy in the last
two decades is one of the key factors helping to curb inflation. I have argued before that this is far from the whole story but it has certainly played a role. However, over the past decade central banks
have bought huge amounts of government debt which has led to a massive rise in
central bank reserves (i.e. liquidity creation) but not resulted in higher
inflation. Indeed, the BoJ and ECB have struggled to push inflation towards
their target goal of 2% despite a balance sheet worth 100% and 40% of GDP
respectively (see chart, taken from the St Louis Fed). This is in part because the institutions which sold their
securities to the central bank have simply gone out and bought other assets, notably
equities, thus pushing up their price. There may not have been too much money
chasing too few goods but there was a lot of it chasing a dwindling pool of
high yielding assets. I have little doubt that liquidity creation will be
inflationary in some form. It will surely push up asset prices although whether
it inflates consumer prices remains to be seen.
The actions of the Fed and BoE in recent days confirm my
suspicion that we will be engaged in financial repression for a long time to
come (i.e. central banks will do everything in their power to keep interest
rates low). They are likely to go further: The BoJ has been buying assets on an
industrial scale for almost 20 years and both the Fed and BoE have a lot of
headroom to ramp up their balance sheets without necessarily sparking CPI inflation
if the Japanese experience is anything to go by. As it currently stands,
central banks buy debt in the secondary market (i.e. not directly from the
issuer) and for the foreseeable future they are going to be buying a lot of
assets. Past experience suggests that at some point they will call a halt to
the process. At that point, they can sit on their bond holdings indefinitely.
As bonds mature, they can roll over the debt by cashing in the proceeds and use
them to buy an equivalent amount of additional securities. In this way, the
central bank balance sheet remains unchanged and it continues to hold the same
amount of government debt.
Technically, this is not monetary deficit financing because
the presumption is that at some point the central bank will sell its debt
holdings back to the private sector. A small complication arises from the fact that
in the UK, the BoE hands over the interest it earns from its bond holdings back
to the Treasury so it is in effect monetising the interest payments, but that
is small beer. A bigger issue is whether at some point the central bank will
simply write off its government debt holdings. It is not going to happen
anytime soon, so we can rest easy on that score. But they may surreptitiously be
able to do so in the longer term. The BoE plans to hold £645 bn of bonds, which
amounts to around 30% of annual GDP. Suppose that in the long-term nominal GDP
growth averages 3.5% per year and that the BoE rolls over its debt holdings ad
infinitum. After 25 years, the bond holdings are worth 13% of GDP and in 50
years just 5% of GDP.
Is anyone going to complain if in 50 years’ time, the BoE
writes off (say) half of these holdings? The current generation of central
bankers will be long gone and I certainly won’t be around to do so! Therefore,
the issue of whether central banks are likely to monetise the debt holdings
built up over the last decade is something we will only be able to judge long
after the current crisis is past. Sometimes playing the long game really is the
only game in town.
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