In defence of monetary financing
Central banks and fiscal authorities must defy convention
by Riaz Riazuddin in Karachi
Fri 2 Dec 2016
The ultimate objective of central banks is to increase the welfare of people through designing and implementing monetary and financial regulatory policies. This mandate is captured in different ways in central bank laws. Within the framework of these laws, many of which justifiably set down the doctrine of central bank independence, it's time to consider again the idea of monetary financing of government deficits. As long as this is not practised excessively, and is carried out as part of agreed co-operation between the central bank and the fiscal authorities, monetary financing has a valid role in promoting growth and employment during downturns.
Some central banks have multiple objectives, like the Federal Reserve, which is required to 'promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates'. No matter how the objectives are written in the primary legislation, central banks must support growth and employment, even if they are primarily pursuing the objective of price stability. Maintaining a prudent balance between these objectives is difficult, shown in many countries' post-2008 experience.
Coordination between monetary and fiscal authorities is crucial, yet this has become weaker with the modern approach to central banks as independent institutions. However, independence in no way precludes such useful co-operation.
The shift to central bank independence was motivated partly by the need to set safe limits on monetary financing of deficits. Unfortunately, post-second world war thinking has progressed to the stage where all monetary financing has been labelled as an evil, to be opposed whatever the circumstances.
It is true that excessive monetary financing has caused hyperinflation in many countries: Germany and Yugoslavia in the 20th century and Zimbabwe in the 21st century are examples. Japan, on the other hand, successfully followed this path in the early 1930s to fight depression.
One possible reason why quantitative easing in Europe and Japan has failed to lift inflation and growth is that the share of (non-debt-creating) monetary financing in total QE is low. In line with the current central bank role as banker to the government, monetary financing results in the accumulation of public debt. However, according to James Buchanan, 1986 Nobel Prize winner in economics, 'The efficient means of purchasing the services of unemployed resources is through inflation of the currency'. Buchanan proposed creating money without increasing the liability of a central bank. This would be controlled by the way resources are transferred to fiscal authorities for undertaking employment-generating development expenditures, and without increasing public debt.
This can be done if government becomes the issuer of currency and the central bank becomes the distributor. Under the existing system, banknotes are issued by central banks, which become their liabilities backed by financial assets like Treasury bills and government bonds that raise public debt. If governments directly issue all denominations of currency notes, these will become assets of central banks, since central banks must purchase these from governments. This mechanism will provide direct nominal seigniorage revenue to the government, instead of increasing government debt.
This approach to financing fiscal deficits is out of fashion, especially in advanced countries. But it is not new. Keynes acknowledged this in A Tract on Monetary Reform in 1923 in these words: 'The method is condemned, but its efficacy, up to a point, must be admitted.'
These important signals cannot be ignored. We need new research to estimate Keynes' 'point' up to which monetary financing is not only harmless, but beneficial. And then we need central banks and governments which are willing to defy convention and implement policies that could help promote growth and jobs at a difficult time for the global economy.
Riaz Riazuddin is Deputy Governor of the State Bank of Pakistan.
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