How “Monetization” Really Works

Posted on November 25, 2020 by Florian Buschek

Most likely you have heard now several times the inflationistas and fear mongers shout about “Printing Money” and “Debt Monetization” or “Fed Manipulation” and warn of Zimbabwe and hyperinflation. Oh, yes and the stock market performance since the financial crisis is all just manufactured by the Fed as well (nevermind that earnings per share have grown at almost exactly the same rate). Notice how these people seemingly always want to sell you gold or a newsletter, have predicted hyperinflation for more than a decade and claim the inflation statistics are all made up?

Scott Fullwiler holds the James A. Leach Chair in Banking and Monetary Economics and is an Associate Professor of Economics at Wartburg College in Iowa. He understands the plumbing of the financial system and has a new must read paper How “Monetization” Really Works—
Examples from Nations’ Policy Responses to COVID-19

Here is the abstract

The severe economic downturn caused by the COVID-19 pandemic has forced governments worldwide to increase spending while tax revenues simultaneously collapsed. Concurrent with this, central banks in several of these countries are financing a significant percent of their direct income support through direct lending or purchases of government bonds in primary and/or secondary markets. Many oppose this for their alleged negative consequences on the economy, inflation in particular. This paper describes the actual workings of what most people (including many economists) often call monetization of government debt and its major implication, namely, that it leads to printing money and, consequently, to inflation. We show that the reality is very different: once one knows how modern central banks manage monetary policy (i.e., through a corridor interest rate targeting system), and how they coordinate their daily operations with their Treasuries, monetization does not occur as it is often described, and it is not nearly as dangerous as its critics argue (and not as useful as its supporters claim). The examples of the Philippines, Singapore, People’s Republic of China, and US clarify this.

In essence what is colloquially called debt monetization is simply part of the day to day operations of modern central banks and printing money as such is not even possible beyond actual cash. Exchanging a government bond for reserves is simply an asset swap that changes nothing in aggregate. It does provide liquidity and is an essential tool to target interest rate corridors or floors.

The core argument of this paper is that “monetization” does not occur in the way most learn it, economists and lay people alike. “Direct printing of money” as commonly understood is not operationally possible.

Yes, even most economists don’t get this – very few know the ins and outs of modern monetary systems and central banking.

In a corridor interest rate targeting system the CB’s purchases of government debt are sterilized by an offsetting reduction in the CB’s assets or an increase in its own interest-bearing liabilities. In a floor system, the sterilization is via interest on RBs. It is not operationally possible for “monetization” to be the macroeconomic equivalent of adding “jet fuel” to a government’s deficits. This means that it is not worth fearing, but it also means that it is not a solution in itself for an economy that is growing too slowly.

In English: If a central bank targets interest rates it buys and sells assets all the time, predominantly government bonds. It buys these with reserve balances (RBs), which it can create at will. These RBs are to the currency you and me use like water and oil, two separate circulations. It is not printing money.

If a central bank (as the Fed does) only provides a floor meaning a lower bound for the interest rate, it simply sets an interest rate on excess reserves (IOER) and buys a sufficient amount of bonds that the banking system is flush with reserves. Since the banks lend reserves to each other the “price” of these reserves ie. the interest rate immediately drops to 0 (hot potato effect) or to IOER since that is what the Fed pays on these reserves. The Fed has adopted a floor system after the GFC to provide enough liquidity to the banking system after the shock and stayed with it ever since.

More balances do not mean however more money in peoples’ pockets. That only the government can do. It also does not mean lending will pick up. Just because a bank can make a loan does not mean it will. You can only lead the horses to the water, they have to drink themselves.

So no, we don’t need to fear hyperinflation. But the central banks also don’t have magic wands to create growth. They are extremely good at protecting the downside by providing liquidity in times of stress. But they cannot take care of the upside – real growth in income.

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