Currently, new money creation by the European Central Bank has been deployed, inter alia, to purchase periphery country government bonds on the secondary market as a purely defensive measure to keep bond interest rates from rising above 6 or 7 per cent.
The question must be asked whether this is the best way to deploy such precious new money.
Clearly, if new money creation is used, instead, to finance the on-going budget deficits of these periphery countries, public debt would not increase further, all else equal. The public debt problem could, thus, be substantially resolved at its source. Sovereign credit ratings would not be further downgraded on account of rising public debt burdens. Periodic financial crises deriving from excessive public debt and resurgent bond interest rates could be avoided.
Historical precedent and support for monetisation of budget deficits
1) Since the Middle Ages, money-issuing organisations used reserves (e.g. gold or other legal tender money) to purchase financial assets, creating money in favour of some borrower, either other banks or the government. ‘More often than not, this borrower was the government’. ‘Over the centuries money-issuing organisations have chiefly supplied credit directly to the state; and even when loans to the banking system have become predominant, central banks have often accorded them provided that the banking system would, in turn, redirect at least part of them to the government’. ‘Historical evidence suggests that neither changes in the organisational model of central banks nor government deficit monetisation should necessarily be seen as evil’. (See Stephano Ugolini, ‘What do we really know about the long-term evolution of central banking? Evidence from the past, insights for the present’, Norges Bank Working Paper, 2011/15).
Deficit monetisation had both successes and some much publicised failures (due, in part, no doubt, to the policy being taken to excess). ‘Sometimes it ended in catastrophe, but on many occasions it did not’. (See Stephano Ugolini “What future central banking? Insights from the past”, VOX, 11 December 2011).
2) In ‘Functional Finance and the Federal Debt’ 1943, Abba Lerner states:
“When taxing, spending borrowing or lending (or repaying loans) are governed by the principles of Functional Finance, any excess of money outlays over money revenues, if it cannot be met out of money hoards, must be met out of printing new money, and any excess of revenues over outlays can be destroyed or used to replenish hoards’.
3) Milton Friedman later proposed that the main function of the monetary authorities could be ‘the creation of money to meet government deficits or the retirement of money when the government has a surplus’. ‘Under the proposal, government expenditures would be financed entirely by either tax revenues or the creation of money, that is, the issue of non-interest bearing securities. Government would not issue interest bearing securities to the public…’. (See Milton Friedman, ‘A Monetary and Fiscal Framework for Economic Stability’, June, 1948).
4) Milton Friedman later proposed the ‘helicopter drop’. This is a temporary tax cut, increase in transfer payments or boost to exhaustive public spending (including infrastructure investment), financed through a permanent increase in the money base. (See Milton Friedman, Optimum Quantity of Money, Aldine Publishing Company, 1969).
5) Ben Bernanke proposed the ‘helicopter drop’ for Japan in 2002 and for economies at zero-bound interest rates. (See Ben Bernanke, 2002, Remarks before the National Economists Club).
6) Willem Buiter formalised the proposition that new fiat money is not a liability to the issuer. (See Willem Buiter, ‘Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap’, NBER Working Paper, No. 10163, December 2003).
7) Richard Wood argued that if the Treasury (not the central bank) printed new money to finance the budget deficit, economic stimulus could be delivered without an increase in effective public debt. (See Richard Wood, ‘Delivering Economic Stimulus, Addressing Rising Public Debt and Avoiding Inflation’, Journal of Financial Economic Policy, April 2012).
8) Willem Buiter argued that the ‘helicopter drop’ (including for Europe) is ‘perhaps the most effective form of stimulus currently’. He also argues for greater coordination between monetary and fiscal authorities. (See Willem Buiter and Ebrahem Rahbari, Global Economics View, ‘What More can Central Banks do to Stimulate the Economy’, Citi, May 9, 2012.)
Based on the above, there is a strong basis for considering deficit monetisation as the likely macroeconomic policy paradigm needed to simultaneously address both falling demand and rising public debt. When policy interest rates approach their zero bound, deficit monetisation represents (perhaps) the only combination of monetary and fiscal policy that could deliver a stimulus ― economic growth ― without increasing public debt (the formula so urgently required for periphery countries).
Hence, while a series of eminent economists have recommended deficit monetisation in the past ― when high public debt was not such a problem ― that policy approach is even more relevant today in circumstances where public debt is high, and threatening global financial stability. Deficit monetisation is particularly relevant, most immediately, for European periphery countries. Policy mistakes ― excessive reliance upon new money ― could be avoided if a strict legislative limit is placed on the amount of new money that could be created for this purpose.