Question

summarize it How Central Banks Monetize Government Debt By Matthew Johnston | March 25, 2016 — 9:29 AM EDT Share With the Bank of Japan’s announcement on Jan. 29 to navigate into negative interest rate territory by charging interest on reserve deposits, yields on government debt have fallen precipitously. The yield on 10-year Japanese government bonds recently fell to a record negative 0.135%, below the BOJ’s negative 0.1% reserve deposit rate. With the BOJ purchasing government bonds at an unprecedented annual rate of approximately 80 trillion yen, it is becoming exceedingly difficult for the BOJ governor, Haruhiko Kuroda, to deny that these policies are not a form of government debt monetization. We explain why below. (See also: How Negative Interest Rates Work.) Independent Central Banks Any government that issues its own currency (e.g. not Greece) could, in theory, continue to create money without limit. The idea that governments either have to tax or borrow in order to spend is really just a consequence of the legal and institutional infrastructure we, as a society, have created. Things could be otherwise, but when the monetary printing press is in the hands of politicians, the temptation to inflate currency is strong. There is the fear that excessive printing of money and subsequent spending will lead to inflation, then hyperinflation, and then eventual abandonment of the currency. Further, assuming the limited nature of economic resources, if the government has unlimited amounts of money, then it could potentially control all of those resources, essentially “crowding out” the private sector. Obviously, this is problematic for some, and any attempt to compete with the government in utilizing resources leads to a bidding up of the price of those resources. (See also: Worst Hyperinflations in History). To mitigate these fears, modern governments have delegated the responsibility of money issuance to independent central banks, hoping to keep fiscal policy considerations separate from monetary policy ones. Since the primary goal of central banks is to maintain price stability (usually interpreted as low and stable inflation of around 2% a year), governments cannot depend on central banks to fund their operations and must either rely on tax revenue or, like everyone else, borrow money in private markets. Debt Monetization The willingness of the private sector to hold government debt will depend on the return and riskiness of that debt relative to alternative investments. Any government that issues debt far in excess of what it could collect in taxes is perceived as an excessively risky investment and will likely have to pay increasingly higher interest rates. Thus, a government’s fiscal policy has definite market constraints. However, central banks have the power to manipulate interest rates. In fact, it is interest rates that they are targeting when they carry out their daily open market operations (OMO) to achieve price stability. The central bank typically states an interest rate target it believes will help it achieve its inflation target, and then increases or decreases the reserves of commercial banks through asset purchases – typically short-term government bonds – in order to achieve that target (QE has extended these purchases to other assets like MBSs as well as longer term government debt). (See also: Open Market Operations vs. Quantitative Easing). The central bank then, by purchasing government bonds in private markets can keep interest rates low, and in a sense, monetize government debt. However, these daily OMO are not what the more hawkish types have in mind when they talk about government debt monetization. What they have in mind is when central banks, by using their power to create money, accommodate massive deficit spending by the government, inflating the government’s debt to levels where it is not clear how or if it will ever be paid off. Such a move causes one to wonder how independent the central bank really is. The Bottom Line At a level of government debt that is more than 230% of its GDP, Japan is the most indebted nation in the world. With bond yields in negative territory, the government is now getting paid to borrow. By charging private banks interest on reserves held at the BOJ, Japan’s central bank is effectively transferring wealth, and thereby the ability to control the economy’s resources, from the private sector to the public sector. It amounts to a “helicopter drop” of new money that is channeled into the economy either through tax cuts or direct government spending. Sounds a lot like debt monetization. Yet, while the potential for inflation is worrisome for the monetary hawks, inflation is actually Kuroda’s intended goal. With deflationary pressures plaguing the Japanese economy, Kuroda has stated, “What’s important is to show people that the BOJ is strongly committed to achieving 2 percent inflation and that it will do whatever it takes to achieve it.” He is still trying to maintain the BOJ’s primary monetary policy objective; it just so happens that the Japanese government is the only economic agent willing and able to spend, thus creating the aggregate demand that is so badly needed. He just doesn’t want to call what he is doing “debt monetization” in hopes that people will still believe that the BOJ maintains, at the very least, a modicum of independence.

Answer 1

On January 29, 2016, the Bank of Japan (BOJ) made an announcement to explore the policy options in the negative interest rate territory by charging a rate of return on reserve deposits. The resultant impact can be witnessed in terms of very low yield on government debt. The annual purchase of government bonds by BOJ at a very high price, and subsequently, charging a very low interest rate on the same, had resulted in a difficult situation for BOJ. Put differently, the governor of BOJ was facing increasing difficulty to deny that the annual purchase of government bonds was anything other than monetization of government debt. The central banks of most countries enjoy a certain degree of autonomy in terms of decision making on different monetary policy initiatives, even though, the government intervenes from time to time. The flip side of such an intervention is that more often, the government resorts to printing money in order to finance government debt. The excessive printing of money would, eventually, lead to inflation, then hyperinflation, and subsequently, the erosion of value of currency. If the government controls economic resources, then by increasing the quantum of money supply, the government will crowd out the private investors by bidding up the prices of those resources. Because of these limitations, modern governments have delegated the task of monetary policy to autonomous central banks, thus separating it from fiscal policy. To execute various operations, the government either rely on tax revenue or public borrowing. The main task of the central bank is to stabilize the general price level by keeping a check on the inflation rate. The percentage of government bond held by the private sector is dependent on the yield rate and the level of riskiness. The higher the risk, the greater should be the yield, in order for private sector to hold government bonds. However, the central bank can manipulate the interest rate, through Open Market Operations (OMO) in order to maintain the price stability and changing the lending reserve of commercial banks. The central bank carry out the OMO through sale or purchase of short term government bonds. The central bank can keep the interest rate low by purchasing the government bonds in the private market. This is a subtle way of monetizing government deficit. But, in recent times, government want to monetize fiscal deficit by pressurizing the central bank to print money. Thus, the main aim is to inflate the fiscal deficit and to gradually push the economy into a recession. This issue has already been dealt with in the preceding discussion. The example of BOJ and Japanese government bore enough evidence to perfectly fit into the present discussion.