Debt monetization: constraints and global implications

For some time now, the direct monetization of fiscal deficit—where a central bank prints money to facilitate deficit spending—has been viewed by some market participants as an alternative approach to supporting economic growth. Increasingly, many believe that the effectiveness of monetary policy might has reached its natural limit and fiscal spending is now what’s required to boost growth.

The coronavirus outbreak, which required governments worldwide to ramp up spending rapidly to contain the economic fallout regardless of their fiscal position, lent a sense of urgency and credibility to these discussions. As interest rates around the world head southward—falling into negative territory in some instances—and central bank balance sheets grow larger, we believe the broadening adoption of direct debt monetization around the world seems all but inevitable. 

MMT is often viewed as a fringe policy and has historically been dismissed out of hand as being a free for all. In reality, MMT/debt monetization is a much more nuanced concept. For it to work, there are constraints that governments will need to adhere to.

As interest rates around the world head southward and central bank balance sheets grow larger, we believe the broadening adoption of direct debt monetization around the world seems all but inevitable. 

To adopt debt monetization in a sustained manner, a government needs monetary sovereignty, which is another way of saying it needs full macroeconomic policy autonomy. What this means is that, as a concept, monetary sovereignty isn’t an absolute; rather, it should be thought of as a spectrum where some countries could have more monetary sovereignty than others. There are, however, three necessary conditions:

1. The government issues the national currency and can impose tax liabilities in that currency. 
2. The government issues debt denominated in its own currency.
3. The currency is fully floating.

What these conditions tell us is this: Economies with a private sector deficit—where investments are funded by debt instead of savings—aren’t able to pursue debt monetization in a sustained manner. The buildup in debt would eventually lead to a private sector debt/financial crisis. Conversely, economies enjoying a long-term private sector surplus can pursue debt monetization to boost growth in a sustained manner.

Based on these conditions, it’s clear debt monetization, as an alternative policy approach, is a nonstarter for economies such as Italy, where monetary policy lies with the European Central Bank, or Hong Kong, whose currency is pegged to the U.S. dollar. Once an economy fulfills the three conditions, other factors come into play—the health of its fiscal account and the state of its private sector.  

These conditions can be seen as an effective, if slightly simplistic, way of assessing which economies are able to pursue debt monetization as a policy to boost growth. However, it doesn’t take into account the health of each economy and how that could influence its ability to pursue such a policy. For instance, if a government chooses to reduce its spending, and the amount withdrawn from the economy isn’t replaced by one of the other sectors, then aggregate demand will decline.

In a sense, economies with external deficits are, technically speaking, net borrowers from the rest of the world. In our view, economies that fall into this category should not pursue debt monetization as a policy option because it can lead to macroeconomic and financial instability. This is especially relevant in the midst of a cold war, typically characterized by heightened geopolitical tensions and volatile market movements. Monetizing debt during such a period can leave these economies much more vulnerable to external factors. Put differently, we believe that only economies with an external sector surplus are able to pursue debt monetization as a policy option during a cold war. 

Given that running an external surplus is key to implementing debt monetization, it’s logical to assume that governments planning to pursue it would be incentivized to engineer that outcome. Mathematically, an external surplus can be achieved by running a private sector surplus that’s large enough to generate a current account surplus. Such policies are likely to be highly protectionist in nature and could include:

• R&D programs to move up value chains 
• Tariffs/import controls/export subsidies to protect domestic industry and corporate profitability
• Domestic infrastructure development programs using domestic capital and labor
• Encouraging domestic consumption through higher household incomes
• The introduction of capital controls to keep extra liquidity from leaking overseas
• Currency devaluation

Economies with limited policy space to monetize debt or that are unable to adopt protectionist policy would need to join currency and trading blocs that do have the space. Unlikely as it might seem in this day and age, there are many historic precedents for this form of global fragmentation, for instance the gold bloc, the sterling area of the 1930s/1940s. 

Based on the conditions required for debt monetization to be implemented effectively, we have a reasonable grasp on which Asian economies could theoretically turn to debt monetization as a policy option. Economies in the Asia-Pacific region with consistent external as well as domestic private sector surpluses and budget deficits include Japan, China, Thailand, and Malaysia; however, we believe that China is running out of policy headroom. Meanwhile, it’s fair to say that if Thailand and Malaysia were to pursue debt monetization aggressively, it could cause unease among investors.

Separately, there are several economies in the region that run sustained external deficits and budget deficits where debt monetization isn’t a sustainable option: Australia, India, Indonesia, New Zealand, and the Philippines. Taiwan, Hong Kong, and Singapore aren’t able to pursue debt monetization as a policy given their managed exchange rates. That said, some economies that, theoretically speaking, shouldn’t monetize debt have either gone down that path (e.g., Indonesia and Philippines) or signaled that they weren’t closed to it, namely New Zealand.

If debt-financed fiscal spending were not only an inevitability, but a development that will play an increasingly significant role in the global economy, what would it mean for investors? The following is a summary of how we expect things to play out and likely investment implications over different timeframes.

There can be no doubt that debate over the question of whether debt monetization works and if it should be taken seriously as a policy option will continue. In regard to the first question, it’s probably fair to say that it could be years before we’ll get anywhere close to having a definitive perspective. Where the second question is concerned, we believe that ship has sailed—as we’ve mentioned earlier, the broadening adoption of direct debt monetization seems inevitable. That said, we believe that relying on it as a policy tool beyond an emergency period would be risky in the medium term.