Should Governments Print Money to Make It through the Pandemic?

Most of the time, governments have two basic choices for financing their deficits: they can borrow (issue debt) or raise taxes.

In a recent paper in the Yale Journal of Financial Crises, we discuss a third, unconventional option that has reentered the discussion lately: printing money.

Money-printing—more technically known as monetization or “money-financed fiscal programs”—occurs when the government finances itself by issuing non-interest-bearing liabilities. Those liabilities could be currency or they could be reserves that banks hold at their central bank.

By monetizing debt, the government uses inflation to finance some of its spending. But that’s OK. With economies shrinking by as much as one-third on an annualized basis in 2020, central banks have had more cause to worry about deflation than inflation. The Federal Reserve last year said in unprecedented guidance that it could allow inflation to exceed its 2% target to escape the pandemic-induced recession; it won’t rush to raise rates to head off inflation.

Several experts have called for cautious monetization during the pandemic. Some have even promoted the idea for emerging-market central banks, so long as they have flexible exchange rates and well-anchored inflation expectations. Of course, any money-printing would require controls and careful messaging about the extent and duration (see page 63 of this report from the Bank for International Settlements).

How would monetization work? The central bank could buy government bonds and cancel them, or similarly, promise to roll the debt over indefinitely. Either way, the result would be the creation of money at no direct cost to the government. Central banks would purchase those bonds by crediting newly created reserves to the government’s account at the central bank. The government could then use the reserves, which would be a liability of the central bank, to pay for its fiscal programs. Alternatively, the central bank could simply create accounts for the public at the central bank with new money, an idea with growing support.

A complication is that most central banks now pay interest on the reserves that banks hold with them. So buying government debt would carry a cost to the central bank, as it would replace interest on debt with interest on reserves. Removing interest on reserves could make it harder to tighten monetary policy—that is, to raise interest rates—when the time comes. A central bank typically sets the rate on reserves as a floor for its target interest rate.

But even a central bank that is legally bound to pay interest on reserves could put monetization in its toolbox. It would have to combine its government debt purchases with convincing guidance that it has temporarily raised its inflation target. If the guidance is credible—that is, if consumers and businesses expect more inflation in the future—then they will consume and invest more in the present, pushing prices up. The higher inflation reduces the real value of existing currency; as a result, consumers and businesses need to hold more of it, which allows the government to finance the fiscal action with non-interest-bearing currency over time.

The challenge is to not let inflation get out of hand. A country’s capacity for monetization is related to the amount of money (currency plus non-interest-bearing reserves) in its economy. When modeled, a program that costs about 1% of gross domestic product (GDP) that is fully monetized corresponds to about a 10 % increase in the price level.

Of course, the mere hint of monetization conjures fears of government overreach and excessive inflation. Many countries don’t allow their central banks to buy government debt at all. Some allow limited amounts to cover short-term cash needs. Others require the government to repay the central bank quickly.

But it was Milton Friedman himself, conservative economist and historian of the Great Depression, who first proposed using “helicopter money” to escape a deep deflationary recession, 50 years ago.

Critics wagged at former Fed chair Ben Bernanke when he mentioned Friedman’s suggestion in 2002, but he still hasn’t backed down from his view that “governments should never have to give in to deflation.”

Some of the same critics made apocalyptic warnings about potential inflationary effects when the Fed and other central banks introduced quantitative-easing programs after the global financial crisis (GFC) of 2007-09. In our view, these were not monetization programs. Indeed, despite trillions of dollars of debt purchases by central banks, inflation hardly stirred. Banks held the new cash in reserves, the broader money supply grew moderately, and the money multiplier—the ratio of commercial bank money to central bank money—shrank. Monetization is thus not inflationary as long as banks are reluctant to lend. As Treasury secretary and former Fed chair Janet Yellen recently said, central banks know how to subdue inflation; it is deflation that continues to puzzle them.

Monetization only works if there is a respected and responsible central bank ready to turn off the taps when inflation threatens to exceed its targets and a responsible government. If the government believes the central bank has a limitless appetite for its debt, it could spend beyond the point at which the central bank can still control inflation. Such “fiscal dominance” is real. For example, the central bank had an explicit obligation to buy government debt in India before reforms in the 1980s and 1990s.

Questions about central bank independence could be mitigated by capping the amount of spending that can be monetized. Bernanke has proposed that Congress create a Treasury account at the Fed that the Fed could fill up to a limit. Congress would retain the authority to decide where to spend any funds the Fed created.

The theory of central bank independence, Bernanke has argued, allows for such close cooperation between a country’s central bank and Treasury during difficult times, when their interests are clearly aligned. During the world wars, for example, the Fed temporarily monetized portions of an expansive fiscal policy at the expense of its independence. After World War II, the Fed artificially kept interest rates low—a policy known as “financial repression”—so the government could more easily repay its debts. But the Fed ultimately recovered its independence. Recent papers suggest that monetization may need to be accompanied by some financial repression to significantly affect debt burdens.

Since we published our paper, President Joe Biden’s $1.9 trillion American Rescue Plan has rekindled this debate. Notable economists like former Treasury Secretary Larry Summers have raised concerns about inflation. It would be fine, Summers says, if the government simply plugged the output gap—the difference between current and potential GDP. But he argues that the proposed relief is much bigger than that. In contrast, he argues that the $840 billion stimulus package of 2009, of which he was a chief architect, was not nearly large enough to address the output gap during the GFC.

To be sure, the Fed now says it will accommodate higher inflation than in the past. Investors seem to have noticed. Ten-year Treasury yields—a market proxy for inflation—have crept higher in recent weeks.

But that doesn’t mean we are in for excessive inflation.

First, the GFC is the wrong historical analogy. It was a balance-sheet crisis, stemming from exposure to highly risky assets and unsustainably high leverage. During the pandemic crisis, financial balance sheets are fine; the shock came from outside the financial system. This makes it more like a war, as economist Paul Krugman has argued and World Bank chief economist Carmen Reinhart recently suggested. Wars, like the pandemic crisis, require huge amounts of government spending, industrial reorganization, and monetary-fiscal coordination. Despite massive, debt-financed spending by the U.S. during both world wars, inflation never got out of hand. Indeed, Fed Chair Jay Powell recently said (page 10) that he does not expect the combined Fed and Treasury measures will lead to “troubling inflation.”

Second, the critics’ argument partly rests on their view of the fiscal multiplier, which measures the effectiveness of a particular fiscal policy program on output. The higher the multiplier, the greater the effect on output. Olivier Blanchard, a former IMF chief economist, estimates that the multiplier of the Biden package will be 1.2, which means that the $1.9 trillion ARP would have an estimated effect of $2.3 trillion on output.

But there is an argument that multipliers could be much lower, both because many sectors of the economy are shut down or operating at reduced capacity and because fear of catching COVID will make people more cautious about completely returning to normal.

Third, the Federal Reserve now has a long track record of well-communicated, timely, and measured monetary policymaking. Consumers and businesses may trust that the Fed can allow prices to rise moderately without risking excessive inflation. Some moderate, controlled inflation would also allow the Fed to begin gradually raising interest rates, which have hovered close to zero since the global financial crisis. Some inflation also could give the Fed some more room to manipulate rates during downturns. Instead of signaling a coming inflationary spiral, increases in 10-year Treasury yields may simply be a sign of markets willing to take more risks. Sound monetary policymaking in the past gives central banks the necessary capacity to effectively combat negative shocks in the present while preserving credibility.

In short, monetization is a powerful tool that countries with strong, independent central banks can use to finance large rescue programs and pay down existing debt.

We may soon have firsthand experience with monetization, with the passage of the latest relief bill and the Fed’s increased tolerance for higher inflation. Only time will tell how the Treasury and Fed will navigate these challenges.