Monetization of Fiscal Deficit – A Primer

Monetization of Fiscal Deficit – A Primer

Recently, there has been a lot talk around monetization of deficit by the Government of India. Many of economic experts and politicians are advocating for it in order to counter the effects of the economic slump caused by the Covid-19 induced shutdown. At the same time a number of experts have warned against it because it may lead to disastrous consequences in future in form of inflation. The opinions are conflicting and there is not a lot of literature that one can find which systematically deals with the subject. Workings of modern financial system are not well understood by an average person and monetization of deficit is a difficult concept to comprehend even for most financially savvy and astute professionals. Hence, the purpose of this primer to make it easier for everyone to understand what is monetization of deficit.

In this primer, I try to answer the following questions

1.      What is a fiscal deficit and how can it be funded?

2.      Why is fiscal deficit a popular method of funding government expenditure?

3.      What is monetization of Fiscal Deficit?

4.      What is the impact of monetization of Fiscal Deficit?

5.      What can you do to mitigate its harmful effects?

What is a fiscal deficit and how can it be funded?

In simple terms a deficit means shortage. In the context a country, it means that the government is spending more than it is earning. The primary source of government revenue is taxation. It levies various direct and indirect taxes on its citizens and uses this revenue to funds its expenditure.

We all know that if we want to spend more than what we earn then we need borrow money in order to undertake the additional spending. This also means that we will, at some point in time have to pay back the borrowed money along with interest. Same is true for the government. Whenever the government needs to spend more than it earns it needs to borrow. It can borrow from the domestic markets, where financial institutions and individuals lend money to the government by investing in bonds issued by the government. In return the government pays interest and repays principal on maturity.

The subject of why do governments need to incur fiscal deficits in first place, is an interesting and vast topic in itself and would be better dealt with separately. So, for the purpose of the current discussion we just assume that there are number of plausible reasons, rational or irrational, for running a deficit. What we want to focus on here is then how could they be funded and what is the impact of choice of the funding method.

In normal times government can meet its borrowing needs by borrowing the money from the market. In a well-functioning domestic bond market like the one we have in India; government bonds have a significant demand since they are considered to be the safest investment. A government cannot default on its debt because it can always print its own money. This is what separates a government from all other classes of borrowers. Government is the only borrower which can print its own money so it can never default on bonds denominated in its own currency. While there is no default risk, government bonds are not immune to inflation. Additionally, too much government borrowing can crowd out private investments by increasing the cost of borrowing for private sector. This limits the government’s ability to borrow.

Why is fiscal deficit a popular method of funding government expenditure?

Now that we understand what is fiscal deficit and how it is funded, it would be beneficial to discuss why is it a popular method for funding government expenditure and why does it become even more tempting during an economic crisis.

Democracy is a popularity contest. The political party which gets the highest number of votes wins the election and forms the government. Primary objective of any political party is to form a government and stay in power. Once you have power you can pretty much do anything. Without it you cannot do much. The way to stay in power is to get highest number of votes and they way to get votes is by increase your popularity. If you want someone to like you, you need to do things which make you likable. Politicians do that by making promises to do things for the people whom they are trying to woo and then implementing those promises when they come in power. Promises may include a number of things including freebies for a particular interest group, employment guarantees, price guarantees for agricultural products, subsidized goods etc. All these freebies do not come for free and they have to be paid for by someone. Government’s primary source of income is taxation. Government raises revenue from tax and spends that money on implementing its promises. This is where the problem starts.

Tax is legalized theft of money from hard working citizens in order fund the promises made by the government. The politicians do understand that taxation is not very popular and citizens do not respond very well to increase in taxation. Since, democracy is a popularity contest, no politician can get elected by increasing the burden of taxation of common citizens. Also, it is a political suicide to propose new taxation during an economic crisis and a bunch of naïve IRS officers may have done a significant damage to their careers by even proposing a new tax to finance government operations during the Covid-19 pandemic. Politicians have to do a delicate balancing act of conferring benefits on a small number of special interest groups and spreading the cost of it as widely as possible. This is where fiscal deficit helps. It helps the government to increase their spending without requiring increase in taxation. It is a win-win combination, government can increase the spending to woo special interests without receiving flak from ordinary citizens for increasing tax burden.

In the times of economic crisis, like the one we are currently facing government revenues would naturally decline. At the same time citizens would expect the government to take measures to support the economy which would require additional spending. When the citizens are making an appeal to government to support them, they do not think too much about how the government is going to pay for the additional spending. They just want relief. They may even assume that government has a hidden pot of money lying somewhere which it can spend to support the declining economy. What they do not realize is that the government is already saddled with debt and does not actually have the money support the additional spending. Ordinary citizens rely way too much on the government to support them. What they fail to realize is that it is the government which is actually reliant on the ordinary citizens. Ordinary citizens are the ones actually supporting the government by paying taxes or funding the fiscal deficits by lending government money and making contribution to the PM and CM CARES funds. Government is using ordinary citizen’s money to provide a relief to ordinary citizens using a very inefficient process which has a lot of value leakage. The system would be much more efficient if we completely bypassed the government and ordinary citizens just help each other. Nevertheless, very few people understand this. Most of citizens expect the government to bail them out of crisis.

No government can afford to say no to its citizens in the times of crisis for lack of money, the money which they fully control and can print out of thin air. If they say no, they will for sure lose the next election. If they do something, then there is a positive chance that they can continue to be in power. Like I mentioned earlier, primary objective of any political party is to stay in power, everything else is secondary. They will do whatever it takes to retain power and hence incurring and even monetizing a fiscal deficit becomes very tempting.

What is monetization of Deficit?

Monetization of deficit is most commonly understood to mean the practice of financing government spending by creating new money out of thin air and spending it. This also implies that government directly controls the money supply. Let’s call this practice, direct monetization of deficit. However, in the modern world, central banks are in charge of controlling the money supply. Hence, the government usually finances its deficits by issuing bonds. These bonds are then purchased by the public by using the existing money supply or can be purchased by central banks by increasing the monetary base which results in increase in money supply. The purchase and sale of governments bonds by central banks, commonly known as Open Market Operations or OMOs, is a one of the tools used by central banks to manage/control the money supply. These OMOs lead to indirect monetization of debt.

In order to understand how OMOs lead to monetization of deficit we need to understand the workings of the modern central banking, especially the part which relates to control/management of money supply. In the modern world, government of every country has Monetary Sovereignty which is the right of the state to exercise exclusive legal control over its currency by exercise of the following powers:

• Legal tender – the exclusive authority to designate the legal tender forms of payment.
• Issuance and retirement – the exclusive authority to control the issuance and retirement of the legal tender.[1]

The issuance and the retirement of legal tender is managed by the central bank on behalf of government of the country. Balance sheet of a central bank commonly look like this.

Liabilities	Amount (INR Bn)	Assets	Amount (INR Bn)
Equity	5	Investment in Govt Securities	30,000
Reserves	50	Other Investments	55
Deposits	10,000
Notes Issued	20,000

The main liability of a Central Bank is the legal tender or currency notes issued by it. Second biggest liability is the money held by commercial banks with the central bank as reserves. On the asset side we have investment in government securities.

Let’s assume that the financial markets liquidity is a bit tight and the central bank wants to increase the liquidity to ensure normal functioning of the market. So, it decides to conduct an OMO where it purchases INR5,000 Bn worth of government securities and there by releases that amount into financial system. If we look closer at the above balance sheet of the central bank, it does not actually have INR5,000 Bn spare to purchase these government bonds. The only way it can do this is by creating new money out of this air. In this case we assume that it did so by issuing new currency notes. After these operations the balance sheet looks as shown below.

Liabilities	Amount (INR Bn)	Assets	Amount (INR Bn)
Equity	5	Investment in Govt Securities	35,000
Reserves	50	Other Investments	55
Deposits	10,000
Notes Issued	25,000

Every time the financial conditions are tight central bank tries to ease them by increasing liquidity or creating money out of this air. But these OMOs could also be used to indirectly finance new government borrowings and thereby leads to monetization of fiscal deficit.

Consider the current situation. Government revenues are on decline and the government needs to increase its spending in order to revive the economy. This means that the government has no option but to increase it borrowings. Former Finance Secretary Shubhash Chandra Garg, estimates that government will have to borrow additional INR10 Lakh Crores this year and it would be very unrealistic to expect the financial market participants to absorb even a quarter of additional government borrowing.[2] So, from where can government borrow if its existing sources of borrowings cannot provide it money.

The problem here is that banking system cannot lend more money to government because they already own a lot of government bonds. Also, Reserve Bank of India (RBI) cannot directly finance new government bonds issuance due to Fiscal Responsibility and Budget Management Act, 2003 (FRBM Act), which prevents the RBI from subscribing to primary issuance of government securities. But the RBI is allowed to purchase government bonds as a part of OMO operations for the purpose of controlling the money supply. The decline in economic activity caused by lockdown provides a perfect cover for RBI to exercise it powers to conduct OMOs to buy government bonds for the purpose of increasing liquidity within the banking system. This increase in liquidity, which will purportedly allow banks to lend to struggling businesses, actually serves another hidden purpose. That is to indirectly finance government fiscal deficit. RBI buys existing government bonds from the banks by creating new money out of thin air. This puts the newly created money in the hands of banks who in turn use that money to subscribe to newly issued government bonds. This is how central banks use OMOs to indirectly monetize fiscal deficit.

Some would argue that OMOs are a tool for Central banks to adjust the monetary base and/or the interest rates in line with their targets. So, a mere purchase of government securities by the central bank should not be seen as monetization. So, does monetization only reflects the central bank’s purchase of government securities in primary but not secondary markets? 

This distinction would only work as long as central banks do not indulge in open market purchases to support the government’s debt financing. If the central bank goes on infusing liquidity to support the banking sector’s purchases of government bonds even while not subscribing to its primary issuance, the net result would be the monetization of debt.[3] That is what is happening currently.

The economy is currently facing a demand shock, due to shut down in economic activity which has been caused by lockdown. People are cutting back on spending because they have lost their source of income. So, the most logical solution to reverse this demand shock is to end the lockdown, so that the economic activity can resume. No amount of additional liquidity can revive the demand if the economy is in cold storage. No bank will lend money to a business which has no revenue and businesses cannot earn revenue if the economy is under lockdown. Hence, it is not very difficult to conclude that the hidden but the primary purpose of infusing liquidity is to support the banking sector’s purchases of government bonds and indirectly monetize fiscal deficit.

Central banks have always been indirectly monetizing fiscal deficits and a lot of it has already been monetized since the beginning of the Covid-19 pandemic. Lot of economists and political pundits are of the view that government should do whatever it takes to revive the economy. They should not hesitate to directly monetize and not worry too much about its consequences. Guess what. Its already happening, albeit in an indirect fashion through liquidity injection. I believe that we may never see a direct monetization of fiscal deficit because indirect monetization works perfectly well. Additionally, there is no bad press or negativity associated with OMOs because the increasing liquidity is supposed to help support struggling businesses, right?

What is the impact of monetization of Fiscal Deficit?

Now let’s look at the consequences of monetizing a fiscal deficit.

Let’s for the time being assume that government borrowing is financed entirely from market and the money supply in the economy is fixed i.e the central bank is not allowed to increase money supply in any manner including OMOs. This means that the maximum government borrowings can only equal available savings in the economy. Hence, it becomes more expensive for the government to increase its borrowings as the marginal cost of additional borrowing keeps on increasing. The debt which has been borrowed today needs to be paid back in the future with interest. This means that in future the government will have to either cut spending or increasing taxation, both of which are highly unpopular. Governments are faced with an impossible situation where they want to increase spending, increase borrowing, keep the borrowing rates low and not increase taxation. How can the government manage to achieve these seemingly conflicting goals?

What if I told you that the government could impose a magical tax on all of its citizens which could not be actually seen by anybody but nevertheless paid by everybody. This tax is so foolproof that no one can escape its burden and best of all the cost of administering this tax is next to nothing.

Does it ring a bell?

Let me give you one more hint. It starts with the letter I.

Yes, you guessed it right. Inflation. It is a magical tax which can be imposed on all of the citizens. It cannot be easily seen by anybody but nevertheless everyone pays it in form of higher prices for goods and service. No one can escape the burden of inflation and the most ironic thing about it is that the people who can least afford to pay it are ones which get taxed the most. There is minimal cost of administering inflation, no need to file returns, no need for an assessment and it gets collected automatically from everyone without fail.

Now how do you create inflation? It’s easy, let the money printer go brrrrr. This is where monetary sovereignty comes into picture. The ability of the government to print its own money and spend it. By increasing the money supply central banks are able to manufacture inflation. Inflation benefits the government at the expense of its citizens. Inflation enables the government to increase spending by increasing borrowing. The continuous expansion of money supply creates new money out of thin air which helps to keep the cost of borrowing low. There is no need to increase taxation because government can finance the additional deficit by borrowing more money that the government itself has created out of thin air. As long as the rate of inflation exceeds the cost of borrowing, government is able to inflate away its debts. Deficit spending, once embarked upon, creates powerful vested interests which demand its continuance under all conditions.

If you are wondering why is inflation bad, I will let Henry Hazlitt spell it out concisely for us?

Inflation itself is a form of taxation. It is perhaps the worst possible form, which usually bears hardest on those least able to pay. On the assumption that inflation affected everyone and everything evenly, it would be tantamount to a flat sales tax of the same percentage on all commodities, with the rate as high on bread and milk as on diamonds and furs. Or it might be thought of as equivalent to a flat tax of the same percentage, without exemptions, on everyone’s income. It is a tax not only on every individual’s expenditures, but on his savings account and life insurance. It is, in fact, a flat capital levy, without exemptions, in which the poor man pays as high a percentage as the rich man.

But the situation is even worse than this, because, inflation does not and cannot affect everyone evenly. Some suffer more than others. The poor may be more heavily taxed by inflation, in percentage terms, than the rich. For inflation is a kind of tax that is out of control of the tax authorities. It strikes wantonly in all directions. The rate of tax imposed by inflation is not a fixed one: it cannot be determined in advance. We know what it is today; we do not know what it will be tomorrow; and tomorrow we shall not know what it will be on the day after.

Like every other tax, inflation acts to determine the individual and business policies we are all forced to follow. It discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse.[4]

Government sponsored economists would argue that fiscal deficits are bad when the economy is doing well but they become almost necessary when economy is not doing well. Especially in the current times where economic activity has almost come to a halt, it is necessary to engage in deficit spending in order to stimulate the economy, to get the wheels of industry turning. Without it there will be stagnation and the economy will function at less than full employment. It may cause deflation which may ultimately result in a depression.

This argument is a result of confusing money with real wealth. Real wealth consists in what is produced and consumed: the food we eat, the clothes we wear, the houses we live in. Whereas money is just a medium of exchange and a unit of account. Money helps us to transact easily with each other and price the exchange rate of various goods in one single unit of account. Simply having more money does not automatically increase real wealth, if the additional money does not enable you to buy more of real goods and services. Real wealth is created by Human Action and not by money printer going brrrr.

When economic activity has come to a halt, in order to get it up and running we need the production and output of real goods and services to increase. This will happen only when the economy is allowed to function unhampered. Because of the pandemic the needs and wants of the people may have changed completely. Relationship between various goods and services and their demand and supply may have changed completely. We cannot simply go back to the old way of doing things. We can not use the pre-covid relationships as the benchmark. We have to let the markets decide which goods should be produced and supplied because markets are much more efficient at allocating scarce resources than the government. Simply increasing money supply without any increase in production will only lead to inflation. 

We can think of the government as a parasite, an organism that lives in or on an organism of another species (its host) and benefits by deriving nutrients at the other's expense. Governments finances itself by taxing and borrowing from its own citizens. When neither is possible, it engages in monetization of deficits. By monetizing deficits, it creates inflation where it feeds of its own citizens, mostly the poor and the middle class and benefits itself at the expense of its own citizens.

What can you do to mitigate its harmful effects?

You would agree that government will do whatever it takes to protect themselves. For them retaining power is the most important prerogative. So, it will not shy away from incurring huge fiscal deficits and even monetizing them, all in the name of greater good of the economy. Inflation is good for the GDP and the government because it creates a mirage of growth, but it does not necessarily mean that it is good for common citizens who are seeing the purchasing power of their money evaporate. Hence, it is important to take steps to protect the purchasing power of your money by investing it in assets which provides a hedge against inflation.

Traditionally real estate and gold have proved to be good inflation hedges due to their limited supply and inability of the government to print real estate and gold out of thin air. Bitcoin also would be a good investment due to its attractive risk-return characteristics and strictly limited supply. Additionally, it is censorship resistant, making it difficult for the government to confiscate it without owner’s permission. Generally, stocks would also help to beat inflation but in the current markets which are juiced by the central bank liquidity it may not be a good idea. The economy is not doing well and there is a total disconnect between on ground realities and stock markets. Eventually the stock markets will catch up with the ground realities and correct themselves. The worst kind of investment would be debt, especially government debt which has the lowest yields. You will have positive returns but the purchasing power of you money would have substantially gone down. The yields would not be sufficient to cover the inflation and on a net basis you will end up poorer. High yielding debt could be able to beat the inflation but given the current ground realities the risk of default is very high.

Apart from investing in inflation proof assets understanding how the newly printed money makes its way through the economy would be helpful to capitalize of opportunities which present itself as the prices of various goods and services adjust to the inflation. Currently, RBI is creating new money by reducing interest rate and conducting term repos. This the newly created money is going to the commercial banks. The banks will use this money to either invest in new government securities or make loans to business. Next, we need to track where the government is spending the new money and which industries are able to get the new loans from banks.

Government might be spending this money on purchasing and supplying food grains for poor. They could be spending it on healthcare to fight the virus. They could be spending it on providing employment under MGNREGA. This means that demand for food grains will go up. Demand of healthcare and related industries would go up. Demand of rural laborers would go up. Once these industries and their employees get the money, they will spend it on things that want. Thus, we might see an inflation in prices of food and healthcare services.

Generally, banks would lend to industries and companies which are resilient and have a strong financial position. Thus, those companies which get the new loans would be able to survive and come out stronger than those who do not get funding. In an inflationary environment, businesses, which are able to pass on the price increases to customers would do well versus those whose customers are price sensitive. You could use this information to adapt your business model to an inflationary environment.

If you have a stable income and have not been much affected by the lockdown and are relatively debt free, it would be a good time to take a new loan and invest the money in inflation proof assets. This way you would be borrowing now when purchasing power of the money is higher and interest rates are lower and paying back it in future with new money, which has a lower purchasing power. This way, you would be able to increase your real wealth as opposed to notional wealth.

If you have made it this far, thank you. I understand this is a fairly long read and requires patience and attention. However, the benefit is that in a short period of time you have acquired a comprehensive understanding on the topic of monetization of fiscal deficit and are way ahead of others who might not even realize that it is already underway. 

Hope you found the article interesting. Hope it has helped you to increase your understating about the topic, how it may affect you and what you need to do about it. Do let me know your reviews in the comments sections. Alternatively, you could send me an email on niravgala@protonmail.com. Please share it with your friends who might find it interesting. Until next time.

Cheers,

Nirav Gala

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[1] "The Legal Aspect of Money" by F.A. Mann, 5th edition, Oxford, 1992, pp. 460-78

[2] Budget 2020-21 Is Falling Apart- Concluding Part III- Financing Extraordinary 10 Lakh Crore COVID-19 Deficit https://subhashchandragarg.blogspot.com/2020/04/budget-2020-21-is-falling-apart.html

[3] Fiscal-Monetary Co-ordination in India: An assessment. https://m.rbi.org.in/Scripts/PublicationsView.aspx?id=14939

[4]Hazlitt, H. (1947). The Mirage of Inflation. In Economics in One Lesson (p. 156). Ernest Benn.