Abstract: In this article, the author examines the prerequisites for monetizing fiscal deficits and explains why China should not adopt this approach. He advocates a fair assessment of the four-trillion-yuan stimulus package in 2008-2009, as well as thoughtful planning and timely introduction of new stimulus measures in response to the pandemic shock.
I. Monetization of fiscal deficits must be bounded by strict limitations
Recently, there is an opinion that the quantity theory of money is outdated, and it is no longer appropriate to measure the macro leverage ratio by money supply. People holding this opinion advocate issuing special government bonds and monetizing fiscal deficits. Regarding this point of view, I think it is necessary to carefully consider the prerequisites for monetizing fiscal deficits.
First, it is normal to see some deviation from the money quantity theory in the short term. There are indeed some problems in describing the leverage ratio with money supply and measuring the economic performance with the debt ratio during the financialization of the economy. However, these problems do not mean that the monetization of fiscal deficits is a theoretical hypothesis or policy proposition without any preconditions.
In the history of modern economics, monetizing fiscal deficits is not a rare phenomenon. Before the existence of laws and rules over central bank independence and fiscal discipline, monetizing fiscal deficits was an often option by many countries to cope with fiscal pressure. Strictly forbidding this approach does not have a very long history. Even so, at some special times, it is necessary to monetize fiscal deficits, because any government debt expenditures and social debt expenditures eventually are converted into currency. The important issue is in which way the conversion is done.
In a broad sense, there are the following several ways to monetize fiscal deficits:
First, the financial department issues government bonds, and the central bank purchases them in the secondary financial market and thereby holds national debt. Its purpose is to adjust money supply and bond yield curve through open market operations, and achieve policy goals of stabilizing price and securing full employment in cooperation with other monetary policy tools.
Second, the central bank directly purchases government bonds in the primary market to help fiscal authorities to finance. It is reflected in the central bank's balance sheet as expanded debt holdings and cash issuance.
Third, debt write-downs. The central bank can directly reduce the size of government bonds it holds to reduce government debt burden.
Fourth, the central bank converts national bonds it holds into zero coupon perpetual bonds.
Fifth, the central bank issues cash.
Sixth, direct transfer for fiscal use. Governments at all levels implicitly convert government debt into monetary credit through various innovated financing instruments, and have the intention and ability to not repay debts.
The theory and policy focus of the monetization of fiscal deficits involves the above-mentioned four practices from the second to the fifth. The first practice is, in nature, an open market operation and a normal approach of monetary policy adjustment, in which central bank can maintain the independence of its monetary policy, instead of being influenced by fiscal policy and government bond issuance. Governments have to repay the principal and interest of government bonds as scheduled. The sixth practice is essentially debt financing in an invisible and soft-constrained environment, such as the existence of various investment and financing platforms after 2009. The monetization of fiscal deficits under discussion amid the pandemic shock and "helicopter money" mainly refer to central bank's direct purchase of government bonds in the primary market.
II. Monetization of fiscal deficits has prerequisites which cannot be ignored
In this round of rescue, developed countries such as European countries and the United States generally adopted the approach where central banks enter the primary market to purchase government bonds directly, so as to realize comprehensive expansion in cooperation with fiscal policies. Therefore, many experts believe that western countries have now fully implemented modern monetary theory (MMT) and have the monetization of deficits normalized.
This kind of understanding is too superficial. There are many strict conditions for monetizing fiscal deficits. It is a rescue tool taken under an extreme condition featuring economic crisis, financial crisis and pandemic shock. Normally, it requires the following premises:
One is that monetary policy is caught in a liquidity trap, where rescue through extremely loose monetary policy is impossible and expansionary fiscal policy becomes the last resort for implementing various rescue measures.
Second, there is no room left for fiscal expansion. A large-scale deficit must be adopted, and it is hardly possible to expand government deficits through normal market sales. For example, market demand for government bonds has dropped significantly, making it difficult to issue government bonds in a normal manner. As another example, the conventional issuance of government bonds may seriously squeeze market liquidity, and can lead to a strong crowding out effect. Under these situations, the central bank monetizes fiscal deficits through directly purchasing the national debt in the primary market.
Third, the market interest rate is already very low (usually zero). The costs of financing through fiscal debt and central bank's currency issuance are basically the same. The former and the latter have an equivalent function.
Fourth, laws including the Central Bank Law must be amended or various exceptions must be initiated to allow the government to break through the deficit ceiling and allow the central bank to enter the primary bond market to purchase government bonds directly. For example, both the European Central Bank and the Federal Reserve have used related exception clauses.
Therefore, the extraordinary policy measures adopted by European countries and the United States at this special time are not normal policy options. We have to pay attention to not only the premises of implementing these policies, but also the exit of these policies after the economy and social activities return to a normal state.
One is whether there is a legal basis for the implementation of these policies when the country resumes its normal economic and social status, that is, whether the exception clauses that enable the monetization of fiscal deficits are still applicable, and whether the central bank has the right to continue to purchase government bonds to assist fiscal policies in financing.
The second is whether the government needs to repay debts incurred during the extraordinary period. Can these debts be wiped off through write-downs and zero-coupon perpetual bonds?
The third is whether the central bank can maintain its independence and unwind its balance sheet in accordance with market laws.
III. China has not reached the point where monetization of its fiscal deficits is imperative
As stated earlier, there are certain prerequisites for monetization of fiscal deficits. Generally, this option can only be introduced after the following situations occur.
First, in the face of acute market failure and the collapse of economic operations, the government needs to carry out substantial fiscal expansion. However, there is no fiscal space left. In this situation, the government can moderately monetize its fiscal deficits.
Second, monetary tools are found with serious flaws, and are ineffective in providing relief. Under this circumstance, monetization of fiscal deficits can transfer monetary expansion onto fiscal expenditures to achieve the effects of targeted and systemic bailouts.
Chinese economy came to a standstill under the pandemic shock. To fully restart the Chinese economy, and hedge against the impact of disruptions in external economies and supply chains, more aggressive fiscal policies are necessary. Though this may pose a great challenge to fiscal policy, the pressure on China's fiscal space demanded by economic recovery is not as large as that in Europe and the US. There is no need for China to monetize its fiscal deficits for the following reasons:
First, China's fiscal space remains very large. China's government debt ratio and general budget deficit are less than 60% and 3%, respectively, both below the world average. So China still has sufficient fiscal space for pandemic rescue.
The second is that China's monetary tools are still highly effective. At the same time, China does not have a serious liquidity trap like the developed countries in Europe and the United States. There is still much room for monetary policy maneuver. The target yield of government bonds of up to about 2% is not in line with the MMT principle that cash and government bonds are equivalent under zero interest rate.
Third, China's government debt still enjoys very large market space. Market demand for government debt is strong. A large number of commercial banks and residents hold abundant cash and are willing to purchase safe assets such as government bonds. Therefore, there is no need for the central bank to enter the primary market to purchase government bonds. In fact, proportion of Chinese residents' financial assets is still very low, and commercial banks still have a certain amount of deposit reserves. Currently, China can release deposit reserves instead of allowing the central bank to directly purchase government bonds.
Fourth, the Article 28 of the Law of the People's Republic of China on the People's Bank of China stipulates that "The People's Bank of China may not provide the State with overdraft facilities, and may not directly subscribe and underwrite state bonds and other government bonds." The Article 29 stipulates that "The People's Bank of China may not provide loans to local governments or governmental departments at all levels, or to financial institutions other than banks, other organizations or individuals, however the special financial institutions other than banks to which the People's Bank of China may provide loans as determined by the State Council shall be excepted." Therefore, to monetize fiscal deficits, China needs to amend or suspend the Law of the People's Republic of China on the People's Bank of China.
Fifth, we must profoundly recognize the additional negative impact of deficit financing on the economic governance system and market operation system. Historically, hyperinflation was always the product of monetization of fiscal deficits. Monetization of deficits often is related to the collapse of the government's governance system, which means that government actions are not subject to fiscal disciplines, and the government can borrow indefinitely and enjoy currency and inflation taxes by issuing banknotes. Therefore, to monetize fiscal deficits is to allow government to behave without disciplines, which will cause anomie of the government, and the collapse of the governance system of a country. This kind of history memory often gives market participants a direct expectation—monetization of fiscal deficits is equivalent to hyperinflation. This expectation can massively disturb market operation even if the government could get out of the plight of deficit financing through self-regulation.
Under the impact of the current pandemic, although there is no immediate expectations of inflation, concerns over the government's governance system, normalization of monetary policy, and future expansion of government power will bring profound economic and social implications. In the process of modernizing China's governance system, it is very dangerous to monetize fiscal deficits without full considerations.
IV. China must break out of the trap of "paling at the mention of stimulus package"
In 2008, the Chinese economy suffered external shocks. Meanwhile, the real estate market was undergoing adjustments. At that time, implementation of the four-trillion-yuan stimulus package was strategically correct. However, when we evaluated policy effects later, we found that the stimulus package left many serious aftereffects. However, these aftereffects were not caused by the package itself, but by some faults in the choice of policy tools, how they were combined and their implementation steps.
First, the four-trillion-yuan stimulus package was essentially monetary stimulus. The indiscriminate strong stimulus failed to benefit specific projects, caused the investment to flow to the virtual economy, and led to many problems.
Second, the stimulus was introduced by the central government but implemented by local governments. The mismatch between financial power and authority power has forced local governments to make up for their fiscal shortage by initiating investment and financing platforms. This phenomenon has led to implicit monetization of fiscal deficits of local governments. Local investment and financing platforms implicitly converted bank credits into government funds through various non-standard operations, which led to high debt levels of local governments and severely damaged financial order.
Third, the stimulus package was used to finance programs in ten major traditional industries, which caused overcapacity in these industries.
It must be acknowledged that though some policy tools and policy combination caused a number of undesirable aftereffects, it should not negate the strategic value of the stimulus policy itself. We should recognize the effect of the four-trillion stimulus package in hedging against shocks and preventing the collapse of Chinese economy.
The evaluation of the four-trillion stimulus policy package requires a dichotomy perspective. We cannot simply say that it is completely correct and appropriate, or it is an absolute mistake. China must break out of the psychological trap of "paling at the mention of stimulus package". If the economy declines severely and needs stimulus, such measures must be put in place. When insufficient demand harms the economic cycle, and causes systematic distortion of resource allocation, we must roll out economic stimulus decisively. However, stimulus policy itself, without appropriate choice of policy instrument and policy combination, may fail to achieve the best result.
China must arrange policies in accordance to the distinct nature of the shocks and choose appropriate policy tools. Stimulus packages are all about details. Instead of simply considering whether there is a need for a stimulus package, we need to think about how to stimulate the economy in a more scientific and effective way. Right now we are presented with an opportunity for economic development. There is an urgent need to bring forward the 6.5-trillion-yuan stimulus package with thoughtful planning.
