Abstract: Before adopting the monetization of fiscal deficit as a real policy option, three critical questions need to be answered: what economic grounds justify deficit monetization; is it worth to sacrifice the coordination between fiscal and monetary policies; and how to deal with the impact of sovereign credit on monetary policy as a result of deficit monetization that will give rise to excessive government debt.
The most important factor affecting each country's economy now is undoubtedly the novel coronavirus pandemic and its global spread. In response to the COVID-19 shock, countries have adjusted their macroeconomic policies, and many of them have also initiated new policy instruments, which have triggered heated discussions over policy options. One of the most typical examples of such discussions in China is about the monetization of fiscal deficit.
I believe that three questions must be answered before "deficit monetization" is adopted as a policy option.
First, the basis for any macroeconomic policy package is economic reality, which means that prior to the discussion of a policy option, actual economic operation must be evaluated. For instance, on April 17, at the meeting for analyzing the current economic situation and deploying the current economic work, the Central Committee of the Communist Party of China pointed out that China should offset the impact of the pandemic with more aggressive macroeconomic policies, and adopt more proactive fiscal policies and more flexible prudent monetary policies. This shows that despite the pandemic shock, macro policy was still oriented towards a combination of active fiscal policy and prudent monetary policy.
The meaning of the monetization of fiscal deficit in a common sense is fund raising of the fiscal authority directly from the central bank (that is, central bank purchases government bonds directly) to make up for fiscal deficit. In terms of policy effect, the increase of fiscal deficit is a typical feature of active fiscal policy, and the base money released as a result of central bank's purchase of government bonds, or "money printing", is a reflection of loose monetary policy. This indicates that the monetization of fiscal deficit in fact equates to a combination of active fiscal policy and loose monetary policy.
So what kind of dramatic changes have the economy experienced that we have to adjust the macro policy direction set less than a month ago by the Central Committee on April 17? This is the first question needed to be answered before adopting deficit monetization. And answering this question does not require a description of the so called "monetary status". According to a recent survey on 10 thousand business entities by the People's Bank of China (PBOC), China’s economic operation has been showing signs of recovery over the past month. As of the end of April, industrial production had basically restored, and the work resumption rate of services industry had been continuously increasing; more than 97.5% enterprises had restarted work and more than half industrial enterprises' equipment utilization rate had reached or surpassed that of the second quarter last year.
Second, from the experience of macro control, better coordination between fiscal and monetary policies means better effect of macro control. However, once deficit monetization is implemented, the coordination between fiscal and monetary policies will disappear. In practice, deficit monetization is simply the purchase of government bonds by PBOC, that is, the central bank will inject an amount of base money into the society equaling the scale of government bonds issued by the fiscal authority, which means the loss of control over these base money by the central bank. In 2007, the fiscal authority issued 1.55 trillion yuan of special government bonds targeting commercial banks, which was then purchased by the central bank through open market operation. This shows that the central bank can provide fiscal support, and such support in itself is a manifestation of the coordination between fiscal and monetary policies, which didn't lead to the loss of control over base money by central bank. This is because government bond as one of the most important underlying financial assets in the financial market, works as a major macro control measure, through the purchase and selling of which in the open market, the central bank adjusts monetary supply. Furthermore, the 29th Article of the current Law of the People's Republic of China on the People's Bank of China clearly forbids PBOC's overdraft for government fiscal spending, and the direct purchase and underwriting of government bonds and other government securities.
What can force us to adopt fiscal deficit monetization despite the consequent loss of the coordination between fiscal and monetary policies, and the breaking of the Law of the People's Republic of China on the People's Bank of China? This is another question that needs to be answered before we proceed with the proposal.
The third question arises from the de facto relaxation of constraint on fiscal deficit due to the adoption of deficit monetization. Once such kind of "soft" constraint gets normalized, the increase of government debt may also become normal; as a result, monetary policy will inevitably get impacted by sovereign credit. Based on domestic experience and international practice, governments to a large extent rely on borrowing to pay existing debts. From the perspective of debtors, the lower the interest rate, the lower the repayment cost, but when a government's debt burden grows excessively, the change of interest rate level will directly affect government's solvency, and hence the rating of sovereign credit. Therefore, objectively, in order to maintain the rating of sovereign credit, the fiscal authority will force the central bank to keep the interest rate low; and once such implicit policy implication becomes a social consensus, it will in fact nullify the interest rate policy of the central bank. How could a central bank without functioning policy rate effectively handle the change of inflation expectation and exchange rate volatility, prevent and resolve financial risks, maintain financial stability, maintain the stability of currency value, and thereby promote economic growth?
Facing such huge risks, should we adopt the monetization of fiscal deficit?
It would be remiss of us not to provide clear answers to the above three questions before advocating deficit monetization as a real policy option.
