Debt monetization: constraints and global implications

The failure of austerity measures to restore growth in a meaningful manner in the aftermath of the global financial crisis has sparked a renewed interest to explore alternative means to revive aggregate demand and inflation. Debt monetization, advocated by proponents of the modern monetary theory (MMT), is one such alternative—will it work?

Turning to debt monetization as governments run out of options

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. 

Is it really a magic money tree for everyone?

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.

Constraints Why it’s important
Inflation/resource
  • If there’s no spare capacity in the economy, higher government spending will lead to inflation. MMT recognizes that inflation isn’t desirable above a certain level—once self-financed fiscal stimulus exceeds what the real economy can supply, spending needs to be cut back or taxes increased.
  • A poor country with no natural resources or industry that’s also home to an uneducated population cannot print unlimited local currency to finance its spending—there needs to be sufficient global demand for its currency to enable it to procure the resources it needs. In contrast, if a developed economy is suffering from high unemployment or a low level of capacity utilization, the same argument clearly does not apply. 
External/currency
  • Large monetized public sector deficits lean toward large current account deficits that require larger external funding, which in turn means that the country’s currency must have global appeal through trade and/or finance.
Social/political
  • Since there are real resource/inflation and external/currency constraints, the process of resource allocation becomes a political choice and draws out the question: Who does the government decide to give money to? This would act as a constraint to the government’s ability to make certain decisions. 
  • Social and political pressure could place limits on the timing as well as the kind of policy measures that a government could implement: Could the government sensibly raise taxes or stop spending shortly after an economic recovery or during an election year?
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. 

Conditions for adopting debt monetization

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.  

Illustrative chart that divides a rectangle diagonally into two halves. The top half represents unsustainable policy space. This is the area that economies with private sector deficit inhabit. Private consumption and business investments in these economies have been funded by a build-up in debt as opposed to savings. Examples of economies inhabiting this area includes Australia and Indonesia. The bottom half of the rectangle represents sustainable policy space. This is the area that economies with private sector surplus inhabit. Savings exceeds private sector investments in these economies. They also have trade surpluses, with government spending exceeding tax revenues. Examples include Japan and China.

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 the event of a new cold war between major economies, an additional condition must be met

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. 

Policy implications

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. 

Reality check: where do key economies stand in regard to debt monetization

Japan United States China Eurozone
In our view, Japan has plenty of space to monetize debt. Even though the country has been running a chronic fiscal deficit since 1965 (apart from the bubble period in the late 1980s, early 1990s), limited external debt and its equally chronic current account surplus have insulated Japan against currency and inflation instability. It should come as no surprise that we think the United States has traditional space to monetize debt. This is in no small way due to the U.S. dollar’s global reserve currency status. In fact, we believe Japan’s experience, specifically through the Bank of Japan’s bond purchasing program, suggests the U.S. Federal Reserve still has room to triple its assets to fund massive budget deficits in the years ahead. China’s policy space has become increasingly constrained due to the marked erosion in its current account surplus in the past decade. This explains China’s more cautious approach to delivering stimulus in the wake of COVID-19 given the risk of destabilizing the renminbi and domestic inflation. At the aggregate level, the eurozone can lean on the European Central Bank to print money. But at a national level, no member state can issue debt denominated in its own local currency or has the sovereign discretion to monetize its own debt. In a sense, the eurozone denied itself the capacity to monetize debt by design. Fiscal rules that member states need to adhere to also shrink an economy’s sustainable fiscal space, since the agreed deficit cap may not be enough to sustain aggregate demand.

What does this mean for Asia?

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.

Chart illustrating which economies in Asia could implement debt monetization and which couldn’t. Once again, the rectangle is divided diagonally, with economies that can implement debt monetization occupying the space. Only Hong Kong inhabit this space, although New Zealand, Indonesia, Australia and South Korea are very close to it. Economies such as Japan, Taiwan, Singapore, Malaysia, the Philippines, India, and China occupy the bottom half of the rectangle

Investment implications

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.

Timeframe

Key macro themes

Investment implication

Short term: next six to nine months
  • We expect our phase two: the stall out theme will be increasingly dominant: economic recovery disappoints, increasing delinquencies/insolvencies, disinflationary pressure builds as demand cannot keep up with supply
  • An emphasis on high-quality assets
  • A preference for long-end government bonds with positive yields
  • The U.S. dollar is likely to strengthen defensive sectors such as utilities, consumer staples, financials, materials, and industrials 
Medium to long term: six months to five years 
  • Governments are likely to play an even bigger role in economies, but the extent of their involvement will vary across the world
  • Central banks will come under increasing pressure to monetize government spending by printing more money
  • We expect this period to be characterized by significant geopolitical upheaval, private sector deleveraging, reshoring, and reindustrialization in developed markets; further industrialization in emerging markets might also come about
  • Lower and flatter yield curves, increasingly negative real interest rates, competitive currency devaluations, more government regulation, and increasing protectionism/localization; development of trading blocs
  • If executed properly, the United States will continue to be the main engine of global growth (by allocating resources productively, for example, stimulating private sector investment, investment in critical infrastructure—power grids, telecoms, and internet speeds)
  • Extended recession and stagnation risk in the eurozone since peripheral countries in the euro area are unable to spend enough to stabilize aggregate demand or manage growing debt burdens; we expect mounting pressure for members (e.g., Spain, Italy) to exit the eurozone to regain monetary sovereignty  
  • Continued emphasis on high-quality assets
  • U.S. assets—equities and fixed income—could outperform their developed-market and emerging-market peers, particularly in markets where there’s less room or willingness to monetize deficits (e.g., eurozone, China)
  • We expect European fixed income to do better than European equities
  • The U.S. dollar will likely fare better than high-beta fiat currency
  • Critical industries benefiting from industrialization and rising living standards such as utilities and materials
  • A growing shift toward alternative assets such as gold, residential real estate investment trusts, and crypto assets as a form of protection against potential fiat currency devaluation

Conclusion

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.

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Sue Trinh

Sue Trinh, 

Senior Macro Strategist

Manulife Investment Management

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