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Governments have rolled out large open-ended fiscal and monetary efforts to tackle the coronavirus pandemic that will require massive borrowing. Anthony Okolie talks with Sohaib Shahid, Senior Economist, TD Bank, on the risks to major economies and the long-term implications for future generations.
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- Sohaib, you wrote a great report on the massive government boring and central bank efforts to support the economy through COVID-19. Now, before we get to the risks and benefits of debt monetization, help us explain what is debt monetization.
- Sure. Debt monetization is an ambiguous concept. Simply put, debt monetization is a permanent increase in the monetary base with the intention of funding the government. So when a central bank permanently purchases a government debt with the purposes of funding its government deficits, then that qualifies as debt monetization.
We can also think about debt monetization by ruling out what it is not. So it is not a simple open market operation that central banks conduct all the time to meet the targets. It is also not quantitative easing. Because under quantitative easing, the central banks have always maintained that their measures are temporary in nature.
And finally, it is also not helicopter money, a term that we often hear because, under helicopter money the, increase in government indebtedness can be written off by the central bank, which does not happen under debt monetization. Another difference is that under helicopter money, the central bank can directly transfer funds to households without having to go through the government. Which, again, does not happen under debt monetization.
- Sohaib, so what are some of the benefits and risks of debt monetization?
- Needless to say, monetization has its benefits under the right circumstances and right conditions. It may particularly be useful in a recession when demand is weak, or when deflation is a risk. But it is a risky endeavor.
For monetization to work properly, it needs an operational framework and a legal framework along with central bank independence. If such frameworks are not there, then there is a risk of central banks' objectives moving away from targeting inflation to funding the government. And when that happens, we run the risk of high inflation, or worse, hyper inflation.
- And so what's been the impact to governments' wallets and central banks' balance sheets as a result of the response to the pandemic crisis?
- So we've seen a large increase in governments' balance sheets throughout the world. So if you look at central banks around the world, we've seen that they have done whatever is necessary to ensure liquidity and market confidence. So if you look at the Bank of Canada, we've seen that it has announced a large scale asset purchase program.
And under this asset purchase program, they're purchasing a wide variety of assets. So these assets include government bonds, provincial bonds, CMHC bonds, and even corporate bonds. And this measure by the Bank of Canada is not only important, it is also welcome. Because it is coming at a time when we expect foreign borrowing to increase going forward.
So it'll make it easier for the government to borrow as we expect it to in the coming months. Now, if you look at the Fed, we see that the Fed has promised to do unlimited quantitative easing, and is also purchasing a wide range of assets. As we look at Europe, we see that the European Central Bank has also pulled out all the stops.
It has increased the assets it's purchasing under its existing asset purchase program, and has also started a new pandemic emergency purchase program. It has also announced to include Greek government debt in the portfolio bonds it purchases. That's part of its quantitative easing. And most importantly, it has also removed the cap on how many government bonds it can borrow-- it can purchase from each eurozone economy.
- And what about emerging markets? Certainly they've been impacted by COVID as well. What's the impact there?
- Well, emerging markets are not too far behind. So if you look at central banks in the Philippines, South Africa, and Colombia, they're all doing quantitative easing. Some emerging market central banks have gone a step further.
So if you look at the central banks of Brazil and Indonesia, they have directly started to purchase government debt. While quantitative easing measures in emerging markets have helped in easing financial conditions, they also carry the risk of unanchored currency weakness.
- So what are the long term implications for Canada's huge deficit? What does this mean for future generations?
- Well, there's no doubt that this is a major shock for Canada's fiscal coffers. This pandemic has led to a major increase in Canada's fiscal deficits. And the question we need to ask ourselves is, will the government be able to maintain the quality of life of future generations as it tries to pay for its debt.
The answer depends on the ability of the government to service its debt. So what we need to really look at is how will this debt servicing take place. I mean, the good news is that interest rates are low, so that helps. On the other hand, if growth stays low for too long or if the bounce back from this crisis is weaker than we expect, then debt servicing may become difficult.
It all depends on how quickly the country recovers from its economic crisis. The longer it takes, the lower growth will be, and the more difficult it will be to service the debt. What the government can do is to increase taxes going forward to make up for the lost revenue today. But if the central bank steps in and monetizes the government debt, then that increase in taxes does not necessarily have to take place.
- Sohaib, thank you very much for your insights today.
- Thank you.
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- Sure. Debt monetization is an ambiguous concept. Simply put, debt monetization is a permanent increase in the monetary base with the intention of funding the government. So when a central bank permanently purchases a government debt with the purposes of funding its government deficits, then that qualifies as debt monetization.
We can also think about debt monetization by ruling out what it is not. So it is not a simple open market operation that central banks conduct all the time to meet the targets. It is also not quantitative easing. Because under quantitative easing, the central banks have always maintained that their measures are temporary in nature.
And finally, it is also not helicopter money, a term that we often hear because, under helicopter money the, increase in government indebtedness can be written off by the central bank, which does not happen under debt monetization. Another difference is that under helicopter money, the central bank can directly transfer funds to households without having to go through the government. Which, again, does not happen under debt monetization.
- Sohaib, so what are some of the benefits and risks of debt monetization?
- Needless to say, monetization has its benefits under the right circumstances and right conditions. It may particularly be useful in a recession when demand is weak, or when deflation is a risk. But it is a risky endeavor.
For monetization to work properly, it needs an operational framework and a legal framework along with central bank independence. If such frameworks are not there, then there is a risk of central banks' objectives moving away from targeting inflation to funding the government. And when that happens, we run the risk of high inflation, or worse, hyper inflation.
- And so what's been the impact to governments' wallets and central banks' balance sheets as a result of the response to the pandemic crisis?
- So we've seen a large increase in governments' balance sheets throughout the world. So if you look at central banks around the world, we've seen that they have done whatever is necessary to ensure liquidity and market confidence. So if you look at the Bank of Canada, we've seen that it has announced a large scale asset purchase program.
And under this asset purchase program, they're purchasing a wide variety of assets. So these assets include government bonds, provincial bonds, CMHC bonds, and even corporate bonds. And this measure by the Bank of Canada is not only important, it is also welcome. Because it is coming at a time when we expect foreign borrowing to increase going forward.
So it'll make it easier for the government to borrow as we expect it to in the coming months. Now, if you look at the Fed, we see that the Fed has promised to do unlimited quantitative easing, and is also purchasing a wide range of assets. As we look at Europe, we see that the European Central Bank has also pulled out all the stops.
It has increased the assets it's purchasing under its existing asset purchase program, and has also started a new pandemic emergency purchase program. It has also announced to include Greek government debt in the portfolio bonds it purchases. That's part of its quantitative easing. And most importantly, it has also removed the cap on how many government bonds it can borrow-- it can purchase from each eurozone economy.
- And what about emerging markets? Certainly they've been impacted by COVID as well. What's the impact there?
- Well, emerging markets are not too far behind. So if you look at central banks in the Philippines, South Africa, and Colombia, they're all doing quantitative easing. Some emerging market central banks have gone a step further.
So if you look at the central banks of Brazil and Indonesia, they have directly started to purchase government debt. While quantitative easing measures in emerging markets have helped in easing financial conditions, they also carry the risk of unanchored currency weakness.
- So what are the long term implications for Canada's huge deficit? What does this mean for future generations?
- Well, there's no doubt that this is a major shock for Canada's fiscal coffers. This pandemic has led to a major increase in Canada's fiscal deficits. And the question we need to ask ourselves is, will the government be able to maintain the quality of life of future generations as it tries to pay for its debt.
The answer depends on the ability of the government to service its debt. So what we need to really look at is how will this debt servicing take place. I mean, the good news is that interest rates are low, so that helps. On the other hand, if growth stays low for too long or if the bounce back from this crisis is weaker than we expect, then debt servicing may become difficult.
It all depends on how quickly the country recovers from its economic crisis. The longer it takes, the lower growth will be, and the more difficult it will be to service the debt. What the government can do is to increase taxes going forward to make up for the lost revenue today. But if the central bank steps in and monetizes the government debt, then that increase in taxes does not necessarily have to take place.
- Sohaib, thank you very much for your insights today.
- Thank you.
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