EconPol Europe: Monetization Should Finance Covid-19 Spending

The authors of a new study from EconPol Europe have called for policy makers to finance Covid-19 spending through monetization rather than the creation of new debt, which they say could risk exposing a number of countries to a new sovereign debt crisis.

Monetization – the financing of public expenditure through money creation by central or federal banks – has long been rejected by mainstream macroeconomics. But, say researchers Axelle Arquié (EconPol Europe, CEPII), Jérôme Héricourt (EconPol Europe, Université de Lille & CEPII) and Fabien Tripier (EconPol Europe, Université Paris-Saclay (Evry) & CEPII), the practice is  an “attractive solution“ in the face of long-term economic stagnation caused by Covid-19.

“Given the scale of the public expenditure to be incurred in the health crisis linked to Covid-19 - health, support for households and businesses - the question of the merits of financing by money issuance, rather than by emitting debt securities that can be traded on financial markets, is becoming more acute than ever,“ they say.

The authors‘ analysis of the theoretical arguements in favour of rehabilitating monetization notes that the idea has been gaining traction among central banks and policy makers. In the current macroeconomic situation, they say, there is growing support for the combination of low interest rates and low inflation tendencies.

“In the special case of the euro area, issuing debt common to the European States in the form of ‘Coronabonds’ would make it possible to limit the exposure of the most fragile European economies to this risk, but it will still result in a further increase in public debt in the European economy. It is in this context that interest in monetizing public debt has reappeared.” 

The issue with debt, they add, is that interest rates are set by the interplay of supply and demand on the securities market, reflecting investor confidence in a government’s ability to repay. Interest rates will rise for countries where there is less confidence in the ability of that country to repay its debt, particularly problematic for countries with low growth rates such as Italy.

The risk of hyperinflation is low, suggest authors, in light of recent quantitative easing measures which had few adverse effects. In the case of the current crisis, aggregate demand would be expected to return more rapidly to its previous level, with current supply and value chains disrupted. This would then lead to the classic demand-driven inflation dynamics, with price increases induced by demand which is structurally higher than supply.

As the treaty of the functioning of the European Union prohibits direct financing of governments by the European Central Bank, the authors acknowledge that national monetary and fiscal policies would need to be coordinated to determine the amounts of money needed and the duration of the policy.

“Money creation can be an emergency time-limited policy to finance the enormous Covid-19 related spending - necessary to avoid a deep recession,“ they conclude. “However, we draw attention to the particular democratic challenges implied by such a policy in the Euro area context while preserving the balance of powers.“

Read the full study: https://www.econpol.eu/publications/policy_brief_28