The novel coronavirus has brought with it an unprecedented shuttering of the global economy and an equally unprecedented policy response. The speed and scale at which central bankers and politicians have moved has already surpassed anything seen during the credit crisis.
On the monetary policy front, we have seen rates cut to zero, the announcement of open-ended asset purchases and the introduction of an alphabet soup of lending facilities. Not to be outdone, politicians have responded with spending programs of their own totalling in the trillions of dollars. These staggering amounts have left many to wonder where all of this money is coming from and, if it’s simply just being printed, whether we will pay with inflation down the road.
Looking at the U.S. Federal Reserve as a representative example, it is reasonable to wonder how they are funding all this stimulus. Are they relying on the kindness of lenders? Do they lean on tax payers to foot the bill? The answer is neither. As the ultimate source of U.S. dollars, they don’t have to bother with such inconveniences. Instead, they just draw on their ability to conjure the required money from thin air. Or, as past Fed chair Ben Bernanke explained in a March 2009 interview for 60 Minutes about quantitative easing: “It’s not tax money…we simply use the computer to mark up the size of the account that they have with the Fed.”
For many readers, hearing a central banker talk like this probably brings to mind images of wheelbarrows full of cash and the hyperinflation-ravaged economies of 1920s Weimer w Republic and early-2000s’ Zimbabwe. But as the experience with quantitative easing over the last decade has shown, central bankers adding numbers to spreadsheets does not necessarily lead to runaway inflation (or even mildly high inflation for that matter).
What many of the hyperinflation narratives fail to recognize is that central banks are not printing this money and then just handing it out in a way that directly adds to recipients’ financial wealth. Rather, they are typically exchanging it for something else, be it a Treasury bond posted as collateral, a mortgage-backed security purchased during quantitative easing, or a commitment to repay a Main Street Lending Program loan. So while they are indeed printing reserves, they are also removing assets from the private sector at the same time. Charts showing ballooning central bank balance sheets only tell one half of this asset swap story – they mask the fact that there is an equivalent decline of those same assets on someone else’s balance sheet.
While there are some situations where these transactions might be more fairly viewed as printing money and adding to peoples’ net wealth – for example, if the central bank buys illiquid risky assets at above-market prices, or ends up forgiving loans it had extended – the fact remains that these monetary operations by and large only alter the composition of net financial assets held by the non-government sector, and not their level.
This isn’t to say that central bank purchases and loans don’t play an integral role, especially in times of widespread panic and elevated volatility. As we have seen over the past several weeks, funding and refinancing risks spike in such environments as market participants make a collective break for the exits. It was under such conditions that central bankers, backed by their unlimited financial resources, stepped into the void recently and delivered the liquidity and bids-and-asks that markets themselves were unable or unwilling to provide. While these measures on their own are nowhere near enough to address the broader economic challenges presented by the coronavirus-induced shutdown, they are essential in stemming the market panic and buying time for policy measures that actually do involve printing money – or rather printing money-like financial assets – to be formulated and implemented. Cue fiscal policy.
Fiscal levers are the only tools that can meaningfully support household and business cash flows and balance sheets when the economy is at a complete standstill. This is because, in contrast to monetary policy, fiscal policy can quickly and directly increase the level of private sector’s financial assets. Take for example a fiscal deficit which, by definition, means that the government is adding more dollars to peoples’ bank accounts via spending than it is taking away through taxes. To cover this gap, the government typically prints new bonds and T-bills that are sold at auction, thereby replacing deposits on the asset side of the purchasers’ balance sheets. The recipients of the government spending, meanwhile, receive a new deposit and a corresponding upwards adjustment to their overall equity.
Importantly, unlike the money-creating bank loans discussed in my previous article this sequence does not generate a corresponding liability anywhere else in the private sector. As a result, the sector as a whole experiences an increase in its financial wealth – total assets increase (by the value of the new bonds or bills), while overall deposit balances remain unchanged (since the decrease in the bond buyers’ deposits is offset by an equivalent increase in the deficit recipients’ accounts). And for those thinking the liability is just being pushed to some future taxpayer, keep in mind that the U.S. has been in a perpetual net deficit position since 1791 – let’s face it, it’s never getting paid off!
While this runs counter to common narratives that frame fiscal deficits as some sort of a drain on the private sector’s finances, it is simply reflects the accounting fact that in order for one sector to save financially, another must do the opposite. And given the current collapse in spending and incomes, it seems clear that the ones who have the ability to print risk-free IOUs are in a much better position to be doing the dissaving than the rest of us. Thankfully, policymakers also seem to recognize this, having responded with historically-large fiscal programs around the world.
The massive scale and scope of these spending programs has left many people wondering where all of this money is coming from. Did the U.S. government get the green light from bond markets for its $5 trillion plans? Were budget surpluses from yesteryear suddenly discovered? No, all that happened is Congress authorized the spending. And in the process it revealed the immense power and flexibility that is enjoyed, but rarely used to its full potential, by governments that issue their own currency. The availability of money is never a constraint for such currency-issuing governments. Rather, in addition to political will, the constraint for them is the availability of things to purchase and the economy’s capacity to absorb the spending. The question isn’t, ‘Do we have enough money to pay for ventilators and vaccines?’ But rather, ‘Are there enough ventilators and vaccines to buy?’
It is here, at the intersection of escalating fiscal deficits and the economy’s real productive capacity, where investors should be looking for coronavirus stimulus-related inflation risks. This dynamic will likely matter a lot more to price pressures in the broader economy than will central bankers’ asset swaps and purchases. If the government ends up commandeering too many real resources (e.g., by hiring workers and bulldozers away from the private sector to build infrastructure) or adding too many financial ones (e.g., by printing new Treasuries in order to send a $1 million cheque to every household), then inflation will result.
These risks currently appear limited given that the fiscal stimulus programs announced thus far, though unprecedented in breadth and scale, still pale in comparison to the devastatingly large amounts of income and revenues being lost in the economy-wide shutdowns. And unlike typical stimulus fiscal programs, these ones are largely designed to support the freezing, rather than stoking, of economic activity. They are designed to help people simply keep the lights on and meet regular financial obligations at a time when their income sources have been ordered shut – this isn’t cash for cars and new TVs, it’s cash for rent, mortgages and wages. Not exactly a recipe for demand-driven inflation.
Policymakers hope that by providing an income bridge to the post-coronavirus world, these deficits will help reduce the number of defaults, evictions, permanent layoffs and bankruptcies that occur through the shutdown. This can help preserve key economic and contractual relationships and make it easier for the economy to pick-up where it left off once the stay-home order is finally lifted. If these relationships are permanently broken, the resulting decline in productive capacity could raise inflation risks, especially if it bumps up against a recovery in demand.
Whatever the outcome, it is this interplay between fiscal deficits and the real economy that will be key in determining inflation’s future path. The absolute size of the deficits, their uses and recipients, their ability to prevent temporary closures from becoming permanent – these are the things that will matter most, certainly more than purported “money printing” binges by central banks. Although central banks’ purchase and lending programs are essential in maintaining financial market stability, they are not set up (at least currently) to easily and directly add the financial wealth that the private sector so desperately needs right now.
The devastating effects of the virus have brought to light the power and flexibility that go along with the ability to directly bolster incomes and balance sheets. It has forced us to replace policy debates around affordability with ones relating to real needs and wants. If this new dialogue continues once life and the economy return to normal, we might one day look back upon the coronavirus crisis as the high water mark for our almost-exclusive reliance on monetary policy. And, to the extent that it means we focus less on the size of numbers on a spreadsheet and more on real life societal goals, that would be a good thing.