How Central Banks Monetize Government Debt

By Investopedia | March 25, 2016

With the Bank of Japans announcement on Jan. 29 to navigate into negative interest rate territory by
charging interest on reserve deposits, yields on government debt have fallen precipitously. The yield
on 10-year Japanese government bonds recently fell to a record negative 0.135%, below the BOJs
negative 0.1% reserve deposit rate. With the BOJ purchasing government bonds at an unprecedented
annual rate of approximately 80 trillion yen, it is becoming exceedingly difficult for the BOJ
governor, Haruhiko Kuroda, to deny that these policies are not a form of government debt
monetization. We explain why below. (See also: How Negative Interest Rates Work.)

Independent Central Banks

Any government that issues its own currency (e.g. not Greece) could, in theory, continue to create
money without limit. The idea that governments either have to tax or borrow in order to spend is
really just a consequence of the legal and institutional infrastructure we, as a society, have created.
Things could be otherwise, but when the monetary printing press is in the hands of politicians, the
temptation to inflate currency is strong.
There is the fear that excessive printing of money and subsequent spending will lead to inflation, then
hyperinflation, and then eventual abandonment of the currency. Further, assuming the limited nature
of economic resources, if the government has unlimited amounts of money, then it could potentially
control all of those resources, essentially crowding out the private sector. Obviously, this is
problematic for some, and any attempt to compete with the government in utilizing resources leads to
a bidding up of the price of those resources. (See also: Worst Hyperinflations in History).
To mitigate these fears, modern governments have delegated the responsibility of money issuance to
independent central banks, hoping to keep fiscal policy considerations separate from monetary policy
ones. Since the primary goal of central banks is to maintain price stability (usually interpreted as low
and stable inflation of around 2% a year), governments cannot depend on central banks to fund their
operations and must either rely on tax revenue or, like everyone else, borrow money in private
markets.

Debt Monetization
The willingness of the private sector to hold government debt will depend on the return and riskiness
of that debt relative to alternative investments. Any government that issues debt far in excess of what
it could collect in taxes is perceived as an excessively risky investment and will likely have to pay
increasingly higher interest rates. Thus, a governments fiscal policy has definite market constraints.
However, central banks have the power to manipulate interest rates. In fact, it is interest rates that
they are targeting when they carry out their daily open market operations (OMO) to achieve price
stability. The central bank typically states an interest rate target it believes will help it achieve its
inflation target, and then increases or decreases the reserves of commercial banks through asset

purchases typically short-term government bonds in order to achieve that target (QE has extended
these purchases to other assets like MBSs as well as longer term government debt). (See also: Open
Market Operations vs. Quantitative Easing).
The central bank then, by purchasing government bonds in private markets can keep interest rates
low, and in a sense, monetize government debt. However, these daily OMO are not what the more
hawkish types have in mind when they talk about government debt monetization. What they have in
mind is when central banks, by using their power to create money, accommodate massive deficit
spending by the government, inflating the governments debt to levels where it is not clear how or if
it will ever be paid off. Such a move causes one to wonder how independent the central bank really
is.

The Bottom Line

At a level of government debt that is more than 230% of its GDP, Japan is the most indebted nation
in the world. With bond yields in negative territory, the government is now getting paid to borrow.
By charging private banks interest on reserves held at the BOJ, Japans central bank is effectively
transferring wealth, and thereby the ability to control the economys resources, from the private
sector to the public sector. It amounts to a helicopter drop of new money that is channeled into the
economy either through tax cuts or direct government spending. Sounds a lot like debt monetization.
Yet, while the potential for inflation is worrisome for the monetary hawks, inflation is actually
Kurodas intended goal. With deflationary pressures plaguing the Japanese economy, Kuroda has
stated, Whats important is to show people that the BOJ is strongly committed to achieving 2
percent inflation and that it will do whatever it takes to achieve it. He is still trying to maintain the
BOJs primary monetary policy objective; it just so happens that the Japanese government is the only
economic agent willing and able to spend, thus creating the aggregate demand that is so badly
needed. He just doesnt want to call what he is doing debt monetization in hopes that people will
still believe that the BOJ maintains, at the very least, a modicum of independence.

How Central Banks Monetize Government Debt | Investopedia

http://www.investopedia.com/articles/investing/032516/how-central-banks-monetize-governmentdebt.asp#ixzz43zBumckO