How can we contain inflation?

Guest PostExpansive Monetary Policy: Where's the Inflation?

The central banks are back in “whatever it takes” mode. They have decided on packages of measures of an unprecedented scale to contain the economic damage caused by the corona pandemic. The European Central Bank has launched additional bond purchase programs with a current volume of 1.35 trillion euros specifically for the fight against the Corona crisis. The US Federal Reserve and the Bank of England are also doing all they can to counter the looming liquidity squeeze and the economic slump.

Nevertheless, in view of this extremely expansionary monetary policy, there is no real alarm mood about potential inflation risks - quite unlike during the global financial crisis of 2008/09. Apparently, many observers have learned from the past decade that unusually expansionary monetary policy does not necessarily lead to disastrous monetary devaluation. Is that why it is completely harmless?

Central banks as "lender of last resort"

In severe crises, central banks have to act as the “lender of last resort”. When no other institution is willing or able to provide liquidity, the central bank has to do it. It was clear that the corona lockdown should also get healthy companies with a functioning business model into trouble quite soon. The looming liquidity squeeze made it necessary for governments, commercial and central banks to act jointly and pragmatically. In an acute crisis, the permissibility of expansionary and, if necessary, unconventional monetary policy is beyond question.

However, the extremely expansionary monetary policy in normal economic times is controversial. Even when the economy is doing well, monetary policy often remains loose these days. The focus of the criticism is on the purchases of government bonds, which always carry the smell of monetary government financing. However, there is one important difference: With monetary state financing, which is prohibited in the euro zone, the central bank would make the money available to the state without receiving anything in return. The money would simply be "printed" and the amount of money increased. In the bond purchase programs, on the other hand, the central bank purchases government bonds that have to be repaid by the state at the end of their term. With the repayment, the money flows back to the central bank and the money supply decreases again by the corresponding amount.

The fact that the bond purchases are nevertheless brought closer to monetary state financing is mainly due to a lack of discriminatory precision: in practice, the end of the term of a government bond does not mean that the state finally repays the money to the central bank. Rather, the central banks often reinvest the repaid amount in government bonds in order to maintain the desired effect of their monetary policy. In extreme cases, such follow-up financing could be continued indefinitely, so that the central bank may have a repayment claim that is ultimately never redeemed. In such a case, the bond purchase program would in fact be very close to monetary state financing.

Japan: pioneer of unconventional monetary policy

A look at Japan also shows how much a central bank can be used for financial policy purposes. Japan was the country with the highest national debt in 2019, with a debt level of just under 240 percent of GDP. The Japanese debt mountain is so huge that the government could hardly finance it at reasonable interest rates. Thanks to massive government bond purchases by the central bank, the interest on ten-year Japanese government bonds is zero percent - as if it were a completely risk-free investment.

Before the Corona crisis, almost 45 percent of Japanese national debt was on the books of the central bank. Without the help of the Bank of Japan, the Japanese model of deficit-financed economic policy would no longer be possible. There are no undesirable side effects of this policy so far. There is no inflation, nor has the yen exchange rate suffered. So what is the problem of permanently expansionary monetary policy if it has not led to the feared side effects for over a decade? Is the “Modern Monetary Theory” (MMT) correct with its thesis that the central bank should, if necessary, finance the state directly? In this way, the state could become independent of tax revenues and the capital markets. According to MMT representatives, this is unproblematic as long as inflation rates do not rise. And if inflation should rise undesirably at some point, the state would have to increase taxes in order to pull excess liquidity out of the market.