May 14, 2020
Can social objectives be financed by money creation?
There exist many proposals for financing the energy transition, medical research, anti-poverty programmes and other social objectives, by creating money. They often boil down to something like this. The government aims at funding expenses, say medical research for a coronavirus vaccine.
Step 1: The government fund expenses by issuing debt.
Step 2: The central bank purchases the government debt. The government never repays the debt.
It seems the government has been able to fund medical research without incurring any cost. What is the trick? While it is true that steps 1 and 2 allow the government to fund expenses, they have two other consequences: one financial (or monetary) and one real (that is, affecting real economic outcomes such as consumption and investment).
The financial implication is the risk of inflation and the risk of asset bubbles. This can be understood by looking at balance sheets. As explained in Part 1, the balance sheet of commercial banks has loans to households on the asset side and deposits on the liability side, whereas it is the opposite for households. Households also own real assets such as houses.
Note that when I write "households", this includes businesses because businesses are owned by households. Households' equity is their net wealth and is equal to their real assets (such as real estate) plus financial assets (such as deposits) minus debt (such as bank loans).
Suppose the government borrows 50 euros by issuing bonds and hire medical researchers, who deposit their wages on their bank accounts (this is step 1). The central bank purchases the government bonds (this is step 2). Remember from Part 2 that the central bank purchases assets by issuing central bank money (CB money). Balance sheets are now:
We can see that the quantity of money – both CB money and bank deposits – have increased. More importantly, household wealth (equity) has also increased. But we must keep in mind that household wealth is measured in euros. Whether households are really wealthier depends on whether they can buy more goods and services with their wealth.
Here comes inflation. The risk is that households having higher amounts of euros on their bank account want to buy more goods and services, pushing up inflation. Households feeling wealthier may also buy more real assets such as houses, leading to higher housing prices and perhaps to a housing bubble. Let us summarize the first cost of excessive money creation:
Fact 5: Money creation can lead to inflation and asset bubbles.
I emphasize the fact that inflation and asset bubbles are potential consequences of money creation but they are not guaranteed to occur. In the current situation, inflation is very low and not an immediate concern. The risk of asset bubbles is more plausible. In addition, inflation and bubbles involve price changes, but they does not necessarily imply that there are fewer real resources available for households.
Financing government projects by money creation has a more fundamental, real cost. When the government borrows to buy goods and services, it diverts scarce resources from other uses. In the example of medical research funded by money creation, the government buys the time of biologists and medical doctors who would otherwise have carried out other useful activities, say, working on a vaccine against malaria.
Fact 6: Projects financed by money creation (or by other means) crowd out other valuable activities.
It is not to say that government intervention is necessarily bad, but one must bear in mind that it has an opportunity cost (real, not only financial). It is not enough to argue that a government's project has social value for it to be a good idea, the project must also have a greater social value than the activities it crowds out.