After struggling to bring a semblance of normality into financial markets and preventing downside to economic growth using various measures which include bank bailouts, guarantees on loans given by banks, deposit guarantees, partial and complete nationalization, fiscal stimulus for economic growth revival etc now some central bankers are treading on a much more dangerous path, that of monetization.
What does this mean ? Normally bank bailouts, recapitalization of banks, fiscal stimulus packages etc are funded by the governments through either their budget surplus ( which still exists in some countries like China ) or by borrowing extra money from the markets – which has an impact of crowding out private investments and can also lead to an uptick in interest rates if the borrowing is too high in a given period of time. In times like these where most economies of the developed West are passing through a time of extremely poor economic growth and their financial system is in doldrums, the governments out there can ill afford interest rates moving up as it will further dampen any sort of economic revival prospects.
A large part of economic growth in Western economies over the last couple of decades has largely been driven by consumption rather than investments. Under the circumstances there is severe pressure in consumption due to increasing unemployment, fall in housing and asset prices ( like shares ) and non availability of credit due to losses suffered by various financial institutions and also increased risk averseness. There is also a very less possibility of private sector investment demand picking up due to low capacity utilization across various industries due to the sharp and unprecendented slowdown in global growth and also non availability of credit to companies that would still like to take a call to invest. Because of all this even banks that are healthy and have sufficient liquidity are not lending, and those which are in a bad shape due to excessive risk taking in the past are only focusing on deleveraging and surviving through this crisis.
As a result of all this, despite all the efforts of governments all over the world ( except China ) bank lending has not picked up. This has forced governments to set up their own fiscal stimulus packages which include various kinds of tax breaks and increased spending. However lately sovereign bond yields have started moving up even before the start of the implementation of most fiscal packages.
This is now scaring the governments and central bankers who are now venturing into the dangerous path of monetizing the deficits which is simple words means printing money for the governments to spend instead of them borrowing the same from the markets. There are two views towards this, one that in a deflationary scenario increase of money supply due to printing money will not lead to inflationary expectations moving up. However monetization to a limited extent might be acceptable, but the kind of monetization proposed by the Bank of England and the UK government where they propose to print nearly 75 billion pounds over the next few months, which is nearly equivalent to 5% of the GDP of UK is an extremely dangerous step if followed by other governments all over the world. This sort of move also has the possibility to causing a sharp depreciation of the currency of the countries undertaking these moves as the supply of that currency increases relative to others. These phenomenon, if not reversed as the economies stabilize will ultimately lead to a huge surge in inflation sometime over the next 3-4 years which can be a genie difficult to control.
Monetization is also being proposed in India where the government is seeking to directly borrow from the RBI next year. In a country like India where we saw a reverse of the phenomenon of Monetization in the years 2006,2007 where they absorbed excess liquidity from the system by issuing MSS ( Market Stabilization) bonds at the time of high capital inflows a temporary phase of monetization which gets reversed at a later date might still be acceptable. However the risks of monetization of having lower interest rates in the short run in order to revive economic growth subsequently leading to a sharp increase in inflation as too much money chases less of goods and services is very realistic.
Overall my view is that monetization might be a necessary evil under the current circumstances, but its impact on reviving some economies like the UK and USA is very suspect as these economies have structural issues related to low savings and excessive leveraging to spend which will take years to resolve. In countries like these and a number of other European countries where profits from assets bought with borrowed money ( not savings as in countries like India) are further leveraged to spend the actual impact can be another kind of asset bubble. For countries like India it can have a real positive impact on economic growth revival as long as the money printed flows into asset creation rather than wasteful expenditure. However the amount of monetization should be limited to not more than 2-3% of GDP over the period of one year.
We need to watch this phenomenon started by the Bank of England where they want to monetize as much as 5% of GDP over a period of 3-4 months very very closely over the next few months as its long term repercussions are very dangerous.