Cao Yuanzheng: monetization of fiscal deficit and Chinas reality

 Cao Yuanzheng: monetization of fiscal deficit and Chinas reality

The central bank should have independent monetary policy

Since the great crisis of 1929-1933, macroeconomic theory began to rise. Before the 1929-1933 crisis, the European and American countries implemented a monopolistic and competitive market economy system without macroeconomic management, which was reflected in the monetary and financial aspects as the gold standard. The price depends on the supply of gold. In a certain scale of social production, when the supply of precious metals such as gold suddenly rises, prices will rise accordingly. After Spain discovered the new continent of America, a large number of gold and silver from Latin America poured into Europe, resulting in the so-called price revolution in European economic history. It constitutes the historical background of the emergence of monetary quantity theory. David Hume and Ricardo were the representatives of this theory. They believed that the fluctuation of commodity price level was in direct proportion to the quantity of money, and the value of money was in inverse proportion to the quantity of money. Thus, the price change related to the quantity of money, namely inflation, appears.

Cao Yuanzheng

However, from a longer global perspective, the growth of gold supply caused by the discovery of the new continent is short-lived after all. The normal situation is that gold supply is stable due to natural conditions, and then prices are stable. In other words, under the condition of gold standard, there is no typical inflation like price rise. However, there is a big problem under the gold standard, which is the risk of deflation. Dominated by the internal law of market economy, the expansion of market can not catch up with the expansion of production, and the result will be periodic overproduction, that is, economic crisis. Reflected in the financial market, the precursor of crisis is the extreme desire for cash, that is, liquidity. There is no cash to pay, and the break in payment is the trigger of the crisis. Restricted by the stable supply of gold under the gold standard system, the lack of market liquidity is the norm, which has also become an important reason for frequent crises. Therefore, the foundational work of modern macroeconomics is Keyness general theory of employment, interest and money. Starting from money supply, he raised the question of liquidity trap. By the way, it is also because the supply of gold can not meet the needs of economic and social development and deflation often occurs, so the gold standard system exits the historical stage.

Keyness contribution lies in his linking money supply with employment. The economic crisis is lack of employment, and unemployment means that the total demand of the whole society is insufficient, and the total demand is a macro level problem. In other words, only by raising aggregate demand at the macro level can we counter the crisis and iron out the economic cycle, which gave birth to macroeconomics.

Theoretically, it is a historical trend that the gold standard is forced to be replaced by a credit standard whose liquidity can be infinitely supplemented due to the lack of liquidity. However, from the perspective of money quantity theory, it is only from the past two factors, price and money supply, to three factors, price, money supply and money circulation speed (the slowing down of money circulation speed means the sluggish liquidity) It does not change the nature of the problem. The money supply that exceeds the circulation speed will still cause typical inflation. Therefore, in the implementation of the above-mentioned macroeconomic management policy framework, people have always been afraid. One of the key points is whether the finance can overdraw the central bank indefinitely? That is to say, is it feasible to support fiscal expenditure by printing money and buying national debt? Is it sustainable?

Historically, this policy has had vicious consequences in practice. In foreign countries, in the 1930s, Germanys hyperinflation was a typical case. After the first World War, the Central Bank of Germany was overdrawn maliciously to pay the war reparations of the Versailles peace treaty, which led to the runaway money supply and the astronomical inflation. In China, the typical case is that in the late 1940s, the Kuomintang governments finance overdrawn the central bank maliciously to fight the civil war, and inflation accelerated the collapse of the Kuomintang government.

Since the World War II, the macroeconomic management policies of all countries have basically followed this point. Although money sometimes supports finance, it is always believed that finance and monetary policy are independent, at least isolated, to avoid hyperinflation. Perhaps because of the painful lessons in history, after the Second World War, the most thorough isolation between the national finance and the central bank was Germany. It has a relatively complete and independent central bank system. Because the independence of its central bank is the highest in the world, the decision-making of its monetary policy is not constrained by the economic situation and fiscal policy, and its only goal is to fight against inflation and maintain the stability of its currency value.

Leverage the government to withstand the financial crisis

As an important aspect of macro Prudential Management, it is the arrangement of emergency rescue. Once it appears in the rapid deleveraging, we have to use the leverage method to resist the deleveraging, to avoid the excessive recession of the balance sheet and the financial crisis. When household balance sheet, enterprise balance sheet and financial balance sheet are all deleveraging, the only way is to block the financial crisis by adding leverage by the government. The governments leverage is to save the situation by expanding fiscal spending, including saving enterprises and subsidizing residents. One of the important results is the increase of deficit, and the way to make up the deficit is to issue national debt.

When the social balance sheet is in recession and the sales of national debts are difficult, in order to deal with the crisis, the central bank has no choice but to become the main or even the only buyer. This forms QE (quantitative easing) monetary policy. In addition to reducing the policy interest rate to zero or even negative, we should also support the issuance of treasury bonds through the expansion of the central banks balance sheet. At this time, the central bank and the finance are linked together and begin to show signs of deficit monetization. By the way, thats why many countries in the eurozone began to criticize the independence of the ECB, which inherited the German central banks mantle, during the European debt crisis in 2010. For example, Greece accused the European Central Bank of being too rigid and unable to finance Greeces issuance of Euro sovereign debt.

Objectively speaking, over the past decade, quantitative easing has been effective, blocking the rapid decline of leverage. But at the same time, people also have doubts about it, not only about inflation, but also about whether there will be new problems if the leverage continues to grow? The conclusion is that once a relatively satisfactory situation is reached, the policy needs to be withdrawn. In the context of historical lessons and foresight, since 2015, quantitative easing monetary policy has been in the process of withdrawal, one of which is the central banks contraction. The central bank gradually reduces its balance sheet by reducing the purchase of treasury bonds and continuously selling them. The shrinking process of the central bank shows that people think that the central banks expansion of its balance sheet to support finance is only a temporary and rescue policy. After the crisis has passed, we should return to a normal state, with fiscal and monetary independence. It is based on this consensus that when will the central bank shrink its balance sheet? How fast? How to shrink? It has been a hot issue in the market in the past few years.

However, after the outbreak of the new crown, under the external impact, the risk of rapid decline of the balance sheet is greater than other economic risks. Once the balance sheet declines rapidly again, there will be not only a public health crisis, but also a financial crisis and an economic crisis, and the whole economy will fall into disaster. At this time, the two evils should be taken lightly, and the only choice is to reuse the method of 2008. Since it is crucial to increase fiscal spending, whether in bail-out or anti epidemic, therefore, when the policy interest rate is zero again, the balance sheet of the central bank not only expands again, but also has no bottom line quantitative easing to support the financing of fiscal deficit.

The monetization of fiscal deficit has changed from a sign of the past to a phenomenon, and new theories are brewing

In the face of the sudden epidemic situation, the monetization of fiscal deficits in European and American countries is at least a helpless move. From the past experience, it is also effective in the short term. This is similar to drinking poison to quench thirst. Drink the poison first to alleviate the crisis at this moment. If today doesnt exist, is tomorrow meaningful? The central bank can only have tomorrow if it supports fiscal expenditure and solves the crisis by turning on the printing press.

However, the importance of the problem lies not in the short-term rescue policy arrangement, but in the past decade, the European and American economies have contracted QE dependence. Once QE exits, the stock market will fall, and leverage will be difficult to maintain, so the economy will suffer. The impact of the epidemic has made dependence more serious. It seems to indicate the normalization of QE policy, and thus brings a new theory - MMT (Modern Monetary Theory), which becomes the theoretical support of deficit monetization. It is found that the so-called deleveraging problem may have new explanations in a sense. The reason is that the two ends of the balance sheet, the capital end and the liability end, can be changed by currency. For example, the central banks basic money supply to financial institutions, through loans out, will increase the leverage of enterprises. But if we use some mechanism, such as equity fund to supplement the base currency to the capital end of the enterprise, the leverage of the enterprise will decline. This constitutes a very important theoretical assumption of MMT, involving how to use money and which end of the balance sheet. In terms of the relationship between fiscal and monetary policy, MMT theory holds that if the government issues treasury bonds to support the capital of enterprises, it will not increase liabilities, but reduce liabilities.

In fact, China also has this experience. In 2004, the so-called capital injection of Chinas banking industry was to support the capital adequacy ratio of financial institutions by issuing special treasury bonds to the central bank by the Ministry of finance, so as to make the balance sheet of financial institutions healthy.

Can fiscal issuance not only increase leverage, but also alleviate the crisis? This has become a new direction of thinking under the impact of the epidemic. In this sense, the monetization of fiscal deficit has become a hot economic topic.

From the above point of view, no matter from the urgency of reality or the expansion of future theory, under the impact of the epidemic, in order to prevent the possible financial crisis represented by rapid deleveraging, the expansion of financial expenditure marked by deleveraging is inevitable. The core of the problem is not the expansion of fiscal expenditure, but whether it is reasonable and accurate. If it is difficult to maintain the leverage of residents, it is necessary to save residents with finance; if it is difficult to maintain the leverage of enterprises, it is necessary to save enterprises. Financial expenditure is first and foremost a matter of direction and purpose. Experience has proved that it is better to use government procurement to support enterprises to return to work, and work relief to support residents income than simply helicopter money. Under the condition of clear direction and purpose, the next problem is to raise income to support expenditure. In the case of the embarrassment of the normal source of income, it is inevitable to expand deficit financing, that is, to obtain income by issuing bonds. If there is no one in the society to buy when issuing bonds, then central bank purchase is necessary. This is not only the reality of European and American countries, but also the logic of anti epidemic.

There is still room for Chinas monetary policy to play its normal role, and special treasury bonds will be digested by the market

In contrast, China is far from monetizing its fiscal deficit. China has a high savings rate and a low leverage rate for its residents. Even if special government bonds are issued to fight the epidemic, residents have the will and the ability to buy government bonds. Compared with other financial assets, treasury bond yield is high and safe, which is the preferred financial asset for Chinese residents. In fact, in the past, the phenomenon of queuing up all night and rushing to the ground is the best explanation. It is precisely because of the difference between Chinas national debt in Europe and the United States that there is still room for Chinas monetary policy to play a normal role. It is not necessary to adopt the QE in Europe and the United States, or even the QE distorted monetary policy without the bottom line. There are two aspects:

First, China is one of the few countries in the world where real interest rates are higher than inflation. Chinas policy interest rate is still positive, which means that if loose monetary policy is needed, China still has room to cut interest rates.

Second, Chinas high savings rate means that even if there is a fiscal deficit, the financing of fiscal deficit can be solved through market-oriented issuance, without relying on the way of expanding the balance sheet of the central bank to purchase treasury bonds.

From our investigation, we can see that the market understands the necessity of Chinas special national debt issued for anti epidemic and makes preparations for it. The reasons are as follows: first, from the perspective of the history of Chinas national debt issuance, the special national debt in 1998 and 2007 was issued in a market-oriented way. Although the purpose of this special national debt issue for the purpose of anti epidemic is different from that of the past two issues, the conditions of issuance have not changed significantly. Second, as far as fiscal expenditure is concerned, an important direction of this special national debt expenditure is to make up for the shortage of public health. This is what the finance should have spent. If it has been spent step by step in accordance with the budget, this time it has only been spent in advance through a package of special national debt financing. Third, another key expenditure of this special national debt is to ease the difficulties of enterprises and low-income groups, mainly by means of work relief, government procurement and expanding infrastructure investment to solve the difficulties of enterprise production and employment. This is actually to solve the problem of idle production capacity by increasing aggregate demand. In the case of normal monetary policy and overcapacity, the probability of inflation due to the expansion of fiscal deficit is very small. Fourth, although the market-oriented issuance of special treasury bonds has an impact on liquidity, as long as the issuance rhythm is well controlled according to the market situation, the term structure is reasonable, and the issuance window is grasped and carried out in an orderly and rolling way, the liquidity of the market will not be greatly impacted.

Finally, from the perspective of broad finance, it is more necessary to pay attention to the sustainability of local government debt, a traditional financial risk than the financial risk of central deficit financing. In the past, the debt of local governments has grown too fast. This time, local governments need to issue special debts, which will make their debts even heavier. Especially with the reform of the land system and the introduction of the policy of housing is not speculation, the traditional source of local government debt repayment, land finance, is more stretched and constitutes a financial risk. However, in a strict sense, local government debt is not a financial problem in essence, but a financial problem. It involves the financial relationship between the central government and the local government, the transformation of local government functions and many other aspects. In other words, only by straightening out these relations can we solve the debt risk of local governments. The key is to speed up the reform of the financial system and the administrative system of the government. The financial risk of local debt reminds us of the urgency of this reform.

To sum up, as a new theoretical trend of economics, deficit monetization is an integral part of the brewing modern monetary theory (MMT), which not only reflects the difficulties of traditional monetary and financial theory, but also reflects the needs of real macroeconomic policies. At present, this theory is still in development, and it is difficult to make the following final conclusion, but it needs close attention. As far as Chinas situation is concerned, it is not necessary for the central bank to finance the fiscal deficit, and the monetization of the deficit will not occur in China at least temporarily. This is only a theoretical discussion, or a hypothesis. We must not treat western theories as Chinas practical problems. Our monetary policy is still normal, the interest rate is still positive, the finance is still relatively stable, there is normal income, the financial debt ratio is not very high, even if the central government has deficit, there is no big problem. The only thing we need to pay attention to is the handling of local debts, which needs to deepen the reform of the financial system.

This article is the exclusive contribution of Netease Research Bureau and does not constitute an investment decision.

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