Debt monetization

Debt monetization or monetary financing is the practice of a government borrowing money from the central bank to finance public spending instead of selling bonds to private investors or raising taxes. The central banks who buy government debt, are essentially creating new money in the process to do so. This practice is often informally and pejoratively called printing money or (net) money creation. It is prohibited in many countries, because it is considered dangerous due to the risk of creating runaway inflation.

Monetary financing can take various forms depending on the motivating policies and purposes. The central bank can directly purchase government debt that would otherwise have been offered to public sector investors in the financial markets, or the government can simply be allowed to have a negative treasury balance. In either case, new money is created and government debt to private parties does not increase.

In its most direct form, monetary financing would theoretically take the form of an irreversible direct transfer of money from the central bank to the government. However, in practice monetary financing is most usually done in a way that is reversible, for example by offering costless direct credit lines or overdrafts to the government. The Bank of England can do this for example through its "ways and means" facility. In these cases, a government does have a liability towards its central bank.

A second form of direct monetary financing is the purchase of government debt securities on issue (i.e. on the primary market). In this case, the central bank can in theory resell the acquired treasury bills.

Those forms of monetary financing were practised in many countries during the decades following the Second World War, for example in France and Canada.

Quantitative easing as practised by the major central banks is not strictly speaking a form of monetary financing, due to the fact that these monetary stimulus policies are carried out indirectly (on the secondary market), and that these operations are reversible (the CB can resell the bonds to the private sector) and therefore not permanent as monetary financing. Moreover, the intention of the central bank is different: the QE programmes are not justified to finance governments, but to push down long rates in order to stimulate money creation through bank credit. The increase in the government deficit that these policies allow is presented as an unintended side effect. This is at least the legal view: for example the European Court of Justice has ruled that the programme does not violate the prohibition of monetary financing as laid down in the European Treaties.

However, it is often said that the frontiers are blurry between QE and monetary financing. Indeed, the economic effect of QE can be considered similar or even equivalent to monetary financing. Insofar as ECB QE effectively reduces the cost of indebtedness of Eurozone countries by lowering market rates, and as central banks pass on to governments the profits made on these public debt obligations, the benefit of QE policy is significant for governments. Some observers thus believe that the distinction between QE and monetary financing is hypocritical or at best very blurry.

Moreover, quantitative easing could become an ex-post monetisation of debt if the debt securities held by the central bank were to be cancelled or converted into perpetual debt, as is sometimes proposed. According to the ECB, an ex-post debt cancellation of public debt securities held under QE would clearly constitute an illegal situation of monetary financing.