Debt monetization is the process by which a central bank lends money to the government.
Debt monetization is a mechanism whose main objective is to help the State. Do not help in the sense that you get more votes (although it could be an indirect effect). We are referring to helping in the sense that the State lacks money and the central bank provides it.
When we talk about the central bank, we are talking, of course, about the central bank of the currency in which it operates. For example, in the case of the United States it would be the Federal Reserve (FED). In Europe, the European Central Bank. And, in the same way, in Japan the Bank of Japan.
Under this perspective, it is necessary to detail some aspects of debt monetization. First, we must know its origin, then the types that exist and, thirdly and finally, see the consequences that this process can generate.
Origin of debt monetization
Since central banks exist as such, monetizing debt was a matter of minor importance. The idea behind the monetization of the debt was to give an advance to the Government. For example, if the State estimated that it would raise 100 million, the central bank would advance that money.
The way he did it was very simple. The government issued debt in the primary market and the central bank bought it. For example, the government issued a bond worth 100 million and the central bank bought it.
To buy it, the central bank, which is the one that has the power to print bills and mint money, simply made money to buy that debt.
Types of debt monetization
Although previously we have indicated that the State issues a debt and the central bank purchases it in the primary market, this is not the only way to monetize the debt. Broadly speaking there are two ways to monetize the debt.
- Direct: This is the case we have talked about. It is a direct purchase in the primary market. The securities acquired by the central bank are newly issued securities.
- Indirect: The indirect route is practically the same process. However, instead of buying such debt in the primary market, the central bank buys the debt in the secondary market. That is, to other investors who previously bought that debt from the State.
The direct way to monetize debt is prohibited in some places. For example, in Europe, the European Central Bank (ECB) can not buy debt from euro area countries in the primary markets. It is a measure with the objective of maintaining financial stability. However, in other countries this practice is allowed.
Consequences of debt monetization
Although, in principle, it may seem like a good measure to reactivate the economy, monetizing the debt can have undesirable consequences. It seems reasonable that, if a State needs money to invest in infrastructure, subsidize companies or pay pensions, the central bank in question lends it money.
At the end of the day, if what is used to buy are the tickets, we might think that the solution is to print more tickets. The reality is not so simple. One of the most feared consequences when using this type of mechanism is inflation.
The state needs money and goes to the central bank. The central bank does print more bills and lends them to the State. Up here fine. Of course, if the central bank and the State use this mechanism in excess, it can cause hyperinflation. With so many bills in circulation, money loses value. A very simple example is gold. Gold is expensive because there is little and it is expensive to extract it. If tomorrow an immense and accessible deposit is discovered, its price will probably fall.
Another consequence, besides inflation, is the loss of credibility. If a central bank and a state carry out this practice in an uncontrolled manner, investors (for fear of losing value of their money) will exchange their currency for another. The exchange of one currency for another strengthens the currency that is acquired and weakens the currency that is sold. It is what is known as depreciation of the exchange rate.