Earlier today, in an attempt to combat the business slump caused by the coronavirus, the UK tore up the economics textbooks by embracing direct central bank financing of the government’s deficit.
The move is highly controversial since the conventional way to finance a gap between government expenditures and revenues is to sell government bonds to investors.
According to theory, financing the deficit by means of an overdraft at the central bank is a big step down the slippery slope towards hyperinflation.
But whether this decision leads to runaway price rises in the UK may depend on the ability of the government to maintain social cohesion, according to one leading student of past inflations.
This morning the Bank of England issued a joint press release with the UK Treasury, saying it would allow a temporary increase in the government’s overdraft limit, which is called the ‘ways and means facility’.
“This will provide a short-term source of additional liquidity to the government if needed to smooth its cashflows and support the orderly functioning of markets, through the period of disruption from Covid-19,” the Bank said.
“Any use of the ways and means facility will be temporary and short-term,” the Bank added.
“Monetary financing has been linked in other countries to runaway inflation”
However, the move contradicted a statement made only three days ago by the new Bank of England governor, Andrew Bailey.
Writing in the Financial Times on Monday (subscription required), Bailey noted that past moves to allow direct central bank financing of government deficits had caused a loss of control over prices.
In the UK, the Bank is required by law to deliver price stability, which is defined as an annual inflation target of 2 per cent.
“Monetary financing—a permanent expansion of the central bank balance sheet with the aim of funding the government—has been linked in other countries to runaway inflation,” said Bailey.
“That is because it could undermine a central bank’s ability to control monetary conditions over the medium term. Using monetary financing would damage credibility on controlling inflation by eroding operational independence. It would also ultimately result in an unsustainable central bank balance sheet and is incompatible with the pursuit of an inflation target by an independent central bank.”
In his article, Bailey argued that what he called the ‘UK’s institutional safeguards’ rule out a direct financing approach, a position that now appears to have been discarded.
Other policymakers have been calling for a more relaxed approach to the direct central bank financing of deficits.
Last month Adair Turner, a former head of the UK’s financial services regulator, said that for countries with national currencies, direct monetary financing of fiscal deficits would be a feasible option.
This approach would provide strong stimulus without increasing the public debt burden, Turner said.
In a 2016 blogpost, former Federal Reserve chairman Ben Bernanke also suggested that direct deficit financing by central banks could be justified as a last resort.
“It’s precisely in the most difficult or extreme circumstances, in which other monetary and fiscal tools might be unavailable or ineffective, that Money-Financed Fiscal Programs might be considered,” Bernanke said.
“Rapid inflations are not so much the consequence of war as of civil war or serious social unrest”
However, according to a leading historian of monetary inflation, past episodes of direct central bank financing of government deficits, often undertaken during wartime, may have different outcomes, depending on the degree of cohesion in society.
Many political leaders have used wartime rhetoric to describe the common battle against the coronavirus.
“Contrary to quite widespread belief, rapid inflations are not so much the consequence of war as of civil war or serious social unrest,” Forrest Capie, professor of economic history at London’s City University, wrote in his book ‘Major Inflations in History’, published in 1991.
“The reason for this is that while governments often print money recklessly in wartime, being united against the common enemy, the populace is persuaded to behave in a patriotic fashion and to abide by a variety of controls, and so inflation is constrained,” Capie wrote.
“However, with civil disorder or the extreme case of civil war, the established government tries to placate the disaffected by printing money,” said Capie.
“At the same time the division in society results in a sharp fall in revenue,” he said.
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