VoxEU Column Macroeconomic policy Monetary Policy

Deflation, debt, and economic stimulus

The US, Japan, and Ireland are threatened by the spectres of deficient private demand, rising debt, and a tendency to deflation. This column questions current monetary policy directions, i.e. quantitative easing, and argues that printing money to directly finance fiscal stimulus may be a better option.

The US, Japan, and Ireland are suffering from deficient private demand, rising debt, and a tendency to deflation. This column asks what can be done about it.

We begin by assuming that relevant authorities have decided that new money creation is necessary to work against deflationary tendencies and to stimulate the economy. The central issue explored here then is how should such new money creation best be deployed to create the required economic stimulus? 

Policy A: Further quantitative easing

Under Policy A the central bank creates new currency to purchase government bonds on the secondary market. The principal purpose is to finance a rise in bond prices and lower interest rates and, thereby, stimulate private investment. 

Considerable risks and side-effects could arise from the continued application of this policy in the current environment of historically low interest rates.

If the consumption/investment preferences of bond holders are unchanged, then, under Policy A, bondholders may simply purchase new domestic bonds (or other close substitutes) with the newly created currency received from the central bank, or they may purchase higher yielding foreign bonds/assets offshore. On this basis, the additional money supply would not go directly, if at all, to domestic consumers, wage-earners, the unemployed, or to non-finance businesses – the areas where it is most needed to generate widespread domestic demand growth. 

Additional reductions in interest rates will further lower interest incomes of state and local governments, mutual funds, and pension funds etc., including the incomes of the elderly, retirees, and savers, which could, in turn, impact adversely on consumption expenditure. As well, at some point the return for not hoarding becomes too low, and with uncertainty high, and financial and borrowing fears elevated, economic agents may prefer to hold cash (and safe currencies) as a store of value. In other words, the liquidity trap could be strengthened (Krugman 1999).

As medium- to longer-term nominal lending interest rates fall toward their lower bounds, the margin between borrowing and lending rates may come under downward pressure, making difficulties for banks in extending credit. As these interest rates fall, insurance companies, heavily reliant on low-risk bond interest income, may be adversely impacted, potentially damaging their effectiveness.

Beyond some point, further rises in bond prices could set the stage for a sell-off of US government bonds, particularly when quantitative easing bond purchases are completed, resulting in potential disruption to financial and exchange rate markets.

Working toward an artificially flat yield curve based on a near-zero interest rate (through excessive quantitative easing), could impart misleading information about underlying risk structures, distort time-dependent investment/purchasing/selling decisions, encourage banks to take on higher-risk positions to maintain profitability, and artificially create illusory, “bubble-like”, share market gains.

To the extent that quantitative easing is successful in reducing longer-term interest rates, there will be an increased incentive for “carry trade” and other cross-border capital flows. The likely effect on capital outflows, and the exchange rate, could be relatively large in open economies where medium-term interest rates approach their lower bound. Foreign jurisdictions may be disadvantaged as domestic inflation there could increase, asset price bubbles could develop, and local exchange rates could rise. This could complicate global economic adjustments and international policy coordination.

The effectiveness of Policy A is highly uncertain. No one knows how much new money needs to be created, and how many government bonds need to be purchased, to force the sought after reduction in business and personal borrowing interest rates. When the time comes to raise interest rates, from their artificially low levels, public debt will increase.

The Fed is limited to holding no more than 35% of any single issue of US Treasury bonds. These limits are rapidly being approached as the second phase of quantitative easing unfolds and may, if maintained, preclude further rounds.

Policy B: New money financed budget deficits 

The alternative approach involves the central bank printing new money to directly finance fiscal stimulus. This neglected policy option – apparently largely overlooked by officials during the global economic crisis – is likely to be appropriate for countries where prices are falling (or inflation drops toward zero), private demand is deficient, interest rates are already too low and where public debt is excessive. 

Policy B provides a capacity to:

  • finance budget deficits without raising public debt levels further;
  • simultaneously stimulate private demand; and
  • retreat from deflation. 

In order for the central bank to expand the monetary base (the liability side of its balance sheet), there must be a matching expansion on the asset side. This would have to be matched by a liability on the central government’s balance sheet. This involves the central bank purchasing newly created bonds from the ministry of finance, thereby creating new intra-governmental debt, which, nevertheless, would normally need to be serviced and repaid.

The interest outflows to the central bank would, over time, be returned as budget revenue to the government, and taxpayers would, on that account, accumulate no liabilities. 

In relation to the redemption value, the government could either refinance the debt in the market or else pay down the debt. Paying down the debt would create a liability for taxpayers when the redemption date is reached. In extraordinary times the government’s liability (the bond) could be issued as “perpetual” debt (i.e., it would provide no set maturity date). This approach would leave a long-term liability on the government’s balance sheet and a long-term asset on the balance sheet of the central bank. There is no effective increase in the overall net debt of the government (considered broadly), and taxpayers would not incur taxation liabilities to finance the deficit.

Policy B would be appropriate if domestic demand is deficient, excess productive capacity exists, unemployment is high, inflation is low or negative, and there is a desire to apply fiscal stimulus without raising the level of publicly-held debt. These prior conditions exist in different degrees in the US, Japan, and Ireland, and potentially in some other European countries.

Policy B directs new money creation to locations in the economy where the marginal propensities to consume, and to invest in real productive assets (as distinct from financial assets under quantitative easing), are the highest. Policy B, therefore, could be expected to impact relatively favourably on consumption and investment spending and provide the time, increased incomes, suitable inflation rates, confidence, and appropriate interest rates needed to work-out of liquidity traps.

Policy B would be wound-down as sustainable economic recovery is established.

Both Policy A and Policy B involve new money creation and, if taken too far, may eventually lead to rising inflation and excess liquidity that may, possibly, later need to be withdrawn by raising bank reserve requirements, asset and mortgage sales, or sales of government bonds.

The policy change and its implications

The application of Policy B to Ireland (a country without its own sovereign currency) could be challenging at the political level, but not necessarily precluded by policy design. The European Central Bank could conceivably directly finance budget deficits of selected small countries, addressing growing “debt” problems at their source. Attempting to resolve debt-crises, as is currently the case, by generating even more (relatively high interest) debt seems counter-intuitive and self-defeating – especially where early economic recovery is unlikely.

There are not endless shots left in the policy armoury. Great care needs to be taken so as not to fire-off the remaining monetary policy shot in the wrong direction. Each creation of new money is not costless, as eventually it could result in a higher rate of inflation than is desirable, and may, therefore, need to be withdrawn from the economy, reducing the scope for more constructively applied money creation in the interim.

If monetary policy is considered on its own then there could be a case for terminating current quantitative easing programmes. This would steer Japan and the US away from the shoals of triple jeopardy (Leijonhufvud 2011).

Quantitative easing could be replaced with a policy of printing new money with an explicit objective to assist in the financing of future budget deficits (see suggested money-financed tax cut: Bernanke 2002 and analysis by Corden 2010). The deployment of new money creation in this manner would take some pressure off the need for severe fiscal austerity measures (at a time when continued stimulus is still required); minimise further increases in public debt; provide clear signals of policy intent (in relation to interest rate objectives, the method of financing deficits and the approach to delivering economic stimulus); and be more effective, have fewer adverse side-effects, and deliver stronger economic stimulus than further quantitative easing.

Countries experiencing a deflationary tendency and deficient private demand that introduced laws in times of high inflation which preclude the printing of new money to finance budget deficits, and the ability of central banks to lend directly to Ministries of Finance, could consider repealing them.

The views expressed in this private paper are those of the author alone and may not be shared by his employing agency, the Australian Treasury.


Bernanke, Ben (2002), “Deflation: Making Sure ‘It’ Doesn’t Happen Here”, Remarks before the National Economists Club, Washington DC, 21 November.

Corden, Max (2010), “The Theory of the Fiscal Stimulus: How will a Debt-Financed Stimulus Affect the Future”, Oxford Review of Economic Policy, 26(1):38-47.

Krugman, Paul (1999), “Thinking About the Liquidity Trap”, December.

Leijonhufvud, Axel (2011) “Nature of an Economy”, CEPR Policy Insight 53, February.



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