The cons and cons of debt monetisation

Steve Saville

Although it probably won't happen within the next couple of months, it's a good bet that the ECB will eventually be prodded into monetising a large amount of European government and commercial bank debt. It is therefore appropriate for us to discuss the pros and cons of such a development, but since we can't think of any pros* we'll have to focus on the cons.

A critical point to understand is that monetary inflation carried out by the central bank is a problem for the same reason that private counterfeiting is a problem. It results in an exchange of nothing for something and is therefore a form of theft. Nobody would argue that a private counterfeiter was providing a valuable service to the economy if he printed-up money to buy the bonds of financially-stressed governments, so why do many people believe that the central bank can do some good when it buys bonds with money conjured out of nothing?

Even believing that under certain conditions the central bank does no harm (rather than does some good) when it creates new money requires disabling the part of the brain devoted to logic and common sense. Of course it does harm! Adding to the supply of money cannot possibly add to the total wealth in the economy, and yet some people get richer as a result of the monetary injection. If some people get richer while the total wealth is not increased, then other people must be made poorer and what we are dealing with is a forced transfer of wealth.

We now get to the essence of what central bank debt monetisation is: a means of transferring wealth from some people to other people. In the specific case of the ECB using new euros to buy-up the bonds of insolvent governments and banks, it would be a transfer of wealth to the investors in these bonds from everyone with euro-denominated savings. In effect, the costs of making a bad investment in bonds would be shifted from those who made the ill-conceived investment decision to those who had nothing to do with the decision. Furthermore, the shifting of costs would be done surreptitiously. If all euro savers were sent a bill for their share of the wealth transfer there would be an uprising, but when the transfer is done via monetary inflation not even one person in one hundred will be able to figure out why he/she has become poorer.

The costs to euro savers are hidden from view because rather than there being an immediate transfer of money there is a gradual transfer of purchasing power. Bondholders and banks see an immediate boost in purchasing power because they are the first receivers of the new money, but savers see a gradual decrease in purchasing power as the new money works its way through the economy. It should also be understood that the price-related effects of the new money will be lumpy, in that some prices will be affected more than other prices. This leads to mal-investment and means that the debt monetisation not only brings about an unethical transfer of wealth, it also brings about a reduction in the overall pool of wealth.

All of which prompts the question: Why do it? Why would a central bank monetise debt when doing so helps a small number of speculators at the expense of a large number of savers and brings about a reduction in the total amount of wealth?

It clearly has nothing to do with protecting bank depositors, because the depositors at a bank don't lose anything when the bank's shareholders are wiped out and bondholders take large losses. It is done, we think, due to ignorance and a willingness to engage in unjust practices for political or financial gain.

Ignorance plays a part in the following ways:

1. Most people don't understand the link between monetary inflation and the eventual decline in their standard of living.
   
2. The top people at a central bank will necessarily be bad economists because a good economist would never want the job or would never be considered eligible for the job. For example, Ben Bernanke would not currently be the head of the Fed if not for his strong belief that creating money out of nothing can benefit the economy.
   
3. Almost all politicians are clueless about economics.
   

A willingness to do whatever it takes to achieve political or financial gain plays a part in the following ways:

1. The ability to create money out of nothing provides politicians with far greater scope to buy votes than would exist if their promises had to be funded by direct taxation.
   
2. Monetary inflation often creates the false impression of a more vibrant economy in the short-term, thus helping to boost the re-election chances of the incumbents.
   
3. The people who benefit the most from monetary inflation often exert a disproportionately large amount of influence over the central bank and the government.
   
4. Due to the promises made by politicians in the past, a lot of voters now have a vested interest in continuing the inflation because it is only via the wealth transfer brought about by monetary inflation that these people will ever receive their so-called entitlements.
   

Due to the combination of ignorance and vested interests outlined above, there will be a lot more monetary inflation in the future despite it being both unethical and economically debilitating. The question is when, not if.

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