Governments’ economic support plans will significantly worsen the public debt of the euro area countries this year. Through its pandemic purchasing program, the European Central Bank will absorb new bond issues from member states of the euro, thereby facilitating the financing of these aid programmes. The additional public debt of 2020, which is a legacy of the current crisis, will therefore be held by the ECB.

The decisive role of central banks

Beginning in March, the world’s major central banks launched new money creation operations to buy back public debt, limiting any interest rate hikes on government loans. The European Central Bank, which originally set a size of its pandemic purchasing program in March at €750bn, increased it by €650bn at its monetary meeting in June.

This action by central banks may be cause for concern, as certain episodes of monetisation of budget deficits have led to periods of hyperinflation in the past, and therefore to a rapid decline in the purchasing power of the currency. This was the case of the Weimar Republic in 1922, Venezuela in 2017, Zimbabwe in the early 2000s, etc.

Little inflation generated by monetary interventions following the financial crisis

Quantitative money theory helps explain the relationship between money supply and the price level. The latter stipulates that, all other things being equal, when the quantity of money increases, the general level of consumer prices must adjust upwards. However, in economics, the status quo is rarely the norm.

In the years following the 2008 crisis, the increase in the quantity of central bank money, which in turn bought public debt, did not translate into higher prices for goods and services, because currency velocity has dropped. This last parameter depends mainly on the confidence of economic agents. The average transaction frequency for a unit of money had decreased as households had built up precautionary savings. However, failing to generate inflation, these central bank purchase programmes supported the price of certain financial assets by exerting pressure on long rates and thus inflating their valuations.

Inflation is not only a monetary phenomenon; other forces also influence it. Among these, note the difference between the level of economic activity and the productive potential of the economy. As the 2009 crisis had created significant overcapacity in our economies, monetary creation alone was not enough to revive the price of goods and services. Likewise, the current crisis will leave traces in the medium term on the level of economic activity, whether in the form of an increase in the unemployment rate or a loss of income for a segment of the population. It is therefore unlikely that prices will surge in the short and medium term.

Permanent or temporary monetary creation?

The situation of full employment and the repetitive nature of direct financing of budget deficits by central banks were necessary conditions for past periods of hyperinflation. These conditions are not met today. Firstly, despite the means deployed by member states to save as many jobs as possible, jobs are disappearing, and secondly, the use of the money machine by central banks on this scale matches an exceptional situation. We should also remember that the statute of the central banks of the 21st century gives them independence from governments.

Yet, the hyperinflationary situations of the past often stemmed from this lack of independence which prompted governments to create money to finance growing budget deficits. In addition, the permanent form of current monetary creation is not a given. In fact, if the inflationary threat reappears in the longer term, central banks could decide after the fact to reduce the money supply by not reinvesting the maturities of the government debts they hold, which would de facto reduce the quantity of money issued. As a result, current monetary creation would therefore ultimately be only a temporary and reversible phenomenon. The American central bank has also shown, from 2018 to September 2019, that it was possible to reduce the size of its balance sheet.

Central banks have learned lessons from the past. Given the unprecedented severity of the shock to activity, the lack of intervention by the monetary authorities would undoubtedly have accentuated the crisis. The indirect financing of the new budget deficits by monetary creation was desirable and should not be feared in the present situation of a sharp fall in economic activity, an increase in the unemployment rate and low inflation. That said, the risk of re-emergence of inflation in the longer term increases if this monetary tool is used systematically at the slightest economic shock.

Some wonder why central banks are not simply canceling the public debt they hold, which would de facto reduce public debt. Such an operation would mean that the European Central Bank, whose capital is held by EU member states, would operate in negative equity since it would suffer a dead loss on its assets. This would imply a bailout of ECB capital by member states, which would not change the problem of public debt, as the state would have to find another creditor to inject capital into the central bank.

On the other hand, if the ECB maintains negative equity, the reaction of the foreign exchange and bond markets is highly uncertain, as well as the legality of this situation. But from a purely economic point of view, I doubt that this will have major consequences. On the other hand, it is entirely possible that the government bonds held by the central bank are renewed perpetually and are therefore never really reimbursed by the governments. This seems to me to be the most likely scenario in the current environment.

Originally published in French by Paperjam; translated into English for Delano