In today's newsletter we talk about something that's been on the news of late and answer questions you were too afraid to ask. Today we will talk about printing money and paying off government debt. And trust me, you do not want to miss this one!!!
But before we get to the heart of the story, a short note on government debt.
The country’s fiscal Fiscal deficit (read as total money spent by the government in excess of the total income earned) stood at 5% of the country’s GDP (as on February). This isn’t all that great considering we were supposed to keep it under 3.8% this year.
But with the lockdown in place, there’s growing consensus that the government ought to throw all caution to the wind and keep spending — on people, on health care infrastructure, and subsidies. Not just spend, but borrow and spend i.e. by issuing new government bonds and mobilizing funds from private investors.
Unfortunately, private institutions don’t have the kind of firepower to fund this extravagant spending program. You can’t call on them for an exercise this massive. No way.
What the government needs right now is someone with pedigree.
They need to call in the Dark Knight.
They need to call — the Reserve Bank of India.
But borrowing from the Reserve Bank isn’t like borrowing from outside investors. I mean, these investors offer the government a small piece of their own savings. What they do is lend money that was already in the system.
But when the RBI does it, it prints new money. Money that didn’t exist in the system, like 10 minutes ago. Money that was whipped out of thin air, all in a bid to support the government’s borrowing spree. We call this— “Monetizing the Deficit”
And since the government will inevitably spend its newfound riches, we will have an expansion of the monetary base i.e. we will have more money in circulation*.
And that is deeply problematic.
Think of it this way. When you offer anything in abundance, the value of said commodity depreciates rather disproportionately. Offer a person too much attention, maybe they won’t value you as much. Circulate a ton of money, maybe the rupee will suffer the same fate. It’s the law of demand and supply.
So if this money makes its way into the hands of people and corporations alike, the value of the rupee (more often than not) tumbles. You’ll have to pay more to get less. While once you could buy 2 litres of milk at Rs. 70, you’ll now have to shell out Rs. 80.
Ergo, there is a very real risk of stoking inflation.
But this theory is replete with problems.
In fact, advanced economies (like the US) have been printing money to pay off their government’s debt for a good while now. And yet, we haven’t seen inflation wreck their economies? Why can’t India do it?
Well, because the Indian Currency does not enjoy the same status as some of these other currencies.
For instance, the Federal Reserve (US Central Bank) can keep printing and pushing more dollars into the ecosystem simply because there’s always more demand for the currency. Americans use it. Foreign investors buy it. Big corporations trade with it. And considering there is an almost overwhelming consensus that the US economy is more stable than other emerging economies, they can simply get away with it.
Besides India also has to contend with rating agencies — The good folks that decide whether the country’s government bonds are investment grade or not. Because if they deem its junk and tell others that the Indian government is likely to default on its repayment, we will have to stop borrowing from reputable foreign institutions altogether.
And the RBI walking in to support the government’s borrowing program is a dead giveaway. It tells the rating agencies we are reckless with our spending and we are printing money to make up the shortfall.
So in summary, we can’t afford to be reckless.
The second question is about execution. If the RBI had to monetize the deficit, how would it go about doing this?
Especially considering there's a law specifically stating they can’t buy government bonds when it goes to auction.
Yes, there's an auction each time the government wants to borrow from outside investors and the RBI can't participate in this auction!!! Bet you didn't know that.
Anyway, although, the RBI can’t buy the bonds the first time around during the primary auction. It can buy it on the second-hand market. Meaning if your next-door neighbour bought the primary issue, the RBI can buy it off of him — all in the name of keeping “money supply” in control.
So then the question is — How can you tell if the RBI is monetizing the deficit or if it's simply fiddling with the money supply (as part of its day to day operations)?
The short answer is — you can’t always tell. The distinction isn’t black and white.
However, if you do start seeing the RBI buying a ton of government bonds from the open market while more money keeps entering circulation, you can maybe tell your friends that the RBI has finally started printing money to pay off the government’s debt.
- A monetary base is the total amount of a currency that is either in general circulation in the hands of the public or in the commercial bank deposits held in the central bank's reserves