The Impact of Debt Monetization

In a decade of extremes, an interesting new matter has popped up, as can be seen in graph 1. At the moment worldwide central banks are buying up more debt than governments issue.

What does this mean?

Central banks buy up more sovereign debt than issued by governments over a certain period. Monetizing this debt means that central banks are buying sovereign bonds with newly created money. Their main reason for doing so is that it adds to the total amount of money in the system and thus keeps interest rates low. However, problems arise when the demand for actual goods and services increases: too much money is chasing after with too few goods/services (inflation). Consequently the most obvious solution would be to start reducing the money supply by selling these sovereign bonds or raise interest rates. Question is, will central banks ever do this?

Economic concerns

In the past few years plenty of serious economists have concerned themselves with the question of what would happen when central banks had to shrink their balance sheets by selling their bonds back into the market. This is the only effective way to reduce the monetary base (made up of bank reserves and physical currency in circulation) and return things to normal. In the long run things will have to return to normal, won’t they?

To be honest, ‘normal’ is still out of reach. In all probability, central banks will never voluntarily sell their bonds back into the market, since this will cause the air to deflate out of the credit bubble.

What happens instead is that central banks will continue to buy governmental debt, put it in their vaults and never look at it again. They are perfectly aware that selling of so many bonds will cause a crash in the debt market. Furthermore, central banks pay the interest they earn on the bonds back to the governments that sold these bonds in the first place.

To put this bluntly: the more debt is bought from governments by central banks, the more government debt goes down. This seems like an ideal solution for governments facing huge debt levels: they can simply sell their debt to the central bank and forget about it. As of now, around 25% of all government debt is stored away on central banks’ balance sheets. In the US it is as high as 50%. Most likely, this debt will never come back into the market again.

Japan as a test lab

For a long time Japan has served as an ‘economic test lab’ where economists could observe the consequences for an economy if a large portion of the population is elderly. In the coming years Japan will retain its function as a test lab and show us how a large developed economy will survive without a proper working bond market.

Moreover, the Bank of Japan (BOJ) is practically buying all of its government’s debt to support Japan’s massive deficit spending. As a matter of fact, the Royal Bank of Scotland (RBS) has stopped being the country's primary dealer for the lack of bonds in the market. With a yield curve that shows negative rates almost up till the 10 years bond, the monetary experiment by Abe is becoming absurd. Therefore, the amount of bonds is not the problem, it is simply Japans’ government aggressive campaign to end deflation that has led RBS to quit as the primary leader.

The president of BOJ, Haruhiko Kuroda, buys up approximately$100 billion in debt per month. This takes the economic concept of crowding out by the government to a whole new level. The current main problem is that Kuroda is clearly fuelling old debt bubbles with new rocket fuel. When BOJ eventually and miraculously manages to achieve their 2% percent inflation goal, they will have a hard time stopping the yield from skyrocketing.

The greater consequence of this is only just coming to light. However, it is clear that things are moving further and further away from normal and into the absurd. We know that in some way, at some time it will all have to get back to normal. This will probably be the case for Japan sooner than for the US or Europe. Therefore, it remains extremely interesting to look at this Galapagos test lab in the Pacific. 

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Gelein Huiskes

Gelein has been interested in the financial world and global economics since high school. For over 3 years he has been a member of a university investment team, of which one year he was the treasurer.

This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.

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