As countries desperately try to flatten the curve of rising COVID-19 infections, the resulting disruption of economic activity is of a scale we have not witnessed in living memory.
Synchronous recession in a large number of economies around the world is a foregone conclusion.
Governments are announcing rapid response measures – to augment resources for frontline first-response agencies in the health sector, to provide immediate relief to affected populations whose lives and livelihoods have been disrupted, if not destroyed, and to prop up as much of the economy as possible.
The fiscal price tag on these measures is massive, and growing rapidly.
There's already been some debate about the financing of this unprecedented fiscal response – whether it will lead to unsustainable fiscal deficits and government debt, and whether it will have to be funded through higher taxes in the future.
However, none of this should be an issue, because there's an alternative way of financing the fiscal response. In fact, the problem of financing the fiscal response is, in our view, a red herring.
The simple alternative mechanism is for the central bank to buy government debt equivalent to the size of the fiscal response, and then to write it off.
To explain the mechanism, note first how governments typically finance their fiscal deficits.
As an illustration, the fiscal deficit of the government of India for financial year 2019-20 (as per the revised estimates) was Rs7.67 trillion, equivalent to 3.8 per cent of GDP. About 65 per cent of the deficit was financed by the sale of government securities in the market (private sector), and another 31 per cent was through issuance of government securities to the small savings fund (household sector).
Though the relative share of market borrowings has generally been higher in years, the key point is that nearly the entire fiscal deficit is financed by issuing government securities to the private or household sector.
The pragmatic though unorthodox alternative of the central bank monetising and then writing off government debt offers a way out.
With the looming recession, the appetite and the ability of the private sector for holding additional government securities could be limited.
Issuing government securities against the national small savings fund may be similarly compromised. But, there is an alternative mechanism.
The Reserve Bank of India (RBI) could directly buy government bonds (call them COVID-19 bonds, if you like) to the tune of the fiscal response, offering money, or more pertinently, crediting an equivalent amount to the government account.
This will inflate government debt on the one hand, and expand the RBI’s balance sheet on the other. But, this need be only temporary. Having thus monetised the additional government debt, the RBI could soon write off the government debt and shrink its balance sheet. There's also no need to finance the fiscal response through higher taxes in the future.
Such monetisation of government debt is anathema to many economists. Of course, you don't want to resort to such a mechanism as the normal mode of operation, in the interest of preserving the independence of the central bank, and to discourage unscrupulous government spending.
The normal procedures for financing fiscal deficits exist for a reason. However, these are not normal times. Writing off government debt incurred in, and limited only to, the exceptional circumstances of supporting an urgent relief effort is justified.
Is there a risk of inflation?
If the RBI monetises government debt, this will certainly inject more liquidity into the economy. Whether it impacts inflation will depend on the supply response.
There are reasons to believe this risk is small.
Firstly, with the impending recession, the economy is well below its potential, and may remain so for quite a while. Secondly, current levels of inflation are not high, and will be further helped by low global oil prices. Thirdly, if a good part of the fiscal response is directed towards maintaining supply chains and facilitating firms (especially small and medium enterprises) to reopen without an overhang of unpaid debts and rents, it will go a long way to mitigate the risk of inflation.
Finally, the COVID-19-induced supply shock is already morphing into a demand shock as people’s livelihoods and incomes plummet, creating a deflationary overhang. A sizeable fiscal response can stem this tide without a major risk of fuelling inflation.
By playing this supportive role, government spending can, in fact, crowd in rather than crowd out private spending. We also note that maintaining supply chains is a priority in any case, irrespective of the size and mode of financing of the fiscal response, and should continue to be so.
No government should shy away from mounting the needed fiscal response to COVID-19 on grounds of limited fiscal space. The pragmatic though unorthodox alternative of the central bank monetising and then writing off government debt offers a way out.
While we've illustrated our key argument using India as an example, it's no less relevant to any country, including Australia, which has launched a significant fiscal package in response to the COVID-19 pandemic.
