Monetization of debt: Where is the fault line?

Central banks across the world are expanding their balance sheets at a rapid pace. By purchasing sovereign debt , central banks are providing a financial backstop for governments that are themselves expanding their expenditures massively. As the debt figures keep growing it seems a natural question to ask how long this can go on and where the potential fault line in this monetization of government debt lies . Put more bluntly: who is paying for all this in the end ? The good news is – at least when considering governments’ crisis fighting capacity – that there is no immediate limit on how far reaching central bank’s support for governments can be. The main short-term risk, in particular in the euro area, seems to be on the political level. It gets more complicated in the medium-term. The first crucial question to ask is whether the bonds issued by governments will be redeemed or whether central banks will continue to rollover the debt ad infinitum. To be sure , this may not be an either/or question as repayment can be spread over a (very) long time horizon that makes it indistinguishable from monetization. The two variables that will determine which “exit” – repayment or monetization – policymakers will choose will be inflation and debt sustainability. All else equal, outright monetization will lead to a higher inflation path than debt repayment. This is because monetization will permanently create additional demand while repayment simply means a transfer of demand across time and sectors. But this does not preclude that monetization may still be the better strategy if it prevents inflation from undershooting. At the same time, inflation may develop to an extent that the ECB could be forced to choose between its inflation mandate and its role as a financial backstop for governments. That said, we think t he ECB is unlikely to have to choose between these two objectives. This is because higher inflation would usually also imply that the growth outlook is improving, which in turn increases debt sustainability. From this also follows that a cost - push inflation – a rise in inflation that does not go hand in hand with stronger growth – would be the biggest risk for the outlook. Ultimately, however, b arring such a shock , we would expect the ECB to continue to rollover its purchases of government debt for a very long time.