ByRichard Wood

Current policies do not address the source of the public debt problem, and provide little hope for economic recovery in periphery countries.


Deficient private demand, weak or falling output, and high and spiralling sovereign debt levels are now evident in many countries.

The recent expensive rounds of ‘quantitative easing’ (QE) in Japan, the United States and the United Kingdom have not sufficiently raised private consumption, investment or employment.  Rather, unproductive reserves have accumulated in banking systems.

In the Euro zone, the maintenance of a uniform exchange rate, and the one-size-fits-all monetary policy, cannot address the problems of low competitiveness, deflation and high interest costs in individual periphery countries.  Deep fiscal austerity is forcing further economic contraction in many countries, lowering tax revenues and further raising public debt.  Defensive ‘bail-out’ policies, bond purchasing on secondary markets and new lending policies are acting as band-aids, but they serve only to contain debt and interest rates at just below critical levels.  They treat symptoms rather than causes and, therefore, they fail to neutralise the source of the public debt problem (the ‘bond’ financing of on-going budget deficits) while creating more unemployment.

What did Keynes Say

In his open letter to President Roosevelt in December 1933, Maynard Keynes argued as follows:

Broadly speaking, therefore, an increase in output cannot occur unless by the operation of one or other of three factors.  Individuals must be induced to spend more out of their existing incomes; or the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees, which is what happens when either the working or the fixed capital of the country is being increased; or public authority must be called in aid to create additional current incomes through the expenditure of borrowed orprinted money*” (emphasis added).*

Keynes’ open letter to President Roosevelt went on to recommend as follows:

Thus as the prime mover in the first stage of the technique of recovery I lay overwhelming emphasis on the increase of national purchasing power resulting from the governmental expenditure which is financed by Loans and not by taxing present incomes”.

That is to say, in his open letter, Keynes did not further discuss the possibility of using new money creation to finance the deficit (beyond the single reference highlighted above).

The reason for this is fairly obvious.  In the mid-20s gross federal debt in the United States had declined to below 20 per cent of GDP, and gross state and local debt was 16 per cent of GDP.   During the Great Depression, Roosevelt boosted gross federal debt to 40 per cent of GDP.    State and local gross debt peaked at 25 per cent of GDP in 1933.

So there was no ‘public debt’ problem in the United States before, or during, the Great Depression.  Because of that fact, bond financing was entirely appropriate.

By contrast, today, total gross public debt in the United States stands at around 105 per cent of GDP or thereabouts, and is projected to rise further.

The situation today in Japan and in the periphery countries is also completely different to that in 1930.   Greece, for instance, has gross public debt of more than 166 per cent of GDP, and Japan has gross public debt of more than 233 per cent of GDP.  If advising today, Keynes would have needed to take these considerations into account.

Keynes would also have noted that interest rates are already at zero bound in some countries.  He would have observed that QE is adding unproductively to risk-free bank reserves: not reaching the incomes of those who create purchasing power in the real economy (the unemployed, the disadvantaged and those who benefit from public infrastructure activities).  Thus, if advising us now, Keynes would almost certainly be opposed to further QE.

Keynes would have taken both these considerations (high debt/historically low interest rates) into account.   He would have concluded that there are two powerful reasons for opting, today, to deploy new money creation (rather than new Loans) to finance public works and other expenditures.

History of deficit monetisation

In an excellent review of the long-term history of central banking and new money creation (Ugolini, 2011(a)), it is concluded that:

“What emerges from the past is that while the relationship between central banking and politics may have been dynamic, it has always been very close.  It also comes out that deficit monetisation has very often occurred almost everywhere.  Sometimes it ended in catastrophe, but on many occasions it did not.  This suggests that the debate we should be confronted with today is not whether monetisation is admissible or not, but whether we can appropriately assess its long-term costs and benefits.”

A more detailed analysis (Ugolini, 2011 (b)) concludes that:

“The findings have implications for the current debate on the institutional design of central banking, both in the U.S. and in the Eurozone.  Historical evidence suggests that neither changes in the organisational model of central banksnor government deficit monetisation should necessarily be seen as evil*…“ (emphasis added).*

The key confusion driving governments to adopt inappropriate policies is that which arises because of a failure by them to distinguish between ‘budget deficits’ and ‘the method of their financing’.  Budget deficits are desirable to raise demand, and should not be seen as evil.  The problem arises from adopting the conventional method used to finance deficits, that is, ‘bond’ (debt) financing.

‘Austerity’ is misplaced, and must be replaced

Austerity was attempted in Japan, and failed.  As a recent short article explains (Tasker 2012):

“The road to fiscal hell is sometimes paved with the best intentions.  As Europe’s politicians seek to win electorates round to brutal budget cuts, they would do well to look to the experience of Japan, which shows how counterproductive austerity can be in a post-bubble recession.”…

The real cause of the fiscal deterioration (in Japan) was the damage done to tax revenues by this protracted slump.  Central government outlays as a percentage of GDP are no higher now than in the early 1980s, but the tax take has fallen by 5 per cent of GDP since 1989, the year that consumption taxes were introduced.”

Austerity is today driving nations into the ground, adding to public debt and raising unemployment.  It is a simplistic, crude strategy, one of despair.

With aggregate demand falling in a number of countries, a new macroeconomic strategy is required to avoid a catastrophe (see Wood, 2012) in a worst case scenario.  The objectives of the new strategy should be to stop public debt rising, provide economic stimulus, and avoid inflation.

A central policy question at the heart of the current debate is the following:  if the monetary/currency authority decided that new money creation is desirable to provide economic stimulus, then how is this new money creation best deployed to provide the strongest stimulus without raising public debt and inflation?

In seeking an answer to this challenging question, policy makers must ask whether it is possible to run budget deficits at higher levels than would be the case under current deep fiscal austerity programs.  If these budget deficits were to be financed by the conventional method — sales of new government bonds — then public debt would increase.  This response would be totally inappropriate.  So too would further QE, which is largely ineffective and slow-acting, as interest rates are already at historically low levels, debt overhangs persist and there is no shortage of liquidity.

Policy makers should, therefore, consider whether part, or all, of the on-going budget deficits could be financed by printing new money while avoiding inflation.  Unfortunately, central banks have limited scope to print new money to finance fiscal deficits in a manner which does not involve an increase in ‘public debt’, as that term is generally defined and used by credit rating agencies.  Public debt includes the government bonds held by the central bank.  To provide new currency to the government the central bank needs to increase its holdings of new government bonds, and so public debt rises.  Credit rating agencies ‘see through’ and recognise that the government bonds held by central banks could be sold to the public at any time.

Consequently, the Treasury/Ministry of Finance in the United States, Japan and in Euro zone periphery countries could be given authority to print legal tender currency, for the strictly limited purpose of financing the budget deficit.

Consider economies where there is already gross excess liquidity, including the United States and Japan.  In the United States, for example, reserves held by commercial banks at the central bank amount to some $US1.4 trillion.  Assume that a strictly limited increase in new money creation is used to directly finance part, or all, of a budget deficit, and at the very same time an equivalent quantum of money is withdrawn (sterilised) from the economy, via bond sales undertaken by the central bank.  In this case, the overall money supply would not increase, inflation could not increase, ‘current public debt’ (as distinct from the ‘perpetual liability’ which occurs when any new money is created) would not rise, and a stimulus would be provided through the (higher) deficit to lift overall economic activity.  This stimulus (the new money), and related multipliers, would reach the unemployed, the disadvantaged and struggling businesses, where marginal propensities to consume and invest are greatest.

To achieve this outcome, the Treasury/Ministry of Finance could simply print the required legal tender currency and directly finance the deficit.  Alternatively, the central bank and the Treasury/Ministry of Finance could swap equivalent tranches of new money creation.  The Treasury/Ministry of Finance would then use the central bank-created currency to finance the budget deficit.  Later sterilisation is possible, and appropriate, because QE has already injected gross surplus liquidity into the financial system.

For Euro zone periphery countries the same general economic logic could be applied, whether they remain in the Eurozone or opt out.


Tasker, Peter (2012), ‘Europe can learn from Japan’s austerity regime’, Financial Times, 13 February.

Ugolini, Stefano (2011)(a), ‘What future for central banking? Insights from the past’, Vox Economics, 11 December.

Ugolini, Stefano (2011)(b), ‘What do we really know about the long-term evolution of central banking?’  Evidence from the past, insights for the present’, Norges Bank Working Paper, No. 15.

Wood, Richard (2012), ‘Delivering economic stimulus, addressing rising public debt and avoiding inflation’, Journal of Financial Economic Policy__,__ Volume 4, Issue No. 1, (forthcoming).  This article is now available on the Emerald EarlyCite website.