Should the RBI print money to revive the economy? It’s not as simple as it sounds

In the recent past, a small-scale industry has sprung up, imploring the Reserve Bank of India to print money and give it to the government to spend it. The logic for it goes somewhat like this.

Thanks to very little production and a dramatic drop in non-essential consumption beyond food, medicine and a few other basic items, the tax collection of the central government through excise duty and the goods and services tax, or GST, has collapsed.

Given that foreign trade has been badly impacted in the post-Covid world, there is enough reason to believe that tax collection through the customs duty route must have collapsed as well. The recent massive increase in the excise duty on petrol and diesel is expected to bring some respite for the central government.

State governments aren’t earning much taxes either. With a lockdown in place, private vehicles are barely moving around; hence, the sales tax/value added tax collected on the consumption of petrol and diesel by state governments has taken a beating. This despite the fact that many state governments have increased the sales tax/VAT on petrol and diesel.

There are barely any real estate transactions happening (neither sales nor rentals). Hence, the stamp duty collected through these transactions has come down dramatically too. With no vehicle sales, no money is being earned through vehicle registration either.

Also, all this while alcohol shops were shut, and state governments lost out on all the tax earned through this route. Now alcohol shops are opening but both social distancing and moral concerns are being raised.

Hence, both the central government and state governments have very little money coming in through the tax collection route. But other than fulfilling its regular expenditures (salaries, pensions, vendor payments, debt servicing, etc.), this is also the time when the government is expected to act as the spender of the last resort. Private sector spending has collapsed due to various reasons (from people being locked down at homes to the psychology of a recession setting in), and the government needs to spend money in order to get the economy going again.

But how does the government spend money if it doesn’t earn it? It borrows. The government borrows by selling bonds which pay a certain rate of interest. These bonds are bought by banks, insurance companies, mutual funds, etc. If the government borrows more, then it crowds out the private sector, leaving a lesser amount of money for it to borrow. In this scenario, the private sector needs to pay a higher rate of interest on its borrowings than it would otherwise have had to. This is something that is best avoidable in the current scenario.

Taking all these factors into account, money printing is being recommended by almost everyone who has access to a regular column on economics in a business or general newspaper or a digital publication.

There is one more reason: If the Western economies can print and spend money, why can’t we? QED.

Now, here is how money printing is expected to happen. The government deals with the RBI directly in this case. It issues bonds and the RBI buys these bonds. Where does RBI get this money from? It creates the money from thin air by simply printing it (or, rather, creating it digitally). This money is handed over to the government or, in other words, placed in the government’s account at the RBI.

The government then spends this money in various ways, acts as the spender of the last resort, gets the economy going again, and we all live happily ever after.

This is largely what’s being suggested by the people belonging to this small-scale industry which has sprung up, urging the RBI to print and the government to spend money. This includes corporate honchos (not surprisingly), business lobbies (not surprising again), economists, lawyers (who have a view on everything), journalists who write columns on the economy (least surprising, given that newspapers have totally run out of ads and their jobs are on the line), and almost anyone else who has access to a regular column on economics in a newspaper or a digital publication.

The trouble is, almost all these individuals have been presenting only one side of the story. In their limited world, money-printing and spending is almost like a free lunch. But then, there is no free lunch in economics, even though the chief economic advisor Krishnamurthy Subramanian was derided for recently saying precisely this.

So, what is this other side, the so-called nuance? Before we get into that, it needs to be said here that many of the small-scale industry wallahs do not really understand the issue, but need to pretend that they do. This includes corporate chieftains, whose expertise beyond their own business is questionable at best, and people running business lobbies. They are being told to parrot money printing whenever they get an opportunity, by those who supposedly do understand the issue (like the economists they have hired). Then there are the experts themselves: the economists and the analysts. Their saying so just proves that economics doesn’t really have many solutions to most problems, even though economists pretend that it does.

Typically, in case of any crisis, there are three things that one generally hears: The banks need to cut interest rates. The government needs to spend more money. And if these two don’t work, then the central bank needs to print more money for the government to spend more.

Of course, analysts and dial-a-quote fund managers, who make a living out of the stock market, need to keep offering theories which can keep investors interested in stocks. They are incentivised to do so. Money printing is the “in theory” these days.

To be fair, there’s a third kind of the money printing wallah as well: the journalist, who is basically trying to hold on to his job in the hope that money printing will ultimately lead to a few advertisements in the publication he works for.

Let’s talk about the nuance now. Most economists and experts who recommend money printing do that on the basis of something called the Modern Monetary Theory, or MMT for short. In this piece, I will use L Randall Wray’s Modern Money Theory - A Primer on Macroeconomics for Sovereign Monetary Systems to explain what the MMT is. Wray is one of the leading votaries and proponents of the MMT. But his recommending it comes with certain conditions and a context. We shall look at both. I will also be using Raghuram Rajan’s note on money printing published yesterday.

Let’s look at this pointwise.

1) Monetary systems all over the world are largely state money systems. This has been the case for the past 4,000 years. What this means is that the government of the day deems what can be used as money and the citizens then use it in their economic transactions.

In the last 100 years, money has basically been a piece of paper not backed by any commodity. In the past few decades, money has also been a digital entry in bank accounts. It’s money because the government deems it to be so. This kind of money not backed by any commodity but just the government is referred to as fiat money.

2) Given that the money is fiat money, it can be created out of thin air — and it is. The central bank, which is an arm of the government, irrespective of whether it is independent or not, does so by printing money (or creating it digitally).

In that sense, given that the government has the right to create money from thin air, it can never be insolvent (i.e. go bankrupt). As Wray writes: “MMT argues...the sovereign government cannot become insolvent in its own currency; it can always make all payments as they come due in its own currency.”

At the cost of repetition, this stems from the fact that the government can simply print money and pay.

3) In this scenario, the MMT basically states that the government which issues its own currency can always act as the employer of the last resort. It can afford to print money, create some work, and hire unemployed workers. When we say that during tough economic times the government needs to be the spender of the last resort, what we are essentially saying is that it needs to be the employer of the last resort. This is precisely what the money-printing wallahs are suggesting. Of course, they may not understand the dynamics of it all, but that is a different issue altogether.

Hence, the RBI needs to print money and hand it over to the government, which can then spend money, create jobs, and revive the economy in the process.

4) All this can happen only because people are willing to transact in the fiat money that the government deems to be money. Why is that the case?

As Wray writes: “The typical answer provided in textbooks is that you will accept your national currency because you know that others will accept it. In other words, it is accepted because it is accepted. The typical explanation thus relies on an ‘infinite regress’: John accepts it because he thinks Mary will accept it, and she accepts it because she thinks Walmart will take it.”

But the MMT proponents find this theory to be very specious. Or, as Wray puts it: “I accept a dollar bill because I think I can pass it along to dupe some dope”.

Other than the right to create money out of thin air, the other major right that any government has is the right to tax its subjects. And these taxes can be paid only in the government’s fiat money. So, if I am paying taxes in the United States, I need to do so in US dollars. If I am paying taxes in India, I need to do so in Indian rupees. And so it goes, from country to country.

5) Hence, the government creates demand for fiat money by essentially accepting taxes in it. But not all fiat money is used to pay taxes. So, people who pay taxes will accept fiat money or what the government deems to be money, but what about others? This is a question well worth asking and probably the most important part of the argument being offered here.

As Wray writes: “In the developed nations, the population is willing to accept more domestic currency than what is needed for tax payments...The normal case — let us say, in the United States or the United Kingdom or Japan — is that anything for sale domestically is for sale in the domestic currency. These sovereign governments never find that they cannot buy something by issuing their own currency.”

Basically, in developed countries governments can print money and spend it and create employment in the process. But things can get a little tricky for a developing country, where paying taxes honestly is not really the order of the day.

As Wray writes: “To be sure, the population will want sufficient domestic currency to meet its tax liability, but the tax liability can be limited by tax avoidance and evasion. This will limit the government's ability to purchase output by making payments in its own currency.”

This is something that applies to India, given the general tax avoidance and the fact that the informal economy forms a large part of the overall economy. Hence, the Indian government cannot print money and spend it in the same way as governments of more developed nations can. Of course, this is something that the money-printing wallahs either don’t understand or simply don’t bother to tell us. As I said, the nuance goes missing when they are trying to make an argument in favour of money printing.

Hence, for the Indian government to be able to print money in the same way as Western governments can, it needs to basically reduce tax evasion and formalise more of the informal sector (and not forcefully by killing it). This will ensure more demand for the Indian rupee and increase the government’s ability to print it, as and when required.

Of course, this can’t happen overnight. It calls for real economic reform, ease of doing business, and cleaning up the financial system, which remains in a mess. All this will encourage entrepreneurial activity, which will end up creating more demand for the Indian rupee. Having said that, this needs a lot of political will too.

6) Also, as anyone who has the most rudimentary understanding of economics knows, money printing can lead to higher inflation. Inflation is the rate of price rise. Even the proponents of the MMT acknowledge this. As Wray writes: “Let us be careful to acknowledge that these principles do not imply that the government ought to spend without constraint...These principles also do not deny that too much spending by the government would be inflationary.”

The logic being that as too much money chases the same amount of goods and services, the prices go up. Or, as Wray puts it: “It might not be effective for the government to simply increase its spending...this could result in inflation, as sellers would accept more domestic currency only at higher prices (as they already have all the currency they need to meet the tax obligation they think will be enforced).”

The argument currently being offered is that inflation is simply not possible. This is because of the huge demand destruction that has happened in the past couple of months. In this scenario, the chances of more money chasing the same set of goods and services, and leading to a price rise, are minimal.

This makes sense to a large extent. The capacity utilization of 701 manufacturing companies surveyed by the RBI for October-December 2019 was 68.6 percent. This basically means that slightly less than one-third of the capacity of these companies is lying unused.

For June-September 2019, the figure was 69.1 percent. These are the lowest two levels of capacity utilisation since the RBI started measuring this metric from April-June 2008 onwards.

What does this tell us? That private consumption in India had been slowing down even before the Covid-19 crisis. This has led to manufacturing companies utilising a lower part of their production capacity. The scene would have only gotten worse since December.

In this scenario, if money printing leads to an increase in demand, Indian manufacturing companies are in a position to increase production quickly, without having to increase prices. Hence, this is one point in favour of money printing not creating inflation, as long as supply chains to bring goods to the people do not break down thanks to the extended lockdown.

7) Let’s try and understand the above point in a little more detail. The RBI prints money and buys government bonds. This money ends up in the deposit account of the government with the RBI. The government then spends this money. Currently, the government has decided to deposit Rs 500 per month into the Jan Dhan bank accounts of women for three months. Let’s say it decides to pay a similar amount for three months in the Jan Dhan bank accounts of men as well.

The men, like the women before them, can withdraw and spend this money. In a time like this, when there has been a huge demand destruction, this increase in spending, as explained earlier, is unlikely to cause higher inflation.

Also, as men spend money, this money will land up with shopkeepers and businesses all over the country. The shopkeepers may hold back some of the cash that they earn depending on their needs. The chances are that most of this money will be deposited back into bank accounts. In the normal scheme of things, the banks would lend this money out. In difficult times, banks are reluctant to lend. Hence, they end up depositing this money with the RBI at a rate of interest referred to as the “reverse repo rate”. This currently stands at 3.75 percent.

What does this mean? It means that the printed money comes back to the RBI and the RBI has to pay an interest on it (the reverse repo rate). Hence, there is no free lunch, even though the RBI is printing money and creating it out of thin air. Also, the RBI gives a dividend to the government every year. As the RBI ends up paying interest even on printed money, the dividend to the government will go down to that extent.*

As of May 5, the total amount of money deposited by banks with the RBI through the reserve repo window stood at Rs 8,53,282 crore. On February 20, just two-and-a-half months back, the banks had deposited just Rs 39,983 crore with RBI under the reverse repo window. This simply shows the reluctance of banks to lend.

Of course, uptil now, there is no direct money printing that the RBI has carried out to finance the government. But even if the RBI had printed money and handed it over to the government to spend, the money would have come back to banks and the banks would have been reluctant to lend it.

8) There is a counterfactual statement that we need to explore here. In the normal scheme of things, the government sells bonds to finance its deficit. These bonds are bought by banks. Currently, the return on 10-year government bonds is around six percent. So, if the banks hold on to these bonds till maturity, they are likely to earn six percent. In a money printing scenario, the returns are down to 3.75 percent, and the banks earn by placing the excess money with the RBI through the reverse repo window. This means lower profit for both public and private sector banks. This means lower dividends for the government by virtue of being the owner of public sector banks.* It also means lower tax collections because of lower bank profits.

9) Money printing by the government can have exchange rate implications as well. As Wray writes: “If the government spends too much, this might set off pressure to depreciate currency...For this reason, while these governments can ‘afford’ to spend more, they might choose to spend less to protect their exchange rates.”

What does this mean? There is nothing forcing foreigners to hold assets in Indian rupees, especially if more of it is being created from thin air. They can sell out of the stock market, the bond market, the real estate market, and so on. When they do this, they will want to convert Indian rupees into foreign currency (particularly the US dollar). This will increase the demand for the dollar against the Indian rupee and lead to a depreciation in the value of the rupee against the dollar. If this happens very quickly, it can lead to a currency crisis — something India has dealt with in the past, as recently as mid 2013.

As economist and former RBI governor Raghuram Rajan put it in a recent column in the Times of India, “a loss of investor confidence could lead to a plummeting exchange rate and a dramatic increase in long term rates in this environment, and substantial losses for our financial institutions.”

This is not a situation the government would want the economy to end up in, given that the shape of Indian banks and non-banking financial companies remains shaky, to say the least.

10) There is another point that needs to be made here. The fact that the RBI is printing money and buying government bonds does not change the fiscal scenario of the government, which rating agencies as well as foreign investors are keeping a watch on. If the rating agencies feel that the government debt has risen to unsustainable levels, they are likely to downgrade India’s rating. If this happens, foreign investors will leave India and that as explained above will create its own set of problems.*

11) Continuing with the above point, it is important to understand that countries like the United States and the United Kingdom have currencies which are international reserve currencies. There is demand for these currencies outside their borders as well. As Wray writes: “There is little doubt that US dollar-denominated assets are highly desirable around the globe.”

Also, the US dollar is deemed to be the global safe haven. Hence, there is perpetual demand for the US dollar globally. This allows the US Federal Reserve, the central bank of the country, to print money without having to face any negative repercussions for the same. In fact, between February-end and April-end, the Fed printed more than $2.5 trillion.

What applies to the US dollar applies to currencies of other developed countries as well. As Wray writes: “To a lesser degree, the financial assets denominated in UK pounds, Japanese yen, European euros, and Canadian and Australian dollars are also highly desired.” This allows these countries to print money.

Of course, something like this does not apply to the Indian rupee. Any hint of direct money printing by the RBI to finance government expenditure might lead to foreign investors leaving the country. This, as mentioned earlier, can create other problems. It can also lead to rich Indians moving their wealth abroad, even though there are limits of doing so legally.

12) The overall point is that the MMT as it applies to developed countries, where the government forms a substantial part of the overall economy, is very different vis-à-vis the MMT as it applies to developing countries, where the government's role in the economy is rather limited. This is the nuance that experts who have been advocating money printing in the Indian context forgot to tell us about. This stems from the fact that any nuance makes the overall money printing argument less desirable and difficult to sell, both to the press and to the government.

To cut a long story short, just because something sounds simple and straightforward, like money printing does, doesn’t mean it is. Also, our minds are built to look for solutions for everything. And money printing sounds like a solution to our current problems.

13) The RBI used to monetise the central government’s deficit up until March 31, 1997. The central government spent more than it earned. A part of this spending was financed by the RBI by printing money. This helped bring down the fiscal deficit or the difference between what the government earned and what it spent. As the third volume of the history of the RBI points out: “In 1989-90, monetised deficit as percentage of GDP was 3.02, the highest on record”.

In my personal opinion, going back to such an arrangement is a bad idea, given that governments rarely stop doing something that they start to do. As economist Milton Friedman once said: “Nothing is so permanent as a temporary government programme.”

14) In fact, media reports suggest that some indirect monetising of the deficit might already be happening with the RBI buying government bonds indirectly through primary market dealers. A primary market dealer basically buys bonds directly from the government, acting as a market maker, with the intention of selling the bonds to other financial firms.

So, in this case, the RBI would have printed money in order to buy government bonds through a primary market dealer. Hence, the RBI may already be printing money and handing it over to the government, though in an indirect sort of way. This may be one of the reasons for the huge surge in the money being deposited by banks with the RBI under the reverse repo window. The printed money is coming back to the RBI.

To conclude, it is worth quoting something that John Kay and Mervyn King write in their new book Radical Uncertainty: “Most important challenges in these worlds are unique events, so intelligent responses are inevitably judgements which reflect an interpretation of a particular situation. Different individuals and groups will make different assessments and arrive at different decisions, and often there will be no objectively right answer, either before or after the event.”**

What does this mean in the current context? It basically means that the politicians running the government need to decide whether they want to print money or not, after having consulted the economists working for the government and even those outside it. At the end of the day, it is a political decision and not an economic one. This is not a binary yes-or-no kind of situation. There is a lot of nuance involved here and the things can go either way. The question is, do the politicians understand that nuance and given that are willing to take the risk of making a decision? On that, your guess is as good as mine.

Postscript: Much of this piece was written during the course of this week. Late last night (May 7), Raghuram Rajan published a note on money printing on his LinkedIn page. I have borrowed some of Rajan’s points and incorporated them into the piece.

References

L Randall Wray, Modern Money Theory - A Primer on Macroeconomics for Sovereign Monetary Systems, Second Edition 2015, Palgrave Macmillan.

* Raghuram Rajan, Monetization: “Neither Game Changer nor Catastrophe in Abnormal Times”, LinkedIn Post, May 7, 2020.

** John Kay and Mervyn King, Radical Uncertainty - Decision Making for an Unknowable Future, 2020,The Bridge Street Press.