Why Do Some Countries Create Money?

Readers Question: Why is it, that some countries e.g USA, UK, Japan etc can electronically create money whereas India, Germany, Euro etc have to work, trade and manufacture exports and growth to keep pace with the above mentioned ?

Any country could electronically create money if they wanted to. To summarise, the only good time to create money is when the economy is in a liquidity trap – a deep recession where even low interest rates fail to close the output gap.

The US, UK and Japan have pursued quantitative easing because the recession of 2008-12 was very deep and conventional monetary policy seemed ineffective in ending the recession.

Arguably, Quantitative easing would have been more successful in UK and US if it had been combined with expansionary fiscal policy or giving to consumers directly. But, the hope was creating money electronically (quantitative easing) would lower long term interest rates, increase bank lending and promote economic recovery.

It is important to bear in mind, creating money doesn’t create any actual output. It’s purpose is to increase demand and help unemployed resources to become better utilized.

Why doesn’t the Eurozone create money electronically?

The ECB is much more reluctant to create money. In the past, they have argued that constitutionally they cannot (though this has become somewhat more blurred recently) . The big fear that Europe (and Germany especially) have is that creating money will cause inflation. Therefore, the ECB have been reluctant to pursue quantitative easing to help the economic malaise.

Essentially this comes down to a different philosophy. (see also: Bank of England v ECB) The ECB are concerned about maintaining low inflation and Central Bank credibility, the UK and US have taken a more pragmatic view – arguing in a deep recession, the Central Bank should act to limit the length of the recession.

Another problem in Europe is that Germany doesn’t need quantitative easing because their economy is doing reasonably well. However, countries in the south of Europe are facing a grave economic crisis – deflation, deep recession and mass unemployment and arguably they do need this money creation to stimulate economic output.

Because southern European countries are pursuing aggressive fiscal tightening (government spending cuts) – their economies have entered into a deep recession. They face an unenviable combination of circumstances:

  • Deflationary fiscal policy
  • Deflation – falling prices or at least very low inflation.
  • Collapse in financial and consumer confidence.
  • Overvalued exchange rates leading to more expensive exports
  • Very high unemployment contributing to a negative multiplier effect.

In this situation, southern European economies really need some monetary easing. This could come in the form of quantitative easing, or even ‘helicopter money‘ – For southern Europe, money creation would ease their debt deflation and promote higher growth, which enables lower unemployment.

However, because they are in the Eurozone, they can’t pursue an independent monetary policy. The ECB act for the whole Eurozone and so there is no money creation. If Spain, Italy were outside the Eurozone, I’m sure their monetary policy would be quite different.

Readers Question For that matter, why is the European Common Market suffering, if it was that easy to print money ?

That is a good question. Arguably, the ECB have made a mistake in their rigid inflation targeting. They have pursued the goal of low inflation, sacrificing more important objectives, such as unemployment and economic recovery. Personally, I believe this is a big mistake. The level of unemployment in unemployment is a significant problem, monetary easing would be helpful in the current economic climate. The threat of inflation, is the very lowest concern for the EU at the present moment.

India

In the case of India, the Indian economy is, if anything, overheating. Economic growth is high, but inflation has been creeping up. Because the economy is growing rapidly, creating money in this situation would be highly undesirable. India probably need tighter fiscal and monetary policy – printing money would almost certainly increase inflation. (why printing money creates inflation)

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