When economy comes at standstill (Like lockdown):
- Central Government’s Loss: No GST, No Custom Duty hence very less revenue to government.
- State Government’s Loss: No Stamp duty on sale of property collection, No VAT income on petrol/diesel, No tax income on sale of Alcohol.
So, to keep the economy moving, the government needs to spend more. Specially, because now individuals won’t buy more of luxuries and cut on unnecessary expenditure thereby stalling the economy.
But, how can government spend money if they are not earning (less taxes)?
Government Borrows. They will issue bonds of certain interest rate. Giving bonds to bank, Mutual Funds, RBI, etc. and take the money from them. Now, more the requirement of money by government, more bonds will be issued. But there is one more thing to this that, these financial institutions like Bank will have lesser fund to lend to private companies (because they bought government bonds). And during crises times, the requirement of loan to run business will be higher compared to money the banks have, and so loans given by banks will be at higher interest rates.
Hence, the worse scenarios above can be balanced by RBI by just printing more money without any backing of asset or commodity (Read Fiat Money ahead). But, it is not easy as it sounds and you need to understand the impact further and deeper.
So, why can’t government just keep on printing money and then spend to uplift the economy? Well, there comes a lot of implication, and specially printing money is concept more familiar in developed countries then developed. Let’s try to understand step by step.
The concept of printing money, which most of the learned people know comes from Modern Money Theory (MMT) by Randall Wray (Mostly applicable in Developed Economy). Combining the MMT and Raghuram Rajan’s note on money printing published on LinkedIn (see source at bottom of this page), we give you 11 point explanation to make you understand better:
- Concept: Fiat Money.
As for the fact, money printed by RBI should be backed by equivalent commodity or asset. But, when RBI with directive of government prints money without backing of any commodity or asset, this money is known as Fiat Money. - Government cannot be Insolvent.
Because of Fiat Money, which is directly under the government, they cannot ever be insolvent. Which means that even if government has huge loans outstanding, they can be repaid just by printing more money (i.e. Fiat Money). - Government is last resort.
Because government has the power to print money, generally at the time of any crises, they are the only hope. Which also means it has power to spend, move economy, employ people and get the country’s activities rolling. - Fiat money is accepted by all.
Technically speaking, fiat money is not proper money and it should not form part of legal money (because not backed by any asset or commodity). But, because it is issued under the backing of government and also looks like normal cash money in hand, fiat money is accept by all. This is the reason that fiat money is still exchanged even though it does not forms part of proper money. - Government tries to get fiat money back through tax (direct way).
Because fiat money is not legal, or backed by any commodity, the government tries to get it back through taxes. Government’s tax collection is their direct income and hence it can also demolish currency collected because they own that money directly. But, the same is problem in developing nation. In developed nation, there are more tax payers (Usually 50% of the population files for tax). But in developing nation like India, only about 3% (As of today 17th May, 2020) of the population pays tax. Also, avoidance of tax is usual thing and hence compared to quantum of Fiat Money issued, usually government don’t receive them all in form of taxes. - Inflationary Pressure.
Now, say this, the currency printed is backed by commodity and assets. Hence, for every commodity and asset, there is equivalent money. But, when Fiat Money (not backed by any asset or commodity) is issued, there is more cash for the same numbers of commodity and assets. Hence, due to more money and less goods the price of the goods rises which we call inflation.
But, considering country like India. Before COVID – 19, the capacity which the manufacturing company were operating is at 69.1% (June-Sept 2019). Hence, even when there is excess demand, the manufacturing companies just can increase the production capacity and bring in the supply to that level. And so, country like India will have less inflationary pressure. - Fiat money coming back indirectly.
Government issues bond to get money from RBI, Bank etc. This money is then spend for people’s welfare and for economy’s progress. The money spend is earned by businessmen of the country, and also say they earn profit (excess cash). Because of such crises situation, business expansion is not done and money is kept idle for the emergency requirement of businessmen. Hence, instead of reinvesting the money in business they put it in Banks (for safety).
Banks at this crises situation do not usually lend to others because of risk of money getting defaulted. So, they again in turn deposit the money with RBI under reverse-repo agreement and earn say 3.75% interest (April 2020 rate). Hence, the money which RBI initially issued to government, comes back to them indirectly from Banks (money deposited by businessmen in bank). - Cost related to Fiat Money printing.
As now, banks deposit the fiat money with RBI for earning reverse-repo rate at 3.75%. Hence, this Fiat money printed by RBI, which came back to them in form of reverse-repos, has additional cost of 3.75% interest attached to it. Also this expense will also reduce dividend income which RBI pays to government on earning profit (because of more interest expense). Because RBI is of government, they not only printed fiat money to run economy, but also had to bring it back and in quest of doing so has lost even more interest meaning less profit. Another implication is that, banks instead of lending business loan and earning say 15% p.a. earned only 3.75%, which also mean less income for banks and in turn less taxes for government. - Exchange rate implication.
Because money is created out of thin air (Fiat Money), foreign investors might come to know through some of their own analysis. When foreign investors come to know, they actually understand that economy of country will now worsen (take for our analysis above, which already showing it worse). Hence, they sell the assets held in India like stock, bond and real estate. When they sell, they convert our domestic currency i.e. INR to say US$. This creates more demand for US$ and so the US$ appreciates and INR depreciates.
When this activity even goes faster, currency crises might happen too soon, harming the economy too bad. (Currency crises also came in mid-2013). - More government debt, worse country’s ratings.
As government takes more loan to run the economy, ratings agency are busy watching these activities. When they think that now the loan taken by the government is way too much than its capacity, they raise a warning bar. This warning bar is in the form of degrading the ratings of the country (Countries are rated based on their credibility). When ratings go down, foreign investor think there is more risk in keeping invested in the country and hence they withdraw their money leading to many other problems apart from currency crises explained above. - Printing currency: Developed country v/s Developing country.
This is the last point, and perhaps the point for which the whole explanation above is given. Developed country’s currency like US$, Euros, Yen, Pounds, etc. are demanded all over the world. Hence, when developed country issues Fiat Money of their own currency, they know that it will be accepted around the world. Hence, the risk which arises by issuing Fiat Money is far more acute in developed countries (compared what is explained above). On the other hand, developing country’s currency like India’s INR is almost only accepted in India. Hence, absorbing Fiat Money is more difficult by Indians itself.
The whole point here to make is, although printing money might seem easy solution. But the concept is more suitable and sustainable for developed countries as compared to developing countries.
Conclusion:
The simple comment of “printing more money will solve the issue” looks so simple but it is not. And why is that? Because the implication are too complicated and problematic. Implications like problem of discarding Fiat Money, Cost incurred to get Fiat Money back, rising level of loan taken by government, Currency Crises, Ratings downgrade and invertors moving their money out of country and the power of absorbing Fiat Money.
These implications state that government might well lift the economy by printing money, but only on temporary basis and the rest of problems might occur making the situation even worse.
Here’s is a thought for you, I guess you got a bit of research to do yourself.
Vital Source: https://www.newslaundry.com/amp/story/2020%2F05%2F08%2Fshould-the-rbi-print-money-to-revive-the-economy-its-not-as-simple-as-it-sounds?__twitter_impression=true.
The above source has the same concept explained in more detail. If you understand this article too well, I recommend you to read above article too.