With the global economic disruption caused by the COVID-19 pandemic well under way, many have been asking whether central banks of developing countries that issue their own currencies should mimic their peers in advanced countries by monetizing fiscal deficits to overcome the crisis. The basic cautionary argument is that if countries engage in overt monetary financing (OMF) – central banks crediting government accounts with new money to finance its spending – they are likely “to exhaust their fiscal space and external financing may not suffice.” [1] The critical questions are what defines ‘fiscal space’ and why will external financing not suffice?

Fiscal space is outlined by existing resources

The conventional view is that fiscal space will be less compromised if the additional spending coming from OMF is temporally limited to health-related expenditures than if it were more widely applied, or especially, if it were made permanent. [2] TThe underlying reason is that relaxing central bank independence would entice myopic politicians to use the institution to serve short-term political gains at the expense of an erosion of material living standards in the long run. [3] This assumes a mechanical link between bank reserves, the money supply, and inflation. But as some central banks continue to stress, the mechanical link presupposed in many textbooks is not so. [4] The relationship is entirely mediated by the economic resources at a country’s disposal and its position in global value chains. 

Inflation is not due to a rise in the money supply per se – a naïve interpretation of the quantity theory of money. [5] A sufficient condition for rising prices is when expenditures rise faster than what the economy’s existing stock of resources can absorb (qualified labour, equipment, raw materials, etc.). This stock can be affected by exceptional demand shocks (such as wars), or by supply shocks (such as raw material shortages, production strikes, or large currency depreciations), which added to the policy of income indexation are the source of the high-/hyper-inflations observed in history. [6]

This means that the inflationary risk of all spending – independently of how it is financed – is the same up until the limit defined by real resource availability. At the point of full employment, taxes on income and wealth are a necessary condition to allow the government to have access to non-inflationary resource space to pursue collective goals by depriving the private sector of purchasing power. Thus, ‘fiscal space’ is intrinsically linked to resource space in all countries. [7] The implication is that if there exists excess capacity – as there is in most developing countries with large low-wage informal sectors, and relatively high unemployment [8] – then the extra spending can occupy existing resource space without necessarily adding to inflation.

Using this framework, it is clear that the current crisis presents a particular type of challenge. While governments can technically guarantee all business loans and subsidise wages of all workers via OMF to counter the demand shock until conditions improve, this policy has to be calibrated to the temporary fall in production coming from confinement and social distancing. Otherwise, it could trigger supply bottlenecks in certain sectors and lead to higher inflation than would be the case from responses to a regular demand shock.

The trilemma of developing countries

Central to the fiscal space constraint levelled on developing economies when invoking OMF is that, unlike advanced economies, they don’t issue a reserve currency – a currency in high demand for making international payments and for accumulating foreign exchange reserves. [9] Indeed, a historic challenge for developing countries has always been their trade balance with the rest of the world. [10]

The principal charge is that deficit spending creates higher demand for imports, widens current account deficits, exhausts foreign reserves, produces exchange rate and price instability, increases deficits further, and so on into a vicious spiral until multilateral foreign intervention. This is not inherent to the deficits themselves but of the economic bind developing nations find themselves in. Figure 1 illustrates this with the well-known trilemma of open economies configurated to countries with non-reserve floating currencies. According to the trilemma, such countries cannot pursue autonomous fiscal and monetary policy for developmental purposes without giving up exchange rate stability or free capital mobility.

The real external constraint of fiscal and current account deficits is the demand of the rest of the world to invest the foreign currency receipts in the deficit country it has sold its goods to. These capital inflows depend on the local economic and political environment. Thus, public spending that enhances domestic productive capacity lessons the exchange rate constraint for the deficit country, as well as improving trade and investment conditions for other countries. It also explains why FDI is preferable to short-term portfolio inflows, as the latter are unconnected to expanding real resource capacity, while their surge preceded “(n)early every major emerging-market financial crisis of the past few decades”. [11] The perceived ‘need’ to attract these capital flows largely explains the punishingly high interest rates in most developing countries.

A wider implication of this schema is that countries with fixed exchange rates or countries using a foreign currency have greater balance of payments constraints on running deficits. In these cases, domestic policy is completely subservient to the control of imports and capital inflows to defend the parity and manage foreign indebtedness at the cost of depressing the economy (decreasing wages and spending, and increasing interest rates). Therefore, enlarging domestic policy space requires these developing countries to transition to a regime of floating currencies and only issue debt in this currency. Yet, these conditions are not sufficient to exit the trilemma’s boom-bust cycle.

Coming out of the pandemic through a new paradigm

Three policy areas continue to be crucial for developing countries to advance: capital controls on destabilising portfolio inflow [12]; fiscal policy targeting import-substitution to expand domestic productive capacity, while shifting the weight of taxation from consumption and production to income and wealth [13]; and multilateral foreign exchange interventions using a permanent global reserve currency, to ease exchange rate pressures from critical imports. [14] The constraint on external financing interventions, it is argued, is a scarcity of funds, especially in times of higher-than-normal demand from member countries, such as the present crisis. [15] But this is not an intrinsic constraint since reserve currencies are not in themselves scarce resources, as they can be created by a keystroke. Scarcity only affects what can be bought with them. The only constraint is political.

If domestic policy and international institutional governance are to honour their developmental goals, fiscal and monetary policy need to coordinate around transparent employment, output and pricing targets that delimit ‘fiscal space’ to real resource capacity, with the aim of expanding this capacity. Geo-politics will remain an obstacle as long as a common understanding of the real economic constraints of developing countries, and the potential economic benefits for all countries, is not translated into popular pressure on global actors. This applies equally to present and future circumstances.