In 2008, China beat the global financial crisis by pouring massive amounts of money into infrastructure, and that is apparently the policy it is pursuing now. Five hundred billion dollars in infrastructure projects have already been proposed for 2020 nearly as much as was invested in the country's huge stimulus program after 2008. The newly injected money will go into the pockets of laborers and suppliers, who will spend it on consumer goods, prompting producers to produce more goods and services, increasing productivity and jobs.
How will all this stimulus be funded? In the past, China has simply borrowed from its own state-owned banks, which can create money as deposits on their books, as all depository banks do today (see here and here). Most of the loans will be repaid with the profits from the infrastructure they create, and those that are not can be written off, or carried on the books, or moved off the balance sheet. The Chinese government is the regulator of its banks, and rather than putting its insolvent banks and businesses into bankruptcy, its usual practice is to let nonperforming loans just pile up on bank balance sheets. The newly created money that was not repaid adds to the money supply, but no harm is done to the consumer economy, which actually needs regular injections of new money to fill the gap between debt and the money available to repay it. In all systems in which banks create the principal but not the interest due on loans, this gap continually widens, requiring continual infusions of new money to fill the breach (see my earlier article here). In the last 20 years, China's money supply has increased by 2,000% without driving up the consumer price index, which has averaged around 2% during those two decades. Supply has gone up with demand, keeping prices stable.
The Japanese Model
China's experiences are instructive, but borrowing from the government's own banks cannot be done in the U.S., because our banks have not been nationalized and our central bank is considered to be independent of government control. The Fed cannot pour money directly into infrastructure but is limited to buying bonds from its primary dealers on the open market.
At least, that is the Fed's argument, but the Federal Reserve Act allows it to make three-month infrastructure loans to states, and these could be rolled over for extended periods thereafter. The repo market itself consists of short-term loans continually rolled over. If hedge funds can borrow at 1.5% in the private repo market, which is now backstopped by the Fed, states should get those low rates as well.
Alternatively, Congress could amend the Federal Reserve Act to allow it to work with the central bank in funding infrastructure and other national projects, following the path successfully blazed by Japan. Under Japanese banking law, the central bank must cooperate closely with the Ministry of Finance in setting policy. Unlike in the U.S., Japan's prime minister can negotiate with the head of its central bank to buy the government's bonds, ensuring that the bonds will be turned into new money that will stimulate domestic economic growth; and if the bonds are continually rolled over, this debt need never be repaid.
The Bank of Japan has already "monetized" nearly 50% of the government's debt in this way, and it has pulled off this feat without driving up consumer prices. In fact, Japan's inflation rate remains stubbornly below the BOJ's 2% target. Deflation continues to be a greater concern than inflation in Japan, despite unprecedented debt monetization by its central bank.
The Independent Federal Reserve Is Obsolete
In the face of a recession caused by massive supply-chain disruption, the U.S. central bank has shown itself to be impotent. Congress needs to take a lesson from Japan and modify U.S. banking law to allow it to work with the central bank in getting the wheels of production turning again. The next time the country's largest banks become insolvent, rather than bailing banks out, Congress should nationalize them. The banks could then be used to fund infrastructure and other government projects to stimulate the economy, following China's model.
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