Monetary financing is a highly controversial practice whereby central banks buy the government bonds of their country. Put another way, it means that a central bank is printing new money for governments to use rather than the governments acquiring money through taxation or borrowing as they usually do. This sounds like a tempting option, but it has numerous drawbacks.

Monetary financing can occur it two main ways - either central banks buy government bonds directly from the government at auctions, or they buy government bonds on what is called the secondary market, which means from banks which already own bonds that were issued previously. The first method means the government can raise money when it might not otherwise have been able to, whereas the second increases the demand for government bonds and hence makes them more valuable, making it easier for governments to raise money than they might otherwise find it.

You might well ask why you should care about this. Allow me to explain. Monetary financing is becoming an increasingly tempting option for governments across the western world who are struggling to make ends meet after the credit crunch. Governments don't want to tax their population or businesses more because the former get angry and the latter are likely to leave and go somewhere else; nor do they want to borrow money and add to their total deficit and debt levels, because eventually this money has to be paid back, which means raising it through taxation. Imagine, then, how tempting it would be to have your central bank - that means the Fed to those of you in the U.S., or the Bank of England or European Central Bank to most of the rest of us - simply print the money and lend it to your government. But the drawbacks ought to be obvious too.

The main reason that central banks control the amount of money in the economy is to control inflation and deflation. In our modern system of fiat money - where money is just created out of the ether rather than being backed by a physical commodity as it was under the gold standard - the power to create money via quantitative easing is an enormous and frankly terrifying one. Central banks could literally flood the economy with trillions of dollars at the click of a mouse or a whir of the printing presses, distributing it out of helicopters to everyone below; the result would be short-term merriment and only slightly longer-term rampant inflation as a vastly increased quantity of money chased the same quantity of goods and services, causing providers of goods and services to jack up their prices like there was no tomorrow.

Imagine, then, the danger of allowing a government - especially a democratically-elected one - to simply print money to please its own constituents or the population as a whole. Without any constraints on the amount of money it could spend, this government would quickly spunk money on everything likely to please its voters and on the basic social services that we all need. It being able to do the latter may sound good, but it becomes clear that this is no solution at all when we remember that every act of monetary financing leads to more inflation and hence gradually erodes the standard of living of ordinary citizens. Avoiding a scenario where the government can manipulate the money supply to its own advantage is one of the main reasons for central bank independence, which is the idea that after the heads of central banks are appointed by governments they are no longer accountable to those governments for their actions, apart from within a narrow remit of controlling inflation.

As the financial crisis marches on, some form of monetary financing - probably not the wholesale abrogation of the principle of central bank independence, but certainly some blurring around the edges - is likely to appear more appealing to governments and even to voters who have been driven to despair and are not considering the full implications of what they are proposing. Quantitative easing is an example of a policy which is already a form of monetary financing, even if helping governments borrow money is not necessarily the main goal of the policy. But everyone would do well to remember that it was the unrestrained growth of money and credit in the economy that eventually led to the credit crunch in the first place; returning to that model, with even fewer constraints, would only provide us with the most ephemeral relief.

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