Daniel Kruppa, 1 August, 2014
At present central banks conduct monetary policy (MP) primarily through targeting of interbank interest rates and asset purchases. Altering the cost or quantity of money and purchasing assets from the marketplace can potentially affect spending primarily through changes in funding costs, increases in the supply of money and wealth effects of agents through portfolio re-balancing (Bank of England 2011).
The effectiveness of a reduction in interbank interest rates in generating spending is dependent upon people’s willingness to borrow and bank’s capacity to make loans or investments. Factors such as debt to GDP levels and balance sheets of debtors and creditors can severely hamper the effectiveness of interest rate targeting as a policy tool. The issue of inequality also arises under interest rate targeting because only banks have access to lower interest rates offered directly by central banks through issuance of securities such as repurchase agreements (repo’s) and because only banks can directly transact in risk free electronic deposits at the central bank.
The nominal lower zero bound (ZLB) also poses limitations to conventional interest rate targeting under the current bank centric approach. At the ZLB the current central bank counter-parties have very little or no opportunity cost when holding reserves due to low investment returns and therefore expansions of central bank money should have a reduced impact on growth and inflation. The overall public on average have a higher opportunity cost when holding money compared to central bank counter-parties due to foregone utility from consumption or other spending. Financial entities such as the current central bank counter-parties are oriented towards realizing profits from investing and inter-mediating whereas people gain greater utility from consuming. Therefore expansions of funds to public would more effectively create spending growth at the ZLB.
The wealth effect which is generated through asset purchases and portfolio re-balancing only reaches existing asset holders and because asset ownership is heavily concentrated most of the wealth effect is experienced by the most wealthy while people with few or no assets experience little to no wealth effect. The richest have a lower marginal propensity to consume than people on average, therefore the impact on spending as a result of the wealth effect is reduced. It is also a manifestation of inequality that monetary policy seeks to create wealth increases but these increases in wealth mainly go to richer people. Inequality of asset holdings can be observed in the US where over 90% of stocks are owned by the wealthiest 20% while the bottom 60% own approximately 2.5% of stocks (Wolff, 2012). Approximately 65% home ownership rate leaves approximately one third of households not experiencing the wealth effect of house price increases (US Census Bureau).
A more effective transmission mechanism for monetary policy needs to be established by the central bank in which it can directly target broader market interest rates (if interest rate targeting) and where it generates a wealth effect to all people.
A more effective monetary policy mechanism
In order to more effectively attain its goals the central bank should bring into effect a mechanism which allows it to directly interact with a wider and more balanced spectrum of the economy not just banks and financial institutions. This can be achieved by the monetary authority through issuance of electronic accounts to the general public allowing people to deposit and transact in central bank deposits in the same manner as banks do at present. It is not proposed that private banks cease to be depository institutions or full reserve banking be implemented. If the CB is tasked with providing money it should therefore also provide an efficient electronic means of payments and deposits of the money it creates. The provision of a payment and depository system by the central bank will be of benefit because it will directly be able to interact with people for monetary policy purposes and the deposits and payment system which is highly systemic will become risk free.
How will monetary policy be conducted through the new mechanism?
When the monetary authority is pursuing expansionary monetary policy in order to attain its goals related to unemployment, GDP growth or inflation it can affect the target interest rate (if interest rate targeting) by periodically expanding the supply of central bank deposits directly and evenly into all citizen’s accounts while open market operations and other policies are performed when necessary. The rate of growth of direct money issuance (DMI) to the public will be periodically adjusted by the central bank in order to attain its targets while temporary open market operations may be used in order to fine tune the short term interest rate or contract the monetary base.
When the money supply is expanded to the public it will be directly issued into all people’s accounts on an equal basis at regular intervals such as once a week or month. The growth rate of the money supply will be adjusted in order to attain the target interest rate or more directly the inflation or GDP growth rate. Historically in most of the first world prior to the 2008 financial crisis the growth rate of the monetary base was approximately 5-10% per anum. If the central bank grows the money base directly to people at 5% per anum and it is suppressing the interest rate too much and therefore causing too high inflation and growth the rate of money growth should be adjusted downwards and vice versa.
During periods when the central bank needs to contract the money supply this can be done through issuance of securities such as reverse repurchase agreements, term deposit facilities or issuance of liabilities. Historically contractions of the monetary base have been rare and short term, most of the time the MB is increasing. The central bank may also employ temporary open market operations in order to fine tune the interest rate target if necessary as is currently performed.
If money is directly issued into people’s accounts no asset purchasing is required to expand the money supply. The people are the central bank’s constituent due to it being an agency of the people and therefore issuance of money to people should be recognized as equity on the bank balance sheet. The expansion of money will not deteriorate the balance sheet of the central bank if money is not recognized as a liability. Financial assets or fiat money do not need to be a liability of the issuer and is an asset for its holder (Buiter, 2004), therefore the monetary base through direct public issuance can expand without a corresponding increase in liabilities for the central bank.
Advantages of conducting monetary policy directly with the public
The various stimulatory or contractionary effects due to adjustments in short term interest rates will continue under direct money issuance with the addition of new direct mechanisms of action through increased public monetary wealth.
Direct issuance of central bank deposits to people on a non lending basis will nominally increase monetary wealth of recipients by the amount of newly created monetary base. Under asset purchases or lending the newly created money received by the central bank counter-party does not result in an increase in wealth because it is offset by a new liability or the loss of an asset. Portfolio balance effects may increase wealth under a regime of asset purchases or money lending but the higher money supply itself will not.
Higher monetary wealth due to DMI would affect spending and creditworthiness of people.
In a climate where the short term interest rate is at the zero lower bound (ZLB) the current central bank counter-parties have very little or no opportunity cost when holding reserves due to low investment returns and therefore expansions of central bank money should have a reduced impact on growth and inflation. The overall public on average have a higher opportunity cost when holding money compared to central bank counter-parties due to foregone utility from consumption or other spending. Financial entities such as the current central bank counter-parties are oriented towards realizing profits from investing and inter-mediating whereas people gain greater utility from consuming. Therefore expansions of funds to public would more effectively create growth at the ZLB. The unemployed, people on low incomes will have a low demand for money at the ZLB and will spend a large proportion of money received from the central bank which will stimulate growth. The demand generated by higher spending from people should place upward pressure on profits and asset prices and therefore also stimulate investment related spending.
The wealth effect as a result of portfolio re-balancing will continue to manifest as it does at present but an additional wider reaching increase in wealth will also prevail under DMI through increased money balances of central bank counter-parties. Asset holdings are concentrated with the wealthier people owning a large proportion of assets and many people owning few or no assets. Therefore under the present system increases in wealth from increased asset prices don’t reach large parts of the population which diminishes the effectiveness of monetary policy. Wealthier people’s propensity to spend out of income is lower than the average person therefore monetary policy induced increases in wealth of all people through money issuance should result in greater spending increases when compared to wealth increases skewed towards wealthier people.
Under the present system central bank actions designed to create a wealth effect throughout the economy are not guaranteed to succeed if asset markets don’t appreciate in response to expansionary monetary policy. Direct money issuance will increase people’s monetary wealth even if asset prices don’t change.
Increased wealth in form of liquid assets such as money is more likely to be used for spending than an increase in wealth in form of less liquid assets such as stocks or housing. Increase in wealth from less liquid assets should lead to a smaller increase in spending due to taxation from capital gains, transaction costs and effort of converting non liquid wealth into money in order to spend.
The money supply to the broader economy could increase without necessitating an increase in debt if the central bank expands the monetary base directly to people. Under the current system expansions of broader money generally require more borrowing because commercial banks usually increase the quantity of deposits through lending. If the money supply can increase while maintaining lower debt to GDP levels greater financial stability should prevail because historically credit booms raise the odds of a financial crisis (Jordá et al. 2014).
Expanding upon the capacity of the central bank to perform basic and systemic banking activities such as deposit taking alongside the private sector will greatly benefit the operation of the economy in terms of increased security and economies of scale.
If the central bank offers operates a depository and payments services this aspect of the economy which is systemic will become risk free. Deposits at the central bank will have the financial backing of the monetary authority instead of the private sector which is segmented and is managed by private companies principally serving their own profit interest.
Efficiencies of scale should be realized if the current depository and payments system is unified and streamlined under the central bank instead of being segmented among an array of private banks and clearing houses. As a result the system should become simplified and less costly to operate. The regulatory load may also be reduced if a significant proportion of depository and transaction activities are performed in house by the authority. Efficiencies of scope should also prevail if basic banking functions such as the deposits, payments and monetary policy are integrated. Deposit insurance provided by the government for the private sector may no longer be necessary.
Increases in the money supply through direct issuance to people will be permanent increases in the money supply because the central bank will not accumulate assets such as government bonds on its balance sheet which draw the money back to the central bank upon expiry of the asset or interest payments.
Monetary policy effectiveness will not be compromised in an instance of dis-intermediation if the central bank can directly interact with people.
Greater systemic safety of the deposits and payments system will be realized if people can also directly deposit and transact in central bank money which is risk free electronically alongside commercial bank deposits.
If people participate in monetary policy as counter-parties to the monetary authority they should become more knowledgeable of economics and gain greater confidence in the monetary system and its key institutions which is vital for a healthy economy.
When the CB expands money into the economy without purchasing assets it will not remove safe assets and risk free returns from the private sector which may induce risk taking. Issues relating to collateral shortages, unwinding of asset purchases or other possible adverse effects on asset markets from expanding the CB balance can be avoided.
In a dynamic stochastic general equilibrium model with rational agents maximizing utility over an infinite time horizon subject to inter-temporal budget constraints an increase in net wealth through helicopter drops would cause agents to increase their current and future spending if there are unemployed resources (Bossone, 2013).
Bank of England (2011), “Quantitative easing explained: putting more money into our economy to boost spending”, London: Bank of England.
Bossone, B (2013), “Unconventional monetary policies revisited (Part II)”, VoxEU.org, 5 October.
Buiter, Willem H (2004), “Helicopter money: irredeemable fiat Money and the liquidity trap”, CEPR Discussion Paper 4202.
Wolff, E. N. (2012), The Asset Price Meltdown and the Wealth of the Middle Class. New York: New York University.
Bossone, B and A Sarr (2002), “A new financial system for poverty reduction and growth”, IMF Working Paper No. 02/178, October.
Òscar Jordá, Moritz Schularic and Alan M. Taylor (2014), “Private Credit and Public Debt in Financial Crises”, FRBSF Economic Letter, March 10, 2014