A Solution to Create a Balanced and Efficient Monetary Policy System (First Posted April 2012)

The current monetary policy (MP) framework in place across most of the developed world is imbalanced and ineffective. It has four main destabilizing features:

1. The monetary authority deals indirectly with most of the economy and depends on commercial banks to create new lending for the broader economy.

2. When conducting policy the central bank deals with a select group of financial corporations, which only represent a fraction of the overall economy.

3. Commercial banks lend based on profit motives. Consequently new commercial bank lending is likely to enter the economy in an imbalanced manner and contribute to instability. As a result banks should not be directly involved in conducting monetary policy.

4. New central bank and commercial bank money is created as debt, therefore the monetary system is debt based. A debt based system is likely to lead to excessive systemic debt levels.

Indirect approach to Monetary Policy

The central bank conducts monetary policy with the economy in an indirect manner through the monetary transmission channel. This consists of the central bank lending reserves to the banking system and commercial banks lending into the broader economy. Therefore private banks and not the authority deal directly with the economy in monetary policy operations. Consequently the commercial banking system has the final say on how monetary policy is formulated, not the authority.

Figure 1: Indirect Approach to Monetary Policy

The effectiveness of monetary policy under the current system is diminished due to the reliance on commercial banks to create new loans aimed at the national economy. If the financial intermediaries determine that it is not profitable or economically viable to lend onwards lending rates may not be at the desired level to attain the CB’s economic objectives relating to growth, employment and inflation.

If the commercial banks decide to expand lending to the economy it is usually at higher rates of interest than central bank funding rates. Therefore the financial system is privileged over all other sectors of the economy. The largest detriment is usually suffered by small to medium size enterprises because they lack the bargaining power to attain cheaper borrowing rates.

As a consequence of the CB not dealing directly with the overall economy the monetary authority only influences policy and much of the monetary decision process is left to private banks. Central bank funding rates are only an element out of many which influence commercial banks’ lending and investment behavior. Factors such as overseas funding costs, alternate domestic sources of funding, confidence, expectations and demand for loans contribute to lending decisions.

A much more effective monetary policy arrangement is one where the financial intermediaries are removed and the CB interacts with the economy directly.

Figure 2: Direct Approach to Monetary Policy

If the CB operates directly with the economy instead of intermediating through the banking system its job will simplified so it can more effectively attain its objectives relating to economic growth, inflation and stability. It will also be more accountable because it will become the only entity responsible for managing the money supply. Bank lending decisions which are guided by individual profit objectives will no longer directly influence or determine the conduct of monetary policy.

limited Participants in Monetary Policy Operations

At present the central bank only lends reserves to the financial sector. If the banking system decides to lend to the broader economy it will usually do so at higher interest rates in order to maximize profit. As a result all components of the economy outside the financial sector are at a disadvantage or neglected by not directly receiving funding directly from the CB. This had led economic instability due to an oversized financial sector and misguided lending practices.

In order for economic stability to prevail new money needs to enter the economy in a balanced manner. This can be performed if the central bank deals directly with the citizenry. Under this approach in times of monetary stimulus funds will be distributed through the economy evenly across the entire system.

Unstable Private Sector Monetary Expansion

At present commercial banks are able to expand lending with few restrictions on how much money they create in the process. Therefore money creation can be excessive during business cycle upswings or insufficient during recessions leading to greater levels of instability and malinvestment.

The fractional reserve requirements in place allow banks to create many times more funds than they are required to hold in reserve. Due to the opacity and unnecessary complexity inherent in the present system it is actually debated as to whether banks are reserve restrained at all. Many believe that banks source reserves after making loans with the central bank providing all the reserves required by the banking system on demand.

The ability to create loans so easily creates an environment amongst many financial organizations where access to funds for speculative investment and lending is abundant. As a consequence lending within the banking sector has contributed to outsized growth of the financial sector relative to the overall economy. Too much growth in lending has also facilitated the creation of bubbles in many housing, commodities and derivatives markets. Excessive lending and leverage provision aimed at trading on commodity exchanges may also be contributing to increased volatility and consumer price inflation from higher commodities prices.

Too big to fail banks which pose a systemic threat to the overall economy sustain themselves at least in part because they have access to debt from the banking system. The shadow banking system which is largely an opaque and speculative aspect of the financial system also benefits greatly from its ability to gain leverage from other banks. Consequently many financial organizations with unviable business models are likely to be artificially supported by access to cheap funding while many viable businesses outside of the financial sector are hampered by higher borrowing costs or lack of access to funds.

Enterprises within the financial sector are profit driven therefore lending policies tend to be formulated in order to advance the interests of the banks with little consideration for the broader economy. Therefore if the financial sector can influence monetary policy it will gain an advantage over the rest of the economy and grow dominant. Private sector money creation is misguided resulting in excesses in some sectors like housing and insufficient lending to many other vital sectors of the economy.

The imbalances created when profit oriented institutions create money need to be eliminated. This can be done if the central bank is the only entity entrusted with monetary policy and all powers to create money are removed from the private banking system.

New money will enter the economy evenly which will act as a systemic stabilizer minimizing the occurrence of imbalances. Money supply growth will be constrained by the CB inflation mandate which will serve to limit the causes of volatility in the business cycle. At present banks largely determine how much money enters the system leading to excessive speculation and malinvestment.

As an added benefit the system will be simplified and easier to understand for the public and the authority because all funds will be central bank money with commercial bank money ceasing to exist. At present accountability is confused because commercial banks and the central bank both create money. Therefore the authority will become more accountable because it will be solely responsible for money creation and its effect on the economy.

New Central bank and Commercial Bank Funds are Created as debt, Therefore the Money System is Debt Based

Under the present approach to monetary policy conducted by the central bank all new CB reserves borrowed by commercial banks are debts that need to be repaid with interest. The commercial banks borrow reserves in order to fulfill their reserve requirements and lend to the broader economy. Therefore excessive indebtedness and credit crises have emerged as a consequence of money being created as debt.

Due to interest payments there needs to be a continual expansion of debt in order for the money supply to sustain itself at any particular level. Therefore it is inevitable that debt levels will become overly burdensome at some point leading to a credit crisis. From a systemic point of view if debt was to be reduced significantly it would need to be accompanied by a large reduction in the money supply causing an economic contraction.

The present debt driven system is vulnerable to events such as a credit crunch in which the general availability of loans or a sudden tightening of the conditions required to obtain these loans occurs. A credit crunch generally involves a reduction in the availability of credit independent of the level of official interest rates. In such situations, the relationship between credit availability and interest rates has implicitly changed, such that either credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability. Figure 3 is a depiction of the broken monetary transmission channel in the US, UK and Eurozone after the 2008 credit crisis.

Figure 3: Large expansion of base money did not significantly affect broader money supply.


Source: Nomura, Based on FRB, ECB and Bank of England data.

In order to solve the problems created by the debt based monetary system we need to stop creating money as debt. When the central bank creates money it will not be accounted for as a debt under this new proposal. Therefore money is free to circulate as the vital medium of exchange and does not need to be repaid to the monetary authority and leave circulation. Consequently the systemic debt load will be significantly lower and within acceptable levels. In times when stimulus is required debts will not increase like they do at present because new money will not be debt. A situation such as a credit crunch will have a minimal impact in an economy that is not credit demand driven.

Benefits of Conducting Monetary Policy Directly with the Broader Economy in a non-debt based system

A superior system where the financial intermediaries are removed and the central bank deals directly with the public has many obvious benefits. Under this approach profit-seeking corporations will not have an influence on how monetary policy is conducted for the economy. The objectives of the monetary authority will be straightforward and much simpler to achieve. When stimulus is required the central bank will expand the money supply and the public will receive it instantaneously in a balanced manner. Under the current arrangement lending is subject to the profit motives of banks, which can lead to excessive lending and speculation in some sectors while large swathes of the economy are underfunded. Alternatively if the CB decides that a neutral policy is necessary that is precisely what will occur. Financial institutions will not have the final say on monetary policy. The profit objectives of private companies will not affect the formulation of monetary policy.

Corporations and the CB may have conflicting aims therefore private organizations should not be involved in MP. OMO’s will be simplified because there will be no need to post collateral. Therefore the system won’t be dependent on government bond issuance for collateral to conduct MP and quality collateral will be freed up for private sector purposes. OMO’s will be simplified as they will be simple transactions with no adjusting of interest rates and no need to repay funds to the central bank. Repayment of central bank reserves is not desirable as reserves are a part of the money supply which is the vital medium of exchange for the economy. Policy implementation will also be simplified if private banks can’t create money because the authority will only have to monitor central bank money in order to conduct MP. As a result tracking monetary aggregates will be simplified for the authority and easier to understand for the public.

A more direct monetary transmission channel will result in the central bank’s actions having a much faster response reducing what is known as an outside lag. In economics an outside lag is the amount of time it takes for the central bank’s actions, in the form of either monetary policy to have a visible effect on the economy. Dealing with the public directly will also eliminate liquidity traps were increased CB lending regardless of the rate of interest is not passed onwards and becomes trapped within the banking system. The system will become more transparent and people will participate directly in monetary policy. If people participate in the system they become more knowledgeable of economics. They will gain more confidence in the monetary system and its key institutions which is vital for a healthy economy.

Implementation of New measures

Every citizen of working age (e.g. 15 and over) will hold an account with the CB for monetary policy. These accounts can be maintained online by the central bank or hosted by any commercial bank using the central bank’s database. All MP account information hosted by any private banking organization is also maintained by the central bank.

Commercial banks will cease to deal with the central bank for monetary policy purposes.

Expansionary monetary policy when required will be conducted by expanding the money base directly to citizen’s accounts in measured regular intervals while taking into account the CB mandate relating to cost inflation. All citizens receive the same amount of funds at the same time intervals in times of stimulus. These new created funds do not need to be repaid as they are not debt. These transactions are simply an adjustment to the vital medium of exchange which circulates in the economy therefore it is not desirable for this medium of exchange to be created as a debt and later return to the CB and stop circulating within the economy.

Neutral monetary policy will entail no monetary action on behalf of the central bank.

Private banks will not be able to create money. Banks will need to obtain funds from retained earnings, shareholder proceeds or borrowing. Commercial bank money will cease to exist. All money utilized in the financial system will be central bank money.

Criticisms

If the CB has exclusive control over the money supply will it have too much power? Its only power is to create money into citizen’s accounts in an equal manner amongst all people. The CB is also limited by mandate relating to consumer price inflation and it does not deal with corporations or government for monetary policy.

Isn’t expanding the money supply inflationary? The CB will be bound by a cost inflation mandate. If inflation goals aren’t met governors will be accountable. If negligence/incompetence or mismanagement of currency is found this will be a criminal offence.

In a country like US you need to establish approximately 200 million CB accounts for each adult citizen. Correct, this is easily done with the present day information systems/banking architecture. Systems that operate on an even greater scale conducting complex transactions already exist. For example 1.7 billion shares was the average daily volume for march 2012 on US based cash share transactions at the NYSE (NYSE, 2012). The CB will only need to conduct simple one way transactions, with no calculating of reserve requirements or interest repayment considerations.

If people receive small regular payments in times of stimulus will their behavior be negatively affected? If payments are small and in regular intervals (like 100$ pw). The new money entering the system on an aggregate basis will affect aggregate demand, but on an individual basis is not enough to adversely affect economic behavior of people.

Money is a financial asset created by the central bank therefore it has to be issued as debt. A financial asset created by the central bank may be created in the form of equity or debt. New units of currency can be accounted for as new equity issuance not debt from the point of view of the central bank. This is true anyway because the owners of the central bank are the citizenry. Therefore at the point of creation the recipient of funds owns the money and does not need to repay. The only recipients of newly created money should be the citizens.

If commercial banks can’t create money there won’t be enough money to underpin economic activity. If monetary expansion is needed the CB will expand the money supply to support the economy. In an efficient system the money supply doesn’t need to constantly expand. Money needs to circulate into the right sectors in order to underpin economic activity. At present money needs to constantly expand to underpin growth because of external leakages to countries like China which hoard currency. Internal imbalances like buildup of funds within banking sector may also remove large swaths of money from the overall economy needing new monetary expansion.

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