How to adjust quantity of money?

Leverage tools prove more sustainable than quantitative easing as they enable an exit strategy.

Leverage tools instantly pass through consumption whereas quantitate easing relies on a transmission mechanism.

Authorities can enforce banks to reduce their capital ratios through expansion of credits. Capital buffers reserved in boom times would thus serve to enhance demand in recessions.

As financial crises become a routine of economies due to the piling interconnectedness amid actors, central banks will need prompt intervention tools.

Quantitative easing vs leverage tools

Until 2008, central banks had overwhelmingly practiced the interest rate tools to manage money supply. When funding rates were stuck at the zero lower bound in 2008, they sought to directly control the quantity of money. Thus, they would not need the intermediation of banks to expand the money supply.

Quantitative easing is not the only quantity tool to control money supply. It is now the right time to discuss alternative quantity tools for different purposes. Macroprudential policy has so far improved quantity tools to cool economies down. Authorities rise the countercyclical capital buffer to constrain credit risk in boom times. Banks' money production capacity falls as they are required to reserve a higher capital to raise the same amount of credits.

Indeed, the countercyclical feature of capital buffers has been supposed to foster credits in bust times. Nevertheless, the COVID-19 crisis shows that banks are reluctant to expand credits despite the buffer. Authorities can compel banks to reduce their capital ratios through expansion of credits. Capital buffers reserved in boom times would thus serve to enhance demand in the recession. Such a tool would reactivate the monetary transmission mechanism over banks. It would fulfill the role of the interest rate tool as in old days. When a higher leverage is enforced, banks would fuel credits and contribute to recovery.

A drawback of the leverage tool would come about when banks are not comfortable with their capital ratios. This is why activation of the countercyclical capital buffer in boom times is crucial for bust times. In such a case, the treasury would have to inject capital into banks as delinquencies triggered by the recession soar. Requiring banks to raise credit through a capital injection would contrarily attenuate nonperforming loans as borrowers would be able to roll over debt.

Authorities require pass-through tools to promptly boost spending in a recession. In fact, quantitative easing was born as a result of this necessity. Nevertheless, quantitative easing also requires a kind of transmission mechanism although it excludes banks. Through purchases of investment-grade assets, central banks aim to boost the demand for riskier assets and, thus, reduce their yields. Though, this mechanism might not always succeed. Borrowers may buy financial assets through funds. The current asset price bubble is the most recent lesson resulted from such a behavior. Furthermore, a financial upheaval might totally break the mechanism, leaving central banks with junk bonds due to the run from risky financial assets.

Leverage tools prove more effective with respect to QE as they directly fund consumption through consumer credits. They bring about a pass-through mechanism in the intermediation of banks. Enforced by a leverage tool, banks would finance consumer loans through lower interest rates. Authorities can ensure the funds are spent but not invested in financial assets via promoting credit card expenditures.

Leverage tools prove more sustainable than quantitative easing as they enable an exit strategy. Even in case banks require capital injection to raise credits, treasury departments can sell bank shares for higher prices in the recovery period. By 2017, the US Treasury had sold all bank shares purchased during the financial crisis. Yet, the Fed could not significantly melt its balance sheet meanwhile. By contrast, the Fed balance sheet redoubles with COVID-19 due to the addictive feature of QE.

Compared to QE, leverage tools impose less credit risk to the tax payer. Banking sector would remain as the risk transformer under the leverage policy. Banks would bear the losses from credit expansion instead of Treasury. Thus, moral hazard concerns would be minimized. Nevertheless, treasury departments might need to put a stake in the ground via capital injections. A bank needs to reserve approximately 1 dollar of equity to create 10 dollars of credit. In recessions, investors want to see banks strong in terms of capital. A capital injection by the Government would thereby facilitate credit expansion. Though, governments would share the credit risk as much as their stake in banks whereas they bear the entire credit risk of trillion-dollar assets in QE.

Central banks can practice a mixture of QE and leverage tools as well. In recessions, money supply does not rise as much as asset purchases as banks shrink credits. This is why the money multiplier slumps alongside with massive asset purchases. Through a leverage tool, central banks can oblige banks to convert excess reserves into credits. Thus, transmission of QE into spending would be ensured.