Macroprudential policy urges income transfers
As macroprudential policy restrains private sector borrowing, authorities need to replace debt with income.
A government can subsidize consumers debt-free through central bank transfers. Such a practice necessitates a central bank not to act as a bank that involves debt relations.
As a public agency, a central bank should transfer money in return of nothing. For accounting purposes, it can create a debit account called 'transfers' and register transfers to that account. Thus, a government can run permanent deficits which do not count even as deficit or debt.
Central bank transfers would restore the spending reduced by debt retrenchment with additional income and, thus, render the financial system resilient.
Delevering private sector
In the 2008 financial crisis, highly leveraged households defaulted on their mortgages. In the aftermath of the crisis, international community agreed on additional capital and liquidity buffers for banks. Banks' steady growth of credits due to deleveraging also contributed to the deleveraging of consumers. Furthermore, some countries constrained household leveraging with respect to the the income (debt-to-income ratio) and collateral value (loan-to-value ratio). Although US authorities have not ordered these ratios, deleveraging trend of banks have dampened the US household debt to GDP ratio since 2010.
Corporate debt has largely been free of household measures. According to the IMF study (2014), while 38 countries applied at least one sectoral macroprudential tool, only six of them targeted the corporate sector. Hence loans have slid to the corporate sector. As shown on the graph, the US corporate debt rebounded in 2010 and continued surge until now.
In the upheaval of COVID-19, this time, corporate debt has prompted fragility in the financial sector. Drying liquidity imperiled highly leveraged businesses. Central banks have fended off the liquidity shock via emergency lending and quantitative easing. Nevertheless, liquidity does not mitigate but merely defer defaults. The mounting concentration of the default risk in financial markets stirs up anxiety and trigger runs in every bad news.
Next time, authorities will have to extend the scope of the leverage tools. The IMF (2014) recommends risk weights, additional capital requirements, loan-to-value (LTV) and debt service coverage (net operating income divided by total debt service, DSC) tools for the corporate sector. Nonetheless, extension of leverage constraints to corporate debt comes with drawbacks.
Restoring spending through income transfers and solving the safe asset problem
An extension of the macroprudential scope would pose deeper contractionary effects on output. Monetary policy cannot compensate the negative output gap induced by deleveraging since the current monetary tools are all debt oriented. Hence, more monetary debt would rebuild leveraging. Fiscal policy can fill the gap through income transfers at the expense of government leveraging. As a mounting public debt also induces fragility, fiscal transfers are not sustainable either.
As modern monetary theory advocates state, government treasuries and money are both liabilities of a country. Nevertheless, the perception of a rise in their supplies differentiate. Surging central bank balance sheets do not signal a negative performance for governments whereas a spiking debt to GDP ratio does. As expectations drive the economy, their deterioration due to a higher debt to GDP ratio might prompt runs from the dollar and its devaluation.
A permanent transfer of income can be achieved without creating new public or private debt. A government can subsidize consumers debt-free through central bank transfers. Such a practice necessitates a central bank not to act as a bank that involves debt relations. As a public agency, it should transfer money in return of nothing. For accounting purposes, it can create a debit account called 'transfers' and register transfers to that account. Thus, a government can run permanent deficits which do not count as deficits either.
A second drawback of a wider macroprudential scope would be in terms of the safe asset problem. When corporate debt is restrained, the demand for safe assets could not be met. Any shortage of supply would eventually induce price bubbles. Authorities thereby need to take precautions to attenuate the safe asset demand. Digital central bank currency would serve this purpose. When the savings glut is allowed to be stored at central bank accounts, demand for safe assets would considerably fall and not prompt asset price bubbles anymore.
The root cause of financial crises
In fact, monetization of spending solves the root cause of financial crises. It is deteriorating distribution of wealth and income compelling households to raise debt since 1980s. Households have piled up debt with respect to the GDP as they lost income and wealth to the top 1% of the population. As they raised leverage, their debt service capacity was impaired in economic downturns. Restraining merely household lending has not contributed to a healthier financial system while lending has slid to the corporate sector. Restraining all credit would shrink debt. Central bank transfers would restore the spending reduced by debt retrenchment with additional income and, thus, render the financial system resilient.
Reference
International Monetary Fund (IMF). 2014. “Staff Guidance Note on Macroprudential Policy: Detailed Guidance on Instruments.” https://www.imf.org/external/np/pp/eng/2014/110614a.pdf
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