Reforming monetary policy

Parliaments should redefine the monetary scope. Central banks should be able to conduct income transfers without involving political decisions.

As money creators, central banks can merely conduct lending operations. Governments can transfer income, yet they cannot issue money.

The current framework does not allow authorities to transfer income without creating debt. A central bank should be able to conduct income transfers leaving all political decisions to the legitimate institutions.

Not to prejudice central bank independence, a central bank may avoid transferring funds to the government. Instead, all income transfers would be conducted via the banking system.

Separation of fiscal and monetary policies

Inflation concerns led to the hard separation of fiscal and monetary frameworks. The basic criteria of separation is in terms of creating income or debt. As money creators, central banks always lend in return of an asset. Governments can transfer income, yet they cannot issue money. When two functions evaluated together, the current framework does not allow authorities to transfer income without creating debt.

It did not have to be this way. The current policy framework has been good at controlling inflation. Nevertheless, it is raising another monster as threatening as high inflation. Once again after 2008, economies are in danger of sticking to a deflationary depression. Lending-based monetary tools don't help recovery due to two reasons.

First, a central bank can lend in return of an asset. Governments and businesses are the major asset issuers. While treasury yields are stuck at the zero lower bound, asset purchases slide to riskier assets such as corporate bonds. Normally, businesses utilize funds in the form of investment. Yet, recessions are not good times to invest while revenues plummet. Access to cheap funds thereby props up financial assets rather than spending. This rational behavior inflates prices of stocks and bonds instead of goods and services. In consequence, central banks can neither boost demand nor fulfill their inflation target.

Second, lending operations are not sustainable because they raise leverages of either private or public sector. An over-leveraged private sector becomes more sensitive to output deviations. Borrowers' need to cut spending to serve loan installments further dampens aggregate expenditure and income. Extending new debt merely defers a financial crisis and feeds the next one. In the next crisis, the debt mount more dramatically exacerbates output and income fluctuations.

Authorities have already recognized the leverage problem. After 2008, macroprudential tools have targeted household debt. Yet, loans slid to the corporate sector and helped zombie firms to stay alive. This time, authorities will need to restrain all private debt. However, as a source of spending, debt limits would retrench the output.

Modern monetary theory

To offset the loss of debt-based spending, authorities will need to produce income. Nevertheless, the current statutory framework does not allow to produce income without creating debt. Modern monetary theory (MMT) overcomes this dilemma by stating that public debt is the debt of a country to itself. On the central bank balance sheet, treasuries and central bank money offset each other. As long as a government borrows in its own currency, concerns regarding public debt is pointless.

Economy is not only driven by the theory of economics but also psychology and political economy. Even though the ''we owe ourselves'' argument makes sense, it would not convince ordinary people when the public debt-to-GDP ratio hit 1000%. Theoretical correctness does not suffice for successful practice as the only constraint on money supply, inflation, is also driven by psychological factors such as expectations.

Redefining the monetary scope

The solution is in politics. Parliaments should redefine the scope of monetary and fiscal policies. The basic criteria to separate monetary and fiscal policy should be political affiliation. A central bank should not make decisions on how to distribute resources. Despite being widely recognized, this criterion has been misunderstood. All types of lending were accepted as nonpolitical while income transfers were fully positioned under fiscal policy.

Income transfers may not require political affiliation whereas lending tools may require. Despite being a lending tool, corporate bond purchases, for example, necessitate central banks to decide which firms' bonds to accept as collateral. To the contrary, a central bank can conduct income transfers leaving all political decisions to the legitimate institutions. Parliaments would decide who will receive grants. Such a tool, thus, would not require central banks' discretion.

Central banks would utilize the income transfer tool to smooth out output deviations. Until achieving the inflation target, they would type money and transfer it to consumers. Once the target is achieved, they would stop transfers. When additional tightening is needed in boom times, they would raise interest rates and capital buffers to restrain the money creation ability of the banking sector.

Not to prejudice central bank independence, a central bank may avoid transferring funds to the government. Instead, all income transfers would be conducted via the banking system. For instance, banks would tap credit cards of beneficiaries with the central bank transfer. Thus, the central bank would not necessitate governmental bodies to execute its tool.

Conclusion

In recessions, economies need a higher demand. Private lending tools do not ensure a higher spending whereas governments are constrained by the public debt-to-GDP taboo. The smooth functioning of monetary and fiscal policies requires a tool which generates income without creating debt. Such a tool could not be positioned under fiscal policy due to inflation concerns. A central bank can generate income and transfer to the beneficiaries that are determined by the parliament. Once all political decisions are taken by political institutions in advance, the central bank would conduct income transfers without needing discretion.