Reforming monetary policy

Traditional monetary tools, like lending and asset purchases, become ineffective when interest rates are low and private investment stalls.

Instead of stimulating the economy, such tools often inflate asset prices and raise private or public debt, increasing financial fragility.

1. The Separation of Fiscal and Monetary Policies

Historically, the rigid separation of fiscal and monetary authority has been considered essential for inflation control. Fiscal authorities may redistribute income but cannot issue currency, while central banks create money only in exchange for assets. This design emerged to prevent governments from monetizing deficits and fueling hyperinflation, as seen in Weimar Germany or Zimbabwe.

Yet, this separation enforces a rigid logic: income transfers require fiscal outlays, which must be debt-financed, while monetary policy is confined to credit operations. Under current frameworks, policymakers cannot transfer income without increasing debt—public or private.

“While fiscal policy can redistribute, only monetary authorities create money. But current institutions do not allow income generation without debt.” — Blanchard and Pisani-Ferry (2020)

This asymmetry became problematic during the post-2008 and COVID-19 recessions, when economies faced deflationary pressures despite massive monetary interventions.

2. The Limits of Lending-Based Monetary Tools

Monetary authorities primarily operate through lending mechanisms: buying government securities, providing liquidity to financial institutions, and lately, purchasing corporate bonds. These tools rest on the assumption that borrowers will deploy new funds toward spending and investment. Yet, this logic collapses during recessions for two reasons:

2.1. Asset Purchases Fuel Financial Markets, Not Demand

When treasury yields fall to the zero lower bound, central banks expand their operations into riskier assets such as corporate bonds or asset-backed securities. However, in recessions, businesses do not invest—regardless of funding costs—due to plummeting revenues and high uncertainty. Instead, they engage in financial arbitrage, buying back shares or acquiring distressed competitors.

Empirical Evidence: During 2020–2021, the Federal Reserve's corporate bond purchase program coincided with record equity prices and rising corporate leverage, while investment growth lagged (Federal Reserve, 2021).

2.2. Lending Amplifies Leverage and Fragility

Debt-fueled recoveries raise private and public leverage. While initially expansionary, this trend makes economies more sensitive to shocks. Indebted households and firms must cut spending to service debt in downturns, thereby reinforcing contractions.

According to the BIS (2020), global non-financial private sector debt rose from 138% of GDP in 2008 to over 160% by 2020.

Macroprudential authorities have responded by targeting household debt. Yet, this only shifted the leverage burden to the corporate sector. Credit-fueled recoveries thus sow the seeds of future crises.

3. Modern Monetary Theory and the Debt-Income Paradox

Modern Monetary Theory (MMT) offers an alternative by positing that sovereign governments borrowing in their own currency face no default risk. From a consolidated balance sheet perspective, government liabilities (bonds) and central bank assets (reserves) offset each other. Public debt, therefore, is “debt to ourselves.”

“A currency-issuing government does not need to borrow its own currency to spend. It creates the currency.” — Kelton (2020)

This logic supports income transfers without new debt issuance. However, political psychology complicates this view. Even if theoretically benign, a rising debt-to-GDP ratio—say, 500% or 1000%—would erode public confidence and prompt inflation expectations.

As Auerbach and Gorodnichenko (2017) note, “Public perception remains anchored to debt ratios rather than net financial positions, regardless of theoretical arguments.”

Inflation is not just a function of supply and demand, but also of expectations. If agents believe that money creation is fiscally or politically irresponsible, inflation could rise even without full employment or output gaps.

4. Redefining the Scope of Monetary Policy

To overcome this dilemma, parliaments must redefine the boundary between fiscal and monetary policy based on political discretion—not the type of tool.

4.1. Political Affiliation, Not Tool Type

Currently, income transfers are viewed as fiscal (and thus political) while lending is treated as neutral. This distinction is misleading. Even lending—e.g., corporate bond purchases—requires political discretion over which firms’ securities to buy. In contrast, income transfers could be politically neutral if their recipients are determined in advance by parliaments.

For example, transferring €200 per month to all residents via central bank money creation would require no real-time political discretion from the central bank once approved.

4.2. Central Banks as Income Distributors

Under this new framework, central banks could execute targeted income transfers to households as a macroeconomic stabilization tool. Parliament would decide who gets what. The central bank would merely implement the decision by “typing money” into designated accounts or credit cards—without expanding public debt or making distributional judgments.

Such operations have already been simulated in the eurozone as "helicopter money" proposals (Galí, 2020).

To preserve central bank independence, such transfers could bypass government ministries and be executed via the private banking system.

5. Policy Design: Combining Transfers and Traditional Tools

This approach would establish a dual-instrument framework:

• During recessions, central banks would transfer money directly to households, aiming to close output gaps and raise inflation expectations.

• In expansions, they would raise interest rates and tighten capital rules to restrain credit growth and inflation.

Such a system ensures countercyclical demand support without escalating private debt or fueling asset bubbles.

Empirical modeling by Andres and Arce (2012) finds that direct fiscal-monetary transfers have a higher multiplier (1.3–1.7) than QE asset purchases (0.3–0.6), particularly in liquidity traps.

Conclusion

Lending-based monetary tools are increasingly inadequate in a world of low interest rates, rising leverage, and frequent crises. Governments are often constrained by debt taboos and political inertia. Meanwhile, central banks operate within a rigid framework that prevents direct income generation.

To ensure monetary policy can support demand without increasing systemic fragility, policymakers must introduce a tool that enables income transfers without new debt. This would require redefining monetary policy's scope, allowing central banks to distribute politically approved transfers during downturns.

Once all distributional decisions are taken by parliaments, central banks can operate income transfers with no discretion—preserving independence while expanding effectiveness.

References

• Andres, J., & Arce, O. (2012). Banking competition, collateral constraints and optimal monetary policy. Journal of Money, Credit and Banking, 44(2), 469-505.

• Auerbach, A. J., & Gorodnichenko, Y. (2017). Fiscal Stimulus and Fiscal Sustainability. NBER Working Paper No. 23789.

• Bank for International Settlements (BIS). (2020). Global debt continues to climb. https://www.bis.org/statistics/g_d.htm

• Blanchard, O., & Pisani-Ferry, J. (2020). Monetary-Fiscal Interactions in the Post-COVID Era. PIIE Policy Brief.

• Federal Reserve. (2021). Corporate Credit Facility Reports. https://www.federalreserve.gov/publications/reports-to-congress-in-response-to-covid-19.htm

• Galí, J. (2020). Helicopter money: The time is now. VoxEU.org, CEPR.

• Kelton, S. (2020). The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy. PublicAffairs.