The Failure of Monetary Control

This article by D'Arista bears understanding as a policy prescriptive for a stop-gap emergency serious financial soloution. It is by no means a final structural solution, but could suffice as a band-aid to hold capitalism's hand until real international financial architecture reform may be considered. Jane has also offered real architecture proposals in the past, but Paul Davidson still offers the wisest course of real structural reform, yet this proposal also warrants our near term attention.

Jane D'Arista

...Rebuilding effective monetary transmission mechanisms

While the once-powerful effects of reserve requirements have atrophied, they remain a promising tool for reviving effective monetary control. But a reserve management system that could be readily adapted to recent and future institutional changes requires
three key operational features: it must extend monetary control to the entire financial sector; apply reserve requirements to financial firms’ assets; and expand the central bank’s eligible holdings by using repurchase agreements as the primary tool of open market operations.

Reserve requirements can and have been applied to all financial firms in asset-based systems and narrow versions of such systems have been employed successfully to influence the allocation of credit in several advanced economies (U.S. House of Representatives, 1972). If used as a broader tool of monetary control, asset-based reserve requirements would enhance stability by tightening the linkage between the central bank and all lenders, investors and borrowers in their national markets.

Under an asset-based reserve system, the central bank would be authorized to engage in repurchase agreements to buy or sell any asset held by financial institutions - bank loans, mortgages, bonds, stocks, foreign deposits, etc. - when there is a change in overall credit or in holdings of one or more of these assets relative to target growth rates. The central bank’s repurchase agreement would be held on the liability side of its balance sheet and would be matched on its asset side by the reserves it creates for financial institutions. The balance sheets of financial institutions would show a reverse placement: they would hold non-interest-bearing reserves on the liability side of their balance sheets and noninterest- bearing repurchase agreements with the central bank as assets.

By creating liabilities for financial institutions, asset-based reserves would remedy a fundamental flaw in the existing model that can slow or even halt recovery in a recession. Under the current system, the amount of reserves held by banks as assets governs the
amount of deposits they can create by lending. When borrowers spend loans extended by banks, they redistribute the deposits created by those loans throughout the financial system. But if banks are too risk averse to lend, the central bank ends up pushing on a string as it creates “excess” reserves for deposits that never materialize – a condition that intensifies deflationary pressures.

Under the proposed asset-based reserve system, the central bank would distribute reserves in the form of non-interest-bearing liabilities that will spur the financial sector to acquire earning assets even in a downturn. Additions of these cost-free liabilities might
also encourage cancellations of non-performing loans and debt securities by providing incentives for the financial sector to replace them with earning assets. This would channel liquidity directly to households and businesses, helping avoid the stagnation that
develops when financial institutions are unwilling to make new loans and investments and cannot cancel debts for troubled borrowers without jeopardizing their own survival. ...Link