Safe mode for the economy

In an economic emergency, when the monetary system is failing, economies need a "safe mode" that can be adopted to allow the economy to continue to function at its most basic level. Sophisticated financial markets may be in disarray. But if governments have a fail-safe back-up plan that allows people to be able to earn and spend their money, they can bring confidence back to the economy.

The following is a series of steps that would enable a country to bring about stability to the monetary system and provide a sustainable base that would allow it continue to function and grow. The steps are intended for a country that has a floating exchange rate system. However, they are equally applicable for a country with fixed exchange rates.

Initially halt all new bank lending. This does not stop all lending. Non-bank financial institutions may continue to lend. But banks are not to guarantee any loans or engage in any form of off-balance sheet lending. This rule applies equally to the central bank, except to the extent that it lends foreign reserves to commercial banks to facilitate foreign exchange transactions. The government may borrow by issuing bonds but the central bank and commercial banks are not to purchase those bonds. Removes excess demand so that imports do not exceed exports and limits inflationary pressures.
At the same time, fix the value of the currency to basket of currencies at a value significantly below the current market rate. Raises demand for domestic products, reduces demand for imports, raises export incomes and provides a net injection of funds into the economy without the need for further fiscal deficit, discourages capital outflow, provides certainty to the economy as to the value of the currency.
Require banks to establish a foreign reserve account with the central bank, into which commercial banks deposit foreign exchange, surplus to their day to day requirements. Provides a saving base and prime assets to which future lending can be linked.
If commercial banks require foreign exchange, the central bank should lend the foreign funds through this foreign reserve account. Provides the commercial banks with the capability to continue to facilitate overseas transactions. This facility is unlikely to be required once stability has returned to the monetary system.
Require banks to make inter-bank settlements through their foreign reserve account. This provides equity (justice) for future lending capacity and will encourage banks to compete for deposits and so reward savings.
Require commercial bank purchases of domestic notes and coins to be made in foreign exchange (from the foreign reserve account). Conversely, the central bank is to buy domestic currency with foreign exchange. Provides central bank with foreign reserves to back the domestic currency and gives certainty to the value of domestic currency.
Once banks start depositing surplus funds in the foreign reserve accounts and raising foreign reserves (so that the foreign exchange deposited exceeds any foreign exchange loans provided to banks by the Reserve Bank), allow banks to maintain current lending levels; that is, the central bank allocates a lending limit to each commercial bank and allows them to lend up to that limit. Means that banks can lend the equivalent of what is repaid to them. It restarts bank lending in the economy when stability has been shown to have returned to the monetary system and it avoids a further leakage of funds from the economy that could cause a recession.
When foreign reserves have proven to be growing, allow the banks to increase their lending capacity, but only by as much as the growth in the deposits in their foreign exchange accounts less any growth in the bank's foreign debt. Allows growth in commercial bank lending but not so much as to cause foreign reserves to be depleted or foreign debt to increase. Excessive commercial bank lending would deplete the banks' deposits in their foreign reserve accounts or raise the banks' foreign debt, curtailing any further increase in bank lending. Hence commercial banks can lend only as national savings increase.
Once stability is proven, start relaxing lending constraints. Allow banks to increase their lending capacity by, say, $5 for every $1 increase in their net foreign reserves (deposits in their foreign reserve account less any increase in bank's foreign debt), provided inflation does not exceed the target level, say, 3%. For every 1% that inflation exceeds the target (of 3%), the amount banks can lend for each $1 increase in the foreign reserve account is reduced by $1. Hence, if inflation were 5%, banks would be able to increase their lending capacity by $3 for every $1 increase in net foreign reserves. Provides monetary growth to stimulate the economy in such a way that it does not deplete foreign reserves. Provides an incentive to banks to avoid lending that may be inflationary as this would curtail future lending.
Once price monetary stability has been established, allow the exchange rate to float initially between pegged limits. Retain the same foreign reserve requirement and continue to use the limit on bank lending to target inflation but link lending to a foreign currency unit such as IMF Statutory Reserve Deposits (SDRs) so that banks are not rewarded with additional lending capacity for devaluing the currency. For example, banks may be allowed to lend $8 for every SDR1 increase in their net foreign reserves. Transitional step to the resumption of a variable exchange rate system.
Before removing pegged exchange rate limits, introduce a new employment target, allowing banks to increase their lending capacity if unemployment is reduced. For example, if unemployment were 4% and the target rate were 2%, allow the banks to lend $10 for every SDR1 increase in foreign reserves but reduce it by $1 for every 1% that unemployment exceeds the target level of full employment. Allows the banks to continue to lending at same levels (say $8 for every SDR1 increase in their net foreign reserves), but provides bank with an incentive to push the exchange rate to a level that would achieve full employment but at a speed that would retain low inflation.
Keep moving the pegs on the exchange rate. When the pegs are no longer binding remove them completely. The monetary system should now be stable with rising foreign reserves, price stability and economic growth targeted to achieve full employment.
Extend the definition of net foreign reserves to include the reduction of bank foreign debt. Rewards banks that reduce their net foreign debt, not only those that increase foreign reserves. These are both forms of increasing national savings.

Central banks need to have a "safe mode" plan ready for their economy in case of emergency. Computer systems are built with a safe mode. The monetary system is more critical than a computer and so it is essential that a safe mode option be available. A safe mode would provide confidence to the central bank and the government. They would know that if all else failed, they had a plan that would enable the economy to continue to function.

Also, it would provide some confidence to financial markets if it were aware that the central bank had a option to run the economy in "safe mode".

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