Mark this date – 10th June 2018. This is the date of the Swiss Federal referendum on the Sovereign Money Initiative (or “Vollgeld-Initiative” in German). Swiss voters will be asked who should be allowed to create new Swiss francs: UBS, Credit Suisse and other private commercial banks or the Swiss National Bank which is obliged to act in the interest of Switzerland as a whole.
This is the latest incarnation of the so-called Chicago Plan, which is an alternative proposal as to how banking, and central banking should be set up.
The ideas are not new, they emerged in the 1930’s, at the height of the Great Depression when a number of leading U.S. economists advanced a proposal for monetary reform that later became known as the Chicago Plan.
It envisaged the separation of the monetary and credit functions of the banking system, by requiring 100% reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this plan: (1) Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money. (2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt. (4) Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. It was supported by other luminaries such as Milton Friedman.
The ideas were brought to more recent attention following the release of an IMF paper – The Chicago Plan Revisited. We discussed the report in an earlier blog.
As we discussed more recently, the classic theory of banking, that deposits lead to banks making loans is incorrect. In fact banks create loans from “thin air”, and have all but unlimited capacity to do so. As customers take the loans, and use them to buy things, or place into deposit, money is created. No other party needs to be involved. The trouble is, not many central bankers get this alternative view, so continue to execute flawed policies, such as Quantitative Easing, and ultra-low interest rates. Banks are intermediaries, not credit creators, they say; when in fact the create funds from nowhere. But this leads to problems as we see today.
But, be clear, when a loan is created, it does indeed generate new purchasing power.It becomes part of a self-fulling growth engine. But at what cost?
Understand that the only limit on the amount of credit is peoples ability to service the loans – eventually. The more loans the banks can make, the larger they become, and the more of the economy banks consume. This is what has happened in recent times. It leads to the financialisation of property, asset price inflation and massive and unsustainable increases in debt. The only way out is the inevitable crash, so we get a state of booms and busts.
Whilst there are some controls on the banks thanks to the Basel requirement to hold a certain proportion of liquid assets against the loans, but it is a fraction of the total loans made, and there is a multiplier effect which means that very little of the shareholders capital in the banks are required to support the loans. In other words, Banks are hugely leveraged. In addition, Basel capital rules favours unproductive lending for secured property (houses and apartments) over productive lending to businesses.
In addition, Central banks have very limited ability to control the money supply, contrary to popular belief, and so their main policy control is interest rates. Lift rates to slow the economy, drop rates to drive the economy harder, against a target inflation outcome. But this is a very blunt tool. This also means that the idea of narrow money, spilling out from a multiplier effect is also flawed.
Well, now perhaps the tide is turning.
In the aftermath of the 2008 financial crisis, Iceland commissioned a report “Monetary Reform – A better monetary system for Iceland” which was published in 2015, and suggests that money creation is too important to be left to bankers alone.
Back in 2014 I discussed this, based on an insight from the Bank of England. Their Quarterly Bulletin (2014 Q1), was revolutionary and has the potential to rewrite economics. “Money Creation in the Modern Economy” turns things on their head, because rather than the normal assumption that money starts with deposits to banks, who lend them on at a turn, they argue that money is created mainly by commercial banks making loans; the demand for deposits follows. Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
More recently the Bank of Norway confirmed this, and said “The bank does not transfer the money from someone else’s bank account or from a vault full of money. The money lent to you by the bank has been created by the bank itself – out of nothing: fiat – let it become.”.
And even the arch conservative German Bundesbank said in 2017 recently “this means that banks can create book money just by making an accounting entry: according to the Bundesbank’s economists, “this refutes a popular misconception that banks act simply as intermediaries at the time of lending – ie that banks can only grant credit using funds placed with them previously as deposits by other customers
“.
So, the Chicago Plan is a alternative approach. Here banks cannot lend by creating new deposits.
Rather, their loan portfolio now has to be backed by a combination of their own equity and non-monetary liabilities. If we assume that this funding is supplied exclusively by the government treasury, private agents are limited to holding either bank equity or monetary instruments that do not fund any lending. Under this funding scheme the government separately controls the aggregate volume of credit and the money supply. The transition to this new balance sheet conceptually takes place in two stages that both happen in a single transition period. In the first stage, banks instantaneously increase their reserve backing for deposits from 0% to 100%, by borrowing from the treasury. In the second stage, the government can independently control money and treasury credit. It exercises this ability by cancelling all government debt on banks’ balance sheets against treasury credit, and by transferring part of the remaining treasury credit claims against banks to constrained households and manufacturers, by way of restricted accounts that must be used to repay outstanding bank loans. This second stage leaves only investment loans outstanding, with money unchanged and treasury credit much reduced. Net interest charges from the previous period remain the responsibility of the respective borrowers.
Part of the transition plan would be the full buy-back of household debt by the government, making all households effectively debt free. This of course means that household consumption is likely to rise.
In the transition period households only pay the net interest charges on past debts incurred by constrained households to the banking sector. The principal is instantaneously cancelled against banks’ new borrowing from the treasury, after part of the latter has been transferred to the above-mentioned restricted private accounts and then applied to loan repayments. From that moment onward the household sector has zero net bank debt, while their financial assets consist of government bonds and deposits, the latter now being 100% reserve backed.
Now this approach to me has significant merit, and I believe it should be considered as a platform to deal with the current economic situation we face. This appears to be a better, if more radical approach than the so called Glass-Steagall separation of speculative banking assets from core banking operations, but which still perpetuates the current rocky banking road. The Chicago Plan offers significantly more benefits, and the opportunity to reset the economy, and household debt.
So, if the vote is successful on 10th June, the sovereign money bill would give the Swiss National Bank a monopoly on physical and electronic money creation, “while the decision concerning how new money is introduced into the economy would reside with the government,” says Vollgeld.
This also means that Central Banks have the ability to managed the overall money supply, rather than just narrow money and interest rates. And the flows of credit can go to productive business investment, rather than inflated housing loans.
So the bottom line is, The Chicago Plan deserves to go mainstream, despite the howls from bankers, as their businesses get rightsized. It can also deal with the problem of highly indebted households and offers a path potentially to economic success. Current models have failed, time to move on!
