Tag: The Chicago Plan

An Alternative Financial Narrative

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!

 

Should Banks Be Able To Create Money?

Banks today have the power to extend their reach by multiplying the value of loans against deposits and shareholder capital held. Indeed, all the recent regulatory work has been to try and lift the capital ratios, to protect the financial system and to try to ensure in event of failure, tax payers are be protected. We have highlighted how highly leveraged the main Australian Banks are. And this morning we discussed the risks associated with a credit boom.

Last year the Bank of England suggested that banks have the capacity to create UNLIMITED amounts of credit, in fact creating money, unrelated to deposits.

In this light, a working paper from the IMF in 2012 (note this is a research document, not the views of the IMF), “The Chicago Plan Revisited“, is worth reading.

The decade following the onset of the Great Depression was a time of great intellectual ferment in economics, as the leading thinkers of the time tried to understand the apparent failures of the existing economic system. This intellectual struggle extended to many domains, but arguably the most important was the field of monetary economics, given the key roles of private bank behavior and of central bank policies in triggering and prolonging the crisis.

During this time a large number of leading U.S. macroeconomists supported a fundamental proposal for monetary reform that later became known as the Chicago Plan, after its strongest proponent, professor Henry Simons of the University of Chicago. It was also supported, and brilliantly summarized, by Irving Fisher of Yale University, in Fisher (1936). The key feature of this plan was that it called for the separation of the monetary and credit functions of the banking system, first by requiring 100% backing of deposits by government-issued money, and second by ensuring that the financing of new bank credit can only take place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks, but not through the creation of new deposits, ex nihilo, by banks.

Fisher (1936) claimed four major advantages for this plan. First, preventing banks from creating their own funds during credit booms, and then destroying these funds during subsequent contractions, would allow for a much better control of credit cycles, which were perceived to be the major source of business cycle fluctuations. Second, 100% reserve backing would completely eliminate bank runs. Third, allowing the government to issue money directly at zero interest, rather than borrowing that same money from banks at interest, would lead to a reduction in the interest burden on government finances and to a dramatic reduction of (net) government debt, given that irredeemable government-issued money represents equity in the commonwealth rather than debt. Fourth, given that money creation would no longer require the simultaneous creation of mostly private debts on bank balance sheets, the economy could see a dramatic reduction not only of government debt but also of private debt levels.

We take it as self-evident that if these claims can be verified, the Chicago Plan would indeed represent a highly desirable policy. Profound thinkers like Fisher, and many of his most illustrious peers, based their insights on historical experience and common sense, and were hardly deterred by the fact that they might not have had complete economic models that could formally derive the welfare gains of avoiding credit-driven boom-bust cycles, bank runs, and high debt levels. We do in fact believe that this made them better, not worse, thinkers about issues of the greatest importance for the common good. But we can say more than this. The recent empirical evidence of Reinhart and Rogoff (2009) documents the high costs of boom-bust credit cycles and bank runs throughout history. And the recent empirical evidence of Schularick and Taylor (2012) is supportive of Fisher’s view that high debt levels are a very important predictor of major crises. The latter finding is also consistent with the theoretical work of Kumhof and Rancière (2010), who show how very high debt levels, such as those observed just prior to the Great Depression and the Great Recession, can lead to a higher probability of financial and real crises.

But this is more than a theoretical discussion, because Switzerland will hold a referendum to decide whether to ban commercial banks from creating money, after more than 110,000 people signed a petition calling for the central bank to be given sole power to create money in the financial system. Its been led by the Swiss Sovereign Money movement – known as the Vollgeld initiative – and is designed to limit financial speculation by requiring private banks to hold 100% reserves against their deposits.

“Banks won’t be able to create money for themselves any more, they’ll only be able to lend money that they have from savers or other banks,” said the campaign group.

If successful, 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.

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.

Consider the impact if banks had to back loans with deposits. Credit would be expensive, and hard to get. Depositors would be better rewarded, and eventually households would deleverage, whilst property prices normalised.  It might just reverse the “financialisation” of society. If it happened, banks would be very different beasts.

Financialisation is a term sometimes used in discussions of the financial capitalism that has developed over the decades between 1980 and 2010, in which financial leverage tended to override capital (equity), and financial markets tended to dominate over the traditional industrial economy and agricultural economics.