Tuesday, July 28, 2015

Money as Debt and the Chicago Plan

The Shifts and the Shocks, Martin Wolf

The legislative response to [2008] crisis, culminating in the Dodd-Frank Act of 2010, could not have been more different. On its own, the Act runs to 848 pages – more than 20 Glass-Steagalls. That is just the starting point. For implementation, Dodd-Frank requires an additional almost 400 pieces of detailed rule-making by a variety of US regulatory agencies.

As of July this year, two years after the enactment of Dodd-Frank, a third of the required rules had been finalised. Those completed have added a further 8,843 pages to the rulebook. At this rate, once completed, Dodd-Frank could comprise 30,000 pages of rulemaking. That is roughly a thousand times larger than its closest legislative cousin, Glass-Steagall. Dodd-Frank makes Glass-Steagall look like throat-clearing [..]

Cynics will be reminded of the remark in Giuseppe Tomasi di Lampedusa’s Il Gattopardo: ‘If we want everything to stay the same, everything must change.’ They will conclude that this manic rule-making is designed to disguise the fact that the thrust of it all has been to preserve the system that existed prior to the crisis: it will still be global; it will continue to rely on the interaction of vast financial institutions with free-wheeling capital markets; it will continue to be highly leveraged; and it will continue to rely for profitability on successfully managing huge maturity and risk mismatches. But the new structure of regulatory oversight and rules displays something equally important: the breakdown of trust between authorities and finance. That was hardly surprising, given the huge costs of the crisis. Nevertheless, the authorities want largely to preserve a system they also mistrust. That is why the regulatory outcome has been so complex and insanely prescriptive, though that has also been affected by the complexity of modern finance itself and by lobbying.

The question remains: will this complex regulatory effort deliver a financial system that is both robust and dynamic? In essence, after all, we need a financial system that will cope with inevitable shocks while not generating huge shocks of its own. Will these reforms provide it? In a word, no. The sheer complexity of the regulatory structure makes it virtually inconceivable that it will work [..].

[From the section pondering possible solutions] Mises concluded that the ability of private institutions to create debt-backed money out of thin air, as a by-product of their lending [..] needed to be brought under control, via 100 per cent reserve banking – that is, a system in which deposits are backed by central-bank reserves, one to one. The Chicago School – another group of free-market economists – came to the same conclusion in the 1930s, for the same reason [..] The economists involved were hugely distinguished and respected: Frank Knight [..] Henry Simons [..] Irving Fisher  [..] and, after the war, Milton Friedman [..] Again, as with the Austrians, these free-market economists concluded that the ability to create credit-backed money had to be ended if the market economy was to be protected from ruinous crises.

The thrust of the plan, which was first proposed in 1933 at the trough of the Great Depression, was to give government the exclusive right to create money, thereby taking it altogether away from private businesses (that is, banks). All versions of the plan required 100 per cent reserve backing of deposits. In other words, households and businesses would keep their holdings of deposits in banks, which would, in turn, hold accounts at the central bank or, possibly, hold government debt. Deposits would, therefore, fund the government. The economic argument is that only in this way would there be no banking crises: banks could not fail. The philosophical argument is that a monetary system is both a social contrivance and a public good. Society should gain the reward from what society has created. The plan then proposed that the money supply, now under full government control, would expand in accordance with a rule – probably a target rate of growth based on expected growth of the economy, expected changes in demand for money and an inflation target.

If reserves backed deposits 100 per cent, what would finance [be] lending to the economy? This is the crucial question for all such schemes. The original Chicago Plan proposed replacing traditional banks with investment trusts that issue equity and sell their own interest-paying securities. But, as we have learned from the emergence of the money-market funds and the repo markets, which played a central role in the shadow-banking system, such debt can once again become an attractive replacement for money, with lethal consequences for stability. Two alternatives were proposed, both of which aimed at eliminating this risk. Under one, recommended by Simons, all private property would take the form of currency, government bonds, corporate stock or real assets. Thus, the investment trusts would take the form of equity or property mutual funds. Under the other alternative, banks would borrow from the government, not the private sector, to fund their riskier assets.

The essential aim of the plan is to give the government a monetary monopoly: private institutions would not issue money-like liabilities except when backed by government money. What would be the advantages? Fisher claimed four. First, preventing banks from creating and then destroying credit and money in self-reinforcing cycles would eliminate the biggest source of instability in the economy. Second, 100 per cent reserve banking would eliminate the possibility of bank runs: banks would be completely safe. Third, if the government financed itself by issuing money at zero interest [hmm, this could be a problem, gov creating money for itself with no end, but some kind of spending limit could be legislated perhaps, at constitutional level even], rather than borrowing at interest, debt interest and net government debt would fall dramatically. Indeed, in almost all countries, government would become a net creditor. Finally, since money creation would no longer need private debt, the level of such debt could fall dramatically. Indeed, in the transition, the government could use the excess of the total supply of money over its own debts to fund a dramatic decline in private debt, through buy-backs. I would add to these benefits that the extinction of conventional bank-created money would almost certainly shrink the financial sector, reduce the aggregate incomes earned by bankers and so improve the distribution of income.

The fiscal implications alone would be dramatic. According to an important International Monetary Fund working paper on the Chicago Plan by Jaromir Benes and Michael Kumhof, total bank deposits in the US are around 180 per cent of GDP. Assume the demand for money merely grows in line with nominal gross domestic product, at about 5 per cent a year. If it failed to do so, interest rates would rise and the economy might be pushed into deflation. So each year the money supply would need to grow by 9 per cent of GDP if it were to remain at 180 per cent of GDP. This would fund about 40 per cent of the Federal government in normal years, allowing a dramatic reduction in taxes. Republicans should love that! To this should be added savings on government-debt interest (on the assumption that these would not be interest-earning deposits) and the earnings on any money lent to the private sector.

Also dramatic would be the implications for the operation of monetary policy. The central bank would have direct control over the money supply. It could be told to follow a strict rule, as the Chicago School proposed, which would include a precise inflation target. The central bank could set any interest rate it liked, including negative rates, up to the point that people preferred to hold cash instead of deposits. The stabilization of the economy would become a relatively simple challenge because the main obstacle to it would have been eliminated.

Not surprisingly, the opposition of the banking industry forced abandonment of the Chicago Plan in the 1930s. Those who enjoy such an extraordinary privilege – in this case to create state-backed money at will – would not willingly give it up. But the idea of what is called narrow banking – an important part of the Chicago Plan – returns, quite understandably, in every generation.


Our preference would be that money creation, just like communication -Internet-, economic activity -individual entrepeneurs-, energy creation -renewables- is decentralized, through a suitable cryptocurrency, like Bitcoin, Litecoin, etc. But if the Integrators are seeking a temporary middle ground, this could be it.



The Chicago Plan