December 1, 2016

Is the Chicago Plan the way forward on monetary reform?

Introduction

The recent election of Donald Trump and the Global Financial Crisis of 2007-09 raise fundamental questions about the state of the global financial system. Massive debt levels in both government and private sectors, housing bubbles, growing gaps between a wealthy elite and a growing mass of low income workers all raised questions about capitalism and global finance. 

Various advocates for monetary reform have advocated changes such as:
  • The issuance of social credit - "debt-free" money issued directly to citizens through a national dividend and or consumer subsidies from the Reserve Bank or a Credit Authority.
  • The enforcement of full reserve banking for the privately owned banking system.[10][11][12]
This article looks at the full reserve banking system advocated in the Chicago Plan and some of its critics.

 The Chicago Plan


In 2012 two International Monetary Fund (IMF) economists published a working paper called "The Chicago Plan Revisited" (Benes & Kumhoff 2012) . The basic idea is that banks should be required to have full coverage for money they lend; this is called 100% reserve banking, instead of currently prevalent system of fractional reserve banking. Under this proposal, banks would no longer be allowed to create new money in the form of credit in connection with their lending activities. Instead, the central bank should be solely responsible for all the creation of all forms of money, not just paper money and coins. The advantages of such a system, according to the authors, are a more balanced economy without the booms and busts of the current system, the elimination of bank runs, and a drastic reduction of both public and private debt.

"The Chicago Plan could significantly reduce business cycle volatility caused by rapid changes in banks’ attitudes towards credit risk, it would eliminate bank runs, and it would lead to an instantaneous and large reduction in the levels of both government and private debt. It would accomplish the latter by making government-issued money, which represents equity in the commonwealth rather than debt, the central liquid asset of the economy, while banks concentrate on their strength, the extension of credit to investment projects that require monitoring and risk management expertise.  Another advantage is the ability to drive steady state inflation to zero in an environment where liquidity traps do not exist, and where monetarism becomes feasible and desirable because the government does in fact control broad monetary aggregates. This ability to generate and live with zero steady state inflation is an important result, because it answers the somewhat confused claim of opponents of an exclusive government monopoly on money issuance, namely that such a monetary system would be highly inflationary" .Benes & Kumhoff (2012)

However, Auerback has criticised the Chicago Plan on the basis that:

"But you would have massive credit constraints and, in the absence of a countervailing fiscal policy that promoted more job growth and higher incomes, there would be the equivalent of a gold standard imposed on private banking which could invoke harsh deflationary forces.”Auerback

The origins of money are set out in the Reserve Bank of New Zealand's publication (2003).  Historically minted coins and notes were a much greater proportion of total money supply in the economy. In 1933 the New Zealand government legislated to bring the power to issue cash currency under the control of the Reserve Bank - rather than let it sit with private trading banks.  Now in the 21st century economy the bulk of the money supply is no longer notes and coins cash. It is computer-generated loans and bank deposits.


Private banks create most of our money supply


Bank of England report in 2014 acknowledged that:
  "The reality of how money is created today differs from the description found in some economics textbooks: Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits; in normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits."
However the Bank of England (2014) paper also maintains that there are limits to the ability of the banks to create credit, that for each new loan created there are new bank deposits which are assets for depositors and liabilities for the banks, and that the banks make their profits by maximising the difference between the costs of the deposits and reserves they need to attract versus the interest payments they receive on the loans they make. Banks must also manage the threat of competition for deposits from other banks and they must also manage the risks of borrowers defaulting on loans the bank has made.

The Central bank sets monetary policy to influence credit creation


Supporters of the status quo argue that banks do not control the money supply because the total supply is influenced by factors outside their control. For example the repayment of loans by households and businesses destroys credit created by banks. Also the central bank controls the price of reserves (interest rates charged by the central bank for reserves sold to banks) which banks need to maintain liquidity and to meet any regulatory requirements imposed on them.  Furthermore no one bank can set the interest rate for the market. That is determined by the rates charged by the various banks and by the cash rate charged by the central bank for reserves which the banks must hold and which cannot be on sold to non-bank customers.


Conclusions

The Chicago Plan would rein in the power of private banks to issue debt-bearing loans and would likely add greater stability to the global financial systems.  However, the challenge would be in the transition from a fractional banking system of today to a 100% reserve based system of tomorrow. The consequent reduction of money supply may create transitional issues that would need to be carefully considered.

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