Lower debt, lower taxes and no spending cuts:

The very real magic of the Chicago Plan

Concern about individual countries’ and the world’s monetary and financial system is currently greater than at any time since the Great Depression. Given today’s far greater number of professional economists, one would have thought that monetary reform proposals would be far superior to those of the 1930s. But surprisingly almost the exact opposite is true:  

Nothing in today’s mainstream economics comes even close to the depth of understanding evident in the monetary reform proposals of Frederick Soddy, Frank Knight, Henry Simons and Irving Fisher. To demonstrate this, Jaromir Benes and I have recently simulated these proposals when applied to the current US economy, in a paper titled “The Chicago Plan Revisited”.
 

It is striking that, while Fisher and his fellow economists fully understood the central role of banks in causing economic cycles, financial crises and excessive debt, in modern macroeconomic theories banks have been almost completely absent for decades. Even recent attempts to remedy this reflect a rather primitive understanding of banks as intermediaries of pre-existing funds, rather than their critical role as creators, ex nihilo, of new funds. It is a simple fact that banks create their own funding in the act of lending, an extraordinary privilege not enjoyed by any other type of business. And it is rather stunning that this fact, and its implications, seems to elude many modern students of monetary matters.

Equally stunning is the fact that many continue to think in terms of the mythical deposit multiplier of economics textbooks, where narrow monetary aggregates are exogenously determined by the central bank, and broad monetary aggregates are endogenously determined as a result. This turns the actual mechanics of the money creation process on its head, and has been refuted in several empirical studies.

With this deficient theoretical understanding it is therefore hardly surprising that many of today’s mainstream analyses and proposals amount to little more than tinkering with the plumbing of the existing system, rather than designing an alternative system that might simply not have many of the problems we are facing today. In stark contrast, the monetary reformers of the 1930s constructed their arguments exclusively on the basis of logical verbal arguments combined with historical experience. This allowed them to think beyond the confines of their existing monetary system, and to design an alternative one.

Their proposal, which later became known as the Chicago Plan, calls for the separation of the monetary and credit functions of the banking system. For money, it requires 100 per cent backing of deposits by government-issued money, combined with a strict money growth rule to control inflation. The government is therefore fully in charge of controlling the broad money supply. But private financial institutions would remain in charge of determining the credit supply. As today’s ex nihilo deposit creation would be made illegal, the financing of new bank credit could only take place through banks retaining earnings or borrowing funds in the form of government-issued money. For priority items such as credit for capital investment, this system can be made more flexible through an additional government credit line to banks.

Categorically, there is nothing inflationary or destabilising in such monetary arrangements. Inflationary pressures arise when the spending public owns an excess of bank deposits relative to goods. But the Chicago Plan leaves bank deposits completely unchanged, it only requires that they be fully backed by government-issued money rather than by private loans. Even the notion of “backing” is in fact a misnomer, because money, being a creature of the law (this has been recognised at least since Aristotle), does not need to be “backed” by anything; it represents equity in the commonwealth of the nation rather than a debt of the nation. Interestingly, that is exactly how treasury-issued coin is treated in US accounting.

As we review in the “The Chicago Plan Revisited”, the historical experience also supports the view that full government control over money issuance is generally not inflationary or destabilising. To the contrary, financial crises only became a regular phenomenon after states had given up this sovereign right to private banks, when previously financial stability had been the norm. It would be a serious logical mistake to treat the inflationary experiences of the last century as a counterargument to this, because during this period sovereigns have only ever been in charge of creating cash and bank reserves, which represent only a fraction, and in most cases a very small fraction, of the overall money supply. Given that banks were in charge of creating a very large share of the money supply, these experiences would in fact suggest that their activities, rather than those of sovereign governments, have been mainly responsible for recent inflationary experiences. As explained by Hjalmar Schacht in “Magie des Geldes” (1967), the German hyperinflation of 1923 is precisely consistent with this account.

Irving Fisher, one of the preeminent economists of the twentieth century and a fervent supporter of the Chicago Plan, claimed that it had four major advantages, and our simulations find strong support for all of his claims: First, preventing banks from creating and destroying their own funds during sentiment-driven credit booms and busts would allow for a much better control of business cycles. Second, 100 per cent reserve backing would completely eliminate the possibility of destabilising bank runs. Third, allowing the government to issue money directly at zero interest, rather than forcing it to borrow that same money from banks at interest, would lead to a dramatic reduction in the interest burden on government finances.

It would also make net government debt negative, because under the Chicago Plan the government would acquire a very large interest-bearing claim on banks when banks borrow to pay for their reserve backing. Fourth, given that money creation would no longer be based on simultaneous debt creation on bank balance sheets, the economy could also see a dramatic reduction of private debts, in our simulation to less than half their previous level. This would evidently contribute to reducing economy-wide financial fragility.

We also find two additional benefits of adopting the Chicago Plan. First, it would generate longer-term output gains approaching 10 per cent, because lower debt levels and higher revenues from non-inflationary money creation lead to large reductions in real interest rates, distortionary tax rates, and credit monitoring costs. Second, situations where monetary policy can no longer effectively stimulate the economy through a higher money supply and/or a lower policy interest rate would become a thing of the past, because broad monetary aggregates are directly under government control, while the interest rate controlled by policy does not face a zero lower bound. The latter also makes it much easier to reduce steady state inflation to zero.

According to our simulations the advantages of the Chicago Plan are therefore many and large. Many of the disadvantages claimed by critics of this proposal reflect either an insufficient familiarity with the historical record, or an incomplete understanding of what the plan proposes. In the most recent draft of our paper we have included detailed refutations of such critiques. In fact, we can think of only one major disadvantage of the Chicago Plan, namely that the transition could be complicated and fraught with dangers. Earlier thinkers, including Milton Friedman, did not share this concern. But even if it were valid, we think we have demonstrated quite clearly that in a proper cost-benefit analysis these dangers would have to be enormous to outweigh the advantages of transitioning to the Chicago Plan.

 

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Michael Kumhof

Michael is Deputy Division Chief of the Modeling Division in the IMF Research Department. His main responsibility is the development of the IMF’s global macroeconomic simulation model. His main research interests are the macroeconomic effects of resource depletion, banking and monetary reform, and the role of economic inequality in causing crises. Between 1998 and 2004 Dr Kumhof was assistant professor of economics at Stanford University. Between 1988 and 1993 he worked in corporate banking for Barclays Bank PLC. Dr Kumhof is a citizen of Germany.

Michael Kumhof
Deputy Division Chief, Modeling Division
Research Department
International Monetary Fund
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T: +1 (202) 623 6769
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Research Department
International Monetary Fund
Washington, US


T: +1 (202) 623 6769
E: mkumhof@imf.org
W: michaelkumhof.weebly.com
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