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Forget Dodd-Frank; Revisited Chicago Plan would Eliminate Bank Money Creation, the FOMC and FDIC

 October 24, 2012 11:20 AM


In an IMF working paper titled "The Chicago Plan Revisited" by Jaromir Benes and Michael Kumhof (August 2012), the authors try to substantiate the claims of Irving Fisher in 1936 that such a scheme would;

(1) Control of a major source of business cycle fluctuations, i.e., sudden increases and contractions of bank credit and of the supply of bank-created money,

(2) Complete elimination of bank runs, and therefore the need for the FDIC or any government-sponsored deposit insurance.

(3) Dramatically reduce net public debt,

(4) Dramatically reduce private debt, as money creation no longer requires simultaneous debt creation.

Using a model of the U.S. banking system in a DSGE (dynamic stochastic general equilibrium) model of the U.S. economy, the IMF paper claims output gains would reach 10%, and steady state inflation dropping to zero without posing problems for the conduct of monetary policy.

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An Economy Dependent on Unmitigated Debt (Credit) Creation for Growth

In college textbooks, a central bank like the Federal Reserve supposedly controls the creation of money, where monetary aggregates are created at the initiative of the central bank, through an initial injection of high-powered money into the banking system that gets multiplied through private sector bank lending through the so-called "deposit multiplier" or "money multiplier". As pointed out by the IMF Paper, this is a myth.  In fact, the Fed (and other central banks) merely controls short-term interest rates and the availability of central bank reserves. However, broad monetary aggregates, as they are actually driven by private bank lending decisions, lead the business cycle, whereas narrow money aggregates, most importantly reserves, lag the cycle. Some 94% of actual money (money supply) created is actually created by private banks. Historically, the availability or lack thereof of central bank reserves did not constrain banks, even when the central bank did in fact o?cially target monetary aggregates.

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Private banks don't make loans because they have extra deposits lying around. The process is the exactly opposite:

(1) Each private bank "creates" loans out of thin air by entering into binding loan commitments with borrowers, corresponding liabilities are created on their books at the same time.

(2) If the bank doesn't have the required level of reserves, it simply borrows them after the fact from the central bank (or from another bank).

(3) The central bank, in turn, creates the money which it lends to the private banks out of thin air.

It has long been recognized that the major failing of private sector money (credit) creation is that it is uncontrolled and creates boom-bust cycles. The large expansion of private credit in the period leading up to the Great Depression was only one of many historical examples of a bank-induced boom-bust cycle, although its severity was exacerbated by mistakes of the Federal Reserve. Even in the worst example of money printing in modern history, i.e., the German (Weimer Rupublic) hyperin?ation of 1923, the real problem ostensibly was that the Allies insisted on grating total private control over the Reichsbank, the German central bank. The Reichsbank as a private institution allowed private banks to issue massive amounts of currency which the Reichsbank readily exchanged for Reichsmarks on demand, while the private Reichsbank also enabled speculators to short-sell the currency. 

It is therefore amazing to learn that Fed Chairman Ben Bernanke is reportedly pushing to eliminate all reserve requirements in the U.S. In other words, American banks won't even have to borrow from the Fed or other banks after the fact to maintain required reserves, thereby completely removing any semblance of control on the creation of money/credit/debt. Yes, government/central bank capital requirements as well as Basell I and Basel III capital requirements ostensibly offer some discipline, but with governments explicitly back-stopping their "too-big-to-fail" financial institutions with bailouts, guarantees and various measures, these capital requirements are not that serious a deterrent. Thus the world economy is essentially driven by an ever-expanding mountain of debt, where any slight contraction in this debt (total credit outstanding) is enough to plunge an economy into serious recession/depression. Between 2007 and 2011, the World Bank estimates domestic credit created in the U.S. by the banking sector (excluding monetary authorities) at 233% of GDP, with only countries like the U.K. (214%), Japan (341%), Ireland (226%), Spain (229%) and Portugal (204%) coming close.  In the U.S., the financial sector has swelled to a dominating position in the economy. From 1973 to 1985, the financial sector never earned more than 16% of total domestic corporate profits. In the 1990s, it oscillated between 21% and 30%, and surged to 41% in the next decade. Thus while finance and insurance accounted for only 4% of U.S. GDP in the 1960s, it swelled to 8% of GDP by 2007. The International Institute of Labor Studies estimates that nearly 1 in every 20 U.S. workers were employed in the financial sector in 2007. 

The Chicago Plan in a Nutshell

In the midst of the Great Depression in 1933 and the obviously serious failure of the monetary system (not just the gold standard) leading U.S. macroeconomists came up with a radical proposal for monetary reform than became known as the Chicago Plan. Its strongest proponent was professor Henry Simons of the University of Chicago, while it was also supported by the infamous Irving Fisher of Yale University. In a nutshell, the Plan would require 100% (fully reserve-backed) bank deposits, versus the current 500-year old fractional reserve system whereby a bank must hold only a fraction of its total deposit liabilities in the form of vault cash or deposits with Federal Reserve Banks. In the U.S., the Fed defines reservable liabilities as net transaction accounts, nonpersonal time deposits, and Eurocurrency liabilities. Private sector money creation in a fractional reserve banking system requires loans from the banking system and therefore an equivalent increase in debt in order for any new money to be created, resulting in an exponential increase in debt, to the point that the system collapses on itself.

In a nutshell, the Chicago Plan provides an outline for the transition from a system of privately-issued debt-based money to a system of government-issued debt-free money, transferring the real control of money creation from private sector banks to the government. By inference, the Chicago Plan would also eliminate the Federal Reserve's ability to create money as a private institution, as it would be nationalized by incorporating it into the U.S. Treasury. Further, such a system would eliminate the need for the FDIC (Federal Deposit Insurance Corp.) as banks could only lend from the deposits they actually had. 

Radical Revision of the Modern Monetary System Likely Not Politically Feasible

While it sounds great on paper, any new Chicago Plan for a radical reform of the monetary/financial system could well suffer the same fate as the original Chicago Plan, which although it was deliberated in Congressional Committees, was never adopted as law, despite widespread approval expressed by 235 economists from academia, including Fisher Fisher (1936) and Graham (1936), and continued advocacy after the war, including Allais(1947), Friedman (1960), and Tobin (1985) supporting. Basically, the Chicago Plan died out due to strong resistance from the banking sector, and undoubtedly resistance from the Federal Reserve.  Interestingly, John Maynard Keynes, the father of Keynesian economic policies that allowed private sector banks to retain control over the creation of money, did not support the Chicago Plan and was squarely in the bankers' corner. 

As even Kansas City Fed president Thomas Hoenig has openly questioned,  "How is it possible that post-crisis legislation (to change/improve the system) leaves large financial institutions still in control of our country's economic destiny?" Washington's reluctance to take on the too-big-to-fail banks as well as the Fed is understandable if you consider, a) the massive political contributions and lobbying by the finance, insurance and real estate sectors, and b) the government's almost total dependence on the Fed to maintain positive economic momentum while Congress dithers on the so-called fiscal cliff. The Sunlight Foundation estimates to be USD6.2 billion in political contributions to federal election candidates over a 13-year period, and some USD2 billion since 1998, The Center for Responsive Politics estimates that the finance, insurance and real estate sector spent USD6.8 billion on federal lobbying and campaign contributions from 1998 through 2011, or USD1 billion more than any other sector. More than have of the lobbyists working for these sectors are ex-government officials and in many cases, onetime lawmakers and staffers who helped write laws that deregulated the industry

Although it has been two years since the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) was signed into law, many rules are still not in place or final. Standard & Poor's now estimate that the DFA could reduce pretax earnings for the eight large, complex banks by a total of $22 billion to $34 billion per year--higher than their prior estimate of $19.5 billion to $26 billion, mainly because of stricter regulation of derivatives trading and limitations on proprietary trading and investments. One can only imagine the hit to large money center bank earnings from a reversion to plain, vanilla envelop lending based on actual deposits, and the corollary hit to sector employment, particularly highly paid traders and investment bankers.  

While Congressmen such as Dennis Kucinich have introduced legislation such as the N.E.E.D Act to nationalize the Fed under the U.S. Treasury and some 250 Congressmen have demanded an audit of the Fed, the economic destiny of developed nations such as the U.S., the U.K. and Japan will be in the hands of a few large too-big-to-fail financial institutions for the foreseeable future, ...until the next financial crisis causes more widespread systemic failure and an implosion of the house-of-cards financial system where money creation is dependent on even more debt creation. 

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(1)
 
10/24/2012 5:15:43 PM
by d hollingsworth
Even if the inflationists worst fears are realized with a debt-free govt. currency and the irresponsible behavior of politicians leads to an erosion of purchasing power. Even if the congress decides to use this new tool to buy votes, create pork, and maintain the culture of corruption. Even if all these things and more are inevitable under a commonwealth debt free currency, HOW CAN THAT NOT BE PREFERRABLE TO A PRIVATELY CONTROLLED, BANK ISSUED DEBT BASED MONETARY UNIT THAT WILL SURELY AND PERPETUALLY COLLAPSE THE ENTIRE ECONOMY UNDER THE WEIGHT OF UNREPAYABLE DEBT?? IS THERE A SINGLE WORKABLE ARGUMENT THAT SUPPORTS THE IDEA THAT ALLOWING BANKS TO ISSUE DEBT BASED MONEY WITHOUT LIMIT CAN DO ANYTHING BUT DESTROY OUR ECONOMY AND CREATE A "TOO BIG TO FAIL" RULING CLASS WHO, WITH THE STROKE OF A PEN, MAY LITERALLY BUY UP THE WORLD? Sorry for the caps, but seriously, what possible monetary system would NOT be better than what we have? Tally sticks and tulips would be better. We have allowed parasties to write themselves a blank check and are now terrified of taking it away from them. Can anything be more ridiculous than that?
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