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Dr Michael Kumhof: "The Chicago Plan Revisited"

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A presentation held by Dr Michael Kumhof, Deputy Division Chief, Modeling Division, Research Department, IMF, organized by the Stockholm based think tank Global Challenge in cooperation with LSE and …

A presentation held by Dr Michael Kumhof, Deputy Division Chief, Modeling Division, Research Department, IMF, organized by the Stockholm based think tank Global Challenge in cooperation with LSE and the Swedish House of Finance on September 12th 2013.

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  • 1. The Chicago Plan Revisited Jaromir Benes, International Monetary Fund Michael Kumhof, International Monetary Fund September 13, 2013
  • 2. Disclaimer The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.
  • 3. Plan of the Talk 1. Introduction 2. Understanding Banks: Key Insights 3. The Six Advantages of the Chicago Plan 4. Will Government Money Issuance Cause Inflation? 5. Summary 6. Discussion
  • 4. 1 Introduction • The Great Recession triggered significant reform of the financial system. • The Great Depression is a useful reference point: It provoked a very deep in- tellectual debate about how to make the financial system safer, culminating not only in the 1933/35 Banking Acts but also in the Chicago Plan. • The Chicago Plan was supported by Frederick Soddy, Irving Fisher, Henry Simons, Frank Knight, Milton Friedman, many others. • In a nutshell, the Chicago Plan proposed: — Separation of the monetary and credit functions of banking. — Deposits/money must be backed 100% by public reserves. — Credit cannot be financed by creation, ex nihilo, of bank deposits.
  • 5. 2 Understanding Banks: Key Insights 2.1 Key Function: Money Creation, not Intermediation • The key functions of banks: Creation (and destruction) of money, ex nihilo. • Are they also “intermediaries”? — Intermediary: Accepts and on-lends non-banks’ deposits of savings. — Under this definition banks are not intermediaries. — Because loans come before deposits, not vice versa.
  • 6. Incorrect View: Intermediation of Savings (Loanable Funds Theory) Bank Balance Sheet Saver Deposit of new savings by Joe Saver Granting of new loan to Jim Investor Investor Implicitly savings are in the form of goods dumped at the bank. GOODS are spent on other goods. Correct View: Creation of Money = Creation of “Loanable Funds” Deposits are in the form of money. They are created by the bank in the act of lending. Bank Balance Sheet Investor Granting of new loan to Jim Investor Creation of new deposit for Jim Investor Investor MONEY is spent on goods. Seller ends up being a saver.
  • 7. Bank Money Creation - Implications • Banks can easily start a lending boom: — They simply grow their balance sheets by expanding the money supply. — They do not have to attract deposits of existing money. • Reserves or cash balances impose no limits on this process (see below). • The only constraints are solvency and profitability: The key is banks’ poten- tially very volatile sentiment concerning their borrowers’ creditworthiness.
  • 8. 2.2 The “Deposit Multiplier” is a Myth • Deposit Multiplier: — Central bank fixes narrow money aggregates first. — Broad money aggregates are a function of narrow money. • Kydland and Prescott (1990) referred to this as a myth. Why? — It turns the actual monetary transmission mechanism on its head. — Monetarist Era: ∗ Broad money aggregates lead the cycle. ∗ Narrow money aggregates lag the cycle. — Inflation Targeting Era: ∗ If you control a price (the interest rate), ... ∗ then you have to let quantities (reserves) adjust. • The evidence for this, both institutional and empirical, is overwhelming.
  • 9. 2.3 Understanding Banks: Conclusions • Transmission starts with loan creation = deposit creation, and ends with reserve creation. • Alan Holmes, Vice President of the New York Federal Reserve, 1969: In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. • Banks are therefore almost fully in control of the money creation process. • The only tool the Fed has for affecting the money supply is very blunt: The policy rate works by making potential borrowers not creditworthy.
  • 10. 3 The Six Advantages of the Chicago Plan Advantage 1: Dramatic reduction of the (net) public debt Advantage 2: Dramatic reduction of private debts
  • 11. Current Banking System Balance Sheet 20 Government Bonds 100 Short-Term and Mortgage Loans 80 Investment Loans 16 Bank Equity 184 Deposits Assets Liabilities All numbers are in percent of U.S. GDP
  • 12. Transition to Chicago Plan Step 1 20 Government Bonds 100 Short-Term and Mortgage Loans 80 Investment Loans 16 Bank Equity 184 Reserves 184 Treasury Credit Banks purchase 100% reserve cover against treasury credit IOU 100% Reserve Cover 184 Deposits Assets Liabilities
  • 13. Transition to Chicago Plan Step 2 20 Government Bonds 100 Short-Term and Mortgage Loans 80 Investment Loans 16 Bank Equity 184 Treasury Credit 184 Reserves 184 Deposits Banks are split into money banks and credit investment trusts Money Banks Credit Investment TrustsAssets Liabilities LiabilitiesAssets
  • 14. Transition to Chicago Plan Step 3 20 Government Bonds 100 Short-Term and Mortgage Loans 80 Investment Loans 16 Bank Equity 184 Treasury Credit 184 Reserves 184 Deposits Bank-held government bonds are cancelled against treasury credit Money Banks Credit Investment TrustsAssets Assets Liabilities Liabilities
  • 15. Transition to Chicago Plan Step 3 - completed 100 Short-Term and Mortgage Loans 80 Investment Loans 16 Bank Equity 164 Treasury Credit 184 Reserves 184 Deposits Bank-held government bonds are cancelled against treasury credit Money Banks Credit Investment Trusts Assets Assets Liabilities Liabilities
  • 16. Transition to Chicago Plan Step 4 100 Short-Term and Mortgage Loans 80 Investment Loans 16 Bank Equity 184 Reserves 184 Deposits Part of treasury credit is distributed as a citizens’ dividend Money Banks Credit Investment Trusts 64 Treasury Credit 100 Citizens’ Accounts Assets Assets Liabilities Liabilities
  • 17. Transition to Chicago Plan Step 5 100 Short-Term and Mortgage Loans 80 Investment Loans 16 Bank Equity 184 Reserves 184 Deposits Mandatory first use of citizens’ dividend is repayment of any debts Money Banks Credit Investment Trusts 64 Treasury Credit 100 Citizens’ Accounts Assets Assets Liabilities Liabilities
  • 18. Transition to Chicago Plan Step 5 - completed 80 Investment Loans 16 Bank Equity 184 Reserves 184 Deposits Mandatory first use of citizens’ dividend is repayment of any debts Money Banks Credit Investment Trusts 64 Treasury Credit Assets Assets Liabilities Liabilities
  • 19. Transition to Chicago Plan Step 6 80 Investment Loans 9 Bank Equity 184 Reserves 184 Deposits Bank equity distribution due to reduced balance sheet size Money Banks Credit Investment Trusts 71 Treasury Credit Equity replaced by additional treasury credit Assets Assets Liabilities Liabilities
  • 20. Transition to Chicago Plan Step 7 - Optional 80 Investment Loans 9 Bank Equity 184 Reserves 184 Deposits Treasury credit used to repay all remaining government debt held outside the financial system Money Banks Credit Investment Trusts 11 Treasury Credit • This is shown to illustrate that there is no need for government to have a dominant role in credit provision • But the drawback is that this completely removes an important financial market benchmark and saving instrument 60 Long-Term Non-Monetary Private Deposits Assets Assets Liabilities Liabilities
  • 21. 80 Gov. Bonds (Debt) 184 Treasury Credit (Financial Asset) 184 Reserves (Equity) Prior to Chicago Plan Chicago Plan: 100% Reserve Backing Chicago Plan: Final Balance Sheet 80 Gov. Bonds (Debt) 80 Other Net Assets 80 Other Net Assets 80 Other Net Assets 11 Net Treas. Credit 91 Reserves minus Loan Buy-Backs (Equity) Net government debt becomes negative. Reserves are equity in the commonwealth, not debt. Changes in Government Balance Sheet in Transition Period
  • 22. Advantage 3: Complete elimination of bank runs • Money is completely safe because its value does not depend on the perfor- mance of private debts. • Credit problems therefore have no effect on the safety of the payments system.
  • 23. Advantage 4: Large output gains approaching 10% - three reasons: 1. Lower interest rates: Due to lower debt levels. 2. Lower tax rates: Due to non-inflationary revenue from money creation. 3. Lower monitoring costs: Because money creation no longer requires moni- toring of private debts.
  • 24. 0 2 4 6 8 10 0 2 4 6 8 10 -4 4 12 20 28 36 44 52 60 GDP (% Difference) 0 5 10 15 20 25 30 0 5 10 15 20 25 30 -4 4 12 20 28 36 44 52 60 Investment (% Difference) -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 -4 4 12 20 28 36 44 52 60 Real Wholesale Lending Rate (pp Difference) -4 -2 0 2 4 6 -4 -2 0 2 4 6 -4 4 12 20 28 36 44 52 60 Consumption (% Difference) -4 -3 -2 -1 0 1 -4 -3 -2 -1 0 1 -4 4 12 20 28 36 44 52 60 Inflation (pp Difference) -6 -5 -4 -3 -2 -1 0 1 -6 -5 -4 -3 -2 -1 0 1 -4 4 12 20 28 36 44 52 60 Labor Tax Rate (pp Difference) 3 Main Macroeconomic Variables __ = Transition to Chicago Plan, .... = Final Values after Transition
  • 25. -5 -4 -3 -2 -1 0 1 -5 -4 -3 -2 -1 0 1 -4 4 12 20 28 36 44 52 60 Gross Debt Service/GDP (pp Difference) -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 -4 4 12 20 28 36 44 52 60 Government Deficit/GDP (pp Difference) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 -4 4 12 20 28 36 44 52 60 Seigniorage/GDP (pp Difference) -25 -20 -15 -10 -5 0 5 -25 -20 -15 -10 -5 0 5 -4 4 12 20 28 36 44 52 60 Government Debt/GDP (pp Difference) -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 -4 4 12 20 28 36 44 52 60 Treasury Credit/GDP (pp Difference) -4 -3 -2 -1 0 1 -4 -3 -2 -1 0 1 -4 4 12 20 28 36 44 52 60 Tax Revenue/GDP (pp Difference) δ 4 Fiscal Variables __ = Transition to Chicago Plan, .... = Final Values after Transition
  • 26. Advantage 5: Much better control of bank-lending-driven business cycles • Under the Chicago Plan bank money creation becomes impossible. • Banks now become true intermediaries rather than money creators. • This makes it much easier to prevent credit cycles.
  • 27. -4 -3 -2 -1 0 1 2 -4 -3 -2 -1 0 1 2 -4 4 12 20 28 36 44 GDP (% Difference) -20 -10 0 10 20 30 40 50 -20 -10 0 10 20 30 40 50 -4 4 12 20 28 36 44 Bank Loans/GDP (pp Difference) -3 -2 -1 0 1 2 3 4 5 -3 -2 -1 0 1 2 3 4 5 -4 4 12 20 28 36 44 Bank Basel Ratio (pp Difference) -3 -2 -1 0 1 2 3 4 -3 -2 -1 0 1 2 3 4 -4 4 12 20 28 36 44 Inflation (pp Difference) -20 -10 0 10 20 30 40 50 60 -20 -10 0 10 20 30 40 50 60 -4 4 12 20 28 36 44 Bank Deposits/GDP (pp Difference) -2 -1 0 1 2 3 4 5 6 -2 -1 0 1 2 3 4 5 6 -4 4 12 20 28 36 44 Real Wholesale Lending Rate (pp Difference) 5 Bank-Driven Business Cycles __ = Pre-Transition, - - - = Post-Transition, with Quantitative Lending Guidance
  • 28. Advantage 6: No liquidity traps • Definition: Central bank loses its ability to stimulate the economy by: 1. Increasing the money supply. 2. Lowering the interest rate. • Neither is a problem under the Chicago Plan: 1. Broad money is directly controlled by government, rather than by banks. 2. The interest rate on treasury credit can become negative ⇒ no zero interest rate floor (ZIF).
  • 29. 4 Will Government Money Issuance Cause Inflation? No, for three sets of reasons, based on: 1. Monetary Theory. 2. Monetary History. 3. Institutional Arrangements for Money Issuance.
  • 30. 1. Government-Issued Money and Inflation - Theory • Inflation is determined by the relative quantities of money in private hands and of goods. • The quantity of money in private hands remains virtually unchanged when transitioning to the Chicago Plan. • This can therefore not be inflationary.
  • 31. 100 Short-Term and Mortgage Loans 20 Gov. Bonds 80 Investment Loans 16 Equity 184 Deposits 16 Equity Prior to Chicago Plan Chicago Plan: 100% Reserve Backing Chicago Plan: Final Balance Sheet 184 Reserves 20 Gov. Bonds 100 Short-Term and Mortgage Loans 80 Investment Loans 184 Deposits 184 Deposits 184 Treasury Credit 184 Reserves 9 Equity 71 Treasury Credit80 Investment Loans The Chicago Plan Is Completely Non-Inflationary Deposits in private hands remain completely unchanged throughout. Inflation is determined by the relative supplies of deposits versus goods and services. What changes is what deposits represent: Indestructible public money rather than volatile, destructible private money.
  • 32. 2. Government-Issued Money and Inflation - History • A long line of distinguished thinkers has advocated government money is- suance under the rule of law. • Historical experience is very strongly in favor of it: — Periods of private money issuance: Constant financial crises. — Periods of government money issuance: Stability, very few crises. • Are the many financial crises of the last 100 years a counter-argument? — This would be a very serious logical error. — Over the last 100 years governments have only ever been in charge of narrow money, and private banks in charge of overall money. — If anything, recent financial crises must thus have been caused to a significant extent by banks.
  • 33. 3. Government-Issued Money and Inflation - Institutional Arrangements • Proposal: Turn money issuance over to a fourth power of government. • Constitutional independence, in U.S. context, similar to that of the Supreme Court. • This would insulate money issuance from pressures coming from both gov- ernment and private interests.
  • 34. 5 Summary • Whether the Chicago Plan is desirable comes down to a cost-benefit analysis. • The Benefits: 1. Dramatic reduction of the (net) public debt, to around zero. 2. Dramatic reduction of private debts, to around half. 3. Much better control of bank-lending-driven business cycles. 4. Complete elimination of bank runs. 5. Large output gains approaching 10%. 6. No liquidity trap problems, zero long-run inflation attainable. • The Costs: 1. Transition period may be difficult. 2. Substitute monies could perhaps become a problem. 3. All other arguments concerning alleged costs can be refuted. • Given the large benefits, the difficulties of the transition would have to be enormous to justify not considering the Chicago Plan at all.
  • 35. 6 Discussion • The Great Recession has shown that too much of an “exciting”, “innovative” financial system can cause significant problems that distract attention from the productive sector. • But we need a really exciting productive sector more than ever. • What we need in order to facilitate that is a really boring financial system: — A completely safe, crisis-proof payments system. — Lending banks that act as conservative intermediaries. • The Chicago Plan has many elements of such a system.