Is the ‘Chicago Plan’ the way forward?

David Grimmond writes about the old Chicago Plan, written up following the Great Depression (Infometrics link).  Given the way it is described by the IMF he believe it:

There are many other examples of low lying fruit in the policy domain where a combination of entrenched interests and innate conservatism inhibits movements to welfare enhancing changes (eg a flat tax/guaranteed minimum income tax benefit system, redesigning GST on a origins basis, and global free trade).

The claimed benefits of adopting the Chicago Plan are truly profound, and if true would have a larger impact on the welfare of New Zealanders than most other issues that dominate political debate.

It would seem to be a good use of government resources to have this issue investigated thoroughly to, either put to bed the claims if they are illusory or to begin implementing a change if they are indeed genuine.

The potential benefits David notes are:

1. Having to obtain outside funding rather than being able to create it themselves would reduce the ability of banks to cause business cycles due to potentially capricious changes in their attitude towards credit risk.

2. Having fully reserve-backed bank deposits would completely eliminate bank runs, thereby increasing financial stability and allowing banks to concentrate on their core lending function without worrying about instabilities from the liabilities side of their balance sheet.

3. Allowing the government to issue money directly at zero interest, rather than borrowing that same money from banks at interest, would lead to a reduction in the interest burden on government finances.

4. Allowing a reduction in private debt levels as money creation would no longer require the simultaneous creation of mostly private debts on bank balance sheets.

5. It generates long term output gains from a lower interest rate profile, lower tax rates (as the government can earn more from seigniorage), and lower credit monitoring costs for banks.

6. It can allow steady state inflation to drop to zero without posing problems on the conduct of monetary policy. A critical underpinning to this result is the greater ability to avoid liquidity traps as the quantity of broad money would be directly controlled by policy makers and not dependent on bank’s willingness to lend, and because the interest on Treasury credit would not be an opportunity cost of money for asset investors, but rather a borrowing rate for a credit facility that is only accessible to banks for the specific purpose of funding physical investment projects, it could become negative without any practical problems.

This does sound to good to be true.  Hence why, as always, there are trade-offs.

In this case, there is full reserve banking, and people’s liquid deposits actually are available for withdrawal “on demand”.  As a result “bank runs” become impossible.  However, since the funds cannot be lent out, the rate of return on those funds would disappear – in fact banks would be simply charging people a service fee to give them a safe place to hold their money.  This implies that charges for saving with the bank will rise.

It is terms deposits that could be lent out, for an equivalent maturity of investment – as a result “maturity mismatch” would disappear, but the advantages of “maturity transformation” would be lost in the regulated banking sector.  Note:  Equity financing would allow banks to lend out funds, and the switch to equity financing could well be seen as a plus!

As a result, the fact that currently accepted forms of banking would be banned would imply that they move into the “unregulated” banking sector – potentially increasing the risk of financial crises rather than increasing them.

Timing effects also matter.  If banks funding will move with the economic cycle in a lagging way (and as lending is pinned to funding in this case, so will lending), and as a result their ability to lend will be as well.  In this environment, it seems a bit of an overstatement to say such constraints will get rid of the business cycle.

Furthermore, the details of the transfer associated with the plan matter – if the shift to reserves through government intervention and corresponding seinorage is a implicit one-off tax, people will lose some trust in government and may expect similar tax grabs in the future.

Remember, high debt levels have downsides, but they can also be a sign that very heterogeneous lenders and borrowers are meeting in the marketplace – the DSGE framework doesn’t capture this, and the associated costs are as a result being ignored.

Do you agree the plan – which would cleanly separate the “deposit holding” function of banks from the “lending and credit creation” function is a good idea?  Are these potential downsides too much?  Or do we simply need more details before we can decide?

  • HJC

    It’s interesting to consider how banking could even work under these conditions. Equity-funded lending is not banking, it has no aspect of liquidity provision. Would banks need to have 100% reserve backing for undrawn facilities (e.g. credit cards), which can become deposits instantly? If the reserve requirement was enforced with a lag there would be massive inter-bank rate volatility on each day of reckoning and the central bank would need to be more active in its open-market operations possibly taking a much wider range of collateral. Maybe there would be no real change at all, other than that the central bank would have a much larger balance sheet.

    • The devil would be in the details. However, I’ll be honest that, from my perspective, the claims that it would increase output by 10% – without a clear explanation of why – appear absolutely outlandish.

      • HJC

        Yes, I agree.

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  • Miguel Sanchez

    Really really baffled by the number of central bankers etc who think that banks can create their own funding (while somehow simultaneously holding the view that banks are at risk of a ‘run’ on their funding). To use a snippet that was quoted in the IMF paper: “Suppose that Bank A gives a new loan of $20 to Firm X, which continues to hold a deposit account with Bank A. Bank A does this by crediting Firm X’s account by $20. The bank now has a new asset (the loan to Firm X) and an offsetting liability (the increase in Firm X’s deposit at the bank). Importantly, Bank A still has [unchanged] reserves in its account. In other words, the loan to Firm X does not decrease Bank A’s reserve holdings at all.” All well and good until Firm X decides to withdraw the money, at which point Bank A has to stump up. And gee, what are the odds that, having borrowed some money, Firm X might want to do something with it other than just leaving it on deposit? Just… so… dumb.

    • Yar, sometimes I think people’s determination to discuss how banks “create their own deposits” forget that it still relies on a transaction with borrowers – who involve their own risks and willingnesses to borrow.