Is the ‘Chicago Plan’ the way forward?

By Infometrics 10/04/2014

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?