[R-G] [BillTottenWeblog] Dust off the Chicago Plan

Wed Dec 24 02:21:12 MST 2008

by Hossein Askari and Noureddine Krichene

Asia Times (September 17 2008)

In a bid to stimulate employment and growth during the period 2001-2008,
central banks pursued an overly loose monetary policy through record low
interest rates, and unwittingly instigated the worst financial
instability in over sixty years. As result, many industrial economies
now face the risk of high inflation and rising unemployment, with
ominous implications for the rest of the world.

In their drive to maintain historically low interest rates, central
banks injected liquidity, set off an uncontrolled credit boom and
ignited intense speculation in housing, commodities, stocks, and foreign
exchange markets. Although supporters of expansionary monetary policy
applaud central banks for stimulating economic growth, the growth that
has come about has been demand- and not supply-driven and has been
accompanied by abnormal inflation in the price of housing and
commodities and large fiscal and external imbalances.

With the bursting of the housing bubble, the meltdown of subprime loans,
and asset price deflation, cheap money policy led to severe financial
crisis and in turn to a slowdown in economic growth. The financial
meltdown has lead to massive and permanent bailouts, the latest batch
being led in the US by the government takeover of Freddie Mac and Fanny
Mae, which hold more than fifty percent of US mortgage loans. This may
be costly for taxpayers and may not even achieve the intended objective
of boosting housing prices in the midst of unfolding credit crisis.

Most recently, Lehman Brothers folded and Merrill Lynch was bought by
Bank of America; AIG, the world’s largest insurance company is on the
brink of disaster; and a number of very large US regional banks could be
in trouble within weeks, if not days. Bankruptcies will exact a heavy
toll, as will bailouts.

While bailouts may appear as costless to central banks, as they amount
to creating money out of thin air, they constitute a heavy tax burden on
those dependent on fixed-income and wage earners and affect large wealth
redistribution in favor of debtors at the expense of creditors. Beside
their distortionary price effects, bailouts have inflationary effects
that will continue to erode real savings and undermine long-term
economic growth.

Although the financial crisis has been massive and has no end in sight,
there has been little urgency on the part of the government or the Fed
to undertake comprehensive studies of the causes of the crisis in order
to propose the fundamental remedies that are needed. Instead, there have
been bailouts.

We need answers before we embrace bailouts and create more problems in
the future. What led to the credit crunch after August 2007, to the near
collapse of many financial giants, and to monumental write-downs that
have so far exceeded US$500 billion? Why did the authorities not move to
mitigate a housing bubble and attempt to realign home prices with
fundamentals? Is the financial system doomed to experience frequent
tremors? What has been the role of financial engineering and
sophisticated financial instruments in creating the crisis at hand? What
reforms would be required for mitigating financial instability in the
future? What led to the sudden collapse of Freddie Mac and Fanny Mae
that had fared well since their creation in 1932? Policymakers have not
addressed these and many other questions.

The financial crisis 2007-2008 is, in many respects, reminiscent of the
Great Depression of 1929-1934 in terms of its causes, intensity, and
consequences. Maurice Allais, the Nobel Prize winning economist, has
written that the causes of the present financial crisis and the Great
Depression are the same. Both were preceded by speculative credit booms
fueled by low interest rates and consequent asset bubbles in stock and
housing markets. Both were triggered by the bursting of these bubbles,
asset price deflation, and were compounded by an ensuing credit
contraction or freeze. The severity of the Great Depression was conveyed
by a drop of real GDP of 29%, a resulting unemployment rate of 25%,
contraction of money supply by thirty percent, and widespread business
and bank failures. The magnitude and ordeal of the Great Depression led
a number of celebrated economists to devote considerable effort to
analyze the true causes of the Depression and to formulate financial
reforms that would immunize the economy against such financial turmoil.

The reform plan that was developed came to be known as the Chicago Plan,
as it was formulated in a memorandum written in 1933 by a group of
Chicago professors, including Henry Simons, Frank Knight, Aaron
Director, Garfield Cox, Lloyd Mints, Henry Schultz, Paul Douglas, and A
G Hart, and was forcefully advocated by the noted Yale University
Professor Irving Fisher in his book titled 100% Money (1935).

Noting the fundamental monetary cause underlying each of the severe
financial crisis in 1837, 1873, 1907, and 1929-1934, the Chicago Plan
calls for a full monopoly for the government in the issuance of currency
and forbids banks from creating any money or near money by establishing
100% reserves against checking deposits. Investment banks that play the
role of brokers between savers and borrowers were to undertake financial
intermediation. Hence, the inverted credit pyramid, the high-leverage
financial schemes (such as hedge funds), and monetization of credit
instruments (such as securitization) were precluded under the Chicago
Plan. The credit multiplier would be far smaller and would be determined
by the savings ratio instead of the reserves ratio.

As stated by Irving Fisher: "The essence of the 100% plan is to make
money independent of loans; that is to divorce the process of creating
and destroying money from the business of banking. A purely incidental
result would be to make banking safer and more profitable; but by far
the most important result would be the prevention of great booms and
depressions by ending chronic inflations and deflations which have ever
been the great economic curse of mankind and which have sprung largely
from banking."

According to Fisher, the creation of money depends on the coincidence of
the double will of borrowers to borrow and banks to loan. Keynes
deplored this "double want" coincidence as a source of large swings in
the circulating medium. Why? In time of recession, borrowers are over
indebted and see narrower profit prospects, they become less willing to
borrow; banks are saddled with impaired assets and are less willing to
lend. Jointly, they cause a contraction of money and, in turn, an
aggravation of the downturn in the economic cycle.

The Chicago Plan was influential in the enactment of the Banking Act of
1935 creating the Federal Open Market Committee (FOMC) with the purpose
of controlling money supply through open market operations using
government securities. Although, the Chicago Plan was shown in 1935 by
Professor James Angell of Columbia University to be easily
implementable, it remained an eloquent academic construction that was
never seriously considered for practical implementation in spite of its
potential contribution toward lasting financial stability.

Irving Fisher wrote: "I have come to believe that that plan is
incomparably the best proposal ever offered for speedily and permanently
solving the problem of depressions; for it would remove the chief cause
of both booms and depressions".

When money creation becomes the sole prerogative of the government and
no money substitutes are allowed, the control of money supply becomes
easier than under a system of money creation by banks. Both Fisher and
Simons proposed a fixed rule for controlling the money supply and
stabilizing the value of the dollar and strongly repudiated
discretionary powers. While they did not settle for a final money
indicator, they nonetheless formulated a few indicators, any of which
could serve as a satisfactory fixed rule for money supply.

These indicators were fixed quantity of money M, fixed turnover MV,
where V is the velocity, fixed price level, or fixed rate of increase in
money supply in line with economic or demographic growth. The choice of
any of these indicators would enable the government to control money
supply and avoid booms and depressions endemic to the banking system
that we have today.

Both Fisher and Simons were preoccupied with the consistency of fiscal
and monetary policy, and proposed that the money rule be immune to wide
changes in fiscal balances, that is, fiscal surplus or deficit will not
entail, respectively, a contraction or an expansion of the money supply
beyond the fixed money rule.

Among strong supporters of the Chicago Plan were Maurice Allais and
Milton Friedman. Both criticized the discretionary rule and wanted a
fixed rule consisting of setting the growth of money supply in line with
real economic growth and a secular moderate inflation at two percent a
year. More than Friedman, Allais was a vocal supporter of the 100%
reserve requirement and for the separation of banking into 100% reserve
banking for checking activity and investment banking for loaning activity.

He noted that the seignorage arising to banks from their money creation
would be diverted to the government and could enable to reduce taxes.
Allais noted that financial innovations, such as securitization, hedge
funds and complex credit derivatives, have increased leverage,
multiplied money substitutes, and increased the power to create and
destroy money through credit expansion and contraction, rendering the
financial system highly vulnerable to instability.

He called for strict regulation of stock markets and abolition of
speculative funds (for example, hedge funds) that are only destabilizing
and have no contribution to real activity. He criticized Alan Greenspan,
the former Federal Reserve chairman, for bailing out hedge funds, and he
considered these bailouts to be detrimental to long-run financial stability.

The recurrence of financial instability since the mid-1970s with
amplifying magnitude, the increasing vulnerability of even the most
advanced financial systems, and the large social costs and inequities
imposed by lasting and growing bailouts make it indispensable to go back
to the armory of reforms developed by the celebrated economists and
devise financial reforms that are capable of thwarting instability and
insuring steady economic growth and price and exchange rate stability.

The Chicago Plan, a response to the Great Depression, remains the best
plan, short of which financial instability cannot be avoided. As Hyman
Minsky puts it: "stability is unstable" - implying that a period of
financial stability will be followed by an episode of financial turmoil,
essentially for the same reasons analyzed in the Chicago Plan and in
Fisher’s book.

Although today we are much farther away from the Chicago Plan in terms
of political support or awareness for the necessity of reforms of the
present central banking system, it is evident that the frequency and
intensity of financial and economic instability have become
overwhelming. As long noted by Simons and recently underscored by
Allais, monetary uncertainties have grown so large, resulting in large
income redistribution, price distortions, and significant credit and
market risks, that it is impossible to make reasonable forecasts of
prices and output.

As an illustration, oil prices exploded from US$65 per barrel in August
2007 to $147 per barrel in July 2008 and plummeted to below US$100 per
barrel this month. The same swings could be noted for exchange rates,
gold, and other commodities as well as for housing prices.

The Banking Act of 1935 called on the FMOC to control money supply.
Since mid-1965, however, the FMOC has been mainly controlling interest
rates and has abandoned control of monetary aggregates. Consequently, it
has allowed the banking system a far greater role in creating and
destroying money.

Both the Great Depression and the present financial crisis are strong
evidence against the applicability of the interest rate rule and
demonstrate the systemic risk, and the huge economic cost and financial
chaos that follow from this rule. In contrast, the financial stability
and steady economic growth experienced during 1950-65 were brought about
by stability in monetary aggregates as the Fed was directly controlling
bank reserves during that period. In the same vein, only after Fed
chairman Paul Volcker controlled bank reserves and money supply during
1979-1982, did inflation come to a stop, restoring financial stability.

The failure of many financial giants such as Fannie Mae, Freddie Mac,
Bear Stearns, Northern Rock, Countrywide, large writedowns by many other
institutions, and abusive recourse to central banks' financing
facilities cannot all be blamed on bad management of financial
institutions. These financial institutions were victims of faulty
policies set by central banks. Now, more then ever before, there is a
need to revive the Chicago Plan, perhaps not in terms of its full
implementation, but at least in terms of its basic principles which call
for a stable and rule binding monetary policy.

In the context of the present destabilizing policies of central banks,
even long-established institutions that were considered too big to fail
have became too vulnerable to financial instability. While it is
pressing to move on the regulatory front and reduce the multiplication
of money substitutes, it is equally pressing to return to controlling
monetary aggregates within strict limits and restoring monetary
discipline. Besides restoring monetary stability, a fixed rule would
limit the power of the banking system in causing over-expansion or
contraction of money, as required under the Chicago Plan, and would
direct credit to high-quality and productive investments.

It is time to part with the fallacy that economic growth and employment
creation are the main duties of central banks, and that the interest
rate rule is the panacea for all economic ills. By tinkering with
interest rates to stimulate economic growth, central banks have instead
created unexpected problems in form of speculative bubbles, over
indebtedness, credit defaults, millions of home foreclosures, collapsing
financial sector, high liabilities on taxpayers, and inflationary bailouts.

By causing stagflation, central banks' economic growth objective has
also become self-defeating. Economic agony and financial disorder will
continue until central banks decide to rehabilitate monetary conditions
and restore direct control of the money creation process.

It's time to dust off the Chicago Plan and take a second look.

_____

Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist at the International Monetary Fund and a former advisor,
Islamic Development Bank, Jeddah.

http://www.atimes.com/atimes/Global_Economy/JI17Dj03.html

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