In my last three articles for this blog, I have been arguing that following the financial crash of 2008, the UK’s road to recovery was always going to be long and slow whichever party happened to be in power. In an economy in which public spending is approaching 50% of GDP, overall taxation is more than 40%, and public borrowing makes up the difference – adding around £120 billion a year to our growing national indebtedness – there is so little room for manoeuvre that quick fixes simply aren’t available. Any increases in taxation to reduce the deficit, for instance, would almost certainly lead to reduced demand, lower economic activity and even lower tax receipts; while any attempts to boost demand, by cutting taxation or increasing spending would obviously necessitate even greater borrowing, which – as I hope I demonstrated in ‘QuantitativeEasing, Bank Lending & UK Government Borrowing’ – could only be sustained through even greater injections of cash from the Bank of England. Whichever party won the 2010 election, therefore, they would have had to have followed more or less the same programme, gradually reducing public expenditure as a percentage of GDP, while at the same time trying to foster growth using non-fiscal methods. Much as opposition politicians would like us to believe otherwise, there just isn’t a viable ‘Plan B’ – or not within the framework of conventional economic theory.
The problem is that, while the current strategy may be the only one any government could have adopted under the present circumstances, I don’t actually believe that it’s going to deliver us into the promised land any time soon, if ever. Oh yes, left to our own devices and given enough time, we could probably claw our way out of the hole we are in. The problem is, however, that being ‘left to our own devices’ is not something the world has planned for us. The UK may be a collection of islands geographically; but it is not so economically. And over the next eight to ten years – well before our own recovery is complete – I believe that further crises in the global economy, on a scale sufficient to render our own self-determined efforts somewhat otiose, are inevitable.
The most serious of these external threats – as I pointed out in ‘The Limitations & Dangers of Quantitative Easing’ – comes from the USA, where the cumulative national debt, currently standing at $16.3 trillion, is forecast to rise to $25.9 trillion by the end of the decade. If this is allowed to happen, I believe that it will almost certainly precipitate a collapse in the US economy, with devastating effects for all of us.
In fact, the proximate cause of this collapse could start to become apparent as early as 2013, when, in addition to the $1.3 trillion dollars the US Treasury will have to issue in new bonds to cover that year’s projected deficit, it will also have to redeem maturing bonds with a face value of $378 billion issued in 2003. To do this, it will therefore have to issue another $378 billion in bonds, simply to recycle or churn the debt.
An extra $378 billion, of course, doesn’t sound too bad. But over the next five years the problem gets progressively worse. By 2019, the churn rate reaches $1.42 trillion. That year, as a result, the total value of new bonds the Treasury would have to issue could well exceed $3 trillion – assuming, that is, that it is able to find enough investors willing to buy them.
Even before then, however, worries over this exponentially accumulating chasm of debt, could well see US bond prices start to fall. Depending on the fiscal and monetary strategy of Obama’s second term administration, this, too, could start to happen as early next year. As a result, future bond issues, will have to be offered at progressively higher interest rates, further increasing the budget deficit in a way not envisaged in the current forecast. If, by 2019, US bond yields were to reach 5%, for instance – as well they might – I estimate that the US government could be spending as much as $1 trillion a year on interest payments alone. This would therefore necessitate even greater borrowing than the $3 trillion for that year already mooted. At this point, however, the bond markets will almost certainly pull the plug, leaving the USA in much the same position as Greece is today, unable to borrow any more money and therefore unable to repay the money it has already borrowed.
Unlike Greece, however, there is no organisation in the world big enough to bail out the US federal government. Not being able to redeem its bonds as they fall due, the US Treasury will therefore have to default. US banks holding US Treasury bonds will consequently have to write down the value of these bonds on their balance sheets. Many, as a result, will go bankrupt. With an impoverished federal government unable to underwrite deposits, most people with money in these banks will therefore lose it. As will many businesses, many of which, as a consequence, will also go bankrupt.
With the government having to match expenditure to tax receipts, pensioners and public sector workers will almost certainly have their salaries and pensions cut. Many public sector workers will also lose their jobs. With so many businesses also failing, the unemployment rate will soar. With far fewer people paying taxes, tax receipts will fall, requiring further cuts in expenditure. As the spiral downwards continues, those living on welfare may not get paid at all. As result, people could well go hungry; and there will almost certainly be social disorder and unrest.
Overseas, many banks holding US Treasury bonds, or loans to US banks, will also go bankrupt. The same domino effect will spread throughout the world. To make matter worse, probable disputes over resources may well lead to wars. In fact, there is ever possibility of a global famine. It could well be the worst disaster in human history. And the terrible truth is that unless someone does something fairly soon to prevent it, it is going to happen as surely as night follows day.
The problem, however, is not just that, to the outsider at least, the US political system seems totally incapable of generating either the will or the unity of purpose to confront this looming threat. It is also that, within the framework of conventional economic theory, it is not at all clear what should actually be done. The IMF, for instance, has recently warned the US government that it risks plunging the world into another economic recession if it fails to get agreement on a new budget, thus causing certain automatic tax rises and spending cuts – the so-called fiscal cliff – to be triggered at the end of this year. As these tax rises and spending cuts are precisely what the US needs in order to tackle its deficit, however, this sounds a bit like a doctor warning a drug addict not to come off the heroin for the sake of his suppliers. If it is a requirement of the global economy, therefore, that the US keeps on spending and borrowing itself into bankruptcy in order to keep the world turning for just a few more years before it finally tears itself apart, you have to ask whether the current economic and financial system is really doing its job.
For some months, as a consequence, I have been saying that if there is a solution to this problem, it will almost certainly emerge in the form of something radically new; something that we will probably look back on as a turning point in history; a Copernican revolution in economic theory. Then, a couple of weeks ago, I was sent a document which has led me to think that, just maybe, this revolutionary new theory already exists.
If so, it is called the Chicago Plan, so named because it was first proposed by a group of economists led by Professor Frank Knight at Chicago University during the late 1920s. In 1933, it was then further developed by Henry Simons and put forward in a memorandum to President Roosevelt as a possible solution to the Great Depression.
Partly because of the opposition of US bankers, and partly, one suspects, because it is so radical that, initially at least, it seems too much of a step into the unknown, Roosevelt declined to take it any further. Now, however, it is being floated once again, this time by the IMF, which, in August this year, published a working paper by Jaormir Benes and Michael Kumhof entitled ‘The Chicago PlanRevisited’.
In it, the two authors re-examine the Plan’s core proposal: to require all banks to hold cash reserves equivalent to 100% of the deposits of their customers. This is what is known as ‘100% Reserve Banking’, and its first intended effect, as the name suggests, is to eliminate the kind of ‘runs’ on banks we saw in Britain, in 2007, in the case of Northern Rock. For if depositors know that, by law, all banks always have to hold enough money to cover 100% of possible withdrawals, in principle at least, they would no longer have reason to fear that, should their own bank come under pressure, it could run out of funds before they can get their own money out. This in turn, therefore, should make people less inclined to take the kind of action which, in the past, has so often made the prospect of a bank running out of money a self-fulfilling prophesy.
What makes the Chicago Plan more than just a form of protection for depositors, however, is that, in order to achieve this first objective, it also requires that a currency’s monetary base – the money issued by a country’s central bank – should become 100% of the country’s money supply: something which, as I pointed in ‘The Limitations & Dangers of Quantitative Easing’, is far from being the way things stand at present. Indeed, the amount of monetary base currently provided by most central banks – the amount of money that can actually be represented as cash – is usually only about 3% of the total money in circulation, the rest being created by the banking system itself.
To understand how this happens, consider the set of very typical banking transactions outlined in Figure 1.
Figure 1: Buying A House
Here, Person A is buying a house from Person B. To do this, he borrows £100,000 in the form of a mortgage from Bank A. Ignoring the fact that, in reality, each of these transactions would take place within the banking system and that no actual money would change hands, Person A then pays this £100,000 to Person B in exchange for the deeds to the property. Person B then deposits the £100,000 in his account in Bank B, while, in order to cover the mortgage, Bank A simultaneously borrows £100,000 from Bank in B, thereby completing the circle.
Without any real money previously existing, the banking system itself thus creates £100,000. We can see this on the balance sheets of the two banks. On the balance sheet of Bank A, there is now a debtor account of £100,000 representing the mortgage and a creditor account of £100,000 representing the Inter-bank Loan. On the balance sheet of Bank B, there is a corresponding debtor account of £100,000 for the Inter-bank Loan and a creditor account of £100,000 in the form of a deposit. Moreover, both banks make a profit on this arrangement. Bank A charges Person A 5% on the mortgage while paying 3% on the Inter-Bank Loan, thus making a net profit of 2%. Bank B makes the same 3% on the Inter- Bank Loan while paying Person B just 1% on his deposit, thus also making a net profit of 2%. And all this on money that didn’t exist prior to the transaction itself.
100% Reserve Banking not only makes this illegal, it makes it impossible. For in order to hold cash reserves equal to 100% of its deposits, Bank B actually has to receive £100,000 in cash from Bank A at the point at which Person B pays the money into his account. This means that Bank A must first have this money before it can grant Person A a mortgage. In this way, the Chicago Plan thus effectively stops banks from creating money.
More importantly, it gives them no reason to encourage people to take out mortgages or loans they can’t afford, simply to go on generating and making profits from inflated and somewhat chimerical assets which then suddenly turn into dust once the bubble bursts and the debts have to be written off. Unlike Gordon Brown’s much vaunted and repeated claims of ‘fiscal prudence’, the Chicago Plan thus really does put an end to ‘boom and bust'.
Not that it’s quite that simple, of course. For there is, as you’ve very probably noticed, one fairly obvious flaw to the Plan thus far. For given that, at present, the monetary base in most countries is only 3% of the money supply, were we to prevent banks from creating additional money through financial transactions without providing some alternative form of supply, it wouldn’t take too long before there wouldn’t be enough money in circulation to do all the things we need to do with it.
This, however, is where the Chicago Plan gets really radical. For it proposes that central banks should, themselves, actually create more money. A lot more! The whole of the other 97%, in fact.
‘But what about inflation?’ you ask. After all, we all know that the phenomenon of central banks printing too much money is one of its primary causes. In ‘The Limitations & Dangers of QuantitativeEasing’, I myself warn that by increasing the monetary base through QE, governments run the risk of starting inflationary cycles once the economy picks up again.
This can only happen, however, if banks are allowed to multiply the monetary base through their transaction flows. Under the Chicago Plan, they are not.
‘But what about this massive new injection of cash itself? Won’t that cause inflation?’ After all, in issuing new cash equivalent to 97% of the current money supply, one is more or less doubling the amount money in circulation.
But this is where the Chicago Plan gets even more radical. For it stipulates that this increase in the monetary base be used to buy up the country’s existing debt. And by this, I don’t just mean government bonds, but private debt as well. Nearly all of it, in fact – every mortgage; every private loan; every credit card balance – so that by the end of the process, the only debts still outstanding are certain categories of investment loan sufficient to keep the banks earning enough interest to make a profit. Instead of adding to the money supply, the new money issued by the central bank thus replaces the old money previously generated by bank lending. More to the point, the debt which currently balances customer deposits on bank balance sheets, is replaced by cash, thereby taking us close to the objective of a 100% cash reserve.
The resulting transformation of bank balance sheets is as shown in Figure 2, which is a slightly simplified version of the model presented by Benes and Kumhof in their IMF paper. The figures represent percentages of US GDP.
Figure 2: Transformation of Bank Balance Sheets under the Chicago Plan
The first two things one will probably notice about the above table are:
a) That the post-transition balance sheet is significantly larger than the pre-transition balance sheet, and
b) That a new category of creditor account has been inserted in the form of Central Bank Credits (CBCs), which is to say loans from the central bank.
This transitional structure is required because, under the new system, in which cash reserves must always be equivalent to customer deposits, banks will not be allowed to use these deposits to fund loans. Without some other form of finance, therefore, all loans would have to be funded out of the bank’s own equity, which, in most cases, would not be enough to generate sufficient interest to cover the bank’s operating costs, let alone make a profit. Under the Plan, it is therefore proposed that the central bank make interest free loans available to banks, both to ensure bank profitability, and to bring the banks’ cash reserves up to 100% of customer deposits. This is achieved because the CBCs are, of course, provided in the form of real cash. Thus while the credits, themselves, are shown as balancing investment loans, the cash that comes with them is added to the cash proceeds from the sale of other debt to provide the full 100% Cash Reserve.
The CBCs also form the basis for further growth. For after the transition, the Central Bank would then issue further cash loans to banks as required. Unlike under the current system, however, this would not be unfettered. The amount of additional money supplied to the banks each year would be strictly controlled, both to prevent inflation and to prevent the banks, themselves, from engineering another artificial boom. To customers seeking loans and mortgages, however, the system should appear no different from what it does today. While the banks would not be issued with enough money to extend mortgages to people who can’t afford them, there would still be enough flexibility in the money supply to meet legitimate demand.
The only question that remains, therefore, is what the central bank now does with all the loans and mortgages – not to mention Treasury Bonds – which it previously bought up and which it still has in its possession.
And here there are a number of options. The simplest, however, and the one originally proposed by the Chicago group, is what might now save us all from disaster. For it is that, in a one-off cleaning of the slate, all these old debts are simply written off. In one fell swoop, as a result, the entire mountain of debt which has been accumulating throughout most of the developed world for the last fifteen to twenty years, and which now threatens to bring the global economy crashing down around us, would simply disappear. Just like that!
So what’s the catch? Why haven’t we done it already?
The first, and I suppose greatest reason to be hesitant is that it is a massive leap of faith. Nobody has ever done this before. We therefore have no idea what all the implications are.
Consider, for instance, the position of savers. In the past, their money has been used to fund at least part of most banks’ lending. As a result, they in their turn have received interest for effectively lending their money to the bank. As already pointed out, however, under the new system, it will no longer be possible for banks to use customer deposits in this way. If the banks are no longer able to earn anything from them, however, not only is it very unlikely that they will be willing or able to pay interest on them, from a banking point of view, it is very difficult to see what use they are. They are simply liabilities. So what’s to stop banks from declining to hold customer deposits at all and concentrating purely on their loan business, using their own profits and CBCs for finance?
Indeed, I’ve been thinking about this problem for the last two weeks and the only measure I’ve come up with that would prevent banks from adopting just this policy is for the central bank to make its loans conditional on – and proportional to – the customer deposits of the receiving banks.
Forcing banks to maintain customer deposits in this way, however, will also force them to try to find ways of exploiting them. Of course, they will be able to charge deposit customers for normal banking services, such as standing orders and issuing cheques; but in a competitive market, these charges are hardly likely bring in very much, and even if they covered the cost of administering current accounts, it still wouldn’t solve the problem of providing some level of interest for savers. One possibility, therefore, is for banks to offer some form of investment account, in which previously unproductive deposits could be used to purchase a range of dividend-paying equities and bonds, on which savers could then make a return and on which the banks could also charge a commission.
This would not contravene the rules of 100% Reserve Banking in that, as long as they did not, in themselves, become tradable entities or near-monies, investment accounts, in which the purchased equities and bonds balanced customer funds, would not be counted in the same way as savings accounts in which cash has to balance customer deposits. Despite being inherently more risky, such investment accounts might even be better for savers than the kind of savings accounts and fixed term bonds which is all most banks offer them at present.
The problem, however, is that this is all just speculation. For we really don’t know how the new system will develop. Indeed, the only thing we can predict with any certainty is that it will throw up features which, today, no on could possibly predict.
That’s not to say, of course, that with respect to the Chicago Plan, itself, there aren’t at least two things of which we can be reasonably sure. The first is that this very uncertainty – regarding its implications – will be used by its opponents to ensure that it is never implemented. The second is that the number of these opponents will be legion, starting, of course, with the banks themselves. For in that the Chicago Plan effectively prevents banks from ‘creating’ money, should it ever be put into practice, it would clearly restrict the ways in which banks were able to ‘make’ money, thus rendering them far less profitable than they are at present. Bankers, far from being ‘masters of the universe’ would thus become mere service providers, a bit like the Post Office. And I can’t see many of them going for that.
Then there are the right wing political parties, such as the US Republican Party and the UK Conservative Party, which adherents of the left automatically assume are tied and beholden to moneyed interests. Whether or not this is true – and their response to the Chicago Plan may well be indicative in this respect – it is certainly the case that there will be those among their ranks who will view such state interference in the banking system as ideologically suspect. If it were ever proposed in the US, for instance, I would expect members of the Republican Party to claim that it was unconstitutional and to oppose it all the way to the Supreme Court.
Not that parties of the right are likely to be the only political opponents. Left wing parties, wedded to Keynesian solutions, which allow them to pump money into social programmes, not of course as bribes to the electorate but as ways of stimulating the economy, may well find that the rather limited annual increases in the money supply, imposed upon them by the central bank, enforce a fiscal discipline which they may well regard as politically unacceptable. It will certainly limit what they are able to promise voters at elections.
With the banks and both ends of the political spectrum thus likely to oppose it, the chances of any government implementing the Chicago Plan any time soon are therefore rather slim. My guess is that we’d have to get pretty close to the brink before any government even considered it, and even then they’d probably try to temper it in ways that would totally defeat its object. For that’s the nature of both politics and politicians.
In my view, however, the ideas at the heart of Chicago Plan deserve real consideration. I am not saying that, as it stands, it is definitely the answer. Even less am I saying that it is the only answer. What is important, however, is that we don’t just blindly walk into the next crisis in the way we blindly walked into the crisis 2008. Nor should you assume that the politicians and their paid financial experts have got this covered. They didn’t see what was coming in 2008, and I don’t believe they see what’s coming now. Or, if they do, they’re floundering and are as much at a loss as to what to do next as everyone else. The important thing, therefore, is to bring this debate out into the open. And one way to do this is to look at proposals like the Chicago Plan, to examine and test them and see whether they really are possible solutions.
At present, however – in the UK at least – the only mainstream publication which has even taken note of the IMF Working Paper is the Daily Telegraph (see ‘The IMF’s Epic Plan to Conjure Away Debt andDethrone Bankers’ by Ambrose Evans-Pritchard), and even here, as the title suggests, it is more sensationalised than explained. What we need, rather, is more informed debate, and for more people to get to know about it. If, after reading this, you therefore think that this is something we should be considering, and if, like me, you believe that the internet is possibly the one place left where ideas of this kind can gain currency and momentum, then perhaps you might pass the information on. And we’ll see where it takes us.