Monday, October 22, 2012

Radical Monetary Reform

This is an interesting development - highly radical monetary reform proposals from two staff economists at the IMF. The often excitable Ambrose Evans-Pritchard writes about it in the Telegraph.

The IMF paper, which apparently came out in August, argues for a renewed look at a "Chicago Plan" which Irving Fisher put forward in 1936. It required 100% reserve backing for bank loans, thus eliminating the ability of banks to create credit. And that, IMF authors Benes and Kumhof argue, would eliminate much of the volatility of the business cycle, eliminate the possibility of bank runs, and dramatically reduce both public and private debts. It would not be inflationary, and it would boost output by 10%. They claim they can demonstrate this with a DGSE model in a way which Fisher never could.

This shows just how disillusioned the wider world has become with the banking and financial system. The IMF staff has always had some variety of viewpoints - and of course this is very strictly speaking the view of the authors, not the institution - but it is still hard to see the folks on 19th St NW producing something like this ten years ago.

Would it work? It essentially replaces a largely private money system with a 100% government money system. Fractional reserve banking means that right now a bank only has typically 5-10% of "money" - mostly central bank reserves - underpinning the rest of the asset side of the balance sheet, which is bank-created credit.

In our current system, a bank creates money by issuing a loan, and crediting the borrower with an offsetting deposit at the same time. ( eg if Citibank lends you $10,000, it has a $10,000 loan as its asset, and you have an additional $10,000 in your deposit account to spend). The proposal would stop banks creating money, because they could only re-loan reserves from the central bank.

The problem, of course, is that money systems can be too inflexible, too rigid as well as too volatile. This most often shows up in exchange rate policy. The gold standard had fixed exchange rates (but freer credit). However, it still forced international adjustment by inflation and deflation of the price level, because gold was the fundamental reserve asset, not central bank fiat money. "Ye shall not crucify mankind on a cross of gold", William Jennings Bryan famously said.The euro is a prime contemporary example of the problems monetary inflexibility can cause.

The "Chicago Plan" would require policymakers to carefully calibrate the supply of reserves, and if they did not there would be serious problems. Of course, many economists think rules rather than discretion is better for policy in any case, as the track record for discretionary monetary policy is mixed at best. So making policymakers stick to a rue or money growth might be a good thing.

The plan would not necessarily imply government would allocate loans , or choose specific winners and losers. Banks could still lend to whoever they wanted, but they could not create money at the same time. the lack of leverage would cripple bank profits, however.

There might be more role for equity based venture investors in such a system, offsetting some of the credit supply. And the reduction of government debt looks very attractive in current circumstances.

Patience with banks is wearing thin. Policymakers are clearly very frustrated that they are launching massive balance sheet expansions like QE3, but the transmission mechanism to convey that liquidity to the real economy seems to be blocked in the banking system. The banks generally claim that it is because there is less demand for loans, not their reluctance to lend. But whatever the cause, the Fed, BoE and others are not getting much traction. Cutting out the middleman becomes more attractive, at least in theory.

Clearly the financial system would fight this to the death, as it would remove most of the profits in the industry. But radical as it is, perhaps it deserves serious scrutiny as a plan - if only as a device to hold over the banks. Our system does seem to have an inherent bias and drift towards debt, both private and governmental.

Perhaps we need a better system of money creation calibrated to create flourishing in society rather than simply credit. The legitimacy of the current system has been shaken by the crisis, and much of the intellectual confidence of mainstream economics has been eclipsed. I'll read further reactions to the plan and examination of potential flaws with interest.



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