The End of Credit as We Know It?

Written by Bradley G. Lewis

Background

Jaromir Benes and Michael Kumhof have an IMF (International Monetary Fund) working paper “The Chicago Plan Revisited” which analyzes a plan for banking that was under discussion in one form or another from the time that it was proposed by Henry Simons in the early years of the Great Depression and strongly supported by Irving Fisher (1936), until the modern monetary school at the University of Chicago became largely aligned with Milton Friedman in the latter years of the twentieth century.

The essence of the “old” Chicago Plan is summarized in the Introduction of Benes and Kumhof which contains this:

The key feature of this plan was that it called for the separation of the monetary and credit functions of the banking system, first by requiring 100% backing of deposits by government-issued money, and second by ensuring that the financing of new bank credit can only take place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks, but not through the creation of new deposits, ex nihilo, by banks.

The conclusions Fisher paper in 1936 are summarized by Benes and Kumhof as follows:

Fisher (1936) claimed four major advantages for this plan. First, preventing banks from creating their own funds during credit booms, and then destroying these funds during subsequent contractions, would allow for a much better control of credit cycles, which were perceived to be the major source of business cycle fluctuations. Second, 100% reserve backing would completely eliminate bank runs. Third, 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 and to a dramatic reduction of (net) government debt, given that irredeemable government-issued money represents equity in the commonwealth rather than debt. Fourth, given that money creation would no longer require the simultaneous creation of mostly private debts on bank balance sheets, the economy could see a dramatic reduction not only of government debt but also of private debt levels.

Benes and Kumhof state that the assertions of Fisher are “self-evident” and that the “old” Chicago plan “represents a highly desirable policy.”  That is the starting point for this essay.

150 Years of History

The theory is coherent and, in one sense, we had it with the national banking system starting with the National Bank Act of 1863 (and subsequent amendments): national banks could issue bank notes to the extent that they bought, and held as 100% collateral, government bonds. It’s worth remembering the outcome of that. The national banks had relatively high capital requirements and, of course, were helping finance the Civil War effort. Part of the Act also taxed state bank notes (banknotes were issued by individual state banks), hoping to knock the state banks out of existence.

• We had a revolution in consumer credit that made it possible for the average person to buy a house and durable goods on time that I think had a lot to do with middle-class affluence. It would appear that the methods to be used to make the system safe might well roll back that entire movement. There is some soothing commentary on how the features of the system the authors propose would allow inter temporal smoothing, but I frankly doubt they’ve really done much here except ensure that a lot of ordinary people will have much less access to credit, even if they have good jobs. Could General Motors Acceptance Corporation have done business under the rules given here? (They borrowed cheaply in the commercial paper market and lent to customers and helped revolutionize the industry.) I’m skeptical.




• Of course, we could have the government supply all the credit, or arrange to guarantee it, and of course, we did have the Federal Home Loan Bank Board, the Federal land Bank and other institutions to ensure that there was lots of mortgage money; low-cost loans for rural electrification when the private sector found it inadequately profitable to string lines to farms; government provision of water and power at subsidized rates, especially in the West and South; and other programs that arguably had a lot to do with middle class affluence.

White, Eugene Nelson. “The Political Economy of Banking Regulation, 1864-1933.” Journal of Economic History 42, no. 1 (March 1982): 33-40.

Keehn, Richard H. “The Political Economy of Banking Regulation, 1864-1933: Discussion.” Journal of Economic History 42, no. 1 (March 1982): 41-42.

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About the Author

Brad Lewis is Professor of Economics at Union College in Schenectady, NY, where he teaches courses in financial markets and institutions, international trade and finance, monetary economics, and urban redevelopment. He has also held senior-level visiting positions for a term or more at Carleton College and Skidmore College in the United States and at Kansai Gaidai University in Japan. He is a long-time member of and has occasionally co-chaired the Columbia University Seminar in Economic History and is Vice Chair of the Schenectady (N.Y.) Metroplex Development Authority.
Curriculum Vitae.