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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 60 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 50% 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 30%, 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.
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 2% 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/barrel in August 2007 to $147/barrel in July 2008 and plummeted to below US$100/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.