Adair Turner's (unconvincing) criticisms of the Chicago Plan

Yesterday, I gave a massive thumbs up to Adair Turner's new book "Between Debt and the Devil: Money, Credit and Fixing Global Finance". But I did say that I found his arguments against banning money creation by commercial banks unconvincing. So, to be fair, I thought it would be worth looking at those arguments in detail. That way, you can make your own mind up.

Adair Turner starts with a very reasonable presentation of 100% Reserve Banking - The Chicago Plan.

"Henry Simons was one of the founding fathers of the Chicago school of economics, a strong believer in the virtues of capitalism and competition and of sound money with low inflation. But in 1933 he joined other economists in proposing to President Roosevelt "the Chicago plan" which would require all banks to operate with 100% reserves.

Under this plan, banks woudl hold money deposits for customers and make payments between accounts, but they would have no other economic function. All deposits in commercial banks would be matched by deposits at the central bank; the money supply would equal the monetary base; the "banking multiplier" through which banks create private money in addition to fiat money would be abolished. Debt contracts would still exist, but they would function outside the banking system, and lending would require the actual transfer of deposit money from the saver to the borrower. The ability of banks to create credit and money by simultaneously crediting and debiting a borrower's loan and deposit account would be eliminated.

In such a system, banks would no longer create new purchasing power. The question therefore arose, how (if at all) would an increase in nominal GDP be achieved? The answer proposed was through money creation by government fiat, with governments running each year small fiscal deficits funded not by bond issues but by the creation of pure fiat money.

Such fiat money creation was the only possible answer. But several of Chicago plan supporters believed it was also positively desirable. Irving Fisher believed that such an arrangement returned to the public authorities, and thus to the people in general, the economic benefit of new purchasing power creation, which under the fractional reserve system has been quite wrongly granted to private banks. He also saw a positive benefit in the fact that the government would be able to run small fiscal deficits without incurring debt interest expense. Milton Friedman supported the same position in a 1948 article, arguing that money-financed fiscal deficits were the best way to stimulate economies in deflationary times, and that appropriate targets could ensure that the size of the unfunded deficits was compatible with a desirable slow expansion of nominal GDP.

Viewing the disaster of 1929-1933, economists who were strongly committed both to free markets and sound money thus supported the radical combination of 100% reserve banks and money-financed deficits. The 2007-2008 crisis has illustrated yet again what harm private credit and money creation can wreak. So is it time to return to the radicalism of Irving Fisher, Henry Simons and the early Milton Friedman?

A recent IMF paper by Michale Kumhof and Jaromir Benes argues that we should, and sets out a detailed transition plan to achieve not only a 100% reserve system for the future but also a radical reduction in today's high level of private leverage. A thoughtful book by Andrew Jackson and Ben Dyson, Modernising Money. Why our Monetary System is Broken and How It Can Be Fixed, argue the same case."

It's looking extremely promising. So it's odd that Adair Turner then raises three reasons for caution and concludes that he is "therefore unconvinced that it is desirable or feasible to go all the way to 100% reserve banking".

Let's have a look to see whether his demolition job of the Chicago plan is convincing.

"The first and most fundamental is there may be some positive benefits to private rather than public creation of purchasing power [....] it could still be true that not only debt contracts but also banks can play a useful role in mobilizing capital investment that would not otherwise occur. " [my italics]

For me, this simply is not a strong argument. Commercial banks could perfectly well extend credit to businesses by simply accepting an IOU from that business. They don't need to create "real" money to do this. The fundamental problem with the current system is that when you or I, or a business, or our government goes to a bank and asks for a loan, there is absolutely no way to know whether the money the bank lends existed before, or whether it was just created out of thin air. For me, that is what needs to change.

"Second, we must be certainly be clear that 100% reserve banking will not be sufficient to solve the problem of excessive private credit creation. A modern economy needs some private debt contracts both to support the mobilization of capital investment and to lubricate the exchange of existing real estate between and within generations."

Again this is not a strong argument. There is absolutely no problem with people (and banks) making loans to other people with money that already exists. Nor is there a problem for someone to accept an IOU from someone who doesn't currently have any money - that is the basis of the OWE'M system that I have been proposing, and allows credit to be created by individuals.  The problem with the current system is that the difference between "real" money, and banks extending credit by accepting an IOU has been deliberately obscured. Banks are allowed to pretend that they are lending "real" pre-existing money, when in fact they are lending thin air.

"Third, the problems of transition from today's highly leveraged economies are significant. The plan outlined by Kumhof and Benes seeks not only to create 100% reserve banks but also to put right the problems of past excessive debt creation by writing off substantially all existing mortgage debt. Under this scheme the government would replace the mortgage debts currently sitting on bank balance with newly created money reserves. But this huge benefit to one group of citizens cannot be achieved without some offsetting loss to others: in economics there are rarely free lunches, at least on this scale."

Sorry, Adair. This is also extremely weak. There are countless ways that we could change the system without plumping for the precise proposal made by Kumhof and Benes. Here's one that I have been proposing. Use the €60 billion a month currently being created by Mario Draghi at the European Central Bank to pump up the financial markets to credit the accounts of the 330 million Eurozone citizens with €186 of debt-free money per month. Those citizens could use the money to pay off their debts, or spend the money into the economy. What's the problem with that??

So, there you have it. Do those three "reservations" really justify the persistence of a system that grants private bankers the right to lend money that they don't have, and charge interest on those loans? Not in my book.

When you consider that UK taxpayers have been paying an average of 4% of GDP every year since the creation of the Bank of England in 1694 in the form of interest payments on public sector debt, and that those payments have gone to bankers that didn't even have the money that they lent to the government, the arguments for maintaining the status quo have to be more solid.

It is not enough to say that "there may be some positive benefits of private [credit] creation", that "100% reserve banking will not be sufficient to solve the problem" and that there will be "problems of transition".

But Adair Turner's final comments on the Chicago plan make it clear that he himself thinks that the debate is still going. I quote:

"I am therefore unconvinced that it is desirable or feasible to go all the way to 100% reserve banking. But the reforms we do implement should reflect the underlying principles and insights that have motivated Chicago Plan supporters". 

And he makes it clear that he understands the fundamental difference between money and other aspects of the market economy.

"Money is different from other commodities, goods and services, and neither the economic nor the political arguments in favor of free markets apply to money. Entrepreneurs should be free to innovate iPads and new restaurant formats and new car designs, and myriad goods and services we cannot yet imagine, both because that will deliver economic benefits and because the freedom to innovate is in and of itself desirable. But creating credit and money is different...

Fisher and Simons were therefore convinced that to apply to banking the same free market principles which apply to goods and services markets was to make a category error. They were right. Credit markets raise issues of vital general public interest: free market approaches to them are simply not valid."

 Hear, hear!