As one would assume, the time just following the Great Depression was one of great intellectual revolution in the field of economics. Just as economists today are studying to try to understand the causes and effects of the Great Recession, even proposing methods of possible prevention, so too were the economists in the decade after the Great Depression trying to analyze the faults of their economic system. A group of economists in the 1930s came up with a proposal for monetary reform with the intention to separate the monetary and credit functions of the banking system — a reform that some economists in 2012 are still calling for today. This proposal became known as the Chicago Plan. Henry Simons of the University of Chicago was the plan’s most aggressive supporter when the idea was first published. Later in 1936, the plan gained great momentum from Irving Fisher of Yale University, who collected the totality of information supporting the plan and wrote a single well-organized paper.
The Chicago Plan based its conclusions on two preceding transformations that would allow for the separation of the banking system’s credit and monetary functions. The first requires 100 percent backing of deposits by government-issued money. The second restricts banks from creating new deposits to finance new bank credit. Financing of new bank credit can be done through either borrowing from non-banks of present government-issued money or through earnings that have been reserved in the form of government-issued money. These two stipulations led the way for four key benefits Fisher projected, which now can be expanded to six as suggested by Jaromir Benes and Michael Kumhof. The six advantages are the likelihood of smoother business cycles, the elimination of bank runs, a huge decrease of public debt levels, a replacement of the aforementioned debt via debt-free government-issued money (reducing private debt levels), long-term output gains of around 10 percent, and the ability for steady state inflation to be zero while lacking the harms that trigger conduct of monetary policy.
The first advantage, respectively of the above-mentioned six, is the stabilization of business cycles through effective control. In the current U.S. financial system, it is the banks’ decision to supply deposits, which then influences the supply of the majority of our nation’s broad money. This control is important because the enthusiasm of banks to extend credit drives the entire nominal aggregate demand. This relationship is evident because bank loans are only given relative to bank deposits. And thus, credit booms and busts linked to the over- or undersupply of money are established simply by the collective banks’ temperament toward the economic forecast. However, under the Chicago Plan both the quantity of credit and the quantity of money would be controlled more efficiently because they would be controlled independently of each other. Banks would thus become complete intermediaries that must first receive outside funding before being able to lend. Money growth would merely be set by the Federal Reserve as a constant growth rate of the money supply independent of current economic fluctuations. So the gain received is the stabilization of business cycles, given that banks cannot any longer intensify these expansionary and contractive periods by their willingness to create credit.
The second benefit of the Chicago Plan is that bank runs would be eradicated. This is made possible by bank reserves being fully backed. This means that reserves of government-issued money are equal to that of the monetary liabilities of the banking system. However, another constraint must hold, which is that policy must dictate that the nonmonetary liabilities that fund the credit assets of the banking system cannot become near-monies. This condition along with the first, both given by the Chicago Plan, then protects the banking system from runs. The assurance and protection from bank runs grants the banks the ability to focus on their main function of lending, which improves financial stability at both the firm and aggregate levels.
The Chicago Plan’s third advantage is the large decline of public debt levels. This advantage is also made possible through full-reserve banking because banks must borrow treasury reserves in order to back their liabilities in full. Under the current system, outstanding U.S. Treasury liabilities are tremendously less than the current U.S. financial system’s (shadow banking included) outstanding liabilities. The current disparity is reconciled under the Chicago Plan, given that the government now acquires a gigantic amount of assets. Consequently, these assets will more than outweigh the government’s outstanding liabilities.
The fourth benefit presented in the Chicago Plan, which originates via the same mechanism that decreases public debt so dramatically, is the intense lessening of private debt. So from the above, the government’s net debt position is enormously negative, and accordingly the government can now hold this large asset and become a big lender to the private sector. However, this action isn’t the most efficient, given the alternative is a vast reduction of the private debt. The private debt is reduced when the government uses its newly acquired fortune to buy debt from the banks. By replacing the banking system’s liabilities with debt-free government-issued money, public debt is first directly diminished followed by the reduction of private debt through a government debt buyback program.
The fifth advantage, like the sixth, was discovered after general equilibrium analysis conducted by Benes and Kumhof. It shows that the Chicago Plan produces longer-term output gains approaching 10 percent. Three reasons have been given for the observed increase in output. The first reason is big decreases of real interest rates, which occur when investors demand lower differences in yield on private and government debt given the lesser levels of net debt. The second reason that long-term output increases 10 percent from the results of this monetary reform is because tax rates become less likely to discourage economically desirable behaviors. The third and last reason is that money no longer needs to be inefficiently allocated to the monitoring and directing of credit to control the money supply, thus freeing these scarce resources to be used more advantageously.
The sixth and final benefit is that the steady state inflation can become zero without generating any evils necessary for monetary policy action. Liquidity traps simply do not exist under the Chicago Plan’s monetary reform. Broad money is no longer attached to banks’ lending but rather can be directly enlarged by a policymaker. Also, steady state inflation can even become negative without creating any real complications. The reason is because the interest rate on treasury credit is simply a borrowing rate that banks will use when funding particular investment projects, and thus it will not be seen by asset investors as an opportunity cost of money.