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WP/12/202The Chicago Plan RevisitedJaromir Benes and Michael Kumhof

International Monetary FundWP/12/202IMF Working PaperResearch DepartmentThe Chicago Plan RevisitedPrepared by Jaromir Benes and Michael KumhofAuthorized for distribution by Douglas LaxtonAugust This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily representthose of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and arepublished to elicit comments and to further debate.AbstractAt the height of the Great Depression a number of leading U.S. economists advanced aproposal for monetary reform that became known as the Chicago Plan. It envisaged theseparation of the monetary and credit functions of the banking system, by requiring 100%reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for thisplan: (1) Much better control of a major source of business cycle fluctuations, suddenincreases and contractions of bank credit and of the supply of bank-created money.(2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt.(4) Dramatic reduction of private debt, as money creation no longer requires simultaneousdebt creation. We study these claims by embedding a comprehensive and carefully calibratedmodel of the banking system in a DSGE model of the U.S. economy. We find support for allfour of Fisher's claims. Furthermore, output gains approach 10 percent, and steady stateinflation can drop to zero without posing problems for the conduct of monetary policy.JEL Classification Numbers: E44, E52, G21Keywords: Chicago Plan; Chicago School of Economics; 100% reserve banking; banklending; lending risk; private money creation; bank capital adequacy;government debt; private debt; boom-bust cycles.Authors’ E-Mail Addresses: ;

2ContentsI.Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4II.The Chicago Plan in the History of Monetary Thought . . . . . . . . . . . . .A. Government versus Private Control over Money Issuance . . . . . . . . .B. The Chicago Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .121217III.The Model under the Current Monetary SystemA. Banks . . . . . . . . . . . . . . . . . . . . .B. Lending Technologies . . . . . . . . . . . .C. Transactions Cost Technologies . . . . . .D. Equity Ownership and Dividends . . . . .E. Unconstrained Households . . . . . . . . .F. Constrained Households . . . . . . . . . . .G. Unions . . . . . . . . . . . . . . . . . . . .H. Manufacturers . . . . . . . . . . . . . . . .I. Capital Goods Producers . . . . . . . . . .J. Capital Investment Funds . . . . . . . . . .K. Government . . . . . . . . . . . . . . . . .1. Monetary Policy . . . . . . . . . . . .2. Prudential Policy . . . . . . . . . . .3. Fiscal Policy . . . . . . . . . . . . . .4. Government Budget Constraint . . .L. Market Clearing . . . . . . . . . . . . . . .IV.The Model under the Chicago Plan . . . .A. Banks . . . . . . . . . . . . . . . . . .B. Households . . . . . . . . . . . . . . .C. Manufacturers . . . . . . . . . . . . .D. Government . . . . . . . . . . . . . .1. Monetary Policy . . . . . . . . .2. Prudential Policy . . . . . . . .3. Fiscal Policy . . . . . . . . . . .4. Government Budget Constraint5. Controlling Boom-Bust Cycles -.2020242626272830303131323232323333. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Additional Considerations.33333637373739404142V.Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42VI.Transition to the Chicago Plan . . . . . . . . . . . . . . . . . . . . . . . . . . .49VII. Credit Booms and Busts Pre-Transition and Post-Transition . . . . . . . . . .52VIII. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .57

3Figures1.2.3.4.5.6.7.Changes in Bank Balance Sheet in Transition Period (percent of GDP) . . . .Changes in Government Balance Sheet in Transition Period (percent of GDP)Changes in Bank Balance Sheet - Details (percent of GDP) . . . . . . . . . .Transition to Chicago Plan - Bank Balance Sheets . . . . . . . . . . . . . . . .Transition to Chicago Plan - Main Macroeconomic Variables . . . . . . . . . .Transition to Chicago Plan - Fiscal Variables . . . . . . . . . . . . . . . . . .Business Cycle Properties Pre-Transition versus Post-Transition . . . . . . . .64656667686970

4I.IntroductionThe decade following the onset of the Great Depression was a time of great intellectualferment in economics, as the leading thinkers of the time tried to understand the apparentfailures of the existing economic system. This intellectual struggle extended to manydomains, but arguably the most important was the field of monetary economics, given thekey roles of private bank behavior and of central bank policies in triggering andprolonging the crisis.During this time a large number of leading U.S. macroeconomists supported afundamental proposal for monetary reform that later became known as the Chicago Plan,after its strongest proponent, professor Henry Simons of the University of Chicago. It wasalso supported, and brilliantly summarized, by Irving Fisher of Yale University, in Fisher(1936). The key feature of this plan was that it called for the separation of the monetaryand credit functions of the banking system, first by requiring 100% backing of deposits bygovernment-issued money, and second by ensuring that the financing of new bank creditcan only take place through earnings that have been retained in the form ofgovernment-issued money, or through the borrowing of existing government-issued moneyfrom non-banks, but not through the creation of new deposits, ex nihilo, by banks.Fisher (1936) claimed four major advantages for this plan. First, preventing banks fromcreating their own funds during credit booms, and then destroying these funds duringsubsequent contractions, would allow for a much better control of credit cycles, whichwere perceived to be the major source of business cycle fluctuations. Second, 100% reservebacking would completely eliminate bank runs. Third, allowing the government to issuemoney directly at zero interest, rather than borrowing that same money from banks atinterest, would lead to a reduction in the interest burden on government finances and to adramatic reduction of (net) government debt, given that irredeemable government-issuedmoney represents equity in the commonwealth rather than debt. Fourth, given thatmoney creation would no longer require the simultaneous creation of mostly private debtson bank balance sheets, the economy could see a dramatic reduction not only ofgovernment debt but also of private debt levels.We take it as self-evident that if these claims can be verified, the Chicago Plan wouldindeed represent a highly desirable policy. Profound thinkers like Fisher, and many of hismost illustrious peers, based their insights on historical experience and common sense, andwere hardly deterred by the fact that they might not have had complete economic modelsthat could formally derive the welfare gains of avoiding credit-driven boom-bust cycles,bank runs, and high debt levels. We do in fact believe that this made them better, notworse, thinkers about issues of the greatest importance for the common good. But we cansay more than this. The recent empirical evidence of Reinhart and Rogoff documents the high costs of boom-bust credit cycles and bank runs throughout history.And the recent empirical evidence of Schularick and Taylor is supportive of Fisher’sview that high debt levels are a very important predictor of major crises. The latterfinding is also consistent with the theoretical work of Kumhof and Rancière , whoshow how very high debt levels, such as those observed just prior to the Great Depressionand the Great Recession, can lead to a higher probability of financial and real crises.

5We now turn to a more detailed discussion of each of Fisher’s four claims concerning theadvantages of the Chicago Plan. This will set the stage for a first illustration of theimplied balance sheet changes, which will be provided in Figures 1 and 2.The first advantage of the Chicago Plan is that it permits much better control of whatFisher and many of his contemporaries perceived to be the major source of business cyclefluctuations, sudden increases and contractions of bank credit that are not necessarilydriven by the fundamentals of the real economy, but that themselves change thosefundamentals. In a financial system with little or no reserve backing for deposits, and withgovernment-issued cash having a very small role relative to bank deposits, the creation ofa nation’s broad monetary aggregates depends almost entirely on banks’ willingness tosupply deposits. Because additional bank deposits can only be created through additionalbank loans, sudden changes in the willingness of banks to extend credit must therefore notonly lead to credit booms or busts, but also to an instant excess or shortage of money, andtherefore of nominal aggregate demand. By contrast, under the Chicago Plan the quantityof money and the quantity of credit would become completely independent of each other.This would enable policy to control these two aggregates independently and thereforemore effectively. Money growth could be controlled directly via a money growth rule. Thecontrol of credit growth would become much more straightforward because banks wouldno longer be able, as they are today, to generate their own funding, deposits, in the act oflending, an extraordinary privilege that is not enjoyed by any other type of business.Rather, banks would become what many erroneously believe them to be today, pureintermediaries that depend on obtaining outside funding before being able to lend. Havingto obtain outside funding rather than being able to create it themselves would muchreduce the ability of banks to cause business cycles due to potentially capricious changesin their attitude towards credit risk.The second advantage of the Chicago Plan is that having fully reserve-backed bankdeposits would completely eliminate bank runs, thereby increasing financial stability, andallowing banks to concentrate on their core lending function without worrying aboutinstabilities originating on the liabilities side of their balance sheet. The elimination ofbank runs will be accomplished if two conditions hold. First, the banking system’smonetary liabilities must be fully backed by reserves of government-issued money, which isof course true under the Chicago Plan. Second, the banking system’s credit assets must befunded by non-monetary liabilities that are not subject to runs. This means that policyneeds to ensure that such liabilities cannot become near-monies. The literature of the1930s and 1940s discussed three institutional arrangements under which this can beaccomplished. The easiest is to require that banks fund all of their credit assets with acombination of equity and loans from the government treasury, and completely withoutprivate debt instruments. This is the core element of the version of the Chicago Planconsidered in this paper, because it has a number of advantages that go beyond decisivelypreventing the emergence of near-monies. By itself this would mean that there is nolending at all between private agents. However, this can be insufficient when private agentsexhibit highly heterogeneous initial debt levels. In that case the treasury loans solutioncan be accompanied by either one or both of the other two institutional arrangements.One is debt-based investment trusts that are true intermediaries, in that the trust canonly lend government-issued money to net borrowers after net savers have first depositedthese funds in exchange for debt instruments issued by the trust. But there is a risk that

6these debt instruments could themselves become near-monies unless there are strict andeffective regulations. This risk would be eliminated under the remaining alternative,investment trusts that are funded exclusively by net savers’ equity investments, with thefunds either lent to net borrowers, or invested as equity if this is feasible (it may not befeasible for household debtors). We will briefly return to the investment trust alternativesbelow, but they are not part of our formal analysis because our model does not featureheterogeneous debt levels within the four main groups of bank borrowers.The third advantage of the Chicago Plan is a dramatic reduction of (net) governmentdebt. The overall outstanding liabilities of today’s U.S. financial system, including theshadow banking system, are far larger than currently outstanding U.S. Treasury liabilities.Because under the Chicago Plan banks have to borrow reserves from the treasury to fullyback these large liabilities, the government acquires a very large asset vis-à-vis banks, andgovernment debt net of this asset becomes highly negative. Governments could leave theseparate gross positions outstanding, or they could buy back government bonds frombanks against the cancellation of treasury credit. Fisher had the second option in mind,based on the situation of the 1930s, when banks