(republished from “A View from the Trenches“)
Click here to read this article in pdf format:Â November 10 2012
On October 21st, 2012, Ambrose Evans-Pritchard wrote a note titled â€œIMF’s epic plan to conjure away debt and dethrone bankersâ€, on UKâ€™s The Telegraph. The article presented theÂ International Monetary Fundâ€™s working paper 12/202, also titled â€œThe Chicago Plan revisited“. I will begin the discussion on this working paper with two disclosures: a) my personal portfolio would profit immensely if the Chicago Plan, as presented by the IMFâ€™s working paper 12/202, was effectively carried out in the US. The reason I write today, however, is that to me, it is more important to ensure that my children live and grow in a free and prosperous world, and b) I have not read the so called Chicago Plan, as originally proposed by H. Simmons and supported by I. Fisher. My comments are on what the IMF working paper tells us that the Chicago Plan proposed, without making any claim on the original plan.
According to the authors of the IMF working paper 12/202, Jaromir Benes & Michael Kumhof (from now on,Â the authors), the key feature of the plan was the separation of the monetary and credit functions of the banking system. This would be achieved by the requirement that deposits be 100% backed by government-issued money. This, according to the authors would be desirable (â€œâ€¦.we take it as self-evident that if these claims can be verified, the Chicago Plan would indeed represent a highly desirable policyâ€¦â€Â (p. 4)
Using charts republished from Laura Davidsonâ€™s â€œThe causes of price inflation and deflationâ€ (2011), what the authors suggest is a transition from here:
This charts are different from the ones presented by the authors: We include the money stock in our discussion and do not show Treasuries as an asset of the banks. They can be included as loans either from time deposits or from demand deposits. Below, I present the consolidated balance sheets represented in the first chart. On the asset side of the consolidated balance sheet of the Banks, we now add Treasuries, to be in line with the argument of the authors:
The authors propose that the following steps (shown below) to achieve the transition, be taken simultaneously, in one single act.
In stage 1,Â â€œâ€¦banks have to borrow from the Treasury to procure the reserves necessary to fully back depositsâ€¦â€ (p. 7). I will call this Treasury credit, â€œGovt creditâ€. As you can see in the chart above, the â€œGovt creditâ€ is created ex-nihilo (an asset of the Government) and is coercively used to â€œpurchaseâ€ the Loans made from Demand deposits and Treasuries. These latter two were an asset of the banks.
In stage 2, the banks simply have a change in the composition of their assets: Govt credit is credited, Loans made from Demand deposits and Treasuries are debited. The principal of all Treasury debt owned by the private sector and loans from demand deposits is cancelled against Govt credit. â€œâ€¦For government debt, the cancellation is direct, while for private debt the government transfers credit balances (Govt credit) to restricted private accountsÂ that can only be used for the purpose of repaying outstanding bank loansâ€¦â€(p. 7).
In stage 3, :â€¦Â Banks pay out part of their equity to keep their net worth in line with now much reduced official capital adequacy requirementsâ€¦â€ (p. 7 )My note: Bankers off course pay themselves with reserves, rather than Govt credit!
At the end of the experiment, this is how the consolidated balance sheets would look like:
Unlike me, the authors omitted two magnitudes: cash outside banks (i.e. currency) and bank reserves held at the central bank. In other words, the authors omitted to include what is called â€œmoney stockâ€ (see our charts above). Why? â€œâ€¦because it is privately created deposit money that plays the central role in the current US monetary system, while government-issued money plays a quantitatively and conceptually negligible roleâ€¦â€Â (p. 10).
The authors find thatÂ â€œâ€¦the government is left with a much lower, in fact, negative, net debt burden. It gains a large net equity position due to money issuance, despite the fact that it spends a large share of the one-off seigniorage gains from money issuance on the buy-back of private debtsâ€¦â€(p. 8 )
The authors will point to the Figures 1 & 2 on pages 64 and 65, to question my position. They will say that â€œGovt creditâ€, an asset of the banks, should be shown as â€œreservesâ€ as they did. Indeed, not only do they show it so, but also show the banks still liable to the government. This is because they really believe that by coercing banks to borrow from the government and apply that borrowing to assets with less liquidity than the money stock (i.e. assets â€œâ€¦that can only be used for the purpose of repaying outstanding bank loansâ€¦â€)Â they will have created money, pari passu with the money stock (i.e. cash outside banks and bank reserves)Â and the public will look the other way and accept it. But thatâ€™s their assumption. It’s flawed. Itâ€™s wishful thinking. The fact is that the money stock they omit exists and the public knows it!
Observations on the Plan
Letâ€™s begin calling things by their name: If a government seizes loans overnight, which belongs to the banks, in exchange of unilaterally imposed â€œcreditâ€, we are in the face of a confiscation! Plain and simple confiscation!Â Credit can never be declared unilaterally! Credit is willingly an agreement â€œinter parsâ€.Â
If the plan was implemented as above, two immediate results would yield:
The first result would be that depositors, bondholders and shareholders would find that they now own an asset that they cannot value, which the government has coercively priced against their new â€œgovernment creditâ€. The natural reaction would be to run for the exits, selling the â€œGovt creditâ€ below par, against the money stock (i.e. cash outside banks and bank reserves), which of course, the authors have carefully omitted because itâ€™s â€œnegligibleâ€!
The second result is that the â€œgovernment creditâ€, regardless of how the authors want to call it, will NEVER be treated as money, as they wish, generating a negative debt burden. Why? Because the authors have told us that this credit â€œâ€¦can only be used for the purpose of repaying outstanding bank loansâ€¦â€!!!!
The authors seem to have forgotten a key rule from economics: Whenever one asset (i.e. same risk) has two different prices, thereâ€™s arbitrage, or its derivative version: whenever two assets (i.e. different risk) have the same price, there is arbitrage. Greshamâ€™s law is an example of this derivative version, when the affected assets are legal tender. Indeed, if the government declares at par both the legal tender (i.e. money stock or cash outside banks plus bank reserves) and a new government credit thatÂ can only be used for the purpose of repaying outstanding bank loans,Â individuals will simply dump the latter at a discount, to obtain the former. THE BANK RUN WILL OCCUR!
A historical example: The Bonex Plan of 1989
Benes and Kumhoff share Alexander Del Marâ€™s observation thatÂ â€œâ€¦as a general rule, political economists do not take the trouble to study the history of moneyâ€¦â€ (p. 12). Unfortunately, I think Benes and Kumhoff themselves fell prey to the same mistake, because the seizure of assets from the banks, although in exchange of government debt â€“not credit- did actually occur in 1989 in Argentina, under the so called Bonex Plan (Bonex = Bonos externos).
This confiscation was even friendlier than the proposed by the authors, because the government continued to recognize its liabilities (i.e. Bonex bonds) and also paid a coupon on them. The Bonex/89 were fully repaid in 1999.
Below, I offer you the evidence of this example: Minister of Finance, Antonio ErnÃ¡n Gonzalez himself, declaring the confiscation (minute 2:22 of the video):
English transcript:Â â€œâ€¦For this reason, and understanding that the best way to preserve not just the savings that stem from the work and savings of the people but also the totally legitimate property rights of the holders of guaranteed investment certificates, we have decided their mandatory repayment in Bonex series 1989â€¦â€
I think the authors are correct in stating that the money stock, relatively speaking, is negligible in the system. Therefore, when the Bonex Plan was announced, the bank run that ensued had depositors claim their government bonds, sell them at a discount to obtain cash outside banks and, with that cash, buy US dollars. The demand for the â€œnegligibleâ€ cash outside banks and the flight from anything related to the local currency were so strong, that by November 1990, the government was printing 100,000 and 500,000 Australes bills, but because the printing presses could not cope up with the inflation, the government had to stamp old pesos bills, to supply the market with Australes bills. Below is the picture of a 10 Australes bill, which had to be stamped on an old $10,000 pesos bill:
The Bonex Plan was announced in December of 1989. At that time, 1,950 Australes were needed to purchase 1 USD. A year later, by the time the government had to unwind the central bank and resort to a currency board fully backing the Australes with US dollars, 10,000 Australes were needed to buy 1 US dollar.
More recent examples
Another example of the reaction of market participants when the assets of the banks are affected is that of the Euro zone banking system in the periphery. In anticipation of theÂ re-denominationÂ in local currency of the bankâ€™s assets, depositors have fled to other jurisdictions within the Euro zone (i.e. to the core of the Euro zone) and not only has the money stock contracted in those countries, forcing the ECB to intervene, but also, credit and production have decreased meaningfully.Â
On the proposed advantages of the Chicago Plan
Even with substantial historical evidence available, the authors still remind us thatÂ Irving Fisher thought this transfer of wealth from the private sector to the public sector had four advantages:
TheÂ first advantageÂ is that the Plan supposedly allows a better control of the volatility in bank credit and avoids business cycles. The quantity of money (i.e. Reserves + currency) and the quantity of credit (i.e. Time deposits) would be independent of each other.
This is completely mistaken, because there will not be any credit available, should the Plan be implemented. Once the confiscation is in place,Â why would the owners of time deposits renew them at maturity?Â If, for any reason, they need to redeem their interest-bearing deposits, they may be required to leave the funds in chequing accounts that could only be used to repay private debt outstanding with the government. Depositors would only renew their deposits at maturity if the interest rate payable on the deposits compensates for the potential discount they may suffer, if they want to liquidate the assets and obtain currency. The recent developments in the periphery of the Euro zone and the Target 2 imbalances vastly illustrate this point.
Furthermore, in a context of high inflation, and we cannot reject the possibility of seeing this Plan proposed in such context, the central bank would even lose control of the quantity of money, because in order to keep the system liquid (in the face of the arbitrage between money stock and Govt credit as well as the non-renewal of interest-bearing deposits), they would either have to buy Treasuries (i.e. quantitative easing) or pay a subsidy on interest-bearing deposits, for the banking system to afford attracting deposits. Argentina faced this dilemma in 1976-77 and chose to subsidize interest-bearing deposits (ref.Â Bill No. 21,572, article 3). The quasi fiscal deficit this situation triggered set the ground for the hyperinflation of 1985. Needless to add, that in this context, volatility spikes, opposite to what the authors suggest.
TheÂ second advantageÂ the authors mention isÂ â€œâ€¦that having fully reserve-backed bank deposits would completely eliminate bank runs, thereby increasing financial stability, and allowing banks to concentrate on their core lending functionâ€¦â€(p. 5)
It is correct to state that with fully reserved-backed bank deposits, bank runs are eliminated. But the Plan does not propose to do this. The Plan does not propose to back deposits with reserves. The Plan proposes to back deposits with â€œGovt creditâ€,Â and force the banks and the public to believe that this Govt credit can be treated just like regular reserves;Â like a component of the money stock before the Plan was implemented. This is incorrect. The authors clearly sustain that these new reserves â€œâ€¦can only be used for the purpose of repaying outstanding bank loansâ€¦â€Â (p. 7). Therefore, financial stability is anything but guaranteed. In fact, the opposite will follow. As the capitalization of banks begins to crumble, because both the quality of the reserves and the availability of long-term funding is questioned, banks will be less able to concentrate on lending, becoming more dependent of the government. This is a story all too familiar and I think there is no need to add more examples.
TheÂ third advantageÂ is â€œâ€¦a dramatic reduction of (net) government debt. The overall outstanding liabilities of todayâ€™s U.S. financial system, including the shadow banking system, are far larger than currently outstanding U.S. Treasury liabilities. Because (â€¦) banks have to borrow reserves from the treasury to fully back these large liabilities, the government acquires a very large asset vis-Ã -vis banks, and government debt net of this asset becomes highly negativeâ€¦.â€ (p. 6)
I think the paragraph above is the confession, of two points: (a) that the whole plan is a confiscation in disguise. By reduction to the absurd, it would seem that the bigger the shadow banking system, the better results one gets, from it; and (b)Â that the authors seriously ignore how the shadow banking system in the USD zone works.
The first point is self-explanatory. With regards to the second, the authors should know that to include the shadow banking system of the USD zone is totally unfeasible. With the USD as the worldâ€™s reserve currency, the players in theÂ inter-bankÂ unsecured funding market, the money markets and repo markets are global!
Did the authors really think that the US government can innocuously take possession ofÂ inter-bankÂ loans made to foreign institutions, commercial paper or Yankee bonds (for instance, USD denominated bonds issued by European corporations)? The consequences of such idiocy would be unimaginable! Even worseâ€¦Did the authors think that such a move could be carried out overnight, surprising everyone? Thatâ€™s naiveness of the first order! The mere suspicion that such a possibility is in the cards would trigger a sell off worse than a Lehman moment and the Fed would be forced to confirm currency (i.e. USD) swaps with every central bank in the world. The US would lose their privilege as the issuer of the worldâ€™s reserve currency and the US Treasuries held as reserves by central banks would be written off by the market, unleashing horrible movements in the (cross)foreign exchange markets, as the market reassesses the relative value of fiat currencies against gold. The end result would be a failed move by the government and higher interest rates to pay. In other words, the burden of the debt would increase.
In countries like Argentina, where by the time such confiscation was implemented, the quasi fiscal deficit incurred by the central bank to fix this mess ended upÂ constituting 80% of the consolidated deficit of the government. And it is quasi fiscal deficits that trigger hyperinflations, not primary fiscal deficits.
â€œâ€¦TheÂ fourth advantageÂ of the Chicago Plan is the potential for a dramatic reduction of private debts. As mentioned above, full reserve backing by itself would generate a highly negative net government debt position. Instead of leaving this in place and becoming a large net lender to the private sector, the government has the option of spending part of the windfall by buying back large amounts of private debt from banks against the cancellation of treasury creditâ€¦â€ (p. 6)
I think that in light of my comments on the three previously suggested advantages, it is clear now that a net government debt position would be impossible to achieve.
THE FOLLOWING ARE ADDITIONAL OBSERVATIONS ON THE FORMAT OF THEÂ ANALYSISÂ AND THE UNDERLYING ASSUMPTIONS OF THE AUTHORS, NOT ON THE PROPOSED PLAN. IF YOU ARE STILL INTERESTED IN THESE OBSERVATIONS, PLEASE CONTINUE READING.
On the format of the message (i.e. the IMF working paper)
After reading the IMF working paper 12/202 , I observe two issues that I think are bad form for the discussion. The first one is the careless references to sources made by the authors, lacking actual quotes, on critical issues. But that, I acknowledge, is simple personal taste. Rather than reading sentences like:Â â€œâ€¦we find supportive statements from bankers arguing that the conversion to 100% reserve backing would be a simple matter. Friedman (1960) expresses the same viewâ€¦â€ on page 18, I think the authors should present the exact quote proving such critical statements by Milton Friedman, in this case.
The second observation on form is the authorsâ€™ careless use of a general equilibrium model, the assumption of steady states and the use of continuous functions to analyze the impact of a confiscation, which by nature, is traumatic. Continuous functions are for analyzing small changes and this is no small change at all! To think in terms of equilibrium in a system based on a Ponzi scheme, where banks are levered, is also completely naÃ¯ve.
On the authorsâ€™ understanding of money
I was surprised by the authorsâ€™ lack of understanding of financial markets. Unfortunately, their ignorance on this topic is surpassed by two serious confusions, namely, on money vs. credit and capital and on money itself.
The authors continuously confuse money with credit. Here is an example: â€œâ€¦The ï¬rst form of usury is the private appropriation of the convenience yield of a societyâ€™s money. Private money has to be borrowed into existence at a positive interest rate, while the holders of that money, due to theÂ non-pecuniary beneï¬ts of its liquidity, are content to receive no or very low interestâ€¦â€(p. 13). And even if this was trueâ€¦.why would the government monopolize the appropriation of the convenience yield, rather than allow free competition to bid for it and in the process, lower it?
Another confusing statement:â€œâ€¦Therefore, while part of the interest diï¬€erence between lending rates and rates on money is due to a lending risk premium, another large part is due to the beneï¬ts of the liquidity services of moneyâ€¦â€œ (p. 13). I confess, this is the first time someone tells me that there is an interest rate attached to money, the medium of indirect exchange. It is clear to me that the authors cannot distinguish capital from money.
More evidence that the authors confuse credit with moneyÂ â€œâ€¦This diï¬€erence is privately appropriated by the small group that owns the privilege to privately create money. This is a privilege that, due to its enormous beneï¬ts, is often originally acquired as a result of intense rent-seeking behavior. Zarlenga (2002) documents this for multiple historical episodesâ€¦â€ (p. 13).
â€œâ€¦The second form of usury is theÂ abilityÂ of private creators of money to manipulate the money supply to their beneï¬t, by creating an abundance of creditÂ and thus moneyÂ at times of economic expansion and thus high goods prices, followed by a contraction of creditÂ and thus moneyÂ at times of economic contraction and thus low goods pricesâ€¦â€ One could easily challenge the authors, by reduction to the absurd, with this question: If private creators of money indeed have this ability to manipulate the money supply and creditâ€¦Why do we need central banks? Why do we need lenders of last resort?
But what is the origin of this confusion? The authors donâ€™t even understand what money is. On page 10, the authors tell us that:Â â€œâ€¦It should be mentioned that both private and government-issued monies are fiat monies, because the acceptability of bank deposits for commercial and official transactions has had to first be decreed by law. As we will argue in section II, virtually all monies throughout history, including precious metals, have derived most or all of their value from government fiat rather than from their intrinsic valueâ€¦â€
This claim is not new. Ludwig Von Mises knew about this twisted interpretation of money and properly devoted it a complete chapter (Chapter three: â€œThe Role of Courts and Judgesâ€) in his book Â â€œOn Money and Inflation: A synthesis of several lecturesâ€. It is too long for me to include here, but I strongly recommend going through this impressive chapter. Another question to the authors on this ridiculous statement should clarify my point: If money always derived its value from government fiat, rather than their intrinsic valueâ€¦why did all coin (i.e. metallic) debasements in the history of mankind always end in inflationary processes?
As I finish these comments, I remember Von Mises’ claim that the history of money is identical to the history of government attempts to destroy moneyâ€¦