Gavin R. Putland,  BE PhD

Sunday, November 25, 2012

(Comment)

How inflationary is government-issued money?

Here are some excerpts from sections I and II of J. Benes and M. Kumhof, The Chicago Plan Revisited, IMF Working Paper No.12/202, August 2012.*

The decade following the onset of the Great Depression was a time of great intellectual ferment in economics...

During this time a large number of leading U.S. macroeconomists supported a fundamental proposal for monetary reform that later became known as the Chicago Plan... The key feature of this plan was that it called for the separation of the monetary and credit functions of the banking system, first by requiring 100% backing of deposits by government-issued money, and second by ensuring that the financing of new bank credit can only take place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks, but not through the creation of new deposits, ex nihilo, by banks...

In a financial system with little or no reserve backing for deposits, and with government-issued cash having a very small role relative to bank deposits, the creation of a nation's broad monetary aggregates depends almost entirely on banks' willingness to supply deposits. Because additional bank deposits can only be created through additional bank loans, sudden changes in the willingness of banks to extend credit must therefore not only lead to credit booms or busts, but also to an instant excess or shortage of money, and therefore of nominal aggregate demand. By contrast, under the Chicago Plan the quantity of money and the quantity of credit would become completely independent of each other. This would enable policy to control these two aggregates independently and therefore more effectively. Money growth could be controlled directly via a money growth rule. The control of credit growth would become much more straightforward because banks would no longer be able, as they are today, to generate their own funding, deposits, in the act of lending, 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, pure intermediaries that depend on obtaining outside funding before being able to lend...

The implementation of the plan is assumed to take place in one transition period, which can be broken into two separate stages. First,... banks have to borrow from the treasury to procure the reserves necessary to fully back their deposits... Second,... the principal of all bank loans to the government... and of all bank loans to the private sector except investment loans... is cancelled against treasury credit. For government debt the cancellation is direct, while for private debt the government transfers treasury credit balances to restricted private accounts that can only be used for the purpose of repaying outstanding bank loans. Furthermore, banks pay out part of their equity to keep their net worth in line with now much reduced official capital adequacy requirements, with the government making up the difference... by injecting additional treasury credit... Money remains nearly unchanged, but it is now fully backed by reserves...

Bank runs are obviously impossible in this world...

[S]teady state inflation can drop to zero without posing problems for the conduct of monetary policy. The reason is that the separation of the money and credit functions of the banking system allows the government to effectively control multiple policy instruments, including a nominal money growth rule that regulates the money supply, a Basel-III-style countercyclical bank capital adequacy rule that controls the quantity of bank lending, and finally an interest rate rule that controls the price of government credit to banks... And... because the interest rate on treasury credit is not an opportunity cost of money for asset investors, but rather a borrowing rate for a credit facility that is only accessible to banks for the specific purpose of funding physical investment projects, it can become negative without any practical problems. In other words, a zero lower bound does not apply to this rate, which makes it feasible to keep steady state inflation at zero without worrying about the fact that nominal policy rates are in that case more likely to reach zero or negative values.

The ability to live with significantly lower steady state inflation also answers the somewhat confused claim of opponents of an exclusive government monopoly on money issuance, namely that such a system, and especially the initial injection of new government-issued money, would be highly inflationary. There is nothing in our theory that supports this claim. And as we will see..., there is also virtually nothing in the monetary history of ancient societies and of Western nations that supports this claim...

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..., virtually all monies throughout history, including precious metals, have derived most or all of their value from government fiat rather than from their intrinsic value...

Bank reserves held at the central bank have also generally been negligible in size, except of course after the onset of the 2008 financial crisis. But this quantitative point is far less important than the recognition that they do not play any meaningful role in the determination of wider monetary aggregates. The reason is that the “deposit multiplier” of the undergraduate economics textbook, where monetary aggregates are created at the initiative of the central bank, through an initial injection of high-powered money into the banking system that gets multiplied through bank lending, turns the actual operation of the monetary transmission mechanism on its head. This should be absolutely clear under the current inflation targeting regime, where the central bank controls an interest rate and must be willing to supply as many reserves as banks demand at that rate. But as shown by Kydland and Prescott (1990), the availability of central bank reserves did not even constrain banks during the period, in the 1970s and 1980s, when the central bank did in fact officially target monetary aggregates. These authors show that broad monetary aggregates, which are driven by banks' lending decisions, led the economic cycle, while narrow monetary aggregates, most importantly reserves, lagged the cycle. In other words, at all times, when banks ask for reserves, the central bank obliges. Reserves therefore impose no constraint. The deposit multiplier is simply, in the words of Kydland and Prescott (1990), a myth.¹⁰ And because of this, private banks are almost fully in control of the money creation process...

There is another issue that tends to get confused with the much more fundamental debate concerning the control over the issuance of money, namely the debate over “real” precious-metals-backed money versus fiat money. As documented in Zarlenga (2002), this debate is mostly a diversion, because even during historical regimes based on precious metals the main reason for the high relative value of precious metals was precisely their role as money, which derives from government fiat and not from the intrinsic qualities of the metals.¹⁵...

In Ethics, Aristotle clearly states the state/institutional theory of money, and rejects any commodity-based or trading concept of money, by saying “Money exists not by nature but by law.” The Dialogues of Plato contain similar views (Jowett (1937)). This insight was reflected in many monetary systems of the time, which contrary to a popular prejudice among monetary historians were based on state-backed fiat currencies rather than commodity monies...

Many historians (Del Mar (1895)) have partly attributed the eventual collapse of the Roman republic to the emergence of a plutocracy that accumulated immense private wealth at the expense of the general citizenry. Their ascendancy was facilitated by the introduction of privately controlled silver money, and later gold money, at prices that far exceeded their earlier commodity value prices, during the emergency period of the Punic wars. With the collapse of Rome much of the ancient monetary knowledge and experience was lost in the West. But the teachings of Aristotle remained important through their influence on the scholastics, including St. Thomas Aquinas^† (1225-1274). This may be part of the reason why, until the Industrial Revolution, monetary control in the West remained generally either in government or religious hands, and was inseparable from ultimate sovereignty... It was the English Free Coinage Act of 1666, which placed control of the money supply into private hands, and the founding of the privately controlled Bank of England in 1694, that first saw a major sovereign relinquishing monetary control, not only to the central bank but also to the private banking interests behind it. The following centuries would provide ample opportunities to compare the results of government and private control over money issuance.

... Del Mar (1895) finds that the Free Coinage Act inaugurated a series of commercial panics and disasters which to that time were completely unknown, and that between 1694 and 1890 twenty-five years never passed without a financial crisis in England...

The United States monetary experience provides similar lessons to that of the United Kingdom... The Continental Currency issued during the revolutionary war was crucial for allowing the Continental Congress to finance the war effort. There was no over-issuance by the colonies, and the only reason why inflation eventually took hold was massive British counterfeiting (Franklin (1786), Schuckers (1874)).¹⁷... The Greenbacks issued by Lincoln during the Civil War were again a crucial tool for financing the war effort, and as documented by Randall (1937) and Studenski and Kroos (1952) their issuance was responsibly managed, resulting in comparatively less inflation than the financing of the war effort in World War I.¹⁸ Finally, the Aldrich-Vreeland system of the 1907-1913 period, where money issuance was government controlled through the Comptroller of the Currency, was also very effectively administered (Friedman and Schwartz (1963), p.150). The one blemish on the record of government money issuance was deflationary rather than inflationary in nature. The van Buren presidency triggered the 1837 depression by insisting that the government issuance of money had a 100% gold/silver backing... As for the U.S. experience with private money issuance, the record was much worse. Private banks and the privately-owned First and especially Second Bank of the United States repeatedly triggered disastrous business cycles due to initial monetary over-expansion accompanied by high debt levels, followed by monetary contraction and debt deflation, with bankers eventually collecting the collateral of defaulting debtors, thereby contributing to an increasing concentration of wealth. Massive losses were also caused by spurious private bank note issuance in the 1810-1820 period...

Finally, a brief word on a favorite example of advocates of private control over money issuance, the German hyperinflation of 1923, which was supposedly caused by excessive government money printing. The Reichsbank president at the time, Hjalmar Schacht, put the record straight on the real causes of that episode in Schacht (1967). Specifically, in May 1922 the Allies insisted on granting total private control over the Reichsbank. This private institution then allowed private banks to issue massive amounts of currency, until half the money in circulation was private bank money that the Reichsbank readily exchanged for Reichsmarks on demand. The private Reichsbank also enabled speculators to short-sell the currency, which was already under severe pressure due to the transfer problem of the reparations payments pointed out by Keynes (1929).²¹ It did so by granting lavish Reichsmark loans to speculators on demand, which they could exchange for foreign currency when forward sales of Reichsmarks matured. When Schacht was appointed, in late 1923, he stopped converting private monies to Reichsmark on demand, he stopped granting Reichsmark loans on demand, and furthermore he made the new Rentenmark non-convertible against foreign currencies. The result was that speculators were crushed and the hyperinflation was stopped. Further support for the currency came from the Dawes plan that significantly reduced unrealistically high reparations payments. This episode can therefore clearly not be blamed on excessive money printing by a government-run central bank, but rather on a combination of excessive reparations claims and of massive money creation by private speculators, aided and abetted by a private central bank...

To be fair, there have of course been historical episodes where government-issued currencies collapsed amid high inflation. But the lessons from these episodes are so obvious, and so unrelated to the fact that monetary control was exercised by the government, that they need not concern us here. These lessons are: First, do not put a convicted murderer and gambler, or similar characters, in charge of your monetary system (the 1717-1720 John Law episode in France). Second, do not start a war, and if you do, do not lose it...

To summarize, the Great Depression was just the latest historical episode to suggest that privately controlled money creation has much more problematic consequences than government money creation. Many leading economists of the time were aware of this historical fact. They also clearly understood the specific problems of bank-based money creation, including the fact that high and potentially destabilizing debt levels become necessary just to create a sufficient money supply, and the fact that banks and their fickle optimism about business conditions effectively control broad monetary aggregates...

The Chicago Plan was never adopted as law, due to strong resistance from the banking industry.

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¹⁰ This is of course the reason why quantitative easing, at least the kind that works by making greater reserves available to banks and not the public, can be ineffective if banks decide that lending remains too risky.

¹⁵ For example, in many of the ancient Greek societies gold was not intrinsically valuable due to scarcity, as temples had accumulated vast amounts over centuries. But gold coins were nevertheless highly valued, due to public fiat declaring them to be money. A more recent example is the collapse of the price of silver relative to gold following the widespread demonetization of silver that started in the 1870s.

¹⁷ The assignats of the French revolution also resulted in very high inflation partly due to British counterfeiting (Dillaye (1877)).

¹⁸ Zarlenga (2002) documents very persistent attempts by the private banking industry, throughout the late 19th century, to have the Greenbacks withdrawn from circulation.

²¹ The transfer problem arises when a large foreign debt is denominated in foreign currency, but has to be serviced by raising revenue in domestic currency. As this leads to the domestic currency's rapid depreciation, it makes debt service harder.

. . .

References

Del Mar, A. (1895), History of Monetary Systems, reprint: New York, A.M. Kelley (1978).

Dillaye, S. (1877), Assignats and Mandats: A True History, Philadelphia: Henry Carey Baird.

Franklin, B. (1786), “The Retort Courteous”, in Franklin, W., 1819, The Posthumous and Other Writings of Benjamin Franklin, London: A.J. Valpy, p. 488.

Friedman, M. and Schwartz, A. (1963), A Monetary History of the United States, 1867-1960, Washington, DC: National Bureau of Economic Research.

Jowett, B. (1937), translation of Dialogues of Plato, Socrates dialogue Eryxias, p. 814, New York: Random House.

Keynes, M. (1929), “The German Transfer Problem”, in Readings in the Theory of International Trade, 1949, Philadelphia and Toronto: The Blakiston Company.

Kydland, F. and Prescott, E. (1990), “Business Cycles: Real Facts and a Monetary Myth”, Federal Reserve Bank of Minneapolis Quarterly Review, 14(2), 3-18.

Randall, J. (1937), The Civil War and Reconstruction, Boston: Heath & Co., 2nd edition 1961, edited by D. David.

Schacht, H. (1967), The Magic of Money, translation by P. Erskine, London: Oldbourne.

Schuckers, J. (1874), Finances and Paper Money of the Revolutionary War, Philadelphia: John Campbell.

Studenski, P. and Kroos, H. (1952), Financial History of the United States, New York: McGraw Hill.

Zarlenga, S. (2002), The Lost Science of Money, Valatie, NY: American Monetary Institute.

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