We propose a generic model of money and liquidity. We provide sufficient conditions under which a swap of private (inside) against public (outside) money leaves the equilibrium allocation and price system unchanged. We apply the results to Central Bank Digital Currency, the “Chicago Plan,” and the Indian de-monetization experiment.
The Federal Council dismisses the popular initiative to implement a Vollgeld regime—the “Swiss Chicago plan.” The Council argues that the proposal to abolish inside money creation runs counter to the government’s financial stability strategy and might undermine credit creation as well as trust in the Swiss Franc.
The Economist reports as well:
As the central bank issued more money, the government points out, its liabilities (cash) would rise without any increase in its assets. This, the government fears, would undermine confidence in the value of money. … There would need to be heavy-handed rules to make sure that banks did not create “money-like” instruments. … Finance, a huge part of the Swiss economy, would be turned inside-out, with unpredictable but probably expensive consequences. … The government also points out that the initiative only guards against one particular form of financial instability.
Narrow banking proposals are fashionable. Here is a selective list of contributions to the debate:
- Cantillon (1755) and Mises (1912) argue that money creation leads to distortions.
- The 100% reserve proposal by Irving Fisher and his colleagues in the 1930s is reviewed by William Allen in the article “Irving Fisher and the 100 Percent Reserve Proposal” (Journal of Law and Economics, 1993). The article covers precursors to the 1930s debate; the March 1933 memorandum by University of Chicago economists; the March 1939 “Program for Monetary Reform;” and Friedman’s “Program for Monetary Stability.” See also Wikipedia on the “Chicago Plan”.
- In 1990, Tyler Cowen and Randal Kroszner wrote an article entitled “Mutual Fund Banking: A Market Approach” in the Cato Journal.
- In the early 2000s, Joseph Huber and James Robertson proposed a “plain money” reform (website with links to various documents). Grass root movements pushing for monetary reform in several countries reference their work.
- On May 14, 2009, Laurence Kotlikoff and John Goodman proposed a system of “Limited Purpose Banking” in New Republic, and in 2010 Kotlikoff published the book “Jimmy Stewart Is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking.” According to the proposal, “all financial corporations engaged in financial intermediation, including all banks and insurance companies, would function exclusively as middlemen who sell safe as well as risky collections of securities (mutual funds) to the public. They would never, themselves, own financial assets. Thus, they would never be in a position to fail because of ill-advised financial bets.” On July 17, 2010, Tyler Cowen criticised the proposal in a blog post; Kotlikoff responded on August, 3 and Cowen responded in turn on August, 4.
- In August 2012, Jaromir Benes and Michael Kumhof published an IMF Working Paper entitled “The Chicago Plan Revisited” (revised paper, slides [pages 18–29 display the balance sheet changes]). Benes and Kumhof write in the abstract: “We study [Irving Fisher’s (1936)] claims [about the advantages of the Chicago Plan] by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy. We find support for all four of Fisher’s claims. Furthermore, output gains approach 10 percent …” Benes and Kumhof also argue that the plan eliminates the zero-lower-bound problem (see my post on other proposals to eliminate the zero-lower-bound problem).
- On April 16, 2014, John Cochrane advertised his paper “Toward a Run-Free Financial System” in a blog post. Key points in the paper are: The recent financial crisis involved a systemic run. Accordingly, one should eliminate run-prone securities rather than guaranteeing them and regulating bank assets. Banks should have to back demand deposits, fixed-value money-market funds or overnight debt by short-term treasuries; they would have to finance risky investments from equity or long-term debt. Fully equity-financed banks (that are difficult to resolve) could still be held by downstream institutions that issue debt (and are easy to resolve). Leverage should be regulated by means of Pigouvian taxes rather than quotas and ratios. Modern technology and large public debt stocks render narrow banking feasible: Treasury-backed or floating-value money-market fund shares can be used for payments; risky assets are highly liquid and can easily be sold and bought for transaction purposes.
- On June 3, 2014, the Swiss group “Monetäre Modernisierung” started to collect signatures with the aim to force a national referendum on changes to the Swiss constitution. In the tradition of Joseph Huber’s work, the group aims at abolishing all money except for base money. See my post on the initiative.
- On June 5, 2014, the Economist’s Free Exchange blog covered the narrow banking idea, somewhat sceptically. John Cochrane argued that the post suffered from misconceptions.
- On July 27, 2014, John Cochrane discussed Sheila Bair’s opposition against letting the broader public hold reserves. On August 21 and September 22, 2014, he approvingly discussed (here and here) the Fed’s balance sheet policy from a financial stability perspective. He published another related post on September 17. On November 21, 2014, he interpreted minutes of an FMOC meeting as suggestive evidence of plans to establish segregated cash accounts. These deposit accounts would be backed by central bank reserves. They would be safe and run proof, and the link to (interest paying) reserves would facilitate a rate rise by the Fed.
- In August 2014, Ralph Musgrave published a paper that defends the full reserve banking model against various criticisms.
- In December 2014, Romain Baeriswyl published a paper that discusses narrow banking proposals in light of Cantillon (1755), Mises (1912) and Fisher (1936).
I have discussed pros and cons of narrow banking against the background of the Swiss “Vollgeldinitiative.” The issue of segregated cash accounts connects the narrow banking debate to the debate on government provided electronic money that I discuss in another post.
This post has been updated and extended after the initial publication.
In the tenth chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” John Cochrane argues that at its core, the financial crisis was a run and thus, policy responses should focus on mitigating the risk of runs (blog posts by Cochrane on the same topic can be found here and here). Some excerpts:
… demand deposits, fixed-value money-market funds, or overnight debt … [should be] backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. …
Banks can still mediate transactions, of course. For example, a bank-owned ATM machine can deliver cash by selling your shares in a Treasury-backed money market fund … Banks can still be broker-dealers, custodians, derivative and swap counterparties and market makers, and providers of a wide range of financial services, credit cards, and so forth. They simply may not fund themselves by issuing large amounts of run-prone debt.
If a demand for separate bank debt really exists, the equity of 100 percent equity-financed banks can be held by a downstream institution or pass-through vehicle that issues equity and debt tranches. That vehicle can fail and be resolved in an hour …
Rather than outlawing short-term debt, Cochrane suggests to levy corrective taxes on run-prone liabilities. Moreover:
… technology allows us to overcome the long-standing objections to narrow banking. Most deeply, “liquidity” no longer requires that people hold a large inventory of fixed-value, pay-on-demand, and hence run-prone securities.
… electronic transactions can easily be made with Treasury-backed or floating-value money-market fund shares, in which the vast majority of transactions are simply netted by the intermediary. … On the supply end, $18 trillion of government debt is enough to back any conceivable remaining need for fixed-value default-free assets.
Cochrane rejects the claim that the need for money-like assets can only be met by banks that “transform” maturity or liquidity. He argues that current regulation reflects a history of piecemeal responses that triggered the need for additional measures; and he points out that the shadow banking system creates run risks because a “broker-dealer may have used your securities as collateral for borrowing” to fund proprietary trading.
Cochrane debunks crisis lingo and clarifies links between aggregate variables:
The only way to consume less and invest less is to pile up government debt. So a “flight to quality” and a “decline in aggregate demand” are the same thing.
He questions the need for fixed value securities other than short-term government debt as means of payment or savings vehicle; offers a short history of financial regulation; and deplores regulatory discretion.
- A 100% money regime reduces the risk of credit bubbles, but requires more and better fine-tuning by the central bank.
- Central banks can already implement higher reserve requirements. If the fact that they don’t reflects policy failure, then the 100% money proposal risks handing more power to one source of the problem.
- A 100% money regime increases financial stability, at least temporarily, but it forces banks to find new sources of funding and lowers the interest rate for depositors, which is fine.
- If lender of last resort support by the central bank occurs at too low interest rates then seignorage revenues are privatised and costs socialised under the current regime. Moving to a 100% money regime would help but so would simple Pigouvian taxation.
- How can a 100% money regime be enforced if market participants end up coordinating to use other securities than deposits as means of payment?
- More stable deposits in a 100% money regime do not imply a more stable banking system unless other regulation is imposed that completely prevents “maturity transformation.”
- Aggregate liquidity cannot be created out of nothing, with or without deposit insurance.
- Societies have to take a stand on whether they want to guarantee broader monetary aggregates than base money. If so, the cost of the guarantee should be privatised. Problems arise if societies pretend not to provide such guarantees but central banks nevertheless feel obliged to step in ex post and market participants are aware of that fact ex ante; bad, self-fulfilling equilibria are the consequence.
- Commitment on the part of policy makers is key; it requires independent central bankers and regulators.