Page 2 of 2 Dust off the Chicago Plan
By Hossein Askari and Noureddine Krichene
wanted a fixed rule consisting of setting the growth of money supply in line
with real economic growth and a secular moderate inflation at 2% a year. More
than Friedman, Allais was a vocal supporter of the 100% reserve requirement and
for the separation of banking into 100% reserve banking for checking activity
and investment banking for loaning activity.
He noted that the seignorage arising to banks from their money creation would
be diverted to the government and could enable to reduce taxes. Allais noted
that financial innovations, such as securitization, hedge funds and complex
credit derivatives, have increased leverage, multiplied money substitutes, and
increased the power to create and destroy money through credit expansion
and contraction, rendering the financial system highly vulnerable to
instability.
He called for strict regulation of stock markets and abolition of speculative
funds (for example, hedge funds) that are only destabilizing and have no
contribution to real activity. He criticized Alan Greenspan, the former Federal
Reserve chairman, for bailing out hedge funds, and he considered these bailouts
to be detrimental to long-run financial stability.
The recurrence of financial instability since the mid-1970s with amplifying
magnitude, the increasing vulnerability of even the most advanced financial
systems, and the large social costs and inequities imposed by lasting and
growing bailouts make it indispensable to go back to the armory of reforms
developed by the celebrated economists and devise financial reforms that are
capable of thwarting instability and insuring steady economic growth and price
and exchange rate stability.
The Chicago Plan, a response to the Great Depression, remains the best plan,
short of which financial instability cannot be avoided. As Hyman Minsky puts
it: "stability is unstable" - implying that a period of financial stability
will be followed by an episode of financial turmoil, essentially for the same
reasons analyzed in the Chicago Plan and in Fisher’s book.
Although today we are much farther away from the Chicago Plan in terms of
political support or awareness for the necessity of reforms of the present
central banking system, it is evident that the frequency and intensity of
financial and economic instability have become overwhelming. As long noted by
Simons and recently underscored by Allais, monetary uncertainties have grown so
large, resulting in large income redistribution, price distortions, and
significant credit and market risks, that it is impossible to make reasonable
forecasts of prices and output.
As an illustration, oil prices exploded from US$65/barrel in August 2007 to
$147/barrel in July 2008 and plummeted to below US$100/barrel this month. The
same swings could be noted for exchange rates, gold, and other commodities as
well as for housing prices.
The Banking Act of 1935 called on the FMOC to control money supply. Since
mid-1965, however, the FMOC has been mainly controlling interest rates and has
abandoned control of monetary aggregates. Consequently, it has allowed the
banking system a far greater role in creating and destroying money.
Both the Great Depression and the present financial crisis are strong evidence
against the applicability of the interest rate rule and demonstrate the
systemic risk, and the huge economic cost and financial chaos that follow from
this rule. In contrast, the financial stability and steady economic growth
experienced during 1950-65 were brought about by stability in monetary
aggregates as the Fed was directly controlling bank reserves during that
period. In the same vein, only after Fed chairman Paul Volcker controlled bank
reserves and money supply during 1979-1982, did inflation come to a stop,
restoring financial stability.
The failure of many financial giants such as Fannie Mae, Freddie Mac, Bear
Stearns, Northern Rock, Countrywide, large writedowns by many other
institutions, and abusive recourse to central banks' financing facilities
cannot all be blamed on bad management of financial institutions. These
financial institutions were victims of faulty policies set by central banks.
Now, more then ever before, there is a need to revive the Chicago Plan, perhaps
not in terms of its full implementation, but at least in terms of its basic
principles which call for a stable and rule binding monetary policy.
In the context of the present destabilizing policies of central banks, even
long-established institutions that were considered too big to fail have became
too vulnerable to financial instability. While it is pressing to move on the
regulatory front and reduce the multiplication of money substitutes, it is
equally pressing to return to controlling monetary aggregates within strict
limits and restoring monetary discipline. Besides restoring monetary stability,
a fixed rule would limit the power of the banking system in causing
over-expansion or contraction of money, as required under the Chicago Plan, and
would direct credit to high-quality and productive investments.
It is time to part with the fallacy that economic growth and employment
creation are the main duties of central banks, and that the interest rate rule
is the panacea for all economic ills. By tinkering with interest rates to
stimulate economic growth, central banks have instead created unexpected
problems in form of speculative bubbles, over indebtedness, credit defaults,
millions of home foreclosures, collapsing financial sector, high liabilities on
taxpayers, and inflationary bailouts.
By causing stagflation, central banks' economic growth objective has also
become self-defeating. Economic agony and financial disorder will continue
until central banks decide to rehabilitate monetary conditions and restore
direct control of the money creation process.
It's time to dust off the Chicago Plan and take a second look.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist at the International Monetary Fund and a former advisor, Islamic
Development Bank, Jeddah.
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