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A return to Sovereign Money?

The International Monetary Fund (IMF) recently published a working paper arguing for the removal of private bank’s privilege of creating the national money supply.  The so called ‘full’ or ‘100%’ –reserve reform has a long history – but, with the Icelandic parliament actively investigating the proposal and little sign of current reforms rebooting the economy, might its time have come? 

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“The financial crisis of 2007/08 occurred because we failed to constrain the private financial system’s creation of private credit and money… the existence of banks as we know them today – fractional reserve banks –  exacerbates these risks because banks can create credit and private money, and unless controlled, will tend to create sub-optimally large or sub-optimally unstable quantities of both credit and private money.” (Lord Adair Turner, Chairman of the UK Financial Services Authority, speech to the South African Central Bank, 2nd November 2012)

If someone told you that the vast majority of the US’s private and public debts could be wiped out via a fairly painless piece of legislation which would simultaneously create a 10% increase in output, remove instability and taxpayer risk from the financial system and stabilize prices, you would probably laugh and tell them to read some economics.

If that someone was the Deputy Division Chief of the Modeling Division in the IMF’s Research Department, responsible for the Fund’s global macroeconomic model, you might think again.  Michael Kumhof is that someone.  Earlier this year, together with Jaromir Benes, he published an astonishing IMF Working Paper – ‘The Chicago Plan re-visited’ – which made just these claims.   The two make use of the IMF’S latest macro modelling to demonstrate how nationalising the supply of money would create these benefits, with no lack of equations and charts filling out the 70 page report. 

What to make of it?  Well, the first thing to note is the word ‘revisited’ in the title.   In fact Benes and Kumhof (henceforth ‘the authors’) are not the most prestigious economists to have made these claims.  Back in the 1930s a number of the US’s top economic minds came to the conclusion that the best way to reform the financial sector following the Great Depression was not to constrain bank’s ability to create the money but simply remove this privilege and hand it over to the state.  These economists – who included Henry Simons and Irving Fisher - came largely from the University of Chicago.  Their proposal, which took various forms, became known as the ‘Chicago Plan’.[1]

Private versus public issuance of money

At the heart of the policy lies the concept of money and its relation to credit and debt.  When banks make so called ‘loans’ they create both an asset (the loan) but at the same time a liability to the borrower. This liability takes the form of deposits that are entered in to the borrower’s bank account.  No deposits are taken from anyone else in this process.  For this reason the term ‘loan’ is rather misleading – better would be ‘credit’ or ‘deposit’ creation.  The bank expands its balance sheet and no other balance sheet is reduced.  And, when the loan is repaid, the deposits are destroyed and the balance sheet contracts. 

These deposits are for all intents and purposes money because they are accepted by the state to pay for taxes and thus accepted by everyone else.  But it was the state’s decision to accept this bank IOU as tax, rather than just a piece paper written out by me or you to our barman to cover the tab.  So it is the state that has determined the ‘money-ness’ of bank credit[2].  As the American economist Hyman Minsky argued, ‘Anyone can create money, the problem is getting it accepted.’  In the UK, 97% of money is created by private banks in this way, with just 3% taking the form of notes and coins or reserves of the central bank[3].  So, private banks monopolise the creation and destruction of the money supply.

As the IMF authors argue in their historical review of monetary systems, the evidence suggests that financial crises seem to be closely associated with private rather than public issuance of money.  Private issuance usually involves the charging of interest and leads to unsustainable build up of debt, inequality and social breakdown – the latter often accompanied by periodic jubilees to main order. 

The authors also do a fine job of dismissing the myth that government money creation is de facto inflationary.  Here we need to be careful with history. The fact that government’s have tended to take over the reigns of money creation at times of war in recent centuries does not prove that government money creation is always inflationary.  Rather, it supports the argument that war is inherently inflationary since it involves the creation of vast quantities of money for economic activity that very suddenly comes to an end (when the war ends), leading to a lot of money chasing no goods and services.  In contrast, what the two great financial crises and the many smaller banking and credit crises of the 20th century do suggest is that private control of money issuance is strongly associated with asset-based inflation or stock market bubbles on a massive scale and the resulting instability and boom-bust cycles.  A recent review of 14 countries over a 140 year period by two economists also supports the link between private credit creation and financial crises.[4]

The Chicago plan and its updated IMF version calls for a return to government or ‘sovereign money’.  Instead of two kinds of money in circulation – state money issued as coins and central bank reserves (that enable the settlement of payments within the banking system) and commercial bank money issued as interest bearing debt, we move to just one kind of money – state money[5].  (To understand the different types of money, and their creation, NEF’s 2011 book, Where does money come from? is an essential guide, reviewed here at openDemocracy by Oliver Huitson.) Banks would still exist but they would only have the power to intermediate and allocate state money, not to create it (which is what most people think they do).  Instead, the sovereign would decide on the quantity of money in circulation and it would be issued interest free as it was for many hundreds of years in Britain prior to the emergence of fractional reserve banking in the late 18th century with ‘Tally-sticks’[6].

Separating money creation from allocation and payment from investment

The IMF authors do not go in to detail as to how the sovereign would decide upon the correct quantity of money in circulation and it has been raised as a critique of Chicago Plan type proposals.  In nef’s (the new economics foundation’s) proposal to the UK Independent Comission on Banking (written with campaign group Positive Money and Professor Richard Werner) we argue for a separation of this duty from the government of the day so as to prevent the creation of money for short term political projects.  Instead the duty could be carried out by an independent committee of monetary experts, just as the monetary policy committee at the Bank of England currently decides upon interest rates.  If this body felt there were inflationary pressures in the economy they would increase taxes and reduce spending and vice versa if there was deflationary tendencies.  It would be for the elected government of the day, however, to decide which taxes and which spending would be adjusted, whilst banks would continue to make allocation decisions of existing funding.

The plan would have multiple advantages.  As well as much greater stability and an end to private credit-driven booms and busts driven by the fickle confidence of private banks and business cycles, there would be no need for deposit insurance.  Citizens could choose to hold money in transaction accounts or investment accounts.  Imagine joining together Paypal and Zopa or any other peer2peer lending outfit.  The money you put in Paypal you know is 100% secure, there cannot be any ‘bank runs’ on it (you really own this money, in contrast to deposits which are a liability of the bank to you).  The money you put in Zopa is invested for a fixed period of time and lent out during that time to borrower.  It is ‘at risk’ and the return on the interest matches the risk (at the present time you can get 7-8% return on Zopa lending compared to 3-4% if you put your money in a bond with a bank).  Alternatively, and for longer term investment, the money could be invested as equity just like buying a share in a company.

These investment accounts or trusts would ensure that the much heralded ability of the banking system to pool deposits to fund longer term lending (‘maturity transformation’ to use the technical term) could still take place, if perhaps on a more limited scale. Existing banks could run these investment trusts – the same set of skills would be required from loan officers.

2 different Chicago schools?

Many on the Left instinctively recoil from any proposal that emanates from the IMF and in particular one associated with the Chicago school, the home of Monetarism.  But we need to be careful to distinguish between proposals for sovereign money (a better name perhaps than 100% or full-reserves given reserves would be the only kind of money in the new system) and Monetarism.  Rather than blaming the private banking sector for  credit booms, Chicago school monetarists, led by Milton Friedman, blamed governments and monetary policy.  They believed that governments could create the ‘right’ (non-inflationary) quantity of money in circulation by adjusting central bank reserves, a result of a wrongly held assumption that banks can only create credit based upon their stock of reserves – the myth of the ‘money multiplier’. When this policy completely failed in the 1980s, the monetarists abandoned direct attempts to control the money supply and instead turned to control an aggregate measure of inflation via the adjustment of the central bank interest rate on reserves.  This seemed to work for a while but eventually helped contribute to the credit bubble that led to the 2007-8 crisis[7].

Although laissez-faire liberals to the core, the 1930s Chicago schoolers saw the private bank monopoly of the money supply as an enormous distortion to the workings of the economy and believed handing over money creation to the state would allow free enterprise to flourish.   It is salient to note (but little known) that Henry Simons was the teacher not just of Milton Friedman but also of Hyman Minsky[8].

Challenges for sovereign money

The actual process via which the move to sovereign money could be achieved is perhaps the area where the greatest concerns arise in the IMF paper.  The authors propose that all existing government and private debt is simply bought up by the Treasury and turned in to public money or equity.  In terms of individuals, this would involve citizens receiving a one off ‘citizens dividend’, distributed equally to everyone, a proposal not dissimilar to that made recently by economist Steve Keen.  Those with debts would pay them off but its not clear what those without debts would do with the money.  Either way, it would seem to involve the potential for inflationary spending given the vast quantities of new money being handed over to citizens.  In Positive Money’s latest version of the full-reserve banking proposal, debts are gradually paid down which should allow for a smoother adjustment and prevent dislocation in financial markets.

Its also perhaps true that the Chicago plan does involve a considerable centralization of power in the hands of the state and would certainly be prone to abuse in countries that lacked sufficiently mature institutional and legal structures.  But we always have to remember with such proposals that we are not necessarily trying to solve all the world’s problems – merely making an improvement on the current situation.  And one thing we can be very sure about is that the current situation – with the financial system dominated by a small number of tax-payer supported ‘too-big-to-fail’ behemouth banks – is about as dysfunctional as its possible to imagine.  It is interesting to note that the only country to officially undertake an investigation of Sovereign Money type reforms is Iceland – the only European country to reject the austerity medicine in Europe, with reasonable success.

‘Chicago plan’ type solutions force us to think in radically different ways about the structures and norms that underly capitalism.  And for this, we should be grateful.


[1] Irving Fisher, ‘100% Money and the Public Debt’, Economic Forum, Spring Number, 1936, p406-420.

[2] See ; Innes, A. M. (1913). "What is Money." Banking Law Journal (May1913): 377-308

[3] http://www.neweconomics.org/publications/where-does-money-come-from

[4] Jordà, Òscar, Moritz Schularick, and Alan M. Taylor. "Financial crises, credit booms, and external imbalances: 140 years of lessons." IMF Economic Review 59.2 (2011): 340-378.

[5] For an explanation of the different types of money and how they interrelate, see Ryan-Collins et al. (2011) Where Does Money Come From, http://www.neweconomics.org/publications/where-does-money-come-from nef: London, ch.4

[6] Historical records suggest that tally sticks were used as an instrument of interest-free (up until the late 17th century) state finance and accounting from at least the reign of Henry I and even earlier on the European continent and in China.  Tally sticks were IOUs: both parties to a transaction would take a Hazelwood twig, notch it to indicate the amount owed, and then split it in half.  The creditor would keep one half, called “the stock” (hence the origin of the term “stock-holder”) and the debtor kept the other, called “the stub”.

[7] The recent announcement http://www.bloomberg.com/news/2012-12-12/fed-boosts-qe-with-45-billion-in-monthly-treasury-purchases.html by the Federal Reserve that it will link any change in interest rates to employment growth suggests that inflation targeting may finally be on the way out.

[8]see Toporowski, Jan. "Henry Simons and the Other Minsky Moment." Studi e Note di Economia 15.3 (2010): 363-368.

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