Monday, 13 August 2012

IMF authors get full reserve wrong.

“The Chicago Plan Revisited” is the title of an IMF paper by Jaromir Benes and Michael Kumhof which supports full reserve banking: a system advocated in the 1930s by Irving Fisher and others and later by Milton Friedman. Unfortunately there is a big mistake at the start of this paper, as follows.

The authors envisage converting from fractional to full reserve essentially by having the central bank print some truly astronomic quantities of new money, and pay off all the country’s debtors. And when I say “astronomic” I mean something like 200% of GDP: which makes QE look like extremely small damp squib.

There is a summary of the bank sector’s balance sheets before and after the transition on pages 64-6, and for the authors’ explanation of these balance sheets, see p.7.

As they say on p.7 “the principal of all bank loans to the government (20% of GDP), and of all bank loans to the private sector except investment loans (100% of GDP), is cancelled against treasury credit.” And later,“The cancellation of private debts reduces both treasury credit and government equity by 100% of GDP.” And again: “These buy-backs in turn mean that the private sector is left with a much lower debt burden, while its deposits remain unchanged.”

Well now, if you happen to be an indebted private sector entity, this is too good to be true isn’t it? Christmas will definitely have come early under this scenario for mortgagors. In fact the effect will be rampant inflation.

Mortgagors will find the tranche of their income previously devoted to paying interest on their mortgage is no longer needed for that purpose. There’ll be a HUGE increased demand for new cars, foreign holidays, and so on.

Moreover, since most mortgagors are comfortable with their mortgage and have borrowed responsibly, the effect of getting a letter saying their mortgage has been wiped out will just induce them to run out and borrow some more: most likely with a view to getting a better house. Demand for housing will sky-rocket.

Social justice?

While wiping out debts sounds like it involves oodles of social justice, this is far from the case. People with big mortgages, at least in Britain, are NOT the poorest section of the community. The poorest are just not credit worthy: they cannot get mortgages. They live in council houses or other forms of social housing.

The biggest debtors are those in the middle of the income range. As to the very rich, they certainly TEND not to need mortgages, on the other hand there is no shortage of people with incomes twenty times the national average who live in houses worth several million, with mortgages to match.

So if you think wiping out debt equals social justice, forget it.

The two account system.

The mistake in the IMF paper stems from a failure to understand a basic feature of full reserve, as follows.

Full reserve is a system under which private banks cannot create money. Only government and central bank can do that. But commercial banks CAN LEND as long as they find depositors willing to have their money lent on by commercial banks.

However, if a commercial bank were to lend on £X at the same time as allowing the money to be still available for use by the depositor, then the bank would effectively have created extra money: both the depositor and borrower would regard themselves as having £X in the bank (that’s until the borrower spent the money, in which case the borrower’s £X is someone else’s £X).

Thus a central feature of full reserve is that depositors must choose how much of their money they want to be “instant access”, and in contrast, how much they want to be loaned on or invested. Indeed, the latter choice that depositors must make is spelled out quite clearly by two contemporary advocates of full reserve: Laurence Kotlikoff and Richard Werner. (Incidentally, while the ideas advocated by these two economists are employed below, this should not be taken to imply their agreement with anything here.)

The actual balance sheet changes.

In the light of the above, let’s now consider the balance sheet changes that occur when making the change from fractional to full reserve. I’ll assume as per the IMF paper that the transition is done more or less instantaneously. (A more gradual transition might easily make more sense, but I won’t go into that here.)

Under Kotlikoff regime, depositors who want their money loaned on or invested, put their money into a mutual fund of their choosing (“unit trust” in UK parlance). That money is then no longer a liability of the bank, and (as is the case with existing mutual funds) the depositor no longer has instant access to the money.

Werner proposes a slightly different system: the bank does the lending or investing, but it is made clear to depositors who want to earn interest from having their money loaned on that they cannot have their money back immediately. Plus there is a sliding scale of interest payable to depositors depending on how long they lock their money up for and what proportion of the losses they carry when the loans or investments go wrong. But to repeat, deposits are no longer an IMMEDIATE liability of the bank.

Personally I prefer the Kotlikoff option when it comes to money that is loaned on or invested. It is simpler, which amongst other things makes explaining the balance sheet changes easier.

In contrast, I prefer the Werner option when it comes to instant access money. Under Kotlikoff, instant access money is handled by cash mutual funds. That would seem to imply that the whole business of operating cheques, plastic cards, etc is taken over by such funds. Personally I don’t see the sense in that. Banks have expertise in operating “checking accounts” as they are called in the U.S. Plus they have expertise in operating plastic card systems.

So I’ll assume a Kotlikoff system for money that is to be loaned on or invested and a Werner system for instant access money.

Balance sheet changes.

To keep things simple, let’s say banks’ balance sheet prior to the change consists of liabilities in the form of deposits equal to 100% of GDP, while assets consist just of mortgages equal to 100% of GDP. For “mortgage” read “mortgage, loans and investments” if you like.

I COULD add equity to the liability side and reserves at the central bank to the assets side, but these two items are small compared to deposits and loans, so I’ll ignore them.

During the transition, depositors have to decide how much of their money they want loaned on / invested, and how much they want to have in the “instant access” form. Let’s say depositors want 75% of their money loaned on and 25% to be instant access.

75% of banks’ liabilities and assets are then wiped out: under Kotlikoff’s proposals, depositors would withdraw the money and put it into mutual funds, while the latter would buy 75% of all mortgages off banks.

Instant access money.

Now for the 25% of deposits that are to be instant access.

As to the mortgages balancing that 25%, the central bank buys these off commercial banks with newly created CB money. And of course mortgagors then pay off their debt to the CB which destroys or “unprints” the relevant money (balancing the money it created to give commercial banks in exchange for the mortgages).

The net result.

The net result is thus. As regards money that depositors want loaned on or invested, that money is transferred to mutual funds as are the relevant loans and investments. So bank balance sheets shrink by a large amount.

As to instant access money, commercial banks owe 25% of GDP to depositors, while in turn the central bank owes central bank money to the tune of 25% of GDP to commercial banks. I.e. commercial banks have reserves equal to 25% of GDP.

Note that there has been no increase in private sector net financial assets, never mind ASTRONOMIC increase therein that occurs under the IMF paper proposals.

Of course, if the net effect of the balance sheet changes done in “Kotlikoff/Werner” style were excessively deflationary, that could easily be countered by the standard cure for excess deflation advocated by we advocates of full reserve: just have government and central bank create new money and spend it into the economy (and/or cut taxes).


  1. Hi again, Ralph. Will certainly have a look at this IMF paper. I've looked at this sort of scheme in my paper 'Public and Private Money Creation: Reform the Banks, not the System' which you can find at Please ignore anything you read there on inflation - this needs re-working - but I think I'd stand by the rest.

    Essentially, my argument is that there isn't, if done right, anything wrong with de-centralised money creation. And even if there is, you couldn't stop it.

    1. Dairmid, I’ll certainly look at your paper and send you some comments in due course.

  2. Ralph,
    With all due respect - and that is whole lot.
    Thanks for taking on an analysis of the Chicago Plan Revisited by Benes and Kumhof.

    You quote from the IMF Research Paper and provide Fig. examples of the various balance sheet results without fault, and postulate certain outcomes.
    I fear that I see the baby going out with the critique.

    My first question is whether you have adequately pointed out where the B-K paper gets 'full-reserve banking' wrong.
    Remember this is not only a revisit of the original Chicago Plan proposal, but the many modifications over half a decade by a series of notable economists - with a focus on Fisher's 100 Percent Money publications.
    Moreover it is really a hybrid of all of those proposals, just as you were being selective between Werner and Kotlikoff on their full-reserve and narrow-banking proposals.
    So, the Chicago Plan Revisited construct is of the Benes-Kumhof creation, but I still see respect for Fishers' observations on how full-reserve banking itself NEEDs to work - perhaps with a view that reflects the REALITY of today's macro-economy versus in Fisher's time.
    IOW - what would Fisher propose today?

    The result is the B-K piece enhancing the CP and Fisher, bringing it more up to date with modern macroeconomic modeling methods not available in the '30s.
    Suffice to say, Ralph, that I do not see any mistake being made with regard to what full-reserve banking really is, using your descriptions.
    Perhaps you could elaborate on that.

    You have brought to major focus one of my concerns with this particular proposal, which is the inclusion of basically "all' of the private bankers' balances as that which is 'replaced' by treasury-credits, as they call the government funding.
    I would have been much happier with modeling only the commercial banking system and leave the great "financial toxic waste true-up" for the future with the chips falling where they may.
    However, having made the decision as to model the shadow bankers as well, my only critique must be with either the methods or results of the model, or, from my perspective, the real political-economy fallout.
    The latter is taken care of as I see a true Chicago Plan solution that reflects even Soddy's view of the Role of Money.
    We have public money administration.
    We have bankers only lending by matching deposits to long-term investment, by any meaning of the term - we solve for maturity mismatch in investment finance.
    We have all money issued without debt.
    And we democratize the money system and therefrom the political system.
    So, that's the baby I see.

    As to the methods and results of the model, you entertain some 'logical' outcomes that are certainly possible.
    But I don't think they are necessary, nor do I know that is how future households/businesses will act after the balance-sheet recession has stabilized.
    Kumhof makes the point that the amount of “money” would remain essentially the same.
    While looking for the macro-results of the spending spree we might fear, what I see is a taming of inflation, and resort to greater economic growth, yes, but slowly over a decades long horizon. The consumption sector sees a fall in activity along with the reductions in debt.
    We're no longer a debt-based economy.

    In short, I don't see the macro-results you imply. Is the model at fault?

    I hope you are open to the broadest possible discussion on the topic of moving to a Greenback-based national monetary system.
    Again, sincere thanks.

    1. Hi Joebhed,

      You ask whether I “have adequately pointed out where B&K get 'full-reserve banking' wrong.”

      I certainly TRIED to point out where I think B-K went wrong. But I’ll re-phrase it, thus.

      As far as I can see, they propose essentially just printing loads of central bank money and paying off all debtors. If you look on their p.64, mortgages appear on the asset side of commercial bank balance sheets before the transition (left hand column). And after the transition (right hand column), mortgages have vanished. Well that’s nice for mortgagors, including the millionaires with million dollar mortgages isn’t?

      Re your point that “I do not see any mistake being made with regard to what full-reserve banking really is…”, it strikes me that the above is quite a big mistake (else it’s me making a big mistake – far from unheard of!!!!).

      Re Soddy, it was you who made me aware of Soddy, and thanks for that. I actually did a post some time ago giving my reactions to his ideas. See:

      Soddy favoured full reserve, as you know. I agree with some of his ideas and not others.

      Re your point that you don’t know “how future households/businesses will act after the balance-sheet recession has stabilized”, I quite agree. That is a bit of an unknown. The biggest problem is that financially unsophisticated households would object to having to give up the automatic right to get their money back if they want interest. But that’s not a fault of full reserve: it’s a fault in the political system. Political pressures over the years have given us a system (thanks to deposit insurance) in which depositors can have their cake and eat it: that can gain the advantages of acting in a commercial manner (i.e. have their money invested) without the usual downside risks that go with investing. And the taxpayer foots the bill for that charade.

      The average voter, when given goodies for free by government, scarcely ever understands that the goodies are not free at all: the voter pays for the goodies via tax.

      Re your point that “Kumhof makes the point that the amount of “money” would remain essentially the same.”, that’s a very questionable claim. As I point out in the above post, a substantial chunk of what is now counted as money would no longer be counted as money (that’s so called money that people have in deposit or term accounts).

      Re your claim that under full reserve, we would “no longer be a debt-based economy.”, I’ve got doubts about that. I set out reasons here:

      and here

      Personally, I think the main advantages of full reserve are, first, that it is a system that does not need subsidising, as does fractional reserve (occasional trillion dollar bailouts and the ongoing TBTF subsidy). Second, it was fractional reserve that allowed commercial banks to create billions and lend it out prior to the crunch. I.e. full reserve would be more stable.

  3. Ralph,
    I hope we can re-begin the above.
    I make this single observation.
    You are not correct that the million-dollar mortgagor get a free ride.
    All mortgagors and all non-mortgagors get the same citizens dividend - just as provided in Steve keen's Debt Jubilee - of a single payment of the same fixed amount.
    This is spelled out several times in the narrative of the document.
    However, as I said earlier, the balance sheet presentations are only partially made as to all of the BS interactions before and after the transition.
    Therefore, somewhat misleading.

    The net effect of such action by the Treasury is to pay off a huge amount of debt overall, with the relative benefit being greater for the smaller debtor and especially the non-debtor, and the smaller benefit to the largest debtors.
    Those with the largest debts will remain with debts and no money to invest.
    Those with smaller debts will remain with less debt, perhaps none, and perhaps some money to spend/invest.
    Those starting out without debts will result with money to invest, leading to spending.

    Ralph I limit my comment here to what you had described as the more egregious error the the Chicago Plan proposal.
    I ask your engagement with the thought that the IMF Research Paper - NOT a Policy Proposal - lays out a very broad interaction of the many aspects of the present financial crisis.
    It includes the necessity of a Steve Keen-like debt liquidation, but does so in a superior manner, that being without a government debt-funding source.
    And it engages the problem of the shadow-bankers' balances being made able for settlement through this broad governmental action.
    As such it is extremely complex, perhaps too much so.
    But what it definitely does not do is to enrich the rich at the expense of the Restovus.

  4. Hi Joebhed,

    Thanks for the comment. I'll have another look at the IMF paper and answer your comment in a day or two. Meanwhile, it will help me if you can explain what the IMF authors mean by "treasury credit". I'm baffled by that.

    Re Steve Keen's debt jubilee idea, that strikes me as complete nonsense for reasons I spelled out here:


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