Some of the earliest banks started operating in Italy somewhere in the twelfth and thirteenth century. These banks were essentially banks of deposits. Merchants deposited their money in the form of gold and silver coins and bars with these banks for safekeeping. The bank in return issued a receipt against this deposit. The receipt could be shown when the coin money was to be withdrawn. Hence, the earliest banks were “banks of deposits” or “store houses of wealth”.
As time went by some banks developed a reputation for probity and honesty. This led to merchants who had accounts with these banks simply transferring receipts of these banks when they had to pay one another instead of going to the bank showing their receipt and withdrawing their gold or silver to pay each other.
Hence, these receipts started functioning as “paper” money. In sometime people running these banks also figured out that their depositors do not all come all on the same day asking for their deposits back. So in the intermittent period they could either lend out the gold/silver to others or simply print fake deposit receipts not backed by any gold or silver bars or coins, but which looked exactly like the original deposit
receipt. Of course they charged a fee for this.
A similar trend seems to have played out in London in the seventeenth century where merchants took to depositing money with the goldsmiths. This happened after King Charles I seized around £130,000 in bullion, deposited by the city merchants at the Tower of London in 1640.
Like the Italian bankers the London goldsmiths also figured out that they could keep lending the gold that was deposited or simply issue fake receipts, and make more money in the process. As Hartley Withers writes in his all time classic The Meaning of Money:
The original goldsmith’s note was a receipt for metal deposited. It took the form of a promise to pay metal, and so passed as currency. Some ingenious goldsmith conceived the epoch-making notion of giving notes, not only to those who had deposited metal, but to those who came to borrow it, and so founded modern banking.
This is how banks evolved from being just banks of deposit to being banks which gave out loans as well. And to this day they work in the same way. This change also gave bank a right to create money out of thin air, something only the governments could do till then.
Let’s try and understand how that happens. Let us say an individual/institution/government deposits $1000 with a bank. Let’s assume that the bank in turn keeps 10% of the deposits (for the ease of calculation) and lends out the remaining 90% or$900 in this case. It thus manages to create an asset from someone else’s money. So we also have a situation here were the money supply has increased by $1900 ($1000 money deposited with the bank + $900 loan given by the bank).
The $900 loan gets deposited with another bank which in turn lends $810 (90% of $900) and keeps $90 with itself. The $810 is deposited in another bank and leads to a loan of $729. So the banks can keep creating money out of thin air and the money supply can keep going up.
This ability of banks to create money out of thin air is believed to be behind the boom and bust cycles (also referred to as business cycle fluctuations) that the world economy has seen over the last three decades. As J write in The Chicago Plan Revisited, a research paper released by the International Monetary Fund (IMF) “sudden increases and contractions of bank credit that are not necessarily driven by the fundamentals of the real economy, but that themselves change those fundamentals.” When banks feel optimistic, they create money out of thin air by lending it and in the process create the boom part of the business cycle. But when the banks feel pessimistic about economies they may call back their loans or not give out loans at all, and in the process create the bust part of the cycle.
The IMF authors feel that this ability of the banks to create money out of thin air needs to be reined in. The ability to create money should rest only with the government. For this to happen they have revisited The Chicago Plan. The plan was first proposed in the aftermath of The Great Depression of the 1930s.
“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, after its strongest proponent, professor Henry Simons of the University of Chicago,” write Benes and Kumhof. Over the years Irving Fisher, who was America’s greatest economist of that era, also came to be closely associated with it.
This plan strikes at the heart of how conventional banking works. A bank raises money as deposits and lends it out as loans. The Chicago Plan separates the deposit and lending functions of the bank. So when $1000 is deposited with the bank, the bank will have to hold the entire money with it and act as a “bank of deposit”. It will not be able to lend this money out. So bank deposits cannot fund its loans. This also eliminates the chances of bank run totally. Even if all the customers of the bank come and demand their deposit from the bank at the same time, the bank can easily repay them.
The question that crops up here is that if the bank does not lend out its deposits how does t fund its loans? As per the Chicago Plan the loans will have to be funded separately from sources which are not subject to bank runs. Hence, loans would be funded out of retained earnings of the bank. They could also be funded out of the bank issuing more shares to investors. And a third source of funding, which is at the heart of the Chicago Plan, would come from the government.
The bank will have to borrow money from the government to fund its loans. The government can ‘print’ this money that it will lend to banks. Hence, this is the way the government can control money in the economy. When it wants to expand money supply it can lend more and vice versa. Banks cannot create money out of thin air because they are not allowed to lend their deposits.
“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,” write the IMF authors.
Also, the government will lend against certain assets of banks. These assets can be included while calculating the net debt of the government and deducted from its total debt. The government can also buy back government bonds held by banks against the loans it will give to banks to fund their loans. Either ways the net debt of the government could come down dramatically.
The government could also use the same method to buy out private debt from these banks. It could buy back private bonds against cancellation of government loans to these banks. And why would the government do that? “Because this would have the advantage of establishing low-debt sustainable balance sheets in both the private sector and the government, it is plausible to assume that a real-world implementation of the Chicago Plan would involve at least some, and potentially a very large, buy-back of private debt,” write the IMF authors.
That’s the plan. But the bigger question that the plan does not answer is how much can governments be trusted when it comes to printing money?
A slightly shorter version of this article appeared in Daily News and Analysis on October 24, 2012.
(Vivek Kaul is a writer. He can be reached at [email protected])