Friday, 26 October 2012

Excerpt from "Chicago Plan revisited" - IMF Benes & Kumhof


Excerpt from Introduction to "Chicago Plan Revisited", a paper on full reserve banking by the IMF economists Benes & Kumhof.  Full paper is here

At this point in the paper it may not be straightforward for the average reader to comprehend the nature of the balance sheet changes implied by the Chicago Plan. A complete analysis requires a thorough prior discussion of both the model and of its calibration, and is therefore only possible much later in the paper. But we feel that at least a preliminary presentation of the main changes is essential to aid in the comprehension of what follows. In Figures 1 and 2 we therefore present the changes in bank and government balance sheets that occur in the single transition period of our simulated model. The figures ignore subsequent changes as the economy approaches a new steady state, but those are small compared to the initial changes. In both figures quantities reported are in percent of GDP. Compared to Figure 3, which shows the precise results, the numbers in Figure 1 are rounded, in part to avoid having to discuss unnecessary details.

As shown in the left column of Figure 1, the balance sheet of the consolidated financial system prior to the implementation of the Chicago Plan is equal to 200% of GDP, with equity and deposits equal to 16% and 184% of GDP. Banks’ assets consist of government bonds equal to 20% of GDP, investment loans equal to 80% of GDP, and other loans (mortgage loans, consumer loans, working capital loans) equal to 100% of GDP. The implementation of the plan is assumed to take place in one transition period, which can be broken into two separate stages. First, as shown in the middle column of Figure 1, banks have to borrow from the treasury to procure the reserves necessary to fully back their deposits. As a result both treasury credit and reserves increase by 184% of GDP. Second, as shown in the right column of Figure 1, 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. For government debt the cancellation is direct, while for private debt the government transfers treasury credit balances to restricted private accounts that can only be used for the purpose of repaying outstanding bank loans. Furthermore, banks pay out part of their equity to keep their net worth in line with now much reduced official capital adequacy requirements, with the government making up the difference of 7% of GDP by injecting additional treasury credit. The solid line in the balance sheet in the right column of Figure 1 represents the now strict separation between the monetary and credit functions of the banking system. Money remains nearly unchanged, but it is now fully backed by reserves. Credit consists only of investment loans, which are financed by a reduced level of equity equal to 9% of GDP, and by what is left of treasury credit, 71% of GDP, after the buy-backs of government and private debts and the injection of additional credit following the equity payout.

Figure 2 illustrates the balance sheet of the government, which prior to the Chicago Plan consists of government debt equal to 80% of GDP, with unspecified other assets used as the balancing item. The issuance of treasury credit equal to 184% of GDP represents a large new financial asset of the government, while the issuance of an equal amount of reserves, in other words of money, represents new government equity. The cancellation of private debts reduces both treasury credit and government equity by 100% of GDP. The government is assumed to tax away the equity payout of banks to households before injecting those funds back into banks as treasury credit. This increases both treasury credit and government equity by 7% of GDP. Finally, the cancellation of bank-held government debt reduces both government debt and treasury credit by 20% of GDP.

To summarize, our analysis finds that the government is left with a much lower, in fact negative, net debt burden. It gains a large net equity position due to money issuance, despite the fact that it spends a large share of the one-off seigniorage gains from money issuance on the buy-back of private debts. These buy-backs in turn mean that the private sector is left with a much lower debt burden, while its deposits remain unchanged. Bank runs are obviously impossible in this world. These results, whose analytical foundations will be derived in the rest of the paper, support three out of Fisher’s (1936) four claims in favor of the Chicago Plan. The remaining claim, concerning the potential for smoother business cycles, will be verified towards the end of the paper, once the full model has been developed..........

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