Every economics textbook will tell you that banking is at its core a process of intermediation designed to facilitate the transfer of savings into investment. In some respects fractional reserve banking does this much too well. It is a system which takes deposits and lends them out. The problem is that this process is built on – for want of a better word – deceit. Borrowers are offered secure term contracts, while depositors are promised their money back whenever they want it. This deceit only works because most depositors are happy to keep their money in the banking system most of the time. Supporters of fractional reserve banking would say – so what. The fact that the system exploits this trait of depositors – to keep their money in banks rather than under their mattresses – is surely a good thing. Without such a system, lending would not happen to anywhere near the same degree, credit creation would be severely impeded and economic activity adversely affected. The problem with this system is that it has a tendency to max out on credit creation in the good times, but chronically undersupply credit in the bad times – thus greatly accentuating the natural ups and downs of the business cycle. And over a course of time, it results in an accumulation of debt in society that is not economically very healthy. Recent events underline these concerns. Any proposed reform of the banking and monetary system needs to be able to illustrate that such a system will be capable of delivering the «right amount» of credit in good times and bad – so as not to impede economic activity in downturns, but also not to act as an accelerator for the good times. We can refer to this as the «optimal» quantity of credit over the course of the business cycle. In this paper, I assess two models. One is a derivative of the so-called «Chicago Plan», and set out in the IMF Working Paper by Michael Kumhof and Jaromir Benes titled The Chicago Plan Revisited published in August 2012. The other is an equity-based proposal which I call the «Huerta de Soto Plan», and derived from proposals set out by Professor Jesus Huerta de Soto in his book Money, Bank Credit and Economic Cycles, published as far back as 1998. The Kumhof/Benes proposal puts monetary policy at the heart of the credit creation process in a way that is far more effective than under the current system. Governments end up achieving far greater control of the levers of monetary power than under today’s fractional reserve system. By contrast, the Huerta de Soto Plan opts for a free-market based approach to money resulting in a free and genuinely open market for credit that is driven entirely by the forces of competition and where governments and central banks have no role to play in monetary policy. This paper spells out the mechanics underlying both plans, and assesses their relative merits. Neither plan is perfect. Both propose extremely radical reform of the modern monetary system, and they can result in – I believe – some potentially very inflationary and damaging behavioral effects in the process of the transition from the present system to what is proposed. The Kumhof/Benes proposal is far and away the weaker of the two – not only would it be economically and politically unworkable – the behavioral consequences would be harder to control. By contrast, the Huerta de Soto Plan – although more radical in many respects – would also be more palatable, albeit it would need certain tweaks, and the adverse behavioral impacts arising from the implementation of this plan would be somewhat easier to offset.
Key words: Huerta de Soto, Kumhof/Benes, Chicago Plan, Fractional Reser-ve, Mutuals, Quantitative Easing.
JEL Classification: B31, B53, E42, E52.
Cyclical Fluctuation, Growth, and Stabilization: An Empirical Investigation of Dual Policy Objectives in Bangladesh
