Page 1 of 2 Dust off the Chicago Plan
By Hossein Askari and Noureddine Krichene
In a bid to stimulate employment and growth during the period 2001-2008,
central banks pursued an overly loose monetary policy through record low
interest rates, and unwittingly instigated the worst financial instability in
over 60 years. As result, many industrial economies now face the risk of high
inflation and rising unemployment, with ominous implications for the rest of
In their drive to maintain historically low interest rates, central banks
injected liquidity, set off an uncontrolled credit boom and ignited intense
speculation in housing, commodities, stocks, and foreign exchange markets.
Although supporters of expansionary monetary policy applaud central banks for
stimulating economic growth, the growth that has come about has been demand-
not supply-driven and has been accompanied by abnormal inflation in the price
of housing and commodities and large fiscal and external imbalances.
With the bursting of the housing bubble, the meltdown of subprime loans, and
asset price deflation, cheap money policy led to severe financial crisis and in
turn to a slowdown in economic growth. The financial meltdown has lead to
massive and permanent bailouts, the latest batch being led in the US by the
government takeover of Freddie Mac and Fanny Mae, which hold more than 50% of
US mortgage loans. This may be costly for taxpayers and may not even achieve
the intended objective of boosting housing prices in the midst of unfolding
Most recently, Lehman Brothers folded and Merrill Lynch was bought by Bank of
America; AIG, the world’s largest insurance company is on the brink of
disaster; and a number of very large US regional banks could be in trouble
within weeks, if not days. Bankruptcies will exact a heavy toll, as will
While bailouts may appear as costless to central banks, as they amount to
creating money out of thin air, they constitute a heavy tax burden on those
dependent on fixed-income and wage earners and affect large wealth
redistribution in favor of debtors at the expense of creditors. Beside their
distortionary price effects, bailouts have inflationary effects that will
continue to erode real savings and undermine long-term economic growth.
Although the financial crisis has been massive and has no end in sight, there
has been little urgency on the part of the government or the Fed to undertake
comprehensive studies of the causes of the crisis in order to propose the
fundamental remedies that are needed. Instead, there have been bailouts.
We need answers before we embrace bailouts and create more problems in the
future. What led to the credit crunch after August 2007, to the near collapse
of many financial giants, and to monumental write-downs that have so far
exceeded US$500 billion? Why did the authorities not move to mitigate a housing
bubble and attempt to realign home prices with fundamentals? Is the financial
system doomed to experience frequent tremors? What has been the role of
financial engineering and sophisticated financial instruments in creating the
crisis at hand? What reforms would be required for mitigating financial
instability in the future? What led to the sudden collapse of Freddie Mac and
Fanny Mae that had fared well since their creation in 1932? Policymakers have
not addressed these and many other questions.
The financial crisis 2007-2008 is, in many respects, reminiscent of the Great
Depression of 1929-1934 in terms of its causes, intensity, and consequences.
Maurice Allais, the Nobel Prize winning economist, has written that the causes
of the present financial crisis and the Great Depression are the same. Both
were preceded by speculative credit booms fueled by low interest rates and
consequent asset bubbles in stock and housing markets. Both were triggered by
the bursting of these bubbles, asset price deflation, and were compounded by an
ensuing credit contraction or freeze. The severity of the Great Depression was
conveyed by a drop of real GDP of 29%, a resulting unemployment rate of 25%,
contraction of money supply by 30%, and widespread business and bank failures.
The magnitude and ordeal of the Great Depression led a number of celebrated
economists to devote considerable effort to analyze the true causes of the
Depression and to formulate financial reforms that would immunize the economy
against such financial turmoil.
The reform plan that was developed came to be known as the Chicago Plan, as it
was formulated in a memorandum written in 1933 by a group of Chicago
professors, including Henry Simons, Frank Knight, Aaron Director, Garfield Cox,
Lloyd Mints, Henry Schultz, Paul Douglas, and A G Hart, and was forcefully
advocated by the noted Yale University Professor Irving Fisher in his book
titled 100% Money.
Noting the fundamental monetary cause underlying each of the severe financial
crisis in 1837, 1873, 1907, and 1929-1934, the Chicago Plan calls for a full
monopoly for the government in the issuance of currency and forbids banks from
creating any money or near money by establishing 100% reserves against checking
deposits. Investment banks that play the role of brokers between savers and
borrowers were to undertake financial intermediation. Hence, the inverted
credit pyramid, the high-leverage financial schemes (such as hedge funds), and
monetization of credit instruments (such as securitization) were precluded
under the Chicago Plan. The credit multiplier would be far smaller and would be
determined by the savings ratio instead of the reserves ratio.
As stated by Irving Fisher: "The essence of the 100% plan is to make money
independent of loans; that is to divorce the process of creating and destroying
money from the business of banking. A purely incidental result would be to make
banking safer and more profitable; but by far the most important result would
be the prevention of great booms and depressions by ending chronic inflations
and deflations which have ever been the great economic curse of mankind and
which have sprung largely from banking."
According to Fisher, the creation of money depends on the coincidence of the
double will of borrowers to borrow and banks to loan. Keynes deplored this
"double want" coincidence as a source of large swings in the circulating
medium. Why? In time of recession, borrowers are over indebted and see narrower
profit prospects, they become less willing to borrow; banks are saddled with
impaired assets and are less willing to lend. Jointly, they cause a contraction
of money and, in turn, an aggravation of the downturn in the economic cycle.
The Chicago Plan was influential in the enactment of the Banking Act of 1935
creating the Federal Open Market Committee (FOMC) with the purpose of
controlling money supply through open market operations using government
securities. Although, the Chicago Plan was shown in 1935 by Professor James
Angell of Columbia University to be easily implementable, it remained an
eloquent academic construction that was never seriously considered for
practical implementation in spite of its potential contribution toward lasting
Irving Fisher wrote: "I have come to believe that that plan is incomparably the
best proposal ever offered for speedily and permanently solving the problem of
depressions; for it would remove the chief cause of both booms and
When money creation becomes the sole prerogative of the government and no money
substitutes are allowed, the control of money supply becomes easier than under
a system of money creation by banks. Both Fisher and Simons proposed a fixed
rule for controlling the money supply and stabilizing the value of the dollar
and strongly repudiated discretionary powers. While they did not settle for a
final money indicator, they nonetheless formulated a few indicators, any of
which could serve as a satisfactory fixed rule for money supply.
These indicators were fixed quantity of money M, fixed turnover MV, where V is
the velocity, fixed price level, or fixed rate of increase in money supply in
line with economic or demographic growth. The choice of any of these indicators
would enable the government to control money supply and avoid booms and
depressions endemic to the banking system that we have today.
Both Fisher and Simons were preoccupied with the consistency of fiscal and
monetary policy, and proposed that the money rule be immune to wide changes in
fiscal balances, that is, fiscal surplus or deficit will not entail,
respectively, a contraction or an expansion of the money supply beyond the
fixed money rule.
Among strong supporters of the Chicago Plan were Maurice Allais and Milton
Friedman. Both criticized the discretionary rule and