Success in any endeavor can only be measured against what one is trying to achieve. If the Vollgeld Initiative is about creating a stable, healthy economy in Switzerland, it will be an abject failure. If the Vollgeld backers are aiming for firmer government control, however, then it might serve the purpose quite well.
My colleague Jason Voss recently wrote about how Switzerland will hold a referendum to vote on Vollgeld, also known as the "full money initiative." If enacted — and this is a big "if" — then Switzerland would end fractional reserve banking and require banks to fully back deposits with reserves.
At first blush, this sounds like a positive development. Alas, the devil is always in the details — and details are something in which the Vollgeld plan is lacking.
It's a potentially big deal. Vollgeld would fundamentally transform Switzerland's entire monetary and banking system. And because Switzerland does not operate in a vacuum, such a changes could have second-order effects on exchange rates, interest rates, capital flows into or out of Switzerland, etc. It could also have third-order effects by inspiring other countries to respond with policy actions of their own, either to control capital flows or to reform their banking and monetary systems as well.
The Chicago Plan
Before we examine these questions, let's take a look at the basic tenets of the Chicago Plan as discussed by IMF economists and cited by Vollgeld backers:
- Banks have to back 100% of deposits with government-issued reserves (i.e., banks cannot lend by creating new deposits). Banks would borrow from the Treasury until they reach 100% of deposits, thereby backing customer deposits with funds from government loans that would (theoretically) support the bank in good times as well as bad.
- Government securities already owned by banks would be purchased by government at par, elevating the cash position of banks.
- Banks would presumably borrow from the Treasury in order to make loans and back deposits. The plan's authors claim that the government would then have a net inflow of assets.
- The government sets the nominal interest rate paid on reserves. The authors advocate rates that are lower than market rates and a real rate lower than the growth rate of the economy.
- Tax rates are reduced materially, particularly on capital.
- Private lending is restricted to socially beneficial physical investments (made through capital investment funds).
- The government embarks on a "full" buyback of household debt and then immediately taxes away the windfall gain made by households.
- The government then follows a money growth rule whereby the money supply grows at a fixed rate each year (presumably to equal real growth). The model assumes a steady-state inflation of zero.
- Interest paid on deposits will be lower than market rates.
How Would the Plan Look in Action?
Consider the following hypothetical: If Larry deposits $100,000 into his local Main Street Bank, the bank records an asset called "cash" or "cash reserves" of $100,000 and a corresponding liability called "deposits" of $100,000. Under the current system, the bank then lends $90,000 to Sally for her home mortgage, leaving $10,000 of Larry's deposit in cash reserves. This mortgage is recorded as a loan on the asset side of Main Street's ledger. Let's also assume that the bank puts up $9,000 of it's own money (equity) for Sally's mortgage. So, Main Street now records $19,000 as "cash reserves" on the asset side of the ledger.
Now, enter the Chicago Plan. Let's assume that Main Street Bank already owns $15,000 worth of Treasury bonds. The Treasury then buys the bonds from Main Street Bank at par. Main Street Bank records an increase to the "cash" account of $15,000 (debit) and simultaneously reduces the "securities" account by $15,000 (credit). On Main Street's balance sheet, it is largely a wash, as they simply swap one asset for another. However, Main Street's income statement is materially affected, because this transaction reduces Main Street's interest income — it exchanges interest-bearing Treasury bonds for non-interest-bearing cash. If the bonds Main Street owned paid 5% interest, Main Street is now foregoing $750 in interest income. In contrast, the transaction has a beneficial effect for the government. It exchanges non-interest-bearing currency for interest-bearing bonds (i.e., the government no longer has to pay $750 in interest).
In the next step of the Chicago Plan, Main Street must back deposits by borrowing from the Treasury. At this point, Main Street owes $100,000 in deposits to Larry and holds only $19,000 in cash reserves. Therefore, Main Street must come up with an additional $81,000 in reserves to back Larry's deposits with securities from the government. It can accomplish this in one of three ways: a) by selling off part or all of Main Street's interest-earning assets (e.g., Sally's mortgage loan, securities owned, etc.); b) by approaching the Treasury to borrow $81,000 (to be repaid with, say, 2% interest); or c) by engaging in some combination of the two. In scenario a), the interest Main Street Bank earns on assets decreases by up to $5,400 (90,000 * 6%), reducing the profitability of the bank. In scenario b), the interest expense of Main Street Bank increases by $1,620 ($81,000 * 2%). In scenario ), interest earned decreases and interest expense increases. In all cases, net interest margins earned by Main Street shrink.
This is, no doubt, why the Chicago Plan advocates the government setting interest rates below market (specifically, below the real rate of growth) — to at least partially compensate banks for the reduction of interest income. By setting interest rates below real growth, Vollgeld will encourage the Swiss to borrow more than they otherwise would. This provision, then, leads to the government needing to control lending. In turn, control of lending inevitably leads to the government directing lending to politically favorable projects and institutions. From the bank's standpoint, it creates a slow but steady decoupling of lending decisions from the merits of those same lending decisions.
Fixing Spreads, Breaking the System
The plan would fix spreads at 2% for residential mortgage loans, 5% for consumer loans, 3% for working capital, and 1.5% for investment. This could in fact be the most foolish part of the plan. Spreads exist for a reason: because they reflect the market's assessment of risk. If the spreads are fixed, then the assessment of risk will remain locked, despite the reality that risk can and does fluctuate over time. If spreads are not discovered by the market, neither the government nor the market will know if housing is overbuilt or underbuilt. Likewise, the market mechanism for correcting misallocations of capital — which typically takes five to seven years — would be foregone. Instead, spreads would be fixed and never reflect changes in the underlying economy. Fixing spreads in this fashion would inevitably lead to gross misallocations of capital that compound over time, creating the appearance of working for a while, until the distortions in the underlying economy gradually build up and, eventually, become so large that the economy must recede.
Money is as money does. People will attempt to shift their means to achieve a desired end. Even if the Vollgeld's backers have noble intentions, they won't be able to control the behavior of the public in the marketplace. Even the chief architect of the Chicago Plan, Henry Simons, sent Fisher a letter in 1934, stating “savings deposits, treasury certificates and even commercial paper are almost as close to demand deposits as are demand deposits to legal tender currency.” As noted in “Irving Fisher and the 100% Reserve Proposal,” just what should be done, for example, to prevent savings banks (a) from acquiring funds which the depositors would regard as liquid cash reserves or (b) from providing through drafts a fair substitute for checking facilities? And if they somehow do exert enough control to stifle the objectives of the Swiss public, the whole Swiss economy will pay a price.
Practically speaking, our present political-financial system is rife with problems, so we should certainly be open to improvements. The idea of separating the lending function and the money function between banks and central banks has intuitive appeal. One of the stated objectives of the Vollgeld backers is to eliminate bank runs. It is no coincidence that the Chicago Plan was developed during the Great Depression, when many US banks experienced crippling waves of bank withdrawals. Backers of Vollgeld suggest that if money is divorced from debt and if the government owns the banks' debt, then a run is impossible.
Unfortunately, the real world is almost never so simple.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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