The success of any business can only be measured by what one is trying to accomplish. If the Vollgeld initiative aims to create a stable and healthy economy in Switzerland, it will be a miserable failure. However, if Vollgeld’s supporters aim for firmer government control, it could very well serve the purpose.
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” – Switzerland would end fractional reserve banking and require banks to fully back deposits with reserves.
At first glance, this looks like a positive development. Alas, the devil is always in the details – and details are lacking in the Vollgeld plan.
This is potentially a big problem. Vollgeld would fundamentally transform the entire Swiss monetary and banking system. And because Switzerland does not operate in a vacuum, such changes could have second-order effects on exchange rates, interest rates, capital flows into or out of Switzerland, and so on. They could also have third-order effects by inducing other countries to react. with political actions of their own, either to control capital flows or to also reform their banking and monetary systems.
Before we look at these questions, let’s look at the basic tenets of the Chicago plan as discussed by IMF economists and cited by Vollgeld’s supporters:
- Banks must guarantee 100% of deposits with government-issued reserves (i.e. banks cannot lend by creating new deposits). Banks would borrow from the Treasury until they reached 100% of deposits, thereby backing customer deposits with funds from government loans that would (theoretically) sustain the bank in good times and bad.
- Government securities already held by banks would be purchased by the government at par, which would increase the banks’ cash position.
- Banks would presumably borrow from the Treasury to make loans and guarantee deposits. The authors of the plan claim that the government would then have a net inflow of assets.
- The government sets the nominal interest rate paid on the reserves. The authors advocate rates below market rates and a real rate below the growth rate of the economy.
- Tax rates are significantly reduced, especially on capital.
- Private lending is limited to socially beneficial physical investments (made through investment funds).
- The government embarks on a “complete” purchase of household debt, then immediately taxes the windfall gain made by households.
- The government then follows a money growth rule that the money supply grows at a fixed rate each year (presumably to match real growth). The model assumes zero steady-state inflation.
- Interest paid on deposits will be below market rates.
What would the plan look like in action?
Consider the following hypothesis: If Larry deposits $100,000 in his local bank, the bank has 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 Sally $90,000 for her mortgage, leaving $10,000 of Larry’s deposit in cash reserves. This mortgage is recorded as a loan in the assets of the Main Street ledger. Let’s also assume that the bank invests $9,000 of its 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. Suppose Main Street Bank already owns $15,000 of Treasury bills. The Treasury then buys the Main Street Bank bonds at par. Main Street Bank recorded an increase in the “cash” account by $15,000 (debit) and simultaneously reduced the “securities” account by $15,000 (credit). In Main Street’s balance sheet, it’s largely a washout, as they’re simply swapping one asset for another. However, Main Street’s income statement is significantly affected, as this transaction reduces Main Street’s interest income – it exchanges interest-bearing treasury bills for non-interest-bearing cash. If the bonds held by Main Street were paying 5% interest, Main Street is now forgoing $750 in interest income. On the other hand, the transaction has a beneficial effect for the government. It swaps non-interest-bearing currency for interest-bearing bonds (i.e. the government no longer has to pay $750 in interest).
In the next stage of Chicago’s plan, Main Street is to back deposits by borrowing from the Treasury. At this point, Main Street owes Larry $100,000 in deposits and only holds $19,000 in cash reserves. Therefore, Main Street must find $81,000 in additional reserves to back Larry’s deposits with government securities. He can do this in three ways: a) by selling some or all of Main Street’s interest-earning assets (eg, Sally’s mortgage, securities owned, etc.); (b) going to the Treasury to borrow $81,000 (to be repaid with, say, 2% interest); or c) engaging in a combination of both. In scenario a), the interest Main Street Bank earns on the assets decreases to $5,400 (90,000 * 6%), reducing the bank’s profitability. In scenario b), Main Street Bank’s interest expense increases by $1,620 ($81,000 * 2%). In scenario ), interest earned decreases and interest expense increases. Either way, the net interest margins earned by Main Street are shrinking.
This is undoubtedly why the Chicago plan calls for the government to set interest rates below the market (in particular, below the real rate of growth) – to at least partially compensate the banks for the reduction in interest income. By setting interest rates below real growth, Vollgeld will encourage the Swiss to borrow more than they would otherwise. This provision therefore obliges the government to control loans. In turn, loan controls inevitably lead the government to direct loans to politically favorable projects and institutions. From the bank’s perspective, this creates a slow but steady decoupling between lending decisions and the merits of those same lending decisions.
Fix the spreads, break the system
The plan would set spreads at 2% for residential mortgages, 5% for consumer loans, 3% for working capital and 1.5% for investment. This might actually be the dumbest part of the plan. Spreads exist for a reason: because they reflect the market’s assessment of risk. If the spreads are fixed, the risk rating will remain locked in, despite the fact that risk can and does fluctuate over time. If the gaps are not discovered by the market, neither the government nor the market will know whether housing is overbuilt or underbuilt. Likewise, the market mechanism to correct misallocations of capital – which typically takes five to seven years – would be abandoned. Instead, spreads would be fixed and never reflect changes in the underlying economy. Setting spreads in this way would inevitably lead to a gross misallocation of capital that would get worse over time, giving the impression of working for a while, until the distortions in the underlying economy subsided. gradually accumulate and eventually become so large that the economy has to shrink.
Money is like money. People will attempt to change their means to achieve a desired end. Even if the Vollgeld supporters have noble intentions, they will not be able to control the behavior of the public in the market. Even the chief architect of the Chicago plan, Henry Simons, sent a letter to Fisher in 1934, stating that “savings deposits, treasury certificates, and even treasury notes are nearly as close to demand deposits as than sight deposits in legal tender”. As discussed in “Irving Fisher and the 100% Reserve Proposal”, what should be done, for example, to prevent savings banks (a) from acquiring funds that depositors would view as liquid cash reserves or (b) provide through drafts a fair substitute for control facilities? And if they somehow do exercise sufficient control to stifle the objectives of the Swiss public, the entire Swiss economy will pay the price.
In practice, our current political-financial system is plagued with problems, so we should certainly be open to improvements. The idea of separating the lending function and the monetary function between banks and central banks has an intuitive appeal. One of the stated goals of Vollgeld backers is to eliminate bank runs. It’s no coincidence that the Chicago plan was crafted during the Great Depression, when many US banks experienced crippling waves of bank withdrawals. Vollgeld’s supporters suggest that if the cash is separated from the debt and the government owns the banks’ debt, then a run is impossible.
Unfortunately, the real world is almost never that simple.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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