By Hema Senanayake –
In my previous writings, like many other writers on the subject of economics, I was critical about what had happened and what is happening. Yet, no solution was proposed other than hinting what ought to be done. From this piece, I am going to suggest a possible solution. As you may understand, here in this column, I could discuss only the concept based on theoretical and empirical evidences, but theories would not be discussed.
In order to put our solution in a correct perspective, we need to understand certain things. First, as Professor Kumar David repeatedly pointed out in his recent writings, the debt crisis is global, and I may add, it is common to any capitalist economy and to any socialist country which happened to use money and market exchange of goods and services. Also, I may add that the debt crises in most of the developed economies do not originate from inequality of income even though increasing income inequality is a problem that needs to be addressed. Also, I may add that debt crises in countries in which so called capital markets exist, do not originate from something known as “irrational exuberant.” Since the crisis is systemic and global, richest, well developed economies are the most indebted.
Second, a recent, unpublished, macroeconomic study has found out that accumulating un-repayable component of debt in each accounting cycle, is inherent to the contemporary economic system which is based upon a monetary infrastructure known as “Fractional Reserve Banking System”, even though there is an income and economic growth. This intimates that the increase of income and economic growth is not a solution but a postponement of the crisis taking place. So, what is the effect of this peculiar phenomenon?
The answer to the above question is; when economies accumulate enormous debt, private or public, and subsequently when the economy reaches to the point that no credit growth takes place, the system crash unless proactive debt-deflation (not outright debt cancellation) is not taken place. This was what happened in 2008 in the United States and Europe. As a result, the world experienced the first severe economic crisis in this century known as Great Recession of 2008-2009.
The countries, Sri Lankan politicians show as models, like Singapore, Malaysia etc. are too, in enormous debt. Kumar David, in his recent writings, has pointed out most of them, with facts and statistics. The only way to be relieved a bit from severe debt pressure is to post a significant economic growth, because growth can postpone (not resolve) a crisis.
Third, our (Sri Lanka’s) growth limits by one single factor that is the inflow of debt-free dollars is less than the outflow of dollars from all sources. This is a gap that is essential to bridge and to do it we need foreign currencies that is mainly dollars. So, we borrow in dollars. This, we got to stop either by discouraging imports and encouraging exports and remittances. In achieving these goals, the effect of the reforms we propose are indirect but significant because the reforms we propose would strengthen the monetary system by lowering rate of interest and tax burden on manufacturers of goods and services who produce to the local market or to export. Hence, we do not discuss the effect on external sector as at now other than mentioning, strict item-by-item import restrictions would resolve the severe problem in trade account but would create unintended bad consequences such as excess liquidity, if the domestic monetary policy is not duly adjusted.
Fourth, we need to understand the money creation process. Most money is not created by the Central Bank. If you figure out the total money stock and deduct the total money created by the central bank from it, you will find possibly that over 90% of money has been created some other entity. Such money is called “credit money.” The “credit money” is created when a commercial bank issues a loan. As acknowledged by Rajendra Thiagaraja who was the former CEO for Hattan National Bank, the bank can create loans amounting to Rs.10 from an incoming deposit of one rupee. Through this process, new money is created, and it is those money that is called “credit money.” Also, it is this monetary system that is called “Fractional Reserve Banking System.” Under this system most money is created by certain commercial banks known as designated commercial banks.
Fifth, we need to understand that there is another system of banking which is called Full Reserve Banking system. The main difference between the Fractional Reserve and Full Reserve Banking is that under the full reserve banking, commercial banks cannot create virtual money called “credit money.” This understanding of the working of Full Reserve Banking is enough for this discussion. I beg your patience and please keep on reading.
Sixth, we need to understand that the economic system always needs to create credit than system’s savings to ensure growth; in fact, this happens even in economic stagnation or in a recession too. However, this requirement can easily be met by the Fractional Reserve System because it can create more credit than incoming deposits but the Full Reserve Banking system itself cannot do it.
In view of above we now are ready to submit our proposal. If we borrow a terminology used by Japanese economist Kaoru Yamaguchi, in brief we name our proposal as “Public Money Administration for Market Economies in Periods of Debt Crises.” This is not something Professor Yamaguchi advocated. Instead he advocated and approved to get rid of fractional reserve system and replace it by full reserve system mentioned above forever. This same idea was ratified by an IMF Working Paper in 2012. Yet, we reject this proposal because Yamaguchi’s proposal (derived from Irving Fisher’s Chicago Plan) cannot ensure the system’s requirement mentioned under the sixth point above. Under such circumstances what they could do is to increase the money supply by a known quantity each year for example say by 3% as Milton Friedman suggested. This would be a highly inflexible system for a market economy. Therefore, we propose to continue with Fractional Reserve System but use public administration of money in periods of severe debt crises. So, we propose for the limited use of Irving Fisher’s Chicago Plan, which Plan has been explicitly studied by Professor Yamaguchi and endorsed by the above-mentioned IMF Working Paper. We do not propose the full implementation of the Plan, as it reduces the flexibility of the monetary system in view of the sixth point mentioned above.
What changes are made by our proposal? It reduces the creation of “credit money” and increase debt-free public money creation for a limited number of years, but the money created by both systems would not exceed the so-called monetary growth targets set by the central bank. It requires a lot of policy adjustments but the implementation of it is very smooth. IMF working paper says exactly that in regard to the U.S. economy. Let me quote the IMF paper.
“At the height of the Great Depression a number of leading U.S. economists advanced a proposal for monetary reform that became known as the Chicago Plan. It envisaged the separation of the monetary and credit functions of the banking system, by requiring 100% reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this plan: (1) Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money. (2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt. (4) Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. We study these claims by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy. We find support for all four of Fisher’s claims. Furthermore, output gains approach 10 percent, and steady state inflation can drop to zero without posing problems for the conduct of monetary policy.” (IMF Working Paper No. W/12/202, August 2012, emphasis by this author)
Therefore, as IMF Working Paper points out the implementation of our proposal would be smooth and especially there won’t be any inflation related to the implementation of the proposal.
However, complete conversion of the U.S. economy to Full Reserve Banking system (or 100% reserve baking system), would not be appropriate due to two reasons. Firstly, the IMF paper has ignored the sixth point we mention above. Secondly, U.S. dollar is the world’s major reserve currency, therefore the creation of it should be highly flexible and full reserve banking system cannot ensure this much flexibility hence what would be more appropriate is to use the said policy for systemic debt-deflation at times of severe debt crises. The ultimate objective is to ensure the use of global productive capacity (out of which 30% is wasted as at now) for the production of goods and services for the wellbeing of people around the world. Towards achieving this goal, let us do what we can do in Sri Lanka getting out of severe debt crisis of our own.