Monetary Central Planning and the State, Part 23: Henry Simons and the "Chicago Plan" for Monetary Reform

Henry Simons was one of the guiding intellectual lights at the University of Chicago in the 1930s and 1940s. Noted members of the Chicago school of economics — Milton Friedman and George Stigler, for example — have emphasized the personal and scholarly impact that Simons had on them and an entire generation of graduate students at the University of Chicago during that period.

Among the outstanding characteristics of Simons’s writings throughout that period was his outspoken and forthright condemnation and opposition to collectivism, neo-mercantilism, and special-interest political plundering. He insisted that the choice before America and the world was collectivist planning or competitive free enterprise. If the collectivist road were followed, it would lead to tyranny and corruption. In his famous 1934 monograph, “A Positive Program for Laissez Faire: Some Proposals for a Liberal Economic Policy,” Simons argued:

“The real enemies of liberty in this country are the naive advocates of managed economy or national planning…. With the disappearance of the vestiges of free trade among nations will come intensification of imperialism and increasingly bitter and irreconcilable conflicts of interest internationally. With the disappearance of free trade within national areas will come endless, destructive conflict among organized economic groups — which should suffice, without assistance from international wars, for the destruction of Western civilization and its institutional heritage. Thus, the increasing organization of interest groups (monopoly) and the resurgence of mercantilism (“planning”) promise an end of elaborate economic organization (of extensive division of labor nationally and internationally), and an end of political freedom as well.”

But while forceful in his criticisms of the collectivist trends of his time, his conception of a “positive program” of laissez-faire, paradoxically, was radically interventionist and redistributive! He advocated the nationalization of utility companies and other “noncompetitive” monopolies; he called for the breaking up of large corporations and for legal limitations on their power and size; he proposed using the income tax as a conscious tool for the redistribution of wealth for a greater equality of income; and he believed that there was an important role at every level of government for social welfare programs to reduce the effects of poverty and to raise the cultural character of the population.

He also argued that the American money and banking system needed a radical revision. He presented his case for such reform in four publications: in a 1933 memorandum that had a wide circulation but was never published; in his 1934 “Positive Program for Laissez Faire”; and in two pieces published in 1936 entitled “The Requisites of Free Competition” and “Rules versus Authorities in Monetary Policy.” Except for the 1933 memorandum, they were reprinted in his 1948 volume, Economic Policy for a Free Society. (The volume appeared posthumously; Simons had died in 1946 at the age of 47, an apparent suicide.) The same proposal was amplified and defended by Simons’s long-time University of Chicago colleague and friend Lloyd Mints in a volume entitled Monetary Policy for a Competitive Society (1950).

Simons’s fundamental premise was that a functioning market economy requires fixed and definite “rules of the game” (rule of law; private property; open competition) in the context of which and with the certainty of which individuals in the private sector can more effectively go about their business of production and exchange for mutual improvement of the human condition. He argued that dramatic and repeated fluctuations in production, employment, and the general level of prices had their origin in the fact that the monetary system operated with no such definite rules.

The business cycle had its cause in two elements of instability in the monetary order. First, central bank managers were empowered with the discretionary authority to increase or decrease the money supply, guided by their own changing views concerning the quantity of money that should be injected into or withdrawn from the economic system to meet equally changing economic policy goals. This meant a relatively high level of unpredictability for private-sector investment decision-making.

Second, the American financial system was constructed upon the principle of fractional-reserve banking. When a bank received a deposit from one of its clients, that deposit then represented a claim for the full amount, payable on demand whenever the depositor wished to either withdraw cash or write a check against his account. But the banks were required to hold only a fraction of the full dollar value of its liabilities to depositors as an actual cash reserve. The rest, above the minimum reserve, was lent out to borrowers as the basis upon which the banks earned interest income.

For example, if Smith deposited $100 dollars in his bank account, the bank might hold only $10 (i.e., 10% of the dollar value of the bank’s liability to the depositor) as an actual cash reserve against any withdrawal(s) he might desire to make. It would extend a loan for the remaining $90 to a borrower, Jones, who desired to use that sum for, say, some investment purpose. The bank now would have as outstanding liabilities to pay on demand to both the original depositor (Smith) and the borrower (Jones) a total of $190. If Jones were to withdraw the $90 from the bank for his investment project, and if the original depositor (Smith) were to want to withdraw more than $10 from his account (in the form of either a cash withdrawal or a check that would return to the bank for payment), it is clear the bank would be faced with insolvency.

The bank would have created a total of $190 of purchasing power on the basis of a $100 deposit. If Smith were to attempt to withdraw the full $100 on demand, the bank would be required — if it were not to break its promise to pay on demand — to call in the loan of $90 for the full amount (assuming that Jones had the full sum to repay immediately). Bank-created purchasing power in the form of deposits and loans would have to decrease by $190 to fulfill its $100 promise to pay on demand. Thus, the amplitude of fluctuations in bank-created purchasing power is a multiple of the actual amount of deposits made into or withdrawn from commercial banks under a fractional-reserve system. To eliminate, or at least diminish, these two sources of instability in the monetary system, Simons argued for the establishment of a “monetary rule” which those responsible for monetary policy within the government would be required to follow. He suggested several possibilities, but the one he finally proposed as the most practicable one was a monetary rule for the stabilization of the general price level as measured by some price index.

In place of fractional-reserve banking, he advocated 100% reserve banking. Banks would be required to hold as a reserve, against their outstanding liabilities to depositors, cash on hand equal to the full dollar value of the deposits left with them. Deposit banking, Simons said, would then become a form of warehousing in which the full sums left on deposit would be not only payable on demand but actually 100% redeemable at all times. For serving as a depository warehouse, banks would receive a fee from depositors for services rendered.

Loan banking, in Simons’s plan, would no longer be possible on the basis of payable-on-demand deposits. Instead, he proposed that other banks be allowed, by law, to undertake the lending business only by selling shares in their company and on the basis of the cash raised extend loans to interested borrowers.

What would be money in such a system and how would the plan be implemented? Simons called for the permanent abandonment of the gold standard. In its place, there would be a single, uniform national paper currency issued by the federal government. Only the government would have the authority to increase or decrease the quantity of money, with this power delegated to a Monetary Authority and the U.S. Department of the Treasury. They would, therefore, be assigned wide administrative powers to implement the program and to manipulate the quantity of money in circulation to maintain a stable price level.

The Monetary Authority would introduce 100% reserve banking by buying government bonds and other securities held by commercial banks and requiring them to use the paper money received as payment for them to enhance their reserve position to a 100% level against outstanding depositor liabilities. (Simons pointed out that this was one way to pay off the federal debt by just printing paper!)

Once the new system was in place, the Monetary Authority would be required to use its powers to maintain a stable price level. In a growing economy, with productivity increases and expanding output, there would be a secular trend towards a slowly falling general price level. To counteract this tendency, the Monetary Authority would have to be continually increasing the money supply at some annual rate.

The initial buying up of government securities, to fill the banking system with sufficient new national paper currency to put the banks on a 100% reserve basis, would have diminished most of the outstanding federal debt. The Treasury Department, therefore, would have to plan running regular budget deficits to put sufficient government securities in the market for the Monetary Authority to have something to buy up when it wished to increase the quantity of paper money in circulation. The Treasury would also have to have, Simons stated, significant discretionary power to modify both federal expenditures and the tax rate by decree, to ensure the requisite deficit spending for the Monetary Authority to be able to fulfill its “rule” of maintaining a stable price level.

In the 1930s and 1940s, this was the Chicago School’s alternative to Keynesian economics: a national paper money managed by a government-established Monetary Authority, working with a U.S. Treasury Department that would have wide discretionary and decree powers to run smaller or larger federal budget deficits so as to manipulate the quantity of money in circulation for the purposes of instituting the rule of a stable price level.

Other than the rule or target — price-level stabilization instead of full employment — the monetary and fiscal powers given to the government under the Chicago plan were not much different than those proposed by the Keynesians. (See “Monetary Central Planning and the State, Part XXI,” Freedom Daily, September 1998.)

Money would be totally nationalized by the government, with no link whatsoever to a market-based commodity such as gold. A monetary central planning board — the Monetary Authority — would have complete control over the issuance and availability of money within the market society. The executive branch of the government, through the U.S. Treasury, would be free of the constitutional restraints that placed legislative power over taxing and spending in the hands of the Congress. The federal debt and all future deficits would be taken off the books through the monetary miracle of the printing press. And the banking industry would be under strict regulations specifying how and in what form they could undertake the business of financial intermediation.

This was the Chicago School’s version of a “New Economics.”

Categories: Freedom Daily Archive, Monetary Policy