Analysis - We can bring the recession to an end without more debt, no cuts and no new taxes

For all the nation's economic woes, the debate seems stuck on tax hikes for the rich or more borrowing from the bankers - we need a new and permanent solution. Just like the one being debated on MSN money, yes that's right Microsoft News Money - http://money.msn.com/investing/no-debt-no-cuts-no-new-taxes we should be debating these issues at the TUC congress this week!

With UK's national debt forever rising, cuts to public services so deep as to threaten their existence and low income families flocking to food banks we all fear for the future and are looking for solutions that do not re-run the tired old ones.

You can never tax the rich enough to pay back the debts and the more you cut public service jobs the higher the costs of welfare rise. Borrowing even more from the bankers to pay for a rise in economic activity just makes them richer and us poorer and even more in debt.

What if there was another way, a way that would not only solve these problems but also address the redress owed to us by the City and Wall Street for its shenanigans -- by reclaiming a great power, the power to create money.

There may be such a way. It's called the Chicago Plan we ran a piece on this in July. And it first came up during a crisis not unlike what we have right now. It's a big plan for big problems. Yes, it's something that may not seem possible given our polarized politics. But it may also be exactly what we need. Here's why.

Making money

The plan was conceived by a group of economists back in the early 1930s. Conditions then were similar to those we face today: a stagnant recovery, banks withholding credit, too much debt, consumer price volatility and the rise of political extremism as a consequence of economic turmoil.

Although it generated much excitement within the academic community and became a more formal proposal by 1939 (.pdf file), its main tenet was that the government, not private banks, should control the creation of money, as it did during the US Revolutionary War and the US Civil War and has the Bank of England has just done to bail out the banks.

As a result, new money would no longer require an offsetting creation of debt, as it does now. And banks should hold 100% of customer deposits in its vaults, not the 10% that is required now while the rest is lent out.

If you're like most people, the inner workings of the financial system are about as intuitive as hooking up a home stereo. But stick with me here. I'll use a simple example to illustrate all this.

The power shifts

The Chicago Plan would change all this by separating money from credit. Bank of America would have to hold the entire $100 deposit in its vaults, acting (as banks originally did) as a safe house for wealth. Customer deposits would sit alongside it. Loans would be funded separately -- via retained profits, equity from investors or loans of currency from the government. The government authority that issues currency -- which could be a restructured Fed -- would directly control the money supply by changing the price and size of those loans of currency to banks versus the indirect control the Fed has now. If it wanted the money supply to grow by $344, it would lend $344 to the banks, which banks would then loan out to make a profit.

The advantages of this are easy to see. Over the past few years, the Fed and the has been pumping cheap money into the financial system in an effort to expand the money supply and support our recovery. But banks have often hoarded the cash -- to the tune of nearly $1.5 trillion. If that money came with an explicit cost, banks wouldn't have the choice of sitting on it. Either they would lend it to consumers or businesses, or they would loan it to other institutions that could. The Bank of England could more easily force that money into the economy by taking over the banks' control of the money-creation process, while banks and other institutions would focus on getting credit to those that need it.

Keep in mind, this plan isn't the ramblings of anti-establishment anarchists. That's why it's so compelling. The original Chicago Plan was backed by members of the University of Chicago, including Frank Knight (who tutored Nobel laureates, George Stigler and James Buchanan) as well as Irving Fisher, whose work on interest-rate theory and the debt-deflation dynamics of depressions remains influential today. Renewed interest in the plan was catalyzed by a recent working paper (.pdf file) by two researchers at the International Monetary Fund, Jaromir Benes and Michael Kumhof.

The duo, realizing the similarities of the problems faced by the Chicago Plan authors to our current predicament, applied its solutions to an advanced model of the U.S. economy. In plain English, their models try to simulate the saving and borrowing activities of various sectors of the economy, from governments and households to manufacturers and unions. It may not be a perfect simulation, but it's as close as we can get.

Here is what they found:

A reduction in business cycle fluctuations -- and therefore more prosperity -- as the boom-bust cycle of lending was diminished and the ups and downs in bank credit and bank-created money were reduced. Banks would concentrate on making loans, not on whether they should expand the money supply. Tighter control would allow monetary authorities to reduce the inflation rate to near 0% while keeping economic growth high.

Elimination of bank runs, since deposits would be 100% backed by the holdings in the banks' vaults.

A dramatic reduction in the government's net debt, because the currency authority would have net assets (loans to banks) worth 100% of the deposits in the financial system. According to Kumhof, this is estimated to be around 180% of gross domestic product, or nearly $30 trillion. The government could, in turn, use part of the windfall to buy back its debt (from, say China) and cancel it.

The creation of another source of government revenue as banks pay interest on their currency loans from the government. If, the interest rate was, say, 1%, the government would gain $300 billion annually. Paired with a strong economy, we could fix our problems without big tax hikes.

Benes and Kumhof took a long, hard look at the history of money and found that it's a government's declaration that something is legal tender that makes it valuable. Ancient history also provides plenty of evidence that government-issued money tends to bring more prosperity and stability than privately issued money.

The early American revolutionaries were remarkably well read in monetary theory no doubt familiar with England's chaotic history following the Free Coinage Act of 1666 that took the power of coin away from the monarch and gave it to the privately controlled Bank of England. Benjamin Franklin, Thomas Jefferson and Thomas Paine all argued in favor of government-backed money, as did John Locke, the influential British philosopher who inspired the revolutionaries.

Its time we re-found this cause to change our money system and place money creation under democratic control - issued without debt to end the savagery of recession.