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An Islamic Chicago Plan?

Asad Zaman
(Posted December 16, 2014)

Introduction: Our topic of discussion is the harms of private creation of money under current financial system, and the necessity to replace this system by a government controlled creation of money. This topic is quite complex. Even my 40 page discussion in The Nature of Modern Money, omits many important aspects. Nonetheless, its vital importance makes it essential to create awareness of the issue among Muslims. This post attempts to summarize the essentials.


Myths of Money Creation: What I learned in graduate courses, and what students are almost universally taught about Money Creation, is almost the opposite of the truth. The standard Monetary Theory course teaches that the government creates High Powered Money, or the Monetary Base. This is called M0 or M1, or narrow money. Loans made by private banks in a fractional reserve banking system multiply this monetary base to create broad money or M2. This discussion implies that the government is in control of the process of money creation. See Busting money's creation myths by Steven Keen for more discussion.

Truths of Money Creation: In financially advanced economies, the monetary base is often less than 5% of broad money. Thus more than 95% of the money in existence is created by private banks. On these facts, everyone agrees. The controversy between endogenous and exogenous theories of money lies in how much control private banks have in this process. According to the dominant exogenous theories, the process of money creation by banks is mechanical and automatic, which means that if the governments sets the monetary base to be MB, then the amount of broad money which comes into existence is M2 = k x MB, where k is the deposit multiplier. The endogenous money theories say, quite sensibly, that banks and borrowers exercise a lot of discretion, so that k is very much dependent on what they choose to do. This means that 95% of the stock is created at the discretion of the private sector. Thus, the amount of money in circulation is not determined by the government, but rather depends on choices made by banks and borrowers. For more details, see Bank of England Endorses Post-Keynesian Endogenous Money Theory.

Exogenous or Endogenous?: There is strong evidence that the endogenous money view is correct. Benes and Kumhoff of IMF write that “The deposit multiplier is simply, in the words of Kydland and Prescott (1990), a myth. And because of this, private banks are almost fully in control of the money creation process.” Mian and Sufi (2014) provide evidence that the Quantitative Easing regime adopted in the recent past, in which Central Banks created huge amounts of High Powered money, had NO effect on the stock of broad money. In effect the Central Bank was powerless to change the money supply, contrary to the conventional theory of exogenous money.

The Mechanism of Money Creation: A small portion of money is created by the Government. Instead of printing money (as it ought to), the government prints treasury bills and sells them to the Central Bank. The Central Bank prints money (or just creates accounting entries) and buys the treasury bills. When the Central Bank prints money, high powered money is created and is credited to the account of the government. When the government spends this money by paying salaries or buying goods or services, it writes checks, so that credits on the Central Bank are transferred from ownership of government to ownership of the private sector. In particular, private sector banks acquire credits in the Central Bank, which is high powered money. Private sector creation of money proceeds quite differently. When a private bank grants a loan to a borrower, it simply writes an accounting entry in its books, which creates a credit of the amount of the loan in the name of the borrower. At this point, “virtual” money comes into existence. The banks make profits from the creation of money by getting interest when the borrower repays them the principal with interest. The process of money creation is described in detail by Bank of England authors: McLeay et. al. Money creation in the modern economy.

The Role of Interest Bearing Debt: One very important point to note here is that the creation of money is directly associated with the creation of interest bearing debt on a one-to-one basis. The government creates money by issuing debt in the form of treasury bills. The banks create money in order to lend it to eligible borrowers. Government debt is harmful to the economy because the government must pay interest on what it borrows. To finance this, the government needs to tax productive sectors of the economy. These taxes lower productivity and reduce the capacity of the economy to produce goods and services. If the government were to print money directly (instead of having the central bank print it and loan it to the government), it would not need to raise taxes to finance it. This would lead to increased productivity. The private sector banks make money by making loans. So it is in their interest to encourage the taking of loans. Therefore they devise schemes to make loans attractive to the public. One of these schemes is the credit card, which takes advantage of psychological tendencies of consumers – whereas people are reluctant to part with hard-earned cash, they find it much easier to swipe a plastic card through the machine, which is just a promise to pay later. Many other schemes of a more damaging nature have been devised by bankers to make the public borrow heavily. The product of the banks is “virtual” money which they sell as loans, and banks go to great lengths to make sales of this product by providing loans to the public. The unjust and economically harmful nature of interest based debt is discussed at book length in “House of Debt” by Mian and Sufi. See their blog for additional empirical evidence.

Implications of Endogenous Money: There are a large number of problems which result from the private creation of money by banks and borrowers. We mention only a few of them


  • Injustice: Banks have the power to manufacture money by the stroke of a pen, but only in response to requests for loans. This power to create money gives them a tremendous advantage over all other segments of society. This is inherently unjust. Why should one particular class of the wealthy be granted this privilege when others are not? Money is a social good and the power to create it should belong to the society as a whole, as represented by the government. An elementary explanation via a fable and an alternative system for social production of money is described by Louis Even: The Money Myth Exploded. A detailed and lengthy historical account of changing attitudes towards the morality of interest-based debt is given by Graeber in Debt: The first 5000 years. A key argument of Graeber is that current institutions of rigidly enforceable debt impoverish societies. The same point is made by Mian and Sufi in House of Debt, on the basis of entirely different arguments.

  • Inequality: Clearly, if one segment of society can create money at will, they will acquire an increasing share of the wealth produced. Following the Great Depression in 1929, a large number of rules and regulation were made to restrict the power of banks. The financial sector and the wealthiest segment of society lost out while the bottom 90% increased their income shares for the next 50 years. The liberals staged a comeback in the Reagan-Thatcher Era, following which these has been increasing de-regulation of the financial sector. As a result, the share of wealth of the top 0.1% started increasing, and has continued its upwards trend until it recently overtook the bottom 90% (see graphical illustration of this historical trend). The RWER blog post (20 graphs) provides many striking graphical descriptions of the massive and increasing inequality.

  • Inefficiency: What is done with money created by banks? If this money is used for highly productive investments, this is beneficial to society. If it is used for wasteful luxuries, speculation and gambling, this is harmful to society. For many reasons, private creation of money leads to highly inefficient investments. One of the arguments made in favour of the current system of private money creation is exactly the opposite: it is argued that this system provides loans for the most profitable investments, the ones that are the most beneficial for society. As against this argument, Keynes wrote in The General Theory of Employment, Interest and Money: “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done…” Keynes argued that instead of investing in productive enterprise, investors borrow from the bank to gamble on the stock market – these gambles determine the investment activities of the economy. For example, the global financial crisis was caused by gamblers who bet on ever increasing house prices in the USA. The stock market channelled money to this market, which was perhaps the most destructive investment, eventually resulting in the blow-up of the global economy.

The Power of Finance: A Historical Account: It should be obvious that any group of people who can capture the right to print money can wield an extraordinary amount of power. A detailed history of how it came to pass that this power was transferred from the government (where it belongs) to private parties is given by several sources, most notably Zarlenga (2002, The Lost Science of Money) and Ellen Brown (2011, Web of Debt) The extraordinary range of ways that the wealthy have used wealth to exploit and oppress the poor is too rich for condensation even at book length. The way that educational system has been captured to teach children to be docile factory workers, instead of creative thinkers, has been described by John Taylor Gatto (2000, The Underground History of American Education). How the newspapers and other media have been captured to propagate views favouring the wealthy elite has been described by many sources, notably Hermann and Chomsky (2011, Manufacturing Consent). How the entire government has been captured by the rich is documented by Dani Rodrik in How the Rich Rule. My own blog post “Deception and Democracy: Convincing the Masses to support the Rich,” provides for examples of how the public opinion is manipulated to support policies favouring the rich. A recent Supreme Court ruling in effect legalizes bribery by permitting the rich to provide unlimited campaign funding to all sides; see Chomsky (2010, The Corporate Takeover of American Democracy). After first weakening or eliminating laws against monopolies, the wealthy have gone on a shopping spree creating an enormous concentration of power, often using illegal tactics involving insider trading and leveraged buyouts. While the system works as a giant vacuum cleaner, sucking all the money to the top, the theory of the trickle-down effect is propagated via economics textbooks as a sop to the poor. A few extraordinary episodes are discussed below as illustrative examples of the power of the wealthy to ruin lives of millions for their personal benefit.

  • The Great Depression (1929): The private creation of money results when banks simply create accounting entries to provide loans, using money not actually in their possession. This is a central characteristic of the fractional reserve banking system. Whereas this was previously considered fraudulent practice, it is now accepted as a normal feature of the banking system. This means that if all customers demand payments, the banks will not have the currency to do so. Banking crises are therefore a regular feature of this system. In response to several such crises, which are said to have been deliberately manufactured especially for this purpose, the Federal Reserve Bank was created in 1913 in the USA. The ostensible goal of this central bank was to prevent banking crises, but it soon led to the biggest banking crisis in history. With the power to create money in the hands of the private sector, the banks set out to create demand for credit, as that was the product they sell. They succeeded in changing the culture so that it became acceptable to buy durables on debt. This led to the roaring 20’s, where the consumer debt multiplied enormously. In particular, easy credit was available to purchases houses, which led to rapidly increasing house prices, as well as massive increases in mortgage debt, just as in the global financial crisis. In addition, easily available credit money was pumped into the stock market which created rapidly appreciating stock market prices. The public was tempted or lured into purchasing stock by taking out loans, as a get-rich-quick scheme. Ultimately it all collapsed in a stock market crash, followed by several bank failures, which resulted in misery for millions. In the aftermath, strong regulations for the banking industry were created, among which was the Glass-Steagall act which prohibited banks from any kind of speculative activity, such as investing in the stock market.

  • The East Asian Crisis of 1997: Armed with enormous wealth, investors have taken down whole economies and their currencies in numerous episodes over the course of the twentieth century. This phenomenon became especially marked during the last few decades, where Mexico, Argentina, and many other countries were successfully attacked by speculators. Among the most dramatic of such episodes was the East Asian Crisis of 1997. The East Asian miracle economies had spectacular growth for three decades which generated a lot of wealth. Political leverage and faulty economic theories were used to pry open the economies, to enable access to this wealth by foreign investors. In a classic financial attack, millions of dollars of hot money flowed into these countries, leading to wild appreciation of real estate, stocks, and construction. A sudden withdrawal led to financial collapse, where the structure of debt and guarantees was such that foreigners acquired a huge amount of assets, industries, and land at fire-sale prices while domestic interests were wiped out by the debt.

  • The Global Financial Crisis of 2007: Keynesian economics led to policies of full employment and regulation of the banking sector which led to an increase in the wealth of the bottom 90% and a reduction in the share of the top 0.1%. The top 0.1% staged a successful revolt in the late 70’s and early 80’s starting with the Reagan-Thatcher era. As an opening shot, Reagan passed the Garn-St Germaine Act of 1982, which de-regulated the Savings and Loan Industry. Almost overnight, this transformed a sleepy, safe and highly conservative industry to a den of high rollers, who gambled wildly with money on national and international stocks. The day of reckoning came quickly with the S&L crisis when many of these gambles went sour. According to informed estimates, the bailout wiped out the entire profits of the banking industry over the past century. But worse was to come. The Glass-Steagall act was repealed in 1999, and many other regulations tying the hands of the financial wizards were repealed in the Commodities Futures Modernization Act of 2007. This created the space for a repeat of the Great Depression, where huge amounts of money was created and lent with abandon, leading to a huge bubble in prices of real estate and stocks. The collapse of the bubble led to failure and bankruptcies of the largest financial institutions in the World. Trillions of dollars were spent on bailouts, in effect allowing the criminal financial gamblers to win their gamble while bankrupting the public. A brief history is provided in my review and summary, while a full and detailed account is available from Mian and Sufi: House of Debt.

The Chicago Plan: In the aftermath of the Great Depression, several economists came to the realization that the source of the problem was the private creation of money by banks. They created the Chicago Plan which designed to provide an orderly transition from the private system to a system where the government would have 100 percent control of the process of money creation. A key feature of the system is that banks would be required to have 100% reserves – they would no longer be able to give loans by creating money as accounting entries not backed by cash. There is strong support for this position from the Sharia’ – the action of coining currency by individuals is considered as a hostility to the nation. This has also been the secular position, where many nations have used the forging of foreign currencies as acts of economic warfare against the foreign country. We turn to a discussion of some of the benefits of the Chicago Plan. Benes and Kumhoff (2012) created a model to evaluate the claims made for the Chicago Plan by its authors, in context of current US economic situation. They found support for all of the central benefits claimed for the Chicago Plan:

  • Elimination of Business Cycles: Because banks can create or destroy money nearly at will, the stock of money fluctuates erratically. As Keynesian economic theory demonstrates, the quantity of money has very important economic effects. Too little leads to recession, while too much can cause inflation. The Chicago Plan gives control of the money supply to the government, which can use it to smooth out economic fluctuations caused by erratic changes in money supply. Government should use counter-cyclical monetary policy – in a booming economy, the money supply should be restricted to prevent inflation. In a slack economy, money supply should be expanded to increase employment and production. Private sector creation of money does the opposite, since the demand for loans is high in a boom and low in a slack economy. Thus the current system of private money production creates or exacerbates the business cycles.

  • Complete Elimination of Bank Runs: There have been more than a hundred banking crises over the past century. The fractional reserve system is prone to runs because it routinely issues loans for a lot more money than is actually in possession of the banks. The 100% reserve requirement eliminates the possibility of bank runs.

  • Dramatic Reduction of Public Debt: In the current system, government sell Treasury Bills and go into debt to finance expenditures. The Central Bank is authorized to print money and buy the Treasury Bills from the government. Instead of incurring debt, the Chicago Plan allows the government to directly print money to finance its expenditures. Government need for financing is reduced, leading to a reduction in taxation. This also increases productivity since taxes dampen productive efforts of both laborers and firms.

  • Dramatic Reduction of Private Debt: the current system links creation of money to creation of debt on a one-to-one basis in the private sector. Money is created when banks give loans. As a large amount of money is necessary for the functioning of the system, so a large amount of interest based debt is equally necessary for the functioning of the system. When government issues money directly, without creating debt, all of this private debt will be wiped out. The threats to an economy posed by excessive debt have been documented by many authors, notably Mian and Sufi in House of Debt.

  • Increased Efficiency of Production: The private banking system creates money to finance investment, which is crucial for the future of the nation. This investment is directed towards the most privately profitable activity, which may be speculative rather than productive. There are many cases where socially profitable investments are not equally profitable on a private basis – most notably education and health. Public creation of money can be used to direct the investments towards the socially most beneficial activities. In addition, reduction or elimination of taxes leads to substantially improved incentives for firms and laborers, enhancing efficient production of goods and services.

Political Economy of the Chicago Plan: If the Chicago Plan has all of these benefits claimed, why has it not been implemented? The simple answer is that it is harmful to the interests of a very powerful segment of the wealthy elites. In the wake of the Great Depression, banking regulations and Keynesian economics created substantial constraints on the power of the rich. Nonetheless, they succeeded in blocking the Chicago Plan, which was even more radical. The effects of the regulation of the banking sector is clearly reflected in the graph of the wealth share of the top 0.1%. This shows a declining trend from 1930 to 1980, after which it starts increasing again, due financial liberalization starting from the Reagan-Thatcher era. The recent global financial crisis of 2007 was engineered by these super-rich elites. The collapse of the housing market led to houses worth more than 100,000 being available for fire sale prices like $5000. A huge amount of wealth was transferred from the public to these wealthy elites. Also, in the aftermath of the crisis, the wealthy were much better prepared. Whereas the Great Depression had led to heavy regulation of banking, all such regulation has been effectively blocked in the Congress. For example, to prevent speculation by banks, the Dodd-Frank act was proposed as an equivalent for the Glass-Steagall Act which was repealed in 1999. However, while Glass-Steagall was only 30 pages and clearly banned banks from all kinds of speculation, Dodd-Frank is a 300 page monstrosity full of loopholes. There is agreement among experts that any competent lawyer can find many ways to permit banks to speculate within the bounds of Dodd-Frank. This is just an illustration of the general picture that none of the problems that led to the financial collapse have been rectified. The Chicago Plan was discussed briefly and buried quietly without much discussion. Similarly, while there has been a lot of hue and cry, conferences and papers, on macro-prudential regulation, nothing has been done to prevent a new crisis of the same type. In other words, the top 0.1% who benefit vastly from the private creation of money are firmly in control, and have blocked even a discussion of the merits of the Chicago Plan.

An Islamic Chicago Plan: There is no magic bullet which will automatically solve all economic problems. The power to create money is very potent, and whoever has it can wreak havoc, or use it for beneficial purposes. The wealthy elite have argued that if governments have the power to create money, they will print huge amounts to fund deficits and thereby create massive inflation. In defence, proponents of the Chicago Plan have argued that historically, excess printing of money by governments has not caused hyper-inflations; see especially, Zarlenga (2002, The Lost Science of Money) and Ellen Brown (2011, Web of Debt). History is not necessarily a guide in this matter. There is no doubt that if the government prints money for the wrong purposes, or that if money created is placed in the wrong hands, it could cause much damage to the economy. Would this be comparable to the damage that has already been caused by the private creation of money? That remains to be seen. In this context, the theory of Islamic Public Finance is of great value. Basically the Shari’a prescribes the duties of the government. If the governments spends money to fulfil its responsibilities, it seems highly likely that no ill effects would result from government creation of money. To the extent that government steps out of these bounds, and spends money on projects which are outside its purview, or for corruption, this could easily create economic problems. There is a need for a mechanism to prevent this. To some extent a powerful judiciary which can enforce the Shari’a rulings on permissible use of government funds would provide an important constraint on the powers of the government to arbitrarily print money. There is a second very important check on the government powers. Decline and volatility in the value of money will hurt most those people who hold the most money, who are wealthy and powerful. Thus, this class will have a strong incentive to keep the power on money creation in check, so as to preserve their wealth. This should also prevent irresponsible money creation. Ultimately, an institutional structure can only enable the wise use of money, and cannot by itself guarantee this. If corrupt people with ill-intentions manage to acquire control of money creation, they may be able to circumvent institutional barriers, and wreak economic damage. Private money creation has already led to disastrous outcomes, and the suggested plan seems more conducive to improved outcomes. It is also much more in conformity with the Shari’ah. This is as much as we can hope for, since the battle between good and evil requires continuous struggle on our part.


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