LONDON, April 28 (Reuters Breakingviews) – Here’s a list of some of the great financial problems of the day: governments are overindebted and the cost of servicing that debt is rising; central banks have swollen balance sheets and face losses on securities holdings; commercial lenders are exposed to rising interest rates and to bank runs fanned by social media; financial regulations are plainly not up to the task; inflation is hard to control; and the fate of the euro zone remains in doubt. To cap it all, central bankers are having trouble finding the appropriate interest rate that will bring inflation back under control without simultaneously collapsing the financial system. These multiple problems appear intractable. In theory, however, they could all be resolved at a stroke. In the early 1930s, economists Henry Simons and Frank Knight of the University of Chicago and Irving Fisher of Yale identified what they claimed was the essential flaw of modern banking. The trouble was that banks perform two functions. They supply credit and, in the process of making loans, create money. They do all this with sizeable amounts of leverage. As a result, the banking system is inherently unstable. During boom times, banks unleash too much credit and inflation takes off. In a bust, bank lending suddenly stops, the money supply begins to contract, and deflation appears. The economists’ solution – often called the Chicago Plan – was to remove commercial banks from the money-creating business. Credit money would be replaced by a state-issued money, and all deposits would be backed by this new money. Fisher outlined the proposals in his 1935 book, “100% Money”. He described how sudden increases and contractions of bank credit would no longer occur. Had this system been in place in the 1930s, there would have been no bank runs, no collapse of the money supply and no Great Depression. Since banks would be more stable, Fisher also suggested there would be less need for banking regulation. Milton Friedman, a keen advocate of the Chicago Plan, argued that it would allow the government to control inflation simply by setting the growth of the money supply at a fixed percentage each year. The idea had another surprising benefit. During the transition, banks would be required to swap their holdings of government bonds for state-backed money. This new money would pay no interest. As a result, Fisher said, “the interest-bearing government debt would be substantially reduced.” In 1933, Frank Knight presented the Chicago Plan to President Franklin Roosevelt, arguing that the U.S. financial collapse had made a major change in the structure of banking unavoidable. In the end, Roosevelt rejected Knight’s pleading, choosing instead to strengthen the powers of the Federal Reserve. Thomas Mayer, a former Deutsche Bank (DBKGn.DE) chief economist and head of the Flossbach von Storch Research Institute, has updated the Chicago Plan for the digital age. There’s never been a better time to implement it, he says. First, central bankers around the world are pondering how to introduce state-backed digital currencies. One of the main problems of a central bank digital currency (CBDC) is that it would compete with old-fashioned bank deposits. Mayer’s answer is that the CBDC should replace bank deposits, roughly as Fisher and Knight envisaged. The conditions for a transition are ripe. As a result of quantitative easing, commercial banks are sitting on large reserves and central banks own a large chunk of the sovereign bond market. Bank reserves can easily be swapped into CBDCs which would be used to back deposits. As with the original Chicago Plan, there would be a steep reduction in government interest payments. Mayer estimates that around half the euro zone’s 12 trillion euros of sovereign debt could, in effect, be eradicated if his plan were implemented. Europe’s single currency project would be on firmer ground, since there would no longer be any need for common deposit insurance or fiscal union. Once bank deposits were fully backed by government-issued money, there could be no more Silicon Valley Bank-style runs. With the digital money supply increasing in line with the economy’s potential growth, roughly as Friedman advised, inflation would soon come under control. A particularly attractive aspect of Mayer’s proposal is that central bankers would no longer be involved in setting interest rates. Instead, under his plan “interest rates are determined by the demand for and supply of loanable funds. The market clearing rate equates the time preference of savers (the price of time) with the demand of investors determined by the marginal productivity of capital.” In other words, the market would discover the rate of interest, just as it discovers the prices of most other goods and services. Interest rates, Mayer suggests, would end up higher than they have been in recent years but would be less volatile. During the recent period of ultralow interest rates, more lending has shifted out of the banking system. Non-bank lenders like Apollo Global Management (APO.N) would have an enhanced role under the digital Chicago Plan. Traditional banks would continue to service their customers, settling transactions and making loans from their own capital or by borrowing. But they could not lend out customers’ deposits. Though banks could still go bust, individual failures would be less contagious and would not lead to a contraction in the money supply. At present, there’s little chance of the digital Chicago Plan coming to pass. Policymakers prefer to patch cracks in the financial system as they appear, rather than address its underlying flaws. Bankers have a vested interest in preserving the status quo. Central bankers won’t surrender their interest-setting powers without a fight. Politicians might welcome the reduction in government debt but would lose the ability to induce banks to finance them by printing money. It may require a complete monetary and financial breakdown before Mayer’s plan is given the consideration it deserves.