Wednesday, 15 August 2018

Simon Wren-Lewis on fiscal versus monetary policy.

SW-L (emeritus economics prof at Oxford) has just published an article on his blog on the above topic. While I often leave comments after his articles, I have so many comments to make on this article that they could occupy more space than the article itself. So I’ve reproduced his article below, with my comments at relevant points in green italics. He starts…..

One divide between mainstream and many heterodox economists is on whether monetary or fiscal policy should be used for macroeconomic stabilisation (controlling demand to influence inflation and output). What makes a good instrument in this context? As I have argued before, a key difference between the mainstream and MMT involves different answers to this question. I think the following issues are critical.

1. How quickly do changes in the instrument (e.g. increases in interest rates) influence demand?

2. How quickly can the instrument be changed? Are there limits to how far it can be changed?

3. How reliable is the impact of the instrument on demand? In other words how uncertain is the impact of a change in the instrument on demand?

4. How certain can we be that whoever has power over the instrument will use it in the necessary way?

5.  Does changing the instrument have ‘side effects’ which are undesirable?

If we apply these questions to whether to use interest rates or some element of fiscal policy, what answer do we get?

Before doing that, it is worth noting this is all about the quickest and most reliable way to influence demand. It is quite separate to how demand influences inflation (as long as we are talking about underlying inflation).

The first question is important because long lags between changing the instrument and it influencing demand mess up good policymaking. Imagine how good your central heating would be if there was a day’s delay between it getting cold and the heating coming on. It is also perhaps the most interesting question for a macroeconomist. A full discussion would take a textbook, so to avoid that I’m going to suggest that the answer is not critical to why the mainstream prefers monetary to fiscal stabilisation.  

The second question is as important for obvious reasons. If an instrument can only be changed every year, that is like having very long lags before the instrument has an effect. On this question monetary policy seems to have a clear advantage given current institutional arrangements. Some of this difference is difficult to change: it takes time for a bureaucracy to move. As I noted with the fiscal expansion implemented by China after the crisis, about half of the projects were underway within a year. Others delays are in principle easier to change: there is no reason why tax changes need only happen during Budgets in the UK, for example.

First, SW-L obviously has a good grasp of what heterodox economists are thinking, when he suggests they have a preference for fiscal over monetary policy.

Next, SW-L says “Some of this difference is difficult to change: it takes time for a bureaucracy to move.” That is rather contradicted by his next sentence which says that half the fiscal expansion measures implemented in China recent were up and running within a  year.

Re “If an instrument can be changed every year…”, presumably SW-L has in mind the annual UK budget “ceremony” in the House of Commons, and I assume the suggestion is that some fiscal changes can only take once a year (apologies to SW-L if I’m putting words into his mouth). In fact that “budget ceremony” is peculiar to the UK: there is no good reason fiscal changes cannot be made at any time. Indeed during the recent crisis, the UK’s VAT rate was changed twice outside the “budget ceremony window”.

Another point here is that if fiscal changes are difficult and slow to implement, that messes up the Job Guarantee. JG is a system where jobs are supposed to be created VERY QUICKLY given a rise in unemployment. Those jobs can be with existing employers (public and/or private) or on specially set up schemes as was the case with the WPA in the US in the 1930s. (For a discussion of the relative merits of “existing employer versus special scheme” see the several articles I’ve written on that topic. Briefly I argue that the “existing  employer” option is better because one gets a better mix of skilled labour, unskilled labour, capital equipment etc, plus more realistic work experience.)

In fact, it shouldn’t be beyond the wit of man to set up a system where local and city governments, central government departments, state schools, state run hospitals etc can be instructed very quickly to spend more and take on a few extra staff, either in the form of JG people or as regular employees (who might then have to be sacked when the fiscal stimulus is withdrawn).

In contrast, other forms of fiscal spending, e.g. construction projects take much longer to get going.

SW-L continues….

The second part of the second question is a clear negative for interest rates, because they have a lower bound. This is not the case for fiscal instruments: you can always cut taxes further for example. Because this is a critical failure for interest rate policy, effectively the discussion in this post is just about what happens when interest rates are not at the lower bound. Even so, potentially having two different instruments for different situations is a count against monetary policy.

There’s another “count” against monetary policy, which I go into in detail here – “here” being a thesis which will hopefully be published (in updated form) in a journal quite soon. The latter count is thus.

As explained in the latter thesis, most of the arguments for government borrowing do not stand inspection. Thus we are in the strange position where interest rates have been artificially elevated for decades, but the state (i.e. government and central bank) cannot reduce interest rates unless they are first artificially elevated, which is an absurdity. Put another way, if we had a permanent zero interest rate policy (advocated by Milton Friedman and several MMTers and in the above thesis), then cutting interest rates would be impossible.

SW-L continues…

The third question is often not asked, but it is absolutely critical. Imagine raising the temperature on a room thermostat which not only had no calibration, but which acted in different ways each day or even each hour. OMT is a clear example of a poor instrument because central banks have far less idea of how effective it is than interest rate changes, partly because of less data but also because of likely non-linearities.

Are interest rate changes more or less reliable than fiscal changes? The big advantage of government spending changes is that their direct impact on demand is known, but as we have already noted such measures are slow to implement. Tax changes are quicker to makes, but many mainstream economists would argue that their impact is no more reliable than the impact of interest rate changes. In contrast some heterodox economists (especially MMTers) would argue interest rate changes are so unreliable even the sign of the impact is unclear.

The fourth question is only relevant if the power to change interest rates is delegated to central banks. Let me assume we have a UK type situation, where the central bank has control over interest rates but it has to follow a mandate set by the government. A strong argument is that, by delegating the task of achieving that mandate to an independent institution, policy is less likely to be influenced extraneous factors (e.g. there is no way interest rates rise until after the party conference/election) and therefore policy becomes more credible. (There is a whole literature involving similar ideas.)

This advantage for monetary policy simply follows from the fact that it can be easily delegated. However even if it is not delegated, fiscal policy has the disadvantage that changes are either popular (e,g, tax cuts) or unpopular (tax rises). In contrast interest rate changes involve gains for some and losses for others. That makes politicians reluctant to take deflationary fiscal action, and too keen to take inflationary fiscal action. So even without delegation, it seems likely that interest rate changes are more likely to be used appropriately to manage demand than fiscal changes.

That problem with fiscal policy was solved by Ben Dyson, founder of Positive Money. As he explained, decisions on the size of the deficit (or surplus) can in principle easily be delegated to some sort of independent committee of economists. (At least I think Dyson was the first person to solve that problem – I may be wrong.)

That committee could perfectly well be the Bank of England Monetary Policy Committee. Moreover, decisions on the size of the deficit are increasingly being handed over to such committees the World over: for example in the UK there’s the Office for Budget Responsibility.

Note that handing the latter decision to the latter sort of committee does not, repeat not mean the committee has powers over strictly political matters, like what percentage of GDP goes to public spending and how that is split between education, health, defence and so on (as Dyson explains).

The fifth and final issue could involve many things. In basic New Keynesian models the real interest rate is the price that ensures demand is at the constant inflation level. Therefore nominal interest rates are the obvious instrument to use. Changing fiscal policy, on the other hand, creates distortions to the optimal public/private goods mix or to tax smoothing.

I’m baffled. Strikes me it is easy to implement fiscal stimulus (i.e. increase the deficit) while not altering the “public/private mix”. To illustrate if the public/private mix is 50:50, then expand public spending by the same amount as taxes are cut. Though to be realistic it’s a bit more complicated: e.g. taxpayers do not spend 100% of the amount by which their weekly income rises as a result of tax cuts. But it’s not IMPOSSIBLY difficult to get quite near to retaining the 50:50 mix. Plus I don't see why interest rate changes are guaranteed to leave the public/private mix untouched.

SW-L continues…..

So the case against fiscal policy as the main stabilisation tool outwith the lower bound might go as follows: it is slower to change and it cannot be delegated. Even if monetary policy is not delegated politicians may allow popularity issues to get in the way of effective fiscal stabilisation. While government spending changes have a certain direct effect, they are also the most difficult to implement quickly.

A potentially strong argument against monetary policy is the lower bound problem. You could argue that having monetary policy as the designated stabilisation instrument gets government out of the habit of doing fiscal stabilisation, so that when you do hit the lower bound and fiscal stabilisation is essential it does not happen. Recent experience only confirms that concern. I personally do not think mainstream macroeconomists talk enough about this problem.

The fiscal rule that Jonathan Portes and I developed, a version of which is Labour's fiscal credibility rule, does attempt to address this very issue. Switching from monetary to fiscal at the lower bound is a key part of the rule. It is also worth stressing that this rule does not prevent temporary changes in fiscal policy to counteract a downturn outwith the lower bound. (Anyone who says otherwise does not understand the rule.) For example if interest rates are already low, a fiscal expansion that is planned to last less than five years is consistent with the rule, and might be a sensible precautionary measure. (Public investment, which is outside the rule, could also be used in this way.) So Labour’s fiscal rule allows monetary policy to do its job, but fiscal policy is always there as a back up if needed.

And my final comment is that I like the fiscal rule thought up by SW-L and Portes. It’s a good idea. But as a self-confessed heterodox economist (and general oddball) I’d prefer fiscal policy to dominate, with interest rate adjustments being only used in emergencies.

Saturday, 11 August 2018

Labour’s strange new fiscal rule.

Warning note added on 13th August. There's a serious mistake below (unlike me of course...:-)). I assumed that if a long lasting and deep recession lasts more than five years, then the fiscal rule would prevent adequate stimulus being implemented. That possibility is actually catered for by Simon Wren-Lewis's so called "knockout" clause, which is that if interest rates are at or near zero, and more deficit is need in such a long lasting recession, then the five year rule is ignored. Put another way, the rule is that if interest rates are well above zero, then a deficit plus interest rate cuts are used to combat the recession, but if interest rate cuts cannot be used because they are at zero, then there's no limit to the deficit. However, I'll leave the paragraphs below unaltered, i.e. I'll leave the mistake there.


The rule is that the budget should balance over the medium term (five years to be exact), while borrowing should only be permitted to fund investment.

Well the first bit of nonsense there is that education is one huge investment, but for some strange reason the advocates of “borrow to invest” never claim the entire education budget should be funded via borrowing. For some more flaws in the idea that public investments should be via borrowing, see sections 4 to 4.6 here.

Next, Labour’s fiscal rule contravenes Keynes’s dictum: “Look after unemployment, and the budget will look after itself”. I.e. given a recession, as Keynes said, the state needs to print or borrow money without limit and spend it (and/or cut taxes) until the recession is cured. If that involves running a deficit for MORE THAN five years, then Keynes’s response would doubtless be “then so be it”, and quite right.

Next, if the budget balances over the very long term, the real value of the monetary base will eventually shrink to nothing because of inflation! I.e. inflation gradually erodes the real value of base money, thus if the stock of base money (and the national debt) relative to real GDP is to be maintained, then a  more or less constant deficit is needed. Plus real economic growth increases GDP, which further increases the need for a deficit if the “base money to GDP” ratio is to be maintained.

Note that the actual size of the deficit needed to keep the stock of base money and debt constant relative to GDP is quite large, as I’ve explained a dozen times on this blog. To illustrate with some not unrealistic figures, if inflation is at the 2% target and the stock of base money and debt are 50% of GDP, and real growth is 2%, then the deficit needed to achieve the latter “constant” relationship is (2+2)x50%=2% of GDP.

Simon Wren-Lewis (emeritus Oxford economics prof and co-author of the rule) claims a fiscal rule is needed so as to deal with what he calls “deficit bias”, i.e. the temptation that politicians always fall for (first pointed out by David Hume over two hundred years ago), namely to borrow too much. (Incidentally I have plenty of respect for Wren-Lewis an read most of his articles, but I think he's gone off the rails here.)

Well clearly the temptation to borrow too much needs to be countered, but there’s a simple solution to the problem, namely to have some sort of committee of economists (e.g. the Bank of England Monetary Policy Committee) decide all matters relating to the deficit, stimulus, etc, while politicians stick to strictly POLITICAL matters, like what proportion of GDP is allocated to public spending and how the latter is split between education, health, defence, etc. And what do you know? That’s the system advocated by Positive Money!

Plus it is hard to see why any government should not be happy with that system because where the central bank (CB) is relatively independent, the government has ALREADY handed the final say over the amount of stimulus to the CB: that is, if government implements what the CB thinks is too large a deficit, the CB can, under existing arrangements, nullify that with an interest rate rise.

Moreover, Wren-Lewis himself claimed recently that CBs ought to have the right to tell governments what to do when it comes to strictly economic rather than political matters.

Friday, 10 August 2018

The IMF still exudes BS.

Bill Mitchell (Australian economics prof and leading MMTer) has claimed more than once that the IMF is a waste of space and should be disbanded. So it was good to see this recent admission by the IMF that they have blundered.

The main problem with the IMF is their non-grasp of macroeconomics, as is shown in this recent blog article of theirs written by Vitor Gaspar and Laura Jaramillo. They claim that high government debt is a potential problem: as they put it, “Countries with elevated government debt are vulnerable to changing financing conditions, which could hinder their ability to borrow, and put the economy in jeopardy.”

Incidentally, I shouldn’t strictly speaking assume that views expressed by two authors of an IMF blog article have the blessing of the IMF as a whole. However, the views expressed in this article are actually very much in line with IMF thinking as I understand it and judging by other IMF articles I’ve read. Plus the IMF like any organisation is certainly not likely to publish articles which flatly contradict their basic thinking. 

Now what exactly are “changing financial conditions”? I’m almost certain what they mean is a rise in interest rates: certainly if you are a debtor and interest rates rise, they you’re liable to have problems.

So why don’t they call a spade a spade? I.e. if they mean a rise in interest rates, why don’t they say so? Well if you’re not too sure what you’re talking about, then it’s best to keep what you’re saying on the vague side. Then if anyone accuses you of saying one thing, you can claim you were saying something else!

At any rate, are rising interest rates a problem for a monetarily sovereign country with a relatively high debt? I’ve been through this several times before on this blog, but when trying to teach the educationally challenged (or whatever the correct PC phrase is), what else can you do apart from repeat yourself till you’re blue in the face?

A rise in interest rates is not a problem for an indebted government  in that the interest it has to pay on its existing debt does not rise immediately: the rate of interest was fixed when the debt was first issued. And that’s an important point in the case of the UK where the average date to maturity of government debt is on the long side: only about 10% of UK government debt matures and needs replacing each year.

As to the debt that DOES NEED replacing or “rolling over”, a monetarily sovereign government is free to tell potential creditors who want more interest than previously to shove off. That is, such a government can simply print money, pay off the creditors and tell them to go away.

Of course that is liable to be inflationary (not that printing billions and buying back government debt as part of the QE operation has actually proved all that inflationary). But to the extent that inflation is a problem, that is easily countered by anti-inflationary measures, like raising taxes and “unprinting” the money collected.

But apparently the IMF doesn’t understand that.

No doubt I’ll be spelling out the same message in six months time. You have been warned.

Thursday, 9 August 2018

Why replace state issued money with privately issued money which has to be backed by the state?

There is a farce at the centre of our money system. It’s the one alluded to in the above title: one that Prof Mary Mellor deals with in her two books, “The Future of Money” and “Debt or Democracy”.

Money, as the saying goes “is a creature of the state”. That is, there has to be general agreement in any country as to what the country’s basic form of money shall be: it would be highly inconvenient if some people used gold coins as money, while others used silver and others used cowrie shells (which have long been a popular form of money on desert islands and similar). And in practice throughout history, money has normally been organized by some central authority: often a king or ruler who wants to make tax collection more efficient.

So the basic form of money in the US is the Fed issued US dollar. In Russia it’s the Russian central bank issued Ruble, etc.

As to the optimum amount of such money to create and spend into the economy, clearly that needs to be whatever brings full employment without causing excess inflation. The more money people have, the more they will spend (not that the relationship there is particularly close or predictable). So ideally an amount of money needs to be issued that (to repeat) brings full employment without too much inflation.

Commercial banks.

Having done that however, commercial banks normally play a little trick which is profitable for them: it’s to issue their own dollars (in the case of the US) or pounds in the case of the UK. To be more exact, they create and lend out “promises to pay” central bank dollars, pounds, etc. In fact commercial banks make good on that promise when you get physical cash from an ATM.

But when you get a loan for $X from a commercial / private bank, and $X is credited to your account, the bank invariably keeps quiet about the fact that you have not actually got $X there: to repeat, what you have is a promise by the bank to pay $X to whoever you want to pay $X to (possibly to yourself at an ATM).

Another important feature of privately created money is that it tends to displace state created money. That is, if the state creates and distributes an amount of money that brings full employment without too much inflation, and commercial banks then start creating and lending out their own home made money, then households and businesses will find themselves with an excess supply of money. Demand and inflation will rise, so the state will have to raise taxes and withdraw some of the state issued money.

An alternative scenario, set out by George Selgin in the first few paragraphs of his Capitalism Magazine article “Is Fractional Reserve Banking Inflationary” is that government lets inflation rip, which means the real value of the stock of state issued money is whittled away to near nothing. But either way, privately issued money displaces state issued money. (Incidentally I am not suggesting Selgin would agree with everything in this article or even most of it.)

But the big problem with commercial bank created money is that it is not 100% reliable: the fact is that commercial banks, regular as clockwork, go bust and have to be rescued by the state. Now what on Earth is the point of replacing state issued money with privately issued money which cannot function unless it is backed by the state?

Moreover, to add insult to injury, it is precisely the fact of trying to create a form of money / liquidity that makes banks vulnerable and prone to bank runs, as Douglas Diamond explains in the abstract of this paper.

Well one apparent advantage of privately created money is that interest rates are presumably lower than under a “state money only” system. Reason is that if a commercial bank can simply print or “create from thin air” the money it lends out, that is clearly cheaper for it than obtaining the relevant money the same way households and non-bank corporations obtain money, namely earn it or borrow it. But in that case lending is being subsidised by money printing, or by seignorage of a sort, and there is no particular reason why money lenders (aka commercial banks) should reap the benefits of seignorage rather than garages or restaurants.

When money is created, the money creator normally makes a profit from doing so. E.g. when the state prints money and spends it on new roads, the state profits in that it obtains more road at zero cost to itself. But we all benefit from improved roads, thus the profit does not matter there. In contrast, there is no good reason for commercial banks to be the ones who benefit from money creation.


Another glaring weakness in any alleged advantages in the relatively low interest rates that stem from private money creation is that private banks have not had to pay a suitable amount of insurance for the risks that such money creation entails.

First, banks were rescued by the Fed in the recent crisis with billions of dollars worth of loans, not at the “penalty rate” suggested by Walter Bagehot, but at a near zero rate of interest. Don’t you wish you could borrow at a zero rate of interest?

Second, it would be perfectly reasonable to charge the bank industry for a significant proportion of the trillions of dollars worth of lost GDP that most countries have experienced over the last ten years as a result of bank irresponsibility: car drivers have to be insured in most countries against the possibility that they cause a serious and life-long injuries which cost millions of dollars to deal with. If banks paid an insurance premium that took account of the latter trillions of dollars of lost GDP, the cost of running commercial banks would go through the roof: put another way, that sort of insurance would make a complete mockery of the idea that privately issued money results in lower interest rates.

But even if the latter insurance point can be ignored, it might seem tempting to favour the lower interest rates that private money creation brings given that stimulus is often imparted by lowering interest rates.

The answer to that is that stimulus is easily imparted without adjusting interest rates: as Keynes pointed out in the early 1930s, stimulus can be imparted by having the state create new money and spend it (and/or cut taxes).

The line between money and non-money.

Another possible objection to the above argument is that even in the absence of commercial banks, individuals and non-bank firms would engage in a significant amount of money creation or at least “liquidity creation”. Thus, so it might be argued, banks should be allowed to do the same. I’ll expand on that.

Assume an economy with state issued money only. In such an economy people and firms would lend to each other and some people would grant relatively long term loans to others, e.g. ten years for a mortgage. But in that scenario, lenders would not be absolutely committed to losing access to their money for ten years. Reason is that if someone who had made a ten year loan wanted their money back after six months, there’d be a good chance they could sell the loan to someone else.

That process makes those loans more liquid. Indeed if the latter “loan selling” were efficient enough, then loans would be almost of liquid as money itself. Thus, so it might be argued, why shouldn’t commercial banks engage in that process and try to make it even more efficient?

Well there is no reason banks shouldn’t do that, but they’ll never be able to produce what is commonly understood to constitute money (i.e. something which is 100% guaranteed not to lose value (inflation apart)) without state backing. An exception to that doubtless comes where the state is very irresponsible (e.g. a Robert Mugabe style hyperinflation economy) and people regard commercial banks as more responsible than government. But that scenario is relatively uncommon.

Put another way, there’s nothing wrong with commercial banks funding loans via what are in effect bonds, even if those bonds take the form of small deposits at such banks. But there is no good reason for the state to give its backing to those “bonds” and turn them into genuine, 100% proof, pukka money. That just constitutes a subsidy by taxpayers of commercial banks.

In short, advocates of full reserve banking are right to claim that loans should be funded via equity or similar (e.g. bonds which can be bailed in).

Is deposit insurance OK?

Having said that depositors should be on the hook where a bank is sufficiently incompetent, another question arises, namely: is deposit insurance of those “bond / deposits” acceptable? Well it’s a bit hard to see why not if the insurance system is run on strictly commercial lines, as is the FDIC.

But doesn’t that then mean that those deposits then become 100% proof, pukka money? Well yes: it does. But there is a catch, as follows.

Milton Friedman and Warren Mosler (founder of MMT) argued for a permanent zero interest rate policy, and I argued the same here. But given that sort of low interest rate policy, how much interest will the above “bond / depositors” actually get after the costs of deposit insurance have been deducted? Well I suggest the answer is “none”, and for the following reason. This reason is not desperately well thought out at the moment – I’ll hopefully improve on the thinking in the future. But here goes.
Interest is paid for two reasons: first, as a reward for accepting risk. But depositors whose deposits are insured by an insurer with an infinitely deep pocket, i.e. the state, are accepting no risk!

A second reason for paying interest is as a reward for the lender for losing access to a sum of money (or some other asset) for a period of time. But if the above depositors have instant access to their money, then they aren’t losing access (to make a statement of the obvious). Conclusion: there is no reason for those depositors to get any interest.

In contrast, if as suggested by some proponents of full reserve banking, depositors do lose access to their money for a significant period, then there is good reason to pay them interest. (E.g. Ben Dyson and Andrew Jackson in their book “Modernising Money”) suggest a minimum of two months.) But in that case, those deposits cannot really be classified as money: certainly a deposit where the “term” is more than about two months is not counted as money in most countries, though obviously that two month dividing line is a bit arbitrary. I.e. there is no sharp dividing line between money and non-money there. But then there never has been a sharp dividing line between money and non-money.

Saturday, 30 June 2018

Random charts - 61.

Large text in pink on the charts below was added by me.

Friday, 29 June 2018

Permanent zero interest rates – an update.

I’ve done a update or “second edition” of the paper I published about a month ago advocating the “no government borrowing / permanent zero interest rate” idea. The update / second edition is here. Title of the update is, "A permanent zero interest rate would maximise GDP - (second edition)".

The basic ideas are the same, but hopefully they are better presented. There’s two or three extra references. The main new idea is in section 15 where I have briefly tried to reconcile the permanent zero interest idea with full reserve banking.  In fact they “reconcile” very nicely: that is, the two ideas, if anything, positively support each other.

The “no government borrowing / permanent zero interest rate” idea is very much an MMT idea: i.e. all the advocates of the idea seem to be MMTers at the moment.

Warren Mosler, founder of MMT, has written three articles advocating the idea. See 2nd last paragraph here. See also here and here. (For the article titles, see list of references below, which are in the order they are mentioned in the main text here).

There’s an article by Bill Mitchell here, and one by Dan Kervick here.

And finally, there’s me. 


Proposals for the Banking System. Huffington.
The Natural Rate of Interest is zero.
There is no right time for the Fed to raise rates. Huffington.

Mitchell. There is no need to issue public debt. Billyblog.

Kervick. Why does Uncle Sam borrow? New Economic Perspectives.

Thursday, 28 June 2018

Deposit insurance would be OK under Vollgeld.

The question as to exactly what form deposits should take under full reserve banking (aka Vollgled aka Sovereign Money) is tricky. The paragraphs below are an attempt at an answer.

The basic problem with the existing bank system is that commercial banks (henceforth just “banks”) create money, and as the French economics nobel laureate Maurice Allais said, that amounts to counterfeiting. To be more exact, what’s wrong with that form of money creation is as follows.

Money creation by central banks and governments (henceforth “the state”) can be done at virtually no cost. As Milton Friedman (who supported Vollgeld) put it, "It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances."  In contrast, money creation by banks costs a significant amount because banks have to check up on the credit-worthiness of those they supply money too, allow for bad debts etc. Thus state created money (base money) would seem to be the best option.

In a simple hypothetical Vollgeld economy (i.e. where only base money is allowed) keeping the economy at capacity is no problem: the state just issues enough base money to induce the private sector to spend at a rate that brings full employment.

In that hypothetical economy people and banks would lend to each other, and there is no obvious reason why interest rates would not settle down to some sort of genuine free market rate.

But if banks are not forcefully prevented from doing so, there’s a trick they can play and which they play big time in the real world: when a bank has received $X in deposits, it can lend out around $X while telling depositors their money is still available to them. And as long as only a small proportion of depositors try to withdraw their money at the same time, banks get away with that trick about 99% of the time. Hey presto: $X has been turned into about $2X. Money has been created.

That trick works because it is clearly cheaper for banks to fund loans via instant access deposits (on which little interest needs to be paid) as compared to long term deposits. The total amount of bank loans rises.

But that increases demand, thus assuming (as per the above assumption) the economy is already at capacity, the state then has to impose some sort of deflationary effect, like raising taxes and confiscating some base money off the private sector. In short, the effect of money creation by banks (as pointed out by Maurice Allais) is much the same as the effect of those naughty backstreet printers who turn out fake $100 bills: for every such bill put into circulation, government has to confiscate a genuine bill from the private sector.

The solution to the above problem, as pointed out by Vollgeld advocates, is to ensure that loans are funded via equity or something similar, like long term deposits that can be bailed in. That way, $X is no longer turned into $X. What happens is that when someone wants their money lending out, they buy shares in a bank or make a long term deposit, and that funds the loan, rather than instant access deposits funding loans. Shares and long term deposits, depending on the exact length of the deposit are not money. So there is no “money multiplication there.

Now while there is a clear distinction between shares and instant access deposits, there is no clear distinction between an instant access deposit and a two month or six month deposit. So where do we draw the line? Plus there’s the question as to whether deposit insurance should be allowed under Vollgeld. If it is, then the switch to Vollgled would be less of a wrench than it is commonly supposed.

Well as regards deposit insurance, there’d be nothing to stop people who want to lend out money person to person, and/or those who want their bank to lend out their money in the above hypothetical economy to arrange some sort of insurance. In a free market, anyone is free to arrange any sort of insurance they like. And as for state sponsored deposit insurance, there is nothing wrong with that either, as long as it pays for itself. Thus it is hard to see what would be wrong with deposit insurance under Vollgeld. Indeed, it is not insurance which results in banks creating money: it’s “maturity transformation” (i.e. “borrow short and lend long”) which creates money. Moreover it is precisely borrow short and lend long that makes banks fragile (as pointed out by Douglas Diamond), and results in catastrophes like Northern Rock and Lehmans.

The next question is: exactly how “long” should deposits be where depositors want their money loaned out? Well strictly speaking, if maturity transformation is to be abolished altogether, where for example deposits fund twenty year mortgages, then deposits need to be for twenty years. 

Clearly no one wants their money tied up for twenty years, but governments issue bonds with ten and fifteen year maturities. And those who buy those bonds and when they want to cash in can always do so by selling those bonds, maybe at a loss. So in a sense, twenty years would not mean twenty years.

Another possibility stems from the fact that money is defined in most countries as something like “stuff in a bank which is available to the depositor within two months or so”. Thus if that two month dividing line is adopted, then strictly speaking money is not created where a bank funds long term loans via deposits with a minimum two month maturity.

Clearly the latter idea is a bit of semantic trickery because there is not particular logic in making the dividing line two months rather than three or four.  However, on introducing Vollgeld, that two month dividing line would be a start: plus it would be away in introducing Vollgeld GRADUALLY. Gradual changes are always better than violent changes.