Krugman confuses fractional reserve and maturity transformation.

I have plenty of respect for Krugman, but he goes off the rails in this article, in which he tries to defend fractional reserve. Near the start there are two paragraphs which read as follows (in italics):

Like a lot of people, my insights draw heavily on Diamond-Dybvig (pdf), one of those papers that just opens your mind to a wider reality. What DD argue is that there is a tension between the needs of individual savers — who want ready access to their funds in case a sudden need arises — and the requirements of productive investment, which requires sustained commitment of resources.

Banks can largely resolve this tension, by offering deposits that can be withdrawn on demand, yet investing most of the funds thus raised in long-term, illiquid projects. What makes this possible is the fact that normally only some depositors want to withdraw funds in any given period, so it’s normally possible to meet those demands without actually having liquid assets backing every deposit. And this solution makes the economy more productive, providing more liquidity even as it allows more productive investment.

The latter process, transforming short term deposits into long term loans, is not fractional reserve: its called “maturity tansformation” (MT). Fractional reserve is the process whereby the private bank system holds a relatively small amount in the form of cash relative to its deposit lilabilities: in other words the private bank system can create and lend out money.

But since Krugman introduces MT to the argument, let’s examine it. It would certainly seem to bring benefits on the basis of the Diamond-Dybvig argument. But the first flaw in this argument is that it equates money (which is nothing more than numbers in computers) with REAL SAVINGS. Real savings are of course not just numbers in computers: real savings consist of houses, office blocks, machinery, etc.

Thus trying to make maximum use of our stock of money is senseless because numbers can be added to computers at no cost anytime. Or as Milton Friedman put it in Ch3 of his book, “A Program for Monetary Stability”, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”

So MT achieves nothing. That is, from the perspective of an individual bank it is profitable. But from the perspective of the country or economy as a whole, it’s a zero sum game.

Moreover, MT amounts to “borrow short and lend long”: an inherently risky strategy which brought down Northern Rock and hundreds of other banks over the centuries. Indeed, Krugman admits as much. He says:

The problem, of course, is the vulnerability of such a system to self-fulfilling panics: if people believe that a bank will fail, everyone will in fact want to withdraw funds at the same time — and because the bank’s assets are illiquid, trying to meet those demands through fire sales can in fact cause the bank to fail.

This then leads to the need for policy: deposit insurance and/or lender of last resort facilities to head off bank runs, and bank regulation to reduce the moral hazard from these explicit or implicit guarantees.

Quite. Put another way, MT is so risky that some sort of compulsory insurance is required to underwrite it. Ideally this insurance should be funded by those taking the risk (which to some extent in some countries it is). Unfortunately, insurance in most countries also comes in the form of the taxpayer funded implicit too big to fail subsidy. And that’s a blatant misallocation of resources.


Banks cannot be defined?

Krugman then claims that it is near impossible to define a bank, plus he points to the large shadow banking industry. This leads him to conclude that controlling fractional reserve is near impossible.

The first problem here is that I suspect the shadow banking industry does not engage in much fractional reserve. I suspect it’s main activity is connecting large lenders with large borrowers. That’s not fractional reserve.

In contrast, there is nothing to stop the shadow bank industry doing MT. And doubtless the latter helps explain the run on the shadow bank industry that contributed to the credit crunch.

Fractional reserve involves the CREATION OF MONEY. And money is defined as anything which is WIDELY ACCEPTED in payment for goods and services or settlement of debts. Now if I am some unheard of outfit claiming to be a bank and I want to do what large banks do, i.e. create money out of thin air and credit the account of someone applying for a loan, and that person then draws a cheque on me, the person who is given the cheque is unlikely to be happy with “payment” that consists of having their account at some “unheard of outfit” credited. The latter outfit could be me or some other shadow bank. They’re probably going to want their account at some large, respectable outfit credited.

Conclusion: it is difficult for shadow banks to do fractional reserve.

And even to the extent that shadow banks do do fractional reserve, I totally fail to see the difficulties in having government keep tabs on them. If government can keep tabs on every household with a view to extracting income tax from households, then where is the problem in keeping an eye on the smallest shadow bank which probably has a turnover fifty times that of the average household?

Government (at least in the UK) keeps tabs on, or tries to keep tabs on, one man band loan sharks who prey on poorer neighbourhoods.

And finally, the turnover of the shadow banking industry has risen sharply in recent years and is now about the same size as the official banking industry. If so called “bank regulators” are to be anything more that unproductive bureaucrats shuffling pointless bits of paper, then they are just going to have to get to grips with the shadow bank industry.

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