Martin Wolf in today’s Financial Times puts seven suggestions for improving the banking system. The fourth involves criticising Lawrence Kotlikoff’s 100% reserve banking ideas. In reference to banks, Wolf says “I accept that leverage of 33 to one, as now officially proposed is frighteningly high. But I cannot see why the right answer should be no leverage at all. An intermediary that can never fail is surely also far too safe.”
There are several mistakes in those two sentences, as follows.
1. If an ultra-high level of safety COSTS SOMETHING, then that could easily be an argument for sacrificing some safety in exchange for reduced costs. But if Wolf thinks such costs exist, he needs to tell us what they are.
The Vickers commission (of which Martin Wolf was a member) CLAIMED such costs were involved. They claimed that 100% safety would supress bank lending, which in turn would supress economic growth. As I’ve pointed out before on this blog, that suppression of economic growth would certainly take place ALL ELSE EQUAL. But all else needn’t be equal. That is, the government / central bank machine can easily expand the money supply to make up for the more conservative way in which money is used under a full reserve or 100% safe regime.
And producing new money costs NOTHING in real terms: money is just book-keeping entries, or if you like, numbers in computers.
2. Where does Martin Wolf think the money came from to boost house prices prior to the crunch? It came from money creation by private banks, not central banks or governments. That is, the money supply expanded thanks to the fractional reserve system. In other words booms and slumps would be ameliorated if we reduce the 33:1 leverage. But as long as there are no costs involved in reducing the leverage to 1:1, why don’t we go for the maximum amount of amelioration possible: i.e. just abandon fractional reserve?
In other words it can well be argued that the real costs – costs of CATASTROPHIC proportions – derive from fractional reserve, not from full reserve.
3. As argued by Huber & Robertson (amongst others) the freedom that private banks have to create “savings” out of thin air and lend them out results in artificially low interest rates. If H&R are right, then that is an argument for a total ban on money creation by private banks: i.e. it’s an argument for 100% reserve.
Personally, I would cite another argument in addition to H&R’s, which is that when a private bank boosts demand by creating and lending out money, demand must be supressed elsewhere in the economy (assuming the economy is already at capacity). And in practice, that suppression of demand takes place in a pretty random fashion, e.g. government might cut spending on education, roads or health care – you name it.
A more efficient allocation of resources would be involved where when one entity wants to borrow more, the concomitant reduction in current consumption is born by whoever is least concerned about abstaining from consumption. And that objective would be attained where when one entity borrows more, interest rates rise. And that increase in rates would occur automatically under full reserve.
A simple question on how banks assist in the efficient economic resource allocation.
ReplyDeleteLet us suppose a bank with only two types of clients, those perceived as fairly “risky” and those perceived as “absolutely not risky”
And then let us suppose there are two different types of capital requirements for banks methods:
The first, let us call it the pre-Basel method, which requires the bank to hold 8 percent in capital against any loans to any of their clients.
The second, let us call it the Basel method, requires the banks to hold 8 percent in equity for loans to those considered “risky”, but only 1.6 percent against loans to the “absolutely not-risky”
It would seem to me that in the first case banks would allocate their funds in accordance to what produces the largest risk-adjusted return to them on their equity, but, in the second, they would allocate their funds in accordance to whatever produces the largest risk adjusted return on the particular bank equity which the regulators have decided should be held for the different assets… and, frankly, both methods can’t be correct from an economic efficient resource allocation perspective
I believe that the “Basel method” seriously distorts the resource allocation process, by dramatically increasing the possibilities of returns on bank equity for what is officially perceived as risky… but this does not seem to concern experts a lot. Why?
http://subprimeregulations.blogspot.com/
In your second scenario, the return per unit of capital is higher. But you seem to allocate this extra return to the risky activity. Seems to me that if the amount of capital held against the less risky activity is reduced, then the return per unit of capital derived from THAT activity rises, not the return on the riskier activity. But perhaps I've got something wrong there.
ReplyDeleteBut that’s all a minor consideration compared to the main and fundamental point, which is that ANY RISK, assuming there is taxpayer backing for depositors is unacceptable, because that backing amounts to a subsidy. And there is no excuse whatsoever for subsidising an activity which is supposed to be commercially viable.
As for Martin Wolf’s argument, namely that the risks can be made very small, all we get in exchange for that risk is having private banks create money. Big deal: central banks can create money at ZERO cost. Alistair Darling created £60bn at the press of a computer mouse when he was rescuing RBS and HBOS.