Monday, 27 August 2012

Jan Kregel of the Levy Economics Institute tries to criticise narrow banking.

First, for the benefit of any readers new to “narrow banking”, the term means much the same as “full reserve banking”, as indeed Kregel himself implies. “Narrow / full reserve banking” is a system in which only the state creates money. I.e. private banks cannot create money or “lend money into existence” in the way they do under the present fractional reserve system.

There are of course different ways of organising a narrow / full reserve system. And equally, there are variations on the “fractional reserve” theme. The variation on the narrow banking theme which Kregel considers is the one proposed by Minsky. And this incorporates a “Glass-Stegall element”: the bank industry is split into two halves: a retail or “basic payments system” half, and an investment banking half.

Under Minsky’s proposal, the retail half would invest in nothing apart supposedly safe securities like government debt. While the investment half would be funded not by deposits of any sort, but entirely by equity.

Is government debt safe?

Of course the idea that government debt is safe is of now a joke in view of the price at which Euro periphery debt now trades. Indeed even the price of non-Eurozone government debt bobs up and down by significant amounts. Thus personally I wouldn’t even allow investment in government debt: I’d forbid any investment of any kind. That would nice and simple.

Indeed as the second paragraph of the preface to Kregel’s article points out, what we desperately need is to simplify the system: the big advantage of complexity for banks is that they can bribe politicians and nibble away at the regulations, bit at a time. In short, we need clear lines in the sand: not complexity.

And if anyone thinks that preventing the above investment in government debt would make it more difficult for government to fund itself, my answer is that government borrowing is a farce. That is, it is pointless for a government which issues its own currency to borrow the stuff which government itself can produce at any time at no cost (i.e. money). Thus if government cannot borrow, it can perfectly well just print new money and spend it into the economy, as indeed Keynes and Milton Friedman amongst others pointed out. I’ve dealt with the farcical nature of government borrowing in more detail here.

Minsky’s proposal is just a variation on a theme.

The above set up proposed by Minsky (the retail banks investing only in supposedly safe securities and investment banks being funded entirely by equity) actually comes to much the same thing as the set up proposed by a much more recent advocate of narrow banking: Laurence Kotlikoff. Kotlikoff suggests having mutual funds (unit trusts in UK parlance) specialising in retail stuff and other funds specialising in investment banking activities. However, I’m not concerned with which is the best variation on the basic theme: it’s the basic principles I’ll consider here.

Voluntary versus forced saving.

Kregel’ first criticism of narrow banking is that it “would create a financial system . . . in which all investment decisions are the consequence of the voluntary savings decisions of individuals.”

Wow! So what exactly is wrong with that? In a desert island economy, Robinson Crusoe cannot “invest” in a new fishing rod unless he makes a “voluntary saving decision”. If there is a problem there, I don’t see it.

Moreover, are we supposed to think that “investment decisions” should be funded by INVOLUNTARY or FORCED savings? Because the latter (and here comes the real joke) is EXACTLY WHAT FRACTIONAL RESERVE INVOLVES!!!! I’ll explain.

Under fractional reserve, when a bank creates money out of thin air and makes a loan, there is an increase in demand. And assuming the economy is at capacity, the result will be inflation unless the authorities curb demand in some way, e.g. by raising interest rates or cutting public spending on roads, schools, health, the military or whatever. In short, when a bank makes a loan under fractional reserve, the necessary saving or reduced consumption is quite likely to be FORCED ONTO a random group of people or consumers: e.g. consumers of educational services, roads, or health care. And if that makes sense, I’m baffled.

It would make far more logical, where additional funds for investment seem to make sense, to get the funds from those most willing to save, which is what happens under full reserve.

So that rather knocks a hole in Kregel’s “voluntary” point.

Other criticisms.

However, Kregel’s central criticisms come in a passage which is riddled with mistakes, and which is thus.

". . .a financial system that was regulated via a 100 percent reserve requirement on deposits and a 100 percent ratio of capital to assets for investment trusts. . . .could neither ensure the stability of the real economy nor assure stability of the capital financing institutions. First, the real investments chosen could still fail to produce the anticipated rate of return; and second, sectoral over investment and financial bubbles could still exist if there were herding behavior by the investment advisers of the trusts that produced procyclical financing behavior. There would always be a risk of investors calling on the government to save them from financial ruin.”

As regards “stability” who ever said full reserve would bring perfect stability? No one I know of. What the advocates of narrow banking or full reserve DO CLAIM is that a system under which the private bank system can create money and lend it out whenever it feels like it, EXACERBATES asset price bubbles. That is, banks create and lend money to for example those speculating in house price appreciation. That pushes up house prices, which in turn makes houses a better form of collateral, which in turn encourages more borrowing, etc etc. I.e. there is a clear feed-back loop there. Indeed, there is a nice chart here showing the expansion of private bank created money relative to monetary base in the UK in the four years or so prior to the crunch. But no advocate of narrow or full reserve banking ever said, far as I know, that removing that loop totally rules out “irrational exuberance”.

(Hat tip to “tutor2u”)

As regards the idea that under narrow banking, those making investments will go running to government when their investments show a loss, attempts to pick taxpayers’ pockets go on all the time under the EXISTING SYSTEM. Attempts by the rich to organise so called “socialism for the rich” are rife.

And it may be that in the near future the rich will organise taxpayer funded bail outs for anyone losing money on the stock exchange. Though thankfully they don’t seem to have thought of this wheeze yet.

Anyway the CRUCIAL question here is whether this sort of begging would be MORE RIFE under narrow banking than under the existing fractional reserve system. And there is a VERY GOOD REASON for thinking it would not, which is thus.

The big confidence trick perpetrated by banks under fractional reserve is that they take deposits (including grandma’s life savings) and invest those savings in less than 100% loans and investments. That trick works for much of the time, but sooner or later it’s bound to go wrong. And when it does, banks have the PERFECT EXCUSE for relieving taxpayers of trillions: “if we aren’t rescued” they’ll tell you, “grandma’s savings disappear”. Cue crocodile tears, contrived weeping, wailing, gnashing of teeth, etc etc. (Personally I’m moved to vomit rather than burst into tears.)

That problem arises because banks have on the liabilities side of their balance sheet a commitment to return $X (or thereabouts) to depositors for every $X deposited, while on the asset side, the total value of assets can easily fall to less than total liabilities, in which case the bank is bust.

Now there’s a beautifully simple solution to the latter problem: narrow banking.

Under narrow banking when a bank expands its loan book, that expansion can only come from funds supplied by equity investors. I.e. balancing the additional loans on the asset side of the balance sheet is additional equity (or as yet unused equity). And NORMALLY, when equity loses its value, the relevant shareholders do not get away with running to government with a begging bowl. For example, at the time of writing Facebooks shares have dropped dramatically, but I haven’t heard anything about shareholders running to government for a bail out.

Narrow banking destroys capitalism?

Kregel continues:

“Indeed, for Minsky and Schumpeter, such a “narrow banking” system could not be considered a modern “capitalist” system; it would be akin to what John Maynard Keynes defined as a “real wage,” as opposed to a “monetary production,” economy. In a monetary economy, it is the role of the financial sector to ensure the financing of the acquisition and control of capital assets by increasing the liquidity of the liabilities of the business sector.”

Not true. Dictionary definitions of the word “capitalism” vary, but most of them give it as something like “a combination of private ownership of the means of production and free markets”.

Now under narrow banking, there is precisely NO NATIONALISATION whatever. In particular, banks are not nationalised. Plus (taking Kotlikoff’s variation on the narrow banking theme) mutual funds are not nationalised.

As to abolishing free markets, markets are just as free as under fractional reserve, with just one exception, namely that banks cannot indulge in the above mentioned “confidence trick”. But making confidence tricks illegal is hardly to destroy the free market. We already have dozens of free market activities which are banned because they are regarded as fraud, confidence tricks, etc.

Moreover, any idea that the current banking system is capitalist is just a joke. It requires an annual too big to fail subsidy plus the occasional trillion dollar bail out. That’s what I call “socialism for the rich”, not capitalism.

Next let’s consider Kregel’s claim that “, in a monetary economy, it is the role of the financial sector to ensure the financing of the acquisition and control of capital assets by increasing the liquidity of the liabilities of the business sector.” I assume that by “increasing . . the liabilities of the business sector” he means money creation. If so, that just begs the question under discussion. That is, the central question here is whether the “business sector” should be able to “lend money into existence” as the saying goes, or whether money creation should be the preserve of the central bank and government (as per narrow banking).

Is narrow banking deflationary?

Kregel’s next criticism runs as follows. “In a narrow banking system the liabilities of the financial system would be composed of (1) investment fund shares representing household savings and business profits used to finance real investments; (2) deposits held by households and businesses in the narrow banks backed by government debt or currency and coin; and (3) government-issued coin and currency held by households and firms. In such a system it is evident that total private saving would exceed investment by the private sector’s holdings of narrow bank deposits and government currency, creating a tendency toward deflation or recession. Price and/or output stability would require an exogenous addition to demand to offset this imbalance, such as might be provided by government expenditures....”

Well it’s stark staring obvious that if restrictions are put on bank lending, then there’ll be a deflationary effect, all else equal. But the simple solution, as indeed Kregel rightly says, is government organised stimulus. And what’s the problem with that? Kregel doesn’t tell us.

Put another way, if the private sector creates and spends less money, that will almost certainly have to be countered by having the central bank / government create and spend some extra money (and/or reduce taxes). I’m baffled as where the problem is.

In particular, the cost, in REAL TERMS of implementing stimulus is precisely and exactly ZERO. (That’s assuming the stimulus is done in a competent manner: if stimulus is effected by the clowns currently running Western economies, the outcome can easily be a complete shambles. But I’ll assume those organising the stimulus have I.Q.s above average.)

To enlarge on that, if stimulus takes the form of the government / central bank machine printing new money and spending it into the economy (and/or reducing taxes), that operation does not COST ANYTHING IN REAL TERMS. Or as Milton Friedman 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.”

Narrow banking requires a once and for all bout of stimulus.

Also, the latter stimulus is only a ONCE AND FOR ALL bout of stimulus. That is, on introducing narrow banking, bank’s freedom to lend is somewhat restricted, which in turn means more money needs to be put into the pockets of the average household and business.

Having expanded the bank balance of the average household and business (and/or reduced the amount they borrow from banks), there is then nor further need for stimulus arising from the switch to narrow banking. (Of course stimulus may be needed for other reasons, but that’s incidental.)

Less power for those criminals and fraudsters – thank God.

Moreover, what’s wrong with the incompetents, criminals and fraudsters who currently run banks having less say in the allocation of the nation’s resources? The people running banks are quite clearly a bunch of buffoons, charlatans, fraudsters and criminals. If they have a bit less say in allocating resources, and the proprietor of the average Main Street small business plus its customers have a bit MORE SAY, I’m all in favour.


  1. 'In a desert island economy, Robinson Crusoe cannot “invest” in a new fishing rod unless he makes a “voluntary saving decision”. If there is a problem there, I don’t see it.'

    A monetary economy involves more than one individual. Consider the arrival of Friday. With Friday's labour and Crusoe's fruit trees they can get a fine crop. But how can Crusoe convince Friday he will get his share of the yet-to-be realised production? Put shortly, that is the role of a bank and its money. The money represents the future crop - before it exists!

    An effective but risky solution, but one that has supported thousands of years of human development. It's also purely voluntary.

    'The people running banks are quite clearly a bunch of buffoons, charlatans, fraudsters and criminals.'

    Indeed - so what if we put some proper people with sensible incentives in charge?

    1. Re Crusoe and Friday, I’m not arguing against “a bank and its money”. The basic question I’m addressing is whether money should just be created by the central bank / government, or whether private banks should get in on the act as well.

      “An effective but risky solution, but one that has supported thousands of years of human development.” Clearly fractional reserve banking works. And I agree it has supported “human development”: e.g. it was the banking system that funded the industrial revolution. But it’s a very imperfect system: it gives rise to booms and slumps, for example. So the question I’m addressing is whether full reserve is better. And when it comes to risks, it certainly is better. That is, under full reserve, it’s almost impossible for a bank to go bust (absent blatant criminality). Plus depositors who want 100% cannot lose their money, so there is no need for TBTF subsidies or occasional trillion dollar bail-outs.

    2. 'But it’s a very imperfect system: it gives rise to booms and slumps, for example.'

      Booms and slumps would not be eliminated by 100% reserve, although ceteris paribus their amplitude would be reduced. But also reduced would be the possibility for private agents (including banks) to agree among themselves to proceed with projects which they thought would produce a future risk-adjusted return for them. Many of these projects will have externalities.

      Under a 100% reserve system many such decisions would be centralised, with all that implies.

      A well-run bank should absorb most of its own risk through equity write-downs. It's clear that banks have not been well-run, so why not start by tackling that issue? The aim should be to make the risk-adjusted social return (including externalities) positive, rather than eliminating all social risk.

    3. I agree that 100% reserve would moderate but not eliminate booms and slumps.

      I don’t agree that potential external benefits are an argument for any given form of economic activity. There are external benefits and costs to nearly every form of activity, and I don’t see any reason to suppose the external benefits deriving from fractional reserve funded activities are spectacular or better than the external benefits deriving from full reserve funded activity.

      Re centralisation, I don’t see why this would occur under full reserve. Under full reserve, any entity in say Aberdeen wanting to borrow would approach a bank branch (probably in Aberdeen) and try to get a loan, just as under the current system. The branch in Aberdeen would get instructions or suggestions (as now) from its head office as to what the bank’s current lending policy was: lax or restrictive, etc.

      There’d actually be LESS centralisation under full reserve in that under full reserve, private entities would have a greater stock of money: i.e. there’d be less need for anyone to borrow. To that extent, economic decisions would be taken more by individual households and firms with less need to go begging to a bank. And banks are just geniuses at allocating resources aren’t they? Look at those NINJA mortgages.

      Re your claim that there is no point in trying to totally eliminate risk, Martin Wolf made a similar claim recently, which I answered here:

      As a supporter of full reserve, I don’t believe in trying to ELIMINATE risk. But I do believe that ALL RISK should be loaded onto those who benefit from such risks: that’s bank shareholders and depositors who want a return on the money they’ve deposited in banks. Plus I don’t think we shouldn’t have so much as 10p a week of “risk bearing” (i.e. subsidy) born by taxpayers. I’m not in favour of hair-dressers or plumbers getting so much as 10p a week of subsidy, and I don’t see why any bank should get so much as 10p a week of subsidy either.

      I might expand on the latter point in a post in a day or two, as it’s a crucial point.

    4. 'The branch in Aberdeen would get instructions or suggestions (as now) from its head office as to what the bank’s current lending policy was: lax or restrictive, etc.'

      Except under full reserve, there is an additional limitation in that there must be agents with surplus funds. It's not necessarily the case that the existence of agents with surplus funds will coincide with the existence of a worthwhile productive plan.

      'under full reserve, private entities would have a greater stock of money: i.e. there’d be less need for anyone to borrow.'

      Are you suggesting that we would all have higher real money balances?

      But more generally I assume that current 'private' money (or much of it) would be replaced by money issued by the government, and so there would be less demand for private money creation anyway. The issue here is that you are then centralising the flow of money into and out of the economy. Apart from a monitoring problem, one effect of this is that the consequences of excessive money issue will always affect everyone. There will be no buffer in the form of bank equity.

      'I’m not in favour of hair-dressers or plumbers getting so much as 10p a week of subsidy, and I don’t see why any bank should get so much as 10p a week of subsidy either.'

      That's not really an economically meaningful analogy. The role of a subsidy is where the true social value of some good or service is greater than the market price, and so it is undersupplied. Generally this is not the case with plumbers and hairdressers. My argument (and presumably Kregel's in essence) is that 100% reserve banking would lead to the undersupply of credit relative to the potential quantity of productive economic activity.

      As a thought experiment try and imagine banks run by sensible people in touch with their local communities. Would there then still be nothing to be said for private money creation?

    5. I’ll take your points in turn.

      There’d be no problem with a VERY “worthwhile productive plan”: it would get priority treatment, as under fractional reserve.

      As to marginally worthwhile plans, borrowing under full reserve is certainly more restricted than under fractional reserve, but private sector entities have a bigger stock of cash, and thus don’t need to borrow so much.

      What “monitoring problem” are you referring to? The government / central bank would just create and spend money into the economy where stimulus was needed (or do the opposite when inflation looms: raise tax and withdraw money).

      Why would there be “excessive money issue”? That problem would occur to the extent that governments and central banks are incapable of fine tuning demand, but their competence in that regard is questionable anyway. So full reserve would be no worse in that respect than the existing system.

      Re hair-dressers and the under-supply of credit, I come back to the point about borrowing being more difficult under full reserve, but that’s balanced by private sector entities having more cash.

      Re your last paragraph, I agree that “sensible people in touch with their local communities” can spot worthwhile borrowing funded opportunities or projects. That’s an argument for, 1, borrowing in some shape or form, and 2, decisions about borrowing to be made by people with local knowledge. But it’s not specifically an argument for borrowing based on private money creation.

    6. '...private sector entities have a bigger stock of cash, and thus don’t need to borrow so much.'

      I'm really not quite sure that this works - real inward flows aren't going to increase, so it implies a decision to hold bigger cash balances. If that were true it seems likely to lead to problems of its own, without necessarily increasing the amounts available for projects. There is also a distributional issue - those with the biggest balances may not have the best projects.

      The inability of govts/CBs to fine-tune money issue would be magnified by the greater quantity of money they were issuing. The monitoring and issue problems relate to determining where the money is issued to and from where it is withdrawn.

      'But it’s not specifically an argument for borrowing based on private money creation.'

      Perhaps not, but it might be an argument for sticking with it (if it has particular benefits) if that change would reduce its risks.

      Another suggestion I've come across recently is 'partial 100% reserve' with designated savings (with a fractional reserve) and non-savings (with 100% reserve) deposits. Any thoughts on that?

    7. I’ll take your points in turn again.

      Re “real inward flows aren't going to increase, so it implies a decision to hold bigger cash balances..” I’m not sure what you mean by that.

      Re “increasing the amounts available for projects” full reserve would result in LESS investment because interest rates would be higher. That’s a corollary of the fact that fractional reserve artificially reduces interest rates. I.e. under fractional reserve, private banks create “savings” out of thin air and lend them out: there is no need (at least on the face of it) for anyone to forgo consumption, which sounds too good to be true, and it is. The reduced consumption is actually forced onto random sections of the population, as I pointed out above.

      Of course it’s possible that the latter interest rate reducing effect of fractional reserve is minimal, in which case converting to full reserve would have a minimal interest rate increasing effect.

      Re “those with the biggest balances may not have the best projects”, I think you’ve assumed that those with big balances NECESSARILY allocate all their cash to their OWN projects. If they behave rationally (under fractional or full reserve) they’ll use their stock of cash to fund “own projects” that bring a commercial return on capital, and then if there is cash left over, do what most people do with spare cash: allocate it between plonking it in a building society, investing on the stock exchange, etc etc.

      Re “The inability of govts/CBs to fine-tune, money issue would be magnified by the greater quantity of money they were issuing”, the injection of central bank money into the economy would be a TEMPORARY phenomenon designed to get private sector cash balances up to the point that induced to private sector to PERMANENTLY increase its spending. To be more accurate, central banks are PERMANENTLY injecting monetary base into economies anyway: they HAVE TO if the monetary base and national debt are to remain constant relative to GDP. That’s why over the last century or whatever, deficits are the rule and surpluses are the exception. Thus the injection of CB money resulting from the switch to full reserve would be a temporary fillip to an already existing permanent injection process.

      Re your last paragraph, are you by any chance thinking of the full reserve systems advocated by Laurence Kotlikoff and Richard Werner / Positive Money? These systems (and I don’t see any other possible full reserve system) involve giving depositors a CHOICE between, 1, 100% safe taxpayer backed instant access accounts which pay no interest, and 2, so called “investment accounts” where there is no taxpayer backing, interest IS PAID, but the depositor carries the loss if the underlying loans or investments go bad.

      You could classify “1” as full reserve and “2” as fractional reserve. But I think that would be a mistake. I.e. both Kotlikoff and Werner’s systems are full blown full reserve, far as I’m concerned.

    8. To some extent in this discussion I may have been assuming that under the type of scheme you suggest the current gross flow of private money creation and destruction would simply be taken over by the state. Now I think that is not actually what you are proposing, which alters things a bit.

      I think this passage from my paper sums up the issue at stake, but I do intend to revisit this topic in any case:

      In balance sheet terms there is the potential to expand the asset side of productive potential, but this may be limited by the inability to issue acceptable liabilities that represent goods to be produced. This greatly increases the difficulty and uncertainty involved in initiating production processes, either because the new output must draw purchasing power away from other output, or because the government must be relied on to produce new purchasing power in time for the new output becoming available.

  2. Not stated, but of great import.

    A sovereign currency issuer, eg the UK, US, AUS, CAN can never be revenue constrained. It always has the means to make good on it's bonds. That was the environment in which Minsky did his analysis. So, depositor monies can be safely invested in sovereign bonds, PROVIDED the Sovereign Bonds are denominated in the Sovereign's own currency, and PROVIDED the Sovereign's currency is a fiat currency.

    Given, elimination of money creation via loan origination, the author correctly mentions that the government should make up the difference through spending. As Mitchell mentions again and again, a sovereign currency issuer spends currency into existence via crediting of bank accounts. Not mentioned by the author is how different the consequences of this method will be for the economy vs the existing system.

    In the existing system currency is created when a loan is granted, and this currency is owed to the originating bank together with interest(rent).

    In the proposed system currency is created when the Sovereign purchases goods and services, and credits the corresponding accounts to pay for them. This currency is not owed to anyone, and no interest is due on it. The new system dramatically reduces indebtedness in the economy, and rent seeking.

    As before, the sovereign will tax to remove surplus savings, or spending power, from the economy via debiting bank accounts.

    With 53 trillion $ in debt, at 5% interest, nearly $2.7 trillion in interest is paid annually to the banking sector under the current regime.

    Had these funds been injected into the economy via sovereign spending, taxes could be $2.7 trillion greater than at the moment and the effect upon the economy would be identical, or taxes could be at the current level, and $2.7 trillion of additional demand would be operative in the economy. That level of additional demand would likely provide full employment.



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