Monday, 15 October 2012

Krugman’s flawed criticism of full reserve.

I normally agree with Krugman, but not with this article where he criticises full reserve banking. He is obviously not up to speed on the subject.

On the subject of money market funds, he claims these represent some sort of quandary for advocates of full reserve, and on the grounds that those depositing money in such funds can write cheques on the funds.

There is actually no quandary there at all because money market funds pretty much obey the rules of the “full reserve game” already.

The basic rule of full reserve is that banks, or any organisation acting like a bank, cannot create money. To that end, where a depositor wants instant access to their money, that money cannot be lent on or invested, else two parties then have a legitimate claim to the same tranche of money: the money has so to speak been doubled. Money creation has taken place.

Now when someone writes a cheque on a money market fund and the fund immediately sells investments of the same value, which is more or less what these funds do, then no money creation takes place. No problem.

Of course there might in some cases be a few days delay between honouring the cheque and selling the relevant investments, which strictly speaking is breaking the rules, but that does not make money market funds the sort of big time creators of money that fractional reserve banks are.

Keeping tabs on money creators.

Krugman then says, “So would a Ron Paul regulatory regime have teams of “honest money” inquisitors fanning across the landscape, chasing and closing down anyone illegitimately creating claims that might compete with gold and silver? How is this supposed to work? OK, I don’t expect a serious answer.”

Well here’s a serious answer.

First, whether the monetary base consists of a rare metal or is in fiat form, as in almost every country nowadays, makes no difference to the basic principles involved. I’ll assume a fiat monetary base.

Creating money or “claims” that constitute money is not easy. IN THEORY anyone can do it in that anyone can write an uncrossed cheque in payment for something, and the recipient can endorse the cheque, and pass it on, in the same way as bills of exchange were passed from hand to hand in the 1800s. But that phenomenon is almost unheard of nowadays.

To all intents and purposes the only organisations that can create BIG quantities of money are BIG organisations (surprise, surprise). That is because no one trusts the paper money produced by tin-pot unheard of organisations. Plus it’s very difficult to set up a bank of any size, or anything that acts like a bank, without being noticed by the authorities. That is, if the income tax authorities can spot self-employed plumbers or electricians who are trying to avoid being noticed, the authorities shouldn’t have too much trouble noticing organisations with a turnover a hundred or a thousand times that of the average plumber or electrician.

So there is no need, as Krugman puts it, to “fan across the landscape”.

There are of course local currencies, like Bristol pounds, and supermarket loyalty points, Airmiles, Bitcoins, etc. But if you look at these carefully, you’ll find that no money creation takes place, and if it is, it’s on a very small scale.

In short, getting full reserve to work would not be difficult.

And finally, the authorities in different countries actually impose reserve requirements on banks, varying from 30% to 0%. If 30% can be imposed, then presumably so can 70% and 100%.


  1. "In short, getting full reserve to work would not be difficult."

    Yes it would, money is naturally endogenous.

    You have forgotten that any organisation on full reserve can push lending and then 'steal' reserves from other organisations to back fill the hole. That leads to a systemic lack of funds in the system which will end up at a different organisation than the one that initiated the systemic shortage.

    That is how an aggressive building society operates and pushes its lending book.

    One of the advantages of living in Halifax is that the people that invented these techniques live here. The extensive consolidation of the building society sector is a result of the aggressive push/pull technique. Before it became a bank Halifax was bigger than all the other UK building societies put together. The bigger it got the more powerful the push/pull technique became.

    No building society and no full reserve organisation will ever ring down to the savings department and see if there is any money in the kitty. The process will *always* be to know the price above which you have to sell loans that will attract deposits at the required margin - stolen from elsewhere as required.

    Limiting reserves just speeds up the consolidation of the sector into very large organisations and creates an enormous barrier to entry.

    If you allow banks in the middle of the transaction then it will not work. The only feasible structure I can see that will do what you want is for banks to be agents in a Zopa like system - maturity matched and no capacity to save or lend at interest unless that match exists in the spot market.

    1. Hi Neil,

      Thanks for your comments.

      I agree, as I pointed out above, that supposedly full reserve organisations don’t necessarily “ring down to the savings department” to make sure funds are actually in the kitty before making a loan. Plus I agree that if the kitty gets seriously depleted, they can borrow on wholesale money markets (presumably what you mean by “stolen”). But that just reduces the ability of wholesale money market lenders to lend, so in the aggregate, no money creation takes place.

      Fractional reserve money creation consists of an entity lending more than has in the kitty, while assuming that other banks or quasi banks are doing the same. And if they are, the first entity ends up receiving deposits that more or less match the excess lending it has done. Everyone is happy: no bank or quasi bank is significantly indebted to another. Meanwhile the money supply has risen.

      As to controlling the latter money creation process, the only way it can be done and actually is done is by the central bank checking up on total loans and/or deposits at each bank and seeing how large the totals are relative to reserves. I.e. commercial banks have to regularly publish audited totals of deposits, loans, etc.

      There might seem to be a weakness in that argument namely that if there is a plentiful supply of viable potential borrowers, banks will increase their lending and interest rates will tend to rise, and there is not much a central bank can do about it if the CB wants to control interest rates.

      My answer to that is that CBs should not control interest rates. This submission to the Vickers commission authored by a bunch of full reserve advocates also argued against interest rates as a regulatory tool:


Post a comment.