Tuesday, 6 November 2012

Angry Bear’s ideas on full reserve banking.

Angry Bear asks what the effect of introducing full reserve would be on total bank lending, invites answers to the question.  OK – here goes.

First, the effect on bank lending depends on the scenario. If commercial banks are in irrational exuberance mode, as they were just before the crunch, full reserve would definitely constrain bank lending (unless of course the central bank is in irrational exuberance mode as well and is expanding the money supply like there’s no tomorrow  - but that’s unlikely).  Under full reserve, a commercial bank cannot lend till it has sufficient deposits to lend. That’s because the total amount of money is determined by the central bank.

In contrast, over the last two years or so, banks and their customers have been in deleverage mode. Broad money has scarcely expanded at all, thus full reserve would not have made much difference over those two years (at least if the central bank had held total money supply constant, it wouldn’t have made much difference).

Angry Bear then asks “Would 100%-reserve banking result in there being more bank capital available — more equity investments in banks — which via its money-multiplying power would offset or more than offset the otherwise decline in loanable funds?” My answer is thus.

Under full reserve, there is little effective difference between bank shareholders and those depositors who want their bank to lend on their money (in contrast to depositors who want their money to be in 100% safe and in instant access form).
The reasons for that are explained by Laurence Kotlikoff and by this publication.

But briefly the reason is thus. Where a bank lends on depositors’ money, and a too many of those loans go bad, the state comes to the rescue: it creates and pumps money into the bank, or at the very least, it rescues depositors.  Quite apart from the fact that that constitutes a subsidy of banks (and is thus a misallocation of resources), extra money has been created, and for no very good reason. In fact the extra money is created for an extremely BAD REASON: to rescue a commercial bank which is clearly incompetent.

Ergo, depositors must bear the risk in that they want their money loaned on or invested by their bank. But in taking that risk, depositors become almost indistinguishable from shareholders.

If that’s correct, then Angry Bear’s point about more capital possibly being pumped into banks to get round the restrictions that result from full reserve is meaningless. First, any such additional capital would have no effect because (to repeat) the total amount of money is determined by the central bank. That extra capital is necessarily money withdrawn from existing banks.  So the “extra capital” is not extra capital at all.
Second, under full reserve, it makes little difference to a bank whether extra funds come its way in the form of extra capital or extra depositors willing to have their money loaned on.

Least, that’s the way I see it.

1 comment:

  1. Thanks Mr. Musgrave for the response. I have forwarded your reply to Steve Roth who is author of the piece which linked to you.

    Angry Bear is a multi author blog, so explanations vary as to theory among us.


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