Douglas Diamond and Philip Dybvig
(DD) attack full reserve banking here, but unwittingly support it here.
Their criticisms of full reserve appear
in section III of the above first paper.
And their first criticism is the bog standard and not too clever criticism made
by others namely that full reserve would constrain bank lending
Now the problem with that
criticism is that it is such a blindingly obvious apparent flaw in full reserve
that the advocates of full reserve would have to verging on mental deficiency
if they hadn’t spotted it and thought of a solution. The UK’s Vickerscommission actually made the same criticism, and I answered it here. But just
to repeat, the solution is that government / central bank can perfectly well
make up for any deflatonary effect of full reserve by creating and spending new
money into the economy.
Indeed, full reserve by its very
nature involves replacing commercial bank money with central bank money, thus
the above “solution” is pretty much part and parcel of full reserve.
The alleged shadow bank problem.
The second
criticism of full reserve made by DD is that if the larger banks are forced to
obey the rules of full reserve, that will just result in shadow banks filling
the void. That is, shadow banks will up their fractional reserve or money
creation activities.
As DD put
it, “Furthermore, the proposal is likely to be ineffective in increasing
stability since it will be impossible to control the institutions that will
enter in the vacuum left when banks can no longer create liquidity”.
(Incidentally, Charles Goodhart also makes much of this problem in the Appendix
here.)
Well there
are simple flaws in the above DD argument as follows.
First,
regulating shadow banks should not be too difficult. One reason for thinking
that is the head of the UK’s Financial Services Authority, Adair Turner doesn’t
think it would be too difficult. As he put it on the subject of shadow banks, "If it looks like a bank and
quacks like a bank, it has got to be subject to bank-like safe-guards."
Next, the
larger the bank (a “formal” bank or shadow bank) the more difficult it is for
it to avoid being noticed and regulated by the authorities. Indeed, it is not
even all that easy for a self-employed plumber or electrician with a turnover
of say £100,000 a year to avoid being noticed by the income tax authorities.
And £100,000 a year is a minute turnover for a bank (shadow or formal).
So the only
shadow banks that MIGHT avoid being noticed by the authorities are very small
shadow banks. And small shadow banks have a problem there, alluded to by Minsky
when he said “everyone can create money; the
problem is to get it accepted”.
The problem is that money creation is an
activity where size definitely pays. To illustrate (and taking the “very small”
end of the scale) any individual person can create money in that they can pay
for goods or services with an uncrossed cheque, and the payee can endorse the
cheque and pass it to a third party. And the third party can pass it to a
fourth, etc. That’s all perfectly legal, and the uncrossed cheque is then in
effect a form of money.
But I’ve
never in my life tried to pay anyone by endorsing a cheque that someone else gave
me, and conversely, no one has ever tried to pay me that way. That method of
payment is very cumbersome compared to normal methods.
Same goes
for small shadow banks. Those small shadow banks will have no problem doing
what shadow banks spend much of their time doing: connecting large borrowers
with large lenders. But that process does not create money: it does not equal
fractional reserve banking. In contrast,
for a small shadow bank, persuading a significant proportion of actors in the
economy to accept its liabilities and pass them from hand to hand - well that’s much harder, if not plain
impossible.
Of course in
the world’s financial centres, numerous small shadow banks will be well known
to those working in those centres, and that small group of people may well
treat a small shadow bank’s liabilities as money. But then all sorts of strange
bits of paper get treated as money in the world’s financial centres: government
debt is often accepted in lieu of cash in those centres. But there is no
country in the world that includes government debt in its money supply.
And
remember, government is an entity that is several thousand times the size of
the average shadow bank. Given that size pays when it comes to having one’s
liabilities accepted and treated as money, small shadow banks have problem
competing with government’s liabilities, to put it mildly.
Maturity transformation.
Another
form of money creation or another aspect of fractional reserve is maturity
transformation (MT), that is “borrow short and lend long”.
Unfortunately
for small shadow banks, this is another area where size pays. MT relies on
calculating what proportion of depositors are likely to withdraw their deposits
in next month or so, and keeping that money available for those depositors,
while lending on the rest of the money.
Now
a bank with say a quarter of a million depositors can calculate with a very
high degree of certainly what proportion of depositors are likely to withdraw
in the next month. But same does not apply to a very small bank with say ten
depositors. The latter sort of bank would be running an excessive risk if it
engaged in any MT at all.
DD’s alleged political problems.
DD’s third criticism of full
reserve is that it involves various unstated “political problems”. They say,
“Fortunately, the political realities make it unlikely that this radical and
imprudent proposal (full reserve) will be adopted.”
Well if DD can’t tell us what
these “political problems” are, it’s a bit difficult to answer their point,
isn’t it? However it’s not too difficult to guess what these political problems
might be, and when time permits, I’ll deal with them.
DD’s advocacy of full reserve.
As pointed out above, in this
paper, DD unwittingly advocate full reserve of a sort. That is they advocate a
system under which in a crisis, or given a bank run, the rate at which deposits
can be withdrawn is limited.
Well now, that is very similar to
the systems proposed by two of the leading advocates of full reserve, Kotlikoff
and Werner (K & W). That is both K and W advocate systems in which various
depositors’ right to withdraw quickly is constrained.K & W however are more sophisticated than DD (unless I’ve got DD wrong). That is, in the K and W systems, depositors have a right to instant access / current / checking accounts. There are never any restrictions on the rate of withdrawal (up to the amount that depositors have put in such accounts). Moreover, the money is 100% safe and is always there because it is not invested or is only invested in ultra-safe and easily marketable securities like government debt.
And that is absolutely right: people
and firms must have checking or current accounts.
In contrast, under DD the rate of
withdrawal from checking accounts might be restricted: totally unacceptable.
As distinct from checking
accounts, under K & W there are investment accounts. And there, there is
little difference between K, W and DD. Withdrawal is slowed down or banned for
a specific period, or (under K) too fast a rate of withdrawal results in
“withdrawers” accepting a loss on their investments.
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