Krugman’s flawed criticisms of full reserve.

I’m a Krugman fan. Unfortunately he makes mistakes in this article which is critical of Martin Wolf’s recent article on full reserve banking.

First, Krugman criticises Wolf for concentrating on retail banks, while ignoring the fact that the crisis was largely a run on shadow banks. Well it’s inconceivable that Wolf is unaware of the latter shadow bank point. Presumably Wolf ignored shadow banks for the sake of brevity.

Next Krugman gives us “three thoughts”, the first one of which is actually closely related to the latter shadow bank point. Krugman says “If we impose 100% reserve requirements on depository institutions, but stop there, we’ll just drive even more finance into shadow banking, and make the system even riskier.”

Well (revelation of the century this) I think we’ve all now tumbled to the fact that it’s daft to impose various regulations on conventional banks while omitting to impose the same regulations on shadow banks, particularly given the huge expansion in shadow banking over the last decade.

As Adair Turner (former head of the UK’s Financial Services Authority) put it and in reference to shadow banks: "If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safe-guards."

Krugman’s second thought.

Krugman’s second “thought” is that “Cochrane’s proposal calls for a remarkable amount of government intervention in finance…” Excuse me? The Dodd-Frank regulations currently stand at about 10,000 pages and according to some have actually made things worse, not better. In contrast, I set out the basics of full reserve banking here in about 300 words.

In short, if it’s near useless regulations of Byzantine complexity you want, don’t bother looking at the rules that govern full reserve banking. Look at EXISTING attempts to prop up FRACTIONAL RESERVE banking.

Krugman’s next criticism of John Cochrane is to querie the idea that “we can easily set things up so that the manager of your index fund sells a tiny piece of your stock portfolio every time you use a debit card”. That point will not be clear to the uninitiated, so I’ll explain.

It would be possible to have a system where checks can be drawn or debit cards “drawn” on an account which contained not money, but investments of the sort that a typical mutual fund makes. Thus it might seem that some of those investments would need to be sold every time someone uses their debit card.

However, selling two shares in General Motors when someone buys their weekly groceries with their debit card would clearly be absurd. I.e. it would be better to keep a stock of base money and only sell a decent sized bundle of investments when the latter stock was too low.

But in any case, most of those who back full reserve do not advocate the above “sell one share at a time” or even a “sell a bundle of shares” system. That is, they advocate a system (much like the existing system) where it’s up to bank customers or depositors to make sure there is enough in their safe / current accounts to fund check or debit card transactions.

However, Cochrane’s “sell a bundle” system would be perfectly feasible, and the question as to which system to implement could perfectly well be left to individual banks. (See “Incidental Note” below for more on this point, if you want).

Krugman’s third thought.

His 3^rd thought is that banking was not the only thing wrong around 2008. I.e. there were other problems: he cites over-indebted households. Well hang on: why were those households over indebted? It was caused in part by irresponsible banks using every trick in the book to get people to take out loans they couldn’t afford! I.e. the problem was BANKS.

And even if there were factors that contributed to the crisis which had nothing to do with banks, the fact remains that banks had an awful lot to do with it.

Incidental Note.

There is actually some logic in the existing practice adopted by most banks, that is requiring depositors THEMSELVES to make sure there is enough in their current or checking accounts. And under full reserve, the same logic would apply. The logic is thus.

If a bank itself is responsible for shifting money from a term or investment account to a safe / checking / current account, then there is no effective difference between the two accounts.

Moreover, under the existing system, banks definitely want to know how much of their depositors’ money those depositors might spend in the next month or so: when banks know that, they know they are free to lend on a proportion of that money. So to that end, banks want to see a POSITIVE COMMITMENT from customers to not spend sundry sums of money in the next month or so. And when depositors THEMSELVES shift money from current / checking accounts to term accounts, that certainly represents a commitment of a sort.

And much the same point would apply under full reserve. Thus my guess is that banks would not be keen on Cochrane’s “sell a few shares every ten minutes” system.

Diamond and Dybvig’s flawed criticisms of full reserve.

I’m always interested in arguments against full reserve. So far all I’ve found is a selection of badly flawed arguments, and this  paper by Douglas Diamond and Philip Dybvig is typical. It’s entitled “Banking Theory, Deposit Insurance, and Bank Regulation”. D&D’s criticisms of full reserve appear in their section III, and their argument (which clearly indicates they haven’t studied the subject) starts as follows. (D&D’s actual words are in green below).

“One proposal is to impose a 100% reserve requirement, that is, a requirement that intermediaries offering demand deposits can hold only liquid government claims or securities, for example, Treasury bills or Federal Reserve Bank deposits (which might pay interest). This proposal specifically restricts banks from entering the transformation business (they cannot hold illiquid assets to transform into liquid assets), and therefore the proposal precludes banks from performing their distinguishing function. If successful, this policy would remove the purely monetary causes of bank runs by limiting banks to performing liability services. The net effect of such a policy is to divide the banking industry into two parts. The regulated part of the industry would still be called banks but would be effectively limited to providing liability side services. The other part of the industry would be an unregulated industry of creative firms exploiting demand for the transformation services previously provided by banks but that banks could no longer supply under 100% reserves.”

Answer to the above passage.

The above passage is a joke. It certainly does not set out 100% reserve banking as proposed by 100% banking’s main advocates (e.g. Irving Fisher or Milton Friedman) in the years prior to D&D’s paper (1986). The above passage is simply D&D’s own bizarre idea as to what 100% reserve banking consists of.

To illustrate, Irving Fisher in his book “100% Money and the Public Debt” (1936) says “..each commercial bank would be split into two departments, one a warehouse for money, the checking department, and the other the money lending department…”. I.e. far from lending being done by what D&D call “unregulated creative firms”, lending entities are very much regulated under full reserve.

And Milton Friedman, another advocate of full reserve, describes full reserve in his book “A Program for Monetary Stability” much as Fisher does. Specifically Friedman says “The effect of this proposal would be to require our present commercial banks to divide themselves into two separate institutions. One would be a pure depositary institution, a literal warehouse for money…….The other institution that would be formed would be an investment trust or brokerage firm. It would acquire capital by selling shares or debentures and would use the capital to make loans or acquire investments.”

Neither Fisher nor Friedman say anything about one half of the banking industry being “unregulated”, as claimed by D&D.

D&D continue.

“Even if banks would still be viable without the rents to providing the transformation service, the proposal would just pass along the instability problem to their successors in the intermediary   business. The instability problem arises from the financing of   illiquid assets with short-term fixed claims (which need not be monetary or demand deposits).”

The answer to that is that obviously if “illiquid assets” are funded from “short-term fixed claims” then the relevant entity is fragile: or in D&D’s words the “instability problem” is “passed along”. Indeed, the latter defective form of funding would make the whole switch to full reserve near pointless. That’s why the advocates of full reserve (Friedman, Fisher, Lawrence Kotlikoff, etc) SPECIFICALLY advocate that funding is done by SHAREHOLDERS and NOT BY “SHORT-TERM FIXED CLAIMS”. Doh!

Mutual Funds.

Then in the rest of that paragraph of D&D’s, they make the point that the deposit taking half of the former banking industry is similar to money market mutual funds, and they complain about the fact that no transformation or “creation of liquidity” takes place as a result.

Well the answer to that is that stopping private banks creating liquidity or if you like creating money is a SPECIFIC OBJECTIVE of full reserve banking: it’s not a flaw which has remained hidden till those two geniuses Diamond and Dibvig revealed it. As Fisher put it, “We could leave the banks free, or at any rate far freer than they are now, to lend money as they please, provided we no longer allowed them to manufacture the money which they lend.”

Next, D&D ask:

"If banks adopted this structure, who would hold the illiquid assets (loans) currently held by banks?"

Well if D&D had bothered reading the Chicago plan and/or Fisher and/or Friedman, they’d know the answer, which is of course that those “illiquid assets” are held by the lending entities or lending departments of banks that arise when full reserve is implemented.

Commercial Paper.

Next (para starting “Commercial banks…”) D&D point out that corporations use commercial paper to raise cash in a hurry, and that this process would be more difficult under full reserve.

Well the answer to that is that short term loans to corporations are only one of many types of loan in modern economies. E.g. there are very small scale high interest loans made by back street loan sharks, and long term and relatively low interest rate loans granted to mortgagors, to name just two. And contrary to D&D’s claims, there is nothing very special about large short term loans to corporations: that is, a number of GENERAL POINTS can be made about lending given a switch to full reserve and which are applicable to all types of lending, not just lending backed by commercial paper. Those points are as follows.

First, full reserve obviously restricts lending, but given the excessive and irresponsible lending that caused the crunch, it’s not immediately obvious why that’s a problem. As to the demand reducing effect of that restriction, that can be made up for by creating and spending base money into the economy, which in turn results in firms and households having a bigger stock of money. Thus any interest rate rise caused by implementing full reserve would tend to be counterbalanced by a reduced need for households and firms to take on debt.

The net result is that those corporations which D&D are so worried about (and indeed all other debtors or potential debtors) would tend to keep a larger stock of money to tide them over periods when their stock of money tended to be low, rather than resort to money lenders. And give current record levels of private debt, that’s probably a desirable outcome.

Money lenders cannot be controlled?

In their penultimate sentence, D&D make the following claim which they don’t even try to substantiate: “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.”

Well the first flaw in that argument is that under full reserve, as explained above, “liquidity” or money is created by the central bank, not private banks. Thus it’s debatable as to whether there is any sort of “vacuum” to which D&D refer.

However, printing money and lending it out, which is what private banks do, is a potentially profitable business. So doubtless numerous shadow banks would try to get into the money or liquidity creation business.

However, one answer to that was given by Adair Turner (former head of the UK’s Financial Services Authority) put it and in reference to shadow banks which prior to the crunch were scarcely regulated at all: "If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safe-guards."

But clearly imposing those “bank-like safe-guards” will never be done with 100% efficiency: that is, numerous smaller shadow banks will try to evade the rules. But actually there isn't a huge problem there, and for the following reasons.

The tax authorities normally manage to trip up naughty self-employed people with a turnover of £50k or £100k a year who are not declaring their earnings to the tax authorities.  And £100k a year is a RIDICULOUSLY SMALL turnover for a shadow bank. Thus the authorities ought to be able to uncover the existence of any shadow bank with a turnover of say more than £1m a year, and if they can do that, that cracks the problem.

Can small entities create money?

Moreover, it is debatable as to how much money creation small shadow banks, particularly small ones can do. My Penguin dictionary of economics starts its definition of money with the sentence “Anything which is generally acceptable as a means of settling debt.” Now the liabilities of well-known and large High Street banks are “generally acceptable” for the purposes of buying a car or purchasing your groceries. E.g. cheques drawn on Barclays or Lloyds are widely accepted, and credit cards with “Barclays” or “Lloyds” or “Visa” printed on them are generally accepted. But you’d probably be wasting your time with a cheque drawn on some unheard of shadow bank.

 

Maturity transformation.

Moreover, size pays when it comes to maturity transformation. To illustrate, if a bank is funded by ten thousand depositors, the bank can calculate very accurately the proportion of those depositors likely to withdraw their money in a particular week or month.

In contrast, if a bank is funded by just TEN depositors or other type of short term creditor, it would be well advised not to do any transformation at all.

So to summarise, failing to keep tabs on the smaller shadow banks would be a minor problem for full reserve.

Conclusion.

Diamond and Dibvig’s attempt to criticise full reserve is hopeless.

 

Full reserve equals monetarism?

A common criticism of full reserve banking is that it equals monetarism or Milton Friedman’s version of monetarism: that’s the idea that controlling the amount of money is the best way of controlling aggregate demand. E.g. see paragraph starting “This is very close…” here.

Apart from Friedman himself, I’ve never come across an advocate of full reserve who advocates monetarism. Certainly I don’t. Thus presumably most of them agree with the more conventional view, namely that while the quantity of money (base money in particular) does have an effect, the ACTUAL PROCESS of expanding that stock also has an effect, where that is done by simply creating new base money and spending it into the economy rather than done via QE. Moreover in his 1948 paper, "A monetary and fiscal framework for economic stability" (American Economic Review) he advocates full reserve, he does not put any emphasis on the monetary rather than fiscal effects of creating new monetary base and spending it into the economy (or cutting taxes). But looks like he changed his mind on that later in his career. (BTW that paper is normally available for free online, but it's vanished today.)

Incidentally, I said “rather than done via QE” above because QE has little effect on the stock of private sector net financial asserts, while in contrast, a “print and spend” policy DOES INCREASE that stock.

To illustrate the above “monetary / fiscal point” if the central bank / government machine creates and spends enough to employ an extra thousand government employees by this time next month, and those extra employees are actually hired, then employment rises by one thousand, all else equal. Revelation of the century that, wasn’t it?

But note, that when those extra employees start work, the money supply won’t have risen: that is, the employment increasing effect comes from what might be called the fiscal element in “print and spend”.

Of course the latter point assumes that the economy has spare capacity, i.e. that the effect of the extra money will not simply be to boost inflation. Plus I’m ignoring the multiplier to keep things simple, plus I’m assuming no Ricardian effects. But as Joseph Stiglitz said “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.” So my “no Ricardianism” assumption probably doesn’t fly in the face of the facts too much.

Martin Wolf and full reserve.

Since Wolf’s article in the Financial Times a few days ago, his article has attracted plenty of criticism. These criticisms are easily dealt with, especially since the critics don’t seem to have studied the BASICS of full reserve. So here is:

1. A quick explanation of the basics.

2. A guide the explanations set out by the main advocates of full reserve (Milton Friedman, Lawrence Kotlikoff, James Tobin, Richard Werner, Hyman Minsky, etc).

The basics.

Under full reserve, the banking industry is split in two. One half simply accepts deposits and lodges the money at the central bank (or – the option preferred by Milton Friedman – invests the money in short term government debt). That money is instant access, but pays little or no interest. Those deposits are backed by the state, but since there is virtually no risk, the cost to the taxpayer of backing those deposits is near zero. I.e. there is almost no subsidy of the banking industry there, plus that half of the industry cannot fail and cause credit crunches.

Or as Minsky put it, "..one such subsidiary can be a narrow bank which has transaction balances as liabilities and government debt as its assets. This narrow bank does not need deposit insurance.."

Loans and investments.

The second half of the industry performs the lending and investing functions performed by conventional banks, but that half is funded by shareholders or loss absorbers who are effectively shareholders. In Laurence Kotlikoff’s version of full reserve, the second half consists of mutual funds, and of course those with a stake in mutual funds are effectively shareholders. The exception there is money market mutual funds: obviously they belong to first half of the industry.

And that second half of the industry cannot fail either, although there is nothing to stop one of the relevant entities declining slowly. That is, if an entity makes silly loans, it doesn’t suddenly become insolvent: all that happens is that the value of its shares (or mutual fund units) fall in value. So no bank subsidies are needed there either.

So to summarise so far, we have, 1, disposed of the need for taxpayers to underwrite bank deposits, 2, disposed of other bank subsides, and 3, disposed of the possibility of sudden bank failures, and hence the severity of credit crunches, and all in a couple of hundred words. Not bad, given the complete failure of Dodd-Frank, Vickers etc to do anything remotely similar despite spending millions on the problem and exuding tens of millions of words on the problem.

Deflationary effects.

Obviously, the introduction of full reserve restricts lending and that reduces aggregate demand. But that’s easily dealt with by standard stimulatory measures. The actual stimulatory measure preferred by Friedman and Positive Money is simply creating and spending base money into the economy (which comes to the same thing as fiscal stimulus followed by QE).

The net result of that is that private debts decline and the typical household and firm has a bigger stock of money. And given the sharp rise in private debts over the last decade that’s probably desirable. Or to use Positive Money (PM) parlance “debt encumbered money” shrinks, and “debt free money” expands.

As to who decides the amount of stimulus, that is done under the PM / Werner system by a committee of economists. And that’s not much different to the existing system: e.g. the Bank of England Monetary Policy Committee decides on interest rates and thus has a big say on stimulus.

Plus, as under the existing system, that sort of committee DOES NOT have a say on strictly political matters, e.g., 1, the proportion of GDP allocated to public spending, or 2, whether stimulus comes in the form of increased public spending or tax cuts, or 3, how any increased spending is split as between  different government departments. I.e. under the existing system the Bank of England MPC adjusts interest rates and leaves it to politicians to adjust public spending if they so wish. While under the PM / Werner system, the committee decides how much extra (or less) base money is to be created and spent, while leaving to it politicians to decide EXACTLY HOW that money is spent (or whether the money is used to cut taxes).

Guide to literature by Friedman, Kotlikoff, Tobin, etc.

For Friedman see his book “A Program for Monetary Stability” (published by Fordham University Press), Ch3 under the heading “Banking Reform”. Here is an extract:

“The effect of this proposal would be to require our present commercial banks to divide themselves into two separate institutions. One would be a pure depositary institution, a literal warehouse for money. It would accept deposits payable on demand or transferable by check. For every dollar of deposit liabilities, it would be required to have a dollar of high-powered money among its assets in the form, say, either of Federal Reserve notes or Federal Reserve deposits. This institution would have no funds, except the capital of its proprietors, which it could lend on the market. An increase in deposits would not provide it with funds to lend since it would be required to increase its assets in the form of high-powered money dollar for dollar. The other institution that would be formed would be an investment trust or brokerage firm. It would acquire capital by selling shares or debentures and would use the capital to make loans or acquire investments.”

For Kotlikoff, and James Tobin, see here.

For Werner and PM, see: p.7 “Step 2” here.

For PM’s latest ideas (which are not much different to those just above) see their book “Modernising Money”.