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.