Cecchetti and Schoenholtz’s strange ideas on narrow banking.

I demolished no less than 38 spurious arguments against narrow banking here recently. But the rubbish arguments just keep coming.

The latest examples in this genre I’ve stumbled across are in an article by the above two authors. (Incidentally, I’ll use the phrase “full reserve banking” instead of “narrow banking”. But the system referred to is exactly what C&S refer to, namely the proposals for bank reform put by Lawrence Kotlikoff,  John Cochrane, Martin Wolf and others cited by C&S)

Indeed, the sheer number of spurious arguments put against full reserve is evidence that the opposition to it is PSYCHOLOGICAL rather than rational. To illustrate, there were very roughly five not bad arguments both for and against invading Iraq ten years ago. But once you get beyond roughly five, you’re into nutter territory.

Cecchetti and Schoenholtz clearly haven’t much grasp of the basics of full reserve, which are incidentally simple enough: I set out the basics in a few hundred words starting on p.4 here.

Anyway, Cecchetti and Schoenholtz’s mistakes are as follows.

Replicating existing bank activities.

They claim that, “Banks serve capitalist economies in two ways that are costly to replicate. First, they are experts in providing liquidity both to depositors and to borrowers.”

So you have to be an “expert” to supply an economy with liquidity? Hilarious. All you need is a government and central bank that prints and spends money into the economy in whatever quantities the economy needs. Printing and spending money is idiot’s work. As for gauging exactly the right amount to print and spend, that’s clearly more difficult. But then governments struggle to get the amount of stimulus right ANYWAY. So full reserve is not inferior to the existing system in that respect. (Incidentally “print and spend” tends to be the form of stimulus favoured by full reservers, and that actually comes to the same thing as a form of stimulus implemented recently, i.e. fiscal stimulus followed by quantitative easing.)

Costs.

As for “costly”, the real costs of having commercial banks supply an economy with money or “liquidity” are quite clearly higher than having a central bank do the job. Reason is that commercial banks have to check up on the value of collateral supplied by would-be borrowers. In contrast, there is no need for a central bank to do that: it simply prints and spends money into the economy in whatever quantity keeps employment as high as possible without bringing excess inflation.

Liquidity for borrowers.

As for Cecchetti and Schoenholtz’s claim that supplying borrowers with liquidity is difficult to “replicate”, that point is nonsense, because under full reserve, the lending half of the banking industry lends in exactly the same way as banks currently lend: that is, it looks at the creditworthiness of potential borrowers and lends (or doesn’t) accordingly. I.e. there is no need to “replicate”. Put another way, and using C&S’s phraseology, banks would “screen potential borrowers” just as they do now.

Runs.

Next, comes what C&S call their “main point” namely that given poor performance by a bank or “lending entity” under full reserve, a run on its shares would be as likely as traditional bank runs.

Well the first answer to that is that runs on stock exchange quoted shares just don’t happen. Reason is that given bad news about a firm or corporation, the value of its shares drop before anyone has time to sell (with the possible exception of some inside traders).

Second, even if a run did take place, there is a HUGE DIFFERENCE between a traditional bank run and a run on bank shares under full reserve: the former leads to the bank going bust or going insolvent, while the latter does not. C&S are oblivious of that difference.

Withdrawals.

C&S then say, “collective attempts at liquidation to meet withdrawal requests would lead to ruinous fire sales.” What in God’s name are they on about?

What’s the phrase “withdrawal request” doing there? A share in a corporation does not involve the corporation owing shareholders one cent. If a larger than normal set of shareholders want out, then the value of the shares drop. There is no need for the corporation (banking corporation or any other corporation) to “meet withdrawal requests”). 

C&S are obviously confused as to the difference between the two halves of the banking industry under full reserve. That is, the safe half clearly faces “withdrawal requests” but it can always meet them because the relevant money is lodged in a totally safe manner. As to the investment or lending half, the value of its assets can collapse, but it never faces “withdrawal requests”.

Illiquid mutual funds.

And finally C&S cite “research” which shows allegedly that the price of mutual funds which hold illiquid assets is more volatile than cash mutual funds. Well – revelation of the century!!!!

The value of a $100 stake in a cash mutual fund should, if the fund is well run, always remain very near to $100. In contrast, funds that invest say in stock exchange quoted shares will be more volatile. But that’s a risk that shareholders deliberately and knowingly accept, in the hopes that accepting that risk leads to a decent return on capital in the long term.

You really have to wonder what C&S think they’re doing writing an article on banking, don’t you?  Still, academics are rewarded in proportion to the QUANTITY of verbiage they churn out, not the QUALITY. So no doubt the above article will improve C&S’s CVs.