Thursday, 19 June 2014

Full reserve does not bail out commercial banks.

Most of Frances Coppola’s articles are quality stuff. But she went off the rails in this article entitled “Full reserve banking: the largest bank bailout in history”.
First, for the benefit of readers not acquainted with the basics of full reserve banking, I set them out on p.4 here.
Now for Frances’s criticisms.
She starts by listing three problems with full reserve, the second of which is that it allegedly involves a “Serious restriction on the nature and scope of bank lending”.
The answer to that is that there is JUST ONE “restriction”, and that is that all loans must be funded by shareholders (or people who are in effect shareholders) not by depositors. And that would certainly reduce the TOTAL AMOUNT of lending (and thus the total amount of debt).
In contrast, and as regards “nature and scope” other than in the above “total amount” sense, there is no reason why FR would influence the “nature and scope” of lending one iota. E.g. if widget makers currently borrow more than other industries, then widget makers would borrow more than other industries under FR.
As to the above mentioned reduction in the total amount of debt that FR would bring about, there is widespread concern (and not just by advocates of FR) about the steep rise in private debts relative to GDP over the last decade or two. If that concern is justified, then the “debt reducing” characteristic of FR would do no harm.

The free market.
But even if the above concern about debts is not justified, the argument that less lending must necessarily be undesirable still doesn’t stand inspection. And the reason is that banks under the existing regime are subsidised (via lender of last resort, the TBTF subsidy and taxpayer backing for deposits under £80,000). And subsidies do not make sense unless there is some very good social reason for them.
Full reserve disposes of bank subsidies, thus the assumption must be that while lending declines under full reserve, lending declines to its optimum or “free market / non-subsidised” level, thus GDP far from falling as a result of less lending, actually rises.

Three versions of FR.
Frances then briefly considers three versions of FR: 1, the version set out by two IMF authors, 2, Laurence Kotlikoff’s version, and 3, Positive Money’s.
As regards the IMF version, I agree with her that that is flawed, and for reasons I set out here.

Laurence Kotlikoff.
Kotlikoff is an economics professor in Boston, and Frances claims that he advocates a system that “includes its own version of what in the UK is known as the Tote”. (That’s a horse betting system). She then goes on to criticise a system that involves betting along the lines found in horse racing.
Well if banking a la Kotlikoff really did involve something similar to betting on horses, then Frances would doubtless have a point. However, Tote type betting or “paramutuel” betting is a system that Kotlikoff advocates for INSURANCE COMPANIES, not for banks, as he explains in section 4 of his book here.

Positive Money.
Frances’s first criticism of PM’s version of FR is that the central bank committee that decided how much central bank money to create (i.e. how much stimulus to effect) under PM’s system might be politically biased or might be corruptible. As she puts it, “why on earth does Positive Money think they would be incorruptible?”
Well the simple answer to that is that EXACTLY THE SAME potential problem applies to EXISTING central bank committees that decide on stimulus (i.e. interest rate adjustments, QE, etc). In the case of the Bank of England, that’s the Monetary Policy Committee. But the latter “potential problem” never seems to have turned into a REAL PROBLEM to any great extent.
Of course it’s impossible for a central bank to do anything which is TOTALLY non-political. Plus politicians are constantly putting supposedly “independent” central banks under political pressure. But certainly the Bank of England has not to my knowledge done anything BLATANTLY political since WWII, like telling government how much to spend in health, education, roads or whatever.
But to repeat, the real flaw in Frances’s argument is that the latter problem would be NO MORE of a problem under FR than under the existing system.
Economists’ inaccurate forecasts.
Frances’s next criticism is that the committee that would exist under PM’s version of FR would not be too good at gauging the right amount of stimulus to implement if recent forecasts by economists are any guide. As she puts it, “The Office of Budget Responsibility's October evaluation report admitted that they got their growth forecasts wrong by a full 5 percentage points.”
Well the answer to that is the same as the answer to the above “corruption” point: that is, the “inaccurate forecast” problem would be no worse under PM’s system than under the existing system.

FR involves a huge bank “bailout”?
Frances next claim is that FR can only be implemented via what she calls the “biggest bank bailout in history.”
Now the first and obvious flaw in that argument is that the EXISTING BANKING SYSTEM had to be bailed out with trillions of dollars of public money about three years ago. Thus supporters of the existing system are hardly in a position to preach sermons on “bailouts” to advocates of full reserve.
Next if FR involved a serious amount of “bailout”, I suspect advocates of FR would have spotted that flaw. In fact little or no “bailout” is involved, and for the following reasons.

Slow conversion to full reserve.
One way to convert to full reserve is to do it over a period of years: i.e. raise bank capital requirements by say 10% a year till after a decade, the percentage had reached 100%. In that scenario, the sort of mutual funds advocated by Kotlikoff would gradually take over lending from banks. Indeed, banks would be free to set up their own mutual funds. And there’d be no need for the central bank to take over or bail out any existing loans made by existing banks.

Quick conversion.
A second method of conversion is what might be called the “overnight” conversion. And certainly Milton Freidman, an advocate of full reserve, saw no problem there. As he put it, “There is no technical problem in achieving a transition from our present system to 100% reserves easily, fairly speedily and without any serious repercussions on financial or economic markets.” 
Moreover, Friedman was a diehard free-marketeer, thus if FR involved any sort of “bailout” as claimed by Frances, I’m 99% certain Friedman would not have touched the idea with a barge pole.  
So how would a “quick conversion” work? It would be along the following lines.
Government announces that by a particular point in time, all depositors must allocate their money as between sums they want to be totally safe, and sums they are prepared to take a bit of a risk with, with a view to earning interest (or more interest than is obtainable on the latter totally safe money).
As regards the latter “risk” money, all that is required is to change the description of the money involved. That is, risk money is classified as “stake in a mutual fund” if we adopt Kotlikoff’s version of full reserve. Or in the case of PM’s system, that money becomes “money in investment accounts”. No bailout or anything that faintly resembles a bailout there.

Safe money.
As to money that depositors want to be totally safe, the central bank would need to create and effectively credit those depositors with £X of central bank money for every £X of existing money that those depositors had in commercial banks and which they wanted to be totally safe. And that, as Frances correctly points out, would be a gift to or “bailout” for commercial banks. But that’s not the end of the story.
What about the loans corresponding to that money? Well that then becomes the property of the central bank. That is, the central bank collects the repayment of capital and interest on those loans till the loans expire. (Incidentally it could easily make sense for commercial banks to collect those repayments of capital and interest ON BEHALF OF the central bank. But that’s an administrative detail.)
So where’s the “bailout”? Basically there isn't one!!!
There is however a small element of potential bailout if the central bank were to carry any losses arising from repayment of those loans. One possibility there is to simply accept those possible bailout costs as part of the cost for the country as a whole of converting to full reserve.
A second possibility is to get the private sector to insure the central bank against loss. There are always willing buyers of junk bonds and other dodgy assets.
But it’s unlikely that the loss would amount to anything more than two or three percent of the total of such loans in the case of bog standard British mortgages. And that accounts for the large majority of lending by banks in the UK.
There is no easy answer to the question as to how to treat potential losses arising from repayment (or rather “non-repayment”) of loans. Government could play hardball with commercial banks and depositors and offer them a miserable price for their loans. But that would be seen as robbing depositors which would be politically unpopular.
At the other extreme, government could be generous and pay full book value for those loans, and thus possibly get involved in an element of “bailout”. But that would certainly not the “largest bank bailout in history” as claimed by Frances.
Moreover, it’s near impossible to get the price exactly right when organising a big transfer of assets between public and private sectors. For example, with the benefit of hindsight it is now clear that the UK’s Post Office was sold to the private sector recently for way below a realistic price - £3.6bn too low according to this source.


  1. That article by Cappola article is indeed a ghastly muddle.However, she does correctly indicate that there would be transition problems, though not her alleged "bailout".

    Regarding your two solutions to the transition problem ("slow" and "quick" conversion), I suspect that both would be have multiple and serious practical difficulties.

    Fortunately here is a much simpler third method to transpose to Kotlikoff style Full Reserve banking - simply abolish the government's distortions of market forces in the savings/banking industry.
    In particular, there should be zero taxpayer funded deposit insurance or bailouts of banks or other financial institutions.
    Note that depositors already have options for investing in unit trusts/ mutual funds. And in the UK there is already the option of safe Full Reserve SAVINGS in the National Savings Bank.
    The latter does not offer chequing, standing order or ATM facilities, but these could well be quickly offered by private sector Full Reserve banks if there were a demand.
    Maybe banks could still be allowed to offer non-Full Reserve deposit accounts, but these would become much less popular (due to risks of bank failure or higher charges to cover private deposit insurance).

    Of course, abolishing deposit insurance and bank bailouts would be unpopular with richer depositors, but it should be popular with taxpayers. Exactly the same political issues arise with all other proposals for Full Reserve banking.

  2. A fourth solution to the transition problem is a tax on bank deposits which are NOT fully covered by safe assets.
    Full Reserve bank deposits would be exempt from the tax.
    Like the third method which I outlined above, a tax on risky deposits would work through market mechanisms within the banking industry. With a sufficiently high tax rate Full Reserve banking would become more attractive to banks and depositors than conventional banking. The latter would wither away.

    The political and theoretical economic justification for the tax would be the external costs of deposit insurance, bailouts and economic instability.

    This option would avoid the political problem of neglecting depositors in failed banks - they could still be insured or bailed out by the taxpayer. But the tax would mean that they would have to pay for these privileges through higher bank charges or lower interest.
    And since the majority of depositors would switch to the relatively attractive Full Reserve banks, the scale of insurance payments and bailouts to conventional deposit holders would be greatly reduced if not completely eliminated.

    1. KK, Strikes me that no one would know at the time when full reserve is implemented whether commercial bank assets eventually turned out to be equal to, less than or indeed more than book value. Thus no one would know whether your tax would need to be imposed, and if so, how large it would need to be.

      One possibility, and perhaps the fairest, would be to make existing bank shareholders carry the risk that a proportion of loans were not repaid. After all, they’re the ones carrying that risk ANYWAY: i.e. even in the event that full reserve is not implemented.

      However I might think some more about this, and come up with more responses to your comments.


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