I prefer Kotlikoff’s full reserve system to Positive Money’s.

The two systems are the same in that those who want a sum of money to be totally safe have it lodged or invested in a way that is totally safe: ie. they put it into an entity or account where relevant sums are simply lodged at the central bank (and perhaps also invested in short term government debt).

In contrast, where someone wants a sum of money loaned on so that they can earn interest, under Kotlikoff’s system that person buys into a unit trust (mutual fund in the US) of their choice. If the unit trust makes poor loans or investments, then those with a stake in the trust take a hair cut assuming they sell out when the poor loans or investments become apparent. A stakeholder can of course hold on in the hopes that the value of their stake recovers. Obviously the value of that stake constantly varies, as is normal with stakes in unit trusts.

However, under PM’s system, those wanting their money loaned on invest in what PM calles “investment accounts”. Investors, as with Kotlikoff’s system have a choice as to what is done with their money. But that’s where the similarities end.

Under PM’s system, investors are promised £X back for every £X they put in (plus interest and less expenses).  Plus investors cannot sell out whenever they want: they invest for some pre-determined amount of time (just as with so called “term” accounts). And the “£X in / £X out” promise is kept unless the bank goes bust, at which point it is wound up and depositor / investors get less than 100p in the £.

As PM puts it on p.184 of “Modernising Money” (I’ve put quotes in blue):

“Investment Accounts will be risk-bearing: If some borrowers fail to repay their loans, then the loss will be split between the bank and the holder of the Investment Account. This sharing of risk will ensure that incentives are aligned correctly, as problems would arise if all the risk fell on either the bank or the investor. For example, placing all the risk on the account holder will incentivise the bank to make the investments that have the highest risk and highest return possible, as the customer would take all the downside of bad investment decisions.”

The conflict.

Now hang on. That conflicts with the paragraph at the bottom of the same page which says investors have a choice as to what is done with their money, and that the categories of assets that investors can go for will be set by government. As the book puts it, “The broad categories of investment will need to be set by the authorities”.

So, assuming banks obey the law and only put money into say relatively safe mortgages where that’s what investors want, then there is no possibility of banks being “incentivised to make the investments that have the highest risk and highest return possible..”.

Existing unit trusts.

In fact with EXISTING UNIT TRUSTS ( a system where it’s essentially those who buy units who carry all losses and profits) there doesn’t seem to be a need for government to interfere: that is, existing unit trusts which declare that a particular trust will invest in say German and French government debt or the chemical industry DO JUST THAT: invest in German and French government debt or the chemical industry. I.e. they don’t try to allocate money in some sort of underhand way to riskier investments.

The only slight reservation to the latter point is that existing unit trusts normally put their managers on some sort of bonus dependent on the performance of investments made by managers. Ad there’d be no harm under PM’s scheme in banks putting investment managers on some sort of bonus. But bonus schemes are two and six a dozen: that is very roughly half the employees in the country are on some sort of bonus scheme.  So in that sense it could be said that “banks” share profits and losses. But any such bonus, both with existing unit trusts and under PM’s scheme would be a small proportion of total amounts invested and total profits and losses on those investments. So all in all, the latter “bonus” point is a near irrelevant detail.

“Incentivise” bank shareholders?

Another way of “incentivising banks” would be to make bank shareholders share some of the loss and profit made on individual investment accounts. But it is patently obvious that the typical holder of stock exchange quoted shares knows very little about the details of the business they invest in. Indeed, prior to the recent crisis, about 99% of bank shareholders clearly hadn’t the faintest idea what was going on.

To summarise, the whole business of “incentivising banks” collapses.

Where banks carry all the risk.

PM continues:

Alternatively, if the bank takes all the risk by promising to repay the customer in full regardless of the performance of the investments, then the account holder would face no downside and would consequently only be motivated by high returns, regardless of the risk taken. This would force banks to compete by offering higher interest rates in order to attract funds, which they would then need to invest in riskier projects in order to make a profit.

Well that scenario is to all intents and purposes what the EXISTING bank system involves! Indeed, the last sentence of the latter quote the effect that the existing system tempts banks to take excessive risk is spot on. I.e. the latter quote is not, as “Modernising Money” implies, a way of running a full reserve system: IT IS THE EXISTING SYSTEM. 

Conclusion.

Kotlikoff’s system is simpler than PM’s and better. Indeed, the basic rule governing K’s system can be reduced to one short sentence as follows. “Entities that lend must be funded just by shareholders, not by depositors”.

That’s beautifully simple. But half the economics profession hates anything resembling simple solutions to complex problems, like E-MC2. A simple solution means less work for them, and as Upon Sinclair put it, "It is difficult to get a man to understand something, when his salary depends upon his not understanding it."