Monday, 4 August 2014

Frances Coppola’s absurd ideas on full reserve banking.

I’m going to run through an article she wrote entitled “Martin Wolf Proposes the Death of Banking”.
First though a brief introduction to full reserve (FR). FR banking is very simple. It consists of the following (in blue). Skip if you like.
The bank industry is split in two. One half offers totally safe accounts where money is simply lodged at the central bank, or maybe also invested in government debt. The other half offers normal bank loans, but that half is funded only by shareholders, or people who are effectively shareholders. For example the latter half can take the form of mutual funds (unit trusts in the UK) with investors having a choice as to what is done with their money, i.e. a choice as to which particular fund they put their money into. The advantages of that set up are:
1. The first half cannot fail. As to the second half it cannot suddenly go insolvent, though a slow decline and consequent takeover by another bank is certainly possible.
2. That means no more credit crunches and subsequent recessions. It also means an end to bank subsidies, an objective which those in charge of reforming bank regulations have set themselves, but which they’ve largely failed to achieve.
3. There’d be no reason under FR for the current limits on how much of depositors’ money is guaranteed (£85,000 in the UK at the time of writing). That is because offering that guarantee under the existing system, where the guarantee is taxpayer funded (as is the case in the UK) is a GENUINE liability for governments (i.e. taxpayers). In contrast, safe accounts under FR are GENUINELY SAFE. Thus there is no reason to limit the guarantee. Moreover the guarantee can be extended from INDIVIDUALS to firms and corporations.

Frances’s article.
As to Frances’s article, its only merit is that she criticises an IMF paper by Messers Benes and Kumhof which advocated full reserve (FR). Agreed. I don’t think much of that paper either.
Next she makes the point (and indeed repeats the point throughout the article) that FR means the end of banking as we know it, hence the title of her article no doubt. (E.g. see her paragraph starting “But there is a problem”)
Well the simple answer to that is that advocates of FR are PERFECTLY WELL AWARE that FR involves a change to banking which is so large and fundamental that successor entities or institutions can arguably no longer be called banks. To illustrate, Matthew Klein penned a Bloomberg article which explains Laurence Kotlikoff’s ideas on FR, and the title of the article is “The Best Way to Save Banking is to Kill It”. That implies a pretty big change.
However, the fact of advocating reform of something that is so fundamental that previous definitions of relevant words like “bank” no longer apply is NOT AN ARGUMENT against such reforms. 

Payments systems.
Next she makes the absurd charge against Kotlikoff (and indeed Bennes and Kumhof) that they “completely ignore the crucial role of banks in facilitating payments”. Messers Bennes, Kumhoff and Kotlikoff would have to be mentally sub-normal not to be aware that it is necessary for people and firms to make payments to each other. And I suspect those three individuals are not mentally sub-normal.

In the next two paragraphs (starting “The third proposal..”) she addresses the point that under FR, those who want a return on their money put their money in special accounts which actually amount to mutual funds (unit trusts in the UK).
But she doesn’t like that, and says, “But once again, there is a problem. Banks are not fund managers.” Well under the EXISTING SYSTEM banks’ main job is not fund management, but under FR that is their main job!
To object to banks becoming fund managers is a bit like objecting in the 1800s to ships being powered by steam on the grounds that “ships are powered by sail”. To repeat, the fact that a reform is fundamental is not an argument against the reform.
Incidentally the above claim that banks are not fund managers is not correct for another reason: banks already manage hundreds of mutual funds with billions invested in them!
Bank desposits.
Next, she tells us that “People put money in banks for two reasons: because they want safety AND a return” and seems to bemoan the fact that people can no longer get that combination, i.e. safety and return.
Well that’s for a VERY GOOD REASON. And this goes right to heart of the basic argument for FR which Frances doesn’t seem to get. So I’ll explain.
Lending or investing money INEVITABLY involves risk, and for the blindingly obvious reason that borrowers sometimes don’t repay loans, and investments sometimes go wrong. And SOMEONE SOMEWHERE has to carry that risk. If it’s not the person lending the money then it’s  . . . wait for it . . . .probably the taxpayer!
Frances may or may not have notice the TRILLIONS of dollars of taxpayers money needed to rescue banks over the last few years: certainly everyone else noticed.
In short, if you want that much vaunted “safety and return” then you are asking to be subsidised. FR disposes of that subsidy. The UK’s Vickers commission backed the idea that bank subsidies should be removed, as did Dodd-Frank (though both Vickers and Dodd-Frank failed miserably so far as subsidy removal goes, in  contrast to FR which succeeds in that respect).
Incidentally, the word “subsidy” does not appear in Frances’s article: obviously existing bank subsidies are a big defect in the existing bank system, so if you’re defending the existing system, what do you do about that defect? Well it’s easy: just don’t mention it! But Frances is nowhere near the only defender of the existing bank system to omit the word “subsidy” from articles and papers. Messers Diamond and Dybvig were guilty of the same omission in a paper in 1986 entitled “Banking Theory, Deposit insurance and Bank Regulation”.

The second reason for depositing.
The second reason she cites for “people putting money in banks” is “because they need liquidity (including access to payments systems)”. You don’t say? Notwithstanding her charge against Benes, Kumhof and Kotlikoff, namely that they apparently aren’t aware that payments need to be made, FR offers accounts which are the basis for making payments with cheques, debit cards, etc in EXACTLY THE SAME WAY as the existing banking system (e.g. the safe accounts proposed by Positive Money). So quite why she comes out with the revelation that people put money in banks because they want “liquidity and access to payments systems” is a bit of a mystery.

 The morning mist.
Next she criticises the half of the bank industry funded by shares (non-money market mutual funds in the case of Kotlikoff’s system and “investment accounts” in the case of Positive Money) on the grounds that:
“I fear that the “investment accounts” Kotlikoff and Positive Money envisage would disappear like the morning mist once the deposit insurance that time and sight deposit accounts currently enjoy is removed. Positive Money UK's proposal therefore probably means the end of commercial banking, unless they could find other sources of funding.”
Now the phrase “morning mist” is wonderfully evocative, and it will impress simpletons and pseudo intellectuals. As for cold logic, the simple fact of saying you “fear” something will disappear is a hopeless argument.
There is actually a very good reason why there would be demand for the shares in the share funded / equity funded / mutual fund half of the bank industry, and that’s that the people ALREADY invest billions (or perhaps it’s a trillion or two) in stock exchange shares. They do that both as individuals and as subscribers to pension funds: i.e. large numbers of people opt for pension schemes where the eventual payout is stock market related.

Lending and debts decline under FR.
Having said that there would be significant demand for shares in lending entities, that is not to say that the volume of lending (and hence debts) under FR would be EXACTLY THE SAME as under the existing system: it would certainly be a bit less.
But that’s for the very good reason that, to repeat, FR removes a subsidy from the borrowing / lending process. That is it forces lenders to foot the entire bill for their little enterprise: lending in the hope of making a profit. And in that a subsidy is removed, the result ought to be increased GDP.

Funding lending entities.
The first sentence of the next paragraph reads “But it is perhaps more likely that commercial banks would find ways of lending without relying on customer deposits for funding.” More likely? What? It’s not “more likely” that “banks would find ways of lending without relying on deposits”: they’d sodding well be FORCED TO DO THAT!  The law under FR would stipulate that that’s what they have to do, else its fines or prison sentences.

Responsibility for lending decisions
Next, she says “Completely eliminating fractional reserve lending means removing banks’ responsibility for lending decisions.” Whaaat?
Under FR (for the umpteenth time) lending entities are funded just by equity, by shares. Why on God’s name does that “remove” their “responsibility for lending decisions”?
If a garage is funded just by shares in the garage held by the person running the garage and relatives (and doubtless that’s how many garages ACTAULLY ARE FUNDED) does that “remove the garage’s responsibility for car repair decisions”?

The committee.
Next, she says, “Wolf’s idea amounts to replacing a demand-driven money supply creation mechanism with central planning of the money supply by a committee. Central banks’ record on producing accurate forecasts of the economy is dismal….”.
Now wait a moment. Under the EXISTING SYSTEM, central banks do a lot of forecasting and determine stimulus (e.g. by adjusting interest rates, QE, etc). So in criticising central banks incompetence, Frances is as much criticising the EXISTING SYSTEM, as FR!!!!
Moreover, under the EXISTING SYSTEM, central bank committees adjust the MONEY SUPPLY when they implement QE. Indeed, fiscal stimulus followed by QE comes to exactly the same as the form of money creation advocated by Positive Money!
And the first sentence of her last paragraph reads “Personally I would prefer the money supply to respond to demand rather than be decided by a committee…” Well now that’s truly hilarious and for the following reason.
Prior to the credit crunch the money supply was very much being determined by supply and demand. And what do you know? Banks were creating and lending out money like there’s no tomorrow, i.e. in a totally irresponsible manner. (See chart below). Then came the crunch, and as always happens, commercial banks suddenly stopped their money creation activities (exactly what we don’t want them to do in a crunch).
Frances’s claim that there are big merits in having the money supply determined by supply and demand is patent and obvious nonsense.

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