A poor criticism of full reserve banking by Charles Goodhart.

I dealt with just under fifty (yes 50) criticisms of full reserve banking (FR) in section two of the book on the left  - criticisms that range from the moderately well thought out to the laughable and hopelessly incompetent. But the criticisms keep coming and as a result of perusing Martin Wolf’s recently published book, “The Shifts and Shocks” I’ve just stumbled across a new one (Ch7). The criticism is made by Charles Goodhart, described by Wolf as the “doyen of British analysts of finance”. Obviously this is important stuff, so we should pay attention.

The criticism is made by Goodhart in a paper of his entitled “The Optimal Financial Structure” and is as follows (to quote, in green). He says in reference to full reserve:

“A problem with proposals of this kind is that they run counter to the revealed preferences of savers for financial products that are both liquid and safe, and of borrowers for loans that do not have to be repaid until some known future distant date. It is one of the main functions of financial institutions to intermediate between the desires of savers and borrowers, i.e. to create financial mismatch. To make such a function illegal seems draconian”

OK, let’s deal with that phrase by phrase.

First there’s that “revealed preference”. The phrase “revealed preference” is academic-ese for the much shorter and simpler word “want”. Academics have to sound technically sophisticated, and one way of doing that is use five times as many words as necessary, each of which is about five times LONGER than necessary to describe something.

Anyway, moving on . . .  savers “want” financial products that are “both liquid and safe”. Well that of itself is not a brilliant argument for providing savers with same, i.e. with what they want.  Drunks want large quantities of alcohol and many children don’t want to go to school.  That is not a good argument for letting those two categories of people have what they want.

As to savers, there is no limit to what they “want”. One of the things they want is the combination of total safety and a return on their savings, which is a flagrant self-contradiction (a self-contradiction that FR disposes of). That is, if money is loaned on or invested with a view to earning interest, it is by definition not entirely safe. And the only way of providing total safety is by having the taxpayer back those savings or deposits, but that’s a subsidy of banking!

Next, FR does not, as claimed by Goodhart stop savers having “financial products that are both liquid and safe”. Under FR, savers are SPECIFICALLY PROVIDED with accounts that provide them with liquidity and total safety: accounts where the relevant money is simply lodged at the central bank and/invested in short term government debt. Indeed the UK government ALREADY PROVIDES savers with that facility in the form of National Savings and Investments.

Borrowers.

Next, according to Goodhart, FR “runs counter to” borrowers desire for “loans that do not have to be repaid until some known future distant date”.

Not true. Under FR, borrowers can borrow from lending entities / banks just as they do under the existing system. The only difference is that those loans must be funded by shares, not deposits.

It is true that the latter form of funding raises the cost of supplying loans, but  only  to the extent that a subsidy of banks is removed (as explained in the book featured at the top of the left hand column). If we had a totally unwarranted subsidy of baked beans, then removing the subsidy would “run counter to the revealed preferences of” baked beans consumers for cheap baked beans. That is not a brilliant argument for subsidising baked beans.

Financial mismatch.

And finally, there is Goodhart’s claim that “. It is one of the main functions of financial institutions to intermediate between the desires of savers and borrowers, i.e. to create financial mismatch. To make such a function illegal seems draconian”.

Essentially that is just a repetition of the point just above. That is, FR does not dispose of “intermediation”. But it does do intermediation in a different way to way that currently prevails in the case of banks and which needs taxpayer backing. (That backing is needed in order to provide savers with the “have your cake and eat it” luxury of having one’s money loaned on (which is inherently not entirely safe) while enjoying total safety.)

Note the phrase “in the case of banks” just above. That is, FR does not do intermediation in a substantially different way to that offered by non-bank corporations. For example, stock exchange quoted corporations are funded to a significant extent by shares. To that extent, when investing in non-bank corporations, savers can get the liquidity they want in that they can sell their shares any time, while corporations can get long term loans or funding.

And finally, Goodhart objects to the “draconian” nature of FR. Well Galileo’s solution to an astronomical problem of the day, namely the apparently illogical movement of the planets, was “draconian”. He proposed that the Earth revolved round the Sun. In fact his solution was so draconian that he was put under house arrest for the final ten years of his life.

In short, the fact that a solution to a problem is “draconian” is not a good argument against the solution. And in fact FR has something important in common with Galileo’s idea: the solution in both cases is extremely simple.