Wednesday, 1 October 2014
Martin Wolf on full reserve banking.
Wolf has been sympathetic towards full reserve (FR) for a few years, while not ENTHUSIASTICALLY endorsing it. That view of his continues in his recently published book “The Shifts and Shocks”. His conclusion about FR is that, 1, we should certainly make a move towards FR in that bank capital ratios should be substantially raised, 2, that adopting FR lock stock and barrel in large countries would be going too far at the moment, but that, 3, it would be nice to try it out in one or two smaller countries.
I’ll run thru the arguments he puts for and against FR which I DISAGREE WITH. In contrast, he makes numerous points I AGREE WITH, but which I've not mentioned below. Doubtless I'll mention those points of agreement at some point in the future. The first relevant passage is under the heading “Henry Simons and the Chicago Plan” (Ch6).
Seigniorage would fund 40% of government spending?
On the second half of p.211, Wolf goes along with the claim made by two IMF authors, Benes and Kumhof, namely that the total money supply is about 180% of GDP, and given normal rates of inflation and growth, the total amount of money that would have to be created per year would be 9% of GDP, which means big seigniorage profits for government under FR, which would fund about 40% of government spending.
There is a flaw in the latter argument, thus. The vast majority of money under the existing system is matched dollar for dollar with debt. Thus money, under current arrangements is not a NET ASSET from the private sector’s perspective.
However, base money IS A NET ASSET – a point often made by MMTers. Thus base money (aka central bank created money) is more potent stuff then commercial bank created money. And that is presumably one reason base money is sometimes referred to as “high powered money”.
In short, under FR, the money supply would be smaller, and indeed money would be more precisely defined. Thus the above 40% is an over-estimate, I think. (Incidentally Wolf’s above 180% figure and my statement that “the money supply would be smaller” are both vague in that there is absolutely no universally agreed way of quantifying the money supply.)
Next, Wolf refers (p.212) to a point made by Bagehot, namely that in the early 1800s, the British tended to deposit their spare cash in banks, whereas continental Europeans tended to keep spare cash under the mattress. And that, according to Bagehot, gave British banks the ability to lend much larger sums to commerce and industry.
The suggestion by Wolf there is presumably that FR in that it lets people simply lodge their money at the central bank would starve industry and commerce of funds.
Well the first answer to that is that, at least in the UK, households can ALREADY lodge their spare cash with government: they can do that at the state run savings bank, National Savings and Investments. But that does not seem to have starved industry and commerce of funds.
Second, under FR people are totally free to have their money invested in loans to businesses or mortgages. The only different as compared to the existing system, is that those investors / lenders carry the full costs when those investments or mortgages go wrong. And what’s wrong with that?
A system underwritten by taxpayers is a SUBSIDISED system, and subsidies distort markets and reduce GDP. So while FR would certainly cause a finite rise in interest rates, the net effect (perhaps ironically) ought to be to RAISE GDP.
Moreover, the rate paid by mortgagors in the UK in the 1980s was about THREE TIMES the current rate. And strange to relate, the sky did not fall in in the 80s. Stranger still, economic growth in the 80s was far better than over the last five years during which we have enjoyed the questionable benefits of record low interest rates.
Next (and still on p.213) Wolf says that while FR would improve stability, “the market economy could still be unstable”. But he doesn’t give any reasons!
In contrast I can think of a very good reason why FR would bring a big improvement in stability: where a lending entity / bank is funded just by shares, it is impossible for it to go insolvent (as George Selgin pointed out in his book on banking (not that Selgin backs FR far as I know) ). That means no more Northern Rocks, Lehmans, etc. That should improve in stability, shouldn’t it?
Later on his p.213, Wolf claims the shift to FR would be “too disruptive”. Again no explanation. He might have dealt with Milton Friedman’s claim that no such disruption would be involved. To quote Friedman, “There is no technical problem of achieving a transition from our present system to 100% reserves easily, fairly speedily, and without serious repercussions on financial or economic markets”.
The second passage in Wolf’s book that deals with FR is in Ch7 under the heading “The case for radical reform”. And Wolf’s first criticism of FR here is one set out by Charles Goodhart, which I dealt with here.
Immediately after the Goodhart quote, Wolf says “We permit many things that are far less than perfectly safe. Consider motorcars or aeroplanes. These are regulated, but not banned, because their benefits exceed their costs.”
Now the suggestion there is presumably that rather than go for a near TOTALLY safe banking system, which is what FR involves, there are benefits in accepting something slightly more risky. But Wolf doesn’t expand on that: he doesn’t tell us exactly what the benefits of a bit more risk might be or how the benefits of those risks can be quantified and set against relevant costs.
In fact there is a very good reason for thinking that a big rise in capital ratios – even up to the 100% as under FR – would not involve an increase in bank funding costs. And that reason is “Modigliani Miller”. MM it is true has been criticised, but those criticisms are feeble, as I show in section 1.4 of the book featured at the top of the left hand column.
Next, on p.236 he says “The upheaval involved in moving towards anything similar to the Chicago Plan or Kotlikiff’s updated version might be large. Well hang on: as Wolf himself pointed out, and as mentioned just above, a big increase in capital requirements IS A SIGNIFICANT MOVE TOWARDS full reserve! And as he pointed out, that can be done without too much disruption!
A halfway house.
Next, Wolf claims (p.236) that there is a “halfway house” which consists of “insisting that demand deposits or maybe just insured deposits would be backed by safe and highly liquid assets: central-bank reserves or short-term government securities. This is narrow banking.”
The flaw in that argument is thus. If all “demand deposits” are backed by the latter ultra-safe assets, then riskier assets (e.g. loans to industry or mortgagors) must be funded by shares or similar. But that’s what FR consists of! That is, FR is a system under which the banking industry is split in two, with one half being totally safe and consisting of deposits with the relevant money being lodged at the central bank (and/or invested in government debt), while the riskier half offers loans, but that half is funded just by shares or similar. In short, Wolf’s “narrow banking” is not a half-way house: it’s full blown FR.
Next, Wolf says “The problem with narrow banking, to which both the Chicago Plan and Limited Purpose Banking might be answer, is that the fragility would migrate elsewhere in the system, as happened with shadow banking.”
Well the simple answer to that “migration” problem is to regulate shadow banks above some minimum size in the same way as regular banks are regulated, as in fact proposed by Adair Turner, former head of the UK’s Financial Services Authority. As Turner put it, "If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safe-guards."
In fact to regulate normal banks and not regulate shadow banks makes as much sense as making men abide by speed limits on the road, but not women (or vice-versa).
It’s nice to see Wolf continue with his mild approval of FR. I’ll continue to read his Financial Times articles (and sometimes criticise them) because they are always interesting.