Mankiw and Krugman and on full reserve banking.

Mankiw expresses sympathy with full reserve banking. He says, “Suppose we were to require banks to hold 100 percent reserves against demand deposits. And suppose that all bank loans had to be financed 100 percent with bank capital. A bank would, in essence, be a marriage of a super-safe money market mutual fund with an unlevered finance company. (This system is, I believe, similar to what is sometimes called “narrow banking.”) It seems to me that a banking system operating under such strict regulations could well perform the crucial economic function of financial intermediation. No leverage would be required.” (Narrow banking is just another name for full reserve banking, btw.)

Krugman answers that by saying “Where Greg goes astray here, I think, is by trying to apply Modigliani-Miller, which says that capital structure doesn’t matter. If you look at the assumptions behind that argument, you realize that it requires that all assets be perfectly liquid.”

 “I think of the whole bank regulation issue in terms of Diamond-Dybvig which sees banks as institutions that allow individuals ready access to their money, while at the same time allowing most of that money to be invested in illiquid assets. That’s a productive activity, because it allows the economy to have its cake and eat it too, providing liquidity without foregoing long-term, illiquid investments. If you were to enforce narrow banking, you would be denying the economy one of the main ways we manage to reconcile the need to be ready for short-term contingencies with the payoff to making long-term commitments.”

Well the answer that is that you don’t need conventional banks, or indeed any sort of bank, to obtain a good degree of liquidity. Your car and house are moderately liquid in that cars can be turned into cash within 24 hours and houses normally in a month or so. Plus the stock exchange funds investments in ILLIQUID assets while ensuring that those who fund those investments enjoy a high degree of liquidity: you can turn your stake in General Motors into cash within 24 hours, though the actual number of dollars you’ll get is not totally predictable.

As to liquidity in the sense of a fixed number dollars, or a liquid asset which is guaranteed to hold its value (inflation apart), traditional commercial banks are just not needed for that purpose. That is, government and central bank can provide an economy with whatever amount of money the economy needs. Indeed, central banks are doing just at the time of writing on an unprecedented scale in that there is a record amount of base money sloshing around thanks to QE.  

Or that “central bank money administering” job can be partially farmed out to commercial banks: that is what Mankiw meant by “Suppose we were to require banks to hold 100 percent reserves against demand deposits.” I.e. the safe half of the banking industry under full reserve deals just in base money or money which is backed 100% by reserves.

Moreover, if a private bank is going to provide customers with what might be called “extreme liquidity”, i.e. a fixed number of actual dollars, that NECESSARILY makes banks’ balance sheets fragile, as indeed Douglas Diamond himself eloquently pointed out.

As he and his co-author put it, in reference to the liquidity / money creation that private banks offer: “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.”

That is, if a banks’ liabilities consist of dollars / money, then those liabilities are FIXED in value (inflation apart). In contrast, its assets (the loans it makes) can fall in value. That equals fragility. It’s asking for trouble.

Conclusion.

Traditonal commercial banks with their money creation activities are a complete pain in the whatsit and for the following reasons.

The stock exchange, or more generally shares, provide a degree of liquidity. Of course banks provide a better way of transferring and storing money that dealing just in physical cash kept under the mattress. But so far as the provision of liquidity goes, commercial banks add nothing. They cannot give us liquidity without at the same time giving us fragility, and possible bank runs, credit crunches, etc.