Saturday, 4 April 2015

Sheffield University authors try to criticise full reserve banking.

Sheila Dow, Guðrún Johnsen and Alberto Montagnoli criticise full reserve banking in this recent paper.

First, the authors (unlike many who write on this subject) do have a reasonable grasp of what FR consists of: their first two or three pages explain what FR is as they see it.

However, they start going off the rails on p.4 which contains the following bizarre sentence: “Even if it were feasible for the state to establish control of the money supply, there would be little scope for credit intermediation or maturity transformation.”

Now as the authors themselves rightly point out, under FR, the bank industry is split in two. One half is totally safe – it does nothing the least risky with depositor’s money, and certainly does not lend money to mortgagors or businesses. The second half which is funded or largely funded by shares DOES LEND to businesses etc. And that activity equals “credit intermediation” at least as I understand the latter phrase. (The Sheffield authors do not define the phrase, so I can only make an educated guess as to what is meant by the phrase)

That is, credit intermediation involves connecting borrowers with lenders. So what’s all that about “little scope for credit intermediation”?

Different versions of FR.

There are of course different versions of FR apart from the Positive Money / New Economics Foundation (PM/NEF) version which is what the Sheffield paper concentrates on. E.g. there is Laurence Kotlikoff’s and Milton Friedman’s version. (And since the authors do not mention Friedman, I assume they are unaware that he backed full reserve.)

Under PM/NEF (and contrary to the Sheffield authors’ suggestions)  maturity transformation CERTAINLY takes place in that relatively short term deposits (of a few months) fund much longer term loans. In contrast, under Kotlikoff and Friedman’s versions, it’s essentially shareholders who fund loans, and in that scenario, the phrase “maturity transformation” takes on a different meaning.

However, shareholders are “lenders” of a sort, thus contrary to the Sheffield author’s suggestions, even under Kotlikoff and Friedman’s versions of FR, lenders are connected to borrowers, i.e. intermediation takes place.

The main critique of FR.

The author’s main criticism of FR comes in their section 3.1 headed “Full Reserve Banking: A Critique” (p.8).  And this section gets off to a bad start: the first sentence reads, “Embedded in all the full reserve banking proposals is the idea that it is socially unacceptable to have a money supply which is almost entirely determined by the private sector.”

Yes - if you needed to read that sentence twice then don’t worry: so did I. The sentence is plain bizarre.

The reality is that (as PM/NEF explain) under PM/NEF, money is kept in safe accounts: indeed PM/NEF go to considerable lengths to try to ensure that those buying a stake in the riskier half of the bank industry DO NOT treat their stakes as money.

So the Sheffield authors claim that advocates of FR think it’s unacceptable for the total amount in safe accounts to be “determined by the private sector”. Well the trouble with that claim is that it flatly contradicts the point very specifically made by PM/NEF namely that given the Keynsian paradox of thrift unemployment (i.e. an increased desire for money savings), the state should MEET THAT DESIRE for more savings: i.e. create and spend extra base money into the private sector. (Indeed, advocates of Modern Monetary Theory advocate exactly the same thing when they talk about the need to meet the private sector’s “savings desires” (to use MMT parlance)).

(But see P.S. below for more on the latter points.)

Safe assets.

The rest of the first paragraph of section 3.1 points out that trust in commercial banks is degraded or destroyed by crises like the one that occurred in 2007/8. But the authors have a great solution for the latter problem. As they put it, “In fact, because of state backing of deposit insurance, public trust in bank deposits as a store of value has been maintained in spite of the crisis.”

Well of course! But that “state backing” is a subsidy of the private banking system! And it is widely accepted in economics that subsidies misallocate resources (unless there are overwhelming social reasons for a subsidy as is the case with for example children’s education). The Sheffield department of economics perhaps needs to be reminded that economics is all about the allocation of resources.

To be more accurate, deposit insurance in the UK is funded by taxpayers, whereas deposit insurance in the US in the case of small banks is self-funding: banks pay a premium to the Federal Deposit Insurance Corporation. As to larger banks, it’s essentially taxpayers that have to foot the bill: witness the billions if not trillions of public money used to prop up those large banks during the recent crisis. And the reason for that is that there’s only one entity that can rescue large banks, namely the state itself. And even some states (e.g. Ireland) were near bankrupted by their attempts to rescue their banks.

Settling up.

The second paragraph of this section criticises FR on the grounds that “the availability of safe assets would be reduced…”. That’s a reference to the fact that taxpayers no longer underwrite loans or investments which involve more risk that that involved in government debt.

As readers will probably notice, that’s essentially a repetition of the point made in the FIRST paragraph of this section: that is, the Sheffield authors are asking for loans and investments to be backed by (i.e. subsidised by) taxpayers.

And if that’s what the Sheffield authors want, perhaps they can explain why they don’t advocate the entire stock exchange being made risk free gratis the taxpayer.

Stores of value.

Next, the Sheffield authors make this claim in respect of traditional bank deposits: “Bank deposits thus perform the money function of means of payment. In addition they act as a store of value, as long as there is public trust in bank deposits.” No: wrong again.

The mistake there is that for every pound of commercial bank issued money there is a pound of debt. And incidentally it’s not just advocates of FR who make that point: advocates of Modern Monetary Theory (MMT) have made the same point numerous times. For example as Bill Mitchell put it, “…horizontal money nets to nothing”. Thus reducing commercial bank deposits does not reduce the stock of “safe assets”: it has no effect on the NET stock of such assets AT ALL!!

In the same paragraph, the authors then claim that since people can no longer save at commercial banks, they’d be forced to place their savings in the riskier half of the FR system: a half where, as the authors rightly point out, savers are required to make judgements about the risks involved in different types of saving or investment. And that, according to the authors, would be a disaster: they claim, “It is totally unreasonable to expect the general public to undertake this kind of assessment and bear the consequences of a financial failure without deposit insurance.”

Now there are three errors there.

First, as already pointed out, the existing commercial banking system does not offer the public a way of saving, or more accurately a way of “net saving” in that for every pound of saving, there is a pound of debt.

Second, since FR involves REPLACING commercial bank money with base money or “sovereign money”, FR would actually INCREASE the scope for risk free saving, since base money is a form of risk free saving from the public’s perspective.

Third, the claim that it would be a disaster if members of the public have to make choices about the riskiness of various types of saving flies in the face of the fact that members of the public ALREADY make choices of that sort. The decision of save in the form of buying a house involves risk: e.g. the value of the house can rise or fall. The decision to save in the form of buying a house with a view to letting it involves risk: the tenants might not pay the rent and the landlord may have to spend hundreds or thousands in legal fees having the tenants evicted. Members of the public buy into unit trusts (mutual funds in the US) all of which have varying levels of risk.

About the only faintly valid idea in the latter passage by the Sheffield authors is the idea that members of the public should have a very safe method of saving available to them for those who want that. Well FR provides just that. First (as mentioned above) there is the safe half of the bank industry that exists under FR. Second, and as regards the riskier half of the industry, people under most versions of FR have a CHOICE as to what to put their savings into. If they want something that resembles a traditional British building society, that sort of thing certainly ought to be made available.

Zero interest on safe accounts?

And the final sentence of that paragraph by the Sheffield authors reads, “Yet the only alternative on offer is zero - risk deposits earning zero return and in fact, if banks are to be induced to manage them, probably attracting bank fees.”

Er, no. As suggested by Milton Friedman in his book “A Program for Monetary Stability” (Ch.3), the safe half of the industry could be allowed to invest in short term government debt, which would earn some interest.

But even if no interest was earned and depositors had to pay “bank fees” what of it? That’s already the case! To illustrate, I personally pay about £12/month in fees for my current / checking account at a well-known British high street bank and get no interest.

And finally, it could be argued that under FR, those with safe accounts would get no interest while paying even LARGER fees than currently obtain on British high street bank current accounts because money from the latter accounts IS loaned on, whereas under FR it possibly isn't. Well the answer to that is that there’s no such thing as a risk free set of loans or investments (think Spanish and Irish property loans if you want an example of loans that went DRAMATICALLY wrong). And if any set of bank deposits and corresponding loans APPEARS TO BE RISK FREE, then you’ve been hoodwinked. That is, given that risk exists, someone somewhere must carry the risk, and under the existing system, to a significant extent it’s the taxpayer.

As the Independent Commission on Banking put it “The risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers.” In contrast, the Sheffield authors clearly want to load risk onto taxpayers. Or perhaps, like most of the population, the Sheffield authors think there are free lunches to be had: in particular that something inherently risky can be made risk-free and at no cost.

Shadow banks.

The next paragraph of the Sheffield paper makes a claim against FR which I’ve seen dozens of times before. To quote, the authors say “It is therefore conceivable that 100% reserve requirements on depository institutions would  ‘just drive even more finance into shadow banking, and make the system even riskier’”. Incidentally the “just drive…” quote is from Krugman.

Well it’s pretty obvious that if something is banned in any industry, that a number of informal or back-street members of that industry will try to circumvent the regulations. In fact it makes no different what bank regulations we have, about the only certainty is that banks (large and small) will try to circumvent the regulations.

The first and obvious answer to that criticism is that if we’re going to regulate banks, we should regulate ALL BANKS. To regulate just the major banks (which is what happened prior to the crisis) is absurd. Or in the words of Adair Turner (former head of the UK’s Financial Services Authority), “If to looks like a bank, and quacks like a bank, it should be subject the same bank-like safeguards”.

Moreover, even if it proves difficult to regulate the smaller shadow banks, that’s not too much of a problem and for the very simple reason that the only way of getting your liabilities WIDELY ACCEPTED as money is to be a large bank which is well know all over the country. Thus while there are various functions that small shadow banks no doubt perform very well, issuing a widely accepted form of money just isn’t one of them.

Limiting the supply of money.

The next paragraph of the Sheffield paper starts, “While the full reserve banking proposals envisage enforced (endogenous or exogenous) limitations on the supply of money, monetary history demonstrates that societies develop money assets according to need, making that enforcement very difficult.”

Now in exactly what sense does FR fail to supply the quantity of money that is “needed”? Much the most important sense in which the money supply should met “needs” is the “need” to supply enough money to keep the economy operating at full employment, i.e. the maximum level of employment that is compatible with acceptable inflation. And lo and behold that’s EXACTLY WHAT the authorities aim to do under FR: that is, they aim to create and spend into the economy every year the amount of money that achieves the latter objective (full employment).    
In contrast, commercial banks fail utterly to provide the economy with the amount of money “needed” to bring full employment. That is, commercial banks act in a pro-cyclical manner: they print and lend out money like there’s no tomorrow in a boom and thus exacerbate the boom (just what we don’t “need” them to do). Then come a recession, commercial banks call in loans and their money creation activities grind to a halt.

Any idea that the commercial bank money creation system meets the “needs” of our economy is laughable.

A “no central bank” scenario.

Next, at the bottom of p.9, the authors make the point that absent a central bank, commercial banks are likely to set up in business and supply a country with some sort of money, the example they cite being the early years of Scottish banking.

Well it’s perfectly true that absent a central bank, one or more commercial banks are likely set up in business. But that’s irrelevant because the reality is that nowadays we have central banks, thus the crucial question nowadays is whether we have, 1, a commercial bank money only system, 2, a central bank money only system, or 3, a mixture of both.

The authors then make the point that while commercial banking worked well in Scotland for a while, “More recent experience of banking indicates the ever increasing scope for much more damaging endogenous financial developments..”. Yes quite. What happened in 2007/8 indicates that there is something seriously wrong with the commercial bank system.

Next, the authors say “Not only is the supply of credit relevant to the development process, but it is relevant too to the income multiplier process, whereby bank credit allows investment to precede the generation of the saving to finance it.” Whaat? It’s possible to invest BEFORE making the savings required to actually effect an investment? This is good news. Hopefully the authors will at some stage expand on this bit of good news, and while doing so, perhaps they can answer the following points.

Assuming an economy is at capacity (aka full employment) and an investment is going to be made, it just isn’t possible to lend the investor the relevant money and let the investment go ahead. What would happen is that demand would then become excessive, and the state would have to impose some sort of deflationary measure: e.g. an interest rate rise which would cut the amount of borrowing and investment back to where it originally was.

In short, if demand is to stay constant, saving (i.e. reducing expenditure on consumer goods and the like has to done AT THE SAME TIME as expanding expenditure on capital or investment goods).

Section 3.2: Controls on the supply of credit and money.

Most of the Sheffield paper (unlike much of the material produced by academics) is clear, if mistaken. Unfortunately the opening paragraphs of section 3.2, in contrast, are verbose gobblegook.

The first paragraph (assuming I’ve understood it correctly) simply makes the point that it’s difficult to predict exactly how well the Positive Money / New Economic Foundation (PM/NEF) version of full reserve would work in practice. Well: revelation of the century! When trying anything new, there are normally teething problems.

The second paragraph is in much the same vein: near meaningless waffle. However, it does contain one sentence I agree with: “The challenge for the committee to identify productive uses of credit is also not insignificant..”

That’s a reference to a peculiarity of PM/NEF, namely that under that version, the state tries to identify allegedly “productive” forms of investment and steer loans in that direction and away from allegedly “unproductive” forms of investment. I criticised that productive / unproductive distinction here.

Revelation: economists are not omniscient.

The next paragraph of the Sheffield paper (starting “Even if we accept…”) makes the profoundly stupid point that under PM/NEF, the committee tasked with determining how much stimulus the economy should get in the next six months or whatever might not estimate the amount of stimulus correctly. Well: you don’t say.

I have news for the Sheffield authors: about 99% of economists admit to not being omniscient. Moreover, those tasked with estimating the amount of stimulus that is suitable UNDER THE EXISTING SYSTEM (as they themselves are doubt less the first to admit) do not get their estimates right much of the time.

Repeat after me: FR does not equal monetarism.

Next on p.12 (para starting “To focus on the money supply…”), the Sheffield authors claim that FR, or at least the PM/NEF version of FR, relies just on the size of the money supply to give us stimulus. (Incidentally the same criticism was made by Ann Pettifor.)

Clearly the authors (and Ann Pettifor) don’t understand the difference between fiscal and monetary effects. As the authors correctly point out, PM/NEF involves imparting stimulus by having the state simply create fresh base money and spend it (and/or cut taxes). And that of course increases the stock of base money held by the private sector, which is a monetary effect. (Incidentally, it’s not just PM/NEF who advocate that idea: most advocates of Modern Monetary Theory advocate the same, far as I can see).

However, the fact of SPENDING that new money is a FISCAL effect. That is (and it’s amazing that I need to spell this out), when the state prints money and spends it on say education and health, one effect is to create jobs for teachers, doctors and nurses, EVEN IF there is monetary effect.

However, while it’s doubtless true that Milton Friedman placed too much emphasis on monetary effects, the opposite extreme, i.e. the idea that the stock of money that households have has NO EFFECT WHATEVER on their weekly spending is clearly nonsense as well.

Section 4. Iceland.

The rest of the Sheffield paper is concerned specifically with Icelandic banks since the crisis started. As the authors put it, “…in section four we look at the behaviour of Icelandic bankers responding to the full reserve requirement constraint in 2008…”.

Now if the rules of FR really had been imposed on Icelandic banks, then doubtless there would have been lessons. But it’s quite clear that so such rules WERE NOT IMPOSED. What did happen, as the authors explain, is that ONE HALF of the FR rules were imposed on the subsidiary of just one Icelandic bank (Kaupthing) operating in Britain. That half is the safe half of the industry and (to repeat) the basic rule is that deposits can only be lodged with the central bank and perhaps also invested in short term government debt.

I.e. the other half of the FR rules, namely the requirement that the half of a bank or of the banking industry which lends must be funded by shares and/or long term deposits was not imposed.

All in all, the idea that there are lessons there for FR is a bit of a joke.

And a second joke here is that we’ve actually had a bank in the UK for decades which obeys the rules of the above “first half”: National Savings and Investments. NSI (as per the above “first half rule”) invests just in base money and government debt. Granted NSI does not carry out all the functions of a normal bank, e.g. NSI does not issue cheque books or debit cards to its customers. However to all intents of purposes it does the same thing: it lets customers transfer sums out of NSI within 24 hours via phone.

And a third point or “joke” here is that a report has recently been commissioned by and written for the prime minister of Iceland which advocates adopting Positive Money policies more or less lock, stock and barrel. Presumably the author of that report wouldn’t be so dumb as to be unaware of the above “lessons” if indeed there were any to be learned.

Revelation: banks try to circumvent regulations.

At any rate, what’s the big lesson that we can apparently learn from the experience of the Kaupthing subsidiary according to the Sheffield authors? Well the only lesson seems to be that banks put a lot of effort into circumventing regulations (something the Kaupthing subsidiary managed to do), and that this can render regulations of the sort advocated by PM/NEF impotent.

Well the idea that banks spend a lot of time breaking the law is hardly news, given the $100bn of fines that banks have had to pay in the US (yes that’s billion, not million). Moreover, the efforts that banks put into circumventing regulations is a problem with ANY SET of regulations, not just the PM/NEF regulations!

However, the simpler regulations are, the more difficult they are to circumvent, all else equal. And the rules of FR as simplicity itself. To repeat, the basic rules are, 1, deposits which depositors want to be totally safe can only be lodged with the central bank or invested in short term government. 2, as regards loans by banks, those must be funded by equity or largely by equity or by a mixture of equity and long term deposits. Compare that to the 10,000 pages of Frank-Dodd!


And the final error in the Sheffield paper is in the first sentence of the conclusion which reads, “Full reserve banking plans arose out of the perception that the crisis resulted from excessive bank credit, which was the counterpart to uncontrolled money creation.”

In fact Irving Fisher in the 1930s put a lot of effort into promoting full reserve. And for all I know the idea is even older than that.  Since the Sheffield authors do not mention Fisher, I assume they don’t know about him. Looks like the Sheffield authors need to do a fair amount of reading and thinking before opining on full reserve banking again.


P.S. 5pm, 4th April 2015. Under the heading “The main critique of FR” above I said the Sheffield authors accused FR advocates of claiming it was wrong for the money supply to be “entirely determined by the private sector”. I should have added that the real flaw in having the money supply determined by the private sector is that private banks quite clearly to do not supply the economy with the money it needs, especially in a recession. That is, private banks act PRO-CYCLICALLY, not counter cyclically. I.e. far from boosting the money supply in a recession, if anything, they do the opposite.

In contrast, under PM/NEF, the money supply is determined jointly by the private and public sector: that is the public sector aims to supply the private sector with whatever amount of money is needed to maximise numbers employed without exacerbating inflation too much.

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