Friday, 9 October 2015

Charles Goodhart finds flaws in full reserve banking?



Patrizio Laina wrote a very good summary of the history of full reserve banking (FR) here (pages 1-19). That is followed by a paper entitled “A Commentary on Patrizio Lain√†’s ‘Proposals for Full-Reserve Banking’…” by Charles Goodhart and Meinhard Jensen (p.20 onwards).

The first weakness in that commentary is that it’s a commentary on the FR idea, not (as per the title) a commentary on Laina’s work which to is largely an impartial historical record of thinking on FR. That is, Laina does not take sides on the actual pro FR versus anti FR argument. Thus comments by Goodhart and Jensen on the historical accuracy of Laina’s points would be in order (if the objective if G&J’s paper is as per its title). In contrast, comments on the pros and cons of FR are not in order.

So that’s the first flaw in G&J’s paper. But never mind: let’s continue with the paper.

Their first criticism (p.21) alludes to the separation of lending from deposit accepting and the authors say:

One of the reasons sometimes put forward by Currency School advocates (i.e. FR advocates) for this separation, though not emphasised by Lainà , is the claim that money creation should be a State monopoly, so that having much of such creation done by private sector banks is, in some senses, an inappropriate transfer of seignorage from the public sector to private sector bodies. A problem with this position is that many of these same economists would probably also endorse the (invalid) Karl Menger theory of the creation of money as a private sector market response to the constraints of bartering, in which story the government only plays a subsidiary role. Holding both positions simultaneously would seem to be logically inconsistent.

Well the first point to note there is that G&J specifically say they are dealing with a point “not emphasised” by Laina. My point exactly: G&J in their paper criticise FR, not Laina’s paper.

Anyway, moving on… I’m baffled by G&J’s claim that advocates of FR are keen on the idea that money exists or arose out of a desire to do away with the inefficiencies of barter.

Of course, money certainly does do away with the inefficiencies of barter, but there is plenty of dispute (as G&J rightly suggest) over whether centuries ago money arose from that desire, or whether it arose mainly from other causes, like the desire to kings and rulers to have a more efficient method of collecting taxes.

However, having read well over a million words written by the advocates of FR, it’s news to me that they’re all that concerned about that historical dispute. Quite the contrary: advocates of FR simply take the existing money and bank systems as they are, and argue that we can do better.


Rules for determining stimulus.

Next (2nd half of p.21) G&J claim that advocates of FR are concerned (unsurprisingly) as to how stimulus should be determined.  And according to G&J there is much dispute between advocates of FR as to what rule or set of rule should be used.

Well there’s an easy answer to that: there’s plenty of dispute, including heated dispute, between advocates of the existing bank system as to how stimulus should be determined! For example there is plenty of dispute as to how effective interest rate adjustments are. Plus there is plenty of dispute at the time of writing over exactly when central banks should raise interest rates. Monetarists argue with Keynsians, who argue with market monetarists, who argue with Austrians. The list is almost endless!!!

And apparently (according to G&J) advocates of the conventional wisdom or the existing/conventional bank system “prefer discretion and flexibility” when it comes to determining stimulus.

Well one current lot of FR advocates (Positive Money, the New Economics Foundation and Prof Richard Werner) actually advocate very much the same degree of “flexibility” as advocates of the conventional wisdom in that they suggest stimulus under FR be determined by an independent committee of economists very much like the Bank of England Monetary Policy Committee which currently does that job. And that committee under the latter PM/NEF full reserve system would be entirely free (as is the BoE MPC) to use its best judgement in deciding on stimulus: if it went for a rules based system, I’d imagine PM and NEF would have no quarrel with that, and if they went for “flexibility” rather than rules, then as I understand PM and the NEF, the two latter organisations would be equally happy.


Banks will circumvent the rules.

Next, (top of p.23) G&J make a claim which has been made a dozen times before, namely that banks would try to circumvent the rules of FR.

So banks scrupulously obey the rules under the existing system? Anyone who thinks that is living in la-la land. G&J may not have noticed but banks have been fined over a hundred billion dollars in the US in the last two or three years for laundering Mexican drug money, fiddling Libor and numerous other crimes. And in the UK we’ve had the payment protection insurance scandal.

As for Dodd-Frank, the legislation in the US which is supposed to clean up banking, Prof John Cochrane in the opening sentence of a paper of his said “In recent months the realization has sunk in across the country that the 2010 Dodd-Frank financial-reform legislation is a colossal mess..”.

Or as Richard Fisher, former head of the Dallas Fed put it,“We contend that Dodd–Frank has not done enough to corral TBTF banks and that, on balance, the act has made things worse, not better. We submit that, in the short run, parts of Dodd–Frank have exacerbated weak economic growth by increasing regulatory uncertainty in key sectors of the U.S. economy. It has clearly benefited many lawyers and created new layers of bureaucracy. Despite its good intention, it has been counterproductive, working against solving the core problem it seeks to address.”

So when it comes to circumventing rules, which looks like being the worse: FR or the existing system? Well Dodd-Frank consists of a good 10,000 pages and counting (a lawyers’ paradise, as Fisher correctly observes). In contrast, the rules of FR can be written out on the back of an envelope. Those rules are basically just two in number. First, all money lenders must be funded by equity, not debt. Second, where depositors want their money to be totally safe, that money must be lodged in a genuinely safe manner or as safe a manner as possible: lodge the money at the central bank or in short term government debt.


And where rules are SIMPLE, then all else equal, they are easier to enforce. Thus the claim by G&J that banks would circumvent the rules under FR is weak in the extreme.


A small amount of circumvention doesn’t matter.

Next, it is not the aim of FR to ban all forms of private money creation. For example most advocates of FR don’t object to local currencies. Plus when it comes to small shadow banks there has to be some cut-off point or size of bank below which it is a waste of time trying to impose FR. Put another way, the important question is what the systemically important LARGE BANKS do.


Flexibility versus inflexibility (continued).

Next, G&J claim that “opponents of the Currency School” i.e. opponents of FR “believe that such rules will tend to be too inflexible, and quite often too deflationary”

Well the answer to that is that under FR (or least Positive Money and the New Economic Foundation’s version of FR) stimulus is determined in very much the same way as it is determined at present, that is (to repeat) by an independent committee of economists. If G&J want to claim that that committee gauges the amount of stimulus correctly under the existing system, but incorrectly under FR, then G&J need to explain exactly why (i.e. why the committee is likely to impose too much deflation). After all, there’s not much difference between the two systems in that under both systems, an independent committee of economists determines stimulus.

Then in support of their point, G&J quote Ann Pettifor as saying, “Linking all current and future activity to a fixed quantity of reserves (or bars of gold, or supplies of fossil fuel) limits the ability of the (public and private) banking system to generate sufficient and varied credit for society’s purposeful and hopefully expanding economic activity.”

That passage of Pettifor’s is riddled with mistakes. First, what’s all that about the quantity of reserves being fixed? Had Pettifor bothered actually reading the material published by Positive Money or other advocates of FR, she’d have discovered that reserves are FLEXIBLE, just as they are under the existing system. That is (to repeat) if the “independent committee” decides what stimulus is needed, then it creates new money (aka reserves) and government then spends that money into the private sector (and/or cuts taxes).

Second, she doesn’t distinguish (in the above passage or the surrounding text in her work) between credit granted by non-bank entities (e.g. trade credit) and the sort of credit created by and loaned out by banks, which might be described as “money-credit” or just “money”.

As to trade credit, there’d be nothing under FR to stop firms granting each other trade credit, and indeed the sums involved there are VAST. The amount owed to small and medium size firms in the UK is three times GDP (more than is loaned out by way of mortgages).

Third, it is nonsense to think, as Pettifor clearly does, that banks under the EXISTING SYSTEM can simply create credit-money willy nilly and lend it out. I set out the reasons here.

Fourth, I am not minded to attach much importance to what Pettifor thinks given that she seems to thinks we can spend limitless amounts on investments without anyone having to save or cut back on current consumption. For more on that, see here.

Fifth, returning to Pettifor’s idea that the amount available for loans by banks is rigidly fixed under FR, that idea assumes that for some strange reason the law of supply and demand doesn’t work when it comes to borrowing and loans.

That is, given a rise in demand for loans under FR, the rate of interest would clearly rise, which in turn would induce more people to put their money in accounts or entities devoted to granting loans (so called “investment accounts” under Positive Money’s system).

Now is there something wrong with the price of something rising (e.g. the cost of borrowing) when demand increases? Not that I can see. The rate of interest paid by mortgagors in the UK in the 1980s was nearly THREE TIMES the rate paid nowadays, but for some strange reason the sky didn’t fall in. Indeed, people in the 1980s actually paid off their mortgages quicker than today: caused no doubt to a greater or lesser extent by the rise in house prices in real terms in the intervening years.

Sixth, the sharp rise in demand for loans prior to the crises was not (as Pettifor seems to suggest) caused by a rise in investment in productivity increasing machinery or other innovations (her “purposeful and hopefully expanding economic activity.”) It was caused by house price bubble blowing.

Thus a rise in interest rates given increased demand for loans, as long as the rise isn't too much and too sudden, would seem to be entirely beneficial in as far as it thwarts house price bubbles.


That’s to be contrasted with the existing system under which when the private sector switches resources to bubble blowing from other forms of expenditure, central banks do NOT RAISE interest rates and on the grounds that aggregate demand and inflation do not seem to have risen – exactly what happened before the crisis.


The opponents of FR normally win.

G&J’s next criticism of FR is thus.

“Be that as it may, the Banking School may lose a few battles (as in 1844), but usually wins the war. One reason for this is that the monetary authorities like to maintain discretionary control, and do not much want to be constrained by the rules that academic economists propose. Per contra, academic economists generally prefer rules to discretion. Even Tobin flirted with narrow bank proposals. Besides the time inconsistency argument, economists can devise rules that provide ‘optimal’ welfare in the context of their own models which they naturally wish to proselytise.” (In 1844 in the UK, private banks were prohibited from issuing their own bank notes)

OK, but another and less impressive reason the “banking school . . . usually wins the war” is that it’s in the interests of banks to win it, and banks deploy HUGE RESOURCES to ensuring they win it (including wads of cash in brown envelopes sometimes euphemistically called “contributions to politicians election expenses” donated to politicians).

Indeed Laina makes that very point. As he put it, “Phillips added  that  bankers were against the Chicago  Plan  as  it  was  seen  to  reduce  their  profits.  They  resisted  any  changes  to  the status  quo,  unless it could  be  demonstrated  that  the  new  system  would  be  even more profitable.    Whittlesey was pretty much of the same opinion as he saw that the proposal was opposed because free services of banks would  no  longer  be  free  as  well  as  bank  owners  would  lose  their main source of profits.”


Conclusion.

Well I’m only half way thru G&J’s paper and hopefully I’ve established that it is riddled with mistakes. Thus I am not minded to read the second half.
                  

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