Ricks is an associate law professor at Vanderbilt Law School who specialises in financial regulation. A recent paper entitled “Safety First? The Deceptive Allure of Full Reserve Banking” claims to set out a fatal flaw in full reserve (FR).
On the plus side, the paper is short and clearly written, and Ricks has a good grasp of the potential problems with FR.
However, the alleged fatal flaw is easily dealt with in principle: indeed the flaw was clearly recognised and fully dealt with in the submission to the UK’s Vickers Commission by Positive Money, the New Economics Foundation and Prof Richard Werner five years ago. The alleged flaw is also fully dealt with in other literature by the latter three authors. (I’ll refer to the latter three authors, and the latter submission and other relevant literature produced by those three authors simply as the “Vickers authors”.)
The layout of Ricks’s paper.
Ricks claims there are two basic flaws in FR, the first of which is non-fatal, while the second is allegedly fatal. The first or “non-fatal” flaw is thus.
Under FR, the private sector, banks in particular, are banned from issuing or “printing” money: an activity they engage in under the existing bank system (sometimes called “fractional reserve banking”). Instead, all money is issued by the state. But as Ricks rightly explains, financial institutions would try to circumvent that ban. However, since, as he says, that problem can be dealt with (a point I agree with), I won’t consider that point further here.
As to the second and allegedly fatal flaw, Ricks calls that “fiscal-monetary entanglement”, and it consists of the fact that under FR, when it is necessary to increase the economy’s stock of money, that money must first be created and spent into the economy (and/or taxes must be cut).
But as Ricks rightly points out, there is an obvious problem there, namely that the need for stimulus is then dependent on the whims of a bunch of people known as “politicians” whose knowledge of economics is hopeless. And that’s doubtless putting it too politely. Plus even in that politicians ARE economically literate, they sometimes devote more effort to squabbling with each other than making sure there’s enough demand to keep as many people employed as possible (particularly in the US).
Well there’s a simple solution to that problem, at least it’s simple in principle, and the solution (to repeat) was set out by the three Vickers authors. The solution is to have the central bank, or some independent committee of economists responsible for the AMOUNT of stimulus (i.e. the AMOUNT of new money created and spent (net of taxes) into the economy, while politicians retain control of obviously POLITICAL decisions like what proportion of GDP is allocated to public spending and how that spending is split between law enforcement, education, defence and the various other items that governments spend money on.
To illustrate, where there is no government borrowing, politicians would decide the proportion of GDP to allocate to public spending and would collect tax to cover that spending, while the latter committee if it though $Xbn of new money should be created and spent net of tax would tell politicians as much, and politicians would get on with spending that extra money, or cutting taxes by that amount, or would go for some mixture of spend and tax cut.
And that of course is a large and fundamental change to the split of responsibilities as between central banks on the one hand and politicians / treasuries on the other. But there is nothing the least undemocratic about it. I.e. the change is (to repeat) simple in principle, though actually getting that change in place might involve political problems (more so in the US than Europe, at a guess).
There’s a somewhat incidental point that Ricks considers and doesn’t get quite right. It’s thus.
As he rightly says, one way to feed extra money into the economy (indeed a commonly used way under the EXISTING system) is to have the central bank buy government debt. But what if there is no government debt – a possibility considered by Irving Fisher and Milton Friedman who were both advocates of FR? Well there’s a very simple solution to that problem, a solution which has been widely discussed in the last year or two: helicopter drops!
Of course helicopter drops are not democratic in that they give an unelected body, the central bank, the right to take a POLITICAL decision, i.e. whether to spend freshly created money on handouts to taxpayers or handouts to the less well off, or whatever. In short, if we’re going to have anything resembling a helicopter drop, it should take the form advocated by above Vickers authors, namely (to repeat): the central bank or some committee of economists decides on the AMOUNT of new money to be created and spend net of tax, while politicians decide the exact nature of that spending.
Thus the Vickers authors’ solution works both where there is government debt and where there isn't.
Milton Friedman and Hyman Minsky.
Not only does Ricks go off the rails in connection with government debt, but Friedman and Minsky did as well! At least according to Ricks, both Friedman and Minsky thought that government debt was essential or at least desirable in order for FR to work, because (allegedly) extra money is fed into the economy by having the central bank buy that debt.
Well that’s an odd claim for Friedman to make, given that it was Friedman who was one of the first to advocate helicopter drops – a system which (to repeat) requires no government debt!
And a final reason for attaching little importance to government debt is that (as pointed out by advocates of Modern Monetary Theory and Martin Wolf (chief economics commentator at the Financial Times)) government debt and base money are almost the same thing. Thus swapping one for the other has almost no effect. Indeed, QE consists precisely of the latter “swap”, and as we’ve discovered, QE does not have a huge effect (something predicted before QE was implemented by a few clued up individuals, including yours truly).
Thus government debt will be ignored for the rest of this article.
Is a big change in central bank / treasury responsibilities needed?
Given that FR requires the above big change in the responsibilities of central banks, treasuries and politicians, it’s reasonable to ask whether in that case the change to FR is worth it.
Well the answer to that is that those changes have big merits even if we do not convert to FR, and the rest of this article explains why. I’ll run thru various problems with the existing system which need dealing with quite apart from FR.
1. Under the existing system, we have TWO entities that are able to implement stimulus: the central bank and treasuries. That makes as much sense as a car with two steering wheels controlled by a husband and wife having a row. In contrast, under FR (to repeat) just ONE entity decides the AMOUNT of stimulus, while the other, treasuries plus politicians, decides on the NATURE of any extra spending net of tax.
That system would hopefully put an end to the absurdity we have seen in recent years where Congress refuses to implement enough fiscal stimulus because a bunch of economic illiterates (politicians) are too busy squabbling amongst themselves on the question as to whether to raise or cut taxes and public spending.
The Nobel laureate economist Jan Tinbergen framed a principle on the subject of just one entity or system dealing with each problem. His principle was roughly to the effect that for each policy objective, one policy instrument is needed and one only.
2. To repeat, as Ricks rightly points out, to get more money into the economy under FR, there has to be fiscal stimulus first. That rather implies a downgrading of the main alternative form of stimulus, namely interest rate adjustments (though it wouldn’t rule out such adjustments, far as I can see).
Well that point is fully dealt with by the three Vickers authors. As they show, interest rate adjustments are a very defective tool. We can well live without them. Moreover, I suggest the optimum or GDP maximising rate of interest is the free market rate: i.e. what’s the state doing interfering with that rate?
3. Another popular objection to the change in responsibilities needed to facilitate FR is that the central bank (or the above mentioned independent committee) then has the power to over-rule stimulus decisions taken by democratically elected politicians, and that’s allegedly not democratic.
Well the simple answer to that is that an independent central bank ALREADY HAS that power: that is, an independent central bank can implement interest rate changes which negate fiscal stimulus (or lack of) which the central does not approve of. Indeed, Scott Sumner has made much of that point, for example in an article entitled “Why the fiscal multiplier is roughly zero”. He claims (if I’ve got him right) that fiscal stimulus is near useless because the central bank will simply overrule any fiscal stimulus it thinks inappropriate.
I think that’s taking the point too far, but certainly there’s no doubt that under the EXISTING SYSTEM, an independent central bank can negate fiscal stimulus.