The Vickers commission’s big mistake.

The UK’s main official enquiry into the 2007/8 bank crisis was the Independent Commission on Banking: sometimes called the “Vickers commission” after its chairman, Sir John Vickers.
 
The commission opposed full reserve banking on the grounds that it would result in less borrowing and lending. See sections 3.21 and 3.22. (Full reserve is a system under which only the central bank or government prints money: private banks are not allowed to.)

Unfortunately, the mere fact that some change results in less of one type of economic activity (e.g. borrowing), and more of another is not a reason to criticise the change: the CRUCIAL question is this. What is the OPTIMUM assortment of the latter forms of activity. As I’ve pointed out a dozen times before, the concept “optimum” seems to be too difficult for many economists.

As to how alternative forms of economic activity arise when there is less borrowing and lending, that’s easy: any deflationary effect stemming from less borrowing can be made good by standard forms of stimulus. And there is no need to increase national debt in order to do that: as Keynes pointed out, stimulus can be funded by new base money rather than extra debt. In short, there is no need for increased government debt.

As to what the optimum or GDP maximising assortment of different forms of economic activity is, well in the absence of good evidence of market failure, it’s reasonable to assume it’s the assortment that prevails in a free market.

Now in a free market, money lenders (aka banks) do not have any sort of artificial advantage or privilege over other corporations. But under the existing bank system, commercial banks DO HAVE such privileges.

The right to create or print money is a privilege which is quite clearly enjoyed by banks, but not other types of corporation. For example see this article by Richard Werner entitled “How do banks create money…” on the legal underpinning for private banks’ right to print money.

But even in the absence of the latter legislation, the idea that traditional banking is a legitimate free market activity does not stand inspection, and for the following reasons.

In a totally free market, there might seem to be no good reason to stop anyone setting up a “bank” and doing what banks normally do: i.e. accept deposits and make loans. But actually there is a fundamental problem there:  if depositors’ money is loaned on, that money cannot possibly be 100% safe: indeed the litany of bank failures thru history is proof that such money is far from entirely safe.

But money is something which by definition is entirely safe: for example a £10 note is as safe it is possible to get (apart from the fact that it loses a small amount of value every year due to inflation). In contrast, a liability of a corporation which is less than totally safe is not money: it’s more in the nature of a share or bond issued by the corporation.

Or to take another example, a gold coin (which has been a popular form of money throughout history) is near totally safe: it’s highly unlikely that gold will lose most of its value.

In short, where a bank lends on depositors’ money at the same time as claiming that money is safe, the bank is guilty of mis-representation, fraud, or something of that sort. And a free market is normally understood to be a system in which fraud is not allowed.

Or as Adam Levitin put it in the opening sentence of the abstract of his paper “Safe Banking”, “Banking is based on two fundamentally irreconcilable functions: safekeeping of deposits and relending of deposits.”

Of course depositors’ money can be made totally safe if it backed by some sort of FDIC type government run insurance system. However that 100% safety is only obtained by the right that the state has to rob taxpayers of near infinitely large amounts of money, in the event of several large bank failures, and that is quite clearly a subsidy. And subsidies do not make economic sense.

And there is a second way in which private banks are subsidised. It’s the above mentioned fact that they have the right to print money.

That is, if you’re a money lender and you can obtain money to lend out simply by printing it, well that’s better than having to obtain the money you want by normal methods: earning it or borrowing it at the prevailing rate of interest!

To repeat, subsidies do not make economic sense. They result in GDP not being maximised.

That is all very basic economics. Sir John Vickers, former chief economist at the Bank of England, and his Vickers commission colleagues ought to have thought of that subsidy point and taken it into account in the commission’s arguments. Had they done so, they would have come to the conclusion that the entire existing bank system is rotten and has been for centuries. So the existing bank system and the Vickers report are fundamentally flawed. The GDP maximising, and far safer bank system is a system under which private money printing is banned: that’s full reserve banking.


Vickers’s flawed “intermediation” argument.

Finally, there is one argument put in the above mentioned sections of the Vickers report which is flawed. It appears at the start of section 3.21 and reads, “If ring-fenced banks were not able to perform their core economic function of intermediating between deposits and loans, the economic costs would be very high.21”

The “21” is a reference to a footnote which reads “A number of prominent economic analyses consider the reasons for the existence of financial intermediaries – i.e. why lending is not simply done directly through markets and why it is useful to have institutions which both take deposits and make loans. The existence of such financial intermediaries is frequently thought to be associated with an asymmetry of information between lenders and depositors. In particular, the delegated monitoring theory says that institutions which both take deposits and make loans economise on the costs of monitoring borrowers (Diamond, D.W., 1984, Financial intermediation and delegated monitoring, Review of Economic Studies, 51(3), pp.393-414).”

Well the flaw in that argument is that full reserve banking (or “limited purpose banking” as Vickers calls it in the relevant section) does not do away with “intermediation”. All it does is to dispose of the above mentioned fraud, and it does that simply by ensuring that when saver / lenders want their money loaned on, the bank where they place their savings cannot make the above mentioned fraudulent promise to return £X to the saver / lender for every £X deposited. That is, the saver / lender has to purchase something like a bond or share in the relevant bank, and, if the relevant loans go wrong, the saver / lender carries the loss.