A switch to full reserve banking could be less disruptive than is commonly thought.

Most advocates of full reserve (certainly Milton Friedman and Lawrence Kotlikoff) assume that switching to full reserve (FR) from the existing bank system involves splitting the bank industry in two. One half has totally safe accounts, and money in that half is simply lodged at the central bank, where it would be as safe as is possible in this world. (Though Friedman actually claimed some “safe” money could be put into short term government debt as well.)

The second half consists of mutual funds (“unit trusts” in UK parlance) where as is normal with mutual funds, investors stand to make a loss as well as possibly making a profit. Positive Money’s system is slightly different, but certainly under PM’s system, depositors who chose to have their money loaned out stand to make a loss if the worst comes to the worst.

But there is a problem with that “stand to make a loss characteristic” as pointed out by the UK’s Independent Commission on Banking, sections 3.20 & 21). It’s that the possibility of loss would be a turn off for many depositors, thus total amounts available for lending out would decline, which would raise interest rates.
 
Up till now I myself have gone along with all of the above. However, there is actually a flaw or at least possible flaw in the above arguments which means it is actually perfectly possible to protect the above depositors via deposit insurance, and that takes the wind out of the sales of the later Independent Commission on Banking objection. The flaw is thus.

The basic objective of FR is to prevent private banks printing or “creating” money. And the way banks “print”, as this Bank of England article explains, is to fund loans at least to some extent by simply opening accounts for borrowers and crediting those accounts with money produced from thin air (though commercial banks actually fund loans to a significant extent with depositors’ and shareholders’ money as well). And certainly one way to blocking that private money creation is to insist that all loans are funded via equity or something similar, like stakes in mutual funds. A stake in a mutual fund is certainly not money, so if loans are funded just via those stakes, then no money creation takes place when loans are made. As to Positive Money’s system, the fact of possibly making a loss means that relevant depositors are in effect holders of stakes in a mutual fund.

However, there is actually a second and entirely separate way of blocking private money creation which is set out in Andrew Jackson and Ben Dyson’s book “Modernising Money” (section 6.7). Incidentally Dyson founded Positive Money.

Now assuming that second “blocker” works, there is no need for the first! That is it ought to be possible (to repeat) to provide depositors who want their money loaned out with complete safety via deposit insurance. That of course means that relevant deposits are no longer stakes in a mutual fund: they become much nearer money, which might seem to defeat the object of the exercise, namely blocking private money creation. But if the above mentioned second blocker is in place, that’s not a problem!


The second blocker.

In brief, the “second blocker” consists of having commercial bank computer systems tied in with the central bank’s computers in such a way that any “creating money from thin air” carried out by a commercial bank would immediately show up.

It could be claimed in objection that commercial banks are free market capitalistic institutions and that it would be unacceptable to have central banks constantly keeping such close scrutiny of what commercial banks do. However those tempted to make that objection need to bear in mind that several major banks would have collapsed during the recent crises had they not been bailed out by central banks. Thus central and commercial banks are already intertwined.

Second, they need to bear in mind that bankers are simply “highly paid civil servants” to quote Martin Wolf.

And third, if the law states that private banks can no longer print money, then the authorities are entitled to implement whatever close scrutiny of private banks is needed to ensure they are not in fact printing / creating money. If the authorities need to occasional random checks on backstreet printers to make sure they are not turning out imitation $100 bills, so be it.

As to exactly how the “second blocker” would work, I’ve copied the section of Modernising Money that sets that out. That makes up the rest of this article and relevant paragraphs are in green. Incidentally note that the authors refer to safe accounts as “transaction accounts”. Plus note that the authors’ method of splitting the bank industry in two is a bit different from Friedman’s and Kotlikoff’s. That is F&K’s preferred method is to have entirely separate institutions making up the two halves of the industry. In contrast, Modernising Money envisages two types of account housed under the same roof: so called “investment” accounts and “transaction” accounts.


Section 6.7 of Modernising Money.

This section explains how banks will normally make loans (including via overdrafts) under the reformed system. For the purpose of the demonstration, we will consider an example where one customer's investment of £1,000 is funding an equal loan to another individual customer. In reality, the amounts loaned may be smaller than the investment and spread across multiple customers, or alternatively, multiple investments may fund one larger loan. There does not need to be any direct link between individual savers and borrowers.

Under these proposals, in order for a bank to make a loan it must have funds on hand. Initially this requires a customer, John, who wants to make an investment using some of the funds currently in his Transaction Account. He first needs to open an Investment Account at the bank and 'fund' it with a transfer from his Transaction Account. John sees the balance of his Transaction Account fall by £1,000, and sees the balance of his new Investment Account increase by £1,000. However, in reality the money from his Transaction Account has actually moved to Regal Bank's Investment Pool at the Bank of England. The Bank of England's balance sheet has now changed (see fig 6.1O). On Regal Bank's balance sheet, the funds are transferred from John's Transaction Account to the bank's Investment Pool, and the bank creates a new liability of £1,000, which is John's new Investment Account (see fig 6.11).

The money in Regal Bank's Investment Pool is then used to make a loan to a borrower, David. David signs a contract with the bank confirming that he will repay £1,000 plus interest. This legally enforceable contract represents an asset for the bank, and is recorded on the balance sheet as such. Simultaneously, money is moved from Regal Bank's Investment Pool at the Bank of England to the Customer Funds Account administered by Regal Bank, and Regal Bank increases the value of David's Transaction Account (see fig 6.12).

The balance sheet still balances, with the Investment Account liability to John offset by the loan asset made to David. Throughout the process, electronic money in the accounts at the Bank of England has moved from the Customer Funds Account to the Investment Pool, and back to the Customer Funds Account. Ownership of the money has moved from John to David.

In summary, any money 'placed in' an Investment Account by a customer will actually be immediately transferred from that customer's Transaction Account (at the Bank of England) to the bank's 'Investment Pool' account (at the Bank of England). At this point, the money will belong to the bank, rather than the Investment Account holder, and the bank will note that it owes the Investment Account holder the amount of money that the account holder invested (i.e. the Investment Account will be recorded as a liability on the bank's balance sheet). When this money is then lent, the money will be transferred from its Investment Pool (at the Bank of England) to the borrower's Transaction Account (at the Bank of England). At no point did any money leave the Bank of England's balance sheet, and no additional deposits were created anywhere in the system. This ensures that the act of lending does not increase the level of purchasing power in the economy, as it does in the current system.