Economic history.

I took this picture of the oldest blast furnace still operating in the UK around 1965. The date on the lintel supported by the two round pillars is 1711!!! It has now stopped operating.

The only reason it was still in operation in 1965 was that it was in a wooded area (Backbarrow, Cumbria) and used some mixture of wood or charcoal and coal as a fuel. This produced iron with some sort of special characteristic for which there was a small amount of demand.

Summary of the Werner / Positive Money / New Economics Foundation paper.

This paper was submitted to the UK’s Independent Banking Commission. Here is my ultra brief summary. Hope it’s a fair summary.

1. Fractional reserve banking promotes instability. A major reason is that during an economic upturn, fractional reserve enables commercial banks to create money out of thin air and lend it to nit wits who see asset prices rising and want to invest in those assets. That raises asset prices still further, creating more collateral to be used for yet further borrowing.

Conversely, during a downturn, everyone deleverages, that is pays money back to banks, which involves the extinguishing of money: just what is not needed in a downturn. Thus fractional reserve should be banned.

2. Another fundamental flaw in the existing banking system is that money from bank accounts which are 100% safe and taxpayer backed is used for commercial purposes. This amounts to a subsidy for commerce, which is wrong. Hence those depositing money in banks must be presented with a clear choice, as follows. 1. put money into 100% safe accounts where the money will be lodged in a 100% safe fashion – i.e. at the central bank, where it will earn little or no interest. Or 2, put money into a “commercial” or “investment” account, which will probably earn some interest, but there is no taxpayer backing if it all goes wrong.

3. Re the systemic risks that derive from the latter commercial or investment accounts, these can be minimised by banning maturity transformation.

4. Banning fractional reserve and maturity transformation involves leaving more money idle in bank accounts. The idea that this equals failure to use real stored wealth is nonsense, because in a fiat money system, money is simply a book keeping entry.

5. The idea that the above, or any form of restriction on bank activity will harm economic growth is nonsense in that the government / central bank machine can perfectly well make up for such restrictions by creating new central bank money (monetary base) and spending it into the economy. (The latter policy incidentally is also advocated by most followers of Modern Monetary Theory).

Indeed, the latter "create money and spend it into the economy" is a better way of regulating aggregate demand than interest rate adjustments. Thus creating (or extinguishing) money should be the prime method of regulating demand, with interest rates being left to find their own value.

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Stop press. The Fed’s Edward Nelson mentions Modern Monetary Theory.



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Re the debt, who are the dummies: the US or Chinese government?

As far as I can see, the average yield on US government debt is now below inflation. So the US government makes a profit on its debt. This is particularly true of debt held by the Chinese, which, as I understand it, is mainly “one or two years to maturity” stuff.

So who are the dummies: the Chinese for making an investment which makes a loss, or the Americans for getting worried about making a profit?



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Modern Monetary Theory meshes nicely with full reserve banking.

Modern Monetary Theory (MMT) consists of several different elements, but for present purposes I’ll take it mean what Abba Lerner (p.39-40) advocated, namely that in a recession, government should simply print extra money and spend it (and/or reduce taxes). And conversely, when inflation looms, government should do the opposite, namely rein in money and “unprint” or extinguish it.

Anyway, it’s nice to see support for the above policy appearing in a paper which advocates full-reserve banking and written by a group (Werner & Co) who do not claim to be MMTers.

As Werner & Co say (p.10), “Under full-reserve banking . . .the Bank of England would control the quantity of money in circulation by increasing or decreasing the money supply which would be allocated through government spending.”

It would be going too far to say that the MMT “print and spend” policy is possible ONLY under full-reserve. But certainly the print and spend policy comes into its own under full-reserve.

This is because under fractional reserve, private banks are more or less in control of the money creation process. Or as Steve Keen put it, “…the credit money dog wags the fiat money tail. Both the actual level of money in the system, and the component of it that is created by the government, are controlled by the commercial system itself, and not by the Federal Reserve.”

In this scenario, the MMT print and spend policy certainly has a finite effect, but it is not dominant.


Also, who decides whether stimulus or deflation should be imposed?

A second reason why full-reserve reasoning meshes with MMT reasoning is thus.

As I pointed out here, the above MMT print and spend policy implies discarding the distinction between monetary and fiscal policy, which in turn raises the question as to who decides whether inflation is sufficiently subdued to warrant extra demand. I suggested that this question was a TECHNICAL one: beyond the competence of politicians, and best left to central banks (or any independent committee of economists).

Of course it is commonly thought that central banks currently DO take the latter decision. But this is not strictly correct in that politicians can also influence aggregate demand by determining the size of the deficit (which has a stimulatory effect). That is, politicians determine matters fiscal.

To have two different bodies both influencing demand is a mess, and this mess is particularly serious in the US right now: members of Congress, precious few of whom have got beyond page one of a basic economics text book are squabbling with each other and with the Fed and the president over deficits, stimulus and so on.


MMT and full-reserve: the two similarities.

So both MMT reasoning and full-reserve reasoning point to the same two conclusions. First, the decision on the stimulus/deflation question is taken by ONE body (the central bank or some other independent committee of economists). And second, if stimulus is deemed to be required, that stimulus should take the form of “print and spend”.

Or as Werner puts it, under the heading "Distributing Newly Created Money", "Rather than lending this money into the economy via the banks.. . .we recommend that the money is spent into circulation via the state.”

Full reserve banking, and the arguments against fractional reserve banking and maturity transformation.

Abraham Lincoln: “The government should create, issue and circulate all the currency and credits needed to satisfy the spending power of the government and the buying power of consumers.”

Thomas Jefferson: "I believe that banking institutions are more dangerous to our liberties than standing armies...The issuing power should be taken from the banks and restored to the Government, to whom it properly belongs."

Milton Friedman: “There is no technical problem in achieving a transition from our present system to 100% reserves easily, fairly speedily and without any serious repercussions on financial or economic markets.”


Introduction and definitions.

Fractional reserve banking is a characteristic of the banking system we have today. Fractional reserve itself consists of two basic characteristics. One is that commercial banks do not need to lodge all the money deposited with them at their central bank: they only lodge a “fraction” of such money at their central bank. The second is that they can lend out more than has been deposited with them, that is, they can create money out of thin air.

Full reserve banking is what might be called the opposite of the above, though there are a number of compromises between fractional and full reserve. Under “pure” or “unadulterated” full reserve, commercial banks must lodge all money deposited with them at their central bank, plus they cannot create money out of thin air. This necessarily means that banks cannot lend. In this scenario, sometimes called “narrow banking”, lending is carried out by institutions which are funded wholly by shareholders rather than depositors. This system certainly has its merits.

However the option advocated below is to insist that where depositors want instant access to their money, such money must be invested in a 100% safe manner and be genuinely “instant access”, i.e. the money must be deposited at the central bank. To that extent, banks would be genuinely “full reserve”. However, it is argued below that depositors should be able to allow their money be loaned on by a bank. But in this case the money is no longer instant access and there is no taxpayer funded rescue for such depositors if the bank goes bust.

Maturity transformation takes place where a bank “borrows short and lends long”: for example, it uses money from instant access accounts to fund relatively long term loans, such as mortgages. This practice is also undesirable for reasons set out below.


Fractional reserve.

One of the main opponents of fractional reserve is Huerto de Soto. In chapters 1, 2 and 3 of his book “Money, Bank Credit and Economic Cycles” he claims that fractional reserve breaks fundamental legal principles, a claim also made by other Austrian economists.

That argument is weak in that if an activity is on balance beneficial, the fact that it breaks laws or legal principles is not important: in this situation, it is the laws or legal principles which need amending, not the activity that should be banned.


Instability.

Another problem with fractional reserve, which de Soto and others have long drawn attention to, is that it leads to instability. The processes via which this instability arises are well known, one of them being asset price bubbles. That is, asset prices rise for some reason. That makes those assets a better form of collateral for further borrowing (i.e. money creation by commercial banks). This money is used to boost asset prices still further, and so on. And we all know the end result: a crash or credit crunch.

Another source of instability is thus. Business and/or consumer confidence can rise for no apparent reason. That swells order books. Firms order more capital equipment, and much of this capital equipment consists of “big spend” items. This large additional expenditure exacerbates the instability. And then it dawns that some of the projects and investments were built on sand, and the crash ensues.

Readers who have studied economics may well object to the latter paragraph on the grounds that another factor making for instability has been slipped into the argument, namely the “accelerator”. This is the above mentioned process whereby a slight increase in demand leads to a relatively big increase in capital equipment spending. But in the absence of commercial banks’ able to create money out of thin air, employers wanting to fund capital expenditure would find the process more difficult. Thus the two problems, the accelerator and fractional reserve reinforce each other.


Then comes the recession.

Come a recession, the whole process goes into reverse. That is, everyone “deleverages”, just as they have in the current recession. That is, commercial banks and their customers put the money creation process into reverse just when they shouldn’t!

The scale of this destruction of commercial bank money during the deleverage phase is documented in this Credit Suisse publication – see in particular the first three or four pages.


Instability and reserve requirements.

The above rapid expansion in private bank created money in a boom would not occur if banks ALWAYS made full use of their reserves AND if central banks strictly enforced reserve requirements. But banks do not always make full use of their reserves: witness the huge excess reserves that they currently have. If banks suddenly made full use of these reserves, there would be a dramatic increase in private bank created money.

As to central banks strictly enforcing reserve requirements, they just don’t, as Steve Keen has shown.


High powered advocates of full reserve.

As for the idea that full reserve banking is an idea advocated by a few cranks, this is far from the case.

1. Milton Friedman (p.247) advocated full reserve, and specifically for the above reason: to bring better stability. See also Friedman’s book, “A Program for Monetary Stability”.

2. Another high powered opponent of fractional reserve is Mike Shedlock.

3. And third, there is William Hummel.



Interest rates are not optimised under fractional reserve.

Another problem with fractional reserve is that it degrades the market’s mechanism for optimising the amount of borrowing. Reasons are thus.

The amount of borrowing is optimised where the benefits of borrowing equal the costs of the consumption forgone in order to make the borrowing possible. Or to be more exact, the marginal benefits of borrowing need to equal the marginal costs or “disbenefits” of forgone consumption.

Under fractional reserve, the BENEFITS of borrowing are quantified well enough. For example a business can easily enough work out the benefits it derives from borrowing so as to purchase machinery. But there is a problem with consumption forgone, which is that when a bank creates money out of thin air and lends it, no consumption is forgone!

Well, on the face of it no consumption is forgone. But of course there is no such thing as a free lunch: that is, someone somewhere has to forgo consumption in order to enable someone else borrow and consume resources.

To be more accurate, the fact of one entity borrowing and spending increases demand, and assuming the economy is at capacity, demand somewhere else has to be reined in. In practice in 21st century advanced economies, and given increased borrowing and expenditure, government will rein in demand by one of the many means at its disposal: increasing interest rates, public spending cuts, tax increases, and so on.

To illustrate, if government damps down economic activity by public spending cuts (e.g. on health and education) then the foregone consumption needed to make additional borrowing possible is born by the employees and consumers of health care and educational services: a nonsense.

The above argument can be put another way, as follows. Assume full reserve is in operation. Assume that fractional reserve is then allowed. Banks will then be able, at least in theory, to create thin air money and lend it at ridiculously low interest rates, e.g. 0.1%. If the going rate is well above 0.1%, that does not matter for the relevant banks because obtaining the money to lend costs those banks nothing.

To summarise, fractional reserve results in an economy with artificially low interest rates which in turn results in too much economic activity being loan funded rather than equity funded.

And finally, assuming we ban fractional reserve, and lending declines, there is the question as to where the extra money comes from the enable more equity funding to take place. Well that’s easy: having the government / central bank machine create and spend extra money into the economy is not difficult.

The latter policy is advocated by Modern Monetary Theory, and by the Werner paper. And as Milton Friedman said in the third chapter of his book “A Program for Monetary Stability”, “It need cost society essentially nothing in real resources to provide the individual with . . . an additional dollar in cash balances.” (From Ch 3 of his book “A Program for Monetary Stability”)


The conclusion about fractional reserve.

The conclusion is that fractional reserve is not beneficial. Interestingly, were it banned, we would revert to what economists call a “loanable funds” scenario. In this scenario, the total amount of money is more or less fixed, or at least it expands at an annual rate strictly controlled by the central bank. This means that given a rise in demand for borrowed money, interest rates would rise.

A rise in demand for anything normally results in a rise in price. Plus, where the rise in demand for borrowed money would in the absence of the interest rate rise result in demand in excess of that planned by the government / central bank, the interest rate rise would constitute an “automatic stabiliser”.


Maturity transformation.

Maturity transformation equals “borrow short and lend long” and on the face of it, everyone wins from maturity transformation (MT). Depositors get a higher rate of interest than they otherwise would. Those borrowing from banks pay a lower rate of interest than they otherwise would. And banks make a profit from organising the whole thing, that is “intermediating”.

The main problem is that MT it is risky: if short term interest rates rise or short term money simply becomes unavailable (much the same thing), then the institutions which engage in MT) are caught short. This explains the downfall of Northern Rock, and the downfall of hundreds of banks since Roman times two thousand years ago.

The problem can on the face of it be solved by having government or central bank stand behind banks engaging in MT. But there is no excuse for taxpayers subsidising this or any commercial activity. Plus the cost of this implicit subsidy is horrendous: it was put by Mervyn King, governor of the Bank of England at £30bn a year for the UK, or roughly 2% of UK GDP, (see p.7 here).

So there is an obvious case for curtailing MT and thus cutting the subsidy and the risks inherent in MT. But this raises an equally obvious objection, namely how far can this curtailment go before it starts to seriously impede bank activity, and in turn, economic activity in general.

Indeed, Mervyn King lends support to this “impede economic activity” argument when he says “Nevertheless, there are benefits to this maturity transformation – funds can be pooled allowing a greater proportion to be directed to long-term illiquid investments, and less held back to meet individual needs for liquidity.” (See p.8 of King's paper). Indeed Brad de Long made a similar complementary remark about MT.

The flaw in King’s “funds can be pooled” argument is that it assumes that bank balances represent REAL and unused resources. The truth is that a bank balance is simply a book keeping entry: it is not composed of real physical resources, as pointed out by Prof.R.A.Werner and co-authors (p.26).


The Tobin tax.

A possible solution to the problems created by MT, a solution advocated by Mervyn King (p.11), is some form tax on banks roughly similar to the well known Tobin tax. This, so the argument runs, would compensate society for the occasional and serious damage done by those once every ten or twenty years recessions or credit crunches.

But that does not actually prevent the damage! It’s like car insurance. Car insurance is better than no car insurance, but it doesn’t of itself prevent the death and destruction wrought by cars. So stopping the damage, if that is possible, is the best solution in the case of cars or banks.


The merits of MT don’t exist.

Having disposed of one popular argument for MT, i.e. that it “makes use of” idle bank balances, is there anything else to be said for it? Well I can’t see anything.

Of course if we halved the extent of MT, that might reduce the risks arising from it to a low or negligible level. But if an activity imposes low levels of risk while conferring no benefits at all, it might as well be banned.

Also MT has similarities to fractional reserve, in that both make available funds that can be loaned out. Thus some of the arguments put against fractional reserve above can also be put against MT. In particular, these additional funds, other things being equal, will require the suppression of various forms of economic activity, and (as pointed out above) in a thoroughly illogical manner.

To summarise, the arguments for MT are feeble, plus it involves risks. Ergo it might as well be banned.


Do we need such a large banking sector?

Another reason for doubting the benefits of a large borrowing or bank sector so far as promoting economic activity goes is that bank assets in the UK relative to GDP have multiplied TENFOLD between 1970 and 2006. (See “Banking on the State”, p.3, (2009) by Piergiorgio Alessandri and Andrew G Haldane.)

In other words, prior to 1970, the UK had a pathetically small bank sector compared to nowadays. But strange to relate, economic growth prior to 1970 was much the same as after 1970.

Or as Lord Turner, head of the UK’s Financial Services Authority put it, much bank activity is “socially useless”.


Political problems.

Stopping government guarantees for deposit accounts which earn any significant interest would be a dramatic change. Howls of protest would ensue. But this is just a measure of how far commercial banks and depositors have wormed their way into the public purse with a view to featherbedding themselves.

Conclusion.

1, Fractional reserve should be curtailed.

2, Where depositors want absolute safety, they are no doubt entitled to taxpayer backing for their deposits. But these depositors cannot have their cake and eat it: that is, they cannot earn nice rates of interest deriving from the fact that their money is used for commercial purposes. Moreover, commercial use of this money amounts to a taxpayer subsidy for commerce, and it is widely agreed that it is not the job of taxpayers to subsidise commerce. Banks holding money in 100% safe deposit accounts should back this with monetary base (plus possibly some government securities).

3, As to deposit accounts where the relevant money is lent on, there should be no taxpayer backing. The possibility that institutions offering such accounts might become systemic risks can be minimised by limiting the size of such institutions. The systemic risk is also reduced by the mere fact of requiring depositors to lock up their money for a significant period: this constitutes a reduction in the extent of maturity transformation effected by banks.

Note: this article was substantially re-drafted on 6th Aug 2011.

Should retail banks be ring-fenced?

The UK’s Independent Banking Commission Interim Report suggests ring-fencing retail banks. I suggest that instead of dividing banks into different types and putting a fence between them, the fence should be between ACCOUNTS which are government backed and supposed to be 100% safe, and in contrast, ACCOUNTS where the relevant money is used for commercial purposes.

There is a fundamental principle that has been broken in the banking system for many years, and which helps explain the horrendous costs of the recent bank bail outs. This is that money in deposit accounts that is government backed and which are supposed to be 100% safe have been used for commercial purposes. This is wrong because it is not the job of taxpayers to subsidise commercial activity.

Put another way, such accounts should be “full reserve”, that is, fully backed by monetary base or government securities.

Thus the “fence” needs to be put between, 1, 100% safe / non-commercial accounts, and 2, all other accounts.

To put the fence between retail and commercial INSTITUTIONS almost seems to imply that retail customers should not engage in commercial activities, which is obviously not true: millions of retail customers engage in blatantly commercial activity like making stock market investments.

Moreover, there is no reason why a retail customer should not put their money into a relatively risky deposit account.

Plus there is no reason why a commercial entity should not put its money into a 100% safe account. This WOULD amount to subsidising the commercial entity IF the 100% safe account system as a whole was subsidised. But there is no good reason for the latter subsidy.


The subsidy.

There might seem to be a contradiction between the latter claim that the 100% safe system should not be subsidised and the claim a few paragraphs above that using 100% safe deposit account money for commercial purposes amounts to a subsidy of commerce. The two statements are however compatible for the following reasons.

Where 100% safe deposit account money is used for commercial purposes, government will periodically have to come to the rescue when the “commerce” goes wrong, thus there is definitely a subsidy involved here. In contrast, where 100% safe deposit account money is invested in government securities and the like, government/taxpayers will scarcely ever have to come to the rescue. Thus little or no subsidy would be involved.


Interest.

Given that the contents of 100% safe accounts are invested in interest earning government securities, it is POSSIBLE that those putting money into such accounts could be rewarded with some interest. But it is equally possible that the costs of the 100% safe system would exceed the interest earned from government securities: in which case depositors would get no interest AND, worse still from their point of view, might have to pay periodic bank charges.

Now, is this “fair” on small depositors? The answer is “yes”, and because while it is no doubt a basic human right that small retail depositors should have available to them some form of 100% safe saving account, there is no reason why taxpayers in general should subsidise those wanting to save (unless it can be shown that there is market failure in this area, i.e. that the total amount of saving is less than optimum).

To summarise so far, the important distinction is between accounts which are supposed to be 100% safe and which will probably earn little or no interest, and on the other hand, accounts where the account holder is made fully aware that their money will be used for commercial purposes thus rendering the account less than 100% safe. Since banks can use the money from the latter accounts for commercial purposes, obviously banks can afford to offer a higher rate of interest on such accounts.

Failure to put the proposed fence at right point leads the commission to get bogged down in a number of questions that it would not need to consider if the fence were put at the right place.

To illustrate, p.191 of the report is not clear on whether a variety of activities should take place within their proposed retail banks. These activities include business loans, trade finance, project finance, mortgages, and credit cards.

All the latter activities strike me as being blatantly commercial. But that question becomes irrelevant if the fence is put round safe accounts rather than round allegedly safe institutions.

Of course allowing any bank to offer 100% safe deposit accounts would require periodic audits to ensure that the contents of those accounts were actually backed by monetary base or government securities. But if the fence is put round institutions rather than accounts, those institutions would need auditing also, so putting the fence round accounts rather than institutions ought not to involve greater costs on the auditing front.
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Also, as regards bank failures, the law would need to stipulate that those with 100% safe accounts have first call on the safe assets backing those accounts.

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Afterthought, 11th July 2011. The above idea about ring-fencing is also advocated in a submission to the UK’s Independent Banking Commission by Positive Money, Prof R.A.Werner and others.




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The UK Independent Banking Commission’s views on narrow banking and full reserve banking.

The UK’s Independent Banking Commission’s Interim Report is quality stuff, though the section entitled “Other Structural Reform Ideas” (p.97) leaves room for improvement.

This section deals with narrow banking, full reserve banking and the like. The weaknesses in this section are as follows, starting with “narrow banking”.


Narrow banking. Sections 4.116-8.

Under narrow banking, institutions accepting retail deposits can only invest such deposits in ultra-safe assets, like monetary base and government securities. Lending is done by other institutions funded by share holders.

The paragraph starting “The social costs…” (section 4.117) claims that narrow banking would reduce the total amount of lending and borrowing. My objections to that idea are thus.

First, the lower interest rates for borrowers are a mixed blessing: these low rates partially explain NINJA mortgages, asset bubbles and the chaos that is Greece.

Second, it is not true that because bank activity is restricted, that therefor economic activity is restricted. This paragraph does not EXPLICITY make the latter point, but it is hard to see why anyone would object to raised borrowing costs or to the “credit restrictions” to which this paragraph objects OTHER THAN for the reason that economic activity is restricted in consequence.

And the REASON why restricting bank activity does not restrict economic activity is that that there are ways of funding economic activity OTHER than via borrowing (as indeed the report itself makes clear in a different section). That is, if there is a reduction in commercial bank created money, this can perfectly well be made good by an increase in central bank created money (monetary base). The net result would be more equity funded economic activity and less loan financed activity. Anything wrong with that?

Third, allowing banks to use retail deposit money for commercial purposes, particularly where this is geared up via fractional reserve and “intermediation” in the form of maturity transformation (MT) involves risks.

MT equals “borrow short and lend long”, and the big risk with this is that short term interest rates rise too far, or short term money becomes hard to find. This is what brought Northern Rock down.

If the WHOLE of that risk is born by the relevant banks, shareholders and depositors, that disposes of some of the objections to MT. But the problem is that in practice, bank losses are often socialised. To that extent, society is entitled to a say in how and when banks engage in MT.

And for a start, “society” can cite the generally accepted principle that it is not the job of taxpayers to underwrite commercial activities, like lending money to businesses garnered from retail depositors (or anywhere else, come to that).

If banks use retail deposit money for commercial purposes, they cannot earn much interest on such money, thus they cannot pay depositors much by way of interest. No doubt paying retail depositors little or no interest could be politically difficult. But this is just a measure of the extent to which commercial banks, depositors and those borrowing from banks have invegaled their way into the public purse and helped themselves to its contents.


4.117, paragraph starting “Government guarantees..”

This paragraph seems to claim that because in a crisis government will not allow ANY sort of deposit taker to fail, therefor government will still have to stand behind narrow banks or full reserve banks. Thus the potential costs to taxpayers remain unaltered.

The answer to that is that the retail deposit accepting institutions are far safer under narrow banking than under conventional banking. Thus the potential costs to government are lower. But of course the dangers from the shareholder funded institutions under narrow banking remain. However those dangers can be largely removed under full reserve banking, of which more below.


Section 4.118.

The first paragraph here claims that narrow banks would “remain exposed to interest rate fluctuations”.

The answer to that is that for centuries, credit crunches or recessions have NOT been sparked off by interest rate changes as far as I know. “Irrational exuberance” and sloppy lending practices are two of the main culprits. Another common culprit is a determination by governments be “responsible” and run surpluses rather than deficits.

If anything makes a bank vulnerable to interest rate changes, it is the standard bank practice of “borrow short and lend long” (i.e. MT). This model is obviously vulnerable to a sudden increase in short term interest rates. Indeed, and to repeat, it is exactly this brought Northern Rock down.

Of course the standard explanation for Northern Rock’s failure was the-non availability of short term money at the height of the credit crunch rather than high short term interest rates. However, had Northern Rock offered a sufficiently high interest rate for the money it wanted, that would have saved it for a time. But of course those high rates would probably have broken it.

Thus “non-availability” and “high interest rates” are much the same thing.


4.118: Panics.

The next claim made in 4.118 is that depositors might quit the narrow banking system “en masse” during a crisis. As regards the equity funded lending institutions under narrow banking, there just aren’t any depositors. There are just shareholders. And as regards the deposit taking institutions, everyone would know that these institutions were backed by more reliable assets than is the case with current or traditional banks.

Thus during a panic, far from funds flowing out of narrow banks, funds would flow out of traditional banks and INTO the narrow banking or full reserve banks. Indeed precisely this phenomenon occurred in the recent credit crunch. As the report rightly points out, the UK National Savings system is a form of full reserve bank. During the “flight to safety” that took place in the credit crunch, National Savings experienced a higher than usual inflow of funds.


Narrow banks and government bonds.

The final sentence of 4.118 claims that “There are also practical problems in finding sufficient UK government bonds to back retail deposits.”

My answer to that is that, apart from the ultra safe bonds held by such a bank, a full reserve bank or a retail deposit accepting institution under “narrow banking” is not capable of holding anything other than monetary base. Thus if, to take the extreme case, government borrowed nothing, i.e. there was no such thing as government securities, it would not matter, because monetary base is tip top reserve material: it is backed by government / central bank machine as are government securities.


Why full reserve banks only hold monetary base.

The REASON a full reserve bank (at least after settling up at the end of the day’s trading) cannot hold anything other than monetary base is thus.

Where a cheque is deposited at a full reserve bank for £X, its account at the central bank will be credited at the central bank by £X more than would otherwise have been the case. Ergo all deposits at a full reserve bank are backed by monetary base (except, to repeat, to the extent that the full reserve bank buys government securities, etc).

In contrast, in the case of a normal commercial bank, where a cheque for £X is deposited, that will often as not be more or less cancelled out by money that the commercial bank has created out of thin air, money which is deposited at some other bank.

Of course the cheque for £X will not necessarily be balanced by EXACTLY by £X created out thin air on a PARTICULAR DAY. But over the long run, money created out of thin air by one normal bank and deposited at another is more or less cancelled out by money created out of thin air at the second bank and deposited at the first. The net result is that the bulk of deposits at normal commercial banks are not backed by monetary base. Or put another way, their deposits are backed by reserves which are a small “fraction” of their total deposits: they engage in “fractional reserve banking”.


Full Reserve Banks - Section 4.120.

Under full reserve, ALL banks or lending institutions have to back their deposits with an equivalent amount of monetary base, though presumably government debt is also allowed by way of backing.

The report claims that, as with narrow banking, the amount of lending or credit would be curtailed. Well it wouldn’t (to repeat) if the amount of central bank created money (monetary base) was expanded to make up for the loss of commercial bank created money.

But the real beauty of full reserve is that it drastically reduces the chances of a re-run of the recent credit crunch and the CATASTROPHIC economic damage done by it.

Put another way, as I admitted above under the “narrow banking” heading, the shareholder funded institutions are still liable to fail en masse: they are still a systemic danger. But this problem almost vanishes under full reserve.

The basic explanation for the recent credit crunch, and indeed all unsustainable booms, is thus. There is a rise in demand for property, or some other asset. That causes the price of the asset to rise. That in turn means the relevant asset class can be used as collateral for further borrowing. And since commercial banks can create money out of thin air to lend, they do so. That causes the relevant asset/s to rise in price still further.

This all sounds too good to be true, and it is. We all know the end result.

In contrast, under full reserve, the quantity of money is fixed, or at least it is determined by central bank. To be more accurate, to fix the quantity of money at exactly the same figure for all time would not be desirable: expanding economies need an expanding money supply. But at least central banks can organise a regular annual increase, instead of the wild gyrations in the money supply that occur under fractional reserve banking.

This is not to suggest that central banks can ever have TOTAL CONTROL over the money supply. After all there is no sharp dividing line between money and non-money. But curtailing the EXTENT of fractional reserve activities would not be difficult.

Some readers might be tempted rebut the argument just above on central bank control of the money supply by pointing out that central banks a few year ago tried to control inflation by controlling the money supply (on instructions from Milton Friedman!). And as it turned out, this didn’t work too well.

The answer to the latter point is that I’m not claiming that central bank control of the money supply solves EVERY problem. I’m just claiming that curtailing fractional reserve, and replacing the money that fractional reserve creates with monetary base would be a more stable system.


Section 4.121

This section claims “There is no prohibition on the establishment of a full reserve bank (or a narrow bank)…” The suggestion being that if there were a demand for such institutions, they would have come into being.

The answer to that is that the reason such banks scarcely exist is that they can’t compete with banks that engage in profitable but very questionable activities, like MT.

And the final sentence of this paragraph says “In light of deposit insurance, mandating that all depositors have such an option appears unnecessary.” (“The option” is of course the option of having narrow or full reserve banking facilities available to those who want same.)

The answer to that is that those perpetrating an anti-social activity should ideally not be allowed to continue with it, even if they ARE insured. To illustrate, the fact that all car drivers are insured (or should be) is not a reason to turn a blind eye to drunk driving. Nor is it a reason to abstain from encouraging safe driving.

Put another way, unsafe banking, just like unsafe car driving, imposes very real costs on the community, even if these unsafe activities are insured.

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