Full reserve wins again.

 
It’s always nice when you find that a solution to a problem which you’ve advocated for years turns out to also be a solution to an entirely new problem. The problem I have in mind is the possible systemic risks caused by the recent big increase in crypto currencies (especially the stablecoin variety), a possible problem which others are concerned about. And the solution I have in mind is full reserve banking.

The basic rules of full reserve were actually imposed on mutual funds in the US a few years ago: that is, funds which did not have $X of US government debt for every $X deposited in those funds where barred from claiming they would not “break the buck”, i.e. that they would never fail to repay depositors $Y for every $Y deposited / invested.

Exactly the same rule would probably solve the “crypto systemic risk” problem. The result would be a clear distinction between on the one hand crypto outfits which are seen by everyone as being risky, i.e. which amount pretty much to shares / equity rather than money, and which would not cause a big disruption if they crash, and in contrast, crypto outfits which everyone DOES EXPECT to be genuinely stable, or “not break the buck”. As former governor of the Bank of England, Mervyn King said (p.2) in his “Bagehot to Basle” lecture, stock market setbacks tend not to cause as big a problem as bank crises. Certainly the recent collapse in the value of Bitcoins did not cause a big disruption: reason (to repeat) was that everyone knew that was on the cards all along.

Having claimed above that the rules of full reserve solve a “new” problem, it should be admitted that that is a slightly dishonest claim in that arguably the problem is not new at all: crypto outfits are essentially banks, thus it is perhaps no surprise that the best rules for governing banks are also the best rules for governing crypto outfits.

Stablecoin is thousands of years old.

A stablecoin organisation is one which accepts deposits from people and promises to return those deposits immediately or at short notice or transfer some of the money to a third party if the depositor so wishes. But that’s what banks have done ever since banks first appeared, which was thousands of years ago: certainly as far back as Ancient Greece and possibly earlier.  

The only difference between a stablecoin organisation and a bank is that stablecoin organisations do the above transfers electronically whereas banks used to do the transfers using paper. But even that difference has diminished in recent decades thanks to credit cards and the like issued by banks.

Thus as Martin Wolf said, stablecoin organisations should be regulated like banks. So what should be basic rules of that type of regulation be? Well here’s a very simple set of rules (approved of by Martin Wolf incidentally).

First, the only organisation (stablecoin or bank) which should be allowed to tell depositors their money is totally safe (i.e. that the “coin” is “stable”) are those which have a stock of reserves to match deposits dollar for dollar.

As for the rest, they should be allowed to do anything they like, long as they do not break the law, e.g. the law of contract. Plus the actual wording of their publicity should be constantly and carefully scrutinised to make sure banks and stablecoin organisations do not indulge in the trick that banks have tried over and over throughout history, namely to give the impression that deposits are safe when they are not.

And what do you know? That’s pretty much what full reserve banking (aka “narrow banking”, aka “sovereign money”) consists of, which is backed incidentally (as intimated above) by Martin Wolf.  


 

A common mistake by defenders of fractional reserve banking.

 

 

Abstract.

A common claim by defenders of the existing bank system (fractional reserve) is that the alternative, full reserve, would restrict credit and thus reduce GDP. That claim is of course true if one assumes “all else equal”. However, the all else equal assumption is nonsense because any cut in demand resulting from credit restriction would result in government and central bank implementing more stimulus, and thus returning, or at least attempting to return demand to its “pre credit restriction” level, with the result that there’d be less lending / debt based economic activity and more non debt based activity.  Thus this above “common claim” by defenders of fractional reserve is false logic.

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A common claim by defenders of the existing bank system  (fractional reserve) is that were banks to be prohibited from lending out money at the same time as accepting deposits (which essentially amounts to lending out depositors’ money), credit would be restricted, which would cut GDP. (Incidentally any readers wanting to claim that banks under fractional reserve create money rather than lend out depositors’ money, which is sometimes claimed to be what this Bank of England article says, please see Appendix 2 (p.12) here. That BoE article actually says (quite rightly) in its second sentence that banks BOTH created money AND act as intermediaries between depositor / lenders and borrowers.

There’s a selection of economists who make the “credit would be restricted” claim listed in the reference section below.

The answer to the latter “credit would be restricted ergo GDP is reduced” argument is that clearly the argument is true ALL ELSE EQUAL: i.e. assuming that upon credit being restricted, forms of economic activity not reliant on credit don’t expand to compensate.

But the latter is a totally unrealistic assumption because governments and central banks are constantly trying to keep demand up, and unemployment down to the level where unemployment is minimised in as far as is consistent with not letting inflation rise too far. Thus WERE full reserve implemented and credit restricted, government and central bank would simply implement some stimulus so as to bring unemployment back down to the latter minimum possible level.

Thus the above “credit would be restricted” argument falls flat on its face. Put another way, the IMPORTANT question is as follows. Which scenario maximises GDP: the fractional reserve scenario where credit is “maximised” (so to speak), or the full reserve scenario where there is less lending (and less debt)?

Well there’s a simple answer to that, which is that under fractional reserve, government (i.e. taxpayers) stand behind money lenders via deposit insurance and bank bail outs. I.e. governments stand behind (aka subsidise) two types of money lender: depositors (who lend to banks) and banks themselves. And GDP is not maximised where government subsidises any particular form of economic activity, whether it’s money lending, car manufacture, restaurants or you name it.

Put another way, government should not subsidise or even so much as hint that it might rescue firms in trouble where those firms are into COMMERCIAL activity, like money lending.  The merest hint that government might rescue incompetents in any industry constitutes a subsidy of that industry because those lending to firms in that industry will know their money is safer, if only marginally safer, than in the absence of that sort of government hint.

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References.

Coppola, F. (2012). Full reserve banking: the largest bank bailout in history. Coppola Comment. She refers to “a serous restriction on the nature and scope of bank lending.”
https://www.coppolacomment.com/2012/10/full-reserve-banking-largest-bank.html
 

Kregel, J. (2012). Minsky and the narrow banking proposal. Levy Economics Institute of Bard College, Public Policy Brief, No.125, 2012, passage starting “In a narrow banking system….”.
 

Van Dixhoorn, C. (2013). Full Reserve Banking. Sustainable Finance Lab, p.21.
https://sustainablefinancelab.nl/full-reserve-banking/
 

Vickers, J. (2011). Independent Commission on Banking Final Report, para 3.21.
https://webarchive.nationalarchives.gov.uk/20131003105424/https:/hmt-sanctions.s3.amazonaws.com/ICB%20final%20report/ICB%2520Final%2520Report%5B1%5D.pdf

Fractional reserve banking caused a disaster in 2007/8. So what compensating merits does it have?

 

 

The quick answer is: precious few. But I set out a fuller answer in the article / paper above, which is about 3,000 words.  The following is a summary of that article (about 500 words).

Fractional reserve (FR)  is defined in economics dictionaries as a system where banks keep a stock of cash or “reserves” which is a small fraction of the amount of cash which they are obliged to hand out to depositors, should every depositor withdraw their money from the bank all at once. Put another way, FR involves “borrow short and lend long”. Obviously that’s a risky strategy, and that risk is the basic explanation for the hundreds of bank failures throughout history and for the 2008 bank crisis, which caused tens of millions to lose their jobs worldwide. (Of course it doesn’t require “every” depositor to withdraw in order to collapse a bank: a fairly small proportion will do, as was demonstrated at Northern Rock and hundreds of other FR banks which have failed throughout history.)

So FR must have some amazing advantages to make up for the latter glaring deficiency, or so you might think. In fact, the “advantages” are a joke.

One alleged advantage is that FR enables commercial banks to create money. But governments and their central banks can create whatever amount of money is needed to bring full employment anytime! Moreover, the amount of money created by private / commercial banks over the last ten years has been WHOLLY INADEQUATE for dealing with the aftermath of the 2008 crisis and Covid: i.e. governments have had to step in and do most of the money creation. So that excuse for FR falls flat on its face.
 

Interest rates.

A second excuse is that FR involves lower interest rates than full reserve. There’s actually a reason for thinking that is not the case, but even if it is the case, the lower interest rates are only possible as a result of government support for FR banks in the form of deposit insurance and bank bail outs, and those two amount to a subsidy of the bank system (sometimes called the “too big to fail” subsidy).

Thus far from the lower interest rates that may obtain under FR maximising GDP, it is actually the higher interest rate scenario (full reserve) which maximises GDP because the higher interest rate scenario is more of a free market, i.e. it’s a subsidy free set up. Certainly interest rates in the 1990s were much higher than nowadays (mortgagors in the UK paid almost three times the rate they do nowadays), yet growth was perfectly respectable in the 1990s.
 

Flexibility.

A third alleged advantage of FR is that it supposedly gives banks more flexibility in that when a bank spots more than the usual number of viable borrowers, it can simply create money out of thin air and lend it. Unfortunately the reality is that banks for the most part use that flexibility to expand their lending during a boom, and then contract their lending or even call in loans come a recession. I.e. the latter much vaunted flexibility actually results in banks exacerbating the boom / bust cycle.

Nonsensical article by Brendan Greeley, a Financial Times journalist.

 

In his para starting “Well yeah…”, he claims that governments do not create money from nothing. And in an attempt to substantiate that claim, he says “If you live in the US, the dollars you use most often in your daily life are bank dollars. Your bank creates them when it loans you money, then deposits them in your account.”

So how does the fact that commercial banks create money prove that governments and their central banks DON’T CREATE MONEY? Bit like saying that because my farmer friend John grows food that therefor my other farmer friend Peter DOESN’T.

Then in his next para, he tries to support the latter argument by saying that commercial bank issued dollars have value because commercial banks are backed by the FDIC. Well clearly Brandan Greeley needs to study the history of banking: had he done so, he’d discover that commercial bank created money had value centuries before deposit insurance was introduced, which was relatively recently (1933 in the US) compared to the total time for which banks have been up and running: arguably several thousand years.

He then claims (para starting “Now take the Fed…” ) that the Fed is little more than a bog standard commercial bank which creates money when it grants loans. Well the flaw in that idea is that while central banks do indeed on occasion lend to various entities, they money they issue IS NOT NECESSARILY a loan: for example as Neil Wilson and co-authors showed in their work “An Accounting Model of the UK Exchequer”, normal procedure for public spending in the UK is for parliament or the Treasury to approve various expenditure items with the Bank of England then supplying the Treasury with the necessary money. No loan is involved there! It’s simply a gift by the BoE to the Treasury. The BoE may or may not subsequently borrow more from the markets depending on whether it thinks the inflationary effect of that extra spending is excessive. 

But even if Wilson & Co are not right, or my interpretation of their work is not right, there is nothing in principle to stop a central bank simply creating money and giving it to government to spend: indeed, as everyone (apart from Financial Times journalists seemingly) knows, various irresponsible governments have done that on an excessive scale for decades, and of course suffered the inevitable inflationary consequences.
 
Moreover (and ironically, given the prominence that Bernanke gets in Greeley’s article) Bernanke himself actually advocates the latter “give to government to spend” idea. That was in a Fortune article by Bernanke. See his para starting “A possible arrangement…”.

PS. Hat tip to Mike Norman Economics for alerting me to the Greeley article.

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P.S. (5th July 2021). I see Ann Pettifor approves of Greeley's article on social media. So big surprise that, given her own ignorance on the subject.

The latest from Steven Keen on debt jubilees.

 

 

Steve Keen's latest iteration of his debt jubilee idea is in this article entitled “What is the role of public debt and private debt in the next great financial crisis?”.

SK has long advocated the debt jubilee idea. His basic idea is to have government create vast new amounts of money some of which is given to indebted individuals on  condition they use the money to pay down debts. And as to those not in debt, they have to use the money to purchase shares in corporations which in turn use the money to pay down corporate debt. But as he rightly says, there is not the remotest chance of the idea being implemented.

But more to the point is the question as to whether it actually makes sense. It would certainly make sense if the gyrations in demand that stem from the build up of debt and its subsequent collapse come a recession (which SK rightly highlights) were so enormous that it was impossible for governments and central banks to counter those gyrations with stimulus. However, he fails to demonstrate that: in fact he does not even try.

I’d suggest, in opposition to his jubilee idea that the reason for failure of governments to implement enough stimulus in the aftermath of the 2007 bank crisis had much to do with the ignoramuses at the top of the economics profession (e.g. Kenneth Rogoff, Carmen Reinhart, the IMF and OECD) who were in a panic about the size of government debts.

The reality (as MMTers have been pointing out till they are blue in the face), is that the size of the deficit and debt do not matter unless they cause excess demand or interest rate increases. Thus it is far from clear that a clued up government and central bank cannot deal with the above gyrations in demand.

SK also says “Basically, we need to be smarter than the banks, because by letting them become the “Masters of the Universe” in the last 40 years, they have made fools of us.” In fact the latter sentence is quoted in bold font at the top of the article, so presumably SK thinks the point is of particular significance. Unfortunately though, he does not explain its significance. Well my explanation is thus.

The best way of making the bank system “smarter” is to implement full reserve banking, a system SK is not averse to, far as I remember. And the particular relevance of that here is as follows.

First, debt does not build up to the same extent under full reserve as under the present system (as Positive Money has been pointing out for years).

Second, if a selection of lenders (banks or other institutions) make a series of silly loans, the resulting collapse in demand is not as dramatic under full reserve as under the present system, as intimated by former governor of the Bank of England in his “Bagehot to Basle” speech, passage starting “And we saw in 1987…”.
 

Conclusion.

MMT plus full reserve is a better solution than debt jubilees.

A Marxist drones on about MMT. How exciting.

 

 

Marxists have a habit of droning on about almost everything without saying anything of any great interest. Anyway the latest in this genre is an article on the “Brave New Europe” site entitled “A look at Modern Monetary Theory (MMT) from a Marxist  perspective.”

The article is actually discussion involving Costas Lapavitsas who is a professor of political economy at the SOAS University of London, and Jonas Elvander who is a Brussels-based journalist.

Anyway, I started to read it and got to this passage: “Second, and more crucially, the policies adopted have driven interest rates down to zero and there are negative consequences to that, which MMT ignores. But they cannot be ignored – we are living through them!”

Well the reality is that MMTers are well aware that their policies drive interest rates down: indeed, MMT actually ADVOCATES a permanent zero rate of interest on government liabilities, as did Milton Friedman.

At that point and given the obvious ignorance of the above two Marxists, I ceased reading any more of their article / discussion.

Yawn. Zzzzzzz.

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P.S. Hat tip to Mike Norman Economics for alerting me to the above "Marxist" article.