In a recent Financial Times article, Alan Greenspan (widely regarded as laughing stock amongst economics bloggers) criticises bank regulation. He claims that making banks safer requires “building up a buffer of idle resources”, and compares this to the resources lying idle in Japan in the form of earthquake protection. The flaw in this argument is as follows.
In the case of earthquake protection it’s true that large amounts of steel, concrete and clever bits of engineering remain idle for decades – till an earthquake hits. But banks are different.
Bank insurance consists essentially of book keeping entries or contracts. If there ARE any physical resources left idle as a result of bank insurance, like piles of gold or something, will some please tell me where these piles of gold or other physical objects are to be found?
As is pointed out in this work by Prof R.A.Werner and others, one way of making banks safer is to go for full reserve banking and/or curtailing maturity transformation. And as Werner rightly points out, this involves a larger amount of money sitting idle in bank accounts, which to the economically untutored, like Greenspan, might seem like a waste of resources.
However, money in a bank account is simply a book keeping entry or a number in a computer. A nation’s stock of money can be increased any time by little more a click on a computer mouse. Or as Milton Friedman put it in Chapter 3 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.”
As regards increased capital for banks, this again is just book keeping entries and bits of paper. Purchasing shares in a bank or any business gives the purchaser the right to dividends plus the right to repayment of very roughly what they paid for the shares (depending on the share price when they sell). But those two rights may be lost when the bank goes under.
No physical resources are tied up here. All that happens is that when the bank goes under, shareholders forgo consumption rather than taxpayers.
A second fundamental and very simple point that Greenspan has not grasped is that economic activity does not have to be bank funded, i.e. loan funded. The alternative is equity funding. And those two basic options apply to ALL economic activity from a household purchasing a washing machine up to a multinational funding a new oil refinery. Thus stricter bank regulation will not curtail economic activity as long as the relevant government / central bank creates and spends new money into the economy to compensate for the reduced availability of money from private banks.
If households and oil companies have more money in their pockets, they won’t need to borrow so much.
There has to be some optimum combination of loan and equity funding for the economy as a whole. Clearly Greenspan favours near unrestricted lehttp://www.blogger.com/img/blank.gifnding – that is thousands of idiots trying to get NINJA mortgages. God first makes mad….
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Stop press, 2nd Aug 2011: About 16 professors in the Financial Times tear a strip off Greenspan. I'm almost beginning to feel sorry for him.
Afterthought, 3rd August. More rotten eggs thrown at Greenspan: today’s Financial Times has a letter from Rober Yohanan (former Chicago Fed board member) criticising Greenspan. Now I really am feeling sorry for him.
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This leading article (4th para) poses a dilemma which the FT (along with 95% of economists) can’t solve. It’s a dilemma that lies at the heart of the current shenanigans in Washington over the debt and deficit, and it’s as follows.
Britain could arguably do with more stimulus, i.e. more deficit. But that will increase the debt. And since the latter is already too large, it would be irresponsible to enlarge the deficit (or slow the pace of consolidation). Well for the benefit the massed ranks of economic illiterates posing as economists. I’ve spelled out the solution to this problem a dozen times. I’ll put the solution in bold coloured letters.
AS KEYNES, MILTON FRIEDMAN AND OTHERS HAVE POINTED OUT, A DEFICIT DOES NOT HAVE TO ACCUMULATE AS EXTRA DEBT. IT CAN PERFECTLY WELL ACCUMULATE AS EXTRA MONETARY BASE.
The various knee jerk objections that economic illiterates come up with in reaction to the above idea are predictable to the point of tedium. But I’ll run through them.
Objection No 1. More monetary base equals more bank reserves, so banks would go on a lending spree which would be inflationary.
Answer: Bank reserves has increased by an astronomic and unprecedented amounts over the last two years and the result? Banks are reluctant to lend!!! So the above objection flies in the face of the evidence. As for the theoretical reasons as to why bank reserves have little to do with bank lending, see here.
Objection No 2. More monetary base increases the private sector’s net financial assets which means the private sector will go on a spending spree and cause inflation.
Answer: There has already been a massive and unprecedented increase in the monetary base. Where is this spending spree? I don’t see it. Of course the amount of money in the hands of the private sector is ONE FACTOR that determines demand. But consumer and business confidence also play a part. The private sector is in cautious mode just at the moment: e.g. it is deleveraging. So if we are going to make up for this caution, increasing the amount of money in the private sector’s hands would be a good idea.
That may well result in excess demand in the future. But in that case, we just need to rein in the above money and “unprint” it, or extinguish it.
3. Inflation is already too high, so we can’t raise demand.
Answer: If that’s the case, then the constraint on stimulus is inflation, not the above “debt is too large” point.
Moreover, if the debt-phobes think the debt is such a problem, it can perfectly well be reduced while maintaining a neutral stance on the stimulus / deflation scale. In other words it would be perfectly possible to stop the debt growing as from tomorrow morning by simply letting the entire deficit accumulate as base instead of debt. It is quite likely that that would be more simulatory / inflationary pound for pound than having the deficit accumulate as base. But so what? The solution to that little problem is to have a smaller deficit, which is what the debt/deficit phobes want, isn’t it? .
The following is re-posted from Warren Mosler’s site.
The main reason we have a large budget deficit is because of all the tax advantaged savings plans- pension funds, IRA’s, insurance and corporate reserve. All of these financial assets, which compound continuously, represent unspent income. And unless they are offset by some other agent spending that much more than his income, the dollars won’t be there to be saved in these tax advantaged entities.
And also realize this is an accounting identity, beyond dispute. Like 1+1=2. Like how your check book must balance or you made an arithmetic mistake.
It works like this:
People work to produce and sell goods and services and someone get the dollars from all those sales. Those dollars that came from the sales are exactly the amount needed to buy those things in the first place. If anyone doesn’t spend the dollars he gets from the sales, there isn’t enough spending for the sales to happen in the first place.
So when a large chunk of our dollars that we get paid from wages and profits go into pension funds, and don’t get spent, all the things for sale can’t get sold unless someone spends that much more than his income.
And if we (both residents and non residents) don’t want to- or can’t- spend more dollars than our dollar incomes by borrowing dollars to spend, sales fall short,so income and jobs are lost in a downward spiral, that doesn’t end until someone finally fills that spending gap by spending more than his income to replace the spending power lost when earned dollars go into pension funds.
That’s where the government comes in. When those dollars piling up in pension funds cause spending to fall short, government can spend more than its income to make up for that lost spending power, fill the spending gap, and keep everyone working and producing and selling real goods and services.
So right now the high unemployment and low sales tell us there is still a big spending gap to fill. In the past, this spending gap might have been filled by people borrowing to spend on houses and cars and all that. But this time around people aren’t willing or able to fill the spending gap.
The current level of government spending that exceeds taxes (deficit spending) is only partially filling the current spending gap. It’s a big economy and pension funds and corporate reserves are huge and growing, which means the spending gap is huge and growing which means the amount government spends that’s more than it taxes (government deficit spending) is still too small to fill the spending gap.
The answer is quite simple - cut taxes and/or increase government spending until output and employment is restored and the spending gap is filled.
Unfortunately our fearless leaders have a large gap between their ears, and have it all backwards, and we’re all paying the price. And it will get a lot worse if they keep cutting the government deficit and make the spending gap wider instead of narrower.
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What I particularly like about the above article is that there is no mention of government borrowing. Quite right. As I pointed out here, the arguments for government borrowing are a load of B.S. Or to put it even more bluntly (if that’s possible), the actual reason for government borrowing is that it enables politicians to buy votes.
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Americans are not too good at distinguishing politics from economics. This article by Robert Schiller in the New York Times is a classic example.
This paragraph is particularly poor:
“Over the long haul, we should engage in balanced support of the economy, find worthwhile jobs for the unemployed and not inject stimulus for its own sake. That means we need tax increases matched by higher expenditures on public goods. Of course, both ideas aren’t very popular right now — but they should be. Granted, they won’t balance the budget immediately; trying to do so would damage the economy. Instead, we should plan to restore budget balance eventually, with matching additions on both sides of the ledger.”
First, who ever said that stimulus was implemented “for its own sake”? Stimulus is effected for the RESULTS it hopefully brings: increased employment, etc. About 95% of the population knows this. How come economics professors like Robert Schiller don’t?
Second, he says he wants “tax increases matched by higher expenditures on public goods”. Well pretty much the only effect there will be to bring a straightforward expansion in the public sector at the expense of the private sector. It will do nothing for job creation. Moreover the question as to what the size of the public sector should be is a PURELY POLITICAL QUESTION. What’s Robert Schiller, wearing his economist’s hat doing expressing a view on this subject?
Third he claims “we should plan to restore budget balance eventually”. Complete nonsense. First, an expanding economy requires an expanding money supply, and an expansion in the monetary base can come from only one source: a deficit. Second, on the over-simple but not totally unrealistic assumption that the national debt remains more or less constant as a proportion of GDP, that expanding debt can, again, come from only one source: a deficit. Third, given the target rate of inflation of 2% or there abouts, both the national debt and monetary base will shrink at about 2% a year unless topped up from somewhere. That topping up, again, can only come from a deficit. That’s quite a lot of deficit.
Which explains why, in case Schiller and his fellow economically illiterate professors of economics hadn’t noticed, most countries for the last century or two have been running more or less constant deficits.
Here is a list of 150 economists who quite clearly cannot distinguish between their own political views and economics, in that they argue for a reduced public sector as some sort of solution for America’s problems.
If they think that a reduced public sector is any sort of solution, they need to explain why Sweden has a standard of living comparable to the U.S., while having its debt and deficit under far better control than the U.S., plus public spending as a proportion of GDP way above that of the U.S.
And before some politically motivated economist accuses me of advocating a bigger public sector, I am not.
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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.
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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