IMF authors get full reserve wrong.

“The Chicago Plan Revisited” is the title of an IMF paper by Jaromir Benes and Michael Kumhof which supports full reserve banking: a system advocated in the 1930s by Irving Fisher and others and later by Milton Friedman. Unfortunately there is a big mistake at the start of this paper, as follows.

The authors envisage converting from fractional to full reserve essentially by having the central bank print some truly astronomic quantities of new money, and pay off all the country’s debtors. And when I say “astronomic” I mean something like 200% of GDP: which makes QE look like extremely small damp squib.

There is a summary of the bank sector’s balance sheets before and after the transition on pages 64-6, and for the authors’ explanation of these balance sheets, see p.7.

As they say on p.7 “the principal of all bank loans to the government (20% of GDP), and of all bank loans to the private sector except investment loans (100% of GDP), is cancelled against treasury credit.” And later,“The cancellation of private debts reduces both treasury credit and government equity by 100% of GDP.” And again: “These buy-backs in turn mean that the private sector is left with a much lower debt burden, while its deposits remain unchanged.”

Well now, if you happen to be an indebted private sector entity, this is too good to be true isn’t it? Christmas will definitely have come early under this scenario for mortgagors. In fact the effect will be rampant inflation.

Mortgagors will find the tranche of their income previously devoted to paying interest on their mortgage is no longer needed for that purpose. There’ll be a HUGE increased demand for new cars, foreign holidays, and so on.

Moreover, since most mortgagors are comfortable with their mortgage and have borrowed responsibly, the effect of getting a letter saying their mortgage has been wiped out will just induce them to run out and borrow some more: most likely with a view to getting a better house. Demand for housing will sky-rocket.


Social justice?

While wiping out debts sounds like it involves oodles of social justice, this is far from the case. People with big mortgages, at least in Britain, are NOT the poorest section of the community. The poorest are just not credit worthy: they cannot get mortgages. They live in council houses or other forms of social housing.

The biggest debtors are those in the middle of the income range. As to the very rich, they certainly TEND not to need mortgages, on the other hand there is no shortage of people with incomes twenty times the national average who live in houses worth several million, with mortgages to match.

So if you think wiping out debt equals social justice, forget it.


The two account system.

The mistake in the IMF paper stems from a failure to understand a basic feature of full reserve, as follows.

Full reserve is a system under which private banks cannot create money. Only government and central bank can do that. But commercial banks CAN LEND as long as they find depositors willing to have their money lent on by commercial banks.

However, if a commercial bank were to lend on £X at the same time as allowing the money to be still available for use by the depositor, then the bank would effectively have created extra money: both the depositor and borrower would regard themselves as having £X in the bank (that’s until the borrower spent the money, in which case the borrower’s £X is someone else’s £X).

Thus a central feature of full reserve is that depositors must choose how much of their money they want to be “instant access”, and in contrast, how much they want to be loaned on or invested. Indeed, the latter choice that depositors must make is spelled out quite clearly by two contemporary advocates of full reserve: Laurence Kotlikoff and Richard Werner. (Incidentally, while the ideas advocated by these two economists are employed below, this should not be taken to imply their agreement with anything here.)


The actual balance sheet changes.

In the light of the above, let’s now consider the balance sheet changes that occur when making the change from fractional to full reserve. I’ll assume as per the IMF paper that the transition is done more or less instantaneously. (A more gradual transition might easily make more sense, but I won’t go into that here.)

Under Kotlikoff regime, depositors who want their money loaned on or invested, put their money into a mutual fund of their choosing (“unit trust” in UK parlance). That money is then no longer a liability of the bank, and (as is the case with existing mutual funds) the depositor no longer has instant access to the money.

Werner proposes a slightly different system: the bank does the lending or investing, but it is made clear to depositors who want to earn interest from having their money loaned on that they cannot have their money back immediately. Plus there is a sliding scale of interest payable to depositors depending on how long they lock their money up for and what proportion of the losses they carry when the loans or investments go wrong. But to repeat, deposits are no longer an IMMEDIATE liability of the bank.

Personally I prefer the Kotlikoff option when it comes to money that is loaned on or invested. It is simpler, which amongst other things makes explaining the balance sheet changes easier.

In contrast, I prefer the Werner option when it comes to instant access money. Under Kotlikoff, instant access money is handled by cash mutual funds. That would seem to imply that the whole business of operating cheques, plastic cards, etc is taken over by such funds. Personally I don’t see the sense in that. Banks have expertise in operating “checking accounts” as they are called in the U.S. Plus they have expertise in operating plastic card systems.

So I’ll assume a Kotlikoff system for money that is to be loaned on or invested and a Werner system for instant access money.


Balance sheet changes.

To keep things simple, let’s say banks’ balance sheet prior to the change consists of liabilities in the form of deposits equal to 100% of GDP, while assets consist just of mortgages equal to 100% of GDP. For “mortgage” read “mortgage, loans and investments” if you like.

I COULD add equity to the liability side and reserves at the central bank to the assets side, but these two items are small compared to deposits and loans, so I’ll ignore them.

During the transition, depositors have to decide how much of their money they want loaned on / invested, and how much they want to have in the “instant access” form. Let’s say depositors want 75% of their money loaned on and 25% to be instant access.

75% of banks’ liabilities and assets are then wiped out: under Kotlikoff’s proposals, depositors would withdraw the money and put it into mutual funds, while the latter would buy 75% of all mortgages off banks.


Instant access money.

Now for the 25% of deposits that are to be instant access.

As to the mortgages balancing that 25%, the central bank buys these off commercial banks with newly created CB money. And of course mortgagors then pay off their debt to the CB which destroys or “unprints” the relevant money (balancing the money it created to give commercial banks in exchange for the mortgages).


The net result.

The net result is thus. As regards money that depositors want loaned on or invested, that money is transferred to mutual funds as are the relevant loans and investments. So bank balance sheets shrink by a large amount.

As to instant access money, commercial banks owe 25% of GDP to depositors, while in turn the central bank owes central bank money to the tune of 25% of GDP to commercial banks. I.e. commercial banks have reserves equal to 25% of GDP.

Note that there has been no increase in private sector net financial assets, never mind ASTRONOMIC increase therein that occurs under the IMF paper proposals.

Of course, if the net effect of the balance sheet changes done in “Kotlikoff/Werner” style were excessively deflationary, that could easily be countered by the standard cure for excess deflation advocated by we advocates of full reserve: just have government and central bank create new money and spend it into the economy (and/or cut taxes).