Jan Kregel of the Levy Economics Institute tries to criticise narrow banking.

First, for the benefit of any readers new to “narrow banking”, the term means much the same as “full reserve banking”, as indeed Kregel himself implies. “Narrow / full reserve banking” is a system in which only the state creates money. I.e. private banks cannot create money or “lend money into existence” in the way they do under the present fractional reserve system.

There are of course different ways of organising a narrow / full reserve system. And equally, there are variations on the “fractional reserve” theme. The variation on the narrow banking theme which Kregel considers is the one proposed by Minsky. And this incorporates a “Glass-Stegall element”: the bank industry is split into two halves: a retail or “basic payments system” half, and an investment banking half.

Under Minsky’s proposal, the retail half would invest in nothing apart supposedly safe securities like government debt. While the investment half would be funded not by deposits of any sort, but entirely by equity.


Is government debt safe?

Of course the idea that government debt is safe is of now a joke in view of the price at which Euro periphery debt now trades. Indeed even the price of non-Eurozone government debt bobs up and down by significant amounts. Thus personally I wouldn’t even allow investment in government debt: I’d forbid any investment of any kind. That would nice and simple.

Indeed as the second paragraph of the preface to Kregel’s article points out, what we desperately need is to simplify the system: the big advantage of complexity for banks is that they can bribe politicians and nibble away at the regulations, bit at a time. In short, we need clear lines in the sand: not complexity.

And if anyone thinks that preventing the above investment in government debt would make it more difficult for government to fund itself, my answer is that government borrowing is a farce. That is, it is pointless for a government which issues its own currency to borrow the stuff which government itself can produce at any time at no cost (i.e. money). Thus if government cannot borrow, it can perfectly well just print new money and spend it into the economy, as indeed Keynes and Milton Friedman amongst others pointed out. I’ve dealt with the farcical nature of government borrowing in more detail here.



Minsky’s proposal is just a variation on a theme.

The above set up proposed by Minsky (the retail banks investing only in supposedly safe securities and investment banks being funded entirely by equity) actually comes to much the same thing as the set up proposed by a much more recent advocate of narrow banking: Laurence Kotlikoff. Kotlikoff suggests having mutual funds (unit trusts in UK parlance) specialising in retail stuff and other funds specialising in investment banking activities. However, I’m not concerned with which is the best variation on the basic theme: it’s the basic principles I’ll consider here.


Voluntary versus forced saving.

Kregel’ first criticism of narrow banking is that it “would create a financial system . . . in which all investment decisions are the consequence of the voluntary savings decisions of individuals.”

Wow! So what exactly is wrong with that? In a desert island economy, Robinson Crusoe cannot “invest” in a new fishing rod unless he makes a “voluntary saving decision”. If there is a problem there, I don’t see it.

Moreover, are we supposed to think that “investment decisions” should be funded by INVOLUNTARY or FORCED savings? Because the latter (and here comes the real joke) is EXACTLY WHAT FRACTIONAL RESERVE INVOLVES!!!! I’ll explain.

Under fractional reserve, when a bank creates money out of thin air and makes a loan, there is an increase in demand. And assuming the economy is at capacity, the result will be inflation unless the authorities curb demand in some way, e.g. by raising interest rates or cutting public spending on roads, schools, health, the military or whatever. In short, when a bank makes a loan under fractional reserve, the necessary saving or reduced consumption is quite likely to be FORCED ONTO a random group of people or consumers: e.g. consumers of educational services, roads, or health care. And if that makes sense, I’m baffled.

It would make far more logical, where additional funds for investment seem to make sense, to get the funds from those most willing to save, which is what happens under full reserve.

So that rather knocks a hole in Kregel’s “voluntary” point.


Other criticisms.

However, Kregel’s central criticisms come in a passage which is riddled with mistakes, and which is thus.

". . .a financial system that was regulated via a 100 percent reserve requirement on deposits and a 100 percent ratio of capital to assets for investment trusts. . . .could neither ensure the stability of the real economy nor assure stability of the capital financing institutions. First, the real investments chosen could still fail to produce the anticipated rate of return; and second, sectoral over investment and financial bubbles could still exist if there were herding behavior by the investment advisers of the trusts that produced procyclical financing behavior. There would always be a risk of investors calling on the government to save them from financial ruin.”

As regards “stability” who ever said full reserve would bring perfect stability? No one I know of. What the advocates of narrow banking or full reserve DO CLAIM is that a system under which the private bank system can create money and lend it out whenever it feels like it, EXACERBATES asset price bubbles. That is, banks create and lend money to for example those speculating in house price appreciation. That pushes up house prices, which in turn makes houses a better form of collateral, which in turn encourages more borrowing, etc etc. I.e. there is a clear feed-back loop there. Indeed, there is a nice chart here showing the expansion of private bank created money relative to monetary base in the UK in the four years or so prior to the crunch. But no advocate of narrow or full reserve banking ever said, far as I know, that removing that loop totally rules out “irrational exuberance”.



(Hat tip to “tutor2u”)

As regards the idea that under narrow banking, those making investments will go running to government when their investments show a loss, attempts to pick taxpayers’ pockets go on all the time under the EXISTING SYSTEM. Attempts by the rich to organise so called “socialism for the rich” are rife.

And it may be that in the near future the rich will organise taxpayer funded bail outs for anyone losing money on the stock exchange. Though thankfully they don’t seem to have thought of this wheeze yet.

Anyway the CRUCIAL question here is whether this sort of begging would be MORE RIFE under narrow banking than under the existing fractional reserve system. And there is a VERY GOOD REASON for thinking it would not, which is thus.

The big confidence trick perpetrated by banks under fractional reserve is that they take deposits (including grandma’s life savings) and invest those savings in less than 100% loans and investments. That trick works for much of the time, but sooner or later it’s bound to go wrong. And when it does, banks have the PERFECT EXCUSE for relieving taxpayers of trillions: “if we aren’t rescued” they’ll tell you, “grandma’s savings disappear”. Cue crocodile tears, contrived weeping, wailing, gnashing of teeth, etc etc. (Personally I’m moved to vomit rather than burst into tears.)

That problem arises because banks have on the liabilities side of their balance sheet a commitment to return $X (or thereabouts) to depositors for every $X deposited, while on the asset side, the total value of assets can easily fall to less than total liabilities, in which case the bank is bust.

Now there’s a beautifully simple solution to the latter problem: narrow banking.

Under narrow banking when a bank expands its loan book, that expansion can only come from funds supplied by equity investors. I.e. balancing the additional loans on the asset side of the balance sheet is additional equity (or as yet unused equity). And NORMALLY, when equity loses its value, the relevant shareholders do not get away with running to government with a begging bowl. For example, at the time of writing Facebooks shares have dropped dramatically, but I haven’t heard anything about shareholders running to government for a bail out.


Narrow banking destroys capitalism?

Kregel continues:

“Indeed, for Minsky and Schumpeter, such a “narrow banking” system could not be considered a modern “capitalist” system; it would be akin to what John Maynard Keynes defined as a “real wage,” as opposed to a “monetary production,” economy. In a monetary economy, it is the role of the financial sector to ensure the financing of the acquisition and control of capital assets by increasing the liquidity of the liabilities of the business sector.”

Not true. Dictionary definitions of the word “capitalism” vary, but most of them give it as something like “a combination of private ownership of the means of production and free markets”.

Now under narrow banking, there is precisely NO NATIONALISATION whatever. In particular, banks are not nationalised. Plus (taking Kotlikoff’s variation on the narrow banking theme) mutual funds are not nationalised.

As to abolishing free markets, markets are just as free as under fractional reserve, with just one exception, namely that banks cannot indulge in the above mentioned “confidence trick”. But making confidence tricks illegal is hardly to destroy the free market. We already have dozens of free market activities which are banned because they are regarded as fraud, confidence tricks, etc.

Moreover, any idea that the current banking system is capitalist is just a joke. It requires an annual too big to fail subsidy plus the occasional trillion dollar bail out. That’s what I call “socialism for the rich”, not capitalism.

Next let’s consider Kregel’s claim that “, in a monetary economy, it is the role of the financial sector to ensure the financing of the acquisition and control of capital assets by increasing the liquidity of the liabilities of the business sector.” I assume that by “increasing . . the liabilities of the business sector” he means money creation. If so, that just begs the question under discussion. That is, the central question here is whether the “business sector” should be able to “lend money into existence” as the saying goes, or whether money creation should be the preserve of the central bank and government (as per narrow banking).


Is narrow banking deflationary?

Kregel’s next criticism runs as follows. “In a narrow banking system the liabilities of the financial system would be composed of (1) investment fund shares representing household savings and business profits used to finance real investments; (2) deposits held by households and businesses in the narrow banks backed by government debt or currency and coin; and (3) government-issued coin and currency held by households and firms. In such a system it is evident that total private saving would exceed investment by the private sector’s holdings of narrow bank deposits and government currency, creating a tendency toward deflation or recession. Price and/or output stability would require an exogenous addition to demand to offset this imbalance, such as might be provided by government expenditures....”

Well it’s stark staring obvious that if restrictions are put on bank lending, then there’ll be a deflationary effect, all else equal. But the simple solution, as indeed Kregel rightly says, is government organised stimulus. And what’s the problem with that? Kregel doesn’t tell us.

Put another way, if the private sector creates and spends less money, that will almost certainly have to be countered by having the central bank / government create and spend some extra money (and/or reduce taxes). I’m baffled as where the problem is.

In particular, the cost, in REAL TERMS of implementing stimulus is precisely and exactly ZERO. (That’s assuming the stimulus is done in a competent manner: if stimulus is effected by the clowns currently running Western economies, the outcome can easily be a complete shambles. But I’ll assume those organising the stimulus have I.Q.s above average.)

To enlarge on that, if stimulus takes the form of the government / central bank machine printing new money and spending it into the economy (and/or reducing taxes), that operation does not COST ANYTHING IN REAL TERMS. Or as Milton Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”


Narrow banking requires a once and for all bout of stimulus.

Also, the latter stimulus is only a ONCE AND FOR ALL bout of stimulus. That is, on introducing narrow banking, bank’s freedom to lend is somewhat restricted, which in turn means more money needs to be put into the pockets of the average household and business.

Having expanded the bank balance of the average household and business (and/or reduced the amount they borrow from banks), there is then nor further need for stimulus arising from the switch to narrow banking. (Of course stimulus may be needed for other reasons, but that’s incidental.)



Less power for those criminals and fraudsters – thank God.

Moreover, what’s wrong with the incompetents, criminals and fraudsters who currently run banks having less say in the allocation of the nation’s resources? The people running banks are quite clearly a bunch of buffoons, charlatans, fraudsters and criminals. If they have a bit less say in allocating resources, and the proprietor of the average Main Street small business plus its customers have a bit MORE SAY, I’m all in favour.