Thursday, 2 May 2013

Full reserve a la Benes and Kumhoff is inflationary.



Messers Kumhoff and Benes produced an IMF working paper last year advocating full reserve banking. (Their paper is NOT official IMF policy, by the way.)

B & K’s ideas have much in common with the ideas put by other advocates of full reserve banking, in particular:
1, that full reserve would ameliorate booms and busts,

2, it would eliminate bank runs and sudden bank failures, and

3, that where stimulus is needed, the government / central bank machine should simply create new money and spend it into the economy (and/or cut taxes).

However, there is one element in their paper which is very different and with which I don’t agree: they advocate a huge debt jubilee and general hand out of central bank created money to the citizenry – amounting to 100% of GDP. Well the effect of that will be rampant inflation won’t it?

Their basic argument is set out below, complete with some of the balance sheets that Kumhoff shows in a presentation he gave in January of this year. Incidentally when you see something like “XX.00” below, this refers to the relevant number of minutes into the presentation.

For a clearer view of Kumhoff’s balance sheets than you’ll see in the video, see here.
The material below is a summary of Kumhoff’s argument. Obviously readers wanting a fuller picture can look at the presentation. I’ve put Kumhoff’s actual words in brown/purple.


The starting point.

Kumhoff starts off with an aggregate balance sheet of the whole US banking system (11.50). As he puts it:

“This is our best rendering of the aggregate balance sheet of the US financial system. We really went into the figures to try to get this right. And all numbers are in percent of GDP. And we include the Federal Banking system. This is important because we don’t want to leave that out of our analysis because it is actually slightly larger than the regular banking system in the US.”

The balance sheet is as follows.

             

Assets
Liabilities

20    Government bonds.
184 Deposits.

100  Short term mortgage loans.

80    Investment loans.

16 Bank equity.




He continues (11.50), “Now the Chicago plan says those deposits, 184% at the top right, need to be 100% covered by reserves, so the banks have to borrow reserves from the government and we put that on the asset side of the balance sheet.  On the liability side what emerges is of course the IOU to the government for providing these reserves. So the government doesn’t just provide these reserves as a gift. There is an IOU. And I call that Treasury Credit.”

The resulting new balance sheet is below. (Note: the cells or boxes in these balance sheets are not EXACTLY to scale. That is, the height of each cell only ROUGHLY corresponds to the “percent of GDP” number that appears in each cell.)

Kumhoff continues (12.30): “Now I can split this institution into what I call money banks at the bottom and credit investment trusts.”


  


Transition to Chicago plan – Step 2. Banks are split into money banks and credit investment trusts.



Credit Investment Trusts.

Assets
Liabilities




20 Government bonds
184  Treasury Credit.

100 Short term and mortgage loans.

80 Investment Trusts.

16 Bank equity.




Money banks.
Assets.
Liabilities.



184 Reserves.

184 Deposits.



Kumhoff continues: “Money banks are just a money warehouse that manage the payments system. And they can manage the payments system without having any concern in the world about the asset quality on the other side of the balance sheet, which means they can manage the payments system in a completely risk free way…..”

“….And so we say this Treasury credit is shared with citizens. But first of all it does something else: it cancels government bonds. That’s 20%...”.

I haven’t specifically shown the effect of that in the balance sheets here as the 20% is a relatively small number. But the net effect is that the total of the liabilities side of the “Credit Investment Trusts” balance sheets shrinks from 200 to 180.



Now comes the coup de grace.

But then, as if by magic, 100 out of the 184 that banks owe to the Treasury is converted to “citizens’ accounts”. Lucky old citizens!! (See top right in the balance sheet just below.)


  


Transition to Chicago Plan Step 4 – Part of treasury credit is distributed as citizens’ dividend.





Credit Investment Trusts.

Assets
Liabilities




100 Short term and mortgage loans.
100 Citizens accounts.

64 Treasury credit.

80 Investment Loans.

16 Bank equity.




Money banks.
Assets.
Liabilities.



184 Reserves.

184 Deposits.





As Kumhoff puts it: “Treasury credit - we now pay what I call a citizens dividend. The government pays a certain amount to every citizen.”

He continues: “The same amount for everyone in the economy would be one way of doing it – into citizens accounts. And the mandatory first use of this money would have to be to repay any outstanding debt. And we’re assuming it would be paid to households and what I call manufacturers to repay all the mortgages and short term loans. Credit investment trusts would be a lot shorter.” (I.e. he means the balance sheet shrinks, presumably).





Transition to Chicago Plan Step 5 – Mandatory first use of citizens’ dividend is repayment of any debts.




Credit Investment Trusts.
Assets
Liabilities


100 Short term and mortgage loans.
100 Citizens accounts.
80 Investment Loans.
64 Treasury credit.
16 Bank equity.



Money banks.
Assets.
Liabilities.



184 Reserves.

184 Deposits.



Then we have the credit investment trusts still financed by treasury credit, and they are only engaged in a very narrow function which is to finance productive loans to firms that make something.


Credit investment trusts.
Assets.
Liabilities.
80 Investment Loans.
64 Treasury credit.
16 Bank equity.



Money banks.
Assets.
Liabilities.



184 Reserves.

184 Deposits.





Kumhoff continues: “I’m papering over the fact that households are very heterogenous and there are still going to be some households that are very rich and have money to lend and households that even after the    citizens’ dividend, have some borrowing needs….”.



No inflation?
He then actually addresses the main point I’m making here, namely that the K&B scheme will dramatically boost inflation. So it seems that others have made the same “inflation” objection that I’m making.

He says (16.30), “The supply of money is completely constant. People say government is printing a lot of additional money here. Nonsense. It is not. What government is doing is requiring that the existing money be backed by reserves. Because the only money that matters is in people’s pockets or their bank accounts.

That remains at 184% of GDP throughout this whole episode. But it represents something. In the beginning it represented a debt. And that’s very fragile. It’s what someone at the ECB called “destructible money” because when the banks decide they don’t want to lend so much any more, some of that money gets destroyed. Because it all depends on what happens on the asset side of the balance sheet. When we are the end of the Chicago Plan, we’re in a situation where all of this money is backed by 100% reserves. That’s indestructible money.

That’s what changes. Not inflation. This is the change in the government’s balance sheet.”



Are you baffled?

Certainly I am. It is true, as he says, that the stock of money that existed at the outset (184% of GDP) is backed by reserves. But as he also says there is an additional handout to all citizens. To repeat what he said above:

“Treasury credit - we now pay what I call a citizens dividend. The government pays a certain amount to every citizen. The same amount for everyone in the economy would be one way of doing it – into citizens accounts.”

Put another way, what started off as a debt owed by banks to the Treasury is simply converted to a debt owed by the Treasury or government in general to citizens. That’s the 100% of GDP which is deleted above with the two red crosses. And that debt or money is simply dished out to citizens.

In other words, every citizen gets a sum of money equal to one year’s disposable income or take home pay, PLUS a sum equal to their share of government spending. So on the simplifying assumption that GDP is split 50:50 as between private and public spending, then everyone gets a sum of money equal to twice their annual take home pay.

Now what’s the reaction of the average household going to be when they get a cheque equal to twice the household’s annual take home pay? In the case of household with no debts, the champagne corks will be flying, and new cars will appear in driveways. In the case of heavily indebted households, the celebrations will be more muted but there’d be expensive celebrations nevertheless.



So what’s the best way to convert to full reserve?

I suggest the following.

Prior to “conversion day”, all bank depositors have to choose approximately how much of their money they want their bank lend on or invest, and secondly, how much they want kept in a 100% safe and instant access fashion. AFTER conversion day, they are of course free to shift money between their 100% safe accounts and investment accounts.

Notice that other advocates of full reserve (Positive Money, Prof. Richard Werner, the New Economics Foundation, Laurence Kotlikoff and William Hummel) advocate this basic split between “loaned on” money and “100% safe” money. For an exposition of the system advocated by the first three, see here.



As to loaned on or “invested” money, that is no longer money. For example if (as per Laurence Kotlikoff’s system) all such money goes into unit trusts (“mutual funds” in the US), then depositors then hold unit trust units, not money. And unit trust units are not counted as money in any country.

Moreover, those unit trusts / mutual funds are         SPECIFICALLY PROHIBITED from issuing cheque books, credit cards, and so on. And that solves what is perhaps the FUNDAMENTAL PROBLEM in banking, namely that banks promise to return SPECIFIC SUMS OF MONEY to depositors while investing in assets which can fall dramatically in value: making it impossible to return depositors’ money. As George Selgin put it in his book “The Theory of Free Banking” (available for free online), “For a balance sheet without debt liabilities, insolvency is ruled out….”.

As to 100% safe money, that’s just deposited at the central bank. If the total that depositors want kept in 100% safe and instant access fashion equals banks’ existing reserves, then no further action is required.

In contrast, if depositors wanted MORE of their money to be 100% safe than the total of existing bank reserves, then some “Kumhoffing” would be needed: that is, have the central bank LEND RESERVES to the relevant commercial banks. But that loan would remain as a loan: it would not (as per Kumhoff) be dished out to the population. So there is no inflationary effect there.

Another group which advocates full reserve (Positive Money) also advocates “Kumhoffing”, but (as per my suggestion above, and in contrast to Kumhoff) they don’t advocate that the relevant sum should be immediately dished out to the population. See Andrew Jackson and Ben Dyson’s recently published book “Modernising Money” (p.230).

The latter authors DO SAY at the bottom of p.230 that “Under normal circumstances the Bank of England will be required to automatically grant the money paid to it as a result of the Conversion Liability to the Treasury to be spent back into the economy.”  And that could be taken to imply that in fact the authors DO ADVOCATE (like Kumhoff) a distribution of the relevant money.

However, Positive Money stress over and over in their literature that the government / central bank machine (GCBM) should only create and spend money into the economy to the extent that stimulus is needed. Thus the above point about spending “Conversion Liability” back into the economy is really superfluous. That is, even if there were no Conversion Liability, GCBM would be creating and spending as necessary. Moreover, there is no good reason, given the existence of the Conversion Liability, for GCBM to create and spend in an amount that would cause excess inflation.



And that’s simpler than Positive Money & Co’s system.

The system advocated by the three authors mentioned above involves the central bank opening an account that corresponds to the total amount that depositors want to be kept in investment accounts. I suggest that is totally unnecessary.

Under full reserve (at least as advocated by Laurence Kotlikoff) the so called “money” that a depositor has invested in a unit trust is little different to a trade debt (e.g. the debt that a car manufacturer owes a car part maker before goods supplied by the latter are paid for). There is certainly no need for central banks to get involved in trade debts, and I suggest equally little need for central banks to get involved when someone buys shares on the stock exchange or buys into a unit trust.






















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