Sunday, 15 February 2015

Is more lending / debt desirable or not?

(Warning: this is yet another of my pro-full reserve banking rants)

The great and the good – aka the dozy elite – often deplore the rise in household and other debts over the last decade or so. But in the next breath they’re quite likely to warn that excessive bank regulation will cut bank loans and hence economic growth.  So do they want more lending / debt or less?

One of the worst offenders is Vince Cable, the UK’s so called “Business Secretary”. For example, according to this Financial Times article he claims (scarcely believable this) that commercial banks shouldn’t be forced to have more capital because  that would allegedly cut  down on bank lending and bank created debt, which would  damage economic growth. Well if there’s one thing nearly every economist now agrees on, it’s that banks SHOULD HAVE more capital. Indeed, Martin Wolf, chief economics commentator at the Financial Times argues that banks should have VASTLY MORE capital: much more than advocated by the Basel regulators.

But in contrast, Cable says here, “I am very concerned by the build-up of household debt in relation to income.” And if you want to watch more members of the great and the good brigade hyperventilating about excessive household debts, see here.
Anyone can take some event or variable, e.g. an interest rate rise, and point to one or two consequences. In contrast, and far more useful is to work out the OPTIMUM level of interest rates, debts, lending etc. So what set up would give us the OPTIMUM amount of lending and debt?

Optimisation: the free market.

It’s widely accepted that the FREE MARKET gives an optimum allocation of resources, bar a number of specific areas where a totally free market does obvious harm: e.g. giving factories freedom to pollute their surroundings. Or in economics jargon, we can’t allow externalities.  Also a free market is a scenario in which there are no subsidies (unless there are very good social reasons for subsidies). Indeed it is widely accepted that bank subsidies should be removed, though the elite is  moving at a snail’s pace to actually remove such subsidies. Or as Labour politician Michael Meacher so eloquently put it, “The pusillanimity of the new capital reserve requirements was accompanied by almost unbelievable procrastination.”

In fact, advocates of so called “free banking”  advocate a removal of all bank subsidies, and indeed  taking that further: letting private banks issue their own dollar bills, pound notes, etc.

Free banking is OK by me as long as depositors have the option of some sort of totally safe state backed account to lodge their money in. With a view to achieving the latter, William Hummel advocates that everyone should be able to open an account at the central bank. But that’s just one way of doing it. As an alternative, one could have commercial banks act as agents for the central bank.

Moreover, totally safe accounts of the latter sort are already up and running. In the UK there’s the state run savings bank National Savings and Investments. And in the US there are money market mutual funds which invest only in short term government debt.

And what do you know? The latter system, i.e.  totally safe, state run accounts combined with a more or less “anything goes” private banking system is pretty much what full reserve banking consists of, a system I back. There’s just one constraint that needs to be put on those private banks (and free banking enthusiasts won’t agree with this), and that is to restrict their freedom to issue any sort of liability which is too near to being money. Reason for that is that private banks, as is currently the case, issue most of the country’s money supply, and if a series of such banks collapse, the country’s money supply vanishes or is dramatically reduced. As Irving Fisher put it in the 1930s, “The most outstanding fact of the last depression is the destruction of eight billion dollars-over a third - of our "check-book money"- demand deposits.” That just isn't acceptable.

To put it in economics jargon, letting private banks issue the country’s money supply involves an externality: those banks periodically impose catastrophic crashes / credit crunches on the economy. That needs to be disposed of just as the pollution externality mentioned above needs to be disposed of.


The optimum amount of lending and debt would arise where borrowers and lenders are free to come to any mutually acceptable agreement they like: using a bank as an intermediary or not. The main constraints needed are first, private banks’ freedom to portray their liabilities as money should be constrained or outlawed.  Second, to make up for that constraint, the state should make totally safe accounts available to anyone who wants them.

Under that system, there is no state support for lending entities / lending banks. And that in turn means that all stakeholders in those entities are effectively shareholders: i.e. in the worst case scenario, they stand to lose 100% of their stakes. So that means a big rise in capital ratios, which in turn would reduce lending somewhat. But if that lead to any reduced GDP, that’s no problem because the latter reduction can be dealt with by standard stimulatory measures: interest rate cuts, a bigger deficit or whatever.


  1. For what it's worth, I've always loved 100% reserve banking. When I place my money in the payment system, I don't want the people who operate the payment system to gamble with the money passing through it. Frankly, it seems ridiculous. I'm fine with paying for financial services via fees, and not at all fine with paying for them through the hidden costs of bail-outs when their bets go bust.

    I am curious about your dislike of private (unregulated) banks issuing money-like liabilities. Suppose a private (unregulated) bank goes bust, and people who thought they had dollar-denominated bank account balances there suddenly don't. As you point out, this is a sudden contraction in the money supply. Can't the central bank offset that contraction by creating new money, buying assets, and effectively creating new deposits in safe (state-run or 100% reserve) banks? Is it possible to have both freedom (including the freedom to lose money) and also macroeconomic stability?


    Kenneth Duda
    Menlo Park, CA

    1. Kenneth,

      I think you have a point of a sort when you say it would be possible to have “unregulted banks issuing money like liabilities”. As you say, if a number of such banks crash, the central bank can at least in theory counteract the deflationary effect. But it strikes me that if a significant proportion of the country’s money supply takes that form, then when a crash comes, the effects are HUGE. And central banks are run by people who (as they themselves are the first to admit) are not omniscient and omnipotent. Thus the reality I think is that crashes will always be very disruptive if unregulated banks issue money.

      Another complicating point is that (as Irving Fisher pointed out), it’s ORDINARY HOUSEHOLDS that see their stock of money vanish in a crash. Now what’s the central bank going to do about that? In theory it could send a check to every household in the country. But that strikes me as very messy and problematic.

    2. Thanks Ralph. I think you're right that a system-wide private banking collapse would be hard for even an NGDP-targeting monetary authority to counteract fast enough. I guess it would come down to what fraction of depositors met their cash-flow needs using public/guaranteed/100%-reserve versus private banks. I agree that if a significant fraction did, enticed by higher returns or whatever, then you'd have the same sort of system-wide failure that would require a system-wide bail-out. so perhaps the best way to avoid that is by preventing private banks from issuing cash-like liabilities, which probably means introducing artificial delay in between a private bank cash balance account and the payment system, i.e., if it took 30 days to write a check or receive currency from a private bank cash account, then most people would probably meet their day-to-day cash flow needs in a public bank, particularly if the public bank offered a form of electronic money that actually makes sense in 2015, as opposed to our current banking system's ridiculous ACH system, where to send someone money, I generally have to have my bank print out a check and mail it to them for them to mail somewhere else. Why can't you attach money to email like you can with google wallet?


      Kenneth Duda
      Menlo Park, CA

    3. Hi Kenneth,

      “I guess it would come down to what fraction of depositors met their cash-flow needs using public/guaranteed/100%-reserve versus private banks. I agree that if a significant fraction did, enticed by higher returns or whatever, then you'd have the same sort of system-wide failure that would require a system-wide bail-out.” I have a few problems with that passage, as follows.

      First, people wouldn’t be attracted to the public/guaranteed sector by high returns. They’d be attracted by SAFETY. Some advocates of full reserve think the relevant money should just be dumped at the central bank, in which case there’d be no return at all, assuming the CB pays no interest on reserves. Others (e.g. Milton Friedman) argue that it would be OK to put the money into short term government debt. Either way, the return won’t be spectacular.

      Re “system-wide failure”, there’s no way the safe half of the bank industry under FR can fail (bar political revolutions, large meteor strikes on Manhatten, etc).

      Re your 30 day delay idea, Positive Money (who back full reserve banking) advocate that idea. I’m not so sure. I prefer a clean distinction between, 1, easily transferable cash which everyone uses their safe account for, and 2, loans and investments which are funded just by shares which float in value and can’t be construed as money.

      Re emailing money, etc, that’s a rapidly evolving scene. From my limited knowledge of the subject, some African countries which have gone straight from no telephones at all to mobiles / cellphones without bothering with landlines – they seem to be ahead of Western countries when it comes to mobile based money transfer.


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