Sunday, 22 November 2015

Malcolm Sawyer’s strange ideas on banking.

Malcolm Sawyer and Giuseppe Fontana published a paper a few months ago entitled “Full reserve banking: More ‘Cranks’ than’ Brave Heretics’”.

As regards the insult “crank” (which is repeated several times in the text of the paper), Sawyer and Fontana (S&F) ought to have thought a bit more about who they’re insulting before firing ahead with the insult. Reason is that the advocates of full reserve banking (FRB) are not limited to the ones which S&F concentrate on, namely Positive Money and the New Economics Foundation. (The latter two can certainly be described as “unorthodox”, though “crank” is going too far.)

S&F’s real problem is that other advocates of FRB include Milton Friedman,  John Cochrane (currently professor of economics in Chicago), Lawrence Kotlikoff (currently professor of economics in Boston) and the economics Nobel laureate, Merton Miller. Are they all cranks as well?  Since S&F don’t mention that the latter four’s acceptance of FRB, I conclude that S&F don’t know about the latter four’s support for FSB, and thus that S&F are not up to speed on this subject.

But obviously I need to substantiate the latter criticism of S&F, so here goes.

S&F’s paper is actually riddled with mistakes. I’ll deal with them in the order in which they appear in the paper. The first two mistakes are not desperately important. They’re under the headings “Mistake No 1” and “The Chicago school” just below, and readers can skip those if they like. But when an author makes numerous minor errors, that is an additional reason for thinking he has a poor grasp of the relevant subject, so I’ve included the minor mistakes.

Incidentally, Sawyer produced another paper on the same subject in the same month as the one dealt with here. That other paper is entitled “The Scourge of Green Monetarism”.  Several arguments and points are common to both papers. I’ll deal with the points that are unique to the “scourge” paper in the near future.

Mistake No.1.

The first paragraph of the paper deals with the various phrases used to describe FRB. As the authors put it “A range of terms are used such as 100 per cent reserve banking, positive money, sovereign money as well as full reserve banking…”.

As to “positive money”, that’s the name of an ORGANISATION: called “Positive Money”. I’ve read a huge amount about full reserve banking, and have written a book on the subject, but I’ve never seen the phrase “positive money”  used as a synonym for “full reserve banking”.

The Chicago school.

Next, the second half of p1 says the paper will concentrate on the ideas put by Positive Money (PM) and New Economics Foundation authors (PM & Co), but not the ideas of the Chicago school. As S&F put it, “….in this paper we do not further consider those coming from the ‘Chicago proposals’ tradition.”

Well there’s a problem there, which is that PM & Co specifically say, “Our proposal is similar in spirit to and modernizes those put forward by the leading monetary economists of the twentieth century, namely Irving Fisher (1936), Milton  Fiedman (1960), and James Tobin (1987).” Now Fisher was very much a member of the Chicago school: at least the differences between Fischer’s ideas and the Chicago school’s were minimal.

The latter quote comes from the submission to Vickers made by PM, the NEF and Richard Werner.

Shadow banks.

On p.2, S&F repeat  a criticism of  FRB that has been made a dozen times by others, namely that FRB is only concerned with clearing banks or what might be called “regular banks”, and not with shadow banks. As the authors put it, “The FRB proposals only relate to clearing banks, and not to the rest of the financial system.”

That is a simple minded criticism of FRB and the answer is equally simple, namely that any organisation which acts in a bank like manner, whether it calls itself a bank or not, should obey the same regulations. As Adair Turner put it, “If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safeguards.”

If shops selling alcohol were allowed to ignore the law on alcoholic drinks as long as they called themselves “hardware stores” or “wedding dress” shops, the law would look an ass.

To summarise, if bank regulations apply only to organisations that CALL THEMSELVES banks, then those regulations would be a farce, as S&F rightly suggest. The solution is to apply the above “Turner principle”.

Net financial assets.

On p.4 (item (i)) S&F try to challenge a point made by FRB advocates namely that the existing bank system enables private banks to profit from seigniorage. 

As part of their argument, S&F distinguish between commercial bank created money and central bank money (i.e. “base money”).  They point out that the latter is a net asset as viewed by the private sector, while the former is not. (That incidentally is a point which every MMTer is very well aware of).

S&F conclude from that that “Thus, there is no seigniorage for banks..” 

OK, let’s illustrate this with the simplest possible example. Joe Bloggs wants some money so he deposits collateral at a bank, which in turn credits £X to Bloggs’s account. Bloggs then spends it and obtains £X of goods in return. Now ASSUMING that that £X of new money continues to circulate as money, i.e. assuming holders of the money never demand anything back from Bloggs or Bloggs’s bank, then Bloggs and his bank have obtained £X of real goods in exchange for bits of paper, or mere book – keeping entries. Or if you like, Bloggs makes a profit, with the bank taking it’s cut. That’s seigniorage.

In contrast, if the holders of the new money eventually want something back from Bloggs and Bloggs’s bank, and they’re only prepared to hold it if paid interest, then that’s a case of the bank intermediating between lenders (holders of the new money) and a borrower (Bloggs). No seigniorage is involved there.

Intermediation and seigniorage.

Later on the same page and still under item i), S&F say “The profits for banks come  from the difference between the rate of interest on loans (with allowance for default) and the costs of deposits including operating costs and any interest payments.”, the suggestion being that the latter is the source of bank profits, not seigniorage.

Well the answer to that is that those two sources of profit are not mutually exclusive: that is, there is nothing to stop banks making a profit from BOTH activities, and that’s in fact what they do (a fact alluded to in the above “Bloggs” illustration.)

Base money doesn’t cause inflation?

Under item ii) on p4, S&F claim that advocates of FRB are wrong to claim that the amount of money printed by the central bank influences inflation. As he puts it “This leads the FRB school into the mistaken belief that inflation can be controlled by the rate of increase of the money supply.”

Well the words “Robert” and “Mugabe” spring to mind. The idea that the amount of money issued by the state has no effect on inflation is straight out of la-la land. Moreover, those CURRENTLY IN CHARGE of western economies (who are not advocates of FRB for the most part) clearly also think the amount of base money in circulation has some sort of inflationary and output increasing effect: that’s why they’ve  run large deficits and implemented QE (all of which boils down to much the same as the FRB idea, namely have the state print money and spend it in a recession).

Incidentally, S&F shouldn’t strictly speaking use the phrase FRB in that as they say, they are concerned specifically with PM & Co’s VERSION of FRB, not FRB in a more general sense, i.e. a sense that includes the proposals of the Chicago school, (never mind Milton Friedman or Lawrence Kotlikoff’s versions of FRB). But that’s a minor blemish in S&F’s paper, and it’s a blemish I’m also guilty of in this article. The blemish is certainly minor if, as I claimed above, there is not much difference between the various versions of FRB.

The stock of money.

Next, (p4, item iii)), S&F accuse  FRB advocates of claiming that commercial banks alone decide the size of the money supply, i.e. that non-bank entities (e.g. households) have no say in the matter. As he puts it “The amount of money will adjust to that which is required for these transactions purposes. Thus it is not correct to say, as the FRB advocates maintain, that the amount of money is solely determined by the banks…”.

My answer to that is that far as I know advocates of FRB all aware that if households have more transaction money than they need, they’ll tend to dispose of the surplus. I.e. it’s pretty obvious they’ll do a variety of things with that surplus, e.g. use it to repay loans, put it into term accounts, buy stock exchange investments and so on. S&F don’t actually cite any FRB advocates who claim the above obvious nonsense.

Would FRB enhance financial stability?

Page 6 sees the start of a section entitled as above.

S&F say, “The first, and perhaps obvious, point to make is that the FRB proposals would only directly affect a small, if important, part of the financial system. It would impact on the creation of money and hence on banks narrowly defined, but not directly on the role of banks as financial intermediaries between savers and investors..”

My answer to that is “point taken”. However, FRB advocates do not claim that FRB would totally eliminate booms and busts. But, as S&F say, FRB does deal with one factor that contributes to the problem, namely that banks create and lend out money like there’s no tomorrow in a boom.

Ignore private money creation?

Next, and still on the subject of financial stability, S&F make this bizarre claim: “In our discussion here it is not necessary to consider the causes of a single bank failure, often arising from corruption and incompetence, and whether such failure that can be attributed to its role as money creator.”

Well it is precisely the fact of issuing money that makes banks vulnerable and contributes to financial instability!!!!!!

Money is a liability of a bank which is fixed in value (inflation apart). In contrast, the assets of banks (the loans and investments it makes) can turn out to be worth a lot less than book value. Think Spanish and Irish property loans. At that point, the relevant bank is insolvent, or likely to be insolvent.

In contrast, if the liabilities of a bank are VARIABLE in value, e.g. if a bank is funded just by shares, bonds that can be bailed in or something like that, then insolvency is impossible. Plus shares, bonds and the like are not money. Thus (to repeat) it is precisely the fact of issuing money that makes commercial banks vulnerable, as indeed is suggested by Douglas Diamond in the abstract of this paper. As he puts it and in reference to banks’ liquidity or money creation activities, “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.”

The solution to that problem as John  Cochrane explains is to dispose of the money on the liability side of bank balance sheets, and replace it with what he calls “non runnable” debt (e.g. shares).

Taxpayers to the rescue!!!

S&F than say “As an aside it could be noted that any liquidity issues can be readily dealt with by the central bank as lender of last resort.”

Well of course!! If you’ve got a sugar daddy willing to come to your rescue it doesn’t matter how incompetent you are. And if you want a phenomenally rich sugar daddy, what better than a central bank with the freedom to print limitless amounts of money and backed by taxpayers? Problem is that that constitutes a subsidy of banks, and subsidies do not make economic sense.

Incidentally it could be argued that central bank / government assistance for commercial banks CAN BE implemented on a commercial basis, in which case there would be no subsidy involved. Indeed, the FDIC is self-funding. But the FDIC only caters for small banks. When it comes to large banks or a series of large banks,  state assistance is the only option that that assistance JUST ISN'T offered on a commercial basis: politicians would far rather quickly paper over the cracks in the bank system (the source of much of the money for politicians’ election expenses) than have banks face brute commercial reality and fail.

Second, I go into the subsidy question in more detail here.

How long would FRB last?

The fourth section of Sawyer’s paper is entitled as just above. He argues basically that banks would circumvent the rules of FRB. There are numerous answers to that point, as follows (and numbered).

1. FRB does not aim to totally eliminate all forms of privately created money. For example most FRB advocates (in my experience) favour local currencies like the Bristol pound.

2. There is a MAJOR PROBLEM facing any bank or similar entity trying to circumvent the rules, which problem S&F don’t mention. It’s as follows.

The ease with which money can be issued is related to the size of the entity that issues it. To illustrate, plastic cards issued by or cheques drawn on well known banks are widely accepted. In contrast, IOUs issued by some medium size City of London hedge fund are completely useless for 99% of transactions outside the City of London, e.g. shopping at supermarkets.

Plus, while it may be hard to keep an eye on what every small shadow bank or hedge fund is doing, it’s relatively easy for the authorities to see what the largest banks (regular and shadow) are doing.  Thus keeping tabs on the vast bulk of the potential sources of privately issued money shouldn’t be difficult.

3. S&F assume that FRB advocates claim that money in deposit or term accounts where access takes 7 or 14 days is not counted as money. Well if S&F are arguing that money available in 7 days is effectively the same as instant access, I quite agree.  But I’ve no idea where S&F get that 7-14 days from. Two or three months is the time normally cited I my experience. Plus that two or three months is a common dividing line between money and non money used by several countries around the world when measuring their money supply.

4. The rules of FRB are simplicity itself compared to Dodd-Frank. And if you want an example of useless bank regulations, look no further than Dodd-Frank. As Richard Fisher, former head of the Dallas Fed, put it, “We conclude that Dodd-Frank has not done enough to corral “too big to fail banks” and that, on balance, the act has made things worse, not better.”

5. If S&F are trying to claim banks haven’t circumvented EXISTING regulations to any great extent, than that’s just a joke. In the US, banks have had to pay a good $100bn in fines for various crimes. Thus if banks DO CIRCUMVENT the rules to some extent under FRB, the extent of circumvention could hardly be worse than under the existing system.

Budget deficits and money creation.

S&F’s fifth section is entitled as just above, and they make the bizarre claim that “The full reserve banking proposals in contrast constrain government expenditure through setting down a rule as to how much money can be created.”

As PM & Co make clear, under FRB government is free to raise tax by any amount it likes and spend the relevant money.  Indeed the latter “tax and spend” decision is quite clearly a POLITICAL decision and it would be wholly wrong for a central bank (or PM’s “Money Creation Committee”) to interfere or in any way influence that decision.

Indeed, that point is so obvious that (to repeat) it is bizarre that S&F think the likes of Positive Money or Richard Werner would be unaware of it.

S&F then repeat the above ridiculous point several times, e.g. a few sentences later they say “…if the growth of the money supply was on track to exceed the target, then the central bank would be forced to deny financing for government expenditure.”

The answer is (to repeat) that under the PM/Werner/NEF system, governments are free, as they are now, to increase “government expenditure” by any amount they like and by collecting extra tax.

What if there’s too much stimulus?

The first half of S&F’s p.14 claims that under FRB whoever decides on how much new money to create (i.e. how much stimulus there should be) might get it wrong. In particular, they might create too much new money in which case the private sector would “bid up prices”, i.e. inflation would ensue.

Well of course that’s a possibility! But are S&F trying to suggest that the authorities under the EXISTING SYSTEM always gauge the amount of stimulus correctly? Any idea that the amount of stimulus after the 2007/8 crisis was adequate given the seven years of excess unemployment that came after that crisis is just a joke. And remember that that crisis was largely the result of a chronic bank system.

If FRB is going to improve on the existing system, frankly it doesn’t have a very high bar to surmount: it could hardly be worse than the existing system.

Fiscal policy is “subordinate”?

In the second half of p.14, S&F claim that under FRB fiscal policy become “subordinate” to monetary policy, and that that is highly undesirable. In the authors’ words:

“The second point is the intimate link between the budget deficit and the change in the stock of money. It then becomes important as to whether the budget deficit determines the change in stock of money or whether the change in the stock of money determines the budget deficit. Under the FRB proposals it is clearly the latter. The central bank then imposes a target growth for the stock of money for the coming period (say year), and that in turn imposes a target for the budget deficit. Thus fiscal policy becomes completely subordinated to monetary policy.”

The reality is that under PM & Co’s FRB system, monetary and fiscal policy are joined at the hip, and there is no clear reason for saying that one is subordinate to the other. That is, if one implements stimulus by creating new base money and spending it, there is an obvious monetary element there: the money supply rises. But there is also an obvious fiscal element, namely that public spending rises (and/or taxes are cut).

Frankly I couldn’t care less which of those two effects is dominant, or whether the effect of the two is the same. And nor (far as I know) does PM. The important point is that as long as one of them works, then stimulus is effected, and unemployment falls.

Automatic stabilisers.

On p.15 S&F claim that FRB would prevent the automatic stabilisers from working. Well that depends on the rules and conventions governing the money creation process.

Clearly if the rule was that the authorities shall decide how much new money shall be created and spent over the next year REGARDLESS of the arrival of a recession in that year, then FRB would indeed thwart the automatic stabilisers.

However, a more sensible rule – and it doesn’t take a genius to work this out – is that the authorities decide how much new money to create and spend on all items OTHER THAN automatic stabiliser items (like unemployment benefit). I.e. government would have freedom to spend more on unemployment benefit if the number of unemployed rose.

An alternative would be for the central bank or Money Creation Committee to keep an eye on the number of unemployed and adjust the amount of new money to create accordingly. That’s what might be called a “semi-automatic” system.

To summarise, S&F’s criticism relating to automatic stabilisers is one that is very easily dealt with. 

Debt free money.

The sixth and final section of S&F’s paper entitled “Debt free money”, tries to cast doubt on the claim by Positive Money that base money is “debt free”. Unfortunately S&F don’t add anything of any interest to the debate on this topic.

It is widely recognised, and not just by FRB advocates, that money created by commercial banks is not debt free in the sense that for every dollar created, there is a dollar of debt. In contrast, base money is an asset as viewed by the private sector. Thus PM are right to make that point. MMTers  (perhaps another lot of “cranks” in the eyes of S&F), often make the same point.

S&F also make the following not too clever point. “Hence the creation of money raises the net financial assets, and carries the implication that the more money is ‘printed’ the better off (wealthier) people will feel. Yet there is no increase in the capacity of the economy to produce.”

What – so printing bits of paper with £10 stamped on them doesn’t automatically cause factories complete with associated machinery to appear from nowhere?  Did Positive Money ever say that the latter magic apparition would actually occur once the printing presses start rolling? Not far as I know.

The basic purpose of creating new money and spending it (and/or cutting taxes) is to raise demand, and that in turn (where there is inadequate capital investment) will cause office blocks to be erected, factories to be built and so on.

As I said, there is nothing of substance in this sixth and final section.


  1. (a) No link given here to the June 2015 Sawyer & Fontana paper. A link is:

    (b) Another "Nobel" prizewinner who supported FRB was Maurice Allais, who is largely ignored by English writers.
    His proposals were not original but have the very important merit of being simple and clear, without the unnecessary and highly controversial "cranky" features of Friedman, Kotlikoff and Positive Money.

    In 1999 Allais wrote (translated from French):
    "...reform must be based on two very fundamental principles:
    1 - The creation of money must be by the state and the state alone. Any money creation other than the base currency by the Central Bank shall be inhibited, so that "false rights" currently resulting from the creation of bank money would disappear.
    2 - Any investment for a fixed term must be secured by loans with longer terms, or at least of the same term.

    This dual condition implies a profound change in bank and financial structures based on the total separation of banking activities observed today and their allocation to three categories of distinct and independent institutions:
    1. deposit banks without any lending acticities; these would handle receipts and payments, and custody of their customers' deposits, the related costs being charged to the latter;
    2. lending banks borrowing for fixed terms and lending funds at shorter terms, the overall amount of loans not exceeding the total amount of borrowed funds;
    3. investment banks borrowing directly from the public or from the lending banks and investing the borrowed funds in companies.

    Un extrait des propositions de Maurice Allais exprimées dans « La crise mondiale d’aujourd’hui »

    1. KK,

      That's a very informative comment. Many thanks. I've put the link in.


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