Thursday, 28 June 2018

Deposit insurance would be OK under Vollgeld.

The question as to exactly what form deposits should take under full reserve banking (aka Vollgled aka Sovereign Money) is tricky. The paragraphs below are an attempt at an answer.

The basic problem with the existing bank system is that commercial banks (henceforth just “banks”) create money, and as the French economics nobel laureate Maurice Allais said, that amounts to counterfeiting. To be more exact, what’s wrong with that form of money creation is as follows.

Money creation by central banks and governments (henceforth “the state”) can be done at virtually no cost. As Milton Friedman (who supported Vollgeld) 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."  In contrast, money creation by banks costs a significant amount because banks have to check up on the credit-worthiness of those they supply money too, allow for bad debts etc. Thus state created money (base money) would seem to be the best option.

In a simple hypothetical Vollgeld economy (i.e. where only base money is allowed) keeping the economy at capacity is no problem: the state just issues enough base money to induce the private sector to spend at a rate that brings full employment.

In that hypothetical economy people and banks would lend to each other, and there is no obvious reason why interest rates would not settle down to some sort of genuine free market rate.

But if banks are not forcefully prevented from doing so, there’s a trick they can play and which they play big time in the real world: when a bank has received $X in deposits, it can lend out around $X while telling depositors their money is still available to them. And as long as only a small proportion of depositors try to withdraw their money at the same time, banks get away with that trick about 99% of the time. Hey presto: $X has been turned into about $2X. Money has been created.

That trick works because it is clearly cheaper for banks to fund loans via instant access deposits (on which little interest needs to be paid) as compared to long term deposits. The total amount of bank loans rises.

But that increases demand, thus assuming (as per the above assumption) the economy is already at capacity, the state then has to impose some sort of deflationary effect, like raising taxes and confiscating some base money off the private sector. In short, the effect of money creation by banks (as pointed out by Maurice Allais) is much the same as the effect of those naughty backstreet printers who turn out fake $100 bills: for every such bill put into circulation, government has to confiscate a genuine bill from the private sector.

The solution to the above problem, as pointed out by Vollgeld advocates, is to ensure that loans are funded via equity or something similar, like long term deposits that can be bailed in. That way, $X is no longer turned into $X. What happens is that when someone wants their money lending out, they buy shares in a bank or make a long term deposit, and that funds the loan, rather than instant access deposits funding loans. Shares and long term deposits, depending on the exact length of the deposit are not money. So there is no “money multiplication there.

Now while there is a clear distinction between shares and instant access deposits, there is no clear distinction between an instant access deposit and a two month or six month deposit. So where do we draw the line? Plus there’s the question as to whether deposit insurance should be allowed under Vollgeld. If it is, then the switch to Vollgled would be less of a wrench than it is commonly supposed.

Well as regards deposit insurance, there’d be nothing to stop people who want to lend out money person to person, and/or those who want their bank to lend out their money in the above hypothetical economy to arrange some sort of insurance. In a free market, anyone is free to arrange any sort of insurance they like. And as for state sponsored deposit insurance, there is nothing wrong with that either, as long as it pays for itself. Thus it is hard to see what would be wrong with deposit insurance under Vollgeld. Indeed, it is not insurance which results in banks creating money: it’s “maturity transformation” (i.e. “borrow short and lend long”) which creates money. Moreover it is precisely borrow short and lend long that makes banks fragile (as pointed out by Douglas Diamond), and results in catastrophes like Northern Rock and Lehmans.

The next question is: exactly how “long” should deposits be where depositors want their money loaned out? Well strictly speaking, if maturity transformation is to be abolished altogether, where for example deposits fund twenty year mortgages, then deposits need to be for twenty years. 

Clearly no one wants their money tied up for twenty years, but governments issue bonds with ten and fifteen year maturities. And those who buy those bonds and when they want to cash in can always do so by selling those bonds, maybe at a loss. So in a sense, twenty years would not mean twenty years.

Another possibility stems from the fact that money is defined in most countries as something like “stuff in a bank which is available to the depositor within two months or so”. Thus if that two month dividing line is adopted, then strictly speaking money is not created where a bank funds long term loans via deposits with a minimum two month maturity.

Clearly the latter idea is a bit of semantic trickery because there is not particular logic in making the dividing line two months rather than three or four.  However, on introducing Vollgeld, that two month dividing line would be a start: plus it would be away in introducing Vollgeld GRADUALLY. Gradual changes are always better than violent changes.

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