Thursday, 20 August 2020

Mervyn King’s ridiculous objections to full reserve banking.


 Mervyn King (former governor of the Bank of England) is quite sympathetic to full reserve (aka “narrow banking”) but he does list some objections – in Chapter 7 of his book “The End of Alchemy.”

His first objection or “disadvantage” (as he calls it) of full reserve is that  “….it would eliminate the implicit subsidy to banking that results from the ‘too important to fail’ nature of most banks. Banks will lobby hard against such a reform.”

Absolutely hilarious!  You might as well claim the fact that murderers or counterfeiters would lobby hard against harsher punishment for murder or counterfeiting is a reason not to impose a harsher punishment on murderers and counterfeiters!

As for the idea that we’re supposed to have any sort of sympathy for a bunch of bankster / criminals who object to losing a subsidy they’ve enjoyed up to now, have you ever heard anything so ridiculous?

OMG: we can’t have any “disruption”.

The second “disadvantage” he lists is that “….the transition from where we are today to complete separation of narrow and wide banks could be disruptive, forcing a costly reorganisation of the structure and balance sheet of existing institutions.”

Well the simple answer to that tired old objection to full reserve (as I pointed out several years ago in my book on full reserve) is that if a change is beneficial, the fact that the change involves significant initial costs is irrelevant because once the change is made, the benefits will continue to flow for decades if not centuries.

The change in the UK from a privatised health care system to the National Health Service just after WWII no doubt involved some “disruption”. Does that mean the NHS was not worthwhile?

Moreover, it is not at all clear that a switch to full reserve would actually involve any great disruption: Milton Friedman claimed the switch would be simple and easy. As he put it in chapter 3 of his book “A Program for Monetary Stability”, “There is no technical problem of achieving a transition from our present system to 100% reserves easily, fairly speedily, and without serious repercussions on financial or economic markets.”

Plus the US mutual fund industry switched to full reserve a few years ago. I didn’t notice the sky falling in when that happened, did you?

Next comes King’s third “disadvantage” (which I've put in green) which is that, “..the complete separation of banks into two extreme types – narrow and wide – denies the chance to exploit potential economic benefits from allowing financial intermediaries to explore and develop different ways of linking savers, with a preference for safety and liquidity, and borrowers, with a desire to borrow flexibly and over a long period.”

Complete nonsense!

Under full reserve, there’d be nothing to stop a bank setting up a department or fund which offered long term loans, while those buying into the fund were offered the possibility of withdrawing their money instantaneously or at sort notice.

Notice that I said “possibility” there: I did not say anything like “binding promise” that depositors would have guaranteed instant access to their money.

The distinction there is crucial: the basic reason why fractional reserve banks have failed regular as clockwork over the last two thousand years, is that they make that guarantee of instant access, and then find that they cannot come up with enough ready cash quickly enough, particularly where they’ve made a series of silly loans. (For some information on banking in Ancient Greece and Rome, see this article, entitled “The Problem of Fractional Reserve Banking, Part 1”, by Pater Tenebrarum.)

Financial intermediation would be more expensive?

Next, Mervyn King says   “Constraining financial intermediation would mean that the cost of financing investment in plant and equipment, houses and other real assets would be higher.”

Well clearly the removal of a subsidy currently enjoyed by banks, which as King says, is part and parcel of introducing full reserve, would mean higher rates of interest for borrowers. But the flaw in his argument there is that, as is widely accepted in economics, the GDP maximising price for anything is the free market price, i.e. the price that obtains in the absence of subsidies. At least, it is widely accepted that the free market price is the GDP maximising price, absent any obvious social reasons for going for some sort of non free market price.

Indeed, mortgagors in the UK in the 1990s paid almost three times the rate of interest they do nowadays. I don’t remember that being a disaster – do you?

Among other things, the main effect of lower interest rates is to raise house prices, thus roughly speaking, the effect of higher interest rates on house affordability is around zero!

In short, low interest rates are very definitely not an unmixed blessing. First, they result in higher house prices. And second, they result in more borrowing and debt.

Aggregate demand.

Mervyn King’s next objection to full reserve is that it does not deal with fluctuations in aggregate demand. Well no one ever said it would!!!  Doh!!

King makes that point in this passage (also in green): “Ending alchemy does not in itself eliminate large fluctuations in spending and production. In a world of radical uncertainty, where it is possible that households and businesses will make significant ‘mistakes’ about the future profitability of investment, there is always a risk of unexpected sharp changes in total spending."

Moreover, the existing bank system, fractional reserve, does not deal with “sharp changes in total spending” either! So it is complete and utter nonsense to claim that the inability of full reserve to deal with those “sharp changes” is any sort of weakness in full reserve.

And if any readers think the existing fractional reserve system does in fact deal with “sharp” reductions in spending, perhaps they could explain why governments and central banks the World over have found it necessary to create and spend astronomic and unprecedented amounts of money in reaction, first to the 2007/8 bank crisis, and second, in reaction to the Covid crisis.

Asset prices.

Next comes a paragraph which starts (also in green) “Ensuring that money creation is restored to government through the requirement for narrow banks to back all deposits with government securities does stop the possibility that runs on the banking and shadow banking sectors will transmit shocks at rapid speed right across the financial sector, as happened to such devastating effect in 2008. But the risk from unexpected events is then focused on the prices of assets held directly by households and businesses and on the solvency of wide banks. It would be possible for governments to stand back and allow the prices of real assets and claims on those assets, including the prices of the bonds and equity of wide banks, to take the hit.”

Now wait a moment. We’re in the middle of an absolute whapper of an “unexpected event” right now: the Covid crisis. And governments and central banks have responded to that by doing money creation a la full reserve: i.e. having the central bank create money,  government spending it.

But where is the “hit” for asset prices?  It’s nowhere to be seen!!!

The stock market, while it did suffer a temporary dip when the Covid crisis first appeared, is now back to where it was. As for house prices, doubtless Covid has hit the house market, but actually prices in the UK are slightly up on a year ago.


To say that Mervyn King hasn’t the faintest idea whether he’s coming or going would be too kind: he’s quite obviously clueless, like most of the elite, bumbling Boris Johnson in particular. 



P.S. 22nd August 2020.   I should have mentioned another flaw in Mervy King’s claim that it’s desirable to link  “…savers, with a preference for safety and liquidity, and borrowers, with a desire to borrow flexibly and over a long period.” The flaw is thus.

If one lot of investors in a corporation make their investment more liquid, that inevitably means the investment held by the remaining investors in the corporation become LESS liquid or at least less money-like. To illustrate, if a corporation is funded entirely by equity, and say 30% of shares are turned into bonds, that simply means that as confidence in the corporation or in the stock market generally ebbs and flows, the gyrations in the price of the remaining shares will become more volatile. I.e. those shares will become less money-like.

And if that does not entirely negate the “liquidity increasing” of the former lot of investors, there’s another point, which renders the entire “liquidity increasing” exercise pointless, which is as follows.

If an investment made by a bunch of people or institutions is in relatively ILLIQUID form, say in the form of equity, and that is then turned into a more liquid form, then that investment becomes more money-like. Thus in effect, the money supply rises – at least on a relatively broad definition of the word money.

But there’s a problem there, namely that the larger the money supply, the higher will aggregate demand be all else equal. Thus assuming demand is as high as it can go without sparking off excess inflation, the effect of the above people and institutions expanding their stock of money is that government and central bank will just take some sort of countervailing measure like  - er – running a lower budget deficit or even running a surplus and confiscating an amount of money from the private sector approximately equal to the above mentioned INCREASE in the stock of money.
The conclusion is that while it is hard to see why any group of investors should be actually prevented from trying to make their investments more liquid, no great social purpose is served by that activity, i.e. there are no advantages for the economy as a whole. Thus when it comes to re-designing the bank system, and contrary to Mervyn King’s suggestions, no weight need be attached to the desire by some investors to make their investments more liquid.

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