Wednesday, 26 August 2020

The volleys fired by Charles Goodhart at full reserve banking just bounce off.


The “volleys” dealt with below consist of a very long comment by Goodhart on an article by Patrizio Laina here. Goodhart is a former member of the Bank of England's Monetary Policy Committee and professor at the London School of Economics.

Patrizio Laina’s article is in “Economic Thought” 2015, Vol 4 No 2.

1. Goodharts first error is his suggestion that because arguments for full reserve have been appeared on and off for a long time, that therefor those arguments can be described as a “hardy weed”. If Goodhart needs to resort to pejorative remarks to support his case, that rather indicates a weakness of his case.

Moreover, the claim that an idea is invalid simply because it is an old idea is just glorified false logic.  The idea that two plus two makes four is a very old idea.

2. He says “. If the risky banks, making the loans to the private sector, can issue short-dated liabilities, (even if they cannot issue demand deposits) whether wholesale or retail, say with a tenor of about seven days, then absolutely nothing has been done to make financial stability greater, rather the reverse. The risky banks would still make loans by writing up both sides of the balance sheet, with the exception that the liability side would initially be in the form of a seven day time-deposit rather than a demand deposit.”

Well who ever said that under full reserve banks WOULD BE allowed to fund their loans via term deposits of seven days? No one that I know of. Under full reserve, deposits in their current form, whether instant access, seven day or one month, are plain simple not allowed.

That is, commercial banks are not allowed to fund loans via deposits which are described by banks as being totally safe. And that is what a traditional deposit is: money placed with a bank which the bank promises to return to the depositor.

Instead, those wanting to fund a bank or bank department which lends out money are told loud and clear that they may not get their money back in exactly the same way as those placing money with stockbrokers, pension funds or unit trusts or mutual funds are given the same loud and clear message. That puts banks on a level playing field with respect to those other lenders, and quite right too. I.e. there is no excuse for preferential treatment for an entity just because it calls itself a “bank”.

Plus if there is a clearly stated risk that so called depositors may not get all or any of their money back, those so called deposits are no longer deposits: they are equity.

3. Next Goodhart says “For obvious reasons, such funding would be considerably more expensive than that facing banks at present.” The implication there clearly being that some sort of overall hit for the economy results from that interest rate rise.

Well that’s a popular criticism of full reserve, but as I’ve been pointing out for several years, there’s simple flaw in that argument, as follows.

If a rise in the price of something (the price of borrowed money or anything else) stems from removing an unjustified subsidy of that item, then far from cutting GDP, the effect will be to increase GDP. And there is widespread agreement that banks are subsidised.

As to exactly which subsidies are removed under full reserve, there is the taxpayer backed deposit insurance enjoyed by banks and the multi billion dollar bail outs which are available when banks mess things up, luxuries not available to the other lenders mentioned above. Plus there is the point that it is widely accepted that it is not the job of taxpayers to stand behind any kind of commerce, absent very good social reasons for doing so. And depositing money at a bank with a view to getting interest is every bit as commercial as depositing money at a stockbroker with the same end in view. Neither of those activities should be protected by taxpayers in any shape or form.

As for any deflationary effect stemming from the reduced amount of lending that might take place under full reserve, that is easily countered via more stimulus. And stimulus dollars, as Milton Friedman said, cost nothing in real terms to produce.

The net result would be less lending and debt based economic activity, and more non debt based activity.

Goodhart ends his objections to the higher interest rates that would probably obtain under full reserve by saying “I doubt whether a narrow banking system would prove attractive in practice to the majority of bank clients.”

Well I’m sure it wouldn’t. Removing the implicit subsidy that coal mines currently get in that they are not charged for the enormous environment damage they do would doubtless not “prove attractive” to coal mine owners.

And finally, given the dramatic fall in interest rates over the last thirty years and the very respectable growth that obtained in the 1990s despite rates being much higher than today, it is far from clear that a rise in rates would be harmful. Low rates are not an unmixed blessing: among other things they have helped the dramatic rise in the price of houses in real terms over the last thirty years.

4. Next, Goodhart says “If we really wanted to get banks back to their original safer form, we should do this by a reform of property lending, with such lending undertaken on the basis of long-dated liabilities, such as covered bonds and equity.”

Well now, that’s what full reserve is!!  It consists of funding loans via equity. Of course Goodhart’s latter suggestion does not EXACTLY equal full reserve, but nevertheless it is strange for an opponent of full reserve to sing the praises of the fundamental characteristic of full reserve!

5. Goodhart’s next mistake is where he says “. But one of the problems with most of the narrow banking (FRB) proposals, is that they make the provision of monetary base far too inelastic.”

Well “provision of monetary base” is ENTIRELY the province of the central bank (CB), both under the existing system and full reserve. CBs can boost or rein in monetary base in whatever quantity they want whenever they want. For example they have implemented an astronomic and unprecedented increase in the base under QE over the last five years. There’d be nothing to stop central banks doing the same under full reserve.

Plus there’d be nothing in principle under full reserve to stop CBs doing helicopter drops, though I’d prefer it if their largesse was distributed in a way approved of by democratically elected politicians: e.g. if politicians want the largesse to go to pensioners and the unemployed, then that’s where it should go.

6. Next, Goodhart says “. I have tried to argue that forcing all credit provision to be done on the basis of long-term liabilities would not be in the best interests of most of society, and, if so, they will get around such government regulations.”

So is he saying that where banks attempt to get round regulations that’s because of bank’s saintly desire to do what’s “in the best interests of most of society”? If so, perhaps Goodhart can explain why US banks have had to pay a total of around $250billion in fines and out of court settlements over the last ten years for “in the best interests of most of society” activities like money laundering.

7. Goodhart’s final argument, before his Appendix (passage starting “Financial intermediation is probably…”) is that modern technology is bringing about substantial changes in the way banks work, thus “the attempt to constrain the core of the financial system into the proposed division of narrow banks and risky lenders will not work in any case.”

Well the simple answer to that is that modern technology is forcing substantial changes to the EXISTING banks system as well!!  A classic example is that credit and debit cards are making the old laws on legal tender very dated. That is, according to those laws, a creditor cannot refuse central bank issued money (e.g. £10 notes) in settlement of a debt or in payment for something. But debit and credit cards are now so widely used that some shops are refusing to take physical cash. To my knowledge, none have been prosecuted for doing that.

Put another way, there is no obvious reason a full reserve system cannot cope with changes in technology any more than the existing “fractional reserve” system cannot cope with those changes. 


Given that Charles Goodhart does not seem to have much of a grasp of this subject, I won’t bother with his appendix. Hopefully I’ve demonstrated that his views can be taken with a pinch of salt.

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