The basic premise of the Vickers report is flawed.

 Vickers advocates separating retail from investment banking so as to prevent problems in the “socially useless” casino section of the banking industry damaging essential or “socially useful” banking activities. (The phrase “socially useless” is a quote from the head of the Financial Services Authority rather than a quote from Vickers.)

The Independent Commission on Banking report (aka the “Vickers” report) quite rightly wants to prevent banks exposing taxpayers to risk. They say “The risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers.” And again, “One of the key benefits of separation is that it would make it easier for the authorities to require creditors of failing retail banks, failing wholesale/investment banks, or both, if necessary, to bear losses, instead of the taxpayer.

Unfortunately, they then go on to advocate the inclusion behind their “ring fence” of activities which are not 100% safe, and which thus inevitably expose the taxpayer to risk. These include mortgages, loans to small businesses and possibly to large businesses.

So why the self-contradiction? The explanation is in this sentence where they say, “The economy would suffer if separation prevented retail deposits from financing household mortgages and some business investment.”

The flaw in that idea is that it assumes there is some sort of fixed amount of money available to an economy. I.e. they’re assuming that if money from retail deposits is not invested, then investment declines. That is not true. I.e. if restrictions are put on the way money is used, clearly the economy will “suffer” ALL ELSE EQUAL. But of course there is absolutely no reason why all else need be equal.

In particular, it is very easy to make up for the deflationary effect or “suffering” effect of placing a restriction on how money is used by increasing the country’s money supply. And the costs of doing that are ZERO.

In the words of Milton Friedman, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.” That’s from Ch3 of his book “A Program for Monetary Stability”.

Having done that, every household and firm would then have a larger stock of money, and thus would NOT NEED to borrow so much. And as to households and firms with surplus cash, not doubt some would invest in interest or dividend earning investments, to which extent the total amount lent or invested would not decline. But possibly the total amount invested WOULD DECLINE somewhat. But so what? The important point is that full employment is still achievable, plus we would have dispensed with a totally unwarranted subsidy: the subsidy of banks.

In short there is choice between using a small amount of money in a dangerous fashion, and alternatively, creating more money, and employing it to set up a safer banking system. Likewise you can absorb a relatively small amount of time doing a car journey by exceeding the speed limit, or you can absorb more time and travel more safely.

In other words, the much vaunted “fence” should be placed between the two following activities. First, bank accounts which the state insures, but which are near 100% safe ANYWAY because the relevant money is just not invested, i.e. not put at risk. Second, there are interest earning or dividend earning forms of saving. But this is a COMMERCIAL activity, and while commercial activity is laudable, there is NO OBLIGATION on taxpayers to underwrite it.

That way it’s virtually impossible for banks to fail, plus there is no taxpayer subsidy worth talking about for banks. Of course, lenders and investors still stand to make substantial losses, but then they run that risk ANYWAY: stock markets crash from time to time. But as Mervyn King pointed out, the effects of stock market crashes are nowhere near as severe as the effects of a collapse of the banking system. Seems they aren’t as severe as the effect of a near collapse of the banking system which is staved off by billions grabbed from the taxpayer, if the last five years are any guide.

Bankia director admits she knows nothing about finance.

Just in case you didn’t realise that there’s a fair sprinking of oafs, imbiciles and criminals in high places:

 a former director at Bankia, Mercedes Rojo-Izquierdo, admits she knows nothing about finance.

Removing bank subsidies leads to full reserve banking.

The major and glaring flaw in fractional reserve banking is that it needs subsidising: it needs taxpayer funded backing. And any subsidy is a misallocation of resources (absent overriding social considerations or market failure).

Frances Coppola accepts that the above subsidy is unwarranted, but supports fractional reserve nevertheless. That on the face of it is an untenable position. I’ve enjoyed thrashing out banking and monetary issues recently with Frances recently here, and I’ve learned plenty in the process.

She says “I can't begin to justify protecting even small amounts of savings by extracting money from people who are too poor to save at all.” And: “I also agree with you that there should be no taxpayer protection for investments, including interest-bearing deposit accounts.” I agree with both statements.

Just to confirm my above claim that removing subsidies leads inexorably to full reserve, I’ll now try to prove the point. Here goes.

ONE WAY of ensuring 100% safety for depositors without any significant taxpayer backing is simply to prevent banks lending on or invest the relevant sums. After all, it’s the fact of those loans or investments going bad that brings banks down.

But of course that means the relevant money is doing nothing. It’s not earning interest, which in turn means the relevant depositors get no interest. And that is a type of account which would certainly suite SOME DEPOSITORS. That is, the deal is: “your money is 100% safe, but there is a penalty to pay, which is you get no interest, and will probably have to pay bank charges”. Indeed, that is hardly a big change from the average current account available at present in the UK. Those accounts normally pay no interest, and in many cases depositors pay bank charges.

But the above is not what every depositor wants, and second, stopping all bank lending would have obvious dire consequences.

Ergo, a depositor must be allowed to let their bank lend on or invest the depositor’s money. But how do we effect that while ruling out taxpayer support? The only way is to have the depositor carry the costs in the event of the underlying loans or investments going bad. And that in effect means the depositor is not so much the holder of a specific sum of money, but is rather the holder of shares in a selection of loans and/or investments.

 
Money creation.
 
Now as regards “safe” accounts (i.e. where money is NOT loaned on) no money creation takes place, and for the following reasons. Where a bank accepts a deposit of £X and lends on the £X, both depositor and borrower then regard themselves as having £X. That is, £X has been turned into £2X. So “no lending on” equals no money creation by banks.

As regards deposit or interest earning accounts, the depositor just doesn’t have quick access to their money. So arguably no money creation takes place their either. That is, the borrower gains £X, while the depositor loses £X (but gains what amounts to a share in the underlying loans or investments). And in fact so called money in deposit accounts (other than very short term deposit accounts) is just not counted as part of the money supply in most countries. 

Provisional conclusion: disposing of taxpayer backing for deposits leads to a regime in which commercial banks do not create money, i.e. where the only money creating entity is the central bank. And that equals full reserve.  

 
Maturity transformation.
 
However, there is a slight flaw in the latter conclusion which is that the EXACT EXTENT TO WHICH money in a deposit account is counted as money is a grey area. To illustrate, if money in a deposit or “investment” account can be accessed within say a week, that is little different to a current account (or to use U.S. parlance, a “checking” account).

Indeed, there are mutual funds in the US which offer cheque books to “depositor / investors”.

But note that where deposit accounts are in effect current accounts, maturity transformation takes place. I.e. “borrow short and lend long” takes place. Plus money creation takes place. That is both borrower and deposit account holder regard themselves as being in possession of that £X. 

Or to be more accurate, assuming no recession, and assuming the relevant bank is run in a competent manner, the value of a bank’s loans and investments should pretty well equate to or even exceed their nominal value, thus where someone has put £X in a deposit account they can be 99% sure of getting £X out fairly quickly.

 
Should we allow maturity transformation?
 
And that leads to the question as to whether we allow maturity transformation (MT) . Well the answer is “absolutely not”, because the basic argument for MT just doesn’t add up, and for the following reasons.

That “basic argument” for MT is that it enables a country to make best possible use of its money supply. That is, under MT, much of the money in current accounts can be invested or loaned on. But the flaw in that argument is that money is simply a book keeping entry: it is “stuff” that is costless to produce. Money is not a REAL ASSET like say the cars owned by a car hire firm or hotel rooms. It makes sense to keep cars and hotel rooms as fully employed as possible.


But that argument does not apply to money. Put another way, if MT is forbidden, that will certainly have a deflationary effect, but the latter effect is easily countered by increasing the money supply (something which, to repeat, can be done at zero real cost).

So there is a choice as follows. Option No 1 is to allow MT. But that involves a risk because MT is inherently risky: borrowing too short and lending too long has brought down hundreds of banks throughout history, Northern Rock being just a recent example. And Option No 2 is to forbid MT. That makes banks safer, which is a REAL BENEFIT. As to the corresponding cost (expanding the money supply) that just ain’t a REAL COST.

Ergo MT should be banned. And if MT is banned, then commercial banks don’t create money. So in that scenario only money creating institution is the central bank. And that equals full reserve banking.

Quad Erat Demonstrandum.

Charlie Bean’s three mistakes.

Charlie Bean is deputy governor for monetary policy at the Bank of England. In this recent speech he makes three mistakes (not something I ever do, of course).

First, he trots out a piece of conventional wisdom, namely that banks should be safe enough to reduce risks to acceptable levels, while not ending up with the stability of the graveyard. In his words he wants to ensure the “resilience of the financial system in a way that does not unduly impede economic growth.”

Well now, would reducing the risk of bank failure to near zero actually impede economic growth? Certainly not. At least not if we adopt the banking regime advocated by Positive Money / Richard Werner and the New Economics Foundation. See here.

Under that regime, the loans and investments made by banks are 100% covered by loss absorbing creditors (of each bank). In particular, depositors who want interest, i.e. who want their bank to lend on or invest their money carry the costs if and when those loans or investments go bad. That way, the bank itself cannot fail (absent blatant criminality by senior bank staff).

Now does that impede that much vaunted “economic growth”? Far from it! It actually results in a better allocation of resources and for the following very simple reason.

If someone invests directly in a small business or in corporation X, Y or Z on the stock exchange and it all goes belly up, the investor takes a hit, or may lose everything. But if the same investor plonks money in a bank and the bank invests in or lends to small businesses or corporations X, Y, Z, etc and it goes belly up, the taxpayer comes to the rescue for some bizarre reason.

That is a TOTALLY UNWARRANTED AND IRRATIONAL subsidy for banks. It is a distortion of the market. It’s a misallocation of resources. And any misallocation of resources hits economic growth.

Conclusion: far from bank safety and economic growth being in any way mutually exclusive, virtual 100% bank safety (done the above way) actually ENHANCES economic growth.

The second mistake.

Bean’s second very questionable claim (p.3) is that central banks can forsee credit crunches and should act to ameliorate them before the event. Now that idea is straight out of cloud cuckoo land.

What proportion of “professional” economists foresaw the recent crisis? 1%? Or was it nearer 0.1%?

The third mistake.

Next, Bean claims that with a view to ameliorating crises, a central bank should “undershoot its inflation target temporarily, if it believes that it will thereby improve its chances of meeting the target later on by avoiding a disruptive bust.” (This of course assumes that central banks really can foresee crises.)

Now “undershoot it’s inflation target” is weasel words for “impose a mini-recession and excess unemployment”. And that’s not too clever – unless there’s no alternative.

But there is a blindingly obvious and very simple alternative! That’s to counteract the recessionary effect of raised interest rates with fiscal stimulus. Simple. That way a country gets less lending based economic activity and more non-lending based activity.

______

Thanks to Gary Brooks for bringing the above Bean article to my attention.

Krugman thinks money is a scarce resource.

In arguing against narrow banking, Krugman trots out the old and wholly fallacious idea that there is some benefit in maximising the use of the available stock of money. He says:

“I think of the whole bank regulation issue in terms of Diamond-Dybvig, which sees banks as institutions that allow individuals ready access to their money, while at the same time allowing most of that money to be invested in illiquid assets. That’s a productive activity, because it allows the economy to have its cake and eat it too, providing liquidity without foregoing long-term, illiquid investments. If you were to enforce narrow banking, you would be denying the economy one of the main ways we manage to reconcile the need to be ready for short-term contingencies with the payoff to making long-term commitments.”

The flaw in that argument is that money is simply a book keeping entry. That is, both central banks and commercial banks can simply create money, and in almost limitless amounts, whenever they see fit. There are of course important differences between central bank and commercial bank money, for example the former is legal tender and the latter is not. Nevertheless, both types of bank are free to create money out of thin air.

Or as Milton Friedman 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” -  (Ch 3 of his book “A Program for Monetary Stability”).

Now that freedom to create money, at least on the face of it, means there is no crying need to maximise the use of the available stock of money. A second point that calls the above point into question, is that it is precisely borrowing too short and lending too long that has brought down numerous banks throughout history, Northern Rock being just a recent example.

So there is a choice. We can have a relatively small money supply with a high velocity of circulation, or a larger money supply with a slower velocity. And presumably there must be some optimum on that scale.

Now in determining where that optimum is, the fact that money can be created at zero real cost  means that the AMOUNT of money needed to attain the optimum is a total irrelevance. I.e. the only important consideration is: what’s the safest banking system?

And a further reason for going for maximum safety is that when banks do go under (particularly large ones), the taxpayer picks up the pieces, and for the simple reason that no private insurance firm has to resources to mount a rescue. Indeed, even entire COUNTRIES have been reduced to virtual bankruptcy in the recent banking crises (Iceland and Ireland for example). Thus ANY taxpayer guarantee is a subsidy of the banking industry, and subsidies do not make economic sense (unless someone can produce some very good reasons for a subsidy).

Well now, given that ANY amount of maturity transformation inevitably involves risks, however small, the inescapable logic is that we should just forbid it altogether!  That is, 1. Just forbid banks from using money in instant access accounts for long term loans.  2. Allow long term loans (there’s nothing wrong with those), but only allow them to be made using money that depositors have placed in deposit or “term” accounts. 3. Have the government / central bank machine print and spend whatever amount of money is needed into the economy so as to negate the deflationary effect of forbidding maturity transformation.

So that’s Krugman’s point  about maturity transformation being a “productive activity” demolished, unless I’ve missed something.