Frances Coppola’s absurd ideas on full reserve banking.

I’m going to run through an article she wrote entitled “Martin Wolf Proposes the Death of Banking”.

First though a brief introduction to full reserve (FR). FR banking is very simple. It consists of the following (in blue). Skip if you like.

The bank industry is split in two. One half offers totally safe accounts where money is simply lodged at the central bank, or maybe also invested in government debt. The other half offers normal bank loans, but that half is funded only by shareholders, or people who are effectively shareholders. For example the latter half can take the form of mutual funds (unit trusts in the UK) with investors having a choice as to what is done with their money, i.e. a choice as to which particular fund they put their money into. The advantages of that set up are:

1. The first half cannot fail. As to the second half it cannot suddenly go insolvent, though a slow decline and consequent takeover by another bank is certainly possible.

2. That means no more credit crunches and subsequent recessions. It also means an end to bank subsidies, an objective which those in charge of reforming bank regulations have set themselves, but which they’ve largely failed to achieve.

3. There’d be no reason under FR for the current limits on how much of depositors’ money is guaranteed (£85,000 in the UK at the time of writing). That is because offering that guarantee under the existing system, where the guarantee is taxpayer funded (as is the case in the UK) is a GENUINE liability for governments (i.e. taxpayers). In contrast, safe accounts under FR are GENUINELY SAFE. Thus there is no reason to limit the guarantee. Moreover the guarantee can be extended from INDIVIDUALS to firms and corporations.

Frances’s article.

As to Frances’s article, its only merit is that she criticises an IMF paper by Messers Benes and Kumhof which advocated full reserve (FR). Agreed. I don’t think much of that paper either.

Next she makes the point (and indeed repeats the point throughout the article) that FR means the end of banking as we know it, hence the title of her article no doubt. (E.g. see her paragraph starting “But there is a problem”)

Well the simple answer to that is that advocates of FR are PERFECTLY WELL AWARE that FR involves a change to banking which is so large and fundamental that successor entities or institutions can arguably no longer be called banks. To illustrate, Matthew Klein penned a Bloomberg article which explains Laurence Kotlikoff’s ideas on FR, and the title of the article is “The Best Way to Save Banking is to Kill It”. That implies a pretty big change.

However, the fact of advocating reform of something that is so fundamental that previous definitions of relevant words like “bank” no longer apply is NOT AN ARGUMENT against such reforms. 

Payments systems.

Next she makes the absurd charge against Kotlikoff (and indeed Bennes and Kumhof) that they “completely ignore the crucial role of banks in facilitating payments”. Messers Bennes, Kumhoff and Kotlikoff would have to be mentally sub-normal not to be aware that it is necessary for people and firms to make payments to each other. And I suspect those three individuals are not mentally sub-normal.

Interest.

In the next two paragraphs (starting “The third proposal..”) she addresses the point that under FR, those who want a return on their money put their money in special accounts which actually amount to mutual funds (unit trusts in the UK).

But she doesn’t like that, and says, “But once again, there is a problem. Banks are not fund managers.” Well under the EXISTING SYSTEM banks’ main job is not fund management, but under FR that is their main job!

To object to banks becoming fund managers is a bit like objecting in the 1800s to ships being powered by steam on the grounds that “ships are powered by sail”. To repeat, the fact that a reform is fundamental is not an argument against the reform.

Incidentally the above claim that banks are not fund managers is not correct for another reason: banks already manage hundreds of mutual funds with billions invested in them!

  

Bank desposits.

Next, she tells us that “People put money in banks for two reasons: because they want safety AND a return” and seems to bemoan the fact that people can no longer get that combination, i.e. safety and return.

Well that’s for a VERY GOOD REASON. And this goes right to heart of the basic argument for FR which Frances doesn’t seem to get. So I’ll explain.

Lending or investing money INEVITABLY involves risk, and for the blindingly obvious reason that borrowers sometimes don’t repay loans, and investments sometimes go wrong. And SOMEONE SOMEWHERE has to carry that risk. If it’s not the person lending the money then it’s  . . . wait for it . . . .probably the taxpayer!

Frances may or may not have notice the TRILLIONS of dollars of taxpayers money needed to rescue banks over the last few years: certainly everyone else noticed.

In short, if you want that much vaunted “safety and return” then you are asking to be subsidised. FR disposes of that subsidy. The UK’s Vickers commission backed the idea that bank subsidies should be removed, as did Dodd-Frank (though both Vickers and Dodd-Frank failed miserably so far as subsidy removal goes, in  contrast to FR which succeeds in that respect).

Incidentally, the word “subsidy” does not appear in Frances’s article: obviously existing bank subsidies are a big defect in the existing bank system, so if you’re defending the existing system, what do you do about that defect? Well it’s easy: just don’t mention it! But Frances is nowhere near the only defender of the existing bank system to omit the word “subsidy” from articles and papers. Messers Diamond and Dybvig were guilty of the same omission in a paper in 1986 entitled “Banking Theory, Deposit insurance and Bank Regulation”.

The second reason for depositing.

The second reason she cites for “people putting money in banks” is “because they need liquidity (including access to payments systems)”. You don’t say? Notwithstanding her charge against Benes, Kumhof and Kotlikoff, namely that they apparently aren’t aware that payments need to be made, FR offers accounts which are the basis for making payments with cheques, debit cards, etc in EXACTLY THE SAME WAY as the existing banking system (e.g. the safe accounts proposed by Positive Money). So quite why she comes out with the revelation that people put money in banks because they want “liquidity and access to payments systems” is a bit of a mystery.

 The morning mist.

Next she criticises the half of the bank industry funded by shares (non-money market mutual funds in the case of Kotlikoff’s system and “investment accounts” in the case of Positive Money) on the grounds that:

“I fear that the “investment accounts” Kotlikoff and Positive Money envisage would disappear like the morning mist once the deposit insurance that time and sight deposit accounts currently enjoy is removed. Positive Money UK's proposal therefore probably means the end of commercial banking, unless they could find other sources of funding.”

Now the phrase “morning mist” is wonderfully evocative, and it will impress simpletons and pseudo intellectuals. As for cold logic, the simple fact of saying you “fear” something will disappear is a hopeless argument.

There is actually a very good reason why there would be demand for the shares in the share funded / equity funded / mutual fund half of the bank industry, and that’s that the people ALREADY invest billions (or perhaps it’s a trillion or two) in stock exchange shares. They do that both as individuals and as subscribers to pension funds: i.e. large numbers of people opt for pension schemes where the eventual payout is stock market related.

Lending and debts decline under FR.

Having said that there would be significant demand for shares in lending entities, that is not to say that the volume of lending (and hence debts) under FR would be EXACTLY THE SAME as under the existing system: it would certainly be a bit less.

But that’s for the very good reason that, to repeat, FR removes a subsidy from the borrowing / lending process. That is it forces lenders to foot the entire bill for their little enterprise: lending in the hope of making a profit. And in that a subsidy is removed, the result ought to be increased GDP.

Funding lending entities.

The first sentence of the next paragraph reads “But it is perhaps more likely that commercial banks would find ways of lending without relying on customer deposits for funding.” More likely? What? It’s not “more likely” that “banks would find ways of lending without relying on deposits”: they’d sodding well be FORCED TO DO THAT!  The law under FR would stipulate that that’s what they have to do, else its fines or prison sentences.

Responsibility for lending decisions

Next, she says “Completely eliminating fractional reserve lending means removing banks’ responsibility for lending decisions.” Whaaat?

Under FR (for the umpteenth time) lending entities are funded just by equity, by shares. Why on God’s name does that “remove” their “responsibility for lending decisions”?

If a garage is funded just by shares in the garage held by the person running the garage and relatives (and doubtless that’s how many garages ACTAULLY ARE FUNDED) does that “remove the garage’s responsibility for car repair decisions”?

The committee.

Next, she says, “Wolf’s idea amounts to replacing a demand-driven money supply creation mechanism with central planning of the money supply by a committee. Central banks’ record on producing accurate forecasts of the economy is dismal….”.

Now wait a moment. Under the EXISTING SYSTEM, central banks do a lot of forecasting and determine stimulus (e.g. by adjusting interest rates, QE, etc). So in criticising central banks incompetence, Frances is as much criticising the EXISTING SYSTEM, as FR!!!!

Moreover, under the EXISTING SYSTEM, central bank committees adjust the MONEY SUPPLY when they implement QE. Indeed, fiscal stimulus followed by QE comes to exactly the same as the form of money creation advocated by Positive Money!

And the first sentence of her last paragraph reads “Personally I would prefer the money supply to respond to demand rather than be decided by a committee…” Well now that’s truly hilarious and for the following reason.

Prior to the credit crunch the money supply was very much being determined by supply and demand. And what do you know? Banks were creating and lending out money like there’s no tomorrow, i.e. in a totally irresponsible manner. (See chart below). Then came the crunch, and as always happens, commercial banks suddenly stopped their money creation activities (exactly what we don’t want them to do in a crunch).

Frances’s claim that there are big merits in having the money supply determined by supply and demand is patent and obvious nonsense.

The intellectual dishonesty of Vickers.

In arguing against full reserve banking, Vickers said (para 3.20):

“Since lending to the private sector necessarily involves risk, such banks would not be able to use the funding from deposits to make loans to individuals and small and medium size enterprises. Should ring-fenced banks be allowed to make such loans? If ring-fenced banks were not able to perform their core economic function of intermediating between deposits and loans, the economic costs would be very high.”

“Very high”? Where do they get that from? Well here’s a clue. On the subject of “very high”, Vickers’s so called “Interim Report” said something very similar to their “Final Report”. The interim report actually said “Like narrow banking, a complete move from fractional to full reserve banking would drastically curtail the lending capacity of the UK banking system, reducing the amount of credit available to households and businesses and destroying intermediation synergies.”

But according to Ben Dyson’s book “Modernising Money”, “In response to requests, the commission would not clarify what they meant by drastic”.

In short, and as far as those phrases “very high” and “drastic” go, it looks as though Vickers is making it up as it goes along.

But never mind. It’s not too difficult to come up with some more intelligent ideas here than Vickers managed as regards the effect of full reserve banking on “…the amount of credit available to households and businesses”.

Under full reserve, those funding businesses and mortgages have to bear the full cost of what they do, as distinct from the existing system under which taxpayers bear the ultimate risk involved in that funding or lending. And that’s the main difference between the existing system and full reserve.

Thus full reserve DOES INVOLVE increased costs for borrowers, BUT ONLY TO THE EXTENT of removing the above taxpayer funded subsidy. Moreover, Vickers’s two reports (interim and final) just like Dodd-Frank clearly state that subsidies are undesirable.

So Vickers advocates the removal of bank subsidies at the same time as objecting to a system which actually removes those subsidies!!! Dear oh dear. And to add insult to injury, Vickers failed to remove bank subsidies for reasons I spelled out in the post just before this one.

Now if Vickers is not well and truly in check-mate there, then obviously I don’t understand the meaning of the phrase “check-mate”.

The delusional Vickers Commission.

The UK’s Vickers Commission was the equivalent of Dodd-Frank in the US. Dodd-Frank was so hopeless that Richard Fisher of the Dallas Fed said, “..the act has made things worse, not better”.

As for Vickers, I particularly like this passage from section A3.3:

“On structure, the proposal is for a ring-fence which would allow vital banking services such as deposits of individuals and small and medium size enterprises to be provided continuously, without the provision of taxpayer support, and insulate them from shocks elsewhere in the financial system.”

Dear oh dear. The taxpayer funded deposit guarantee that operates in the UK is a form of “taxpayer support” for banking. Nowhere in the Vickers report is there any suggestion that that guarantee be removed.

Second, lender of last resort is another form of public support for private banks. Or to be accurate, lender of last resort is not a subsidy if the support or loans to private banks by the central bank is at a penalty rate of interest. But of course it’s not. Again, no suggestion in the Vickers report that that form of support be removed. Indeed, the phrase “lender of last resort” does not appear in the Vickers report.

The Vickers commission clearly wouldn’t recognise “taxpayer support” if it stared it in the face.

Tim Worstall goes off the rails.

Tim gets an awful lot right, but he want off the rails in this Forbes article. (I would have commented there, but Forbes makes it difficult.)

Tim quotes a sentence of Paul Krugman’s, namely: “The only piece of our system that seemed to have learned anything from history was the Federal Reserve, and the Fed’s actions under Ben Bernanke, continuing under Janet Yellen, are arguably the only reason we haven’t had a full replay of the Depression.”

And Tim deduces from that that: “The implication of all this being that it is monetary policy, monetarism, that is important in not having depressions, not fiscal policy.”

Nope. False logic. The fact that the Fed learned something from the 1930s depression does not prove that were politicians to learn the same lesson, that fiscal policy would not be effective in dealing with recessions. The fact that a wife learns something from a marital problem and the husband doesn’t, does not prove that were the husband to learn, that benefits wouldn’t derive from that: i.e. were the husband more clued up, benefits would probably flow from that.

Tim continues: “The stimulus that we did have, the fiscal policy that we did have, a larger fiscal policy even, would not have prevented a depression.” Oh yes? Where is the evidence? Tim doesn’t provide any.

Monetary policy involves printing money and stuffing the pockets of the asset rich, e.g. holders of government debt. That’s what QE consisits of. In contrast, fiscal policy involves feeding money into Main Street. I prefer the latter, and there is no reason for it not to work.

Private banks don’t exacerbate debts.

Positive Money, along with many others falls for the superficially plausible argument that private banks create a form of money which is “debt based”, thus the latter activity might seem to exacerbates indebtedness, ergo we should dispose of debt based money. There is actually a very good argument for doing the latter, i.e. disposing of debt based money (and more on that below). But the latter "superficially plausible" argument is not it. The flaw in the "superficial" argument is thus, and we’ll start with day to day transaction money as opposed to long term loans.

If you want £X of transaction money from a bank, the bank credits your account with £X which is an artificial debt owed BY THE BANK TO YOU. And you can force the bank to “owe” that money to someone else, using your cheque book or plastic card. Plus you undertake to eventually recoup the debt / money from the “someone elses’” and repay the £X to the bank. So initially there are two equal and opposite debts there. No net debt exists before you actually start to spend the money the bank credits to your account.

In fact there’s probably a THIRD debt: if you deposited collateral at the bank, the bank owes you that collateral when you repay the bank. So in that scenario, there is initially a net debt OWED BY THE BANK TO YOU!!!!! 

Spending starts.

Once you start spending your day to day transaction money, then your debt to the bank rises (or if you like, the bank’s debt to you falls). But let’s say everyone else in the economy has done the same as you: got themselves some transaction money which they spend. That money must end up somewhere, and some of it will end up in YOUR ACCOUNT, assuming like 99% of the population you have some sort of income (e.g. from work, benefits, etc). So on balance (to oversimplify the real world a little, but not by all that much) having private banks supply debt based transaction money does not result in increased debts.

Long term loans.

In contrast to day to day transaction money, there are LONG TERM LOANS, of which mortgages are the biggest example. Having got your long term loan from a bank and spent it, that money must again end up in someone else’s account.  But the someone else must be willing to leave it there for a longish period, and for the simple reason that if they didn’t, aggregate demand would rise as a result of you spending the money you borrowed. And if the economy is at capacity, a rise in AD is not permissible. (As to where the economy is NOT AT capacity, that’s dealt with below).

In short, private banks cannot create debt based money without willing savers. But in the absence of banks, those willing savers would still be there: they’d just lend direct to those wanting mortgages. Indeed that’s exactly what happens with collateralised debt (CDOs).

In short, disposing of debt based money does not in any DIRECT WAY reduce debts any more than ceasing to use gold coins as money means the World’s stock of gold declines. (There is actually a minor and INDIRECT way in which disposing of debt based money cuts debts, but I won’t go into that here).

As Keynes said, banks don’t do anything that wouldn’t happen anyway. All private banks do, so far as long term loans are concerned,  is to intermediate between savers and borrowers: i.e. assuming private banks work efficiently, they just make the lending / borrowing process more efficient.

Moreover, in the case of long term loans, those who have deposited money in banks for longish periods will tend to put the money on “term” or deposit accounts rather than in current or checking accounts. And normal practice round the world tends to be to not count as money sums deposited in term accounts.

Indeed Positive Money itself does not count as money sums placed in the investment accounts proposed by PM. Quite right.

The economy is not at capacity.

As to where the economy is NOT AT capacity, i.e. in a recession,  the fact of banks creating money out of thin air and lending it ABSENT THE EXISTENCE of willing savers, well the increased demand stemming from that wouldn’t matter. But it’s very doubtful as to what extent that  phenomenon actually takes place. That is, as Keynes pointed out, economies can get stuck in high unemployment equilibria. Put another way, private banks far from ameliorating booms and busts  EXACERBATE  them, if anything. Certainly prior to the recent crisis, banks in the UK were creating new money like there’s no tomorrow, then come the crunch, far from helping us escape the recesssion, they drastically CUT DOWN on their lending / money creation.

Conclusion.

In the case of transaction money, commercial banks do create money, but that does not give rise to debts. And in the case of long term loans, commercial banks just organise lending / debts that would exist anyway, but that tends not to result in money creation.

Ergo, contrary to PM’s claim in the above tweet, commercial bank money creation does not exacerbate indebtedness.

But that’s not to say there isn't a strong argument for disposing of debt based money and switching to a system that involves only debt free money (i.e. base money). The argument for doing the latter are not as suggested in the above tweet; it’s briefly as follows.

Money is a liability of a bank. Or to be more accurate, money appears on the liability side of banks’ balance sheets. (The extent to which that liability really is a liability in the case of central banks is debatable, but let’s gloss over that for the sake of simplicity.)

Next, money is fixed in value (inflation apart). That’s unlike the value of other assets like houses or shares which fluctuate in value. Ergo commercial banks have assets which can fall  in value and liabilities that are fixed in value, which is recepie for disaster. And indeed, regular as clockwork over the last few centuries, private banks have gone bust one after another. Ergo they have to be backed or subsidised by a host of different taxpayer funded subsidies: TBTF, depsot insurance, lender of last resort, etc. And subsidies misallocate resources: they reduce GDP.

Ergo commercial bank created money should be disposed of and replaced entirely by central bank or “debt free” money.

As to debts, there is no obvious reason why that switch to debt free money would greatly reduce debts.