A slight mistake by David Graeber and others.

Graeber should be congratulated for helping explain how the bank and monetary system really works, which is significantly different from how the proverbial man in the street understands it, and indeed how some economics text books explain it. However the following sentence of his in The Guardian is not correct. (The same error is made incidentally by others)

 “What this means is that the real limit on the amount of money in circulation is not how much the central bank is willing to lend, but how much government, firms, and ordinary citizens, are willing to borrow.”

The flaw in that argument is that the total amount of debt VASTLY exceeds the amount of money needed to make the economy work.

To illustrate, in the UK, SME trade debts alone amount to three times GDP, never mind mortgages and debts between large firms, etc. (That probably doubles the "three times" figure).

In contrast, the amount of money needed by the average household is little more than what's needed to tide them over from one monthly pay day to the next. That's roughly one twelfth GDP. But trebble that if you like and make it a quarter of GDP. That quarter of GDP figure is a minute fraction of the above three or six times GDP figure.

That point can be illustrated by reference to King Henry I and tally sticks, which are a form of money. Henry (who came to the throne in 1100) introduced tally sticks to England in a big way (though tally sticks were being used in some sort of fashion throughout Europe long before that).

You could argue that the amount of tally stick money was limited during Henry’s reign by the amount of wood available from which to make those tally sticks. However, that’s not a brilliant argument given that the amount of wood available for tally stick production was probably a good million times the amount actually needed.

12 year old girl takes the p*ss out of our existing bank system.

James Tobin advocated full reserve banking.

James Tobin wrote a work entitled  “The Case for Preserving Regulatory Distinctions”. The following is a longish extract.

I believe, therefore, that the monetary and depository system should  be restructured to reduce the reliance now placed on deposit insurance  to protect the monetary payments system. I have two proposals. One  is to provide a kind of deposit money so safe that it does not have  to be insured. The second is to make in advance a sharp distinction  between insured and uninsured liabilities, and to stick to it. This involves  separating "commercial banks," which accept insured  deposits, from "investment banks," which do not.    

To diminish the reliance of the payments system on deposit insurance,  I have proposed making available to the public what I call  ' 'deposited currency. " Currency-today virtually exclusively Federal  Reserve notes-and coin are the basic money and legal tender of the  United States. They are generally acceptable in transactions without  question. But they have obvious inconveniences-insecurity against  loss or theft, indivisibilties of denomination-that limit their use except  in small transactions (or in illegal or tax-evading transactions.)  These disadvantages, along with zero nominal interest, lead to the  substitution of bank deposits for currency. But deposits suffer from  their own insecurity, unless guaranteed by the government; and the  guarantees of deposit insurance are subject to the abuses discussed  above.   

I think the government should make available to the public a  medium with the convenience of deposits and the safety of currency,  essentially currency on deposit, transferable in any amount by  check or other order. This could be done in one or more or the following  ways:     

(a) The Federal Reserve banks themselves could offer such deposits,  a species of "Federal Funds." Presumably they would establish conveniently  located agencies in private banks or post offices. The Federal  Reserve banks would pay for the services of the agents. Potential  agents could bid for the contracts. Transactions between holders of  deposited currency accounts, or between them and, directly or indirectly,  other Federal Funds accounts would be cleared through the  Federal Reserve. Wire transfers, as well as checks, would be possible.  Giro-type payment orders to other accounts in the system could  be made. Overdrafts would not be allowed. Computer capabilities  should soon make it possible to withdraw conventional currency at  any office or agency, and even to order payments to third parties  by card or telephone. Interest at a rate sufficiently below the rates  on Treasury securities to cover costs could be paid, and some costs  could be charged to accountholders.     

(b) Banks and other depository institutions could offer the same  type of account, or indeed be required to do so. The deposited funds  would be segregated from the other liabilities of the institution, and  invested entirely in eligible assets dedicated solely to those liabilities.  These would be Federal Funds or Treasury obligations of no more  than three months maturity. As in case (a), interest might be paid  on Federal Funds in such segregated portfolios.     

An anomaly in the existing bank system.

If you lend direct to a corporation, i.e. buy its bonds, there is no taxpayer support for you if it goes wrong, and quite right. In contrast, if you lend to a bank (i.e. make a deposit at a bank) and the bank lends to the same corporation, government guarantees you’ll get your money back.

So if you lend DIRECTLY to a corporation, you’re on your own. But if you lend via a bank, the taxpayer rescues you if it all goes wrong. That is an obvious anomaly. So what’s the explanation?

Well the authorities’ motive for maintaining that anomaly is the idea that “money should be used”. I.e. the idea is that money deposited at banks should as far as possible be put to good use. (See for example the Vickers report, sections 3.20-24) That is, if deposits were not loaned on, that money would stand idle, plus total amounts loaned would decline, which would first, cut demand, and second raise interest rates.

As to the “cut demand” point, that is easily dealt with by raising demand (surprise surprise). That is, for example, the state can simply create new money and spend it, and/or cut taxes, with a view to keeping demand at the full employment level, or NAIRU if you like acronyms.

As to the interest rate rise point, the crucial question there is whether the free market rate of interest is attained under the above “anomalous” regime, or under a regime where money which is supposed to be safe is not loaned on. And the answer is that the free market rate of interest (i.e. the GDP maximising rate) is achieved under a “not loaned on” regime.

Reason is that the only way of making loaned on money is safe is to have the taxpayer stand behind that arrangement, i.e. subsidise the arrangement. And subsidies, unless they are for good social reasons, result in GDP not being maximised.

And finally you may have noticed that the above “idle money should be used” argument is just one of dozens of examples of one of the most common mistakes in economics, namely applying microeconomic rules at the macroeconomic level. That is, it makes sense for a microeconomic entity like a firm or household to put its stock of money to good use as far as possible. But from the point of view of the economy as a whole, that argument doesn’t hold. That is, if a proportion of the population decide to hoard large quantities of money, that matters not one iota: the deflationary effect of that can easily be dealt with by having the state simply create and spend whatever amount of money is needed to keep the economy at capacity.

Regulate the asset or liability side of banks’ balance sheets?

Warren Mosler says in this Huffington article, “The hard lesson of banking history is that the liability side of banking is not the place for market discipline.” Normally I agree with Warren, but no this occasion.

First he doesn’t tell us what the “hard lessons” are or whereabouts in history those lessons are.

Second, regulating the asset side is complicated: witness Warren’s own list of ideas for regulating the asset side in the above Huffington article. But if you want REAL complexity, look at Dodd-Frank: it consists of about 10,000 pages and counting.

In contrast, regulating the liability side is simple. One popular form of “liability side” regulation is raising bank capital ratios. The rule “Banks shall have a capital ratio of 25%” (as advocated by Anat Admati and Martin Wolf) is simple enough.

And taking that further, the basic rules of full reserve banking (which involves a 100% capital ratio) can be written on the back of an envelope. They are:

1. Entities accepting deposits which are supposed to be totally safe can only lodge that money at the central bank (and/or perhaps invest in government debt).

2. Those funding money lenders must accept the risk involved in doing that (rather than having the taxpayer carry the risk).

3. Money lenders must offer a variety of types of loan that “lender funders” can fund. I.e. savers must have the choice of putting their money into safe mortgages, NINJA mortgages, small firms, etc.

And that’s it.

A third problem with regulating the asset side is that the obvious way to make banks / lenders safer is to make the nature of the loans they make safer, e.g. insist that mortgagors have some minimum equity stake in their houses.

But doing that rules out risky loans, and some risky loans turn out to be winners: they’re the basis for starting up businesses which subsequently prosper.

So…. why not allow lenders make any loans they want, as long as those funding those loans carry any loss (rather than taxpayers carrying the loss), and as long as lenders are open and honest with funders as to what’s involved?

And what do you know? The above sort of “regulate the liability” side is what’s involved in full reserve banking, at least as per Lawrence Kotlikoff and Positive Money.

The free market’s cure for unemployment.

Krugman considers the free market’s cure for recessions, and points to the fact that in a recession, prices would fall, which would raise the real value of money, which in turn would increase the paper assets of the population, which in turn would encourage spending. That’s known as the Pigou effect (though Krugman doesn’t mention Pigou). As Krugman puts it:

“How is the self-correction of an economy to its long-run equilibrium supposed to work? In textbook analysis, the story is that falling prices raise the real money supply, pushing down interest rates, and hence restoring employment.”

Note that BASE MONEY is the all important form of money here because base money is a net asset as far as the private sector is concerned. In contrast, commercial bank created money nets to nothing because for every dollar or pound of such money, there is a dollar or pound of debt. Thus commercial bank created money is not a net asset as far as the private sector is concerned.

Krugman however doesn’t mention Say’s law, which is another mechanism that tends to bring full employment (though like the Pigou effect it doubtless doesn’t work all that well). Say’s law works even in a barter or non-money economy. I set out a full explanation here.

At least I take it the latter exposition of mine is how Say’s law works. Maybe I’ve thought up an entirely new mechanism that enables the free market to bring full employment, in which case I’d like a Nobel Prize please.

Separating money lending from accepting deposits.

Summary.   Conventional banks combine two activities, lending and accepting deposits. That combination is essentially fraudulent. The harmful effects of that fraud are remedied to some extent by deposit insurance and lender of last resort. However no public purpose is served by those forms of state assistance to money lenders any more than offering that form of assistance to non-bank corporations would serve public purpose or bring social benefits. Ergo those two activities, lending and accepting deposits, should be separated.

____________

 
Private banks have always liked to merge the above two activities, that is, have the same institutions (private banks) perform both functions. Reason is that that “merge” enables private banks to engage in “borrow short and lend long” (i.e. maturity transformation). And that’s profitable.

Unfortunately the above merge is risky. As Adam Levitin (professor of banking law) put it in the first sentence of the abstract of this paper: “Banking is based on two fundamentally irreconcilable functions: safekeeping of deposits and re-lending of deposits.”

The irreconcilability or fraud consists of the fact that banks promise depositors they’ll get their money back at the same time as putting that money at risk by lending it on. That tactic is bound to fail at some point, and when it does depositors are fleeced big time, as happened in the 1930s. Or if government run deposit insurance is in place, which it wasn’t in the 1930s, then it’s still someone other than the miscreant bank who pays, which is nice for the miscreant bank and those funding it. A second form of protection offered by governments / central banks for the above merged system is lender of last resort (LLR).

So there are two possible bank systems. First, a system under which entities which accept deposits lend on those deposits. In view of the risks involved there, taxpayers have to stand behind private banks.  Second, there is a system which solves the above problems by having the state only guarantee money lodged with the state. As to lending, that is funded by people who specifically choose to have their money loaned on, and who buy shares or similar stakes in money lenders, and those shares are of course not the same thing as deposits.

A “merge” system protected by deposit insurance and LLR might seem to make sense. In fact it’s a system riddled with flaws, as follows and numbered.

1. The system involves moral hazard: the temptation to take excess risk, keep profits when that works and send the bill to the insurer when it doesn’t. Indeed, it was precisely that that contributed to a significant extent to the crisis in 2007/8.

2. One common excuse for having the state insure money lenders and those who fund them (cited for example by the UK’s Vickers commission) is that doing so encourages loans and investment. Unfortunately exactly the same argument applies to every other industry and those funding them. That is, the latter “encourages investment” argument could equally well be applied to all stock exchange quoted shares and corporate bonds.

Of course there’s no harm in letting those who buy stakes in money lenders or any other industry insure themselves against loss, and a certain amount of that type of insurance takes place. However, to justify the state getting involved in that insurance, there must be some very clear social benefit or public purpose served.

3. The idea that governments or regulators are actually able to work out likely risks and charge an appropriate insurance premium is a joke in view of 2007 crisis.

4. Banks are bound to lobby politicians for an unrealistically low insurance premium.

5. When there are bankruptcies in any industry, it is positively HEALTHY for those who funded the industry to lose out. Bankruptcies tend to indicate the industry is too large, and that resources should be diverted to other activities. Thus far from any public purpose being served by deposit insurance, harm is actually done: that is, the effect is to recompense those who fund money lending, which encourages them to engage in more money lending, or “debt creation”.

I.e. when the FDIC reimburses depositors in a failed bank, depositors put the money in another bank. Failing to deal with malinvestments is a misallocation of resources: it reduces GDP.

It could of course be argued that if state sponsored deposit insurance does harm or reduces GDP, then the same applies to the private insurance (mentioned above) that is sometimes taken out for stakes in industries other than banking. That argument is not totally invalid: that is, possibly the latter form of insurance should be banned.

On the other hand, private insurance is not as “sure” as state sponsored insurance in that private insurers can go bust. I.e. private insurance is in a sense not insurance. Also it’s a generally accepted principle that people should be allowed to do whatever they want (e.g. insure their own legs) unless some very clear harm comes what they do.

So it’s debatable as to whether private insurance of investments like stock exchange quoted shares should be allowed or not.

6. Where money lenders are funded by shares, the entire system is more robust. As the former governor of the Bank of England, Mervyn King put it: “..we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis. Equity markets provide a natural safety valve, and when they suffer sharp falls, economic policy can respond. But when the banking system failed in September 2008, not even massive injections of both liquidity and capital by the state could prevent a devastating collapse of confidence and output around the world.”

In short, banks funded by equity are more resilient than where they are funded by debt (e.g. deposits).

7. Bank regulators the world over have expressed approval of the principle that banks should be treated like any other industry: i.e. that ideally governments should openly declare that no form of assistance will be offered to banks in trouble. Of course what regulators and politicians say in private is very different. As John Kay put it, "With crass hypocrisy, political leaders have set their public faces against future bank rescues while their operatives have reassured markets that they do not mean what they say."

But assuming a government does openly and explicitly declare that there will be no assistance for failing money lenders, then the stakes in those lenders (deposits in particular) ipso facto become shares or bonds or something of the sort: so those stakeholders stand to lose money, whereas depositors are guaranteed not to lose out.

8. Another point which casts doubt on any idea that any public purpose is served by having the state insure those with stakes in money lenders (or any other industry) is the fact that there is a nonsense at the root of that type of insurance, as follows.

The only reason that those who fund money lenders (or any moderately risky industry) get a larger return than is obtainable from near risk free loans, is that more risk is involved. Now if the risk consists for example of a one in X chance of losing all your money in any one year, then the appropriate annual insurance premium would be 1/X of the sum insured. But that wipes out the profit derived from taking the extra risk (never mind the fact that the insurer will want some sort of profit on turnover and capital employed).
In short, insuring those who fund money lenders is as daft as insuring your own legs: to repeat, it probably doesn’t do any harm to let people take out daft forms of insurance, but there certainly isn't any public purpose or social benefit to be had from insuring those who fund money lenders or other industries.

9. In addition to deposit insurance, another form of assistance for private banks is LLR. The rate charged for LLR loans are supposed to be the “penalty” rates suggested by Walter Bagehot. In practice, and thanks to political pressures and bribes payed by bankers to politicians, those rates are nearer zero than “penalty”: a form of subsidy for banks.

10. Contrary to popular belief, Bagehot did not advocate LLR: in the final chapter of his book “Lombard Street” he simply said he thought LLR was so entrenched that it would be very difficult to remove.

11. It is often argued that if the PROPORTION of funding for money lenders that comes from shares is sufficiently high (i.e. if bank capital ratios are high enough), that solves the problem: that is, the chance of depositors losing out can be reduced to a vanishing small level. Thus there is no need for 100% of those who fund money lending to be exposed to risk, i.e. depositors can still to some extent fund money lending.

A problem with that argument is that if those depositors are in fact totally safe at say a 30% capital ratio, then they’d also be totally safe of the rules of the game were changed and their stakes in money lenders became say preference shares. And in that case, those shareholders would charge the same for funding the bank as those former depositors (because the charge made by funders is related to risk, and the risk in both cases is the same). Thus if bank capital ratios are raised to whatever level makes banks totally safe (say 30%), then the cost of funding banks will not rise any further if the ratio is raised to 100%.


Arguments against separation.

The main argument put against separating lending from deposit accepting (put for example by the UK’s Independent Commission on Banking) is that the result would be large amounts of money not being used: effectively, if you like, money sitting in metaphorical safe deposit boxes. The result, allegedly, would be a fall in demand and rise in unemployment.

The answer to that is that the deflationary effect of the separation can easily be countered by standard stimulatory measures, e.g. simply having the state print money and spend it (and/or cut taxes). Thus there is no reason for separation to increase unemployment.


Interest rates.

Another poor argument put against separation is that it would raise interest rates which allegedly would reduce investment and cut economic growth.

The answer to that is that as is widely accepted in economics, GDP is maximised where there is an absence of subsidies, except where there is a clear social case for a subsidy, as is doubtless the case with for example kid’s education. Or in more general terms, there is a case for subsidies and taxes where those subsidies put right an instance of market failure. (Taxes are imposed for example on alcohol because it is thought, rightly no doubt, that social harm derives from excess alcohol consumption.)

However, the onus is on those advocating subsidies and taxes to prove the existence of social benefits, market failure and so on. To repeat, the general and widely accepted rule is that GDP is maximised where market prices prevail, i.e. where there is an absence of subsidies or taxes.

In short the free market rate of interest is probably somewhat higher than the currently prevailing rate, thus moving to that higher rate ought to increase GDP, not reduce it, as claimed by the ICB and others.