Alan Greenspan doesn’t understand banking.

In a recent Financial Times article, Alan Greenspan (widely regarded as laughing stock amongst economics bloggers) criticises bank regulation. He claims that making banks safer requires “building up a buffer of idle resources”, and compares this to the resources lying idle in Japan in the form of earthquake protection. The flaw in this argument is as follows.

In the case of earthquake protection it’s true that large amounts of steel, concrete and clever bits of engineering remain idle for decades – till an earthquake hits. But banks are different.

Bank insurance consists essentially of book keeping entries or contracts. If there ARE any physical resources left idle as a result of bank insurance, like piles of gold or something, will some please tell me where these piles of gold or other physical objects are to be found?

As is pointed out in this work by Prof R.A.Werner and others, one way of making banks safer is to go for full reserve banking and/or curtailing maturity transformation. And as Werner rightly points out, this involves a larger amount of money sitting idle in bank accounts, which to the economically untutored, like Greenspan, might seem like a waste of resources.

However, money in a bank account is simply a book keeping entry or a number in a computer. A nation’s stock of money can be increased any time by little more a click on a computer mouse. Or as Milton Friedman put it in Chapter 3 of his book “A Program for Monetary Stability”, “It need cost society essentially nothing in real resources to provide the individual with…. an additional dollar.”

As regards increased capital for banks, this again is just book keeping entries and bits of paper. Purchasing shares in a bank or any business gives the purchaser the right to dividends plus the right to repayment of very roughly what they paid for the shares (depending on the share price when they sell). But those two rights may be lost when the bank goes under.

No physical resources are tied up here. All that happens is that when the bank goes under, shareholders forgo consumption rather than taxpayers.

A second fundamental and very simple point that Greenspan has not grasped is that economic activity does not have to be bank funded, i.e. loan funded. The alternative is equity funding. And those two basic options apply to ALL economic activity from a household purchasing a washing machine up to a multinational funding a new oil refinery. Thus stricter bank regulation will not curtail economic activity as long as the relevant government / central bank creates and spends new money into the economy to compensate for the reduced availability of money from private banks.

If households and oil companies have more money in their pockets, they won’t need to borrow so much.

There has to be some optimum combination of loan and equity funding for the economy as a whole. Clearly Greenspan favours near unrestricted lehttp://www.blogger.com/img/blank.gifnding – that is thousands of idiots trying to get NINJA mortgages. God first makes mad….

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Stop press, 2nd Aug 2011: About 16 professors in the Financial Times tear a strip off Greenspan. I'm almost beginning to feel sorry for him.

Afterthought, 3rd August. More rotten eggs thrown at Greenspan: today’s Financial Times has a letter from Rober Yohanan (former Chicago Fed board member) criticising Greenspan. Now I really am feeling sorry for him.





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