Monday, July 18, 2011

Summary of the Werner / Positive Money / New Economics Foundation paper.

This paper was submitted to the UK’s Independent Banking Commission. Here is my ultra brief summary. Hope it’s a fair summary.

1. Fractional reserve banking promotes instability. A major reason is that during an economic upturn, fractional reserve enables commercial banks to create money out of thin air and lend it to nit wits who see asset prices rising and want to invest in those assets. That raises asset prices still further, creating more collateral to be used for yet further borrowing.

Conversely, during a downturn, everyone deleverages, that is pays money back to banks, which involves the extinguishing of money: just what is not needed in a downturn. Thus fractional reserve should be banned.

2. Another fundamental flaw in the existing banking system is that money from bank accounts which are 100% safe and taxpayer backed is used for commercial purposes. This amounts to a subsidy for commerce, which is wrong. Hence those depositing money in banks must be presented with a clear choice, as follows. 1. put money into 100% safe accounts where the money will be lodged in a 100% safe fashion – i.e. at the central bank, where it will earn little or no interest. Or 2, put money into a “commercial” or “investment” account, which will probably earn some interest, but there is no taxpayer backing if it all goes wrong.

3. Re the systemic risks that derive from the latter commercial or investment accounts, these can be minimised by banning maturity transformation.

4. Banning fractional reserve and maturity transformation involves leaving more money idle in bank accounts. The idea that this equals failure to use real stored wealth is nonsense, because in a fiat money system, money is simply a book keeping entry.

5. The idea that the above, or any form of restriction on bank activity will harm economic growth is nonsense in that the government / central bank machine can perfectly well make up for such restrictions by creating new central bank money (monetary base) and spending it into the economy. (The latter policy incidentally is also advocated by most followers of Modern Monetary Theory).

Indeed, the latter "create money and spend it into the economy" is a better way of regulating aggregate demand than interest rate adjustments. Thus creating (or extinguishing) money should be the prime method of regulating demand, with interest rates being left to find their own value.


Stop press. The Fed’s Edward Nelson mentions Modern Monetary Theory.


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