Brad DeLong’s flawed criticisms of full reserve banking.

Brad DeLong has penned an article on Austrians’ objections to fractional reserve banking. I have plenty of respect for DeLong, but he is out of his depth on this particular subject. His second paragraph reads:

“I mean, it has always been a peculiarity of that (Austrian) school of thought that it praises markets and opposes government intervention — but that at the same time it demands that the government step in to prevent the free market from providing a certain kind of financial service. As I understand it, the intellectual trick here is to convince oneself that fractional reserve banking, in which banks don’t keep 100 percent of deposits in a vault, is somehow an artificial creation of the government.”

First, it is not true to claim there is any self-contradiction in advocating free markets at the same times as advocating various interventions in the market. Nearly EVERY ADVOCATE of the free market ALSO advocates numerous government interventions , e.g. intervention in some or all of the following forms: intervention in the trade in firearms, and dangerous or addictive drugs, taxes on alcohol, provision of free education for kids (and/or university students), provision of free healthcare and so on.

Second, the idea that fractional reserve is an “artificial creation of the government” is nonsense, and I’ve never seen that idea put by Austrians or any other advocate of full reserve. It’s obvious from the history of banking, particularly prior to about 1850 when there was very much a free market in banking, that fractional reserve arises automatically in a free market. 



Money market funds.

DeLong continues: “But consider a more recent innovation: money market funds. Such funds are just a particular type of mutual fund — and surely the Austrians don’t want to ban financial intermediation (or do they?). Yet shares in a MMF are very clearly a form of money — you can even write checks on them — created out of thin air by financial institutions, with very few pieces of green paper behind them.”

The answer to those points by DeLong are thus.

The purpose of full reserve is to prevent the creation of money by private banks: that is to make money creation the sole preserve of government and central bank. Private money creation takes place (to over simplify a bit) when someone deposits $X in a bank current / “checking” account (or short term deposit account,) and the bank then lends the $X on to a borrower. In that scenario, both depositor and borrower have access to $X. That is, $X has been turned into $2X.

Now MMFs just don’t do that: they simply take money off depositors and invest the money in very safe investments, like short term government debt. No money creation takes place. So under a full reserve system, MMFs would simply be left to get on with their usual business.

Indeed, Laurence Kotlikoff (an advocate of full reserve) SPECIFICALLY ADVOCATES the setting up of a variety of mutual funds, including money market funds, to take over some of the functions of banks.





Intermediation.

Next, let’s deal with the question posed by DeLong: “surely the Austrians don’t want to ban financial intermediation (or do they?).”

The quick answer is that pretty well all intermediation by banks ceases under full reserve, though that depends on EXACTLY what you mean by a “bank” and by the word “intermediation”. And that curtailment of intermediation is for very good reasons, as follows. The reasons are a little complicated. But read on if you’re interested.

A bank is an institution which accepts deposits and promises to return the money to depositors (maybe plus some interest and maybe less bank charges). Now if a bank takes any risk whatever with that money the possibility arises of it NOT BEING ABLE to repay depositors’ money. And in fact is that history is JUST LITTERED with examples of banks doing just that: going bust and failing to return depositors’ money.

In short, the reality is that banks regularly cheat depositors unless taxpayers back-stop the above semi-fraudulent promise that banks make to their depositors. But that back-stopping amounts to a subsidy, and banks are supposed to be COMMERCIALLY VIABLE.

The actual size of this subsidy was estimated by Andrew Haldane of the Bank of England to be several times larger than banks’ annual profits over the last decade or so. In short, banking in its present is a PATHETIC FARCE.

IT’S A JOKE.

Banks in their present form are not the free market, capitalist institutions that Brad DeLong seems to think they are. Banks are actually parasitic organisations. They are part of the “socialism for the rich” system.

So what’s the solution? Well it’s easy, and as follows. First, banks (or any institution that promises to return money to depositors dollar for dollar) should be forbidden from taking any risk whatever with that money. Second, there are the commercial and risky activities that banks currently engage in, and these activities are for the most part perfectly acceptable: there is nothing inherently wrong with commercial activity. Commercial activity is almost by definition a risk. But the risk should be carried by people who have clearly and consciously accepted risk: that’s people who are, or who are in the nature of equity or bond holders rather than depositors.

To summarise so far, if a depositor wants 100% safety, NO RISK should be taken with their money. And that in turn means they get no interest (though they CAN HAVE instant access). As to depositors who want interest on their money, i.e. who want their bank to lend on or invest their money, they’ll just have to accept that their desire to act in a commercial manner involves risk: if the loans or investments their money is put into go bad, they take a hair cut.



Would full reserve outlaw all forms of private money creation?

Next, DeLong says, “One of the key lessons of the 2008 crisis was precisely that banks are defined by what they do, not by what they look like, and there are a whole range of financial arrangements that in economic terms act a lot like fractional reserve banking. So would a Ron Paul regulatory regime have teams of “honest money” inquisitors fanning across the landscape, chasing and closing down anyone illegitimately creating claims that might compete with gold and silver? How is this supposed to work?”

The answer is thus.

First, the more clued up advocates of full reserve have actually tumbled to the fact that whether an institution has the word “Bank” emblazoned over its front door has nothing to do with whether it acts like a bank or creates money.

Second, the above clued up advocates have also tumbled to the fact that there are an almost limitless number of institutions and indeed individual people who can get in on the money creation process. For example if I give Joe Bloggs an uncrossed or negotiable cheque, Joe can endorse the cheque and use it in payment for goods or services he wants to purchase. And the cheque can in theory pass through any number of hands.

The cheque is then a form of money.

But it’s a very awkward and inefficient form of money. Personally I’ve never in my entire life been offered a negotiable cheque in payment for anything and I probably wouldn’t accept one if it WERE OFFERED. Negotiable cheques are never going to compete to any serious extent with a properly organised monetary system, full or fractional reserve. 



Size pays.

Next, when it comes to money creation, big institutions have a huge advantage over smaller ones. For example, about 90% of retail outlets accept plastic cards issued by well-known institutions like Visa or American Express. But you try foisting a card on a retail outlet issued by an organisation no one has ever heard of: you’ll have problems.

Now if the only institutions that can do money creation in any serious way have to have a turnover of at least say $10m a year (and very few small banks have a turnover that small), they can hardly avoid being noticed by the authorities. If you are a self-employed plumber with a turnover of just $50,000 a year trying to avoid being noticed by the income tax authorities, you probably won’t get away with it for long: never mind $10m a year.

Thus DeLong’s point about “teams of “honest money” inquisitors fanning across the landscape” is an argument that is easily rebutted: 99% of private money creation is implemented by institutions which cannot possibly hide from the authorities. “Fanning across the landscape” is totally unnecessary. 



Is full reserve deflationary?

A common objection to full reserve (at least in the above form) is that it would curtail lending, which would have a deflationary effect or hinder economic growth. Well the simple answer to that (as indeed Kotlikoff and other advocates of full reserve like Positive Money) have pointed out, is that the government / central bank machine can perfectly well create and spend extra money into the economy to give enough stimulus to counteract the above deflationary effect.

Indeed, the above deflationary effect is actually the OPPOSITE EFFECT to that which would occur if a country were to do a switch in the opposite direction from that advocated above: i.e. switch from full to fractional reserve, as pointed out by George Selgin. As Selgin rightly points out, switching FROM full reserve TO fractional reserve would have a temporary INFLATIONARY EFFECT.



Conclusion.

Austrians are not the smartest people on planet Earth and they make plenty of mistakes in their advocacy of full reserve. But when it comes to the more clued up advocates of full reserve (like me?????), that’s a tougher nut to crack. And if DeLong’s article is any guide, he has a long way to go before he cracks it. .