Tuesday, November 13, 2012

Krugman thinks money is a scarce resource.

In arguing against narrow banking, Krugman trots out the old and wholly fallacious idea that there is some benefit in maximising the use of the available stock of money. He says:

“I think of the whole bank regulation issue in terms of Diamond-Dybvig, which sees banks as institutions that allow individuals ready access to their money, while at the same time allowing most of that money to be invested in illiquid assets. That’s a productive activity, because it allows the economy to have its cake and eat it too, providing liquidity without foregoing long-term, illiquid investments. If you were to enforce narrow banking, you would be denying the economy one of the main ways we manage to reconcile the need to be ready for short-term contingencies with the payoff to making long-term commitments.”

The flaw in that argument is that money is simply a book keeping entry. That is, both central banks and commercial banks can simply create money, and in almost limitless amounts, whenever they see fit. There are of course important differences between central bank and commercial bank money, for example the former is legal tender and the latter is not. Nevertheless, both types of bank are free to create money out of thin air.

Or as Milton Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances” -  (Ch 3 of his book “A Program for Monetary Stability”).

Now that freedom to create money, at least on the face of it, means there is no crying need to maximise the use of the available stock of money. A second point that calls the above point into question, is that it is precisely borrowing too short and lending too long that has brought down numerous banks throughout history, Northern Rock being just a recent example.

So there is a choice. We can have a relatively small money supply with a high velocity of circulation, or a larger money supply with a slower velocity. And presumably there must be some optimum on that scale.

Now in determining where that optimum is, the fact that money can be created at zero real cost  means that the AMOUNT of money needed to attain the optimum is a total irrelevance. I.e. the only important consideration is: what’s the safest banking system?

And a further reason for going for maximum safety is that when banks do go under (particularly large ones), the taxpayer picks up the pieces, and for the simple reason that no private insurance firm has to resources to mount a rescue. Indeed, even entire COUNTRIES have been reduced to virtual bankruptcy in the recent banking crises (Iceland and Ireland for example). Thus ANY taxpayer guarantee is a subsidy of the banking industry, and subsidies do not make economic sense (unless someone can produce some very good reasons for a subsidy).

Well now, given that ANY amount of maturity transformation inevitably involves risks, however small, the inescapable logic is that we should just forbid it altogether!  That is, 1. Just forbid banks from using money in instant access accounts for long term loans.  2. Allow long term loans (there’s nothing wrong with those), but only allow them to be made using money that depositors have placed in deposit or “term” accounts. 3. Have the government / central bank machine print and spend whatever amount of money is needed into the economy so as to negate the deflationary effect of forbidding maturity transformation.

So that’s Krugman’s point  about maturity transformation being a “productive activity” demolished, unless I’ve missed something.

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