Thursday, January 10, 2013

Yet more flawed criticisms of full reserve banking by Messers Diamond, Dybvig and Goodhart.

I dealt here with a criticism of full reserve made by Diamond and Dybvig (DD). Their criticism was that if full reserve is imposed on the formal banking sector, then fractional reserve type activities will just migrate to the informal or shadow bank sector.
A similar sort of “migrate” criticism is made by Charles Goodhart.
His argument is that if full reserve is imposed on the formal bank sector, money will flow to the shadow sector in search of better returns and then rush back come a crisis. As he put it, “when there is a crisis the savers and depositors who shifted towards the higher-yielding institutions will come rushing back either to cash or to the protected sector. But that will just worsen the pro-cyclicality of the whole system.” And certainly there was a “rush back” recently if the chart below is any guide.


( The chart runs from 1960 to 2011. The blue line is shadow bank liabilities, and the red line is formal bank liabilities. Hat tip to Azizonomics and Zero Hedge.)
And that rush back is of course just a repetition of the phenomenon pointed to by Walter Bagehot well over a century ago, namely that come a crisis, everyone flees to safety.
Well the simple answer to Goodhart’s criticism is that if the shadow sector is regulated in the same way as the formal sector, there is no temptation to migrate or “rush”. And as I pointed out here, that regulation can never be done with perfection, but it can be done far more efficiently than hitherto.

The existing system worked – oh yes?
Next, there is a bizarre defence of pre-crunch bank regulations put by Goodhart,namely that those regulations and systems worked in that they saved retail banks. Well my answer to that is “you bet they worked: at a cost to the taxpayer of several billion”!
Quite why the need to subsidise and bail out entities that are supposed to be commercially viable is anything to crow about, I’m not sure.
So that’s another criticism of full reserve (an oblique criticism) dealt with in short order!

Political problems.

Returning to DD, another anti-full reserve point they make that “Fortunately, the political realities make it unlikely that this radical and imprudent proposal (full reserve) will be adopted.”
Well there’s a big problem there, namely that DD don’t actually spell out what these mysterious “political realities” are, so there are no SPECIFIC points to answer.
But never mind. I can come to their rescue and spell out at two “political realities”. One is that the criminals and fraudsters running banks spend huge sums bribing and cajoling politicians into implementing the banking regime that said criminals and fraudsters want. (Banks in the UK spend £93m a year on lobbying.)
And if that’s what DD had in mind, that is certainly a significant “political” problem. However (assuming that’s what DD had in mind) it doesn’t say much for DD that they are happy to cave into criminals and fraudsters rather than campaign against them.

Subsidies are hard to remove.
Another political problem is one that was spelled out by Samuel Brittan in the Financial Times long ago when he said that subsidies are easy to implement and difficult to remove.
And fractional reserve banking is a system that cannot work without subsidies: occasional trillion dollar bailouts plus the on-going “too big to fail” subsidy.
That is, banks plus depositors and those borrowing from banks gain from those subsidies. And certainly banks and those dealing with banks will object when they find that the terms and conditions of bank accounts under full reserve are in some ways not as attractive as under fractional reserve. But that is a defect in the brains of the general population, not a defect in full reserve.
Ancient Romans were liable to riot if they weren’t supplied with the quantity of free bread and circuses they wanted. But that doesn’t prove that food should be free or that having lions eat Christians is a good idea.
For those of us who want to make the world a better place, if something is clearly desirable, but implementing it is resisted by the general population, the solution is simply to carry on campaigning for the idea until it becomes accepted. An alternative is to introduce the idea gradually.

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