Friday, April 19, 2013

Full reserve is better than the bank levy.

The UK has a bank levy. It is imposed on banks with assets of more than £20bn of debts, the idea being to encourage banks to shrink, i.e. reduce the too big to fail problem (TBTF). Plus the levy is charged on debts other than retail deposits, so as to discourage risky forms of funding: the forms which dried up during the recent crisis.
Those two benefits, reducing the TBTF problem and reducing risks, are also achieved by full reserve banking. So which solution is better?
Well first, reducing the size of the biggest banks does not solve the problem in that when one large bank goes bust it’s likely that other large banks are in trouble as well because all large banks operate in similar ways. E.g. most of them were making silly loans prior to the recent crisis.
In contrast, a bank just cannot go bust under full reserve: any losses are born by depositors who have chosen to have their money put at risk, that is, loaned on. Under full reserve, a bank can certainly shrink, or even shrink to nothing over a period of time, but it cannot suddenly go bust. Or as George Selgin put it “For a balance sheet without debt liabilities, insolvency is ruled out…” (p.30 of his book “Theory of Free Banking” – available online.).
Moreover, that solves the TBTF problem. That is, under full reserve, a bank CAN GROW to the size of current TBTF banks, but since a “too big to fail” bank under full reserve cannot fail, that solves the problem.
But that is NOT TO SAY that full reserve deals with the “anti competitive” practices that can arise when too few employers have too big a market share. So stopping any one bank taking more than some given proportion of the market might still be desirable under full reserve.

The levy still involves disruption.
Next, if there is a serious banking problem say every 20 years, the amount collected by government via the levy may well be enough to rescue banks in trouble. But that process is still disruptive. That is, come a bank crisis, the government / central bank machine can easily print billions to rescue banks, but that is inflationary, which means taxes have to be raised and/or public spending cut. (It might seem that the government / central bank machine does not have to “print” any new money to rescue banks if it has already collected enough money via the levy. The answer to that is that the whole concept of “money in the hands of the money issuer” is essentially meaningless. That is, a currency issuer can credit a trillion trillion to itself anytime: a meaningless exercise. So whether you want to regard the money spent by a government on bank rescues as “new money” or “money collected via the levy” doesn’t make any difference.)
In contrast to the above disruption, under full reserve, bank failure is more gradual. That is, as it becomes apparent that loans made by banks are not worth their paper or nominal value, the value of depositors’ stake in the relevant bank drifts downwards. And that is very different from fractional reserve, where a bank tries desperately to pretend that all is well until one day the word gets out that the bank is about to run out of cash, and a run ensues.
It could be argued against the above inflation point that banks tend to fail in recessions, and hence that no tax increase will be needed to counteract the inflationary effect of money  printed to bail out banks. However there is still a diversion there of large amounts of money from normal public spending items to funding bank bail outs. Put another way, given a recession and ABSENT bank failures, government can simply up public spending (and/or cut taxes) with the result that household spending and amounts spent on law enforcement, education, etc remain more or less constant.
In contrast, and given a recession PLUS bank failures, government would not be able to keep public spending (and/or taxes) at the same relatively constant level.

Risky types of funding.
This problem is also solved by full reserve. Under full reserve, anyone depositing money at a bank or lending money to a bank has to specify whether they want their money to be put at risk (i.e. loaned on by the bank) or kept 100% safe (e.g. lodged at the central bank). If the former, then the lender / depositor carries the risk inherent in “lending money on”. So there is no risk for the bank there. Alternatively, if the money is 100% safe, then it cannot be lost. There is no risk for the bank there either. Though why anyone would want to lend to a bank knowing they’d get the sort of zero or near zero interest that comes from lodging money in a 100% safe manner is a mystery: they probably just wouldn’t lend to the bank.

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