Positive Money and Milton Friedman are agreed on three points. First, that monetary and fiscal policy should be merged. Second that those depositing money at banks should have to choose between two types of account: 100% safe full reserve accounts which pay little or no interest, and second, accounts where depositors’ money is loaned on or invested and where depositors foot the bill if those loans or investments go wrong, rather than taxpayers footing the bill. Third, that full reserve aka 100% reserve banking should be implemented (which is really just to repeat the above idea that depositors should have the option of full reserve accounts.) The paragraphs below explain why all three policies are right.
Re the first of the above three points, merging monetary and fiscal policy, I dealt with that yesterday.
The two account system.
Now for the second point. Positive Money (PM) like Milton Friedman and Lawrence Kotlikoffadvocates that those who deposit money at banks have to choose between 100% safe, full reserve, instant access accounts, and in contrast, so called “investment accounts” where money IS LOANED ON or invested and thus depositors get interest. But depositors (rather than taxpayers) foot the bill if and when the loans go bad.
However, those opting for investment accounts have a choice as to what happens to their money. E.g. they might opt to fund relatively safe mortgages (e.g. mortgages where house owners had a minimum 30% equity stake). And in that case, depositors’ money would be about 99.9% safe. And that element of the system has a definite merit: it stops banks using grandma’s savings (unbeknown to her) to bet on dodgy derivatives and such like.
But there is a difference between PM and Friedman there, namely that PM claims the two types of account (safe and investment) can be run by the same organisation or bank, whereas Friedman said they should be under separate roofs: a difference I might deal with at a later date. But for rest of this article, and by way of glossing over that difference, I’ll refer to
“investment accounts” or “investment departments” of a bank as “investment banks”.
The pros and cons of the two account system.
The big merit of the two account system is as follows. All money loaned out by investment banks is supplied by shareholders, or other types of loss absorber who are in effect shareholders. And that means it’s plain impossible for an investment bank to become insolvent. As George Selgin put it “For a balance sheet without debt liabilities, insolvency is ruled out…”. That means a reduced chance of credit crunches and the succeeding years of excess unemployment that tend to follow credit crunches.
On the insolvency point, there is another slight difference between PM and Kotlikoff and Friedman. The latter two claim that the value of the stakes held by shareholders should vary with the value of the underlying loans and investments: so in effect investment banks become unit trust managers (“mutual fund” managers to use US parlance). In contrast, PM claims the value of depositors’ stakes should remain at their face value until the investment bank (or individual “unit trusts”) go badly wrong, in which case they are closed down and depositor / investors get their money back less whatever loss they have signed up for. Personally I think the Kotlikoff / Friedman model is better.
An obvious possible defect in the two account idea is that while a substantial rise in capital requirements from the existing ridiculously risky 4% or so would bring a big improvement in bank safety, a rise to 100% is arguably over the top.
Or as Martin Wolf put it, “I accept that leverage of 33 to one, as now officially proposed is frighteningly high. But I cannot see why the right answer should be no leverage at all. An intermediary that can never fail is surely also far too safe.”
My answers to Wolf’s point are as follows.
First, there is nothing wrong in 100% safety if the costs are minimal. E.g. if you could make your car so safe that there was no chance of your being killed in a car accident, and that cost you one cent or one penny a day, you’d go for it.
And as to banks, the additional cost of a 100% capital requirement rather than say the 25% or so advocated by Martin Wolf is negligible to the extent that the Miller Modigliani theory is correct (which I think it is more or less).
The instability of privately created money.
A second reason for going for a 100% capital ratio is that the lower the capital ratio, the more freedom commercial banks have to create and lend out money, for reasons explained below. And the unfortunate reality is that commercial banks engage in the latter “create and lend out” activity in a pro-cyclical manner. That is, during booms or asset price bubbles they print money and lend it out like there’s no tomorrow (as they were doing before the recent crisis), which exacerbates the boom or bubble. Then come the crunch, and commercial banks do the opposite of what we want them to do. That is, they exacerbate the crunch or crash by ceasing or even reversing their money creation wheeze, as pointed out by Irving Fisher.
And the latter defect with private money creation means that government and central bank have to counter that unstable characteristic of commercial banks. And assuming the combined fiscal and monetary system advocated by Friedman and PM is adopted, that means that in a recession for example, government and central bank have to create and spend money (or cut taxes) so as to counterbalance the failure of private banks to do so.
Well now, in view of the above instabilities, it would solve a lot of problems if private banks were simply barred from the money creation process, wouldn’t it? I.e. the existing system is a bit like letting your child mess with your car’s accelerator while you’re driving. Of course if the child presses too hard on the accelerator you could always counteract that by applying the brake. Or you could push up on the accelerator when the child presses down too much. But it would be much simpler to do what virtually every car driver in World does: just bar children from any access to the accelerator.
Why low capital requirements facilitate private money creation.
As to why low capital ratios facilitate private money creation, the reasons are as follows.
Where an investment bank’s only creditors are shareholders (or other types of loss absorber), the stake that those creditors have in the bank are not money. That is, while there is no sharp dividing line between money and non-money, there is no way that shares in Exxon or J.P.Morgan are ever counted as money. Thus under the two account system, and given a 100% capital requirement for investment banks, an investment bank can certainly expand the amounts it lends IF IT CAN FIRST attract base money from a new creditor/shareholder (or an existing creditor/shareholder who increases their stake in the bank). And that base money will be loaned on to the new borrower. But the new creditor LOSES BASE MONEY and gains an asset, namely a stake or share in the bank. Thus overall, no new money is created.
In contrast, given low capital requirements (e.g. the existing paltry 3% or so), commercial banks have almost complete freedom to engage in their traditional “loans create deposits” activity. That is, when the commercial bank system sees a range of viable lending opportunities, it can simply create money out of thin air and lend it out. That money of course gets deposited back into commercial banks, which may mean the amount of capital they have is then inadequate. But if $97 can be created and loaned out for every $3 of new capital needed, that is no big constraint on the “loans create deposits” activity or “private money creation” activity.
Why constrain viable lending?
There might seem to be a weakness in the above argument, namely that if the commercial bank system spots a selection of viable lending opportunities, then banks’ freedom to exploit those opportunities is constrained under a 100% capital ratio.
Well the first answer to that criticism is that “viable” is a loaded word. If “viable” means house prices are rising faster than normal, then taking the short term view, obviously lending to fund house purchases is – er – “viable” in a sense. But we all know where that leads: house price bubbles, followed by house price crashes.
So where “viable lending opportunities” means “start of an asset price bubble” then constraining banks’ freedom to increase lending would be beneficial.
In contrast to asset bubbles, it is conceivable that the demand for loans for other purposes (e.g. businesses wanting to invest) might rise or fall. But I don’t believe the gyrations there are as dramatic as in the case of house price bubbles.
And in any case, it’s hard to see what is wrong with interest rates rising given an increased demand for loans – and interest rates certainly would rise given the combination of increased demand for loans and constraints on banks’ freedom to create new money and lend it out. That is, given an increased demand for anything, it is normal for its price to rise. That’s free markets for you.
The crisis would have been less sever under a PM / Friedman system.
In fact a PM / Friedman system would have done better prior to the recent crisis than the existing system. That is, prior to the crisis, various economies were kept going by excessive private sector borrowing - used to fund property purchases. But interest rates didn’t rise to reflect the increased demand for loans, which simply encouraged more borrowing.
In contrast, under a PM / Friedman system, interest rates would have risen, which would have been deflationary (assuming interest rate changes have any effect at all). But the latter effect would have been countered by increased government net spending. And assuming that net spending had not been allocated exclusively to the public sector or exclusively to the private sector and private sector, then extra money would have been spent on bog standard boring items like roads, education, etc, in the case of the public sector. And as to the private sector, more would have been spent on the sort of bog standard items that the average household spends money on: cars, holidays, etc. In short “bog standard and boring” expenditure would have been higher, while expenditure on property speculation would have been lower.
And as to the possibility that interest rate changes have no effect (as implied by the above mentioned Fed study), that makes a nonsense of the main form of monetary policy (interest rate changes). So either way (interest rate changes do / don’t have an effect) it looks like the PM / Friedman system comes out on top.