Sunday, April 27, 2014

Martin Wolf and full reserve.

Since Wolf’s articlein the Financial Times a few days ago, his article has attracted plenty of criticism. These criticisms are easily dealt with, especially since the critics don’t seem to have studied the BASICS of full reserve. So here is:
1. A quick explanation of the basics.
2. A guide the explanations set out by the main advocates of full reserve (Milton Friedman, Lawrence Kotlikoff, James Tobin, Richard Werner, Hyman Minsky, etc).

The basics.
Under full reserve, the banking industry is split in two. One half simply accepts deposits and lodges the money at the central bank (or – the option preferred by Milton Friedman – invests the money in short term government debt). That money is instant access, but pays little or no interest. Those deposits are backed by the state, but since there is virtually no risk, the cost to the taxpayer of backing those deposits is near zero. I.e. there is almost no subsidy of the banking industry there, plus that half of the industry cannot fail and cause credit crunches.
Or as Minsky put it, " such subsidiary can be a narrow bank which has transaction balances as liabilities and government debt as its assets. This narrow bank does not need deposit insurance.."

Loans and investments.
The second half of the industry performs the lending and investing functions performed by conventional banks, but that half is funded by shareholders or loss absorbers who are effectively shareholders. In Laurence Kotlikoff’s version of full reserve, the second half consists of mutual funds, and of course those with a stake in mutual funds are effectively shareholders. The exception there is money market mutual funds: obviously they belong to first half of the industry.
And that second half of the industry cannot fail either, although there is nothing to stop one of the relevant entities declining slowly. That is, if an entity makes silly loans, it doesn’t suddenly become insolvent: all that happens is that the value of its shares (or mutual fund units) fall in value. So no bank subsidies are needed there either.
So to summarise so far, we have, 1, disposed of the need for taxpayers to underwrite bank deposits, 2, disposed of other bank subsides, and 3, disposed of the possibility of sudden bank failures, and hence the severity of credit crunches, and all in a couple of hundred words. Not bad, given the complete failure of Dodd-Frank, Vickersetc to do anything remotely similar despite spending millions on the problem and exuding tens of millions of words on the problem.

Deflationary effects.
Obviously, the introduction of full reserve restricts lending and that reduces aggregate demand. But that’s easily dealt with by standard stimulatory measures. The actual stimulatory measure preferred by Friedman and Positive Money is simply creating and spending base money into the economy (which comes to the same thing as fiscal stimulus followed by QE).
The net result of that is that private debts decline and the typical household and firm has a bigger stock of money. And given the sharp rise in private debts over the last decade that’s probably desirable. Or to use Positive Money (PM) parlance “debt encumbered money” shrinks, and “debt free money” expands.
As to who decides the amount of stimulus, that is done under the PM / Werner system by a committee of economists. And that’s not much different to the existing system: e.g. the Bank of England Monetary Policy Committee decides on interest rates and thus has a big say on stimulus.
Plus, as under the existing system, that sort of committee DOES NOT have a say on strictly political matters, e.g., 1, the proportion of GDP allocated to public spending, or 2, whether stimulus comes in the form of increased public spending or tax cuts, or 3, how any increased spending is split as between  different government departments. I.e. under the existing system the Bank of England MPC adjusts interest rates and leaves it to politicians to adjust public spending if they so wish. While under the PM / Werner system, the committee decides how much extra (or less) base money is to be created and spent, while leaving to it politicians to decide EXACTLY HOW that money is spent (or whether the money is used to cut taxes).

Guide to literature by Friedman, Kotlikoff, Tobin, etc.
For Friedman see his book “A Program for Monetary Stability” (published by Fordham University Press), Ch3 under the heading “Banking Reform”. Here is an extract:
“The effect of this proposal would be to require our present commercial banks to divide themselves into two separate institutions. One would be a pure depositary institution, a literal warehouse for money. It would accept deposits payable on demand or transferable by check. For every dollar of deposit liabilities, it would be required to have a dollar of high-powered money among its assets in the form, say, either of Federal Reserve notes or Federal Reserve deposits. This institution would have no funds, except the capital of its proprietors, which it could lend on the market. An increase in deposits would not provide it with funds to lend since it would be required to increase its assets in the form of high-powered money dollar for dollar. The other institution that would be formed would be an investment trust or brokerage firm. It would acquire capital by selling shares or debentures and would use the capital to make loans or acquire investments.”
For Kotlikoff, and James Tobin, see here.
For Werner and PM, see: p.7 “Step 2” here.
For PM’s latest ideas (which are not much different to those just above) see their book “Modernising Money”.

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