A hopeless defence of fractional reserve banking in the Financial Times.

Ben Dyson of Positive Money authored an article in the Guardian earlier this week attacking fractional reserve banking. This blog article at the Financial Times authored by Izabella Kaminska responded. The latter’s attempt to demolish Dyson’s arguments are hopeless.

Dyson argues against the right of private banks to create money. The first five or so paragraphs of Kaminska’s article respond by pointing out that economists realised a century or more ago that private banks do this. Thus Dyson’s point, according to Kaminska is old hat.

The answer to that is that Dyson does not claim to be revealing anything that most economists are not already aware of. As Positive Money’s literature points out time and again, the object is to educate the PUBLIC. (I could cite ignorant economists who quite clearly DO NOT get Dyson’s point, but I don’t want to be cruel.)

Second, in the paragraph starting “Having staggered…” Kaminska claims that Positive Money “plans to end evil debt everywhere”. Wrong again. The advocates of full reserve banking (including Positive Money) are well aware that borrowing and lending will always take place. What advocates of full reserve object to is (amongst other things) the fact that fractional reserve exacerbates instabilities.

That is, during a boom, asset prices rise. It was primarily property prices in the run up the recent credit crunch, and in the late 1920s it was primarily share prices. This price rise makes assets better collateral to back further lending. That further lending boosts asset prices still further. And so on.

Third, and credit where credit is due, Kaminska claims that the whole full versus fractional reserve argument is complex. Agreed.

And finally, Kaminska makes the bizarre claim that “Without debt, after all, you can’t have money.” Oh yes? What about a commodity based currency, like gold coins? If I have some gold coins, exactly where is the “debt” associated with these gold coins? Answer: the debt does not exist!

And it’s not only commodity based money systems that involve debt free money. In our existing fiat money system, monetary base is effectively debt free. Of course monetary base IN THEORY has an associated debt: a debt owed by the central bank to holders of monetary base. Those £20 notes (which are part of the monetary base) have imprinted on them the phrase “I promise to pay the bearer on demand the sum of £20”. But of course that is meaningless: try going along to the Bank of England and demanding £20 of gold (or anything else) in exchange for your £20 note. You’ll be told to shove off.

In short, there is no debt associated with monetary base.


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A flaw in Nominal GDP targeting.

There was a debate on NGDP targeting on Winterspeak’s site recently. One point missing (I think) from that debate (perhaps because it was too obvious) was as follows.

Advocates of NGDP claim that if the authorities concentrate EXCLUSIVELY on inflation, they’ll pitch aggregate demand too low when inflation has a significant cost push element.

As David Beckworth (probably the main high priest of NGDP) says,

“Inflation is the result or symptom of underlying shocks to aggregate demand (AD) and aggregate supply (AS). Monetary policy, however, can only meaningfully influence AD so that is where its focus should be. This cannot happen with strict inflation targeting because it requires the central bank to respond to any change in inflation, regardless of whether it is caused by AD or AS shocks.”

Well the answer to the latter point is that the authorities JUST DON’T concentrate exclusively on inflation: that is, the DO LOOK at the reasons behind inflation.

For example, Britain’s government and central bank think that the current excess levels of UK inflation are to a significant extent cost push and temporary. They are thus doing nothing too drastic to bring down this inflation to the 2% target within the next six months.

I don’t have any big objections to NGDP targeting: I just think it’s merits are exaggerated.

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Dennis Kucinich tells banks what they can do with themselves.

One minute clip:

http://www.youtube.com/watch?v=VaF_MZVWM3E

(Hat tip to Richard Shelley)

Krugman confuses fractional reserve and maturity transformation.

I have plenty of respect for Krugman, but he goes off the rails in this article, in which he tries to defend fractional reserve. Near the start there are two paragraphs which read as follows (in italics):

Like a lot of people, my insights draw heavily on Diamond-Dybvig (pdf), one of those papers that just opens your mind to a wider reality. What DD argue is that there is a tension between the needs of individual savers — who want ready access to their funds in case a sudden need arises — and the requirements of productive investment, which requires sustained commitment of resources.

Banks can largely resolve this tension, by offering deposits that can be withdrawn on demand, yet investing most of the funds thus raised in long-term, illiquid projects. What makes this possible is the fact that normally only some depositors want to withdraw funds in any given period, so it’s normally possible to meet those demands without actually having liquid assets backing every deposit. And this solution makes the economy more productive, providing more liquidity even as it allows more productive investment.

The latter process, transforming short term deposits into long term loans, is not fractional reserve: its called “maturity tansformation” (MT). Fractional reserve is the process whereby the private bank system holds a relatively small amount in the form of cash relative to its deposit lilabilities: in other words the private bank system can create and lend out money.

But since Krugman introduces MT to the argument, let’s examine it. It would certainly seem to bring benefits on the basis of the Diamond-Dybvig argument. But the first flaw in this argument is that it equates money (which is nothing more than numbers in computers) with REAL SAVINGS. Real savings are of course not just numbers in computers: real savings consist of houses, office blocks, machinery, etc.

Thus trying to make maximum use of our stock of money is senseless because numbers can be added to computers at no cost anytime. Or as Milton Friedman put it in Ch3 of his book, “A Program for Monetary Stability”, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”

So MT achieves nothing. That is, from the perspective of an individual bank it is profitable. But from the perspective of the country or economy as a whole, it’s a zero sum game.

Moreover, MT amounts to “borrow short and lend long”: an inherently risky strategy which brought down Northern Rock and hundreds of other banks over the centuries. Indeed, Krugman admits as much. He says:

The problem, of course, is the vulnerability of such a system to self-fulfilling panics: if people believe that a bank will fail, everyone will in fact want to withdraw funds at the same time — and because the bank’s assets are illiquid, trying to meet those demands through fire sales can in fact cause the bank to fail.

This then leads to the need for policy: deposit insurance and/or lender of last resort facilities to head off bank runs, and bank regulation to reduce the moral hazard from these explicit or implicit guarantees.

Quite. Put another way, MT is so risky that some sort of compulsory insurance is required to underwrite it. Ideally this insurance should be funded by those taking the risk (which to some extent in some countries it is). Unfortunately, insurance in most countries also comes in the form of the taxpayer funded implicit too big to fail subsidy. And that’s a blatant misallocation of resources.


Banks cannot be defined?

Krugman then claims that it is near impossible to define a bank, plus he points to the large shadow banking industry. This leads him to conclude that controlling fractional reserve is near impossible.

The first problem here is that I suspect the shadow banking industry does not engage in much fractional reserve. I suspect it’s main activity is connecting large lenders with large borrowers. That’s not fractional reserve.

In contrast, there is nothing to stop the shadow bank industry doing MT. And doubtless the latter helps explain the run on the shadow bank industry that contributed to the credit crunch.

Fractional reserve involves the CREATION OF MONEY. And money is defined as anything which is WIDELY ACCEPTED in payment for goods and services or settlement of debts. Now if I am some unheard of outfit claiming to be a bank and I want to do what large banks do, i.e. create money out of thin air and credit the account of someone applying for a loan, and that person then draws a cheque on me, the person who is given the cheque is unlikely to be happy with “payment” that consists of having their account at some “unheard of outfit” credited. The latter outfit could be me or some other shadow bank. They’re probably going to want their account at some large, respectable outfit credited.

Conclusion: it is difficult for shadow banks to do fractional reserve.

And even to the extent that shadow banks do do fractional reserve, I totally fail to see the difficulties in having government keep tabs on them. If government can keep tabs on every household with a view to extracting income tax from households, then where is the problem in keeping an eye on the smallest shadow bank which probably has a turnover fifty times that of the average household?

Government (at least in the UK) keeps tabs on, or tries to keep tabs on, one man band loan sharks who prey on poorer neighbourhoods.

And finally, the turnover of the shadow banking industry has risen sharply in recent years and is now about the same size as the official banking industry. If so called “bank regulators” are to be anything more that unproductive bureaucrats shuffling pointless bits of paper, then they are just going to have to get to grips with the shadow bank industry.

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The scourge that is unemployment.

Fractional Reserve.

Once upon a time there was an economy with a central banker called Ab Lerner. He spent money into the economy at a rate that brought full employment (and occasionally raised taxes and withdrew money when the population was gripped by irrational exuberance).

He didn’t want to operate bank accounts for households and businesses, i.e. “private sector entities” (PSEs). That function was performed by Lloyd Bankfiend, the commercial banker.

Each PSE wanted a stock of money to meet its need to make transactions, plus some extra money against a rainy day: the so called precautionary motive for holding money. Each PSE kept pretty well to its “transaction and precautionary” stock of money.

That in turn meant that no PSE could borrow unless some other PSE took the deliberate decision to forgo consumption and save money.

PSEs wanting to borrow sometimes borrowed direct from other PSEs, and sometimes they borrowed via Mr Bankfiend.

Mr Bankfiend only lent money that had been deliberately deposited with him in savings accounts rather than current or checking accounts.

The rate of interest in this economy was determined by market forces, that is, it was determined by the relationship between borrowers and lenders. That in turn optimised the amount of borrowing and lending and investment. Reason was that at the margin, the benefits of borrowing (e.g. the return on capital that businesses could obtain by making investments) was equal to the pain or disutility suffered by those abstaining from consumption so as to save.

Then one day Mr Bankfiend had an idea. “Why”, he said to himself “do I bother waiting for people to deposit money with me before crediting the accounts of those who want to borrow?”

He couldn’t think of a reason for not doing this. So next day when people came in applying for loans, and after making sure they had adequate incomes and net assets, Mr Bankfiend just clicked his computer mouse and credited the accounts of the borrowers.

The big advantage of this for Mr Bankfiend was that he collared the interest paid by the borrowers without having to pass any of it on to those who had put money in deposit accounts at his bank. Or as Murray Rothbard put it, fractional reserve bankers “can charge a lower rate of interest than savers would”.

But of course there is no such thing as a free lunch. The going rate of interest dropped, which meant that lenders (i.e. those with deposit accounts) lost income, while Mr Bankfiend gained.
Moreover, interest rates were no longer at the level at which costs and benefits at the margin were equalised. As a result GDP fell.

To make absolutely sure he retained this easy source of income, Mr Bankfiend paid the election expenses of various politicians so as to make sure they didn’t interfere with his new source of income.

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P.S. 28th Jan 2012. There is a much more detailed version of the above argument here.

Workfare.

An economy consists of a labour force of twelve people and two firms. Demand is enough to employ ten people (including the two employers). So there are two unemployed.

Wages are sticky downwards, but prices are flexible. Government is too incompetent to raise aggregate demand. What do do?

One solution is to tell the two unemployed individuals that if they want to continue receiving benefits they have to turn up at an employer’s premises and work part time.

The availability of this new source of free labour would induce the employers to cut the price of their products by enough to raise output by enough to keep the two unemployed people busy. That’s Say’s Law (I think).

That’s not as good as providing full time work for the two unemployed people (assuming they want full time work). But it’s better than having them full time unemployed.

Note that even if unemployment is at NAIRU in this economy (or at the “inflation barrier” as Bill Mitchell calls it), the above system would still work – at least to some extent. Reason is that at NAIRU, employers do not take on the unemployed because of the latter’s unsuitability. So if the employment subsidy involved here makes up for this unsuitability, employment would rise.

QED.

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