Let’s subsidise banks and everything else.

An articleabout the UK government’s enthusiasm for peer to peer lending says  “Government is also keen to encourage alternative finance and last week announced four peer-to-peer lenders will be given a total of £55m in taxpayers' money…”

So the solution to the TBTF subsidy and occasional billion pound bail outs for large banks is to subsidise smaller lending entities as well?

But wait a moment. That means preferential treatment for ALL LENDING entities vis a vis other sectors of the economy. What to do?

I know: why not subsidise EVERY FIRM IN THE COUNTRY with taxpayers’ money!

But wait a moment (again). That means impoverishing the poor old taxpayer. Now what’s the solution to that? Scratch head…... I’ve got it: hand out taxpayers’ money to taxpayers.

As Tim Worstall put it in answer to the politician wanting to know why people hated politicians:

“Because you’re ignorant fuckwits who steal all our money” .

_________

Hat tips to Mike Norman’s blog and Washington’s blog.

Hopeless criticisms of full reserve by Messers Wolf, Diamond, and Dybvig.

Martin Wolf claims full reserve would mean an end to monetary policy. 

He assumes that full reserve banks would hold only very safe assets like government debt. That assumption is actually debatable: that is, it can well be argued that where depositors want 100% safety, the relevant bank should back that simply with monetary base, not government debt. But there isn’t a huge difference between debt and base, so let’s run with Wolf’s assumption.

He then claims that full reserve would “eliminate monetary policy” because “Public debt held by banks would set the money supply.”  I’m baffled.

The proportion of public debt held by commercial debt is small (2% in the US and 11% in the UK). So quite why the fact of commercial banks holding a small proportion of debt would stop a central bank buying or selling debt with a view to influencing interest rates is a mystery.

My source of the 2% and 11% figure is here.

Moreover, even if full reserve DID MEAN an end to monetary policy, that outcome would be enthusiastically embraced by the authors of at least one of the leading works advocating full reserve: the submission to Vickers by Richard Werner, Positive Money and the New Economics Foundation. That submission was very explicit on the deficiencies of monetary policy and why we should rely on fiscal policy alone (or to be more accurate, why we should merge monetary and fiscal policy).

Full reserve would cut funds available to borrowers or investors?

The above is silly criticism because it is so obvious. It’s a bit like telling a bicycle manufacturer that bicycles are inherently unstable, so we’d be better off with tricycles.  

Advocates of full reserve, along with bicycle manufacturers and users, have tumbled to the above blindingly obvious apparent problems, and have solutions. They’d be verging on mentally deficiency if they hadn’t noticed those very obvious apparent problems.

Martin Wolf makes the above criticism when he says “the supply of funds to riskier, long-term activities would be greatly reduced if we did adopt narrow banking”.

Wolf concentrates (to repeat) on what he calls “long-term activities”, while Diamond and Dybvig (DD) concentrate on shorter term loans (p.65-6). But that difference is unimportant. The important point is that implementing full reserve would, at least initially, constrain bank activities and thus reduce lending (probably both long and short term).

But that’s no problem because any deflation stemming from such reduced lending can be countered by having government and central bank create and spend new money into the economy. And one side effect of that is that everyone would have more money, thus people and firms would NOT NEED TO borrow so much. I.e. total debts would decline.

So the crucial question is: which system gives us an optimum or nearer optimum allocation of resources: a “high debt, high lending” system under which bank lending is underwritten by, and thus subsidised by taxpayers, or a lower lending / lower debt system (full reserve) which requires no subsidy?

Well that’s an absolute no-brainer for anyone who has got as far as GCSE in economics. That is, subsidies of so called “commercial” entities are completely and wholly unjustified. Period. Full stop. End of. Finito.

Forgive me for flogging a dead horse, but the mere fact that fractional reserve cannot do without a taxpayer backing means that fractional reserve is kaput. It’s in check mate. In the words of Monty Python, “Look, matey, I know a dead parrot when I see one, and I'm looking at one right now.”

Incidentally, the reason why it’s virtually impossible for a full reserve bank to fail is that, first, as regards money which depositors want to be 100% save, that is not invested at all – or is only invested in ultra-safe securities, like government debt. And second, as to money which depositors want loaned on or invested, depositors carry most of or all the costs if and when those loans or investments go wrong.

Adair Turner’s odd reasons for opposing full reserve.

Turner is head of the UK’s Financial Services Authority and he often promotes thoughtful and radical ideas. But he went right off the rails in this speech. He very eloquently set out some of the defects in fractional reserve banking. (For some relevant quotes, see here.)

But he ends (p.16) by giving some utterly feeble and laughable reasons for RETAINING fractional reserve. And I think I know why.

This is part of a pattern. Mervyn King did the same: set out some well thought out criticisms of fractional reserve while in the end backing the Vickers commission’s very timid changes to bank regulation (which will be watered down to nothing within 5 years thanks to bank lobbying).

The pattern is that people in high places cannot openly oppose the conventional wisdom or the consensus establishment view too strongly (at least not if they want to keep their jobs and/or get gongs). Also members of the establishment don’t want to be seen to be too openly squabbling with each other.

Anyway, Turner’s first reason for retaining fractional reserve is (in green italics):

 . . .  that some private credit and money creation may be essential to the effective mobilisation of savings and that this requires a role for fractional reserve banks.

What?

Take an ultra-simple economy in which the money supply is fixed. Some people save and plonk their money in banks. Others want to borrow, so they borrow from banks.

Now unless I’ve temporarily gone round the twist, that system “mobilises” savings doesn’t it? Why on Earth is it necessary for banks to create money out of thin air for the above “mobilisation” to take place. I’m baffled.

Turner continues:

Banks perform risk pooling, enabling the funds of multiple savers indirectly to finance multiple borrowers: in theory at least this function could be performed by non-bank loan funds, but how truly practical that is, particularly in SME sectors, remains unclear.

Well the word “unclear” is ust a euphemism for “I don’t know”. I.e. if something is unclear to Turner, why doesn’t he just keep quite on the point? Any normal person who wants to make a useful contribution to this world says what they think where they have definite views, while in contrast, they keep quiet when they aren’t sure. In fact even drunks in pubs up and down the land normally obey that rule: that is they let everyone know in no uncertain terms what they think when they have a view, while in contrast they keep quiet when they aren’t sure about something.

In contrast, academics, intellectuals, pseudo-intellectuals, quangocrats, etc. when they aren’t sure – well they just carry on talking, while interspersing their hot air with the occasional “remains unclear” sort of phrase.

As to why it should be difficult for “non-bank loan funds” to gauge the creditworthiness of SMEs or anyone else is a mystery. Creditworthiness appraisal nowadays is very automated: unlike in the days of “Captain Mainwaring” banking where personal relationships were more important. And in as far as personal relationships ARE RELEVANT, there is no conceivable reason why those relationships should be any harder to build up in a non-bank / borrower relationship than in bank / borrower relationship.

In fact UK building societies used to work in a full reserve manner: that is they didn’t lend out money till they’d got the requisite funds in the kitty. Indeed some mutual building societies may still work in this full reserve manner, but whether they still do is beside the point. The real point is that building societies which work on full reserve principles had / have no trouble arranging for “funds of multiple savers indirectly to finance multiple borrowers”.

And then there are credit reference agencies: organisations that gauge the credit worthiness of people and firms. But those agencies are not banks. How on Earth do those agencies do their job and make a living? I’m baffled (not).

Turner continues:

But more fundamentally, banks perform maturity transformation, enabling households and businesses to hold shorter term financial assets than liabilities. And that is likely to enable greater long term investment than would otherwise be supported. As Walter Bagehot argued persuasively, the development of joint stock fractional reserve banks may well have played an important role in the development of the mid-nineteenth century British economy, giving it an advantage over other economies where maturity transforming banking systems were less developed.

OMG. Not the tired old “maturity transformation” argument.

It’s blindingly obvious that maturity transformation (MT) enables more lending to take place – but it’s risky! It is precisely MT (i.e. “borrow short and lend long”) that has brought down hundreds of banks throughout history.

And how is that risk covered nowadays? Well it’s the taxpayer that carries much of the risk. In other words the additional lending that MT brings only comes about thanks to the astronomic subsidies that banks get. And an industry (or any part or aspect of it) that needs subsidising does not make economic sense. Subsidies (unless there is a very good reason for them) reduce GDP.

In short, the fact that MT increases investment DOES NOT prove that that investment increases GDP. If that investment takes place partially or wholly because of a subsidy, the result will be more than the optimum amount of investment, which in turn will REDUCE GDP.  

As to the reference to Walter Bagehot, that is COMPLETELY IRRELEVANT. In Bagehot’s day the gold standard prevailed, that is the money supply (or monetary base to be exact) was fixed. Or at least it was very inflexible. And that in turn meant that it made sense to maximise the use of money.

However we are no long in a gold standard environment: i.e. the monetary base is infinitely flexible. Indeed (and perhaps Adair Turner hasn’t noticed) the base has expanded by astronomic and unprecedented amounts recently thanks to QE.

And that all means that any deflationary effect that comes from banning MT can be countered by simply creating and spending new money into the economy. Which in turn means we can get rid of the risks involved in MT at zero real cost! What more do you want?

As Milton Friedman put it in his book “A Program for Monetary Stability” (which advocated full reserve), “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”

Now for the next “Turnerism”:

The second is that quite apart from mobilising savings and allocating them to alternative investment projects, the creation of credit and private money can support life cycle consumption smoothing (with e.g. mortgage debt and matching deposit savings lent to and borrowed from people at different points in their life cycles), and that this can be welfare enhancing even if it has no necessary impact on growth rates.

Why in God’s name does allowing “private money” creation enhance “life cycle consumption smoothing”?  Turner’s “mortgage debt and matching deposit savings” would take place perfectly OK in the above hypothetical economy where total money supply is fixed. Or have I (again) gone round the twist?

Why do central banks normally impose positive rates of interest?

I’ll argue below that there are two reasons, both of them bizarre. One reason stems from corruption. The second is that those positive rates stop what would otherwise be rampant inflation caused by the fractional reserve banking system. Hope that’s bizarre enough for new year’s day. Here goes.

As everyone knows, the current zero or near zero rates are an exception: normally central banks implement a positive rate of interest of a few percent: perhaps about 3% on average over the decades.

But why does the government of a country that issues its own currency borrow money? Such a government can simply print money. Borrowing something, and paying interest for the privilege when you can produce the thing yourself for free is crazy. At least that is certainly true where a government needs money for stimulus purposes.

As to where a government borrows as substitute for collecting taxes, it may well have to pay interest. But such borrowing makes no sense, for reasons I set out in detail here. As I pointed out in the latter article, the REAL REASON that politicians borrow instead of collecting tax is that voters tend to blame politicians for tax increases, but not for any interest rate increases that stem from government borrowing. So borrowing is a great way for incumbent politicians to buy votes and that is plain straightforward corruption.

So there you have one reason why central banks normally impose positive rates of interest: corruption – a brilliant reason for such positive rates, don’t you think? But there is another reason for positive rates which will never have occurred to you, and it’s as follows. It’s a bit complicated, but here goes.

Fractional reserve banking.

Several economists have advocated, I think quite rightly, that the rate paid by governemnts / central banks should be permanently set at zero. For example Milton Friedman and Warrant Mosler have advocated that the government / central bank machine should not issue interest yielding liabilities: that is the only liability (if you can call it that) that they should issue should  be cash, or “monetary base” to be exact. And cash pays no interest.

But there is actually a problem with that zero interest rate policy not spotted by Friedman or Mosler. It’s a problem alluded to by Selgin and Huber (p.31), and it’s the fact that commercial banks can print and lend out money. That is, such banks do not always need to pay interest to anyone in order to obtain funds to lend out: i.e. such banks can simply create money from thin air and lend it out. That way they undercut what you might call “genuine savers”.

Now if commercial banks do that when the economy is already at capacity (which is exactly when they’re likely to do it), the result will be excess demand and inflation. But why should commercial banks or those they lend to care about inflation? No reason at all. As to borrowers, they are more than happy to see their liabilities eaten away by inflation. As to commercial banks, their money printing operation costs nothing, so if the value of that money when repaid has halved, why should commercial banks care as long as they get paid interest?

In short, I suggest that fractional reserve based on a fiat monetary base leads to rampant inflation, unless the inflation is controlled by having central banks artificially boost the rate of interest a bit. In contrast, fractional reserve based on a gold monetary base does not suffer the same problem because gold blocks the inflation.

Banks’ administration and bad debt costs.

The above argument is a slight over simplification in that part of the so called interest that banks charge is necessary to cover administration and bad debt costs. But in addition to the two latter, there is what might be called “genuine interest”: that’s a reward to the lender for foregone consumption. In other words the above argument ignores (for the sake of simplicity) administration and bad debt costs.