Positive Money and Milton Friedman are right to advocate full reserve banking.

Summary.

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.

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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.

Capital requirements.

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.

Merging Monetary and Fiscal Policy.

Summary. The advantage of merging monetary and fiscal policy is that monetary policy negates the defects of fiscal policy and vice versa.

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Several economists and groups advocate merging monetary and fiscal policy: e.g. Milton Friedman and Positive Money (PM). Also most advocates of Modern Monetary Theory seem to favour the merge.

What that means, to illustrate, is that when stimulus is needed, government and central bank (GCB) simply create money and spend it, and/or cut taxes.

For Friedman see here in particular the paragraph starting “Under the proposal…”, p.250). And as Claude Hillinger, another advocate of the merge put it, “An aspect of the crisis discussions that has irritated me the most is the implicit, or explicit claim that there is no alternative to governmental borrowing to finance the deficits incurred for stabilization purposes. It baffles me how such nonsense can be so universally accepted. Of course, there is a much better alternative: to finance the deficits with fresh money.”

Separating politics from economics.

The above merge has an apparent problem, namely that the decision as to what the TOTAL SIZE of a stimulus package should be (economics) might seem to get mixed up with the ACTUAL FORM of the package (e.g. whether it should take the form of increased public spending or tax cuts, which is obviously a political decision. In fact, as is explained in PM literature, those two can easily be kept separate.

Monetary policy is distortionary.

For example, in the case of interest rate cuts, stimulus is channelled into the economy only via increased borrowing and lending and investment. That makes no more sense than channelling stimulus into the economy just via extra car production and more restaurant meals. Plus a recent studyby the Fed claimed that interest rate adjustments don’t work too well.

As to quantitative easing (the other main form of monetary policy), that is also distortionary: it channels money into the pockets of a small section of the population, namely the asset rich. And the recent bout of QE failed in one of its objectives, namely to boost investment. But even if it did boost investment, that would still be distortionary. Moreover, QE caused flows of hot money into developing countries: yet more distortion.

Fiscal policy on its own means crowding out.

As to using fiscal policy alone to impart stimulus, that suffers from a well known defect, namely interest rate crowding out, though there is not much agreement on the actual extent of that defect .

Ergo . . . why not combine monetary and fiscal policy? Each deals with the other’s defects.  That is, in the case of fiscal policy, it’s the additional government borrowing which to a greater or lesser extent raises interest rates and negates the stimulatory effect of additional government spending (or reduced tax). But under the combined system, there is no borrowing and thus no crowding out.

As to the defect in monetary policy, namely that it is distortionary, that can be dealt with by having the fiscal element of the combination implemented in a non-distortionary manner. E.g. raising or reducing taxes on everyone’s income would involve little distortion.

The only difference between PM and Friedman here, is that Friedman thought the automatic stabilisers alone would deal with fluctuations in demand, and hence that no DISCRETIONARY changes to demand would be needed. In contrast, PM advocates “discretion”. And indeed, a substantial majority of economists are with PM on that one.

The merge assumes national debt shrinks to nothing.

A “no fiscal policy on it’s own” objective would actually mean the national debt shrinking to nothing eventually while the monetary base would expand so as to keep it roughly constant relative to real GDP. Now that might be unconventional, but would it be a disaster? Well not according to Friedman (see the above link to the relevant paper of his). Plus Warren Mosler advocates a “no government debt” policy (see 2^nd last paragraph here).Plus I attacked the whole idea of government debt here.

Bank reform shambles.

Here is a selection of literature spelling out the chaotic nature of recent attempts to reform banks.

1. Article by Gordon Brown (Britain’s former prime minister) in the New York Times (Dec 2013) entitled “Stumbling towards the next crash”. Here’s an extract:

“….most of the problems that caused the 2008 crisis — excessive borrowing, shadow banking and reckless lending — have not gone away. Too-big-to-fail banks have not shrunk; they’ve grown bigger. Huge bonuses that encourage reckless risk-taking by bankers remain the norm. Meanwhile, shadow banking — investment and lending services by financial institutions that act like banks, but with less supervision — has expanded in value to $71 trillion, from $59 trillion in 2008.”

2. Article by Robert Schiller (recent economics Nobel Laureate) entitled “The Financial Fire Next Time.” Published by Project Syndicate.

3. Article in the Financial Times (mid Jan. 2014) entitled “Nothing can dent the divine right of bankers”. If you Google that title, obviously you’ll find the actual FT article, but it’s behind a pay-wall. However it’s been re-produced on a Spanish web site: “Hipona”.

4. Article by Alistair Darling (Britain’s former finance minister) entitled “A crisis needs a firewall not a ringfence” published by the Financial Times. Darling’s article claims that the ring fence proposed by the Vickers commission would not have prevented the crisis. (The Vickers commission was the committee in Britain which has produced a new set of rules to govern banks which will supposedly make the banking system safer.)

5. Book by Lawrence Kotlikoff (economics prof. in Boston) which is much more scathing about Vickers than Alistair Darling. The book is entitled “The Economic Consequences of the Vickers Commission”.  The book is free online.

6. New York Times article by Simon Johnson, former chief economist at the IMF, entitled “The Rich Country Trap”. It’s about the corrupt politician / banker nexus and he predicts it will continue.

7. Article by Martin Wolf entitled “Why bankers are intellectually naked”. This argues that the capital requirements envisaged by Vickers are nowhere near enough (a point which Sir John Vickers himself has now conceded).

8. Article by John Cochrane(University of Chicago professor) entitled “Stopping Bank Crises Before They Start” published by the Hoover Institution. Opening sentence: “In recent months the realization has sunk in across the country that the 2010 Dodd-Frank financial-reform legislation is a colossal mess.”

Negative interest rates are daft.

Miles Kimball is one of the long list of economists advocating negative interest rates. And the idea has an obvious appeal, approximately as follows.

Interest rate adjustments are one of the conventional tools used to control demand, so if it seems that demand is deficient despite interest rates being reduced to zero, then the obvious next step is to go for negative rates.

Now the first flaw in that idea is that interest rate adjustments are an inherently defective way of adjusting demand because (assuming they work at all) they influence just one form of economic activity: borrowing, lending and investment. But whence the assumption that a recession is necessarily caused by a drop in investment? Recessions can be caused, partially or wholly by a drop in current as opposed to capital spending.

Next, according to a recent Fed study, there is little relationship between interest rates and investment spending. But that all pales by comparison to the defects in negative interest rates, which are as follows.

If I can borrow money at say minus 4%, it will pay me to do something that yields minus 2%: like say buying up 100 houses per year and knocking 2 of them and selling the remaining 98. Now that’s a really useful thing to do, isn't it?

Of course no one is going to do anything so blatantly pointless just because they can borrow money at a negative rate. But that’s near irrelevant because in most forms of economic activity, e.g. running a chemical plant, it’s impossible to tell simply from looking at the stuff consumed and the stuff produced whether you’re doing anything useful. E.g. a chemical plant might consume chemicals A and B and produce chemicals C and D. But how do you know that’s a useful thing to do? Why not put it all into reverse and consume C and D and produce A and B?

Well the conventional way of determining whether you’re doing something useful is the bog standard profit and loss account. That is, if the market price of stuff produced exceeds total costs (including interest payments) then you’ve made and profit and you’ve done something useful.

So returning to the above genius form of housing development, and replacing the 100 houses with say two chemicals W and X and replacing the 98 houses with two chemicals Y and Z, it’s possible to run a chemical plant in a negative interest rate scenario where wealth destruction takes place, that is the value of chemicals produced is less than the value off the stuff consumed (including chemicals, negative interest payments made to creditors, and so on).

There is of course a much better way of implementing stimulus. It’s the way favoured by most MMTers I think. And that’s simply to create new fiat currency and spend it and/or cut taxes.

An alternative (favoured by market monetarists) is to have the central bank create new fiat currency and buy assets. While that is better than negative interest rates, I don’t like it because it channels money into the pockets of a small section of the population: the asset rich. Plus it boosts (at least initially) only a narrow range of types of economic activity. That is, it just boosts just investment spending.