Huerta De Soto and full reserve banking.

Mervyn King, Governor of the Bank of England, said recently: “Of all the many ways of organising banking, the worst is the one we have today.”

Agreed. Question, is: what’s the best alternative?

Huerta Do Soto (DS) proposes an alternative. It’s set out in his book, “Money, Bank Credit, and Economic Cycles”, which is downloadable here. I’ll try to summarise the book: a summary which will doubtless be unfair, inaccurate and biased towards my own views. Anyway, here goes.

Paragraphs in italics below are 100% my own views, not DS’s.

Ch 1 (pages 1 – 37). This sets out the difference between two very different “animals”. First there is a deposit for safe-keeping which is intended to be repayable on demand by the depositor. The depositor may well have to pay the depositee for costs involved in safe-keeping. Second there is a loan for a longer or specific period of time. In this case the depositee normally pays interest to the depositor or lender.

Banks blur the distinction between the two, that is deposits that are supposed to be instantly repayable are not – because about 90% of them have been loaned on to others. De Soto attaches importance throughout the book to the fact that his breaks fundamental legal principles.


I disagree with the “legal” point. The fact an activity breaks a law or basic legal principles is not important. The important question is “what harm is done by the law breaking?” FR certainly does harm in that it amounts to letting commercial banks print money, which they do big time in a boom (exactly when the extra money is not desirable). I.e. FR leads to instability. Put another way, the harm comes from the instability, not from the fact that a legal principle has been broken.


Ch 2 & 3 deal with historical examples of the above illegality and attempts to legally justify fractional reserve.

There is plenty of historical material here. I am grateful to DS for opening my eyes to the extent to which many of the problems relating to money and banking were being discussed by ancient Romans and Spaniards and other mainland Europeans 500 years or so ago: long before Anglos got in on the act.

Another interesting point is that when FR first started, the bankers concerned were aware that they were doing something underhand. I.e. it has taken time, even centuries, for the process to become respectable.

Ch 4. This deals with the credit expansion process. De Soto says in respect of the generating money ex nihilo that “businessmen rush out to launch investment projects as if society’s real saving had increased, when in fact this has not happened. The result is artificial economic expansion or a “boom,” which by processes we will later study in detail, inevitably provokes an adjustment the form of a crisis and economic recession.” That is one of the central messages of the book.

Ch 5. Pages 256-291. An explanation of capital investment involving Robinson Crusoe and his desire to make a stick to collect fruit, and how making the stick involves sacrificing current consumption.

p. 291-341. DS (like many Austrians, I think) attaches importance to what are sometimes called “intermediate goods”. E.g. one firm makes metals, another turns metals into car parts, and finallya car manufacturer puts the parts together.

I just don’t get this. If FR leads to instability, then that is the problem. No doubt the latter problem plays out differently as between an economy where a lot of intermediate production is involved, and in contrast, a simpler economy with relatively little intermediate production. But this strikes me as unimportant. But maybe I’ve missed something here.

Pages 347-95. De Soto claims that FR produces artificially low interest rates which in turn leads to a misallocation of resources. De Soto claims that the above mentioned “intermediate goods” point is central to explaining this misallocation of resources.

I agree that FR leads to artificially low interest rates and a misallocation of resources. As to the intermediate goods point, as I’ve already said, I don’t get it. Seems to me that artificially low rates will clearly lead to a misallocation of resources - end of argument. Period. I don’t see the need for the “intermediate goods” points, but to repeat, maybe I’ve missed something.

DS repeats the classic Austrian idea that recessions are good in that they hasten the destruction of malinvestments made during the preceeding boom.

I’ve always disagreed with the latter point because malinvestments are CONSTANTLY BEING DISPOSED OF, in that hundreds of firms go bust or lay off staff per week and hundreds of new firms start up, or existing firms expand. Do we need two million people unemployed and GDP lower than it could be in order to get rid of malinvestments? Plus if a recession is unnecessarily prolonged, some malinvestments will go bust which given less of a recession may turn out to be viable in the long run given a bit of re-organisation, new management, or whatever.

Chapter 6. More on the history and theory of business cycles.

Chapter 7. Criticism of Keynsianism and Monetarism.

Chapter 8. Arguments for and against central banks. DS (like von Mises and Rothbard) is anti-central bank mainly because in acting as lender of last resort, they encourage recklessness.

Central banks do have that weakness. But at the same time, in an ideal world, a responsible central bank supplies extra monetary base when it is needed. I don’t see an efficient way of doing this in a “no central bank” scenario. DS’s proposed way seems to be prolonged periods of deflation (in both senses of the word). The latter certainly would result in falling prices and hence a rise in the value of the monetary base per unit of currency, but I dread to think what levels of unemployment would need to be endured and for what period to achieve this.

Also, if memory serves, the Bank of England intervened in the 1800s to provide liquidity in various crises between its foundation and WWI. Britain did not suffer rampant inflation at any time in that period.


Ch. 9. DS wants “elimination of legal tender regulations which oblige all citizens, even against their will, to accept the state-issued monetary unit
as a liberatory means of payment in all cases. The revocation
of legal tender laws is therefore an essential part of any
process of deregulation of the financial market. This “denationalization
of money,” in Hayek’s words, would allow economic
agents, who possess far more accurate, first-hand information
on their specific circumstances of time and place, to
decide in each case what type of monetary unit it would most
benefit them to use in their contracts.”

p. 739. De Soto says “Therefore our proposal of free choice in currency is clear. In the transition process which we will examine further on,
money in its current form is to be privatized via its replacement
by that form of money which, in an evolutionary manner,
generation after generation, has prevailed throughout history:
gold. In fact it is pointless to attempt to abruptly
introduce a new, widespread monetary unit in the market
while ignoring thousands of years of evolution in which gold
has spontaneously predominated as money”


I don’t agree that gold has in some way been the “natural” currency for centuries, while (presumably) debt based money has not.

This article by A.Mitchell Innes in the Banking Law Journal shows that if anything, it’s been the other way round.

A.Mitchell Innes article is here.


Indeed, the earliest tally stick dug up by archeologists dated from 30,000 years ago. So we can say that debt based money has been practiced for at least that period of time.

Thus the use of debt as a form of money is natural phenomenon. Thus isn’t DS being naïve in thinking that allowing the market to come up with its own form of money will get rid of debt as a form of money?

Third,the gold standard has big problems, e.g. the following:

i) The price of gold fluctuates. Of course governments can get round this by fixing the price of gold, but in this case, the price of gold is what it is because government says so. That’s not much different to a £20 note being worth something because government says so (or says the note is an acceptable way of paying tax).

ii) There isn’t nearly enough gold in the world to supply the world with an adequate amount of money. On can get round this by having central banks hold only small amounts of gold relative to total money supply, but the further this policy is taken, the nearer the currency becomes to being fiat.

According to de Soto, his system has numerous advantages, one of which is “The Proposed Model Promotes Stable, Sustainable Economic
Growth, and Thus Drastically Reduces Market Transaction Costs
and Specifically the Strains of Labor Negotiations.”

I don’t see Bob Crow, leader of the London Tube workers, and one of the most belligerent union leaders in Britain being all sweetness and light just because we have a De Sote monetary set up!!!


p. 760. De Soto then deals with various possible objections to his system. One of these is that: “The proposed system would largely decrease the amount of available credit, thereby pushing up the interest rate and hindering economic development.”

I quite agree. Essentially DS proposes cutting all commercial bank created money or credit, which leaves just monetary base. Plus the latter is presumably limited to the amount of gold available to back the monetary base. That is a HUGE HUGE reduction in the money supply, isn’t it?

De Soto then says “Hence we conclude that there is absolutely no theoretical basis for the assumption that the interest rate would be
higher in the proposed system than it is now. Quite the reverse
would be true.”

Well, that contradicts earlier parts of the book where he says that one of the main faults of FR is that it brings artificially low interest rates !!!!

Incidental points:

Re insurance companies acting as banks, De Soto is aware of the problem here, but does not think it is serious.

He is happy with a scenario where prices gradually decline (deflation in one sense of the word).

I think there is a problem here. Trade unions are very much wedded to their annual wage increase, even if it is only in nominal terms. I feel he is too optimistic about a scenario where deflation (in both senses) reins supreme. Personally I’d prefer to ban FR and maturity transformation and keep central banks plus aim for 2% inflation. That scenario involves risks, as De Soto rightly points out. But I feel it is the least bad of the various options.

A new way to rob taxpayers and subsidise banks.

This debate between Tim Congdon and Robert Skidelsky is worth a read.

Tim Congdon has long had thing about the monetary aggregates. He has discovered there is a relationship between the money supply and GDP, and in particular that the money supply collapses in recessions. From this he concludes that if the money supply is boosted, that helps us out of the recession.

The big flaw here, as Skidelsky rightly points out, is that it is questionable as to which way the cause effect relationship runs. Commercial bank created money is created when a private sector entity thinks it’s worth their while borrowing from the bank, and the latter condition will tend to obtain when businesses have full order books and/or the economy is at full employment and everyone runs out to get mortgages to fund house purchases. I.e. the cause effect runs from GDP to money supply (at least as far as commercial bank created money goes).

Indeed, what exactly IS the cause effect relationship running from money supply to GDP?

Congdon actually proposes a solution to the recession which we can use to examine the latter question. His proposal is for money to be created by government borrowing from commercial banks. So let’s say government borrows a trillion from commercial banks. What of it? If the mere fact of crediting government with a trillion has an effect, I don’t see it. Of course, as soon as government starts SPENDING that money (a la Skidelsky), then there is an effect. But not before. David Hume made very much the same point 250 years ago when he said in respect of money supply increases “If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.”

Anyway, moving on, the next question in relation to Congdon’s idea is: what on earth is government doing letting commercial banks create money out of thin air, when the government / central bank machine can perfectly well do this itself? Moreover, this proposal is a stealth subsidy for commercial banks (to add to the various subsidies of this nature already in operation). That is, a 100% reliable debtor (i.e. government) would be added to such bank’s balance sheets. Now that kind of dilutes the toxic debtors on those balance sheets, doesn’t it?

And finally, note that the above argument between Congdon and Skidelsky is one of the many problems that come out in the wash under Modern Monetary Theory (MMT). I drew attention to a couple of other problems that come out in the wash here.

Under MMT, given a recession, government prints money and spends it (and conversely, given an inflationary boom, government raises taxes and/or cuts government spending, reins in money and extinguishes it). In a recession, whether the effect comes the act of spending (as per Skidelsky) or from the money supply increase (as per Congon) doesn’t matter!

Afterthought (26th Oct): Congdon is not the only one to advocate the above “have government borrow from commercial banks” policy. Another advocate of this policy is here:

The stimulus was never designed to do much.

The billionaire funded anti stimulus movement in the U.S. is fond of claiming that the original stimulus did not achieve much. Well the answer is that it wasn’t designed to do much, apart from prevent the entire U.S. economy grinding to a halt. It was certainly never designed to bring the U.S. back to full employment in two or three years.

See here, and search for the three or four paras starting:“The most important question facing Obama…”.

Let’s re-allocate the bloated monetary base into household pockets.

People are employed when other people wave their dollar bills or credit cards in the air and demand goods and services. It is tragic that this statement of the obvious needs to be made, but as I pointed out here, half the economics profession seems to have forgotten the above point.

The big obstacle to getting more dollars into household pockets is the dreaded deficit. That is, channelling money into household pockets can only be done by increasing the deficit, and Republicans and supposedly liberal Democrats (who largely accept conservative thinking when it comes to deficits, as Bill Mitchell has pointed out time and again) won’t wear any significant increase in the deficit because they think the latter involves increasing the national debt.

The latter idea is nonsense, of course, because deficit can perfectly well accumulate as additional monetary base instead of national debt. (Incidentally, politicians’ failure to get this point is a problem in the UK as much as the US, however there is less scope for stimulus in the UK just at the moment because inflation is around 3%. Thus the real potential benefits from politicians’ grasping the above point are to be had in the US rather than the UK, at the time of writing.)

However there is a solution of sorts to the political log jam which is thwarting economic progress. This solution derives from the fact that there is already a huge amount of monetary base out there doing little or nothing. It derives from quantitative easing. It is now widely accepted that QE is near useless: “pushing on string” to use the popular phrase.

So why not use the money which is already out there doing nothing, to actually DO something? In other words why not reverse QE and channel the money so obtained into household pockets?

When QE was first started, conservatives, like so many Pavlov dogs, started chanting “Weimar . . .Mugabwe”. Well they’ve been proved wrong on that one.

If the excess supply of monetary base already out there is simply re-allocated, they can’t possibly do their “Weimar . . . Mugabwe” chant. No increase in the monetary base is involved. And another beauty of this wheeze is that while the deficit goes up, no increase in the national debt ensues. So conservatives cannot cite their “national debt” argument. They’ll be stumped.

Afterthought (20th Oct). There is a vaguely similar suggestion by David Blanchflower: have the Fed buy the debt of individual states in the U.S. That’s kind of “the Fed doing fiscal policy”.

That rather falls for moral hazard: it encourages reckless behavior by states in the future. But the benefits might outweigh the costs.

100% reserve banking: lecture at the LSE by de Soto.

Jesus Huerta de Soto, is a Spanish prof who has written an entire book against fractional reserve banking (750 pages!). He goes into the entire history. Seems to me (and don't take my word for it) that we are still all arguing about the points relating to banking that ancient Romans were aware of and that various Europeans were aware of 500 years go.

The book is called "Money, bank credit and economic cycles" and it's available online.

His lecture at the London School of Economics is on Thursday 28th Oct., which I intend going to. Details here:

Conference on Banking, Money, etc in London, 13th & 14th November, 2010.

See:
http://www.positivemoney.org.uk/studentconference

See here for more details about the Positive Money Campaign:

http://www.positivemoney.org.uk/issues/

I think the conference is open to almost anyone who is interested. At least they’re letting me attend, so it must be open to almost anyone! Cost: £10 for students and £20 for non students.

Ricardian equivalence is nonsense.

At least there is a way in which Ricardian equivalence is applied to the stimulus debate which is nonsense, and as follows.

If government borrows and spends in a recession, so the Ricardian argument goes, it will have to raise taxes and pay back the money sooner or later. Plus households are allegedly aware of this. So given a deficit, households will allegedly start saving now for the above future tax hike. And this in turn renders stimulus ineffective. The flaws in this argument are thus.

First, the idea that the average household has enough knowledge about economics to be able to calculate the “deficit per household” is an idea that comes from “la-la” land, as Bill Mitchell put it in his recent blog post about Ricardian equivalence.

However, let’s proceed on the basis that the average household CAN make the above calculation, and proceed to “flaw No. 2”, which is thus.

Government will not necessarily get the money for the payback from increased tax. It may get the money from public spending cuts. Indeed, govt probably WILL do this, to a greater or lesser extent.

And there is no need for households to “save up” for public spending cuts. When the cuts arrive, govt just spends a bit less on roads, the armed forces, the police and so on, and that’s that.

Third, and assuming the pay back comes from tax increases, there is no point in govt paying back the above debt till the economy looks like overheating. I.e. the debt is paid back in a scenario where households cannot effectively spend any more (on pain of causing inflation). Thus taxes have to rise. However there is no point in “saving up” to pay this extra tax in as far as govt grabs this extra tax before the average household gets its hands on the money.

For example most income tax (i.e. for wage earners) is deducted before wage earners see the money (at least that’s the case in Britain and most Western countries). In that govt grabs extra tax before households get their hands on the relevant money, any household which “saves” to meet the tax liability is engaged in double counting.

Turning now to where households DO get their hands on income before govt confiscates a proportion in the form of tax, there is a paradox or self contradiction in household behaviour here, if the average household “saves up” to meet the alleged future tax liability. The paradox is thus.

As pointed out above, a rational govt will only raise taxes where the economy looks like overheating, that is, where households are attempting to spend too much, i.e. and demand goods and services in such a volume that the economy cannot meet the demand.

Now what is the central objective in “saving so as to meet a future tax liability”? The objective is presumably to be able to meet the liability while leaving the household bank balance undiminished. But the whole cause of the problem (excess demand) is caused by households attempting to RUN DOWN their bank balances too fast (or “dissave”).

Let’s summarise that. If the average household is thrifty and saves to meet some future tax liability, demand will not become excessive, so there’ll be no need for the tax! Alternatively, if the average household becomes too spendthrift, demand will rise too far, thus govt will have to increase taxes so as to damp demand. But in this situation, the average household is clearly not aiming to “leave its bank balance undiminished”!

There is a fourth and less important flaw in the Ricardo argument. This is worth a mention because the mere fact that you never see it mentioned by advocates of the argument illustrates their ignorance. The flaw is thus.

If the monetary base and national debt are to remain constant as a proportion of GDP, they will have to be constantly topped up because they are constantly declining in real terms because of inflation. To illustrate, if nat debt and mon base are say 50% of GDP and inflation is 2%, you need a constant and never ending deficit of 2 x 0.5 = 1% of GDP. That portion of the deficit is NEVER paid back. I.e. it is not “future tax”. To illustrate, the U.S. mon base increased from around $50bn in 1960 to around $2,000bn in 2010. (And you can just imagine the average household being fully conversant with that point, can’t you!)

To reiterate, I’ve never seen advocates of the Ricardo argument mention the point in the above paragraph. That is they never say something like “households will save to meet the cost of deficits, except in as far as there is there is need for a constant and never ending deficit of about 1% of GDP per year”.

___________

Finally, it is always possible that the above mentioned situation where debt has to be paid back to stop the economy overheating may take several years to materialise, during which time a somewhat bloated national debt persists. This may strike some readers as unsatisfactory and I quite agree. That is, I think Keynesian “borrow and spend” has serious flaws. I much prefer what might be called “Modern Monetary Theory / Abba Lerner print and spend”. I’ve set out the reasons here: