George Selgin’s odd claim that central banks are destabilising.

I have a plenty of respect for George Selgin, despite the fact that he advocates fractional reserve banking while I advocate full reserve. He knows a lot about the history of banking, plus (unlike many academics) everything he writes is clear, precise, waffle-free and informative.

But he had an off day when writing this article which claims that central banks are destabilising.

Summary.

His basic argument is thus. First, central banks can create money willy nilly (true). Second, in a gold standard environment that freedom to create excessive amounts of money can lead to a general excess supply of money which leads to inflation, which in turn leads to gold being drained out of the country (true). And that in turn can lead to the central bank suddenly realising it is short of gold (true). So it suddenly brings the money supply expansion to a halt or reverses it, which results in a depression (very plausible).

Most readers will presumably have noticed the big flaw in that argument: no country is now on the gold standard! And as far as a balance of payments deterioration goes, that is dealt with nowadays by exchange rate adjustments (except of course within the Eurozone).

Selgin’s encyclopedic knowledge of the history of banking has got the better of him!

But that’s not to say central banks cannot be sources of instability: the lender of last resort function can be a source of instability. However that source of instability is ruled out in a full reserve environment. 

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Is the commercial bank system stable?

The first weakness in his argument comes where he claims that the commercial bank system is inherently stable. His argument is that no one bank can expand too fast, else it loses reserves to other banks (true). Therefore the entire commercial bank system cannot expand too fast. As he puts it, “This routine note-exchange and settlement process imposes strict limits on credit expansion by individual note-issuing banks and, hence, by the banking system as a whole…”

Incidentally the reason for the phrase “note exchange” is that he assumes a system in which each commercial bank can issue its own banknotes. Strange as it may seem to 21^stcentury folk who have spent their entire lives under a system where only central banks can issue notes, that assumption does not influence the argument one way or the other: it’s no big deal.

Of much more relevance is the historical fact that (contrary to Selgin’s above argument) commercial banks behave like lemmings. That is, while no individual bank can expand much faster than its rivals, the fact is that, for example, British banks loaned money into existence like there was no tomorrow prior to the recent crisis. The chart below shows commercial bank money expanding much faster than central bank money in the three years prior to the crisis.

So that rather dents Selgin’s claim that the commercial bank system is inherently stable.

Central banks promote instability under the gold standard.

The next problem with Selgin’s argument is that he assumes a gold or “specie” standard. As he puts it “I assume that banks, whether enjoying exclusive privileges or not, are obliged to redeem their notes on demand in specie—that is, in gold or silver coin.” Moreover, he assumes a WORLDWIDE gold standard.

He then points out, correctly, that given central bank privileges, central banks are under nowhere near the same constraints as commercial banks. That is, they can print money almost willy nilly, and if they do, that enables commercial banks to expand in a similarly irresponsible manner. And that according to Selgin leads to inflation and a movement of gold out of the relevant country.

As a result, in Selgin’s words, “The central bank consequently finds itself in danger of imminent default and proceeds to save itself by aggressively contracting credit. The contraction reduces commercial banks’ reserves, forcing them to contract as well and thus triggering a general credit crunch.”

Now there is nothing wrong with that argument, given Selgin’s assumptions. But there is just one whapping great and totally unrealistic assumption, namely the gold standard assumption. That is, no country nowadays is on the gold standard! That is, the “loss of gold” or “specie” point is plain irrelevant for 21^stcentury purposes. Thus Selgin’s argument falls to pieces.

Put another way, central banks nowadays are free to print their way out of trouble, and as to currencies, they float relative to each other.

Central banks can nevertheless be destabilising.

But that is not to say that central banks cannot be destabilising. For example the idea that Argentina’s central bank is a source of stability is a joke (particularly when, as is normally the case, the bank is under the control of Argentine politicians.)

One important reason why central banks can be destabilising nowadays is actually one that Selgin points to. It’s the “lender of last resort” function that those banks perform.

If central banks abided by Walter Bagehot’s prescription and lent to problem banks at penalty rates and in exchange for first class collateral, there wouldn’t be a problem. But of course the reality is that (thanks to political and populist pressures) that function has degenerated into lending at zero or near zero rates of interest and on the basis of some very dodgy collateral.

And that just fuels credit expansion based on NINJA mortgages and other questionable bits of paper.

Full reserve comes to the rescue.

But this is where full reserve banking comes to the rescue. Under full reserve, commercial banks just don’t have any reason to go running to central banks for assistance. Under full reserve, commercial banks perform just one basic and very simple function (with a possible second function thrown in).

The first or basic function is to act as what might be called depositories. That is banks accept deposits and do nothing with the relevant money – or at most, they invest in ultra-safe securities like government debt. So that part of commercial banks cannot fail.

As to the second function, granting loans and making investments, that function is carried out (at least under the version of full reserve advocated by Laurence Kotlikoff) by entities that amount to the same as unit trusts (mutual funds in the US). Again, there is no reason for commercial banks to go  running to central banks any more than existing unit trusts go running to central banks. That is, if a series of loans or investments made by a bank’s “unit trust” division go wrong, then those who have invested in the unit trust find the value of their holding declines, just as is the case with existing unit trusts.

In contrast to Kotlikoff, other advocates of full reserve don’t propose unit trusts playing a big role, but they do advocate other ways of achieving what Kotlikoff aims to achieve with his unit trusts: that’s to make sure that depositors who want their money invested carry some or all the losses when those investments go bad.

Diamond and Dybvig, opponents of full reserve, advocate full reserve.

Douglas Diamond and Philip Dybvig (DD) attack full reserve banking here, but unwittingly support it here.

Their criticisms of full reserve appear in section  III of the above first paper. And their first criticism is the bog standard and not too clever criticism made by others namely that full reserve would constrain bank lending

Now the problem with that criticism is that it is such a blindingly obvious apparent flaw in full reserve that the advocates of full reserve would have to verging on mental deficiency if they hadn’t spotted it and thought of a solution. The UK’s Vickerscommission actually made the same criticism, and I answered it here. But just to repeat, the solution is that government / central bank can perfectly well make up for any deflatonary effect of full reserve by creating and spending new money into the economy.

Indeed, full reserve by its very nature involves replacing commercial bank money with central bank money, thus the above “solution” is pretty much part and parcel of full reserve.

The alleged shadow bank problem.

The second criticism of full reserve made by DD is that if the larger banks are forced to obey the rules of full reserve, that will just result in shadow banks filling the void. That is, shadow banks will up their fractional reserve or money creation activities.

As DD put it, “Furthermore, the proposal is likely to be ineffective in increasing stability since it will be impossible to control the institutions that will enter in the vacuum left when banks can no longer create liquidity”. (Incidentally, Charles Goodhart also makes much of this problem in the Appendix here.)

Well there are simple flaws in the above DD argument as follows.

First, regulating shadow banks should not be too difficult. One reason for thinking that is the head of the UK’s Financial Services Authority, Adair Turner doesn’t think it would be too difficult. As he put it on the subject of shadow banks, "If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safe-guards."

Next, the larger the bank (a “formal” bank or shadow bank) the more difficult it is for it to avoid being noticed and regulated by the authorities. Indeed, it is not even all that easy for a self-employed plumber or electrician with a turnover of say £100,000 a year to avoid being noticed by the income tax authorities. And £100,000 a year is a minute turnover for a bank (shadow or formal).

So the only shadow banks that MIGHT avoid being noticed by the authorities are very small shadow banks. And small shadow banks have a problem there, alluded to by Minsky when he said “everyone can create money; the problem is to get it accepted”.  

 The problem is that money creation is an activity where size definitely pays. To illustrate (and taking the “very small” end of the scale) any individual person can create money in that they can pay for goods or services with an uncrossed cheque, and the payee can endorse the cheque and pass it to a third party. And the third party can pass it to a fourth, etc. That’s all perfectly legal, and the uncrossed cheque is then in effect a form of money.

But I’ve never in my life tried to pay anyone by endorsing a cheque that someone else gave me, and conversely, no one has ever tried to pay me that way. That method of payment is very cumbersome compared to normal methods.

Same goes for small shadow banks. Those small shadow banks will have no problem doing what shadow banks spend much of their time doing: connecting large borrowers with large lenders. But that process does not create money: it does not equal fractional reserve banking.  In contrast, for a small shadow bank, persuading a significant proportion of actors in the economy to accept its liabilities and pass them from hand to hand  - well that’s much harder, if not plain impossible.

Of course in the world’s financial centres, numerous small shadow banks will be well known to those working in those centres, and that small group of people may well treat a small shadow bank’s liabilities as money. But then all sorts of strange bits of paper get treated as money in the world’s financial centres: government debt is often accepted in lieu of cash in those centres. But there is no country in the world that includes government debt in its money supply.

And remember, government is an entity that is several thousand times the size of the average shadow bank. Given that size pays when it comes to having one’s liabilities accepted and treated as money, small shadow banks have problem competing with government’s liabilities, to put it mildly.

Maturity transformation.

Another form of money creation or another aspect of fractional reserve is maturity transformation (MT), that is “borrow short and lend long”.

Unfortunately for small shadow banks, this is another area where size pays. MT relies on calculating what proportion of depositors are likely to withdraw their deposits in next month or so, and keeping that money available for those depositors, while lending on the rest of the money.

Now a bank with say a quarter of a million depositors can calculate with a very high degree of certainly what proportion of depositors are likely to withdraw in the next month. But same does not apply to a very small bank with say ten depositors. The latter sort of bank would be running an excessive risk if it engaged in any MT at all.

DD’s alleged political problems.

DD’s third criticism of full reserve is that it involves various unstated “political problems”. They say, “Fortunately, the political realities make it unlikely that this radical and imprudent proposal (full reserve) will be adopted.”

Well if DD can’t tell us what these “political problems” are, it’s a bit difficult to answer their point, isn’t it? However it’s not too difficult to guess what these political problems might be, and when time permits, I’ll deal with them.

DD’s advocacy of full reserve.

As pointed out above, in this paper, DD unwittingly advocate full reserve of a sort. That is they advocate a system under which in a crisis, or given a bank run, the rate at which deposits can be withdrawn is limited.

Well now, that is very similar to the systems proposed by two of the leading advocates of full reserve, Kotlikoffand Werner (K & W). That is both K and W advocate systems in which various depositors’ right to withdraw quickly is constrained.
K & W however are more sophisticated than DD (unless I’ve got DD wrong). That is, in the K and W systems, depositors have a right to instant access / current / checking accounts. There are never any restrictions on the rate of withdrawal (up to the amount that depositors have put in such accounts). Moreover, the money is 100% safe and is always there because it is not invested or is only invested in ultra-safe and easily marketable securities like government debt. 

And that is absolutely right: people and firms must have checking or current accounts.

In contrast, under DD the rate of withdrawal from checking accounts might be restricted: totally unacceptable.

As distinct from checking accounts, under K & W there are investment accounts. And there, there is little difference between K, W and DD. Withdrawal is slowed down or banned for a specific period, or (under K) too fast a rate of withdrawal results in “withdrawers” accepting a loss on their investments.

Assessing the Effect of Leadership and Entrepreneurship Development

Why would anyone want to be a leader? Has the effect of conventional leadership in business and entrepreneurship means having more responsibility, accountability, and more lost. To compensate for the difficulties, high positions typically includes an increase in salary, stock options, and other shiny objects to distract you from the long hours you will work and a greater amount of crap you'll eat. The problem is that most people climb the corporate ladder or start a business from scratch is too much focus on making money and gain power. People appreciate the dollar during the study, and the control of inspiration. As a result, they are left unfilled and no real influence, no matter how high they climb.

Let pleasure be your guide and influence. Right home, car, or salary will not signal "coming" in your life. The actual size of your arrival is the level of enjoyment and influence you have achieved. How much do you enjoy your life every day? How many people do you inspire and motivate positive action every week? Instead of worrying about making money and controlling people, focus on learning, enjoying, and inspiration. After all, what good is a giant business title and salary without happiness and fun? Likewise, what is the point of having authority over a group of people if they do not respect you, or even worse, you hate? In today's world, the best way to get ahead in business and entrepreneurship is to focus on leadership and influence to help others in their entrepreneurial development.

Focus on the vehicle, not just the end. Began to notice processes that shape your life. Every day, ask yourself, "What did I learn?," "How can I enjoy more,"? "Who am I inspiring?," And "How can I help others improve?" These four questions will help you stay focused on generating more pleasure making money, and produce the effect on power gain. Look for new ways to make yourself and those around you a better entrepreneur. Find new ways to help others learn, be creative, have fun, and thought to myself two feet. Real connection comes through increased autonomy of all people, not through changing all be the same person. Effect of true leadership is achieved when no one knew there was a leader. People can not be forced to be inspired. Leadership is influence of anemia in the world today, largely due to dependence on power as a motivational tool. Power, or authority, breeds only three things: fear, hatred, and the bare-minimum results. However, the authority is still the gold standard method in which most leaders seek to motivate their subordinates. Fear is poison and immediately drain the excitement and creativity. Fear also spawned hatred. People do not respect leaders who use fear to motivate them, but instead, they find subtle ways to undermine or sabotage the pursuit of the leader. Most often, this is done by a reduction in productivity just above the level of "You're fired". Leading with influence, not power. Focus on learning, enjoyment, and development of entrepreneurship over making money. Influential leaders spark of excitement, enthusiasm, and creativity in their subordinates. A true leader in the development of entrepreneurship as everyone connects them all under one goal. Understand: everyone wants to improve. True leaders entering this desire and inspires others to fulfill their own goals and objectives of the group.

S*d the debt and deficit: Keynes said as much.

Far too many economists are still stuck with the notion that national debts are comparable to household debts. That is, that national debts should ideally be paid off, or that there should be some target for reducing the deficit and/or debt.

Ideas of the latter sort are UNMITIGATED HOGWASH. They are total and complete nonsense. Cr*p. Bu**shit. I’ve run out of words.

Here is quick guide to debts and deficits for the poor benighted folk who still don’t get Modern Monetary Theory.

1. As Keynes pointed out (and as is indeed little more than common sense) if the private sector saves an increased amount of money, it must ipso facto SPEND LESS MONEY, all else equal. That is demand declines, and unemployment rises.

Ergo, given the above increased saving, government must run a deficit. And conversely, if the private sector runs too much of a deficit (i.e. “dissaves”), then government may well have to run a SURPLUS.

2. Any country that issues its own currency has a choice as to what rate of interest it pays on its debt. E.g. it can always cut that rate essentially by funding more government spending via tax rather than borrowing.

However it’s not QUITE THAT easy (but very nearly that easy). The above “tax more and borrow less” is probably deflationary: it’s liable to increase unemployment. But that niggle is easily dealt with: just fund some of the debt reduction or reduced borrowing from newly created money. The latter has a stimulatory / inflationary effect. So as long as the latter simulatory effect equals the above deflationary effect, demand and GDP remain unaltered. I.e. the only net effect is that interest on the debt declines.

3. That raises the question as to what the best rate to pay on debt is. Well that’s a complete no-brainer: the best rate is nothing at all!!!! And government debt on which no interst is paid is virtually the same as money (or monetary base, to be exact).

I’d guess that’s why Milton Friedman and Warren Mosler(amongst others) have advocated that government should issue no liabililties in the form of interest paying debt: the only liability they should issue is money.

 4. Having said that governments should aim to pay a zero rate of interest on their debt, there is another technical niggle: should that be “zero” in nominal or in real (i.e. inflation adjusted terms? However that’s a technicallity I basically won’t address here, except to say that a zero or slightly negative rate in real terms is probably best.

5. There might seem to be a problem arising from the zero interest rate policy, namely that it rules out or severely hinders interest rate adjustments by central banks. My answer to that is, “I couldn’t care less”. For reasons given here and here, interest rate adjustments are a nonsense.

6. So what’s the ideal size for the deficit / surplus? Well having some sort of “target”, e.g. aiming to “halve the deficit in three years” is nonsense. Moreover, the widely accepted target, that is aiming to balance the books over the economic cycle is equally nonsensical.

The ideal size of the deficit / surplus is simply:

the size that maximises employment without exacerbating inflation too much and at a zero rate of interest on the debt.

Or as Keyes put it: “Look after unemployment, and the budget will look after itself”.

Got it?

Just to make sure, I’ll repeat that in bold red letters.

Look after unemployment and the budget will look after itself.

Margaret Hodge’s hypocrisy.

 Congratulations to Hodgy-Wodgy, the Labour Member of Parliament, for the sharp rap over the knuckels she recently gave Starbucks and other wicked multinationals for their entirely legal tax avoidance efforts.

But there is just one fly in the ointment: Margaret Hodge herself is one of the country’s leading tax avoiders. The corporation in which she has a holding worth several million paid 0.25% tax on its profits in the UK.

Plus she is making strenuous efforts to ensure her children pay the minimum possible inheritance tax on the several million she will leave them. See here, here and here.