Martin Wolf in today’s Financial Times puts seven suggestions for improving the banking system. The fourth involves criticising Lawrence Kotlikoff’s 100% reserve banking ideas. In reference to banks, Wolf says “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.”
There are several mistakes in those two sentences, as follows.
1. If an ultra-high level of safety COSTS SOMETHING, then that could easily be an argument for sacrificing some safety in exchange for reduced costs. But if Wolf thinks such costs exist, he needs to tell us what they are.
The Vickers commission (of which Martin Wolf was a member) CLAIMED such costs were involved. They claimed that 100% safety would supress bank lending, which in turn would supress economic growth. As I’ve pointed out before on this blog, that suppression of economic growth would certainly take place ALL ELSE EQUAL. But all else needn’t be equal. That is, the government / central bank machine can easily expand the money supply to make up for the more conservative way in which money is used under a full reserve or 100% safe regime.
And producing new money costs NOTHING in real terms: money is just book-keeping entries, or if you like, numbers in computers.
2. Where does Martin Wolf think the money came from to boost house prices prior to the crunch? It came from money creation by private banks, not central banks or governments. That is, the money supply expanded thanks to the fractional reserve system. In other words booms and slumps would be ameliorated if we reduce the 33:1 leverage. But as long as there are no costs involved in reducing the leverage to 1:1, why don’t we go for the maximum amount of amelioration possible: i.e. just abandon fractional reserve?
In other words it can well be argued that the real costs – costs of CATASTROPHIC proportions – derive from fractional reserve, not from full reserve.
3. As argued by Huber & Robertson (amongst others) the freedom that private banks have to create “savings” out of thin air and lend them out results in artificially low interest rates. If H&R are right, then that is an argument for a total ban on money creation by private banks: i.e. it’s an argument for 100% reserve.
Personally, I would cite another argument in addition to H&R’s, which is that when a private bank boosts demand by creating and lending out money, demand must be supressed elsewhere in the economy (assuming the economy is already at capacity). And in practice, that suppression of demand takes place in a pretty random fashion, e.g. government might cut spending on education, roads or health care – you name it.
A more efficient allocation of resources would be involved where when one entity wants to borrow more, the concomitant reduction in current consumption is born by whoever is least concerned about abstaining from consumption. And that objective would be attained where when one entity borrows more, interest rates rise. And that increase in rates would occur automatically under full reserve.
Just in case you thought central banks know what they are doing, this Bank of England (BoE) article will disabuse you.
The article claims quantitative easing was implemented primarily to keep inflation up to the 2% target: a strange objective (see 2nd para of “Introduction”, p.200).
Personally I think that maximising GDP within environmental constraints and providing jobs for those who want them is a more fundamental and important economic objective.
Their reasoning becomes SLIGHTLY clearer a few paragraphs later in a sentence that is not 100% clear: it says that a below target rate “could have led to inflation expectations, which would have pushed up on real interest rates, even with nominal rates kept at very low levels and reduced spending in the economy”. Presumably they meant “pushed up” rather than “pushed up on”. Also they don’t actually mention NEGATIVE rates of inflation, but I assume they had that in mind.
Now this reasoning is bizarre. The only circumstance in which inflation is likely to drop to zero or below is where there is a serious collapse in demand and unemployment reaches the worst levels experienced in the 1930s. AND THAT’S THE REAL PROBLEM: the collapse in demand and the unemployment.
That a zero or negative rate of inflation adds to the problem because it causes a rise in REAL interest rates is a possible CONTRIBUTORY FACTOR – that’s all. It’s a bit of a technicality.
Might, can, could and may.
Anyway, moving on . . . on page 201 they say “there are a number of potential channels through which asset purchases might affect spending and inflation..”.
“Might”? That fills me with confidence about the whole QE idea.
A couple of sentences later they say, “Asset purchases may also have a stimulatory impact through their broader effects on expectations..”
“may also have”? My confidence that the BoE knows what it is doing grows by the minute.
Still on page 201 and under the heading “Portfolio balance effects”, they say, “Unless money is a perfect substitute for the assets sold, the sellers may attempt to rebalance their portfolios by buying other assets that are better substitutes…”
“may”? I’m even more convinced.
Next, (p.202) under the heading “Liquidity Premia Effects” they say, “When financial markets are dysfunctional, central bank asset purchases can improve market functioning by increasing liquidity through actively encouraging trading. Asset prices may therefore increase through lower premia for illiquidity.”
There’s a “can” AND A “may” in that passage. Two uncertainties for the price of one!
Next, under the heading “Confidence effects”, they say, “Asset purchases may have broader confidence effects..”
“may have”? Now this is getting silly.
Then under the heading “Bank Lending Effects” they say “A higher level of liquid assets could then encourage banks to extend more new loans..”
“Could”!! Well that makes a change from “may” and “might”. No – it’s worse than that: the idea that banks lend out reserves or that they are encouraged to lend when reserves are boosted is an idea that has attracted widespread criticism. E.g. see about one minute into this video clip:
We plebs and peasants always knew QE wouldn’t work.
I pointed out on this blog when QE was first mooted about two years ago that it wouldn’t have much effect. And for a more professional demolition of the whole idea, see here.
So what does work?
Well fantastic as it might seem, if consumers are given more money, guess what they do with it? Yep: they spend a significant proportion of it!!!!
Amazing that, isn’t it? The average mentally retarded six year old probably knows that. But there seem to be no end of academic economists and central bankers who can’t work that one out.
To be more exact, when the average consumer comes by an increase in income or a windfall, they spend anything between about a third and two thirds of it within about six months, plus they save between about a third and two thirds (depending on the exact nature of the windfall).
That’s what the empirical evidence shows. See here, here, here, or here.
No “maybes”, “mights”, “coulds” etc. The empirical evidence is quite clear.
But as I pointed out here, many academic economists are not too interested in reality.
And finally, I owe a hat tip to Neil Wilson for drawing my attention to the above BoE article.
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And employed 800 people to do the lobbying. See here and here.
Just when you thought banks’s depraved behaviour couldn’t get any worse.
Though on second thoughts you can't really blame banks: they recognise a sucker when they see one.
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Dean Baker recently advocated reduced working hours in The Guardian, and praised Germany for doing so.
I normally agree with Dean Baker, but not this time. The basic flaw in the hours reduction idea is thus.
The ultimate constraint on raising employment is the inflation that arises when unemployment drops to some level or other (which you could call “the economy being at capacity”, but I’ll call it NAIRU). That is, as employment rises, it becomes increasingly difficult for employers to find the labour they want from the ranks of the unemployed, so they resort to outbidding each other for “already employed” labour. And that means inflation.
That constraint probably does not apply at the moment in most countries. That is, employment at the moment in those countries could probably be increased by a straight rise in demand. So even if the NAIRU constraint does NOT APPLY, hours reduction is STILL NOT the best cure for the problem.
But assuming the NAIRU constraint DOES APPLY, a compulsory reduction in hours has NO EFFECT WHATEVER on the number or variety or quality of people making up the unemployed. There is thus NO INDUCEMENT WHATEVER for employers to abstain from bidding up the price of already employed labour or giving in more readily to union demands at that “capacity” or NAIRU employment level.
Thus hours reduction WOULD MAKE SENSE just at the moment for almost every country in the Eurozone APART FROM Germany. That is because those countries are stuck (thanks to the EZ) in a situation where they cannot raise demand.
But Germany, in contrast, CAN RAISE demand to the level where excess inflation becomes a serious possibility. Indeed, many have argued it should go even further and deliberately engineer a few years of excess inflation because, so the argument runs, that would help periphery countries (though I’ve got doubts there).
Ergo hours reduction for Germany makes no sense. It makes no sense for the U.S., U.K. or any other monetarily sovereign country. But it would make sense, to repeat, for most EZ countries other than Germany.
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Summary. Assume a pure fractional reserve banking system. Also assume the simplest and most extreme case of banking collapse: all banks go bust. In this scenario the money supply vanishes: not too clever.
In contrast, under FULL RESERVE, where deposits are taxpayer guaranteed that encourages the misuse of depositors’ money. Plus when all banks go bust, and assuming government reimburses all depositors, the money supply initially doubles which is liable to be inflationary, until that supply is withdrawn via tax. Also not too clever.
The best system is full reserve plus the “Kotlikoff / Werner” condition that where depositors let their bank use their money in a commercial fashion, and it all goes belly up, depositors lose their money.
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Fractional reserve.
Take the simplest possible pure fractional reserve system. There is just one private bank with no assets or liabilities. It creates $P out of thin air and lends it to X to enable X to build a house. X pays the money to Y to build the house. The house turns out to be worthless. The words “Spain” and “Ireland" should spring to mind. That means X is bust. The bank is also bust, and Y’s money vanishes into thin air.
As Irving Fisher put it in his paper “100% Money and the Public Debt” (1936), “The most outstanding fact of the last depression is the destruction of eight billion dollars - over a third – of our “check-book money” - demand deposits.”
Full reserve plus taxpayer backing for deposits.
Take a second scenario: full reserve with taxpayer guarantees for depositors regardless of what use banks make of depositors’ money.
Initially the central bank / government spends $P into the economy, and that money ends up in the hands of A,B & C, and they deposit the money in the private bank, and the private bank in turn deposits that money at the central bank (private banks always keep their monetary base at the central bank).
As in the above fractional reserve example, X applies for a $P loan from the bank, and pays Y to build a house. The house again turns out to be worthless. And as in the above illustration, the private bank is bust. Or to be more accurate, the bank has $P at the central bank, but it owes $P to A,B & C, plus it owes $P to Y (i.e. the bank owes a total of £2P).
However, deposits are taxpayer guaranteed, so the government / central bank machine graciously gives $P to the private bank.
But that means the money supply has doubled.
Notice how we’ve had a ballooning of monetary base / reserves over the last three years?
Alternatively, government does NOT FULLY reimburse private banks: but that just leaves banks in a precarious position – ring any bells?
Full reserve with no taxpayer backing for all deposits.
Lawrence Kotlikoff and Richard Werner advocate banking systems which have in common the characteristic that depositors must decide how much of their money they want to be 100% safe, and how much they want their bank to use in a commercial fashion: that is lend on to businesses and mortgagors.
Incidentally, citing the above two individuals here should not be taken to imply their agreement with this post.
Anyway, forcing depositors to make that choice means that depositors will put money they are likely to need in the coming months into their safe accounts. While money which they think they won’t need and/or which they are prepared to risk will go into “risky” or “investment” accounts (under a Werner system), or into “non cash mutual funds” to use Kotlikoff terminology.
Let’s assume everything is the same as the illustration just above (except of course that there is no taxpayer backing for depositors’ money in investment accounts). I.e. the private bank lends to X, who pays Y with the house turning out to be worthless.
In this scenario, the private bank does not go bust: it is depositors, i.e. A, B & C who lose out.
There is not too much of a deflationary effect because A, B & C still have the money they intended spending in the near future (in their safe accounts).
There is no need to double the money supply.
It is true that something has disappeared: the investments made by A, B & C. However, the disappearance of an investment does not have anywhere near the same deflationary effect as the disappearance of the same amount of money: a fall in the value of the Dow Jones or FTSE does not influence the weekly spending habits of the wealthy by all that much.
Conclusion.
I vote for the third option. That’s the full reserve plus making depositors decide how much of their money they want to be, 1, instant access, 100% safe, but not earning any / much interest, and 2, how much of their money they want to earn a significant amount of interest, while not being instant access and not 100% safe.
Quite right. See here.
The U.K.’s “Independent Commission on Banking” (often called the Vickers commission after the surname of its chairman) advocated a partial separation of High Street or retail banking from casino or investment banking.
As has been pointed about five hundred times by as many different individuals, that sort of separation, even if complete (a la Glass-Steagall) would not have stopped the credit crunch. Reason is that even if banks cannot use the money in grandma’s account for INVESTING, there are still plenty of silly things banks can do.
Look at Ireland and Spain. Banks there basically LENT TO property ventures, rather than actually invest or buy shares in property businesses. So Vickers would not have prevented the banking fiasco in Spain or Ireland.
In fact Vickers specifically allows banks to lend to any business (bar financial business) in Europe.
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I’m much heartened by the response so far to the Krugman / Layard manifesto. That is, I’m heartened by the low quality of the criticism aimed at it.
First, there is a hopeless article by Tim Worstall in the Telegraph. Worstall is normally clued up on economics (and witty and sarcastic, which I like). But he went right of the rails in the Telegraph article.
He makes a very common mistake, namely claiming that deficits during recessions have to be matched by surpluses at other times. He argues further that since it is difficult to cut public spending or increase taxes (with a view to implementing surpluses), Keynsianism is fatally flawed.
Deficits never have matched surpluses!!!
As to the idea that deficits need to be matched by surpluses at other times, the first whapping great flaw in this idea is that deficits over the last century or so JUST HAVEN’T matched surpluses. I.e. it’s been a case of more or less constant deficits. For some figures, see here or here. It’s a sea of red ink!
And there is a simple and perfectly acceptable reason for this more or less constant deficit, which stems from the fact that we aim (I think rightly) for inflation of around 2%.
First, assume national debt (ND) and monetary base (MB) are to remain constant relative to GDP (which over the very long term is the actuality). For example UK national debt relative to GDP in 1900 was much the same as a century later: a bit under 50% of GDP.
Assume also that inflation is running at the target 2% rate. That means ND and MB will decline at 2% p.a. in real terms unless they are constantly topped up. And that topping up can only come from a deficit.
Moreover, there is economic growth in real terms to consider. If that’s running at say 2%, and assuming again that ND and MB are to remain constant relative to GDP, than requires even more “topping up”. Now that’s a fair amount of “topping up induced deficit” in total.
That explains why deficits during the last half century or so just haven’t matched surpluses at other times. It’s been a case of more or less constant deficits.
Bread and circuses.
As Worstall’s final point, namely that the plebs are always demanding more bread and circuses, i.e. more free goodies supplied by the state, while objecting to the increased taxes inevitably required to pay for the goodies, well that’s ALWAYS a problem. But the fact that the average citizen or voter lives to some extent in Alice in Wonderland is not a valid criticism of Keynes.
Moreover, Keynsian style deficits DO NOT NECESSARILY require increased public spending. A Keynsian deficit can perfectly well consist of reducing taxes rather than increasing public spending: a further nail in the Worstall coffin.
Josef Joffe
Another silly attack on Krugman and Layard appeared in a letter in the Financial Times from the editor of Die Zeit. (I thought Germans had brains!!).
Joffe employs about three hundred words to tell us he doesn’t understand where the money for the KL manifesto will come from. Well I’ve got news for Joffe.
The entire world now operates a fiat money system!!!! That’s a system under which banks, both central and private, can create money out of thin air.
Of course, as the massed ranks of economic illiterates never tire of reminding us, that ability to create money out of thin air has inflationary risks. But the historical reality is that for 95% of the time, responsible countries manage to keep inflation under reasonable control.
Keynsianism does have an inflationary bias. Keynsians are well aware of that. I’m not sure exactly what the alternative to Keynsianism is, but let’s call it a “gold standard / Austrian / do nothing” policy. And the problem with the latter is that it has a DEFLATIONARY bias: i.e. it gives us 1930s style decade long mass unemployment and human misery.
I prefer Keynsianism warts and all.
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