Wednesday, 1 October 2014

Martin Wolf on full reserve banking.

Wolf has been sympathetic towards full reserve (FR) for a few years, while not ENTHUSIASTICALLY endorsing it. That view of his continues in his recently published book “The Shifts and Shocks”. His conclusion about FR is that, 1, we should certainly make a move towards FR in that bank capital ratios should be substantially raised, 2, that adopting FR lock stock and barrel in large countries would be going too far at the moment, but that, 3, it would be nice to try it out in one or two smaller countries.
I’ll run thru the arguments he puts for and against FR which I DISAGREE WITH. In contrast, he makes numerous points I AGREE WITH, but which I've not mentioned below. Doubtless I'll mention those points of agreement at some point in the future. The first relevant passage is under the heading “Henry Simons and the Chicago Plan” (Ch6). 

Seigniorage would fund 40% of government spending?
On the second half of p.211, Wolf goes along with the claim made by two IMF authors, Benes and Kumhof, namely that the total money supply is about 180% of GDP, and given normal rates of inflation and growth, the total amount of money that would have to be created per year would be 9% of GDP, which means big seigniorage profits for government under FR, which would fund about 40% of government spending.
There is a flaw in the latter argument, thus. The vast majority of money under the existing system is matched dollar for dollar with debt. Thus money, under current arrangements is not a NET ASSET from the private sector’s perspective.
However, base money IS A NET ASSET – a point often made by MMTers. Thus base money (aka central bank created money) is more potent stuff then commercial bank created money. And that is presumably one reason base money is sometimes referred to as “high powered money”.
In short, under FR, the money supply would be smaller, and indeed money would be more precisely defined. Thus the above 40% is an over-estimate, I think. (Incidentally Wolf’s above 180% figure and my statement that “the money supply would be smaller” are both vague in that there is absolutely no universally agreed way of quantifying the money supply.)

Walter Bagehot.
Next, Wolf refers (p.212) to a point made by Bagehot, namely that in the early 1800s, the British tended to deposit their spare cash in banks, whereas continental Europeans tended to keep spare cash under the mattress. And that, according to Bagehot, gave British banks the ability to lend much larger sums to commerce and industry.
The suggestion by Wolf there is presumably that FR in that it lets people simply lodge their money at the central bank would starve industry and commerce of funds.
Well the first answer to that is that, at least in the UK, households can ALREADY lodge their spare cash with government: they can do that at the state run savings bank, National Savings and Investments. But that does not seem to have starved industry and commerce of funds.
Second, under FR people are totally free to have their money invested in loans to businesses or mortgages. The only different as compared to the existing system, is that those investors / lenders carry the full costs when those investments or mortgages go wrong. And what’s wrong with that?
A system underwritten by taxpayers is a SUBSIDISED system, and subsidies distort markets and reduce GDP. So while FR would certainly cause a finite rise in interest rates, the net effect (perhaps ironically) ought to be to RAISE GDP.
Moreover, the rate paid by mortgagors in the UK in the 1980s was about THREE TIMES the current rate. And strange to relate, the sky did not fall in in the 80s. Stranger still, economic growth in the 80s was far better than over the last five years during which we have enjoyed the questionable benefits of record low interest rates.

Next (and still on p.213) Wolf says that while FR would improve stability, “the market economy could still be unstable”. But he doesn’t give any reasons!
In contrast I can think of a very good reason why FR would bring a big improvement in stability: where a lending entity / bank is funded just by shares, it is impossible for it to go insolvent (as George Selgin pointed out in his book on banking (not that Selgin backs FR far as I know) ). That means no more Northern Rocks, Lehmans, etc. That should improve in stability, shouldn’t it?

Later on his p.213, Wolf claims the shift to FR would be “too disruptive”. Again no explanation. He might have dealt with Milton Friedman’s claim that no such disruption would be involved. To quote Friedman, “There is no technical problem of achieving a transition from our present system to 100% reserves easily, fairly speedily, and without serious repercussions on financial or economic markets”.

Radical reform.
The second passage in Wolf’s book that deals with FR is in Ch7 under the heading “The case for radical reform”. And Wolf’s first criticism of FR here is one set out by Charles Goodhart, which I dealt with here.

Immediately after the Goodhart quote, Wolf says “We permit many things that are far less than perfectly safe. Consider motorcars or aeroplanes. These are regulated, but not banned, because their benefits exceed their costs.”
Now the suggestion there is presumably that rather than go for a near TOTALLY safe banking system, which is what FR involves, there are benefits in accepting something slightly more risky. But Wolf doesn’t expand on that: he doesn’t tell us exactly what the benefits of a bit more risk might be or how the benefits of those risks can be quantified and set against relevant costs.
In fact there is a very good reason for thinking that a big rise in capital ratios – even up to the 100% as under FR – would not involve an increase in bank funding costs. And that reason is “Modigliani Miller”. MM it is true has been criticised, but those criticisms are feeble, as I show in section 1.4 of the book featured at the top of the left hand column.

Next, on p.236 he says “The upheaval involved in moving towards anything similar to the Chicago Plan or Kotlikiff’s updated version might be large. Well hang on: as Wolf himself pointed out, and as mentioned just above, a big increase in capital requirements IS A SIGNIFICANT MOVE TOWARDS full reserve! And as he pointed out, that can be done without too much disruption!

A halfway house.
Next, Wolf claims (p.236) that there is a “halfway house” which consists of “insisting that demand deposits or maybe just insured deposits would be backed by safe and highly liquid assets: central-bank reserves or short-term government securities. This is narrow banking.”
The flaw in that argument is thus. If all “demand deposits” are backed by the latter ultra-safe assets, then riskier assets (e.g. loans to industry or mortgagors) must be funded by shares or similar. But that’s what FR consists of! That is, FR is a system under which the banking industry is split in two, with one half being totally safe and consisting of deposits with the relevant money being lodged at the central bank (and/or invested in government debt), while the riskier half offers loans, but that half is funded just by shares or similar. In short, Wolf’s “narrow banking” is not a half-way house: it’s full blown FR.

Shadow banks.
Next, Wolf says “The problem with narrow banking, to which both the Chicago Plan and Limited Purpose Banking might be answer, is that the fragility would migrate elsewhere in the system, as happened with shadow banking.”
Well the simple answer to that “migration” problem is to regulate shadow banks above some minimum size in the same way as regular banks are regulated, as in fact proposed by Adair Turner, former head of the UK’s Financial Services Authority. As Turner put it, "If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safe-guards."
In fact to regulate normal banks and not regulate shadow banks makes as much sense as making men abide by speed limits on the road, but not women (or vice-versa).

It’s nice to see Wolf continue with his mild approval of FR. I’ll continue to read his Financial Times articles (and sometimes criticise them) because they are always interesting.

Tuesday, 30 September 2014

Amazing news: we can have the £80bn new HS2 rail line for free.

Fuddie duddies like me have always been under the impression that if we want to make an £Xbn investment, we have to sacrifice £Xbn of current consumption, i.e. we have to save. But according to Ann Pettifor this is not the case (as I understand her). At least that’s the impression I get from this, which she tweeted today.

And on page 26 of her book “Just Money”, there is a paragraph all on its own which says “Savings are not needed for investment.”  And that’s repeated on p.104 where she says “Under a well-managed banking system, and with the sagacious use of bank money, surplus wealth is no longer needed for loans and investment.”

I’ve contacted the Nobel prize committee to propose her for a Noble prize in economics. Will someone second that?

Monday, 29 September 2014

A poor criticism of full reserve banking by Charles Goodhart.

I dealt with just under fifty (yes 50) criticisms of full reserve banking (FR) in section two of the book on the left  - criticisms that range from the moderately well thought out to the laughable and hopelessly incompetent. But the criticisms keep coming and as a result of perusing Martin Wolf’s recently published book, “The Shifts and Shocks” I’ve just stumbled across a new one (Ch7). The criticism is made by Charles Goodhart, described by Wolf as the “doyen of British analysts of finance”. Obviously this is important stuff, so we should pay attention.

The criticism is made by Goodhart in a paper of his entitled “The Optimal Financial Structure” and is as follows (to quote, in green). He says in reference to full reserve:

“A problem with proposals of this kind is that they run counter to the revealed preferences of savers for financial products that are both liquid and safe, and of borrowers for loans that do not have to be repaid until some known future distant date. It is one of the main functions of financial institutions to intermediate between the desires of savers and borrowers, i.e. to create financial mismatch. To make such a function illegal seems draconian”

OK, let’s deal with that phrase by phrase.

First there’s that “revealed preference”. The phrase “revealed preference” is academic-ese for the much shorter and simpler word “want”. Academics have to sound technically sophisticated, and one way of doing that is use five times as many words as necessary, each of which is about five times LONGER than necessary to describe something.

Anyway, moving on . . .  savers “want” financial products that are “both liquid and safe”. Well that of itself is not a brilliant argument for providing savers with same, i.e. with what they want.  Drunks want large quantities of alcohol and many children don’t want to go to school.  That is not a good argument for letting those two categories of people have what they want.

As to savers, there is no limit to what they “want”. One of the things they want is the combination of total safety and a return on their savings, which is a flagrant self-contradiction (a self-contradiction that FR disposes of). That is, if money is loaned on or invested with a view to earning interest, it is by definition not entirely safe. And the only way of providing total safety is by having the taxpayer back those savings or deposits, but that’s a subsidy of banking!

Next, FR does not, as claimed by Goodhart stop savers having “financial products that are both liquid and safe”. Under FR, savers are SPECIFICALLY PROVIDED with accounts that provide them with liquidity and total safety: accounts where the relevant money is simply lodged at the central bank and/invested in short term government debt. Indeed the UK government ALREADY PROVIDES savers with that facility in the form of National Savings and Investments.


Next, according to Goodhart, FR “runs counter to” borrowers desire for “loans that do not have to be repaid until some known future distant date”.

Not true. Under FR, borrowers can borrow from lending entities / banks just as they do under the existing system. The only difference is that those loans must be funded by shares, not deposits.

It is true that the latter form of funding raises the cost of supplying loans, but  only  to the extent that a subsidy of banks is removed (as explained in the book featured at the top of the left hand column). If we had a totally unwarranted subsidy of baked beans, then removing the subsidy would “run counter to the revealed preferences of” baked beans consumers for cheap baked beans. That is not a brilliant argument for subsidising baked beans.

Financial mismatch.

And finally, there is Goodhart’s claim that “. It is one of the main functions of financial institutions to intermediate between the desires of savers and borrowers, i.e. to create financial mismatch. To make such a function illegal seems draconian”.

Essentially that is just a repetition of the point just above. That is, FR does not dispose of “intermediation”. But it does do intermediation in a different way to way that currently prevails in the case of banks and which needs taxpayer backing. (That backing is needed in order to provide savers with the “have your cake and eat it” luxury of having one’s money loaned on (which is inherently not entirely safe) while enjoying total safety.)

Note the phrase “in the case of banks” just above. That is, FR does not do intermediation in a substantially different way to that offered by non-bank corporations. For example, stock exchange quoted corporations are funded to a significant extent by shares. To that extent, when investing in non-bank corporations, savers can get the liquidity they want in that they can sell their shares any time, while corporations can get long term loans or funding.

And finally, Goodhart objects to the “draconian” nature of FR. Well Galileo’s solution to an astronomical problem of the day, namely the apparently illogical movement of the planets, was “draconian”. He proposed that the Earth revolved round the Sun. In fact his solution was so draconian that he was put under house arrest for the final ten years of his life.

In short, the fact that a solution to a problem is “draconian” is not a good argument against the solution. And in fact FR has something important in common with Galileo’s idea: the solution in both cases is extremely simple.

Sunday, 28 September 2014

Anat Admati makes a good point on TBTF.

As she points out, to measure the size of the TBTF subsidy, it is necessary to look at more than the DIRECT TBTF subsidy enjoyed by large banks. As she puts it here (1):

"In this context, it is also important to appreciate the role played by  government guarantees for  counterparties of banking institutions. In a financial system with a complex network of inter- institution contracts, the individual institution  benefits not only from government guarantees  protecting its own creditors but also from government guarantees protecting the counterparties of those in which it invested. For example,  the AIG bailout benefited many  counterparties of AIG, not the  least of these being the many banks that had purchased credit insurance from AIG." 

1. Statement for Senate Committee on Banking, Housing and Urban Affairs Subcommittee  on Financial Institutions and Consumer Protection.


P.S. (29th Sept 2014). According this Huffington article, Goldman Sachs managed to help itself to $2.9bn of taxpayers' money as part of the taxpayer funded bail out of AIG.