Sunday, 3 September 2017

Fontana and Sawyer’s incompetent criticisms of Positive Money on full reserve banking.

Summary.   A debate has taken place in the Cambridge Journal of Economics over the last year or so between on the one hand Giuseppe Fontana and Malcolm Sawyer (F&S) and on the other hand, sundry Positive Money authors. This present article of mine is a response to the latest F&S paper in that journal.

To summarise, a few of F&S’s criticisms of the Positive Money authors are valid, but basically F&S’s paper is a litany of nonsense. Among other things, F&S attribute ideas to PM without saying whereabouts in the PM paper those ideas appear. Moreover, far as I can see, some of those ideas don’t actually appear in the PM paper at all.

Details on this series of papers.

F&S published a paper in the above journal in 2016 entitled “Full reserve banking: more ‘cranks’ than ‘brave heretics’”. I actually reviewed that paper here just over a year ago.

Messers Dyson, Hodgson & Van Lerven of Positive Money responded to that with a paper in the same journal entitled “A response to critiques of “full reserve banking”. I’ll refer to that as “the PM paper” or “the PM authors” or similar.

F&S have recently responded to that PM paper with a paper entitled “A rejoinder to “A response to critiques of ‘full reserve banking’”.

This present article of mine examines the latter F&S paper.

The details.

F&S start by saying that while the PM authors claim their proposals are different from full reserve banking, in fact PM proposals and full reserve are to all intents and purposes the same. I agree with F&S there.


F&S then claim on their p.2 that contrary to the claims of the PM authors, “No agents involved in the loans supply process, including commercial banks, have a seigniorage privilege.”

Well the first problem there is that the word “seigniorage” does not appear in the PM paper. Second, F&S do not say where the “seigniorage claim” is in the PM paper.

The first sentence of the Oxford Dictionary of Economics (2009) definition of seigniorage is “The profits made by a ruler from issuing money”. Obviously “rulers” are irrelevant here, in that we are considering the possibility that a “non-ruler” i.e. a commercial bank can make seigniorage profits.

Clearly a private / commercial bank cannot do exactly what a back-street counterfeiter or legitimate state / “ruler” can do, namely print money and buy whatever the printer wants with the freshly issued money. In the case of back-street counterfeiters, that’s bog standard consumer goods: booze, food, holidays, etc. And in the case of governments (aka “rulers”) it’s the various items that states or governments normally buy: roads, military equipment, hospitals, schools, etc. However, what commercial banks can do is to create and lend out their liabilities, which are treated as money.

Plus money lenders who can simply print the money they lend out, are clearly in a different and better position to a money lender who has to come by money in the way the large majority of households and employers do, namely earn it or borrow it.

Of course, private banks do not charge what might be called a “normal” rate of interest  on the money they have to borrow BEFORE lending it out, and a lower rate on the money they themselves print or create (at no cost to themselves). What they do, as explained by Joseph Huber in his work “Creating New Money” is to use the cost savings derived from money printing to charge less interest than they otherwise would, and hence expand the overall size of their business and the overall size of their profits. As Huber put it:

“Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves. So their profit on this part of their business is not, say, 9% credit-interest less 4% debit-interest = 5% normal profit; it is 9% credit-interest less 0% debit-interest = 9% profit = 5% normal profit plus 4% additional special profit. This additional special profit is hidden from bank customers and the public, partly because most people do not know how the system works, and partly because bank balance sheets do not show that some of their loan funding comes from money the banks have created for the purpose and some from already existing money which they have had to borrow at interest.”

So to summarise, it is true that private banks to not earn seigniorage profits on a narrow definition of the word “seigniorage”, but it’s pretty obvious they earn an unjustifiable profit which amounts to “seigniorage profit” on a broader definition.


Next, and still on their p.2, F&S criticise a claim allegedly made by the PM authors namely that the money supply can be used to control inflation. F&S say the PM authors claim “Inflation can be controlled by the rate of increase of the money supply, as in the standard though now discredited monetarist theory.”

Well the answer to that is that the PM authors and PM literature in general certainly do not go along with the Milton Friedman idea that we should have the same annual increase in the money supply (if that’s what F&S mean by “the standard though now discredited monetarist theory”).  Indeed PM literature in general is perfectly clear that there will always be unforeseen fluctuations in economic activity, and that those fluctuations will need to be counteracted by varying  the amount of stimulus.

Moreover, PM literature in general makes the very obvious point that where the state creates and spends money, there is a fiscal as well as a monetary effect. That is, to illustrate, if the state creates $X and spends it on roads and education say, the fact of that extra means more jobs for contractors and teachers, plus there is the purely monetary effect (i.e. the increase in the money supply) which comes a bit later and which also has a stimulatory effect.

In fact F&S themselves actually quote a passage by the PM authors which makes just that point. The quote is on p.5, where F&S quote the PM authors as saying “Consequently, in a sovereign money system, monetary policy would work by financing a fiscal stimulus…”.

It’s a trifle incompetent to accuse someone of saying X when you yourself specifically quote them as contradicting X!!!

But if F&S are claiming that there is no monetary effect at all, then in effect they’re saying that when people come by a windfall, e.g. win a lottery or come by a tax rebate, their weekly spending does not rise at all. Well first that is obvious nonsense on common sense grounds. Second, it is clear from the empirical evidence that (amazing as it might seem) when households come by windfalls, their weekly spending rises!

Demand for loans.

Next (item No.3, p.2) F&S attribute a truly extraordinary idea to the PM authors namely that “The demand for loans is of little or no consequence for the determination of the quantity of money in the economy.”

Well, first, F&S do not say where the PM authors make that claim, and I can’t see where they do make that claim. Moreover, the PM authors say on their page 2: “a bank cannot make a loan unless it can find a willing borrower”.

Well that’s clear enough isn't it? The PM authors are saying the amount of bank loans made is determine much like the way the number of apples sold is determined: an interplay between supply and demand.

Bank loans create debts.

Next (item No.4, p.2) F&S say the following claim by the PM authors is false: “The new supply of bank loans produces an equivalent increase in the amount of outstanding debt in the economy.”

Well frankly that’s bizarre. So when I borrow £Y from a bank I’m not £Y in debt to the bank???  This is good news. Perhaps F&S can tell us where these amazing banks are where one can borrow money, yet not become indebted!!

By way of justifying the above, F&S say (same page) “The reflux principle operates in modern economies such that much or all of newly created money is extinguished by the reimbursement of previously accumulated debt.”

Well quite. In other words if someone borrows £A from a bank, £A of money and £A of debt is created. And when the debt is repaid to the bank, the money vanishes, and that’s very conventional thinking. I.e. there’s nothing controversial there.

PM’s work “Sovereign Money”, is perfectly clear on the latter point. It says for example on page 9, “As bank balance sheets contracted, broad money was destroyed.”

And on page 15 they say  “First, following the crisis households lowered their consumption spending in order to focus on repaying debt. Deleveraging requires loan repayments to be made at a faster rate than new loans are taken out. Because loan repayments are the reverse process of money creation, money is being destroyed at a faster rate than new money is being created, lowering spending, nominal demand and income.”

Matters green.

Next, (top of page 3), F&S criticise the PM authors for getting environmental and equality matters mixed up with the decision as to whether we have full or fractional reserve banking. I agree with F&S there.

The truth is that even under the existing (i.e. fractional reserve) system, we can be as green as we like, plus we can have any level of equality we like. Thus green and equality matters have little to do with the decision as to whether to adopt full reserve banking.

House prices.

Next, F&S claim that full reserve would not tame rising house prices. Well there is a very simple and obvious reason why it WOULD, at least to some extent. It’s that full reserve makes lending and borrowing more difficult which is bound to mean a finite rise in interest rates. Indeed, that’s one of the most popular criticisms made of full reserve.

And higher interest rates means it costs more to buy houses. In fact the big rise in house prices in REAL TERMS in the UK over the last twenty years or so is clearly related to some extent to the steady and large decline in interest rates over that period. (To be more accurate, the rise in house prices probably has much to do with increased demand for housing as a result of lower interest rates, COMBINED WITH the suppression of additional supply thanks to local authorities failure to make enough land available: witness the HUNDRED FOLD increase in the price of land once it gets planning permission.)

And as for any idea that a rise in interest rates would be a catastrophe, people with mortgages in the UK in the 1980s were paying almost THREE TIMES the rate of interest they do nowadays. For some strange reason the sky did not fall in, nor were the streets lined with homeless beggars. If anything, the number of beggars has RISEN over the last twenty years, though admittedly I’m not the World’s expert on begging.

And finally, low interest rates are not an unmixed blessing: they encourage asset price bubbles plus they hit savers and pensioners.

So what’s the optimum rate of interest?

Since there are clearly advantages and disadvantages in both high and low interest rates, an obvious question arises, namely what’s the optimum or GDP maximising rate? My answer to that is “the free market” rate. And that’s pretty much PM’s answer in that PM advocates leaving interest rates largely to their own devices.

Financial stability.

Next (still on the same page and paragraph) F&S claim full reserve would not bring improved financial stability. Well that is a truly hilarious claim: reason is that under full reserve it is plain impossible for a bank to go bust. Reason is that under FR, loans are funded by equity. Thus if the value of loans made by a bank turn out to be worth only half their face value (which has never happened in the case of a large bank) all that happens is that the value of the shares / equity approximately halves. The bank as such does not go bust.

Also in the same paragraph, F&S make the bizarre claim that investment grinds to a halt entirely under FR. They say “When investments are halted…”. That is such obvious nonsense that I can’t even be bothered dealing with it.

Alternative forms of money.

Next  (bottom a p.3) F&S repeat a popular claim made by critics of full reserve, namely that if conventional forms of privately issued money are banned (that’s money issued by high street banks), then alternative forms of private money will arise.

The first answer to that is that opponents of fractional reserve banking have never advocated a TOTAL BAN on privately issued money. For example many advocates of full reserve are happy with local currencies, e.g. the Lewis pound or the Ithaca dollar.

Second, there always have been and probably always will be strange bits of paper which serve as money in the world’s financial centers, e.g. London and New York. For example short term government debt is often accepted in lieu of money in those centers.

Third, whatever bank regulations we have, banks will always make big efforts to circumvent the regulations. In that connection, the fact that the rules of full reserve can be written on the back of an envelope, compared to Dodd-Frank which occupies well over ten thousand pages, is a big plus for full reserve: simple rules are relatively easy to enforce.

Fourth, F&S cite PayPal as an alternative form of money. Well it just isn't: PayPal is simply an alternative way of TRANSFERRING existing sums of money between different peoples’ and firm’s bank accounts. As Wikipedia puts it, “PayPal . . . . supports online money transfers and serves as an electronic alternative to traditional paper methods like checks and money orders.”

The cost of current accounts.

Next, (p.4) F&S trott out the ever popular criticism of full reserve, namely that it would result in those with current accounts (checking accounts in the US) having to pay more for their accounts because account holders would no longer be helped by the interest that comes from lending out some of their money.

The answer to that is that cross subsidisation is generally frowned on in economics and quite right. To be more exact, under the existing or fractional reserve system, the lodging and transfer of money is subsidised by another activity, namely the lending out of money. There is no particular merit there, any more than there are merits in having baked beans subsidised by a tax on rice pudding.

Matters fiscal.

Next, on their page 5, section 4, F&S set out a totally bizarre and nonsensical argument relating to fiscal stimulus.

F&S point out that the government of a country which issues its own currency can simply print money (in physical or electronic form) and spend that into the economy. Indeed, governments (in the sense: “government plus central bank”) already do that: witness the fact that the stock of base money in private hands has steadily risen since WWII and before, with a particularly sharp rise as a result of QE.

F&S then point out that governments clearly do not fund their spending PURELY via new money: they also fund it via tax and borrowing.

So far so good. Those are widely accepted common sense points.

But F&S also accuse the PM authors of being confused over the latter points. Well I’m darned if I can see why. To repeat, the above points are very simple and straightforward. But F&S end with what they clearly think is some sort of punch line or crucial flaw in PM thinking, namely: “A legitimate question then arises: if the government has the power to create money once, in order to promote—in their words—the central bank money monetary circuit, why then could the government not use the same power in the future?”

Well if you can work out the relevance of the latter question, you’re smarter than me. Elucidation will be welcomed in the comment section below.

Anyway, my answer the latter “why could the government not use the same power in the future?” question is: “IT CAN!!!”.

Indeed PM has devoted tens of thousands of words to setting out the exact circumstances in which government SHOULD create and spend new money (and/or cut taxes). Plus PM has devoted thousands of words to explaining how to avoid an excessive and irresponsible use of that source of funds.

F&S’s argument is a bit like explaining that a baby can suck milk from its mother’s breast and then asking, “what’s to stop it sucking more milk?” The answer is . . . wait for it . . . “nothing”….it CAN suck more milk.  Babies can suck as much milk as they want, assuming an adequate supply is there.

Put another way, if someone is able to drive a car a hundred miles, what’s to stop them driving another ten miles? My answer is: “probably nothing”!

Hope that’s cleared that one up!


I’ve had enough of this nonsense. I can’t be bothered with the final couple of pages of the F&S paper. I’ve got better things to do than parley with self-styled professors of economics who are a long way from being totally clued up.


  1. Let me comment on just one issue, that under your heading “seigniorage”.
    F&S are correct on this issue. Huber, PM and your good self are seriously mistaken.

    Huber considers a loan by an investment bank which results in:
    9% credit-interest less 4% debit-interest = 5% normal profit.
    He claims that the same loan by a commercial deposit taking bank would result in:
    9% credit-interest less 0% debit-interest = 9% profit = 5% normal profit plus 4% additional special profit.
    However, this would only be correct only on the ridiculous assumption that the borrower never makes any use of his loan!

    When the borrower makes use of his loan the bank has find funds to finance withdrawals. This has costs similar to those borne of Huber’s investment bank, but it is completely ignored in Huber’s analysis.

    PRIOR TO making loans investment banks have to raise funds from financial markets. The costs of such funds over the term of the loan are represented as 4% debit-interest in Huber’s analysis.

    AFTER making loans to customers, commercial banks likewise have to raise funds from financial markets to cover customers spending out of their loan accounts. The costs of such funds over the term of the loan are similar to those of investment banks.

    1. Huber considers a very over simple version of reality, as I point out above. But let’s start with simplified versions of reality.

      Assume there is only one commercial bank which opens its doors for the first time and makes its first loan. That bank does not need to “find funds to finance withdrawals” because there is only one bank at which recipients of the original borrower’s money can deposit their money: that’s the above bank.

      Next, assume two banks. Obviously if loan money issued by one is all deposited at the other, then the first bank has a problem. But (moving on to the real world) the reality is that loan money issued by for example Lloyds or Barclays each month is approximately equalled by deposits received by Lloyds or Barclays each month. In short, as long as each bank expands at about the same rate and doesn’t make too many silly loans, then the private bank system as a whole can create / print money and lend it out, no problem.

    2. How newly created bank money swishes around the banking system is irrelevant. It does not affect the cost of funds to lenders. This is so irrespective of whether there is one, two or many banks, and irrespective of whether banks or growing at similar rates.
      Even if some of the funds used by commercial banks to make new loans come from deposits resulting from previous loans, the new lending still has an opportunity cost. For example, the funds could be invested in bonds, or on the interbank loan market. By lending to a customer the bank foregoes the interest which it would otherwise have earned.
      In the case of an investment bank, the cost making loans is well understood. It is the banks own cost of raising capital (e.g. the interest rate it has to pay on its own borrowing). Or it is the opportunity cost of diverting funds from other investments, e.g. government or company bonds.

      Exactly the same principles apply to lending by commercial/deposit taking banks. ALL of their spending likewise has an interest (or similar) cost if new capital is raised, or the spending has an opportunity cost because funds are diverted from other profitable uses.
      A loan made by commercial/deposit taking bank is merely a book-keeping entry initially. But when a borrower spends his loan, the bank has to raise funds and incurs interest and/or opportunity costs just like any other lending institution.


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