Positive money advocates a system of full reserve banking to address the problem, as they see it, of private banks creating too much money in the process of credit creation.
Click to access Full-Reserve-Banking-in-Plain-English1.pdf
So how, in simple terms, would full reserve banking actually work? It is actually directed towards making banks work more in the way many mistakenly think they do already work. Current accounts, or checking accounts as they are known in the USA, would outwardly remain the same. No interest will be paid on these. The difference will be that the money in them would not be IOUs of the commercial bank but instead would be the IOUs of government. The commercial bank would therefore have to keep an account at the reserve or central bank, the BoE, the Fed, or RBA for example, which held an amount equal to the total of all customer current accounts. This would cover the possibility that all customers may simultaneously wish to drain their current accounts. If the commercial bank became bankrupt customers would be easily able to reclaim their money from the account held at the central bank.
Interest bearing accounts would work slightly differently. Money would be deposited for a fixed term, say 6 months or 1 year and so the usual practice, from a customer’s point of view, of easily moving their funds from one account to the other would have to end. This would give the bank the opportunity to lend out money during this period without having to create extra money itself. Money lent out from these accounts would not, according to PM, be guaranteed in the event of a bank failure. Although, I’m not quite sure why not. If banks weren’t allowed to write their own IOUs any longer then there would be nothing for them to default on. The pool of deposit money, having been lent out, would only be at risk if the borrowers of that money defaulted rather than if the bank itself defaulted. Depositors could choose to invest in relatively safe ways for a modest interest, or if they wished to take a greater risk could aim for a higher return.
The idea of course is that as all money is the IOU of government, therefore the money supply is totally controlled by government and problems of inflation, booms and busts caused by stop-start bank lending will be ended.
Does this superficially plausible argument stack up?
The PM group tend towards the nonsensical quantity theory of money. The idea is that money simply in the process of existing has an effect on prices. Would doubling the supply of money mean the price of bread doubled? Maybe, if it were spent and the doubling caused spending to double but if it just sat as cash in a bank vault it would obviously have absolutely no effect whatsoever. It is the spending of money which has an effect on prices. Not its mere existence. Lenders of money, almost by definition, have no pressing need to spend it. Borrowers do. So all lending tends to have an inflationary or stimulatory effect in the economy. Changing all lending to be via government money does not change that in the slightest.
It should be recognised that no country anywhere in the world has a system of full reserve accounting. If any one country tried to impose one it would cause the banks, in that country, to be at a disadvantage to their foreign competition. It would risk pushing any problem underground or, more likely, overseas. There is no reason why , in the age of the internet, any bank operating in a country, would need much physical presence at all in that particular country. It would be quite possible for a Hong Kong based bank to offer a banking service to UK customers in UK £. If that bank was well capitalised, and their issued IOUs were credible then no sensible person or organisation would refuse to accept them. (edit: see Neil Wilson’s comment about this below)
But leaving these practical arguments aside, would FRB work any better in principle? Would making all money an IOU of government rather than an IOU of the bank stop the cycle of booms and busts? That would happen if all banks were nationalised and put under the control of the central bank. If they carried on as normal then nothing much would change, so the type of IOUs, pe se, cannot be the fundamental problem. Governments, at present, have control over the lending practices of banks, except they tend to misuse it.
It is often said, especially in MMT circles, that banks don’t lend out their reserves ie they don’t lend out government created money. This is literally true. If I borrow £1000 then the bank just credits my account by keystroke. The bank has created the money out of thin air as we hear often enough. But, if I then put my bank card into the ATM and take the money in cash, or use it to pay my taxes, or maybe buy some premium bonds, or whatever, then effectively the bank has done just that. ie lent out some of its reserves. Even if I left it in the bank until spent via, say, an internet transaction, I would almost certainly use that money to purchase goods and services. Sooner or later, whoever held the IOUs created by the bank would want to buy UK government bonds or pay UK taxes, or they would be held by a different bank which would not want to hold another bank’s IOUs. My bank would have to take them back and pay with real government cash. The half-life of any bank created money is probably no more than a few months.
The banks understand all this and they know they can’t be quite as gung-ho about creating new money, or writing out IOUs, as the PM group would have us believe. Having said that, the problem for most banks is usually not that they have too little government money but they have too much. It is therefore not a restraint on their lending. Because governments, in the UK , the USA and Australia tend to issue more money into the economy than they receive back in taxes, it is easy to see that the excess is going to largely end up with the commercial banks. This causes them a problem. It pays no interest if they just hold it. So their first reaction might be to ask if other banks wish to borrow it from them. They ask 5%, or the pro-rata equivalent for a short term loan, but they have no takers. All the other banks have plenty of government cash too! So they ask 4%, 3%, 2% and they eventually drop down to almost 0%. There is hardly any point lending it out if it really is 0%!
So, as part of the Government’s monetary policy their central bank set a floor on interest rates by taking their money back temporarily. Not that they need the money. Why would they? They can write out as many IOUs as they like. They do it to control interest rates in the economy and therefore the level of lending. So rather than let the level fall to 0% they will intervene and offer interest at, say, 3% (pa) pro-rata on an overnight rate. The Australians have the most descriptive term. They call it the OCR or overnight cash rate. The Australian Reserve Bank, like all central banks, sets the level at whatever rate it likes. Governments and their central banks also have the power to mop up excess reserves on a longer term basis, which they do as part of their monetary policies, through the issuing of bonds/gilts and other securities which pay a return to those holding them. As the RBA put it themselves:
“Monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation.”
Note that the banks would get short shrift if they tried to ask for 3% on money they have created themselves! That would make life just too easy for them. The Central Banks may be generous enough to pay interest on their own issued money but they aren’t quite so generous as to pay it on someone else’s issued money. Positive Money really ought to do more to explain that.
As the system works at present, the commercial banks can choose to lend risk free to their central banks at a rate influenced by the overnight rate or they can choose to lend at a higher rate to home buyers, industry and others but with the acceptance of a higher associated risk and administrative expenses.
Therefore I would argue that Governments already have the ability to control the level of lending without having to radically change their banking systems. If they want banks to lend more they should lower interest rates. If they want them to lend less they should increase them. It all seems simple enough. So why don’t they just do it?
The answer to that is they like the temporary effect of banks’ over-lending. It makes the economy zip along. The banks’ issued IOUs end up back with government, in taxes, which are then exchanged for real government money from the banks and so the governments finances look temporarily very good. Their deficits fall. They claim the credit for reducing unemployment. Until the crunch comes of course. The blame for letting that cycle happen rests with government itself. Not the banks. In the boom times they should raise interest rates to slow down lending, but to keep the economy moving they should increase their deficits. If inflation starts to be an issue they should think about raising their interest rates rather than just reducing their deficits which is their first reaction right now.
The main problem governments have right now is that interest rates are far too low. They are almost at zero in many countries. Incidentally this is the main reason for high house prices, another PM concern, FRB wouldn’t necessarily fix that. Governments can’t do anything with monetary policy. They have relied far too much, for far too long, on it to keep their economies growing and forgotten they have fiscal policy at their disposal too. But they are so debt averse that is almost unthinkable! If pressed, they will try any other kind of irrational approach instead such as the nonsense known as Quantitative Easing.