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.
Peter, why are you so fixated on the fallacy that the money that Positive Money proposes is an IOU of government? It is proposed that it be created debt-free and interest-free and spent by the government, in lieu of taxation, into more or less permanent circulation.
PJM, This is a subject I addressed in part 2. The idea that government can issue currency without it being a debt, or a liability, is a fallacy. If the government give you a tax rebate of $10 their debt rises by that amount. If they give you a tax bill for $10 their debt falls.
It is not a debt in the normal sense that it has to be repaid. If you and I were isolated on a desert island one of us has to be in debt, for the other to be in credit. It is just a matter of accountancy. There is a link under “Videos” on the right hand column which explains the concept. Three sectors financial balances.
“If that bank was well capitalised, and their issued IOUs were credible then no sensible person or organisation would refuse to accept them.”
They would, because they wouldn’t be able to be transferred within the Sterling payment system.
For a liability to be Sterling it would have to be transferable within the Transaction account area of the Bank of England, or convertible to notes issued by the Bank of England. There are only two ways that can happen – by being a regulated entity able to operate Transaction Accounts, or by holding a Transaction account via a regulated entity yourself.
If an offshore institution was caught using an account via a UK regulated entity for the purposes of operating fractional reserve deposit taking in Sterling, the Bank of England would just direct the regulated entity to terminate and freeze all accounts for that offshore institution – for operating illegal deposit taking activities in Sterling.
Sterling is a monopoly. Never forget that.
I must say I hadn’t considered this difficulty! (I have added a note to the main text). There is such a thing as a a Eurodollar which is a pseudo currency time deposit originally created by European banks and guaranteed by them to be a 1:1 swap with a US dollar. Would they need any real dollars to offer these or just the financial ability to back up their guarantees? So I was thinking there could be a “Europound” too but you are saying not? I accept that it may be a bit harder to get around such imposition of a FRB requirement than suggested but the banks would try if it were causing them problems.
I’d say the chances of that happening are pretty close to zero anyway. The question is whether a FRB system would be even theoretically desirable and I think we both agree that it wouldn’t.
Eurodollars have the same issue. They are fractional ‘shadow banking’ deposits, and require real dollars to allow them to be transferred out.
Europounds exist as well, and under a Full Reserve system the institution would need a Transaction account at the Bank of England to do the transfer. If the BoE found it was being used for that, it would just close it and those people with ‘Europoounds’ would suddenly find that their ‘Europound’ were floating in value against real Pounds.
Price equality is enforced by convertibility. Remove the convertibility and the price floats.
“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.”
The whole debt free issuing nonsense that you get from full reservists is just using fiscal policy – as MMT has long advocated.
In the UK we can already do that. The government has a ‘Ways and Means’ account at the Bank of England, which is essentially an unlimited overdraft, and the legislation is already in place allowing the government use that for whatever it wants to.
So we could stop government gilt issues tomorrow and just use the Ways and Means account. If you like theatre and appearances you could go through the ritual of the Bank of England topping the account up to some arbitrary positive number via an internal transfer from the Issue department to the Banking Department. This is, of course, little more than a conjuring trick for those who are hard of accounting.
And we could remove the Financial Compensation Scheme from Banks and Building Societies, which would cause insured deposits to move to National Savings. Those deposits would then be replaced at the commercial banks by an overdraft with the Bank of England via the various discount schemes. The commercial banks would then pay the Bank of England, and any remaining customers with ‘bailed-in’ deposits.
Here in the UK we have a very effective clearing system which is run via a set of centrally managed companies under the auspices of UKPA. To make clearing go even faster we could uplift current accounts to that central company, and require the commercial banks to operate them on an agency basis. That would allow the UK to have near instant clearing on any transaction – removing any remaining payment friction from the payments system. It just needs government to put their foot down and insist on it.
So really the only reason to bang on about full reserve is to hide the changes you actually want to make to the banking system. Because we can already do all of them with the existing infrastructure if we want to.
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