Full Reserve Banking Is No Bailout

A recent blog by Frances Coppola describes full-reserve banking as ‘the largest bank bailout in history’. In the interests of mutual understanding and accuracy, the following clarification and response addresses a few points that are unclear. We accept culpability for potential confusion here – the submission to the Independent Commission on Banking, which Frances links to, is around 2 years old now, and we’ve advanced our thinking on the proposals since then. A lot of this latest work hasn’t been released yet, but will be in the forthcoming book Modernising Money.

Frances addresses three proposals:1) The working paper by IMF economists Benes & Kumhof2) The proposals for Limited Purpose Banking by Laurence Kotlikoff3) Positive Money’s own proposals in the form that we submitted to the Independent Commission on Banking in late 2010.The first two have very significant differences to the proposals put forward by Positive Money, so I will leave them aside. I have copied and pasted, in order, the sections of Frances’s post that I want to address:“Kotlikoff and Positive Money propose cash backing for sight deposits (current/checking accounts) only.”Strictly, we propose abolishing sight deposits (liabilities of the bank) altogether and replacing current accounts with custodial accounts that allow banks to hold electronic money at the central bank.

In fact all three are, perhaps unsurprisingly, complacent about their proposals and apparently blind to their flaws. Here are a few gems:…

 Positive Money propose that the Bank of England’s Monetary Policy Committee (MPC) should control the money supply so that inflation remains stable. Quite apart from the political implications of this (MPC members are political appointees – why on earth does Positive Money think they would be incorruptible?), there is a serious information problem. The Office of Budget Responsibility’s October evaluation report admitted that they got their growth forecasts wrong by a full 5 percentage points. Under Positive Money’s proposals, the money supply for the economy would be directly determined by such forecasts. Had their system been in force, we would now be suffering serious monetary restriction, not because “banks aren’t lending” but because the MPC had not produced enough money to support growth. In what way is this an improvement over the present system?Yes, there needs to be efforts to keep the MPC as independent of political control as possible. However, the problems Frances alludes to are far worse in the current system. We are currently suffering a serious ‘monetary restriction’ because banks refuse to lend whilst customers are simultaneously paying down their loans, causing the money supply to shrink. Our version of full-reserve banking ensures that post-reform, the money supply is not increased by bank lending or loan repayments. That means that the money supply would stay constant whether or not banks were lending or not. This is a key point; although it is rarely presented this way, a major purpose of QE (Quantative Easing) was to allow the Bank of England to step in to take over the role of increasing the money supply when the banks stopped lending.

As to the wrong forecasts, it’s extremely difficult to do the forecasts in the current inherently unstable manic-depressive economy with too many distorting factors. One of the major benefits of our proposed reform would be an economic stability. In this environment it will be far more easier to be precise in the forecasts.

“Under full reserve banking, all banks would have to hold enough funds to allow all sight deposits to be drawn at once. To achieve this, central banks would have to produce a simply ginormous amount of new money: the IMF estimates that for the US, it would be 184% of GDP.”

The Positive Money proposals allow the sight deposits of banks to be converted into funds at the central bank (which will belong to the customer). There is no increase in the money supply; simply a conversion of the current risk-bearing accounting liabilities of banks into risk-free electronic money (tokens) at the central bank.

Does this amount to a bank bailout? No, because the sight deposits that were liabilities of the banks will be replaced by a matching-value liability to the Treasury (effectively a face value charge for the money that was created by the banking sector in the form of demand deposits). So there is absolutely no change to bank’s balance sheets. The liability that the bank had to its customers now simply becomes a liability to the Treasury. The bank does not increase its net worth by one single pound. Its assets do not change at all (so it cannot change bad quality assets for good quality ones). This is no bailout.

“Whether a full reserve banking system is “safe” for depositors depends on the trustworthiness of politicians and political appointees. The value of the currency is only as good as the willingness of government to support its value. Which is why inflation targeting is so crucial to economic management…We would be putting a great deal of faith in our politicians not to pursue policies that erode the value of the currency – especially as they, or their appointees, would be directly responsible for producing it.”

This is precisely why we advocate making the MPC independent of the elected politicians that run the Treasury and government departments, but accountable to the Treasury Select Committee. However, Frances also seems to be forgetting the situation that we have today. Never mind placing faith in politicians not to pursue policies that erode the value of the currency; we currently rely on the senior staff at high-street banks not to pursue policies that will erode the value of our currency, even thought those staff are given the incentives to lend more, and create more money in the process. Look at the track record of the people and the institutions that have been creating the vast majority of our currency (and the consequent inflation) for the last 40 years:

Will an independent committee, who’s task is to increase the money supply only while inflation is low and stable, manage to produce more inflation than a banking sector that has increased the money supply by an average of 11.5% a year for the last 40 years? It seems unlikely.

“…this brings me to my fundamental moral issue with full reserve banking. Why should the interests of people who have money trump those of people who have not? Why should those who, through no fault of their own, have become dependent on state benefits in order to live, have their standard of living cut to the bone to protect people who have far more?”

I think most people would read the following as being a critique of the current system. When this system failed, the costs were passed onto taxpayers, and those who were on state benefits are seeing those benefits cut in order to protect the banking system and those very people “who have far more”. Yet Frances seems to believe this is the likely outcome of full-reserve banking, even though it is the proven outcome of the current system.

In contrast to the current system, full-reserve banking allows banks to be allowed to fail with no cost to taxpayers. It allows customers who do not want their money to be put at risk to hold their money in risk-free accounts, and leaves customers who are willing to take risks in order to earn a return, to place that money into risk-bearing investment accounts.“To maintain a full reserve banking system, we would end up locking ourselves into an economic straitjacket which would seriously disadvantage the poorest in our society (both fiscal austerity and the gold standard are bad news for the poor in economic downturns). How on earth is this progress?”

There is no convincing argument for this provided on the blog, but once again it sounds more like a description of our current system.

“Even the transition to full reserve banking to my mind raises moral issues. If the US can afford to produce $4tn of new money (or debt) to protect depositors, why can’t it afford to produce $4tn of new money (or debt) to relieve poverty and create a decent healthcare system?  If the UK can afford to produce enough new money to back all current accounts pound-for-pound, why can’t it afford to produce enough new money to improve its creaking infrastructure? “

This is an excellent point, but it’s an argument for full reserve banking, not against it. If the UK can afford to create £375 billion through Quantitative Easing in order to pump money into the investment markets, why could it not instead give that money to ordinary people in order to get the economy going and help people escape from a debt trap that is designed into the monetary system? More to the point, why is it a good thing to allow banks to create £1 trillion of new money in just 8 years and put most of this money into property bubbles and speculation, but a bad thing for an independent part of the state to take the power to create money away from banks and use it in the public interest instead?

As to the creaking infrastructure and public services – these are exactly those areas that could benefit from Full Reserve Banking – if the reforms would be implemented as we propose, it would free up resources to improve our infrastructure (and unlike in the current system, without increasing the national debt and consequent costs to the taxpayers.)

The moral issue is not with full reserve banking; it is with the current system.

“We cannot say for sure that there would never be another economic crisis, never another recession that needed fiscal stimulus and extraordinary macroeconomic measures. Banks are not the only cause of economic problems. It would be madness to lock ourselves into an economic system that prevented us from responding appropriately to, say, a major oil price shock. But full reserve banking would force us to do that.”

Again, Frances seems to have forgotten what system we have today. We had a crisis caused by over-indebtedness, and the only policy response that the Bank of England could come up with was a) to lower interest rates to make it cheaper to borrow even more, and b) to create money, via QE, in the financial markets, where it is extremely unlikely to ever reach the real economy or stimulate GDP. The current system has completely failed to respond to a crisis, and there are no policy options that the Bank of England or government can use to get us out of a crisis in the current system.

“As far as I can see, full reserve banking is politically and morally disastrous. Either we would hurt the poor through harmful economic policies, or we would deceive depositors into believing their money is safe when it isn’t. I don’t know which is worse.“

I’m afraid this is based on a deep misunderstanding of the proposals. Again, to anyone who has been alive through the recent crisis, it should be obvious that it is the current system which has harmed the poor, and deceived depositors into believing their money is safe when it isn’t. We’re proposing an alternative to this system.