Monday 9 November 2015

Matthew Klein’s flawed criticisms of full reserve banking.


Klein in this Financial Times article says he supports full reserve (FR) banking. His actual words were “….proponents have included Milton Friedman, James Tobin, researchers at the International Monetary Fund, John Cochrane, and Martin Wolf. (And me.)”

However, Klein does make some criticisms of FR. In relation to Iceland’s proposed FR system his first criticism is thus:

“Sigurjonsson’s report makes a convincing case that private lenders aren’t the best judges of how much money the economy needs to sustainably grow. Why should central bankers and politicians be any better?”

The answer to that is that it’s widely accepted that lending by private banks is pro-cyclical. That fact stares you in the face from any money supply chart.  The chart below shows the steep rise in private bank lending prior to the 2007/8 crisis.






 


But quite apart from that, WE ALREADY HAVE “central banks and politicians” attempting to iron out fluctuations in GDP, unemployment levels and so on. Indeed, if government and central bank don’t do that job, then no matter how inefficiently, who else does do it?  Thus having “central banks and politicians” trying to counteract cycles is not a peculiarity of FR. FR simply advocates a slightly different way implementing those anti-cyclical efforts.


Klein advocates full blown monetarism?

Shortly after that, Klein says “If Iceland were successful in centralizing the control of nominal purchasing power, the appeal of policymaker discretion should vanish and a simple money-growth target would suffice.”

Well a fixed annual increase in the money supply was what Milton Friedman advocated and that didn’t work too well. In defence of Friedman, his idea is not completely daft: i.e. anyone can be forgiven for thinking that a fixed and small annual money supply would work. But the fact is that it didn’t work too well. So that’s that.

If Klein now thinks that monetarism a la Friedman is actually desirable, most economists would regard that as a joke. But I’m broad minded: I’m happy to listen to explanations from Klein that support his pro-monetarist belief.


Investment accounts.

Next, in the paragraph starting “Those are minor criticisms.” (and subsequent paragraphs), Klein argues that the FR system Iceland envisages would be as liable to runs as the existing system. As he puts it, “banks would be almost exactly as vulnerable to runs as they are in today’s system”. To explain Klein’s concerns, it is necessary to delve into the detail’s of Iceland’s proposed system.

Iceland’s proposed system (far as I can see) is a direct copy of Positive Money’s FR system. And under that system, those who want a bank to lend on their money put their money into so called “Investment Accounts”. Those accounts are not protected by taxpayers, plus instant withdrawal of fund is not allowed: depositors have to wait a few months to withdraw. And therein lies the first weakness in Klein’s claim that those accounts would be subject to runs. Runs occur where depositors have a right to INSTANT ACCESS to their accounts. So when there’s a suspicion that a bank is in trouble, queues appear outside relevant bank branches (as at Northern Rock). The queues consist of people demanding instant access.

In contrast, with investment accounts, a run would be a slow motion affair, and that gives the bank time to find alternative sources of funding. Thus Klein is clearly wrong to claim that FR banks would be as subject to runs as existing banks.

Moreover, there’d be nothing to stop the terms governing those investment accounts including a clause to the effect that in the event of the bank having problems, depositors’ access to their money can be extended by the bank. After all: those depositors have absolutely no cast iron guarantee they’ll get any of their money back at all, given that there is not government backing for those accounts. So they’d be daft to object to having access to their money delayed: that delay might enable them to eventually get their money back.


Milton Friedman and Lawrence Kotlikoff.

Next, the above “run problem” to which Klein refers is not actually a weakness in FR as a whole: it’s a peculiarity and weakness in the Positive Money / Iceland version of FR.

That is, in other versions of FR, in particular Milton Friedman and Lawrence Kotlikoff’s versions, those who want their money loaned on buy what are essentially shares in a unit trust (“mutual fund” in US parlance). Under that arrangement, insolvency of the investment department of a bank (i.e. those mutual funds) is plain impossible.

To illustrate, if 90% of relevant borrowers turn out to be dud (which is about as likely as being hit by a meteorite), all that would happen is that the value of the mutual fund shares would drop to 10% of their book value.

If you have a SHARE in a corporation as distinct from a FIXED VALUE claim on the corporation, there is no point in running, as John Cochrane explains.


Interest rates.

Next, Klein claims that in the event of a number of bank failures (i.e. failures of the lending or investment department of banks) “you could expect a sudden spike in the cost of borrowing.”

True, but what’s wrong with that? If there were a series of failures in the food retailing industry, that would indicate that the industry had overestimated the size of the potential market and had pitched its prices too low. If market forces were working properly, the result would be that a number of retailers would go out of business, and the remainder would raise prices.

That’s in contrast to the existing and barmy set up where when there’s a series of bank failures, or near failures, government comes riding to the rescue with the result that excessive lending and excessive debts get back to where they were before the problem exploded.

The world is awash with people (mainly politicians and economics commentators) who advocate more bank lending in one breath so as to promote “growth”, while in the next breath they deplore the rise in private sector debts (caused by those bank loans).

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