Full reserve banking: the largest bank bailout in history
I've now read three different proposals for full reserve banking - respectively from the IMF, Lawrence Kotlikoff and Positive Money. Each is slightly different, but they all share the following essential characteristics:
- 100% backing for deposits with cash and/or government debt. The IMF proposes cash backing for ALL deposits, including wholesale ones. Kotlikoff and Positive Money propose cash backing for sight deposits (current/checking accounts) only.
- Serious restriction on the nature and scope of bank lending
- All money issued by the central bank only. The proposals differ as to whether the money supply should be directly managed for macroeconomic benefit or whether there should continue to be indirect control via interest rate policy.
I've both written about and had extensive debates with Positive Money about their proposals, and I recently wrote about the IMF proposal. Kotlikoff's proposal is similar to both of these, in that it fundamentally changes the nature of banking, but structurally different in its extensive use of mutual funds and securitization of lending. It is also wider-ranging than the other two, covering not only shadow banking but insurance.
The nature of banking is by no means a simple matter, and none of these proposals is easy to understand. Consequently much of the public commentary revolves around the economic problems and moral concerns in our present system. There is little discussion of the likely economic problems with a full reserve system, or of the moral concerns that it raises. In fact all three are, perhaps unsurprisingly, complacent about their proposals and apparently blind to their flaws. Here are a few gems:
- The IMF produced a DSGE model that painted a very rosy picture of an economy under full reserve banking. The model itself was lovely, but the calibration made a great many assumptions for which they produced little justification and some of which in my view were actually wrong: there were weird interest rate assumptions, and very optimistic ideas about inflation (since the proposal included writing off most private debt). I suppose the idea was to blind everyone with advanced maths. But I'm not that easily fooled. DSGE models are only as good as the accuracy of their assumptions. As we used to say about computer systems, garbage in = garbage out.
- Kotlikoff designed a system which includes its own version of what in the UK is known as the Tote. He claims that this is "perfectly safe betting". Crikey. Regarding betting as "safe" is the cause of much damaging addiction to gambling. And no-one who has ever bet on the outcome of a horse race would regard any form of betting as "safe". Quite apart from anything else, the opportunities to game the system are legendary. The use of a totalisator does make betting safer for the average numpty, but to describe it as "perfectly safe" is laughable. I suppose betting on horses is not quite so much of a tradition in America as it is in the UK, so Kotlikoff maybe doesn't know much about it. But in what way is replacing a casino with a betting shop an improvement?
- 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?
My greater concerns over full reserve banking, however, are its cost and its safety. Let me explain.
Both the IMF and Positive Money consider how the transition to a full reserve system might work - the IMF in some detail. But there is only one way full reserve can be introduced, and that is by means of the biggest bank bailout in history.
At present, bank funding for payments works on a just-in-time basis, with banks running daylight overdrafts at the central bank and clearing them by the end of the day from a mixture of sources: banks do not have enough funds at any one time to allow all sight deposits to be drawn at once. The possibility of banks simply not being able to obtain the funds to allow deposits to be drawn is covered to a limited extent by deposit insurance, but like all insurance schemes, deposit insurance is not intended to cover a situation in which all deposits were withdrawn from all banks at the same time. It is intended to deal with individual bank failures.
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.
Positive Money would no doubt say that as their proposal involves moving transaction accounts from private bank to central bank books, no new money needs to be created. I disagree. In order to move the transaction accounts, the central bank would have to create new reserves to the value of the total balances in those accounts. This is simply a consequence of double entry accounting: it is not possible simply to eliminate deposit balances from private bank balance sheets without also writing off the debt assets that currently back them. So either the central bank must produce new money, or there must be a debt jubilee. (The IMF noticed this and opted for the debt jubilee, but their accounting was wrong and they didn't consider the inflation consequences of such a massive debt write-off).
Some would argue that a one-off bank bailout on this scale is a small price to pay for safety in the future. Which brings me to my second issue. Would it really be safe?
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. I've said before that government debt and fiat currency are equivalent: assuming that under full reserve banking most money wouldn't be interest bearing as it is at the moment, the inflation rate is, domestically, the currency equivalent of the yield on government debt (externally, the exchange rate is the equivalent of the price). And just as economic and political difficulties can push up the yields on government debt, so they can push up the inflation rate, too, and/or debase the exchange value of the currency. 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. The UK and the US both have substantial trade deficits: debasing the currency is very, very tempting macroeconomic policy for politicians wanting to improve exports. And both the UK and the US have high public debt: inflation is very, very tempting as a way of reducing the debt burden without unpopular spending cuts. I suspect that before very long there would be political pressure to provide further protection to depositors by anchoring the currency to a physical asset such as gold, thus preventing too much money being produced. Welcome to the gold standard, 21st-century edition.
Kotlikoff suggests that government debt would be an alternative "safe" backing for deposits. But government debt is as subject to variation in value as the currency. Safety for depositors would be dependent on the willingness of government to support the value of its debt - and that would mean not allowing the debt to grow. Even cyclical deficits would represent a risk to depositors. There would therefore be political pressure to run balanced budgets or surpluses AT ALL TIMES, even in economic downturns. Welcome to the UK of the
So safety for depositors would depend on the willingness of government to give priority to the interests of depositors over everyone else. And 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? 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?
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?
To me, full reserve banking looks like a very regressive idea. I suspect those who support it think that it would end economic downturns, and therefore the restrictions on economic policy that I note above wouldn't matter. That was certainly the implication of the IMF's analysis. But that sends a shiver down my spine. When did we last hear that we had "ended boom & bust"? 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.
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.