Are Positive Money Their Own Worst Enemies With Regards to the Case for Full Reserve Banking?

We have covered the mechanics of full reserve banking before.

We have considered as a result of our modelling the case unproven as its advocates may have incorrectly identified ‘fractional reserve banking’ as the problem – it may not be, rather the problem may be the ability to charge an economic rent on money itself – rentier income – and drive up debt to unsustainable levels, as well as the system of endogenous money creation itself which makes it almost impossible for governments to effectively control the money supply.  The advocates of full reserve banking have fixated on fractional reserve banking because they say it creates credit too quickly, but creating money too slowly can be an equal threat and neglects the key issue that creating money too quickly is only a problem when used for speculative and consumptive purposes.  In many cases you need to create money quickly because you need to expand or rebuild the real economy quickly (such as after a natural disaster).  Issues which full reserve banking by itself will not solve only slow.

My views on this were confirmed this week when some blog comments by fellow sceptic Francis Coppolla were lept on in a rather crude way on the positive money blog.

Their were two issues.  The first I think is a bit of a red herring, on monetarism,  but on the second, on the lowing of credit growth, the positive money blogger was the worst possible advocate of the case, failing to understand how full reserve banking itself would function.

The first issue was whether full reserve banking suffers from the same weakness as monetarism, governments cannot control the monetary base.  This is a bit of a red herring because during the highpoint of monetarism – monetary base control of the early 80s, the experiment was abandoned within only a few years because the Treasury found it could not control the rate of endogenous money creation by banks, as I found reading through the recently released Treasury file on monetary base control.  Positive Money say that banks will no longer create money – not true advocates of full reserve banking have always accepted the case for term deposits, and term deposits are money creation through maturity transformation.  Positive moneys own proposals include one for ‘investment accounts’ – a special form of term deposit not guaranteed by the central bank, exactly as proposed by Austrian advocates of full reserve free banking.  As I understand their proposals the positive cashflows from investment accounts would count as reserves in terms of the reserve limit of banks that they could lend to – as would profits from interest not returned to shareholders as dividends (what is known as the bankers surplus).  Whenever a bank grants a loan it would do so electronically by creating a deposit in an account as now.  You might object that this is not money creation net as the creation of money would be exactly balanced by the destruction of money through repayment of principal, if banks were restricted to lending no more than reserves on hand.  This is a mistake, if there is an interest rate spread between savings (investment accounts) and lending then the cashflow into the ‘revolving fund of credit’ (Keynes’s term) will grow over time, more money will be created than lent over a period because loans (and savings) accounts will generate profits, so though at any one moment in time cash flow in will equal cash flow out (loans) so it looks like their is no net money creation their will be as cash flow in over the term of the loan will be greater than the amount loaned.  Indeed were it not their would be no business case for banking at all as banks make their money from this spread – the very business model of banking.  If banks cannot create money they cannot make money, unless they charge exorbitant fees (which must annually be equal to the average rate of profit in the economy)  It is disingenuous then to say that lending based on term deposits is not money creation – it is.

So the same macroeconomic tools as now would be used to control the still endogenous money supply.  As credit creation would be slower arguably they would be harder to apply as the ‘lag’ to effecting base money would be much slower.

On the other hand credit would be much less important to money supply growth than ‘inside’ state money.  You can argue I think that use of inside state money is a more effective means of directly controlling the money supply.  On this grounds then I think full reserve banking can escape part of the ‘monetarism doesn’t work’ argument.   But this in itself raises other objections.  Firstly if the rate of credit creation is slowed, and positive money accept that without the fractional reserve channel it would be drastically slowed, then in order to re-establish the business model of banking then in order to attract equity by restoring the rate of profit the spread of interest rates would have to be widened.  Savers would have to earn a lower rate of interest and borrowers would have to pay a far higher rate of interest than now.  How then will banks restore their reputation and function if they give a far worse deal to lenders, depositors and borrowers?

The counter to this argument is that state money creation would be used to restore the balance   But this can only occur in one of two ways.  Either by the state investing equity in banks and accepting a lower than market rate of return, or through government spending more state money into existence than it destroys through taxation.  There are arguments for doing this especially at times when banks are not lending but either approach would involve the state undertaking investments at less than the market rate of return of banks.    This is a form of soft budget constraint and would only lead to malinvestment.    It would institutionalise low rates of profit for banks leading to an equity drain, a credit crunch and forced government take over of banks.  Err wasnt that the kind of bank crash we are trying to avoid?

There may be aspects of the positive money proposals that are salvageable.  The modelling done so far suggests that a greater role for state money creation will lessen the burden of debt and lead to less rentier extraction of income.  Good arguments, but ones that derive their advantages from the ownership of banks and the issuance of state money, not from the artificial restriction of one channel of money creation by banks.

Perhaps the worst argument used though is the response to the arguments that full reserve would be less efficient at lending than fractional, that nothing could be more inefficient than fractional.  Case not proven and a classic logical fallacy, it ignores the evidence over the efficiency of one object by countering with evidence of efficiency of another.