Richard Jenner: 100% reserve banking

Richard is a Postgrad student who has no economics qualification beyond A Level but is still going to give this a shot.

> Policy summary

To institute a system of 100% reserve banking and remove the Government from manipulation of the money supply, including the abolition of the Bank of England.

> Policy explanation

The free-market Austrian school of economics (Hayek was a member) have vociferously criticised the process by which banks create money by lending more than they have in their reserves. According to Austrian business cycle theory, the extra money artificially lowers interest rates and encourages investment in capital goods despite the lack of real savings. (This is because lower interest rates suggests less demand for consumer goods according to the Austrian theory of time preference.) As there is no genuine demand for the capital goods the investments will have to be liquidated - resulting in a bust. In short, bank-created money is the main culprit behind the business cycle. The Bank of England, by acting as lender of last resort, encourages this system by providing banks with backup funding if they are unable to pay their debts. Bank-created money also has the negative effect of benefiting those who first borrow the money at the expense of those who receive it in later transactions. Those who borrow first are able to take advantage of the fact that prices haven't yet risen. Suffice to say prices have risen (due to the extra credit) by the time the later recipients come to spend it.

The Austrian answer to this problem is to introduce a system of 100% reserve banking whereby banks are unable to lend more than they have in their reserves, thus ending the bank-created expansion of the money supply. This usually goes together with the idea of a gold standard although for practical reasons I wouldn't advocate that policy at this stage.

Milton Friedman and the Chicago School, although disagreeing with Austrian business cycle theory, have also supported the idea of a 100% reserve system. The difference is that they believe the Government should increase the money supply gradually by about 2% per year. The Austrians are opposed to this idea because they believe it has the same negative effects as bank-created inflation. Conservative policy, in my opinion, should be to implement a 100% reserve system, shut down the Bank of England and remove the Government from control of the money supply except for the minting of currency to replace lost or ruined coins and notes. All money created by loans that weren't backed up by real savings would have to be liquidated. It would be possible to back up all currently existing loan money with paper notes but as soon as the recession brought about by the business cycle kicked in, loans would have to be liquidated to prevent inflation. The advantage of immediately shrinking the money supply is it gets it over and done with in one go.

For a more in-depth analysis of the problem I recommend the following weblinks:

• Austrian Theory of the Business Cycle - a better summary than mine
• And here - another better summary than mine that is somewhat more in-depth
• And here - very in-depth explanation of the Austrian theory of the business cycle and proposed solutions
• The problem with Central Banks
• Application of the Austrian theory to the Great Depression
• Application of the Austrian theory to the dot.com boom

> Political risks and opportunities

It's a very radical idea. Very few free-market economists (if any) outside of the Austrian school (which is itself very small) accept the Austrian analysis of the business cycle and the idea of a 100% reserve system probably won't be espoused by many "mainstream" economists either, even if Friedman and co are sympathetic to it. One wouldn't expect to find the Bank of England happy about being shut down either.

Implementing the idea would also be highly painful at first - it would involve an immediate shrinkage of the money supply and a recession. As there would no longer be a lender of last resort banks and their customers would no longer be protected from bad investment decisions.

The primary political opportunity would be the promise of an end to the business cycle and inflation.

> Questions for ConservativeHome readers

• How do we measure the amount of money going missing and in need of replacement? Note that this proposal does not include the Chicago scheme of gradually increasing the money supply.
• What would be the technicalities of initially shrinking the money supply i.e. which loans and investments would have to be liquidated? Would it be a proportion of all loans for example?

> Costs

As mentioned above, an initial recession.

   

Comments

[TomTom]

According to Austrian business cycle theory, the extra money artificially lowers interest rates and encourages investment in capital goods despite the lack of real savings.

Now let me rain on your parade. Maybe international currency flows are not your thing, but since the British introduced The Gold Standard in the early 19th Century, major currencies have been in essence bankers to the global economy.

Until 1914 it was the British Pound Sterling which upset the Americans and encouraged The Bi-metallism debate with William Jennings Bryan in 1896.

Since the US Dollar supplanted the Pound on a fixed Gold Parity until 1971 and continued in a floating relationship to be the global reserve currency until today; it has been the role of Central Banks to manage a currency where huge balances are outside their control being in places like China or Eastern Europe.

Even BUBA with the tightest monetary base control in Europe could not control the D-Marks in Serbia, Russia or much of Eastern Europe............the Germans never wanted Reserve Currency status because of the damage it does to Domestic Credit Expansion............that is one reason the Euro was an option to function as a reserve currency without seeing European currencies in competition.

The idea of 100% reserve backing is a funny one since it essentially means no Government borrowing, and reduces society to a cash economy thus shrinking GDP enormously.

It would mean noone could build the Olympic Stadium unless first the Governnent increased taxes to produce the £8-12bn cash balances and such things as mortgages would be redundant.

There would be no portfolio theory, no hedging, no arbitrage, and no credit. In fact we can see such a system in action today. If you live on a housing estate say in Dagenham or Tower Hamlets or Buttershaw - you might find it impossible to get credit and can only draw upon what you deposit.

So let us examine living standards on these estates and contrast them with those who draw credit and live in owner-occupied housing with high debts say in Holland Park

[Umbrella Man]

Absolutely crazy idea. Why is CH even hosting it? ..... 'Vote Tory For A Recession' !!

[aristeides]

Er, what are the good points?

[TomTom]

Let us go further and look at the identity Y = C + S

WHy do people save under your system Richard Jenner ? They would only save if they cannot Consume - but what consumption would they forego - food ? Health ? Sewage ?

This leads us to the old 'Pool of Savings' doctrine and the Pigouvian Real Balance Effect whereby all factor prices are fully flexible and Full Employment is the norm.

The Austrian School blames Unemployment on human intervention seeing a natural balance in the economy which is caused by monetization.

It is the idea of 'Money as a Veil' that causes them to functionally separate Product and Money Markets as if the economy has a natural rate of expansion which bankers should finance, neither more nor less.

In fact Friedman had a good piece of work in the Permanent Income Hypothesis
trying to explain the Consumption Function which flies in the face of your notions of 100% reserve backing as opposed to fiduciary issue.

You will find that the economy described by the Austrian School was essentially a simple economy based on primary and secondary industry with limited number of sectors. Since a large part of the employment in the United Kingdom - and of Corporation Tax revenues come from financial services sectors these would disappear under 100% reserve banking.

There would be no LBOs, MbIs, or PFIs, or Gilts, or Pensions, or Investment.......and Friedman's theoretical postulates of expanding money supply at the pace of natural expansion of the economy are just that - theoretical - a kind of Monetary Just In Time procedure...........

It ignores lags in the economy and is why Friedman's more extreme nostrums re-packing the Fisher Equation MV=PT in a modern form, failed in implementation.

It would be good if you would read A Treatise on Money by J.M. Keynes (1930) and The Economic Consequences of Mr Churchill (1925) before proceeding to look at works by Harry Johnson and Don Patinkin..............

[aristeides]

"What would be the technicalities of initially shrinking the money supply i.e. which loans and investments would have to be liquidated?"

Other than rioting, collapse of the government, collapse of the legal system due to mass bankruptcy, and widespread suicide, there would be few technicalities.

[pl]

You people are all nuts. Rioting? Collapse of government? Mass bankruptcy? Suicide?

All because it would be a lot harder for people to borrow a lot of money?

How about this benefit: massively lower rate of inflation and hence debasement of the currency and people's savings.

I can't believe you really think the consumer society is the best we can do!

Unbelieveable.

[aristeides]

"How about this benefit: massively lower rate of inflation and hence debasement of the currency and people's savings."

I don't see how a debasement of the currency and people's savings is a benefit. I am not sure you quite meant that either but that is in fact what would happen. Given the practical impossibility of being able to borrow to invest, capital would fly out of the country causing a run on the pound. Along with the attractive sounding recession, this would certainly be an antidote to the consumer society we Tories should apparently be opposing. Did you ever go to Russia before 1990? It was quite like that too.

[Jonathan Powell]

I'm not impressed with this idea at all, mainly because it confuses a government created fiat money system with fractional banking. The latter is a free market innovation which makes the banking system more efficient. In order to make this policy a reality it would require government intervention to outlaw fractional banking. There would probably emerge a black market in which fractional banking went "under-ground".

Personally, I would be more inclined to back a system of free-banking

http://en.wikipedia.org/wiki/Free_banking

which is what Friedman advocated in later life.

The idea of 100% reserve backing is a funny one since it essentially means no Government borrowing, and reduces society to a cash economy thus shrinking GDP enormously.

It would mean noone could build the Olympic Stadium unless first the Governnent increased taxes to produce the £8-12bn cash balances and such things as mortgages would be redundant

I don't see how this follows at all. Surely the government could still issue bonds?

[Fred]

Completely bonkers. Why not suggest bringing back the Church's prohibition against usury, and abolish paper money in favour of the silver penny as well? Then we can return to the fanastic prosperity of the middle ages.

[ToMTom]

I don't see how this follows at all. Surely the government could still issue bonds?

Posted by: Jonathan Powell | November 29, 2006 at 11:03 AM

How ?

Government Bonds for the asset-base of the banking system and they are completely uncovered IOUs. The most basic bond is one which states I Promise To Pay the Bearer On Demand and banknotes are non-interest bearing government bonds.

The purchasers of Gilts essentially use them to create the Reserve Asset Ratio and leverage their own lending. Government Bonds coupled with T-Bills expands the asset base of the banks, just as PFI is now doing by providing asset-backed lending with government guarantee

[TomTom]

"What would be the technicalities of initially shrinking the money supply i.e. which loans and investments would have to be liquidated?"

Try reading Kindelberger - or Harold James...........then look at Germany 1925-1932 when GDP fell 30% or even the US 1929-1939...............it might be worth looking at the death of Benjamin Strong in 1928 and how the Fed then reversed policy leading to a liquidity problem for banks like Goldman, Morgan Guaranty etc..............and how they used mutual fund cash reserves to offload their shareholdings so individual investors could carry losses...............I bet Macquarrie Bank wouldn't do that

[Milton]

I think this is an excellent idea.

It's just the kind of the out-of-the-box thinking which David Cameron needs to endorse.

After his great 'Tosser' campaign, this is exactly the kind of well-thought-through policy we need to link our broad macro- policy to a coherent micro- policy.

Don't worry about the nay-sayers, Richard.

[Richard]

"Don't worry about the nay-sayers, Richard."

I'm not, I always knew this idea was going to get savaged because a)it's supported by only a minority of Austrian school economists and b)there is the big question that even I find hard to answer about incentives to save. Perhaps the answer would be government injections of money that affected the whole economy equally, although how this would work in practice I have no idea.

The usual Austrian retort is that "the amount of money does not matter, the economy will adapt itself through decreasing prices" etc.

Anyhow, I thought the idea should be given a hearing.

[angry economist]

100% reserve banking is completely insane as everyone suggests. It would result in a massive reduction in liquidity and in the ability to speculatively lend, borrow or trade (in anything).

Essentially you are proposing to go against one of the age old sayings "if it aint broke don't fix it". The current system is working well, and in the UK we have had encouraging stability from this.

[Matthew Sinclair]

The problem with a massive contraction in the money supply is that the flexibility the Austrians rely on just doesn't exist. Essentially, you would be imposing what happened in the Great Depression in the US (thanks to a rising reserve ratio due to lack of confidence in banks) on yourself. The problem has been highlighted by a great many people starting with Friedman and proceeding to Bernanke.

[Mark Wadsworth]

A slightly less radical is as follows: Bank of England (remaining under state ownership for time being) becomes like any other bank. What do banks hate? Inflation, recessions and asset price bubbles.

So if it does its job well;
- there'll be less of all these things,
- no stupid "targets" whatsoever (why target one narrow measure of inflation? Why set target rate at 2%?)
- it will make money that can be returned to taxpayer, and finally
- when appropriate it can be privatised (again benefitting taxpayer).

[Adam]

This measure would not have to result in a recession. The government could gradually raise the reserve ratio over time until it reaches 100%.

The Good:

1. Society would become much more stable without the money supply constantly shrinking and growing as people deposit and withdraw money from banks. In other words, no money multiplier affected by the velocity of money.

2. No more bank runs, no more bailing out of banks.

3. No more debt society. In the U.S. the average American has a negative savings rate because debt is so cheap!

The Bad:

1. Fractional-reserve banking subsidizes the banking industry (by allowing them to rake in profits from the money multiplier). This makes the financial sector of the economy over bloated. Therefore, if a 100% reserve ratio were imposed the banking industry would inevitably shrink leading to frictional unemployment.

2. Banking services would cost more because no longer can they pay for their offered services by lending out your money to other people.

3. (biggest concern by critics but overblown) There would be far less investment in society b/c no loner would banks act as an intermediary to leverage out all the savings in the country. However, it is my belief that new institutions would rise to take the role of directing money towards investment. For instance, money market funds would take a more prominent role. Nobody is going to sit on their money! everybody wants a rate of return so it will be invested somehow.

4. The interest rate would temporarily go up until new investment institutions are formed during the readjustment.

Summary:

The negative mostly has to do with adjustment costs. The positive would help stabilize capitalism. The free market, if set up correctly is extremely stable, and its set up wrong right now! Historically people have practiced fractional reserve banking with wheat and they were criminalized! And yet, we allowed people to do it with gold and now paper money.