Friday, August 17, 2012

Lord Keynes — A Simple Question for Opponents of Fractional Reserve Banking


For Ralph Musgrave.

Social Democracy for the 21st Century
A Simple Question for Opponents of Fractional Reserve Banking
by Lord Keynes

22 comments:

Ralph Musgrave said...

Lord Keynes’s argument goes as follows.

1. There is nothing wrong with one farmer lending a chicken to another farmer.

2. Therefor there is nothing wrong with one person lending MONEY to another.

3. Therefor there is nothing wrong with a bank lending money.

4. He then says “It is only a few further steps to see that there can be nothing wrong with fractional reserve banking….” But he doesn’t say what those steps are – not very helpful.

Anyway, the flaw in the above argument is that there is a BIG DIFFERENCE between one PERSON lending to another, and a BANK lending to a person or other entity.

When one PERSON lends to another, there is no increase in the money supply. In contrast, when a bank lends, it can just create the money out of thin air: the money supply increases. To be more accurate, there is very little restraint on the money supply expansion that the PRIVATE BANKING SYSTEM can bring about.

There is a chart that shows the expansion in broad money relative to base money in Britain prior to the crunch. Scroll half way down here:

http://tutor2u.net/economics/revision-notes/a2-macro-monetarism.html

That money supply increase boosts asset prices, which in turn makes those assets better collateral, which facilitates more borrowing, etc etc. There is an obvious feed- back loop there.

Another difference between full and fractional reserve is that when a bank goes bust under fractional reserve, money vanishes. As Irving Fisher put it “The most outstanding fact of the last depression is the destruction of eight billion dollars - over a third – of our “check-book money” - demand deposits.”

In contrast, full reserve is a bit like a monetary system that consists just of gold coins. Whatever happens, the actual coins cannot disappear.


Carlos said...

Money is actually created when a bank goes bust. The unpaid loans exceed the deposits. The loans never get paid back in full so the loaned dollars are still out there somewhere.

When the farmer has 9 sons who each want a chicken to start a farm and there are no spare chickens. We need fractional reserve chickens.

Tom Hickey said...

Yes, people like Bill Mitchell say that if one is serious about ending private bank money creation and moral hazard, the way to deal with it is to nationalize the banks. Banks could be administered by agents on contract and there would be plenty of bankers out of a job that would line up even with a a huge cut in salary and perks.

I say let the govt deal with retail banking with 100% guarantee, which only govt can provide, and let commercial and investment banking do their thing without govt backstop. If the banking system runs itself on the rocks, then it is summarily nationalized, reorganized and privatized under new ownership and management. Oh, and with clawbacks. I would also end the corporate veil in the financial sector and go back to the sole proprietorship and partner modes with full individual responsibility.

Matt Franko said...

Good recomendations Tom,

Ralph,

The govt side can always control it by not approving the appraisal values of the collateral...

ie if the govt does not approve of an increase in the appraisal value of the collateral, the system can not go asymptotic...

rsp,

Anonymous said...

Hold on let me get this right.

Reserves dont play any part in lending. So why are we arguing about FRB when we dont use that system?

Tom Hickey said...

Under the current monetary regime the use of reserves is only directly related to the payment system, not to lending. Banks have to get reserves to settle accounts and to meet RR where required. That comes after the lending and only the cost of reserves to the bank is relevant to lending, i.e., the spread affects the interest rate charged for borrowing.

Matt Franko said...

" That comes after the lending"

And the lending only comes with government approval of the collateral values corresponding to the loans...

rsp,

Anonymous said...

So what shall we call it then?

Tom Hickey said...

"Fractional" and "full" reserve banking are convertible fixed rate terms that should have been jettisoned along with bonds with the shift to a non-convertible floating rate system.

AndyCFC said...

Indeed Tom, and an argument ive had many times elsewhere and the whole name we use is IMO half the problem why people dont understand QE.

And btw the prove you are not a robot is getting harder than understanding our monetary system :)

Anonymous said...

Reserves do play a part in lending. When the bank creates a deposit account for its loan customer, it is creating a claim against its reserves. So as soon as the customer begins spending the money, the bank's reserves begin moving - unless the borrowers's spending takes place purely among customers of the same bank, which is rare. If the customer writes a check against the account to a person or business with an account at another bank (or pays with an ATM card), the settlement of the check will clear with a transfer of reserves from the loan customer's bank's reserve account to the reserve account of the bank of the other customer. If the loan customer decides to withdraw cash, then that cash comes from the banks vault, and is a subtraction from its total reserves.

We don't live in a system in which banks are issuers of their own fiat currencies, which they create at will. We live in a system in which banks can create liabilities at will. A liability is always a liability for something. And in our system, commercial bank liabilities are liabilities for the government's currency.

Tom Hickey said...

Dan, this is a matter of the payment system and that only comes in after lending. Banks can always obtain reserves need to clear and to meet RR when the cb is operating as LLR since the cb automatically credits the banks' reserve account if the bank comes up short at the end of the period. This just costs the bank a bit more in interest than it would if it had managed its rb better.

Lord Keynes said...

Ralph Musgrave@August 17, 2012 4:33 PM

When one PERSON lends to another, there is no increase in the money supply. In contrast, when a bank lends, it can just create the money out of thin air: the money supply increases.

Ralph Musgrave,
Anyone can create money!: you can create a promissory note or bill of exchange. As Minksy says the trouble is getting it accepted as
money.

Bu private sector, non-bank agents create money all the time: have you never heard of the negotiable cheque? When people accept the negotiable cheque as a means of payments for goods, cheques increase the money supply.

So have negotiable promissory notes or bills of exchange down trough history.

Lord Keynes said...

"Another difference between full and fractional reserve is that when a bank goes bust under fractional reserve, money vanishes."

When a debtor who has created a bill of exchange/promissory note used as money goes bankrupt, this means money vanishes too.

Are bill of exchanges/promissory notes therefore illegitimate?

Tom Hickey said...

And have you ever heard of "rent-to-own." Many firms finance their own goods using some form of this. Seller delivers goods on a note secured by the goods and buyer promises to pay, often a higher than ordinary rate (especially poor people), or perhaps a very low rate as a way for the firm to push its product (auto companies). If bank credit is restricted, it will pop up somewhere else because there is a demand for it and people willing and able to meet the demand.

Anonymous said...

Tom I agree, but I just don't think it is helpful to say that reserves are not directly related to lending. Whether the bank can acquire reserves after the lending (our system) or is required to possess excess reserves before the lending (possible alternative systems), when the bank expands its deposits, it has expanded its liabilities. And in the state-organized fiat monetary systems we all live under, these liabilities are liabilities for the government's money.

We do not live under the kinds of radically endogenous monetary systems envisioned by some theorists of completely independent commercial banking. MMT is (to its credit) a theoretical fusion between models of pure endogeneity coming from parts of the PK tradition and pure exogeneity coming from Knapp and others in the chartalist, fiat money tradition.

Banks without excess reserves can acquire reserves after expanding their lending, and so in that sense are not constrained by their present reserve position. But "acquiring" in this context is another word for "buying". The bank has to borrow these additional reserves, and thus pay an interest rate for them them. If the rate is less than the expected return from the loans, expanding lending will be a good deal for them.

paul meli said...

Lord Keynes:When a debtor who has created a bill of exchange/promissory note used as money goes bankrupt, this means money vanishes too

State money doesn't vanish. MMT is about state money.

Leverage said...

"Bu private sector, non-bank agents create money all the time: have you never heard of the negotiable cheque? When people accept the negotiable cheque as a means of payments for goods, cheques increase the money supply."

True, as I've said before private sector through history has ALWAYS found ways to leverage itself to achieve full economic potential (even if it involved monstrous asset bubbles). I'm a defender of full reserve or something similar (along the lines of what Tom says maybe), but I'm a realist and know that it would be very difficult to achieve a stable banking-financial system, all this would do is make cycles longer and soften them maybe.

I think FR vs. fractional-reserve is more a political argument than a legal one. Is about control and sovereignty, democracy and privileges, etc.

It's not a legal argument, neither is completely a financial one (it's not only about financial stability). Most people misses the point completely about fractional vs. full reserve argument.

Anonymous said...

This kind of thing happens everywhere like LK is explaining. If private firms have maturity mismatch (liabilities assets), that is the same thing.

And sure, proving you are not a robot is hard around here. Makes me think, whether we are robots or not, is becoming more of a philosophical question these days

beowulf said...

As I wrote over at LH's...


"I know you keep a reserve stock of chickens – since you are a farmer"

The reserve stock of chickens (whether you mean the power to create new money or simply FDIC insurance) is owned by the government, not the farmer/bank. The contract is such that private banks take the profits while the public treasury takes the losses, I would suggest there's something wrong with that.

Ralph Musgrave said...

Andrew (August 17, 2012 6:08 PM),

Yes the loaned dollars are still there, but depositors’ money vanishes.

Matt Franko (August 17, 2012 7:49 PM),

Your suggestion that government should examine and approve of collateral values is also suggested by Laurence Kotlikoff. I’m not sure . . .I think that’s too bureaucratic.

Tom Hickey,

You say, “If bank credit is restricted, it will pop up somewhere else because there is a demand for it and people willing and able to meet the demand.”

I don’t agree, and the reason is that while full reserve obviously restricts banks’ activities, full reservers advocate that the deflationary effect of that is nullified or countered by having government and central bank spend base money into the economy (and/or cut taxes). I.e. everyone has more money, so there is less need for credit or borrowing.

Lord Keynes,

What I’ve written below pretty much duplicates the answer I put on your own site.

Money is defined as anything widely accepted in payment for goods and services. Re negotiable cheques, I don’t think I have ever in my entire life been offered or accepted a negotiable cheque in payment for anything. By that I mean a cheque that has previously been negotiated or “endorsed” by anyone. Nor have I ever accepted a cheque with a view to “negotiating” it. And as long as a check is not negotiated in the latter way, the check ITSELF is not a form of money: that is, it does not get passed from hand to hand in payment for goods and services. Thus the idea that negotiable checks are a significant part of the money supply is a non-starter.

As to whether bills of exchange should be counted as part of the money supply, they again can hardly be described as “widely accepted”. Even in the days when they were far more widely used (roughly 100 to 200 years ago?), they were only accepted by people who knew and trusted the drawer and drawee and other endorsers of the bill. That’s not my idea of “widely accepted”.

As to whether money that can vanish given a bank failure can be called “illegitimate”, I wouldn’t use the word illegitimate. I’m just saying that given the choice between a system where money can vanish and another system where it cannot, then all else equal, the latter is preferable.

Tom Hickey said...

I don’t agree, and the reason is that while full reserve obviously restricts banks’ activities, full reservers advocate that the deflationary effect of that is nullified or countered by having government and central bank spend base money into the economy (and/or cut taxes). I.e. everyone has more money, so there is less need for credit or borrowing.

Without permitting direct issuance by the Tsy or cb, "more" state money in the economy means both a huge change in the rules and higher deficits unless the debt offset is stricken. While I am all for this, good luck getting it passed through legislatures controlled by savers concerned with "money printing" leading to inflation.

It is also a fact that when there is not enough "standard" money available, people get creative, as is presently happening in deflationary times.