Monday, August 25, 2014

Musgrave on 100% reserves

In a comment on an earlier post, Ralph Musgrave pointed to his interesting new paper on 100% reserve banking.

I haven't read the paper yet, but I love the Table of contents, reproduced partially below.

The name "narrow Banking" or "full reserve banking" needs improvement. It's really very wide banking -- so long as the banking is funded by equity or long-term debt. To say "narrow" is almost a fallacy in itself, and perpetuates the fallacy that bank lending will dry up. Maybe "Equity financed banking" or "full reserve deposit taking" would be better. Can anyone think of a name that is both sexy and accurate?

Musgrave's Fourty-four fallacies regarding full reserves:

Section 2: Flawed arguments against FR. .............................. 36
1. FR limits the availability of credit? ................................................................. 36
2. Central bank money is not debt free?............................................................ 38
3. Bank capital is expensive for tax reasons?.................................................... 38
4. FR means the end of banks?......................................................................... 39
5. Central banks will still have to lend to commercial banks? ............................ 39
6. FR stops banks producing money from thin air which can fund investments?... 41
7. Investments under FR might not be viable? .................................................. 41
8. FR will not reduce pleas by failing industries to be rescued by government? 42
9. The cost of converting to FR will be high?..................................................... 42
10. Central bank committees won’t be politically neutral? ................................... 42
11. Administration costs of FR would be high?.................................................... 44
12. The cost of current accounts will rise under FR?........................................... 44
13. FR is dependent on demand injections? ....................................................... 45
14. The effect of FR on inflation and unemployment is unclear?......................... 45
15. FR would drive business to the unregulated sector?..................................... 46
16. The state cannot be trusted with peoples’ money?........................................ 46
17. Vested interests would oppose FR?.............................................................. 47
18. FR will reduce innovation by banks? ............................................................. 48
19. Deposit insurance and lender of last resort solves banking problems?......... 48
20. Lenders will try to turn their liabilities into “near-monies”? ............................. 49
21. Anyone can create money, thus trying to limit money creation is futile?........ 50
22. Advocates of FR are concerned just with retail banking? .............................. 51
23. Central banks will still have to lend to commercial banks? ............................ 39
24. It wasn’t just banks that failed in 2008: also households became overindebted?...........................................................................................................52
25. Creation of liquidity / money is prevented?.................................................... 53
26. Funding via commercial paper would be more difficult under FR? ................ 54
27. FR is nearly the same as monetarism? ......................................................... 54
28. There is no demand for safe or warehouse banks?....................................... 55
29. FR would cause a stampede to safe accounts? ............................................ 56
30. FR would raise the cost of funding banks?.................................................... 56
31. Fractional reserve is not fraudulent? ............................................................. 57
32. FR will not stop boom and bust? ................................................................... 58
33. Bank shareholders will demand a high return to reflect their uncertainty about
what a bank actually does? ................................................................................. 60
34. FR reduces commercial bank flexibility? ....................................................... 60
35. FR would not stop bank runs?....................................................................... 61
36. Vickers’s flawed criticisms of FR. .................................................................. 61
37. Regulating loans is better than FR? .............................................................. 68
38. FR doesn’t insure against liquidity shocks?................................................... 69
39. Government couldn’t produce enough money under FR? ............................. 70
40. FR prevents all lending?................................................................................ 70
41. Banks will try to circumvent FR rules?........................................................... 72
42. Converting to FR involves a huge bailout of existing banks? ........................ 72
43. The Money Creation Committee would not regulate demand accurately? .... 75
44. Interest rate gyrations would be larger under FR?......................................... 76

28 comments:

  1. Can you share the Musgrave paper with your Chicago colleagues? Raghuram Rajan especially could use some good advice now that he is running a central bank. He and Diamond like to point out that demand deposits are the cheapest form of funding for banks. People do seem to want money-like assets so much that they will provide funding for banks very cheaply, but you can remind Rajan that funding the US Treasury is a safer option.

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  2. John (and Ralph),

    This in particular stood out to me:

    41. Banks will try to circumvent FR rules?

    Answer. It is 100% certain that banks would try every trick in the book to circumvent the rules of FR. But then it’s a 100% certain they’ll try to circumvent ANY RULES or laws. Banks are quasi criminal organizations. The total fines that have been imposed on banks in the US in connection with sundry crimes committed during and before the crisis is in the order of $100bn at the time of writing (yes, that’s billion, not million). But to repeat, at least the rules of full reserve are simple. So to that extent they are easy to enforce.

    ???. First, there is more than one central bank in the world (Europe, England, U. S. , Japan, etc.) and even more sovereign countries, each with it's own system of laws regarding banking. With the advent of electronic banking, dodging full reserve banking rules is easy as pie. Don't like the U. S. central bank and banking laws - switch to Japanese. Is Ralph really advocating a set of "global banking rules"? Who enforces those rules on countries that choose not to accept them?

    Second, as I already mentioned in numerous prior articles, money is fungible. When an individual / firm uses a multiplicity of funding options (short term debt, equity, cash flow from operations) to fund a multiplicity of objectives (long term lending, payrolls, capital improvement projects), there is no way to determine which funding source is used to achieve which objective. Hence, identifying outlawed activities (borrow short, lend long) becomes impossible.

    IMHO, full reserve banking is not enforceable in any measurable way.

    Also, simple is not necessarily better. A simple government would be a king or Czar. The U. S. decided a long time ago that complicated (legislative, executive, judicial branches of government) was the better route.

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  3. Please note: errors and omission expected!

    In particular I think I went off the rails in section 1.4: “Doesn’t a 25% or so capital ratio bring near total safety?”

    I.e. proving the case for much higher capital ratios (e.g. about 25%) is easy. Also proving there is little difference between 25% and 100% is easy. As to proving that 100% is definitely better than 25%, I don’t think I’ve pinned down the argument there yet, and possibly there just isn't any big difference between 25% and 100%.

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    1. After a night’s sleep and a strong cup of coffee, I think I’ve got it. The reason why 100% is better than 25% or so is simple: Modigliani Miller. See:

      http://ralphanomics.blogspot.co.uk/2014/08/an-answer-to-martin-wolfs-question.html

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    2. Ralph,

      http://en.wikipedia.org/wiki/Modigliani–Miller_theorem

      "This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible."

      Also, the statement from Mr. Wolf:

      "An intermediary that can never fail is surely also far too safe."

      Even under full reserve equity funded banking, an intermediary can still fail - value of equity falls to zero. The difference is that equity holders do not have the same avenues of legal recourse that bond holders have (bankruptcy court).

      And so I am not sure what he means by an intermediary (financed entirely by equity) being too safe.

      Does he mean that an intermediary (financed entirely by equity) will be too cautious when selecting projects to invest in? I would argue the opposite, that companies financed entirely by equity tend to be more aggressive, more willing to take chances. The elimination of bankruptcy risk mitigates the stigma of failure.

      Anytime someone uses the word "surely", I get suspicious - "self evident" logic is the worst kind.

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  4. Arguing for the indexation of bank debt, to a suitable economic benchmark, is also easy. Showing that this eliminates the need for capital regulation ... might be possible, but is less obvious. Our focus right now should be to push back the people who want a big chunk of the global financial system on the balance sheet of the US Treasury. What we want from our monetary system is price stability, and in our financial system we want the allocative mechanisms advocated by Hayek.

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  5. So what you want is a treasury only money market fund on top of a closed end fund with wide investment powers (perhaps wider than are currently allowed under the Investment Company Act).

    I understand your belief that such an arrangement would be "run proof", but I am not sure why customers or bankers would want it. In particular, I don't see how a money market fund could economically support the depositor side services that banks have traditionally provided.

    I don't see that there is a political path to this type of arrangement.

    I can see how higher capital requirements could be sold. But this is a case that would be very hard to make against the come back from the bankers that they would have to close their branches.

    Mr. Musgraves 25%, Prof Admati's 30%, and my own tortuous route to 25 -- 33% for the bigger banks, are, IMHO, more politically doable.

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    1. Good summary. What they "want" is 5% interest, government guaranteed, with nice TBTF bailouts, and high priced jobs for retiring government officials. The issue is what they will get! A bank can run a money market fund, so it's not clear to me why the technology of supporting transactions etc. has to be married to tiny equity financing and lending activities.

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    2. “It's not clear to me why the technology of supporting transactions etc. has to be married to tiny equity financing and lending activities.” Or as James Tobin put it, “The linking of deposit money and commercial banking is an accident of history…”.

      Fat Man, I agree this is politically difficult to sell. But then the abolition of slavery was difficult to sell. Economists’ job is to set out what they think the best system is. If the corrupt banker / politician nexus messes that up, then so be it. The solution to that is to stand outside the Goldman Sachs head office and throw rotten eggs at Lloyd Bankfiend as he comes out the front door . . . . or something like that.

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    3. Fat Man,

      With higher capital requirements - is that a continuous time requirement or an "on issue" requirement? Meaning, is a bank only required to use the correct mix of debt and equity for new financing or must the bank maintain that mix as the value of existing debt and equity changes over time.

      For instance, suppose a bank sells $1 million in 10 year debt. Over time the market value of the debt rises as the term of the debt falls (courtesy of roll down in corporate yield curves). Must the bank sell additional equity because the market value of its debt has risen?

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    4. John,

      You mention two different aspects of the same problem:

      1. Government guaranteed returns on investment
      2. Too big to fail bailouts

      Solving #1 is the easy part - government under no circumstance sells bonds - Done. No extra regulation required, no deciding who gets saved / who doesn't. Government either runs a perpetual balanced budget / surplus or government sells equity.

      Solving #2 is the harder part.

      Do the easy part first.

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    5. Mr. Cochrane: We can disparage what the bankers and their customers (a/k/a voters) want, but we have to live with the political reality that the bankers are a small group with deep pockets and an "all in" interest in banking regulation. No regulatory proposal that will impoverish them has much of a chance. I agree with you and others here that capital requirements should be much higher, but I would look for a proposal that can easily be sold to voters and which might have a chance of dividing bankers. My proposal is intended to do that, by fixating on the 35 or so biggest banks in the country and by not being an all out purist proposal.

      Mr. Musgrave:

      "the abolition of slavery was difficult to sell." The difference between slavery which affected the entire society, and which was in conflict with the moral and political basis of American society, and banking regulation is polar. The latter is really a question of prudence. As such it can be argued in terms of more and less, an argument which will bore witless even the most contentious non specialist.

      “The linking of deposit money and commercial banking is an accident of history…” The same could be said for our respective existences at this time and place, but here we are. Any path to the future must start from here.

      Mr. Restly: You raise questions of regulatory detail which are best left to the accountants. I have a general principal: Banks should have much more of their own money on the table. The details are for a much later stage of discussion.


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  6. Based on how much I usually like Ralph Musgrave's comments, and the table of contents, I'm really looking forward to reading the paper! I downloaded the PDF, but I have a big deadline this week so it will probably have to wait until next week.

    In the mean time, in reference to John's request for "a name that is both sexy and accurate", a couple of suggestions occur to me off the top of my head (although personally I think Full Reserve banking is fine).

    Given that the current (dubious) system is called Fractional Reserve" banking, one could call Full Reserve banking:

    1) Non-Fractional Reserve (NFR) banking. A bit long, but it certainly hits it on the nose.

    2) Integral Banking (IB). Integer is the opposite of fractional, and Integral connotes Integrity.

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  7. This may be old ground, but I wonder why the emphasis on regulation when the central bank could simply crowd out the private sector, so that banks (and everyone else) no longer find maturity transformation attractive. Instead, they will voluntarily match the term of their assets and liabilities because it's the most profitable thing to do.

    The problem with regulation is that it's likely to shift "run" risk from one type of firm to another, rather than eliminate it, as long as the profit opportunity (from maturity transformation) still exists.

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  8. Jose Romeu RobazziAugust 26, 2014 at 6:19 AM

    I would suggest: Vault Banking

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  9. If full reserve banking were economically efficient it would have arisen spontaneously through market forces. It has not. Reserve banking aggregating small deposits and transforming maturity has been the common model which arises spontaneously. Most recently "no reserve" banking arose spontaneously in the shadow banking/commercial paper/money market. Fractional reserve banks are vulnerable to bank runs but a government ready to provide liquidity can address that problem.

    The major problems we had in 2007-2008 was not with fractional reserve banking but was because England and the United States had engaged in competitive deregulation and banks had moved beyond deposit aggregation and maturity transformation.

    Full reserve banking is a solution in search of a problem.

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    1. Jose Romeu RobazziAugust 27, 2014 at 6:45 AM

      It looks to me that what has spontaneously arisen is a commodity money (gold). Every human enterprise can benefit from leverage, banking is not different. But, one thing is to protect other people's money reserves (deposits), another thing is lending and tranforming maturity, it is an investment activity. They don't have to go tegether. What has not arisen spontaneously in the market is the monopoly to issue notes, this is a political construction. A simple better design would be to separate deposit accounts from invetment activities entirely, allow leverage, but not based in deposits, and create competition in both activities. No monopolies, and particularly, no government monopolies or lenders of last resort.

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    2. “If full reserve banking were economically efficient it would have arisen spontaneously…”.

      It HAS ARISEN spontaneously: there are money market mutual funds which invest only in ultra safe stuff assets, that is base money and short term government debt. But even if it hadn’t arisen spontaneously, there’s a simple explanation which is that government (i.e. taxpayers) stand behind banking or accounts which earn interest from loans to mortgagors, businesses, etc.

      Why invest in a low or zero interest account when you can get better interest thanks to the taxpayer?

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    3. Arisen spontaneously, the free market would have invented it, etc. is a common complaint, dealt well with in my own writing as well as anyone else who has written on the subject. Runs are a clear externality, like pollution. A money market fund invested in Treasurys at 1% cannot compete against another fund that invests in Greek subprime mortgages, pays 2%, is prone to runs, and, especially, can get bailed out ex post.

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    4. Funding of banks is a tricky problem because we have multiple objectives. We want banks to issue a large quantity of liabilities that remain liquid at all times, so that we can use them as a basis for the payment system. But we also want the banking system to remain solvent in crises, without any need for a bailout by taxpayers. Historically we have been willing to innovate in money and finance to solve complex problems, and there is no reason to stop innovating now.

      Indexed debt can be viewed as a hybrid between debt and equity. It enhances solvency of banks, which is a central concern of banking reformers. But as a senior claim, it also helps with the information problems that typically promote reliance on debt. And these are not just the agency problems of bank management - highlighted by Diamond and Rajan - but also the information insensitivity that is required of a medium of exchange, in Gary Gorton's analysis.

      For indexed debt to be highly liquid, we need to agree on a suitable economic benchmark for such claims. Agreement on a generally-accepted medium of exchange is a collective action problem, which is why it does not solve itself - though the government has already helped us by establishing national income accounts. Still, our institutions base their ledgers on the dollar, and try to guarantee dollar deposits even though the assets backing these deposits is of the wrong risk profile.

      If deposits were indexed to a suitable benchmark, then we could allow individual medium-sized banks to fail without worrying about failure of the system, or needing to bail out the system. When we start thinking about suitable benchmarks, the candidates are pretty obvious. Hence we have Hans Gersbach writing about bank depositors insuring banks against macroeconomic risk, once this becomes possible technologically.

      But we also need coordination to make this happen. Otherwise we get the current equilibrium where banks simply rely on the cheapest funding, without needing to buy macroeconomic insurance from depositors, or from anyone else, because it is provided by the government.

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    5. Anwer,

      "For indexed debt to be highly liquid, we need to agree on a suitable economic benchmark for such claims."

      "If deposits were indexed to a suitable benchmark.."

      Two questions:

      1. Should the value of the index and thus the value of the debt be pro cyclical or counter cyclical? Meaning should the value of the debt rise or fall during a recession?

      2. Should the value of the medium of exchange used to service the debt be pro cyclical or counter cyclical? Same question, should the value of the medium of exchange rise or fall during a recession?

      The reason I ask is this - if the value of the debt is allowed to fall during a recession and the value of the medium of exchange used to service the debt is allowed to fall during a recession by the same amount, then you have not eased the debt burden.

      It sounds like you need debt and deposits to be indexed by two different benchmarks. For instance debt indexed to current GDP growth and deposits indexed to potential GDP growth. During a recession, value of debt falls while value of deposits rises - burden of debt falls.

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    6. That's a great question, Frank. I've thought about it myself, and feel that bank liabilities are affected more by such a change than bank assets, because deposits are guaranteed. Whereas bank loans, even when they are not indexed, have reduced performance in recessions. If I were more skilled at modelling I would demonstrate the effect of my proposal on the general equilibrium.

      But regarding whether the index should be pro-cyclical or counter-cyclical, I'll follow the Chicago economist Amir Sufi who wants to index debt in a way that stabilizes balance sheets, thereby reducing economic fluctuations. He focuses on households rather than on banks, but similar reasoning should apply in both cases. Some people want to stabilize balance sheets via monetary policy, but many of us want the central bank to focus on price stability.

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    7. Anwer,

      "Some people want to stabilize balance sheets via monetary policy, but many of us want the central bank to focus on price stability."

      Price instability (on the downside) can affect balance sheets. Part of any balance sheet includes inventories of physical goods. Even newly produced goods go through a time period where they "sit on the shelf". And so I don't think you can easily separate price stability from balance sheet stability.

      "Chicago economist Amir Sufi who wants to index debt in a way that stabilizes balance sheets..."

      Whose balance sheets - borrowers or lenders? I think you would try to stabilize both, but you can't rely on monetary policy alone to do that.

      We could easily stabilize borrower balance sheets by getting rid of bankruptcy law - I borrow and never have to pay it back. Of course you wouldn't find many lenders under those circumstances.

      We could easily stabilize lender balance sheets by relying entirely on public (government debt) for financing. Government is, by law, the only enterprise allowed to borrow money. All financing (interest) costs are paid through taxation.

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    8. Mian and Sufi are focused on the balance sheets of liquidity-constrained households - in other words, poor people. We don't want them to stop spending during downturns because that makes economic fluctuations worse. They want lenders to bear more risk, and hence the proposal of indexed debt.

      As you recognize in your previous comment, banks are both lenders and borrowers. Indexation of debt will affect them in a complex manner. I would hope that it reduces the likelihood of banks becoming zombies, which is a problem discussed by bank reformers like Anat Admati. We don't want banks to avoid worthwhile loans due to their own balance sheet problems.

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    9. Arisen spontaneously. What all critics of banking, both left and right, need to understand is that banking institutions we have were not created by a market process, nor were they created by benevolent law makers seeking to provide us with good macro economic policy.

      Our banking institutions were created by the state to finance its wars. The first modern bank was the Bank of Amsterdam, which enabled the Dutch to maintain their independence from Spain (which had the gold and silver of the New World), deal with the 30 Years War, and fend off invasions by Louis XIV. William III, Stadtholder of the Netherlands, was made the King of England by the Glorious Revolution in 1688, and with him came the idea of a Bank. The English created the Bank of England which enabled them to finance the rise of the British Empire in the 18th Century.

      In the US, central banking was long resisted because of the fear of its power. But, when the Civil War broke out, the Federal government created the National banking system to enable it to finance the war. In 1913, the National banking system was centralized through the Federal Reserve System, just in time for the world wars of the 20th Century.

      Banks as we know them are not emergent institutions of the free market, nor should bank failures be used to lumber free market institutions ("capitalism" in the nomenclature of socialism). Banks have been and are creatures of the government finance system, which is why the Federal government is so concerned with their health.

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  10. Re John Cochrane's desire for better phraseology, Ben Dyson who founded Positive Money (which backs full reserve banking) is also unhappy with existing phraseology. Plus I point out in the paper that the terms "full reserve" and "fractional reserve" are misnomers. But I don't have any good suggestions for improving the phraseology.

    On a different point, I've just stumbled across yet another Nobel Laureate who approved of full reserve: Merton Miller, who was co-author of the Modigliani Miller theory.

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  11. I well understand the basis for Musgrave's long winded piece, but should any serious consideration be give to someone who uses a 7th grade child's capitalization? I'm sorry, but when I read things written using 7th grade formatting, with less than 10th grade logical structure, and with no real effort at counterfactual lines of logical discourse, I conclude that this is a person who is not intellectually relevant. Economics is described by coupled differential equations, too many for us to evaluate, so we resort to other approximations. Where is there a single mathematical description in this piece? It's part of the whole insanity of economics. People like Musgrave who appear unable to write down a simple differential equation, much less a complex system of millions of them in some form of a partial differential equations using distributional functional stand ins for massive sets of coupled individual agents. I fear there is no hope when this level of (BIG TEXT) discourse becomes acceptable.

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  12. Here is something I did not know. From John Taylor's eulogy for Gary Becker at the meeting of the the Mont Pelerin Society in Hong Kong on Monday.

    http://economicsone.com/2014/09/02/family-economics-and-macro-behavior-at-a-gary-becker-memorial/

    "Most interesting was his 1956 “A Proposal For Free Banking,” a short paper which remained unpublished for 37 years, though Friedman referred to it in his famous 1960 Program for Monetary Stability. Gary was reacting to the 100% reserve requirement proposal then popular at the University of Chicago, arguing that the banks were already too regulated."

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