Taxpayer backed support for banks and depositors is absurd.

A bank is an entity at which you deposit money. The entity then invests or lends on your money so as to earn interest for you. Plus the entity makes the absurd promise that your money is totally safe: you’re guaranteed to get $X back for every $X you put it.

That promise is absurd because money which is loaned on or invested is never totally safe.

Indeed, if you deposit money at an entity which does exactly the same job as the one set out above, but it does not have the word “bank” over its front door, then the entity is SPECIFICALLY FORBIDDEN from making the above promise. Examples of those other entities include stock–brokers, unit trusts (“mutual funds” in the US), etc.

So what’s the big significance in ordering the letters B,A,N and K from a sign manufacturer and putting them over your front door, as opposed to putting the letters U,N,I,T, T, R,U,S and T over your front door?  Darned if I know.

Does it make a difference exactly how the letters are attached to the wall or what colour they are? I look forward to enlightenment on that point....:-)

That’s not to say there should NEVER be any sort of taxpayer backed support for those with bank accounts: everyone is entitled to a totally safe bank account. But they are most definitely NOT ENTITLED to let their money be loaned on or invested and then go running to taxpayers for help if the loan or investment does not pay off.

Ergo it’s justifiable to have taxpayer funded support for bank accounts where money really is totally safe: i.e. where it is NOT loaned on or invested (e.g. where the relevant money is simply lodged at the central bank). But there is no excuse for such support for investors and money lenders.

Random charts - 41.

Text in pink in the charts below was added by me.

Are Simon Wren-Lewis and Krugman now MMTers?

Lars Syll says “So SW-L has joined Paul Krugman and become an MMTer at the ZLB?” My answer is: “Yes they have”. And here’s my attempt to show why they should be MMTers at ALL TIMES. (I’m sure they’re hanging on my every word, ho ho.)

We’ve established that MMT is a good idea at the ZLB. So is it a good idea when interest rates are higher? Well the answer to that is that interest rates (at least the rate of interest on government liabilities) should basically NEVER be higher.

Warren Mosler (founder of MMT) explained why interest rates should never be higher,  i.e. why a permanent zero rate is desirable in his paper, “The Natural Rate of Interest is Zero”. Milton Friedman agreed with that “permanent zero” idea, incidentally, except that Friedman thought that perhaps government borrowing was justified in war-time. (That’s in Friedman’s American Economic Review paper “A Monetary and Fiscal Framework…”).

As for Mosler’s REASONS for advocating a permanent zero policy, I think I can set out a reason for that policy much more briefly than he does. Here goes.

Assume the yield on government liabilities (i.e. “government debt”) is currently zero or near zero. Assume a rise in demand is required. One way of doing that is simply to issue more government liabilities in the form of zero interest yielding base money. I.e. the state simply prints more money and spends it (and/or cuts taxes). The fact of that spending (on say more education) is to increase the number of teachers employed. Plus the increase in the private sector’s stock of money also increases demand stemming from the private sector.

An alternative and “interest rate increasing” method of raising demand is to issue AN EXCESSIVE amount of government liability and to the extent that government has to rein in some of the resulting demand by raising interest rates.

But what on Earth is the point of issuing an excess amount of “government liability / base money” and then borrowing the excess back? All that does is to artificially raise the rate of interest.

Ergo the optimum arrangement is a permanent zero rate, though I wouldn’t rule out artificial adjustments to interest rates in emergencies. Indeed, that’s more or less what Friedman said, when he suggested that government borrowing was justified in war-time.

Conclusion.  The optimum or GDP maximising arrangement is a permanent zero rate. And from that I conclude that SW-L and Krugman will now declare themselves to be MMTers….:-)

Martin Sandbu’s none too clever idea on bank capital.

Sandbu, concludes a recent article in the Financial Times on bank capital ratios with: “We may be uncertain where the right number is, but until equity requirements are manifestly harming the broader economy (and not just banks’ bottom lines), it is safest to keep making them tougher.” (Article title: “Banking systems remain unsafe”).

Well the first problem there is this. How on Earth do we know when excessive bank capital ratios are “harming the economy”?

An excessive ratio will not show up as excess unemployment for the simple reason that whatever the deflationary effect of raising bank capital, government can always counteract that with stimulus (fiscal and/or monetary). Of course that’s on the optimistic assumption that those in power have heard of Keynes and know what stimulus is, which is a debatable assumption. But I’m an optimist, so let’s assume those in power are not completely economically illiterate.

Next, would a substantial contraction in the bank industry prove that capital ratios were excessive? Well the trouble with that idea is that the bank industry in the UK has expanded a whapping ten fold relative to GDP since the 1970s. So if the bank industry HALVED in size it would still not be back to its 1970s size, and there were no howls of anguish that I remember in the 1970s to the effect that the bank industry was too small.

Next, whence the assumption that raising capital ratios constrains the bank industry at all? High capital ratios do not seem to constrain other industries: for example Google is 90% funded by capital. Far as I know, Google is not a disastrous flop.

And apart from the latter evidence that high capital ratios do not constrain an industry, there is a big theoretical flaw in the “constrain” idea, as follows.

Equity holders only demand a higher return than depositors or bond holders because equity holders run a bigger risk: in the event of a bank going under, equity holders are wiped out before bond or deposit holders take any sort of hit.

However, it’s a huge mistake to think that therefor if capital ratios are raised, the cost of funding banks rises: reason is that the capital ratio rises X times, then the risk run by equity holders must be 1/X what it previously was. And if you want proof of that consider two banks which are identical in all respects except that one is funded entirely by equity and the other entirely by bonds or deposits.

The risk of the bank’s assets declining to Y% of their book value is exactly the same in each case because that risk is determined by the nature of the loans and investments made by the bank, not by the way it is funded (e.g. NINJA mortgages versus sensible mortgages). And the nature of the two banks’ assets is the same.

Incidentally, the idea that a bank can be funded entirely by deposits or bonds is a trifle dishonest since any claim by a bank that all of those funding a bank are guaranteed their money back is patently dishonest: reason is that if the bank’s assets do decline to Y% of their book value, then clearly the bank cannot repay depositors or bond holders.

But then as others have pointed out, even the equivalent claim by a conventional bank (funded by say 5% capital and 95% bonds and depositors) is dishonest, since if assets decline to less than 95% of book value then in principle the bank cannot repay depositors and bond holders, i.e. the bank is technically insolvent.

Anyway, returning to the above point that equity holders only demand a higher return than depositors or bond holders because of the extra risk run by equity holders, that difference in risk is a mirage for a second reason: while depositors do not charge for the risk they run, banks are still charged for that risk via state run deposit insurance (e.g. FDIC in the US). At least banks ought to be charged for that risk.

Of course given that politicians have a habit of doing whatever banksters tell them to do (in exchange for – er – “generous donations to electoral expenses”), banks often do not get charged for deposit insurance, or they do not get charged the full and appropriate amount.

But assuming they are charged the right amount, then the total charge to banks made by equity holders and depositors and bond holders ought to be the same. At least the above is a strong case for thinking that the total charge will be very similar.

Hence raising capital ratios ought to have little effect on the cost of funding banks.

And the final joke is that at the time of writing, the return on bonds is higher than the return on equity.

All of which makes a bit of a nonsense of Sandbu’s claim that at some point, as bank capital ratios are raised, we will be able to detect when they have risen too far.

Random charts - 40.

Large pink text on the charts below was added by me.

Sheffield University authors’ strange ideas on bank and monetary reform.

 
Three Sheffield University department of economics authors, Sheila Dow, Guðrún Johnsen and Alberto Montagnoli, published a paper a year or two ago entitled “A Critique of Full Reserve Banking.”

The first seven pages simply describe full reserve are perfectly OK. However, the authors’ criticisms of full reserve start in their section 3.1 (p.8) and the mistakes from that point onwards come thick and fast.

For example the authors say at the end of the first para of section 3.1, that bank crises tend to destroy trust in commercial banks, but, apparently unbeknown to advocates of full reserve, trust can actually be maintained via taxpayer backed deposit insurance.

Well I have news for the Sheffield authors: advocates of full reserve and indeed everyone else has actually tumbled to the fact that the trillions dished out or loaned by central banks during the 2008/9 crisis did actually save the system. Plus the entire country, is aware that governments (i.e. taxpayers) stand behind private bank accounts.

But the Sheffield authors miss the crucial point here, namely what are taxpayers doing backing a commercial operation: money lending etc? Taxpayers do not back money lending when it’s done in a slightly different form, namely lending to friends and relatives or the purchase of corporate bonds by unit trusts / mutual funds.


The history of money.

Then at the start of the next para, the authors say “…money in  practice has always been created by private sector institutions and has involved a token of credit extended by some and received by others…”

If the authors studied the history of money they’d discover that money in most civilisations stems from a desire by kings and rulers to make tax collection more efficient. So the King or ruler pays for what he wants using his home made money, while at the same time demanding that taxes be paid in that form of money – else you’re in trouble. That threat gives the ruler’s money plenty of clout.

Thus it is quite untrue to say that “money has always been created by private sector institutions..”.


Safe assets.

Later in the same para, the Sheffield authors say that “the availability of safe assets would be reduced” as a result of implementing full reserve.

Well simply saying that the supply of something is reduced is not a brilliant criticism. The crucial question is whether the supply is reduced to (or increased to) some sort of GDP maximising amount. If the supply of apples is not at its GDP maximising amount, e.g. because apple growers have formed a cartel, then the supply and GDP can potentially be increased by breaking up the cartel.

In the case of full reserve, the supply of totally safe and very liquid assets, i.e. money, would very definitely at its optimum level, at least in the following sense.

Given an inadequate stock of money, the population would tend to try to save with a view to acquiring its desired stock. That would cause Keynes’s “paradox of thrift” unemployment, which in turn would induce government to print and spend extra money into the economy, thus bringing the stock up to its “GDP maximising” or optimum level.


Risky savings.

Next, the Sheffield authors say in relation to implementing full reserve, “Savings accounts would now carry risk about which the general population would need to take an informed position. But  even  financial  experts  in  the  run-up  to  the  crisis  failed  to  price  in  risk  adequately –   the effect  of  unreasonable  conventional  judgements  arrived  at  under  uncertainty.  It  is  totally unreasonable  to  expect  the  general  public  to  undertake  this  kind  of  assessment  and  bear  the  consequences  of  a  financial  failure  without  deposit  insurance.”

The answer to that is first that the majority of the savings of the average household are ALREADY difficult to “price” in the sense that it is not clear what they will fetch when they are eventually turned into cash. The biggest chunk of saving for the average household is their house, and given that house prices in Britain have doubled in real terms over the last twenty years (compared to Germany where they have remained constant in real terms), there is plenty of scope for that big chunk of household savings to fall dramatically in value.

Another big chunk of saving comes in the form of private pension schemes. But they are normally related to stock market performance, and it’s impossible to say where the stock market will be in ten or twenty years time.

Third, under full reserve, and as explained just above, people are free to stock up on whatever amount of base money (i.e. totally safe money) they want if they are keen to have a stock of savings the value of which is totally clear.


Subsidized bank accounts.

Then at the end of the same paragraph, the authors object to the fact that if depositors’ money is not loaned out (thus earning interest), banks might have to charge for transaction accounts.

Well one answer to that is that banks ALREADY charge for transaction accounts. I pay about £12 a month for my high street bank current account and get next to nothing by way of interest.

But doubtless if depositors’ money is not loaned out, banks would charge MORE FOR current / checking accounts. But charging the full cost of supplying goods and services is hardly unusual. When you buy baked beans, cabbages or a car you pay the full cost of acquiring those items.

A system under which the income from money lending is used to defray the cost of running a current / checking account is simply a form of cross subsidisation, and subsidies are frowned on in economics: they reduce GDP unless there is a good social justification for the subsidy.


The precautionary motive.

Next (para starting “It seems to be assumed…”), the Sheffield authors say there is demand for money not just for transaction purposes, but also for the well-known “precautionary” motive, and that under full reserve, the authorities would need to take that into account in deciding how much  money to create.

Well as just explained, any tendency to increased saving by households and businesses, with a view to increasing their stock of safe money would tend to cause paradox of thrift unemployment, and the authorities would need to react to that by increasing the amount of money created and spent. But the authorities need to do that ANYWAY!!! That is, it is not just under full reserve, that gyrations in the private sector’s desire to save money is a source of instability!


Safe assets.

Later in the same paragraph, the Sheffield authors say “But the build-up to the crisis demonstrated the widespread capacity for conventional expectations to be unreasonable and, in particular, to underestimate risk. As a result high expected returns on market assets could entice society into treating assets as safe which are in fact much less safe than current bank assets.”

Well frankly it’s a bit odd to claim that if the supply of stuff with characteristic X is reduced, people will make believe that other commodities normally regarded as NOT POSSESSING characteristic X will all of a sudden acquire characteristic X. Does his strange new theory apply anywhere else?

If the supply of alcoholic drinks is reduced, would people start trying to make believe that milk or orange squash contained alcohol? Or if the supply of petrol was reduced, would people trying filling up the tanks of their vehicles with water?


The shadow banking sector.

Next in the same paragraph, the authors trott out the old criticism that if money creation is suppressed in the regular bank sector, then money creation will just migrate to the shadow sector. Well clearly that will happen to some extent. But there are several answers to that problem.

First, illicit money creation has been going on since the dawn of time in the form of counterfeiting central bank notes. The fact that counterfeiting has never been TOTALLY suppressed and never will be as long as we have physical money, is not a reason for not suppressing counterfeiting.

Second, there is a simple way of dealing with shadow banks: regulate them the same was a regular banks. As Adair Turner, former head of the UK’s Financial Services Authority put it, “If it looks like a bank and quacks like a bank, it has got to be subject to bank-like safeguards.”

Of course it will never be possible to regulate every single small shadow bank. Indeed most of us are a bank in the sense that most of us have loaned money to friends or relatives at some time. However, that does not matter. Reason is that money is defined as anything WIDELY ACCEPTED in payment for goods and services. And while I can write out IOUs on the back of envelopes and while those IOUs might be accepted by a very small number of people, my “envelope money” clearly does not constitute money as per the above definition.

Same goes for small shadow banks: their liabilities scarcely qualify as money.

Third, the private sector only produces its own money where government fail to produce an adequate supply, as indeed the Sheffield authors themselves say. But if government / the state issues enough to give us full employment, it is hard to see why private sector entities would want a further supply of money, at least for transaction purposes: at full employment, further transactions just ain’t possible.

Of course there may well be a desire by some people to have government (i.e. taxpayers) provide some sort of guarantee that sundry assets will never lose value. But if taxpayers are going to do that in the case of bank liabilities, why not also in the case of non bank corporation liabilities, e.g. bog standard stock exchange shares or bonds?

The latter is clearly not a justifiable use of taxpayers’ money: there are whole string of more pressing uses for taxpayers’ money, like spending more on health and education.


Section 3.2.

The first paragraph of this section tries to cast doubt on the idea that stimulus can be effected by having central bank and government vary the amount of money created and spent. The authors say:

“But even if these judgements about the feasibility and merits of central bank independence are accepted, it is much more problematic to judge the work of a central banker or a committee whose job would be to inject money into the banking system and to place a limit on the amount. The performance would have to be based on a counterfactual, but it is difficult to envisage how this would be chosen and estimated.”

“Problematic to judge the work..”? What on Earth does that mean?

Moreover, having government and central bank create money and spend it amounts to exactly the same thing as traditional fiscal stimulus followed by QE, which is what we’ve done and big time over the last five years or so. (Traditional fiscal stimulus equals “government borrows £X, spends it and gives bonds worth £X to lenders”. While QE equals “central bank prints £X and buys back those bonds”. That all boils down to “the state (i.e. government and central bank) prints £X and spends it (and/or cuts taxes)”.


Lending.

The Sheffield authors next para (starting “These issues..”) casts doubt on the Positive Money claim that in addition to the state effecting stimulus by creating money and spending it, the state should also keep an eye on whether enough is being loaned to allegedly “productive” activities.

I agree with the Sheffield authors there: the decision by households and firms as to how they allocate additional money that comes their way strikes me as being their business, not the business of bureaucrats in London who think they have better ideas on how resources should be allocated.


The authorities need the “correct” economic model?

In the next para (starting “Even if we accept…”), the authors argue that if the central bank is to inject the right amount of money into the economy, the CB needs the “correct” economic model of the economy in order to get that decision right.

Basically that’s nonsense, though obviously it would be nice to have some sort of model which is a perfect replica of the real world economy. The reason that idea is nonsense is that all the CB needs to do when determining the suitable amount of stimulus is very much what CBs and fiscal authorities do at the moment: make a guess at how much stimulus is needed and see if the guess works out.

In other words what monetary and fiscal authorities do at the moment is “suck it and see”. And under the slightly different way of imparting stimulus advocated by Positive Money and the New Economics Foundation, they’d adopt the same “suck it and see” ploy.

“Suck it and see” is not ideal of course, but at least the PM/NEF system is no worse in that respect than the existing system.


Conclusion.

Well I’m now half way through the Sheffield paper and I think I’ve established that the authors are not too clued up. I do not have time to deal with the rest of their paper, and I imagine readers will not be too interested either.



   

The basic principles that support full reserve banking.

Principle No.1.    Everyone has a right to a totally safe bank account in the same way as everyone has a right to enough food, a roof over their head and so on. Plus many employers find a totally safe bank account useful.

Principle No.2.     The fact that everyone has a right to something is not necessarily an argument for supplying the item to them for free. For example the way food is delivered to everyone is normally to ensure everyone has sufficient cash income; then people are free to choose the food they want and they pay for it, using that cash.

Principle No.3.     Various basic essentials are supplied to everyone for free in many countries, e.g. health care and education for kids. The argument for that, rather than having people to pay cash for those items is that some people would choose not to purchase those items, and instead would spend the relevant cash on luxuries. That would impose costs on the community at large, for example the failure by some to purchase health care could promote the spread of contagious diseases, and the costs of not teaching kids the three Rs are heavy for society at large later in those kids’ lives: they are unlikely to find jobs, which means society as a whole has to support them.

Principle No 4.     There are no particularly heavy costs for society at large that derive from someone NOT HAVING a bank account (i.e. letting them deal just in cash). Therefor there is nothing wrong with requiring people to PAY FOR the privilege of having a bank account.

To that extent, the argument that it is important to let banks lend on depositors’ money so as to earn interest and thus defray the cost of administering bank accounts is not valid. Moreover, cross subsidization (e.g. having money lending subsidise the cost of administering a bank account) is generally frowned on in economics. Indeed, subsidies in general are frowned on unless there is a good social case for subsidies.

Of course the possible withdrawal of physical cash in the next few years might seem to weaken the latter argument. However, even if physical cash is withdrawn, there would still be a few people happy to go without a bank account: for example one member of a husband and wife couple who was happy for their partner to do all the financial transactions for the family. Same applies to children not considered by their parents to be responsible enough to have a bank account.

Principle No.5.     Where anyone wants interest on the money they’ve deposited at a bank, there is only one way the bank can supply that interest, which is to lend on relevant monies. I.e. anyone who wants interest in effect is a lender. That is, they are into commerce, and it is a widely accepted principle that it is not the job of governments or taxpayers to stand behind commercial transactions. Thus there should be no taxpayer deposit insurance where a depositor wants their money loaned on, any more than there is taxpayer backed insurance for people who deposit money at a mutual fund / unit trust, or who deposit money with their stock broker with a view to that money being invested or loaned on.

Principle No.6.     The argument that if deposits ARE INSURED BY TAXPAYERS, that banks will lend more and thus boost GDP does not stand inspection. Clearly if deposits where relevant monies are loaned on ARE INSURED by taxpayers, there would SEEM TO BE a rise in GDP. However, governments (assisted by their central banks) have complete control of aggregate demand, and can thus raise demand and GDP any time they want. To that extent, the additional above mentioned demand stemming from extra private bank lending is irrelevant: i.e. given inadequate demand stemming from deposits no longer being insured by taxpayers, government can easily make good that deficient demand with conventional stimulus, fiscal or monetary.

Thus given that keeping demand at the full employment level is not difficult in principle, the question than arises as to what the GDP maximising banking set up is.

Well it’s widely accepted in economics that GDP is not maximised where anything is subsidised for no good reason. And taxpayer backed insurance for money which is deposited at banks and loaned on is an unjustified subsidy for reasons given above.

Ergo taxpayer backed deposit insurance reduces GDP. Put another way, bank loans should be funded via equity. Or put another way, where X lends to Y and Y does not repay the money, X should foot the bill, not the taxpayer.

A second weakness in the argument that taxpayer backed insurance for lenders increases lending and thus GDP and/or investment is that exactly the same argument applies to lending in the form of the purchase of corporate bonds and even corporate shares. For some strange reason, advocates of the above “taxpayer backing for lenders increases GDP” argument apply that argument to bank deposits, but never to corporate bonds or shares. That is a clear inconsistency.

Principle No.7.     Taxpayer backed insurance is subsidised insurance because everyone knows the “insurance company” cannot possibly fail, unlike private sector insurance companies. Of course taxpayer backed insurance could take account of the artificial privilege that taxpayer backing brings by making an extra charge for its insurance. However the reality is that over the last hundred years or more, bankers have regular as clockwork bribed or persuaded politicians into doing the exact opposite: i.e. bankers have induced politicians to grant private banks special privileges rather than make sure banks and their customers PAY FOR special privileges, like taxpayer backed insurance. Thus the idea that an extra charge for the privilege of taxpayer backing would ever be made, or the idea that if it were made, the extra charge would last any length of time, is a joke.

Principle No.8.      Funding bank loans via equity rather than deposits might seem to raise the cost of loans because equity holders demand a higher return than depositors. That apparent difference is largely or  entirely an illusion: reason is that once the cost of deposit insurance is taken into account, the total cost of funding via deposits is in theory no different to the cost of funding via equity. Reason is that the risks of bank funders losing a given proportion of their money is determined by the nature of the bank’s ASSETS (e.g. NINJA mortgages versus safer mortgages) not by the nature of its funding.

Put another way, the extra return demanded by equity holders as a percentage of their total stake in a bank should be equal to or related to the risk they run. But the risk run by depositors is the same. Ergo the insurance premium, as a percentage of the sum insured for depositors, ought to be the same or at least very close to the latter percentage in the case of equity holders (i.e. the amount equity holders charge for “self-insuring”).

Moreover, the return on bonds (which are similar in nature to deposits) in the US is currently HIGHER than the return on equity!


Conclusion.

The best bank system is one where people can have totally safe accounts if they want, but those accounts are inherently safe because relevant money is not loaned on. Alternatively, if they want interest, they themselves carry the risk of having their money loaned out, not the taxpayer. Under such a system it is plain impossible for banks to fail: to illustrate, if a bank’s assets (i.e. the loans it has made) turn out to be worth only 75% of book value, then the stake in the bank held by those who have chosen to have their money loaned on drops to about 75% of book value. The bank as such does not go bust.

That system is full reserve banking.