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Economics

Carswell and Baker on bank reform

Yesterday, Douglas Carswell and I spoke in the Chamber during the backbench banking debate.

From Douglas’ speech:

Banking is undoubtedly corporatist. To put it another way, if one were to read Ayn Rand’s “Atlas Shrugged” and to replace the words “railroad” and “rail company” with the words “credit” and “bank”, one would get a pretty good description of what has been going on in recent years. We have had a failure of the free market in the allocation of credit in this country. It is extraordinary that we compound that failure by talking ourselves into seriously suggesting that politicians and technocrats should ration credit. The absence of a pricing mechanism at the heart of the banking system is ultimately what caused the credit boom and the banking failure. In a normal market, when demand for a product increases, the price for that product goes up. That, in turn, stimulates supply.

In banking, unfortunately, things are a little different. When demand for credit increases, the price-the interest rate-is kept low or constant. Pricing does not therefore stimulate increased supply. On the contrary, a supply of additional credit is not met through higher savings. It is met by the creation of candyfloss credit-by banks being able to conjure up credit out of thin air. Banks do not meet the additional supply of credit by encouraging more people to save; on the contrary, they continue to lend IOUs on the basis of IOUs on the basis of IOUs. At the height of the credit crunch, for every pound deposited in a bank, IOUs had been written out some 44 times through the miracle of fractional reserve banking.

Banks have a legal privilege to conjure up credit out of nothing that ultimately stems from their ability-this is an extraordinary fact-to call a depositor’s deposit their own, to treat it legally as if it were their own, and to lend against it many times. It is that practice that has resulted in a credit pyramid and runaway credit booms, unrestrained by the pricing mechanism that would normally apply and would normally restrain demand and supply. The demand is unrestrained, the supply is unrestrained, and the price is low. The result is Ponzi credit bubbles. An incredibly distortive and disruptive effect is created every 20 or 30 years in supposedly free-market economies that have corporatist banking at their heart, and it leads to sugar-rush booms.

From my own:

To challenge the terrain of this debate, I should like to take the House back to a landmark in the development of British monetary and banking orthodoxy-the Bank Charter Act 1844, also known as Peel’s Act. It represented the victory of the currency school over the banking school. The former had realised that systemic crises and banking collapses were largely attributable to the excess creation of fiduciary media-that is, claims on money not backed by a fund of actual money. The Act, introduced by Peel, therefore eliminated the practice of banks issuing their own notes. Unfortunately, the currency school had not realised the economic equivalence of notes and demand deposits, so the Act left the banks virtually unmolested in their ability to issue fiduciary media.

My hon. Friend the Member for Bromsgrove (Sajid Javid) mentioned the wall of money that hit the markets, and we might reasonably ask where that wall of money came from. It has become common practice to say that interest rates were too low for so long, and therein lies the insight. When that happens, people are encouraged to borrow and the banks are encouraged to extend fiduciary media well in excess of real savings. Low interest rates ought to indicate prior production and real savings, but when central banks deliberately suppress interest rates and issuing banks pour fuel on the fire by issuing fiduciary media, what we find is that wall of money hitting the market. In our case, that money principally headed off into the housing market.

At the heart of our difficulties is the fact that there was an omission in the 1844 Act. The deposit-taking banking system is built upon that Act and a body of case law, which have left the banks with the legal privilege of treating demand deposits as their own property. That allows the system as a whole to create a wall of fiduciary media. That is the heart of our crisis, but it is not part of the mainstream contemporary debate, and I believe that it should be.

We both said much more: please follow the links above for the full text of our speeches.

13 comments to Carswell and Baker on bank reform

  • I can’t recall having heard mention of the word ‘ration’ in reference to government’s control over the money supply, but it is an interesting point. Thanks for the intellectual ammunition!

  • Is there any feedback on this from the leadership and financial media? I think it’s a great development to formally introduce these ideas into the public discourse and I agree with Steve that the idea of a clearing house must be a market initiative. Financial accounting is a multi dimensional labyrinth and I don’t see how Whitehall can be the steward of such a ship.

    Very encouraging nonetheless. Congratulations to MP’s Baker and Carswell.

  • Current

    I like the juxtaposing here… Doug Carswell asks for market forces in Banking. Then Steven Baker praises the Peel Act which eliminated those market forces and goes on to say that it didn’t go far enough in eliminating those forces.

    Which is it to be lads? ;)

    • Come on Current, you have far too much intellect to know the difference between a bank / goldsmith over issuing promissory notes in the full knowledge that they would never be able to redeem in full to all promises and therefore should have been banned as at best a negligent misrepresentation in contract law and a worst both fraud in contract and tort. This is what Peel outlawed. People were never offered “I will take your property, I will give you a promissory note, I will issue many more promissory notes against this property, thus property rights for you will be diminished today, but if you use the promissory note and exchange for goods and services, hey , you are happy and what’s more, I can pay you for the privilege, and don’t worry, when you do want your property back, you will more than likely get it back as the other 40 people I have promised it to will not want it at the same time.” They were not free market consensual transactions but license. This is what (or one of the things) fractional reserve free bankers struggle to entertain. Carswell wants free banking within the commercial law, the contract law, the same accounting standards applied and freely consenting adults doing things they actually think they agree to do.

      • Current

        > They were not free market consensual transactions but license.

        Yes, banking was licensed and controlled in 19th century England. But, I don’t really agree that bank customers were not aware of what they were doing. At that time in England the smallest banknote was for £5, that was by law. (The supposed justification for the law was that it prevented poor people from being ruined by the bankruptcies of banks). Anyway, bank customers were not average people, they were the well off. And, in those days there was no state-backed deposit insurance. There were bank failures and in those failures customers lost money. I think some banks even supplied their annual accounts to customers. In my view it’s sensible to suppose that at that time those who were using banking were aware that it was fractional-reserve banking that they were using.

        As Selgin points out, think about what would have occurred if people really preferred 100% reserve banking, but they didn’t know that the banks they were using weren’t supplying it. During the 19th century 100% reserve banking wasn’t illegal. A 100% reserve bank, or warehouse bank, could have been setup. As Selgin points out such a bank could have advertised it’s reserve policy to the public and pointed out that it’s competitors were fractionally reserved.

        As I said earlier the issue that the debates at that time were over were whether bank creation of money had negative repercussions for the overall economy.

        > Carswell wants free banking within the commercial law, the
        > contract law, the same accounting standards applied and freely
        > consenting adults doing things they actually think they agree to do.

        I certainly agree with that. But, it’s a matter of interpretation. As we’ve discussed earlier I don’t really agree with you that applying normal accounting standards requires banks to hold full reserves.

  • Current

    I’ll reply to Toby when I have some time. For now though I think it’s interesting to talk about what the Peel act and the Currency school were concerned with.

    From 1797 the Bank of England suspended redemption of notes. The government permitted them to do this because the possibility of an invasion by Napoleon’s threatened to cause a run. Notes became what Mises calls “Credit Money”. At that time joint-stock businesses were banned in Britain unless they had a warrant from the government, so banks were generally partnerships or owned by individuals. (The Bank of England was a joint-stock company though). From 1808 note issuing banks had to have a license but it wasn’t that difficult to obtain. The government and Bank of England only resumed redemption of notes in 1821.

    Throughout that period and for some time afterwards there was a lot of instability in the economy and the banking industry. The focus of the debates at that time was on finding the cause. The “Currency School” saw the cause in the ability of the County banks and the Bank of England to change the supply of money. The “Banking School” saw the cause as being real shocks, they saw both commercial banks and the Bank of England as blameless. The “Free Banking School” saw the cause as being the central bank and the laws surrounding it’s existence.

    In the present debate there are two different branches. There’s the issue of the macroeconomic consequences of policy, and the more local issue of whether or not banks are acting honestly and within normal commercial law. The 19th century debates though were primarily about the macroeconomic side. AFAIK none of the schools of thought I mention thought that banks were acting dishonestly to their customers in the local sense. That part of the argument is mostly from Rothbard.

    In 1844 with the Peel act the Currency school won and County banks were effectively prevented from issuing banknotes. In the eyes of the people behind this those laws were not supporting a free-market in banking, that was what they were opposing. You can take the view that the Currency school were wrong in that and that they were really supporting a free-market position, but that wasn’t what they thought.

    I suppose it’s rather like the way the WI sing “Jerusalem”. William Blake meant Jerusalem to be satirical.

    • “To challenge the terrain of this debate,” ought to speak volumes…

      Given that this was a six-minute speech off the cuff, I’m quite happy with it. I certainly hope you will follow the link to the rest of it.

      • Current

        I have now. I agree with what you said about the proposed derivatives clearing house, and I agree with you about risk. But, I don’t agree with you about fiduciary media. I’ll write more about that when I reply to Toby.

  • [...] place. Jesse Norman argues taxpayers deserve a rebate from PPI, Douglas Carswell and Steve Baker tackle banking reform, plus Chris White has a ‘Big Society’ Private Member’s [...]

  • donbiblo

    Sincere apologies if my poor understanding of English subtleties (being from a different continent altogether) has motivated this comment but it seems as if Douglas remarks present a genuine misinterpretation of banks credit creation.
    A bank in the the UK as in most countries that we would be familiar with cannot lend more money than it has borrowed or has under deposit at any point in time. If that was the case the central bank, the daily final clearer for the banking system (the banks ‘ bank if you like) would declare it mechanically insolvent at the end of the day when the wire goes down and the given bank cannot square its balance sheet (asset = liabilities). The fact that banks feel free to extend loans with 30 years maturity funded with sight deposit is a different story. That is to do with the amount of maturity transformation or liquidity risk that regulators, shareholders and ultimately the public at large are happy to tolerate within the banking utility function. So it is not the solvency leverage (equity to total asset, i.e 1 to 44) that is responsible for the bubble but the amount of misrepresented and finally wrongly priced liquidity risk. Douglas is therefor perfectly right to denounce the cartel practice of not remunerating current accounts and sight deposits at the level of their true value for the banks given the strong demand for credit. Once you have suppressed the market mechanism (or competition) for establishing the right price for this scarce commodity (credit) you have indeed created created a monopolistic situation which can only end in pain as ever. Please correct me if I misunderstood Douglas presentation.

  • lola

    May I use a parable to explain this. It’s one I use with clients. It goes as follows:

    In 1997 one G Brown managed to gain control of the Columbian Cocaine Cartel. He set about doubling supply and halving the price and reducing the quality of the product. To ensure that distribution went unhindered he moved to undermine the existing distribution and quality control checks and balances by creating mutual suspicion and ignorance and created new set of enforcers (the FSA) that reported only to him and which set about cartelising the self employed pushers (aka the retail banks) who in turn set about getting us (me and you)addicted to the drug (debt). This was aided by the pushers who also cut the product and arbitrarily increased supply, whilst passing back part of the excess profit to G Brown. Unfortuneatly for G Brown this couldn’t last once it became clear to the coca growers and cocaine factories that they were being suckered into an ever increasing spiral of undepriced production, and one day they decided it was time to make sure their supply lines were safe and that G Brown (and various other international Drug [aka Money] Barons would have to go.

    Money is a drug. Governments and banks are pushers. We are the addicts.

  • “IOUs had been written out some 44 times through the miracle of fractional reserve banking.”

    As much as I admire Carswell, the above is just guff. The amount of credit/leverage created by fractional reserve banking is dependent on interest rates and capital reserve requirements. Currently, with 10% reserve requirements those “IOUs” can only have been written out 9-10 times. In reality most banks have only created credit of 4-5 times original deposits.

    No bank out there is 44 times leveraged – especially not on deposits/lending alone. I doubt even that any hedge funds, raditionally more leveraged than the banks get past about a 30 aspect ratio…..

    • Current

      Tyler,

      We don’t have a 10% reserve requirement in Britain. In fact, there’s no reserve requirement at all. However the BoE require banks to fulfill certain financial requirements (for reserves and capital) before they can become part of the important inter-bank transfer systems. I had a look in BoE bankstats, at present UK banks in aggregate are running ~12% reserves. But they could run much less.

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