In defence of ‘demand’ deposits

I owe a debt of obligation to my fellow Cobdenites for kickstarting a debate about money and banking amongst the UK Austrian community. As a participant in that debate – both on this blog and on the Cobden Centre mailing list – I decided to write up a working paper on the sound money debate. I’m delighted that it has now been published, and those with institutional access can find it here (PDF).

The abstract is:

This article contributes to a recent debate between Barnett and Block (J Bus Ethics 88(4): 711–716,2009), Bagus and Howden (J Bus Ethics 90(3): 399–406, 2009), Barnett and Block (J Bus Ethics 100: 299–238, 2011), Cachanosky (J Bus Ethics 104: 219–221, 2011) and Bagus and Howden (J Bus Ethics 106: 295–300, 2012a) regarding the conceptual distinction between demand deposits and time deposits. It is argued that from an economic perspective there is nothing inherently fraudulent or illegitimate about deposit accounts that are available ‘on demand’, but that this relies on certain contractual provisions. Particular attention is drawn to option clauses and withdrawal clauses, which “solve” the problems raised by Barnett and Block, and Bagus and Howden. Previous authors have also neglected the asset side of banks balance sheets, and this is shown to further justify the legitimacy of fractional reserve banking. 

If you don’t have access, please email me and I’ll be glad to send you a copy.


The Yakiniku recovery

Readers of The Cobden Centre blog may be interested in the recent report from Kaleidic Economics. It focuses on an analysis of Japan’s “lost decade”, and how this relates to the UK. In particular, it assesses some of the academic literature – especially from the Austrian school perspective – about whether the lost decade is a myth or reality, and what the root causes were. 

You can download the report here (PDF).


A prudent second best

A great post by George Selgin: Is there a prudent second best?

I don’t think I’m adding anything original but as I understand things, George’s position rests on two claims. (1) In an “ideal” system (i.e. free banking) there would be an increase in the money supply in response to an increase in the demand to hold it. In other words the banking system would ensure that MV is stable. (2) In the present system, the costs of attempting to “do nothing” are higher than the costs of attempting to simulate a free banking system, even though you can’t do this perfectly. Therefore if V increases the Fed should increase M. Hence there is “a case” for QE.

Many Austrians deny the first point, and so it is obvious that they would reject the second. Peter Boettke is right to say that the second point doesn’t necessarily follow from the first (although I’m not totally sure if he fully agrees with the first point himself). But – and let’s take it as given that the first point is accepted – here are a few things to consider when thinking about the second point:

  • As George says, the Fed is always doing something. “Do nothing” is not an option.
  • If we don’t possess the knowledge required to know when the Fed should increase M, how can we possess the knowledge to declare that they were increasing it too much during the boom? If we literally have no idea whether money is too tight or too loose, surely this dramatically reduces the plausibility of using ABC as an explanation for the underlying cause of the crisis?
  • NGDP is a better way to infer the monetary stance than consumer prices, or real GDP. Therefore thinking in terms of NGDP targets as opposed to inflation targeting is worthwhile.
  • Market monetarism seeks to replace all discretionary monetary policy with a very simple rule. Targeting NGDP expectations is a contemporary version of a Friedman rule and also can be seen as a step towards free banking. Of all the monetary policy rule on the table, it’s hard to beat. *If* you want to have some policy relevance, this is where the action is. It directly leads to an acknowledgement that monetary policy should be neutral, and that it should distinguish between productivity shocks and reductions in AD. It would be a massive improvement over the status quo, albeit we’d remain a long way from the ideal.
  • Even if you think there’s a case for the Fed to increase M, there’s a number of ways to go about doing it. QE is not necessarily the best. The likes of George, Steve Horwitz, etc, have been very clear from the start that QE as implemented by the Fed has been an error. And particularly on the Robust Political Economy grounds that Pete raised. There are two questions to consider: by how much do you want to increase M? and how? QE as practiced has dramatically increase Fed discretion and could be opposed on those grounds alone. It’s also not been accompanied by an effective communication strategy, meaning its supposed effectiveness has been curtailed. I’ve been in print myself arguing against it on both grounds (i.e. undesirability, and that it will fail on its own terms).

Finally, I sense that Pete (and many other Austrians) accept the basic arguments put forward above but just can’t bring themselves to be seen to be endorsing any action of a government agency. The analogy I use here is that the state is like a wife beater. We all see the damage being done but for whatever reason the person being beaten always offers forgiveness and a belief that things will improve over time. In which case the bystander/economist has two options. You could try to minimise the harm being caused. Or you could try to engineer an event so catastrophic she finally confronts the problem.

Maybe if the Fed tried to “do nothing” in 2008 there would have been such a crisis that faith in central banking would be completely shattered, and we would usher in a new era of free banking. In which case maybe +10% unemployment and a breakdown in monetary calculation “would be worth it”. But holy shit! Maybe if that had occurred it’d have been used as a reason to have an even more centrally planned economy, because instead of putting forward the ideas of liberty in a pragmatic, policy-oriented public debate, our best and brightest are too busy seeking the luxury of irrelevance!

I say this as someone who’s turned down opportunities to discuss the evils of central banking on TV because I know full well an uncharitable audience would fail to understand that you simply cannot spent 10 minutes defining terms and explaining caveats in a brief live interview. Bravo to anyone who has the courage to state their case publicly.

I can sleep at night because although people may mistake me as a Keynesian, a Monetarist, an endorser of monetary socialism, etc, my criticisms are more effective if they are informed criticisms; I find common ground with intellectual opponents where it exists; I have “spoken truth to power”; and I’m staying true to “good” monetary theory as I understand it. Such attacks say more about deficiencies in their knowledge than it does mine.

I have great respect for Joe Salerno and have learnt a lot from him. But I think George is right to say “there is a case for QE” and I think that needs to be opened up and discussed, not shouted down.


2 days, 2 weeks, 2 months: A proposal for sound money

In light of recent events, we’re bringing forward this proposal from June 2010.

There’s two ways to view the financial meltdown that occurred in 2008. The first is that it was a rare and unfortunate blip that can be remedied with calm and enlightened improvements in the regulatory framework. The second is that it exposed a serious flaw in the entire monetary system, and is likely to be repeated unless a radical transition takes place.

It’s no surprise that politicians, bankers and regulators – the architects of the banking industry – favour the first idea. This is why their response has skirted around the edges instead of dealing with the core. Even supposedly extreme measures such as nationalising banks are in fact attempts to preserve the status quo.

For those of us who favour the second idea, 2008 provided a golden opportunity to join the public debate and present a credible alternative. Perhaps we missed it. But if indeed another crisis is coming, this article attempts to outline a 14-point plan that could be implemented quickly and genuinely reform the institutions that create financial instability.

The key aspects of this proposal have been made previously, notably by economists Kevin Dowd and Richard Salsman. It could be implemented in three phases:

Over 2 days the aim is to ensure that all operating banks are solvent

  1. Deposit insurance is removed – banks will not be able to rely on government support to gain the public’s confidence
  2. The Bank of England closes its discount window
  3. Any company can freely enter the UK banking industry
  4. Banks will be able to merge and consolidate as desired
  5. Bankruptcy proceedings will be undertaken on all insolvent banks
    1. Suspend withdrawals to prevent a run
    2. Ensure deposits up to £50,000 are ring fenced
    3. Write down bank’s assets
    4. Perform a debt-for-equity swap on remaining deposits
    5. Reopen with an exemption on capital gains tax

Over 2 weeks the aim is to monitor the emergence of free banking

  1. Permanently freeze the current monetary base
  2. Allow private banks to issue their own notes (similar to commercial paper)
  3. Mandate that banks allow depositors to opt into 100% reserve accounts free of charge
  4. Mandate that banks offering fractional-reserve accounts make public key information (these include: (i) reserve rates; (ii) asset classes being used to back deposits; (iii) compensation offered in the event of a suspension of payment)
  5. Government sells all gold reserves and allows banks to issue notes backed by gold (or any other commodity)
  6. Government rescinds all taxes on the use of gold as a medium of exchange
  7. Repeal legal tender laws so people can choose which currencies to accept as payment

Over 2 months the aim is the end of central banking

  1. The Bank of England ceases its open-market operations and no longer finances government debt
  2. The Bank of England is privatised (it may well remain as a central clearing house)

You can download a copy of the plan in pamphlet form here.


The resource cost of a gold standard

We are currently incurring costs akin to having a gold standard – in that we are using gold for monetary purposes, as an inflation hedge. But we don’t get any of the benefits.

In my City AM column on September 4th 2012, I discussed the resource costs of a gold standard. This was triggered by reading Lawrence White’s estimate that the benefits of a commodity standard outweigh the costs once inflation hits around 4%. Due to space constraints, the calculations were not included in that article. I thought I’d provide them here. The basic analysis is (White, 1999, p.42-50).

Following Friedman and White we first need to know the ratio of gold to money. This is equal to the typical reserve ratio (like White I used 2%) multiplied by the ratio of currency notes and demand deposits to M2 (52.7%), plus the ratio of coins to M2 (0.18%).

G/M = R + Cp/M = [(R/N)+D][N+(D/M)] + Cp/M

(Where R is bank reserves, Cp is gold coins held by the public, M is M2, (R/N)+D is the ratio between gold reserves and demand liabilities, (N+D)/M is the ratio of notes and deposits (but not coins) to M2).

Assuming the marginal reserve ratio is equal to the average reserve ratio, the resource cost is equal to this ratio (1.2%) multiplied by the change in money supply that would keep the price level unchanged, multiplied by the ratio of M2 to GDP.

ΔG/Y = (ΔG/ΔM) (ΔM/M) (M/Y)

I used 4% for the former (as a rule of thumb), and 176% for the latter (from the World Bank). All in this suggests that a gold standard would cost 0.085% of GDP, which amounts to around £31bn, or £512 per capita.

Back of the envelope calculations, to be sure. I encourage others to give it a better stab.

This article was previously published at Kaleidic Economics



Readers of the Cobden Centre may be interested in a new book by Paul Knott. “Ouch!: Ignorance is Bliss, Except when It Hurts – What You Don’t Know About Money and Why It Matters (More Than You Think)” is written for ordinary people, but provides an extraordinary overview of the financial system and why it matters to everyone.

Amongst the swathes of books released following the financial crisis, this is both readable and full of sound economics. It explains fractional reserve banking, introduces readers to Austrian economics and to behavioural finance, and is done so in a highly engaging style. It will make you laugh out loud and shake your fist in anger.

I strongly recommend it, and indeed was lucky enough to read several drafts of the manuscript. At under a tenner it’s the perfect gift for people who moan at bankers and politicians, but want to understand a bit more about the monetary system.


Corporate giants rarely outlast their usefulness

In this article for City A.M. I discuss Joseph Schumpeter’s concept of “creative destruction”, and why Karl Marx was wrong to suppose that capitalism generates an increasing concentration of capital:

In 1987, Forbes magazine released a study looking at how large companies fare over time. It took the 100 biggest companies in 1917 and looked at what had happened to them since. Rather than see the big companies getting bigger, they found the opposite. As the chart shows, 61 per cent of the companies became defunct. 21 per cent still existed, but had fallen outside the top 100. That left only 18 of the biggest 100 companies in 1917 still there 70 years later. Of those, 16 companies underperformed the market as a whole, leaving just two companies that managed to “beat” the market. One of those companies was GE, and the other was Kodak.

Read more


The single income tax

Last week saw the launch of the 2020 Tax Commission report on UK tax reform. It’s called “The single income tax” and can be downloaded from the website (PDF).

I was honoured to serve as a commissioner and learnt a great deal from the discussion  meetings. It was a long process and the result is something I’m very proud of.

I think there are three important things to say about the report. Firstly, it is thorough. At over 400 pages we wanted to survey the academic and policy literature to base the proposals in strong theory and rich evidence. Secondly, it is policy-focused. It attempts to find a balance between being genuinely radical (which it is) and politically feasible. Or, if not feasible, then relevant to debate. It is not intended to be utopian, but at the same time stays true to some basic principles of public finance. Thirdly, it directly confronts the moral and ethical dimension of taxes. It discusses the libertarian perspective and does not treat ethics as a no go area. Indeed it is one of the few tax studies I’ve seen that attempts to engage with different ideological positions.

Personally, I find it hard to truly advocate 30% tax rates. But this isn’t about what we’d like in theory. It’s about mapping out a direction of travel, shifting debate, and engaging with policymakers and the public. If you believe such aims are futile, then you may be disappointed. But if you want a well researched and implementable proposal for radical tax changes – this is it.


It’s hard to account for flaws in the rule-book

In my latest City AM column I discuss Gordon Kerr’s recent book, which points to the role of accounting regulations in the obfuscation of the price system that contributed to the financial crisis:

When economists talk about the efficiency of the profit and loss system, we tend to take for granted that the profit and loss we observe matches with reality. But government interventions are liable to disrupt these signals – inefficient taxes, arbitrary subsidies, and monetary debasement all separate prices from the underlying conditions of demand and supply. Another source of noise is faulty accounting standards – as Gordon Kerr has pointed out in his fascinating new book The Law of Opposites: Illusory profits and the financial sector.


To QE or not to QE?

I was recently quoted in Management Today with some thoughts on current monetary policy:

The Bank of England’s policy rate has been historically low for some time now and this cannot continue indefinitely. The aim of low interest rates is to boost the economy by creating incentives to borrow money and invest. But higher capital requirements and policy uncertainty create counter forces that restrict bank lending.

In these circumstances the purported “benefits” of low interest rates fail to materialise, but the costs certainly do. These include the lack of an incentive to save (and actually rebuild banks’ balance sheets through voluntary lending), distortions to the capital structure of the economy (making white elephants like the HS2 line appear profitable) and the erosion of people’s savings.

The fact that real interest rates (the difference between inflation and the return you get on your savings accounts) is negative is a harmful confiscation of wealth.

When interest rates are close to zero policymakers look to alternatives, and quantitative easing has emerged as their favoured tool. However grateful banks and the financial community are in general to have an injection of freshly-printed money, it’s not clear how much this is helping the real economy. The aim shouldn’t be to preserve the status quo, but to find ways to allow banks to fail without exposing the general public to the fall-out.

Read more.