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By Steven Baker MP, on 25 January 10
 Should banks be permitted to operate with a fractional reserve on demand deposits or should 100% reserves be a legal requirement? Should there be a central bank with a monopoly on note issue? What are the consequences of these choices? These were mainstream questions in the 19th century and they demand attention today. Here, following the ESCP Europe/Cobden Centre “Colloquium on Honest Money”, Steve Baker frames the debate to be had about money and banking.
Today, people are well aware that we have a banking crisis, a “credit crunch“. That is, there is a problem in the financial system, a system which is centrally planned — see Economic Interventionism, Banks and the Crisis – and an approach which necessarily works badly – see Strip the Bank of England of its power. So, what are the features of the present system and what are the alternatives?
The two important features of the present, orthodox system are:
- The banks are not required to keep money in reserve to the value of demand deposits. That is, they operate with a fractional reserve. As Toby Baxendale has pointed out, today if more than one person in 34 asks their bank for their money back in notes and coins, which is a reasonable, contractually-sound request, we will have a systemic banking crisis — a run on all banks — because there is simply not as much cash as people’s bank statements say there is.
- There are, across the world, central banks in which committees of experts set “monetary policy” — see The kindness of geniuses – a rate of interest which, through various mechanisms, affects the entire economy. And the economy is, of course, what people choose to do, since the economy is nothing more or less than the cooperation of thinking, acting individuals and of corporations run by thinking, acting individuals; therefore, manipulating the interest rate necessarily distorts the actions of people and the productive structure. Central banks also act as “lenders of last resort” in the event of a run on a particular bank — which is possible because of their fractional reserve — but in the case of Northern Rock, the Bank of England did not ultimately fulfill that role.
Stepping back from today’s monetary orthodoxy — a fractional reserve and a central bank — the options are plain: we can have a 100% reserve on demand deposits, or not, and separately, we can have central banks with a monopoly on the supply of currency, or not. Hence, Jesús Huerta de Soto models (PDF) the banking debate as follows:
 The shape of the debate (click to enlarge) As Irving Fisher, one of the founders of Monetarism, pointed out in the sub-title and content of his book 100% Money, there are potential benefits to be gained from moving to another system. For example, Fisher identified the following as the headline benefits of moving to a 100% reserve requirement:
- keeping chequing banks 100% liquid so that there can be no more runs on banks,
- preventing inflation and deflation,
- largely curing or preventing depressions,
- and wiping out much of the National Debt.
Since we have had a run on a bank, since the money supply has deflated, since attempts to reflate the money supply risk price inflation and distort the economy, since the boom-bust cycle is evidently still in progress and since we are doubling our national debt, it is perhaps worth taking seriously the question of how our system of money and banking is organized.
Furthering that discussion was the purpose of the recent ESCP Europe/Cobden Centre Colloquium on Honest Money directed by Founding Fellow Dr Anthony J. Evans, Chaired by Corporate Affairs Director Steve Baker and attended by Chairman Toby Baxendale amongst 9 other academics and practitioners in the field of money and banking.
We will continue to develop and promote a range of ideas to open up and further the debate on money and banking.
Further Reading
- Baxendale, A day of reckoning: how to end the banking crisis now
- Frank Whitson Fetter, Development of British Monetary Orthodoxy 1797 – 1875
- F. A. Hayek, Denationalisation of Money: The Argument Refined
- Huerta de Soto, Money, Bank Credit and Economic Cycles
- Gordon Kerr, How To Destroy the British Banking System and Bailing out the Banks – Glaring Evidence of Moral Hazard
- James Tyler, My Journey to Austrianism via the City, Money is not working and How to avoid future encounters with financial meltdown
- Irving Fisher, 100% Money, 1935
By Steven Baker MP, on 14 December 09
 This article gives a summary of the legal nature of banking contracts as presented by Jesús Huerta de Soto in Money, Bank Credit and Economic Cycles (PDF). A second article will discuss artificial credit expansion and its effects.
In his speech in the 2009 Banking Bill debate, the Earl of Caithness, one of the most experienced Conservative peers, said:
My Lords, the Banking Bill which we are currently discussing in the House is very complex and detailed, but it does nothing to resolve the current banking crisis, which lies at the heart of our economic problems. [...]
The Banking Bill fails to address the fault which has led to every major banking and currency crisis during the past 200 years, including this one. It merely, lazily and weakly, papers over the cracks. Like Lilliputians, we are trying to tie down Gulliver with ever more strands of rope. It did not work then; it has not worked since 1811; and it will not work now.
He went on to explain that no Act of Parliament established the present banking system but that it emanates from a base of judicial decisions:
Prior to 1811, title to the money in depositors’ accounts belonged to the depositor. However, in that year, decisions in Carr v Carr and, in 1848, Foley v Hill gave legal status to the banking practice of removing depositors’ money from their accounts and lending it to others. Since then, title to depositors’ money has transferred from the depositor to the bank at the moment when the deposit is made.
Bankers have always seen it as their job to invest as much of their depositors’ money as they prudently can, in order to earn income for themselves while, at the same time, maintaining sufficient cash flow to be able to honour depositors’ cheques when presented and to meet withdrawals when demanded. If new deposits fail to materialise in sufficient strength or if borrowers fail to repay on time or at all, banks need to be rescued or they will fail. Historically, bank failures then led to a demand for central banks to act as lenders of last resort to save imprudent bankers who got caught short.
These judicial decisions meant that, from then until now, money deposited belonged to the bank and not the depositor, thereby allowing bankers to use customers’ deposits as they saw fit, always provided that they could manage cash flow so as to meet depositors’ requirements. In good times, that enabled them to take greater risks. Then, with the advent of central banks as lenders of last resort, the bankers soon learned they could take even greater risks with virtual impunity. When their lending became too aggressive and their reserves and deposit receipts were less than required to meet cash flow, they began to lend to each other. Banks with excess reserves would lend on the overnight market to those with a shortfall. With all these supposed safety mechanisms to protect them, bankers came to believe they could become even more aggressive in their lending, enabling them to make increased profits for themselves.
The provision of these safety mechanisms had, in some cases, merely encouraged them to take excessive risks. Further, these two judicial decisions overlooked or failed to consider the fact that when banks lend depositors’ funds, more than one receipt for the same deposit is issued. This was not done intentionally by individual banks or it would immediately have been seen as fraudulent. Rather, it was done by the system as a whole. This process continued to the present. It is as a result that our UK money supply has grown from £31 billion in 1971, when President Nixon closed the gold window, to in excess of £1,700 billion today. Let us consider the implications of those last two figures. They mean that every year since 1971 the banking system has created, on average, for its own use, in excess of £44 billion. That is more per year than the entire money supply which had, until 1971, sustained our economy since recorded history and through two world wars. Is it any wonder that we have suffered such serious inflation over that period? It is clear that the normal, everyday onward lending of depositors’ funds by retail banks has been the principal producer of inflation.
Now, the 1844 Bank Charter Act ended the overissue of notes over specie but it did not deal with the overissue of demand deposits drawn by cheque. This omission, combined with the judicial decisions described by Caithness, left open the possibility of the same mechanism which was known to cause economic crises in the nineteenth century and which has caused the crisis we are in today: artificial expansion of credit.
This article deals with the legal principles under which banking should operate; a second article will explain artificial credit expansion and its consequences.
Continue reading “What is wrong with banking, part 1: the legal nature of banking contracts”
By Gordon Kerr, on 17 November 09
Via Now State takes over bankers’ contracts – Telegraph:
The new rules, which critics are likely to suggest amount to a State-enforced “incomes policy” for banks, will be contained in the Financial Services Bill to be announced in the Queen’s Speech.
The bill will give the Financial Services Authority (FSA) the power to cancel bankers’ contracts to prevent them receiving payments that it believes would cause instability in the financial system.
The FSA could stop bankers receiving bonuses that it believes are too high, or cancel remuneration packages that it thinks reward undue risk-taking.
It is hard to see this proposal as anything other than political posturing given the forthcoming election. Are we to establish a new quango/ regulator “Ofpay”? What will be the cost of that? What access will individual bankers be allowed to their assessors? How can the state decide which bankers have performed socially-useful functions and made positive contributions to the long term good of the bank concerned? Working in a structured finance role in a dealing room environment is like being an MEP in the EU. You have to be part of a team. Management will only negotiate with voting blocs! One member of the team has to play the internal politics as in many other businesses, but this is of course an unproductive waste of time as far as shareholders are concerned. How much more unproductive time will be spent trotting off to Ofpay to explain your achievements?
The root of the problem is the unreliable nature of banks’ reported profits. If the p&l was a sound number, surely the state could rely on employers to reward? This news affirms my fear that the Government knows that the front-ending of prospective profits from derivatives trades and treating them as today’s “profit”, along with similar bank specific accounting wheezes, produce unreliable reported accounts. That is the mischief the legislators should be focussing on.
Get that right and wages will look after themselves.
Further Reading
By Steven Baker MP, on 11 September 09
Revised and updated: reconciling our conflicting views of the market through consistent principle and morality. This post originally appeared on www.stevebaker.info.
 Leviathan, 1st Edition, 1st Print, from Toby Baxendale's original A Christian friend is an avowed socialist and another associate is determinedly left wing. I asked them recently what socialism meant to them. The answer was essentially “people being good to one another”: kindness, compassion, fairness and justice, even liberty. Who would oppose that?
But can force make it so?
Though I write with great affection for my friends, when I hear or read “socialism”, I understand a quite different thing: misery. Everywhere Marxist theory was determinedly put into practice, the result was tremendous suffering, not utopia, and yet Marxist ideas persist in our thinking.
Socialism, though formally hopeful, causes misery because a socialist society must force individuals to take particular courses of action for the good of all. For example, Lenin’s acclaimed Marxist philosopher Bukharin wrote:
For a long time yet, the working class will have to fight against all its enemies, and in especial against the relics of the past, such as sloth, slackness, criminality, pride. All these will have to be stamped out. Two or three generations of persons will have to grow up under the new conditions before the need will pass for laws and punishments and for the use of repressive measures by the workers’ State.
And so socialist societies have justified sustained repression.
When the Soviet Union fell, it seemed we all accepted that public ownership of the means of production was a dead end. New Labour and the “Third Way” came to prominence, despite the third way being nothing new, merely the idea that government can successfully intervene in a market economy to bring about positive outcomes. The problem is, it does not work.
Today, we have a financial crisis, a credit crunch, but few reflect that for a long time we have laboured under the most pervasive price control of all: deliberate manipulation of the rate of interest. Around the world, millions have waited with trepidation for committees of wise men to announce the interest rate. We have had a combination of historically low levels of saving combined with historically high levels of borrowing. Where did this mismatch come from? The rate of interest has been deliberately suppressed, misleading people into saving less and borrowing more than would have been sustainable.
The phenomenon is rather like a gym in which the treadmills may be remote controlled. If just a few people slow down, the central controller does nothing. But imagine the controller sees “too many” people slowing down at once for a break. “This will not do!” he cries, “We must have higher levels of activity!” He turns up all the treadmills at once, and keeps turning them up as exhaustion builds. Eventually large numbers collapse at once. Do we take a break and rebuild ourselves? No! We must inject adrenalin, take sports drinks, anything to get back to peak activity immediately. Eventually, this must end in catastrophe for the participants, but with artificially-low interest rates and quantitative easing, this is what we do to individuals and corporations in the economy.
The consequence is social disaster: high levels of government debt, unemployment and the direct creation of new money, a phenomenon which can only widen wealth inequality because new money is given to the wealthy. Yet this is the consequence of just one intervention in the free market.
When people set out to intervene in the economy by force of authority, they usually fail to realise a simple point: you cannot control the economy without controlling people. The economy comprises the actions of thinking, purposeful human beings with their own ends and means. Socialism requires intervention in that striving, intervention that at best has unintended consequences because the information necessary to intervene successfully is simply not available. Jamie Whyte’s The kindness of geniuses explains charmingly.
Those of us of good faith all want the same thing: prosperity, kindness, compassion, fairness, justice, liberty. People being good to one another. The twentieth century teaches us that state planning of the economy does not deliver these things, so how should society be organised?
Views of the free market
I asked my friends how they reacted to the term free market. They understand this term to mean exploitation. I understand it to mean freely-chosen cooperation for mutual benefit.
As we were sitting in a bar, I asked “Where was the exploitation when you bought that last round?” We wanted a drink, we had earned it in our own ways and the barman was happy to serve it to us. Perhaps the barman was there against his will, but how are we to know? Are we all to approach every transaction with a questionnaire? Should the barman have asked us if we had been exploited before serving us? Are we to invent possible exploitation somewhere up the supply chain for beer? Is it intrinsically exploitative for one man to serve beer to another?
Of course, this is absurd, but people suppose the free market inherently exploits without demonstrating how. This is not to deny the existence of isolated exploitation, but to question how free exchange is inherently exploitative, or corrupting, or the cause of whatever harm is perceived by the commentator. This is Marxist thinking and we know where it leads.
Before me, I have four books which begin to reconcile these difficulties:
Continue reading “Moral Markets and Honest Money”
By Sean Corrigan, on 10 August 09
Sean Corrigan, Chief Investment Strategist at Diapason Commodities Management, has kindly agreed to the reproduction of his briefing “Material Evidence” by the Cobden Centre. In this, 9 July 2009, edition, Sean restates the his position on banks: that they should have to comply with basic, everyday property and contractual law.
 Material Evidence, Sean Corrigan As we have often expounded, the vicarious gangsters we call politicians – while only to glad to bask in the reflected glory (and to revel in the enhanced campaign contributions) during the Boom – have now turned into a whole bath‐house full of petty Marats in their vituperative attempt to harness understandable popular anger and disquiet at the evils inflicted upon the citizenry by the dysfunctional, modern, state‐directed financial system.
This we again face the prospect of ‘hearings’ (would ‘show trials’ be a more accurate description?) in Congress aimed at limiting access to the commodity futures markets to the politically‐favoured few. Here we can only pause briefly to re‐iterate our fervent belief that there would be no need for any new ʹregulationʹ to prevent so‐called ʹspeculative excessesʹ anywhere if banks simply had to comply with basic, everyday property and contractual law; if money were a hard, free market good and not a pliable construct of the State; and, perhaps if recourse to that other positivist legal fiction, the limited liability partnership or corporate entity, were denied to those with fiduciary responsibility for other peopleʹs affairs. It would be much more effective ‐ if politically inconceivable – to address the root cause of all our ills, rather than to visit economically‐illiterate prejudices on its symptoms. If we cut the shoals of ʹvampire squidʹ down to their proper size, we could abolish the CFTC, the FDIC, the OCC, the SEC and the rest of the New Deal alphabet soup altogether, rather than uselessly empowering yet another tool for arbitrary, legislative grandstanding.
By Steven Baker MP, on 5 August 09
Via FT.com / Capital Markets – Lehman Brothers set for landmark appeal:
Lawyers for the Lehman Brothers US estate will appeal against a decision by English courts that retail investors from Papua New Guinea, Australia and New Zealand should be paid ahead of the failed bank in the unwinding of a complex structured vehicle, according to people familiar with the situation.
…
Analysts believe the case could have important implications for the securitisation market.
“A ruling against the investors would be hugely negative for the credit markets as the concept of bankruptcy remoteness will most likely not be value for any transaction if the swap counterparty has a US connection,” said analysts at Creditsights in a report. They believed such a decision could lead to further rating downgrades for similar collateralised debt obligations and could force rating sensitive investors to sell their holdings, pushing spreads up.
By Steven Baker MP, on 17 July 09
De Soto’s treatise Money, Bank Credit and Economic Cycles is one of the most comprehensive treatments in print of ideas on banking and the business cycle. It is highly recommended for those embarking on a serious study of the subject and for those who wish to dip into a scholarly treatment of the following subjects:
- The legal nature of the monetary irregular deposit contract. Types of deposit contract including the deposit of fungible goods, such as money. The economic and social function of irregular deposits. The essential differences between the irregular deposit contract and the monetary loan contract. The emergence of general legal principles governing the irregular deposit contract.
- Historical violations of the legal principles governing the monetary irregular deposit contract. Greece and Rome. The late Middle Ages: the Mediterranean, Florence, Medici and Catalonia. Banking under Charles V and the doctrine of the school of Salamanca. A new attempt at legitimate banking: the Bank of Amsterdam, David Hume, Adam Smith, the Banks of Sweden and Amsterdam, John Law and Richard Cantillon.
- Attempts to legally justify fractional-reserve banking. The error of equating irregular deposit and loan contracts. Redefining the concept of availability. Deposits, repurchases and life insurance.
- The credit expansion process. The bank’s role as a true intermediary in the loan contract. The bank’s role in the monetary bank-deposit contract. The effects produced by bankers’ use of demand deposits: individual banks of various sizes and the entire banking system. Simultaneous credit expansion by all banks. Deposit creation compared to unbacked bank notes. Credit tightening.
- Bank credit expansion and its effects on the economic system. Capital theory. Effects on the productive structure of an increase in credit unbacked by voluntary saving. The circulation credit theory of the business cycle.
- Additional considerations on the theory of the business cycle. Crises and real saving. Postponing crises. Consumer credit. The self-destructive nature of artificial booms and forced saving. Squandering capital. Credit expansion as the cause of massive unemployment. The inadequacies of national income accounting. Avoiding business cycles. The manic-depressive economy. Marx, Hayek and the view that economic crises are intrinsic to market economies. Empirical evidence for the theory of the business cycle.
- A critique of monetarist and Keynesian theories. The mythical concept of capital. The mechanistic quantity theory of money. Rational expectations. Say’s law of markets. Keynes’ arguments on credit expansion. The marginal efficiency of capital. The Marxist tradition.
- Central and free banking theory. A critical analysis of the Banking School. The Currency School and the Banking School. Central banking vs free banking. The impossibility of socialism and its application to the central bank. The failure of banking legislation. The concept of saving and the demand for money. The false debate between supporters of central banking and defenders of fractional-reserve free banking.
- A proposal for banking reform.
Over the coming months, we will provide articles covering the scope of this work, supplementing de Soto with insights from across our base of literature.
The book is available in full as a PDF here. It can be purchased from the IEA or the Mises Institute.
By Steven Baker MP, on 30 June 09
Via Lords Hansard text for 5 Feb 200905 Feb 2009 (pt 0003):
My Lords, the Banking Bill which we are currently discussing in the House is very complex and detailed, but it does nothing to resolve the current banking crisis, which lies at the heart of our economic problems. The noble Lord, Lord Peston, has just said that it is the fault of the bankers. I agree with him up to a point, but would go further and say that the fault that really needs correcting is our whole banking system. …
The Banking Bill fails to address the fault which has led to every major banking and currency crisis during the past 200 years, including this one. It merely, lazily and weakly, papers over the cracks. Like Lilliputians, we are trying to tie down Gulliver with ever more strands of rope. It did not work then; it has not worked since 1811; and it will not work now.
… The current crisis, like previous ones, emanated from a base of judicial decisions. Prior to 1811, title to the money in depositors’ accounts belonged to the depositor. However, in that year, decisions in Carr v Carr and, in 1848, Foley v Hill gave legal status to the banking practice of removing depositors’ money from their accounts and lending it to others. Since then, title to depositors’ money has transferred from the depositor to the bank at the moment when the deposit is made.
The noble lord’s entire speech is highly recommended.
See also What is wrong with banking, part 1: the legal nature of banking contracts.
By Steven Baker MP, on 25 June 09
Via FT.com / Columnists / Martin Wolf – Reform of regulation has to start by altering incentives:
At the heart of the financial industry are highly leveraged businesses. Their central activity is creating and trading assets of uncertain value, while their liabilities are, as we have been reminded, guaranteed by the state. This is a licence to gamble with taxpayers’ money. The mystery is that crises erupt so rarely.
The place to start is with the core of modern capitalism: the limited liability, joint-stock company. Big commercial banks were among the most important products of the limited liability revolution. But banks are special sorts of businesses: for them, debt is more than a means of doing business; it is their business. Thus, limited liability is likely to have an exceptionally big impact on their behaviour.
…
Regulatory reform cannot end with incentives. But it has to start from incentives. A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple – and brutal – as that.
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