Most people — from young to old and from all ends of the political spectrum — are united by a common bond. The idea that banks are deserving of taxpayer support is viewed as morally repugnant to them. Business owners see bank bailouts as an unfair advantage that is not extended to all businesses. Those typically on the political left see it as support for the establishment, and a slap in the faces of the little people. Those more at home on the political right see it as just another form of welfare: a wealth redistribution from the hard working segment of the population to the reckless gambling class of banksters.
Despite this common disdain for bankers, there is considerable disagreement on how to deal with them. One group sees less regulation as the solution — letting market forces work will allow the virtues of prudence and industry to prevail. This formulation sees these same market forces as limiting firm size naturally to evade the “too big to fail” issue, through many of the same incentives that foment competitive economic advancement.
Another group sees the solution as more regulation. The natural tendency in business, according to this group, is for large monopolies to form. As companies grow in size, they gain political influence as well as an aura of indispensability. The consequence is that not only will a company come to be seen as too big to fail, but it will also be politically influential enough to seek such recourse if troubles surface.
Like most answers, the truth lies somewhere in the middle.
The first group correctly notes that there are two specific drawbacks of increasing regulation. On the one hand, “one size fits all” regulatory policies (such as is commonly the case on the Federal level) are rarely capable of handling the intricacies and dynamics of business. They also have the effect of relaxing the attention individuals and businesses afford to their own behavior. Under the pretense that the state has enacted wise regulations, individuals see little need to actively monitor companies to make sure they behave in a responsible manner. Businesses too succumb to this mentality. By abiding by the existing regulatory regime, they take solace in knowing that any attack on their integrity can be brushed aside as an attack placed more appropriately on the failures of the regulating body.
On the other hand, increased regulation breeds the problem of what economists call “moral hazard.” An activity is morally hazardous when a party can reap the benefits of an action without incurring the costs. The financial industry is very obviously afflicted with moral hazard today.
Banks and other financial companies have largely abided by the law. I would venture a guess that there is no industry more heavily regulated than the financial services industry, and no industry that spends more time and resources making sure that it complies with this complex regulatory maze. Capital levels must be maintained, reporting must be prompt and transparent, and certain types of assets must be bought or not bought. Banks following these regulations get a sense that they will survive, if not flourish, provided they work within the confines of the law.
However, it is increasingly evident that the financial regulations put in place over the past decades are woefully inept at maintaining a healthy financial industry. In spite of (or perhaps because of) all these regulations, a great many companies are, shall we say, less than solvent. So, who is to blame? It would be easy to blame the companies themselves, except that they did everything that the regulators told them to do.
Why not at least consider relaxing regulations? Doing so would have a two-fold advantage.
On the one hand, businesses would be more obviously responsible for the instability they have now created. On the other hand, without regulations, more reckless or clumsily managed companies would have gone out of business already, lacking the benefit of a regulatory “parent” scolding them for their mistakes. The result would be fewer unstable businesses, and more attention to the dangers of one’s own actions.
I previously mentioned that both sides are correct to some degree, implying that those calling for more regulation had some merit to their arguments. And this is indeed true. However, to paraphrase Inigo Montoya, when they use the word “regulation,” I do not think it means what they think it means.
It is true that not all companies play on a level field. In the financial services industry, and particularly in the banking sector, this is especially apparent. Banks are granted a legal privilege of “fractional reserves.” The result is that banks behave in a way which is fundamentally different from any other type of business, and which is easy to misdiagnose as “inadequate regulation.”
A depositor places money in his bank. The result is a deposit, and the depositor has a claim to this sum of money at any moment. One would think that the bank would be obliged to keep the money on hand, much in the same way that other deposited goods — like grain in an elevator — must be kept on hand. The law begs to differ. Banks are obliged to keep only a portion, or fraction, of that deposit in their vaults and are free to use the remaining sum as they please. Canada and the United Kingdom are examples of countries where there is no legal requirement for a bank to hold any percentage of that original deposit in its vault. In the United States, if a bank has net transactions accounts (deposits and accounts receivable) of less than $12.4 million, the reserve ratio is also set at zero. This differs greatly from grain elevators, where the law strictly states that the elevator owner must keep 100 percent of the deposited grain in the silo.
There are two results of the practice of fractional reserve banking, neither of them positive for the average person.
First, banks grow larger because they have access to a funding source that would otherwise not be available if they conducted themselves by the same laws as other businesses. When commentators say “banks are different,” there is truth in the statement. They have a legal privilege that enables them to grow in scope beyond that which they could naturally. This also explains why many banks, and financial services companies, come to be viewed as too big to fail.
Second, banks become riskier. Every time a deposit is not backed 100 percent, the depositor is exposed to the possibility of not getting his deposit back in full. If a bank uses his deposit to fund a mortgage, and the borrower defaults and cannot repay the bank, there is a risk that the original depositor will lose some of his money. A more common case is a bank run, in which many depositors try to withdraw money at the same time. The result will be insufficient funds to simultaneously honor all redemption demands. This occurred with various banks in Iceland, Ireland, Britain, and Cyprus over the last four years.
Few people worry about this latter problem, however, because of the former one. Since banks have become too big to fail, we are assured that if one goes bankrupt, we as depositors do not stand to lose personally. The government has pledged implicitly, or even explicitly through deposit insurance, that it will step in and bail out the irresponsible actors.
The result is the confusing state of affairs that we have today with two sides both arguing for the same thing — banking stability — via two diametrically opposed means. The “more regulation” camp is pitted against the “less regulation” camp.
These two camps are not mutually exclusive. We can solve the problems of moral hazard and “too big to fail” in one fell swoop by ending fractional reserve banking.
By ending this legal privilege, we eliminate the ability for banks to grow to such inordinate sizes. By abiding by the same legal principles (or “regulations,” if you will) as any other deposit-taking firm, banks are not unduly advantaged. If banks shrink in size, the “too big to fail” doctrine is eliminated, or at least greatly reduced. This means that depositors and bankers will realize that if a loss occurs to their bank, they personally stand to lose.
The risk of loss is a great force in removing moral hazard. Remember that it only arises when one person’s ability to gain is not constrained by the threat of a loss. Cognizant of ensuing losses, depositors will demand that their banks adhere to more prudent operating principles, and bankers will be forced to meet these demands.
The critics worried about “too big to fail” are right. We do need more “regulations,” in a sense. We need banks to be regulated by the same legal principles regarding fraud as every other business. The critics worried about moral hazard are also right. We need fewer of every other kind of regulation.
Repairing a broken financial system does not have to be hampered by irreconcilable political differences. Recognizing the true issues at stake — legal privilege and unconstrained risk taking — allows one to bring together advocates of widely differing solutions into one coherent group. Getting bankers to agree to all this is another story.
This article was previously published at Mises.org.
The “Cyprus deal” as it has been widely referred to in the media may mark the next to last act in the the slow motion collapse of fractional-reserve banking that began with the implosion of the savings-and-loan industry in the U.S. in the late 1980s.
This trend continued with the currency crises in Russia, Mexico, East Asia, and Argentina in the 1990s in which fractional-reserve banking played a decisive role. The unraveling of fractional-reserve banking became visible even to the average depositor during the financial meltdown of 2008 that ignited bank runs on some of the largest and most venerable financial institutions in the world. The final collapse was only averted by the multi-trillion dollar bailout of U.S. and foreign banks by the Federal Reserve.
Even more than the unprecedented financial crisis of 2008, however, recent events in Cyprus may have struck the mortal blow to fractional-reserve banking. For fractional-reserve banking can only exist for as long as the depositors have complete confidence that regardless of the financial woes that befall the bank entrusted with their “deposits,” they will always be able to withdraw them on demand at par in currency, the ultimate cash of any banking system.
Ever since World War Two governmental deposit insurance, backed up by the money-creating powers of the central bank, was seen as the unshakable guarantee that warranted such confidence. In effect, fractional-reserve banking was perceived as 100-percent banking by depositors, who acted as if their money was always “in the bank” thanks to the ability of central banks to conjure up money out of thin air (or in cyberspace).
Perversely the various crises involving fractional-reserve banking that struck time and again since the late 1980s only reinforced this belief among depositors, because troubled banks and thrift institutions were always bailed out with alacrity—especially the largest and least stable. Thus arose the “too-big-to-fail doctrine.” Under this doctrine, uninsured bank depositors and bondholders were generally made whole when large banks failed, because it was widely understood that the confidence in the entire banking system was a frail and evanescent thing that would break and completely dissipate as a result of the failure of even a single large institution.
Getting back to the Cyprus deal, admittedly it is hardly ideal from a free-market point of view. The solution in accord with free markets would not involve restricting deposit withdrawals, imposing fascistic capital controls on domestic residents and foreign investors, and dragooning taxpayers in the rest of the Eurozone into contributing to the bailout to the tune of 10 billion euros.
Nonetheless, the deal does convey a salutary message to bank depositors and creditors the world over. It does so by forcing previously untouchable senior bondholders and uninsured depositors in the Cypriot banks to bear part of the cost of the bailout. The bondholders of the two largest banks will be wiped out and it is reported that large depositors (i.e., those holding uninsured accounts exceeding 100,000 euros) at the Laiki Bank may also be completely wiped out, losing up to 4.2 billion euros, while large depositors at the Bank of Cyprus will lose between 30 and 60 percent of their deposits. Small depositors in both banks, who hold insured accounts of up to 100,000 euros, would retain the full value of their deposits.
The happy result will be that depositors, both insured and uninsured, in Europe and throughout the world will become much more cautious or even suspicious in dealing with fractional-reserve banks. They will be poised to grab their money and run at the slightest sign or rumor of instability. This will induce banks to radically alter the sources of the funds they raise to finance loans and investments, moving away from deposit and toward equity and bond financing. As was reported Tuesday, March 26, this is already expected by many analysts:
One potential spillover from the March 26 agreement is the knock-on effects for bank funding, analysts said. Banks typically fund themselves with some combination of deposits, equity, senior and subordinate notes and covered bonds, which are backed by a pool of high-quality assets that stay on the lender’s balance sheet.
The consequences of the Cyprus bailout could be that banks will be more likely to use contingent convertible bonds—known as CoCos—to raise money as their ability to encumber assets by issuing covered bonds reaches regulatory limits, said Chris Bowie at Ignis Asset Management Ltd. in London.
“We’d expect to see some deposit flight and a shift in funding towards a combination of covered bonds, real equity and quasi-equity,” said Bowie, who is head of credit portfolio management at Ignis, which oversees about $110 billion.
If this indeed occurs it will be a significant move toward a free-market financial system in which the radical mismatching of the maturities of assets and liabilities in the case of demand deposits is eliminated once and for all. A few more banking crises in the Eurozone—especially one in which insured depositors are made to participate in the so-called “bail-in”—will likely cause the faith in government deposit insurance to completely evaporate and with it confidence in the fractional-reserve banking system.
There may then naturally arise on the market a system in which equity, bonds, and genuine time deposits that cannot be redeemed before maturity become the exclusive sources of finance for bank loans and investments. Demand deposits, whether checkable or not, would be segregated in actual deposit banks which maintain 100-percent reserves and provide a range of payments systems from ATMs to debit cards.
While this conjecture may be overly optimistic, we are certainly a good deal closer to such an outcome today than we were before the “Cyprus deal” was struck. Of course we would be closer still if there were no bailout and the full brunt of the bank failures were borne solely by the creditors and depositors of the failed banks rather than partly by taxpayers. The latter solution would have completely and definitively exposed the true nature of fractional-reserve banking for all to see.
This article was previously published at Mises.org.
Once the public furor and shrill media coverage have died down it will become clear that events in Cyprus did not mark the death of democracy or the end of the euro but potentially the beginning of the end of deposit ‘insurance’. If so, then three cheers to that. It may herald a return to honesty, transparency and responsibility in banking.
Let us start by looking at some of the facts of deposit banking: When you deposit money in a bank you forfeit ownership of money and gain ownership of a claim against the bank – a claim for instant repayment of money but a claim nonetheless. In 1848 the House of Lords stated it thus:
Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it…The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted.
This is not legal pedantry or just a matter of opinion but logical necessity that follows inescapably from how deposit banking has developed, how it was practiced in 1848 and how it is still practiced today. If ownership of the money had not passed from depositor to banker than the banker could not lend the money to a third party against interest and he could not pay interest to the depositor. If the depositor had retained full ownership of the deposited money, the banker would only be allowed to store it safely and to probably charge the depositor for the safe-keeping of his property. Money stored in a bank’s vault earns as little interest as money kept under a mattress. It is evidently not what bank depositors contract for. If interest is being paid – or ‘free’ banking services are being provided – the depositor must have agreed – at least implicitly – that the banker can ‘invest’ the money, i.e. put it at risk.
For more than 300 years banks have been in the business of funding loans that are risky and illiquid with deposits that are supposed to be safe and instantly redeemable. When banks fail, depositors lose money, although in former times, sturdier and more honest, no rational person claimed that the depositors were unfairly ‘bailed in’ or were the victims of ‘theft’.
Although the mechanics of fractional-reserve banking have not changed in 300 years the public’s expectations have evidently changed greatly. Today banks are expected to lend ever more generously while depositors are supposed to not incur any risk of loss at all. This means squaring the circle but it has not stopped politicians from promising just such a feat: Enter deposit insurance. State deposit “insurance” is not insurance at all. Insurance companies calculate and calibrate risks, charge the insured party and set aside capital for when the insured event occurs. A state deposit ‘guarantee’, by contrast, is simply another unfunded government promise, extended in the hope that things won’t get that bad. When they finally do the state does what it always does: it will take from Peter to pay Paul. Cyprus is a case in point: Private insurance companies would have pulled the plug on a ballooning banking sector long ago while the Cypriot state, still the local monopolist of bank licensing and bank regulation, evidently looked on as the banks amassed deposits of four times GDP. In the end Cyprus’ government ran out of ‘Pauls’ to stick the bill to – and ‘Hans’ in Germany refused to get ‘bailed in’ completely (although he is still providing the lion’s share of the bailout).
Cyprus is just an extreme example of what the institutionalized obfuscation of risk and accountability that comes with state-protected banking can lead to. Deposit ‘insurance’ masks the risks and socializes the costs of fractional-reserve banking. Unlimited state paper money and central banks that assume the role of “lenders of last resort” have the same effect. If the original idea behind these innovations was to make banking safer, it has not worked, as banks have become bigger and riskier than ever before, although I suspect that the real purpose of these ‘safety nets’ has always been to provide cover for more generous bank credit expansion.
Under present arrangements there is little incentive for banks to position themselves in the marketplace as particularly conservative. Depositors have been largely desensitized to the risks inherent in banking. They no longer reward prudent banks with inflows and punish overtly risky banks with the withdrawal of funds, and even if they do, the banks can now obtain almost unlimited funds from the central bank, at least as long as they have any asset that the central bank is willing to ‘monetize’. This is a low hurdle indeed as banks have become conduits for the never-ending policy of ‘stimulus’ and are thus being fattened further for the sake of more growth. Once a bank has ‘ticked the boxes’ and meets the minimum criteria of regulatory supervision, any additional probity would only subtract from potential shareholder returns. Our modern financial infrastructure has created an illusion of safety coupled with an illusion of prosperity thanks to artificially cheapened credit. The risk of the occasional run on an individual bank has now been replaced with the acute and rising risk of a run on the entire system.
This would change radically if we reintroduced free market principles into banking. Bankers would again be answerable to all their lenders, including small depositors, who would no longer be lulled into a false sense of security but, in their correctly-understood role as creditors to the banks, would become ‘deposit vigilantes’ and would help keep the banks in check. The banks would again have to communicate balance sheet strategy and risk management to the wider public in order to gain and maintain the public’s trust, and not just to a handful of highly specialized bureaucrats at the central bank or the state’s bank regulator. Banking would become less complex, more transparent and less leveraged. Conservative banking would again be a viable business model. And the wider public would begin to appreciate how dangerous the populist policies of cheap credit and naïve demands for ‘getting banks lending again’ ultimately are. The depositors are underwriting these policies and carry a lot of their risks.
“When you’re one step ahead of the crowd you’re a genius. When you’re two steps ahead, you’re a crackpot.”
-Rabbi Shlomo Riskin
Lincoln Square Synagogue, February 1998
“I hold all idea of regulating the currency to be an absurdity; the very terms of regulating the currency and managing the currency I look upon to be an absurdity; the currency should regulate itself; it must be regulated by the trade and commerce of the world; I would neither allow the Bank of England nor any private banks to have what is called the management of the currency.
I should never contemplate any remedial measure, which left to the discretion of individuals to regulate the amount of currency by any principle or standard whatever… I should be sorry to trust the Bank of England again, having violated their principle [the Palmer rule]; for I never trust the same parties twice on an affair of such magnitude.”
Report from the Select Committee on Banks of Issue
British Parliament, April 1840
It is a great privilege to write this essay on money and banking reform to mark the retirement of Dr. Paul from Congress. We in the United Kingdom have much to thank Dr. Paul for his tireless campaigning on these issues, especially those raised in the full public glare of two Presidential campaigns, making money and banking reform resonate here as well more than it otherwise would have.
At the Cobden Centre, we have two great parliamentarians, like Dr. Paul also inspired by the Austrian School of Economics: Steve Baker, Member of Parliament (MP) for High Wycombe (my co-founder of the Cobden Centre); and Douglas Carswell, MP for Clacton. Taking the idea of full-reserve free banking, currency competition, honest accounting, and full open liability for bankers, they have produced four bills in Parliament which we will discuss next in summary.
The Financial Services (Deposit and Lending) Bill – 2010
Carswell describes the Deposit and Lending bill as follows:
My bill would give account holders legal ownership of their deposits, unless they indicated otherwise when opening the account. In other words, there would henceforth be two categories of bank account: deposit-taking accounts for investment purposes, and deposit-taking accounts for storage purposes. Banks would remain at liberty to lend on money deposited in the investment accounts, but not on money deposited in the storage accounts. As such, the idea is not a million miles away from the idea of 100% gilt-backed storage accounts proposed by other hon. Members and the Governor of the Bank of England.
Currency and Banknotes (Amendment) – 2011
Carswell describes the Currency and Banknotes Amendment as follows:
That leave be given to bring in a Bill to amend the Currency and Banknotes Act 1954 to allow banknotes in addition to those issued by the Bank of England to be legal tender; and for connected purposes. … My Bill would amend the Currency and Banknotes Act 1954 to enable a range of different currencies to be used as legal tender in Britain. The idea comes from a 1989 Treasury paper from when John Major was Chancellor. What the Treasury proposed as theoretically possible 22 years ago, the internet now makes practically achievable.
The internet has given people unprecedented choice. We have access to a greater range of music, financial services, groceries and books than ever before, so why do we have legal tender laws that create a monopoly currency?
In an email to me, Carswell expressed the influence Congressman Paul has had on his work:
Reading Ron Paul’s End the Fed gave me the confidence to speak out. I suddenly realised it wasn’t just a few of us Brits who doubted the whole fiat money/candy floss currency scam. He has given hope to those of us throughout the West.
Financial Services (Regulation of Derivatives) Bill
Steve Baker compiled the Regulation of Derivatives Bill with the help of Gordon Kerr, Tim Bush, and Kevin Dowd. When he introduced the legislation on 15 March 2011, he described the Bill as requiring “certain financial institutions to prepare parallel accounts on the basis of the lower of historic cost and mark to market for their exposure to derivatives; and for connected purposes.” Baker explained how the accounting rules for banks incentivize trading in derivatives by enabling unrealized profits to be booked up-front, leading to large but unjustified bonuses and dividends.
More broadly, banks are producing accounts that grossly inflate their profits and capital in three ways:
(1) Using mark-to-market and mark-to-model accounting, banks record unrealized gains in investments as profits.
(2) International Financial Reporting Standards (IFRS) prevent banks from making prudent provision for expected loan losses by allowing recognition only of incurred losses.
(3) IFRS encourages banks not to deduct staff compensation from profits.
Taken together, these flaws mean that banks’ accounts under IFRS are at once rule-compliant and dangerously misleading. The Regulation of Derivatives Bill deals with this broad problem. For much more detail, see Gordon Kerr’s Adam Smith Institute pamphlet, “The Law of Opposites.”
Baker compiled the Financial Institutions Reform Bill with the help of Gordon Kerr and Kevin Dowd. The bill was introduced on Wednesday, 29 February 2012. The key provisions of the bill would:
(1) Enforce strict liability on directors of financial institutions;
(2) Enforce unlimited personal liability on directors of financial institutions;
(3) Require directors of financial institutions to post personal bonds as additional bank capital;
(4) Require personal bonds and bonuses to be treated as additional bank capital;
(5) Make provision for the insolvency of financial institutions; and
(6) Establish a financial crimes investigation unit.
The purpose of this Bill is to minimise moral hazard within the financial system by ensuring that those who take risks are held personally liable for the consequences. Since rules can usually be gamed by financial institutions, a principle underlying this Bill is to minimise scope for evasion.
The public are rightly incensed at the injustices we see across the financial system but our economy must have responsible, innovative and enterprising financial services. It is essential that commercial freedom is maintained while creating a system in which remuneration is a just reward for success, not the unjust product of unrealised profits and bailouts.
My Bill would make directors of financial institutions personally liable for losses. It would ensure that losses came first out of institutions’ bonus pools then directors’ personal bonds before hitting equity. Directors would also be exposed to unlimited personal liability long before any suggestion of taxpayer bailout.
With key decision makers’ own wealth at risk, they would take responsible decisions instead of expecting rewards for failure.
It’s time to tell bankers, “Yes, innovate. By all means earn large rewards for providing valuable financial services. But bear your own commercial risks. Don’t expect the rest of us to bail you out.”
Public Attitudes to Banking: A Survey Commissioned by the Cobden Centre (2010)
When we started the Cobden Centre, we all thought we knew about money and banking and all thought we knew what our fellow Brits thought about it all. To the great credit of Prof. Anthony Evans, he said let’s do some empirical testing. And so the Cobden Centre commissioned a survey. This research formed the basis of much of the work our parliamentary friends have embarked upon.
The survey was conducted by the market research company ICM with 2,000 participants. The results offer us a rather confusing array of views as to what people think banking is about.
74% of respondents thought that they were the legal owner of the money in their current account, as opposed to the bank being the legal owner.
66% of respondents answered “don’t know” when asked what proportion of their current account was used in various ways by their bank.
15% wanted safe-keeping services.
67% wanted convenient access.
8% knew correctly that they had lent money to the bank.
33% think it is wrong that the bank lends out what they view as their money.
61% said they would not mind the bank lending if it was done safely.
26% wanted reserves to match deposits.
It would seem a sizeable minority percentage would want some form of safe-keeping services. Most would want easy access, which would imply short-term borrowing matched with short-term lending, so as to avoid runs, rather than the current practice of lending long and borrowing short.
The needs of savers and borrowers would be better aligned by requiring depositors to choose, at the time of making a deposit, how much money they wished to put into plain saving (i.e., savings set aside for safe/precautionary holding as opposed to investment purposes — a distinction made by the Austrian scholar Ludwig von Mises) and how much into capitalist saving (i.e., savings set aside for investment gain as opposed to safe/precautionary savings). This would provide the setting for, and lead to, much more stable and substantial growth.
In a modern setting, the ability for banks to distinguish between plain savings, those savings that people want for safe keeping, and savings for capitalistic investment via the normal savings bonds, time deposit accounts, and so on and so forth, would allow the banking system to mediate more accurately the diverse time preferences of all savers and borrowers. (The Manchester/Lancashire system of full reserve banking and private money creation that we will discuss in the last part of this essay is a good historical example of how mediating only capitalistic savings, and not plain savings, created a system of safe credit—until it was interfered with by the Stamp Act.)
The ICM survey showed all of us that there is a need to sort out what people actually think happens with their money and banking and what actually does happen—as the two things are very different.
The Jesus Huerta De Soto Monetary Reform Proposal in Summary
Some three years ago I was fortunate enough to introduce both of our Parliamentarian friends to the greatest of all the living Austrian School economists in the full reserve tradition, Professor Jesus Huerta De Soto. His 1998 book, translated into English in 2006 as Money, Bank Credit, and Economic Cycles, is the seminal treatise on the matter.
In chapter nine, he outlines his reform proposal. (All quotes in this section are taken from chapter nine and the full book can be downloaded at http://www.cobdencentre.org/tag/downloads/.) The aims of the reform, as summarized by Prof. Huerta De Soto himself, are as follows:
[O]ur proposal is based on privatizing money in its current form by replacing it with its metallic equivalent in gold and allowing the market to resume its free development from the time of the transition, either by confirming gold as the generally accepted form of money, or by permitting the spontaneous and gradual entrance of other monetary standards.
This second element of our proposal refers to the necessity of revoking banking legislation and eliminating central banks and in general any government agency devoted to controlling and intervening in the financial or banking market. It should be possible to set up any number of private banks with complete freedom, both in terms of corporate purpose and legal form. …
Nevertheless the defense of free banking does not imply permission for banks to operate with a fractional reserve. At this point it should be perfectly clear that banking should be subject to traditional legal principles and that these demand the maintenance at all times of a 100 percent reserve with respect to demand deposits at banks. Hence free banking must not be viewed as a license to infringe this rule, since its infringement not only constitutes a violation of a traditional legal principle, but it also triggers a chain of consequences which are highly damaging to the economy. 
The crux of his reform proposal is as follows (the description is mine and made UK-specific by me — read chapter nine in full for the complete version in the Professor’s own words):
(1) All demand deposits are immaterial money, and are not the depositor’s money but a liability from the bank they deposit with to pay them back money in the same amount as deposited, on demand.
(2) Let the government back all these demand deposits for physical cash and place them as reserves against the existing demand deposits. This is virtually a costless activity on behalf of the state. It is also not inflationary, as the backing, the physical cash, cannot be spent, as it sits in reserves.
(3) The money supply can neither expand nor contract at this specific point.
(4) The banks, where they had current liabilities, now no longer have them as they are fully reserved.
(5) This generates a one-off gain to the banks in terms of their net worth. In short, so much as they had these current demand liabilities, now they have these backed with paper notes for the same value, so their net worth has gone up by the equivalent amount.
(6) The asset side of the balance sheet, their loan portfolio, stays intact.
(7) As there are over £1 trillion of demand deposits in the UK banking system, the banking system’s net worth would have risen by £1 trillion.
(8) Why give this one-off gift of largesse to the shareholders and bonus-hungry bankers? Well, don’t. Form special purpose vehicles to hold the asset side of the balance sheets of the banks to collect on these outstanding loans and you can contract out the management of this to the existing banks.
(9) By doing this, the banks’ net worth on the day after the reform is still the same as the day before the reform, but the £1 trillion loan repayments are now paying off our national debt obligations. This is a unique one-off gain and is a byproduct of this reform.
(10) The gold price would need to rise to back all the deposits with gold and then you fix all money in one of its historic anchors: gold (you could also use silver or other successful monies). Since gold increases in physical supply at the rate of approximately 2% per year, if productivity gains run at about this rate you will have stable prices; if productivity rates are greater, then a benign price deflation.
(11) Let the people spontaneously discover what their most favoured money actually is.
In short, I would have no-reserve banking, not 100% reserve. By this, I have suggested that all demand deposits should actually be swapped out for physical cash and the current liability of the bank just rubbed out. Then the people would actually own their own money on deposit and not be current creditors, thus I would question the need to perform point number two and substitute along the lines of what I just suggested.
Would 100% Reserve Free Banking be the End of Lending and the End of Commerce as We Know It?
This is the question that gets asked when most people have understood that 100% reserve banking would be the end of bank-created credit. Many credible and distinguished people attribute the creation of bank credit as the source of the Industrial Revolution itself. Such a powerful thing is alleged. The noted Daily Telegraph writer Ambrose Evans-Pritchard says in his 21 October 2012 column:
One might equally say that this opened the way to England’s agricultural revolution in the early 18th Century, the industrial revolution soon after, and the greatest economic and technological leap ever seen. But let us not quibble.
For those followers of Dr. Paul and those generally interested in monetary reform in this tradition, I did some research into the genesis of the Industrial Revolution to see if this assertion held any merit. I have focused my research into the County of Lancashire and what became the first industrial city of the world, Manchester. In this concluding historical section, I will show that in the first third of the Industrial Revolution, private credit, bills of exchange, backed by the goods and services that were being traded for and by gold and silver, was the preferred modus operandi. The taxation of this private money by the 1815 Stamp Act led to their slow decline in favour of the privileged note issue of, in particular, the Bank of England. However, by late 1874 some 45% of all credit was still private credit in the form of bills of exchange. Private credit was the preferred medium of the Industrial Revolution, and not bank-created fiduciary credit.
Early Banking in Manchester
The historian Arthur Redford in his book about merchants and foreign trade in Manchester described the early bankers of the town:
The first Manchester Bank, that of Byron, Sedgwick, Allen, and Place, was opened in 1771, in combination with an insurance office, and the Mercury welcomed it with the comment that “from the general Approbation the Scheme has met with amongst all Ranks of People, it is not questioned that it will be of infinite Utility to the Trading Part of the Town, and to the County in general.” …. It was not the only Manchester banking business, for in 1772 John Jones and Co. were “Bankers and Tea Dealers” and within thirteen years were to have offices in London from which Jones Lloyds sprang. In Liverpool also most of the early bankers, says their historian, “arose out of general merchants, some few from tea dealers, and one from linen merchants.” Even after declaring themselves bankers, the banking business was usually continued along with trading. But the use of the term banker was late, and until almost the end of our period the commerce of Liverpool, with its complex dealings in foreign exchange, and the internal trade of Lancashire seem to have been carried on mainly through the bill discounting side of the merchants’ and traders’ businesses. In Liverpool marine insurance broking was closely allied.”
The key thing I observe here is that in the first part of the Industrial Revolution the issue of notes (which were the chief means of bank fiduciary credit) was a side issue and bills of exchange were the main mechanism to facilitate this massive explosion in trade. Also, this first bank in the UK’s main industrial area was nearly 100 years behind the establishment of the Bank of England and the Scottish public banks.
Data supplied by Prof. Angus Maddison shows us that from 1700 to 1820 there is 338.38% growth in measured economic activity. The next 130 years saw 960.06% growth when the Industrial Revolution was in full flow. Nevertheless, with the initial explosion of activity in the mid- to late-1700s, to the early 1820s, we see the prime industrial county in the world exist with few or no banks and banks not providing credit services as we know them today, and clearly not to its detriment.
Economic historian T. S. Ashton quotes William Langton (a driving force behind the founding of the Manchester Statistical Society in 1833) writing later in the 19th century:
“It is exceedingly natural,” said Langton, “that those banks which still retain the privilege of issuing their own notes should desire to retain it, since it naturally adds to their profits; but it has always been recognised in the great industrial district of Lancashire that it is no essential condition to the wielding of manufacturing and commercial enterprise, and that the banks not possessing this privilege have not stinted their customers of any legitimate accommodation.”
Langton also notes their usefulness vis-a-vis other modes of money:
My personal memory of trade only extends back to the year 1820; but at that time the Liverpool merchants received nothing but bills in payment from Manchester of their cotton invoices; every such payment, if in what was called promiscuous paper, requiring a calculation of interest to make a settlement per appoint. This practice gradually disappeared with the resumption of cash payments by the Bank of England and the lowering of the standard rate of interest; but if economy of interest of money is to be taken as the special recommendation of any particular kind of circulating medium, this one surely ought to bear the palm!
W.T. Crick and J.E. Wadsworth note the significance of Manchester and the nearby City of Liverpool by observing:
Yet, in spite of Lancashire’s advanced industrial organization, banking was rather later to develop than in some other areas. No banks are recorded in Manchester until 1771 or in Liverpool until 1774, and when eventually they were formed, they do not appear to have acquired note circulations except in a few unimportant instances.
Ashton describes the special preference for bills of exchange over notes:
These are reasons explaining the ubiquity of bills of exchange at this period. The special preference of Lancashire for bills rather than notes is a matter deserving of research. It arose, no doubt, out of a high degree of commercial confidence, no less than out of a low degree of trust in note-issuers, and the fact that Lancashire bought raw material from distant places and sold products in distant markets must also have engendered a preference for a document the circulation of which was not confined to the sphere of operations of a local bank. As time went on the domestic bill came to play a smaller part in commercial transactions: the increase of the stamp duties after the Napoleonic War dealt a blow to the system; and the growth of large banks of deposits with many branches, together with the shortening of the customary terms of credit, led to a substitution of cheques for bills in inland trade during the later decades of the nineteenth century. But in the period with which we are concerned cheques were in their infancy and the bill had no serious rival as a medium of exchange between traders.
Ashton also gives us clues as to why they have almost vanished today from the commercial idiom as the stamp duty applied to them was less advantageous vis-a-vis note or chequebook issue as the latter provided quicker redemption in money possibilities.
If we dig a bit further into the historical record we see that these bills arose spontaneously to fulfill a need to be able to facilitate the smooth transmission of trade. A wonderful book written by Alfred P. Wadsworth & Julia De Lacy Mann, The Cotton Trade and Industrial Lancashire 1600-1780, documents this history quite thoroughly:
We have seen Marsden as a manufacturer, putting out cotton and yarn through his agent and debiting the materials and wages against the value of the finished goods. On the other side he maintained a London house, through which he bought his raw materials and sold his fustians, and in connection with which he conducted extensive operations as a bill discounter. Between 1688 and 1690 he was involved in a maze of lawsuits, from which some account of his business may be constructed
Having “constantly great and considerable sums of money in his hands” [Marsden] lent money to other dealers in return for their bills on London; or he “furnished them with bills of exchange for payment of considerable sums of money at London to them or their order, or to such persons as they appointed to receive the same,” either receiving cash, or, generally, giving them credit at an agreed rate of interest. When they failed to pay him for the bills he had given them, he would take an assignment of their goods at Liverpool —cotton or linen yarn, promissory notes, or bills drawn on their London debtors. But apart from his own trading credit, he had “for many years past been intrusted or employed with greate parte of the monies retorned out of the county of Lancaster to London.”
Marsden the industrialist had become the banker as well as the chief remitter of revenues back to Lancashire and the principal collector of taxes. Daniel Defoe, trader, writer, and journalist, remarked in 1727, that:
[A] very great part of the bills drawn out of the several counties in England upon the tradesmen in London, such as factors and warehousekeepers, are made payable to the General Receivers of the several taxes and duties, customs and excise, which are levied in the country in specie, and the money is remitted by those collectors and receivers on account of those duties; this generally appears by the bills or endorsements, which often mention it in these words for his Majesty’s use.
Thus credit was granted and discounted bills accepted and paid with specie, not with notes or other such fiduciary credit. The Crown accepted these bills!
In commenting upon the various inaccuracies with traders being bankers, after an extensive investigation into the disputes listed in the court records, Wadsworth and Mann conclude:
Much might be said of the use of the bill in the general system of credit, but enough, perhaps, has been suggested in earlier pages to indicate its importance. The bill on London, then as a century later the dominant form, entered at every stage, and into every form of transaction, ran from the smallest to the largest sums, and passed even more freely than cash. The financial mechanism which turned on the bill, the promissory note, and other credit instruments, and has here been summarily illustrated, bulks large in all the commercial manuals of the time. … It is apt to be forgotten that the credit machinery of industries like the textile trades was hardly less extensive before the foundation of the country banks than it became after.
Unwin, Hulme, and Taylor did a fantastic investigation into the affairs of Samuel Oldknow and his mill at Mellor. There is also some evidence to show why Lancashire rejected bills vs. notes:
Enough has been said to show the almost desperate condition of Oldknow’s affairs at the beginning of 1793. He had invested an immense capital—for those days—in the fixed forms of land, buildings, and machinery which could not yield any return without the assistance of commercial credit—and owing to the outbreak of war commercial credit had almost ceased for the time being to exist. No fewer than 872 bankruptcies were recorded between November 1792 and July 1793. The problem of credit currency became acute. The country banks, which had multiplied greatly during the previous decade, had produced an over-issue of notes, some of them for such small amounts as to provoke the derisive issue by a Newcastle cobbler of a note for two-pence. But the notes even of the sounder banks were now returned on their hands and many were obliged to close their doors.
The instability that these free banks issuing fiduciary credit afforded the industrialist in the times of crises was very destabilising, as you did not want to become a creditor to a bankrupt banker. This is one way to accelerate your own potential to become bankrupt. So commercial credit, or bills backed by real goods, was sought in preference.
Why did these Lancashire Bills Decline?
Henry Thornton, an economist, banker, and Parliamentarian, commented on the demise of bills to the favour of notes in 1802: “Some Bank of England notes have also been recently employed in the place of small bills on London, the use of which has been discouraged by the late additional duty on bills and notes.”
Redford discusses the response of Manchester merchants to the duties and taxes imposed on bills of exchange:
A much more protracted struggle, extending throughout the second quarter of the nineteenth century, was waged by the Manchester merchants against excessive stamp duties on various kinds of legal documents. … Bills of exchange and promissory notes were first subjected to stamp duties in 1782; a general Stamp Act of 1815 had increased the duties, which thenceforth discriminated between short-dated and long-dated bills. In the post-war period the average duty on all bills of less than £50 was 1/2 per cent.; but this charge was felt to be prohibitive, and had in Manchester caused bills to be almost completely replaced by bank notes. Bank notes, however, were considered to be a much more inconvenient and risky means of payment, since they were payable “to bearer” and not “to order.” The Manchester Chamber of Commerce therefore moved in 1822 for the reduction of the duties, and sent up several petitions on the subject, to the Prime Minister, the Chancellor of the Exchequer, and the Houses of Parliament. The petitioners described the serious inconvenience to business which had resulted from the virtual extinction of “a description of currency of great convenience and security”; they suggested a greatly reduced scale of duties, and argued that, if this were adopted, not only the business community but also the revenue would benefit greatly, because of the increased use of bills of exchange.
The Bank of England (BoE) was still a private bank at the time. However, as the government’s favoured bank it had certain privileges and was always lobbying for more. The 1815 Stamp Act made the reissue of bills of exchange virtually impossible. Some were taxed up to 460% higher than Bank of England note issue, or subject to great penalty that made the issue of private credit by other banks more expensive than BoE note issue. In 1825 the Bank of England set up a branch in Manchester specifically to take advantage of the terrible taxation placed on private bill issue and make sure that those pioneers of the Industrial Revolution had to take BoE credit.
The significance of Manchester as the prime industrial area of the world at the time does make it a meaningful and worthy study area from which we can extrapolate, hopefully, our findings to the wider canvas of today and I submit that in the absence of bank-created credit we, like our ancestors, have nothing to fear. Indeed, like the pioneers of the Industrial Revolution, we should embrace private money solutions such as bills of exchange and rely on the lending of real savings to provide real capital to entrepreneurs and not bank credit created out of nowhere. Full-reserve systems are not only stable, but growth enhancing. Lending does not die as many advocates of fractional reserve banking dread.
 Although the City of Manchester is now part of Greater Manchester or the Greater Manchester Urban Area, prior to 1835 it was part of the Salford Hundred of the county of Lancashire. By 1853, it had reached full City status. So for the majority of this essay’s focus, when Lancashire is referred to, it certainly should be read to be synonymous with what is the heart of Manchester City today. Also, you will see Liverpool mentioned as well, often in the same light as Manchester. This is due to their close geographic connection and the Port of Liverpool being often the import and export venue for the Manchester manufacturers.
 Dun, John. British Banking Statistics. London: E. Stanford, 1876, p. 87.
 Redford, Arthur. Manchester Merchants and Foreign Trade. Manchester: Manchester University Press, 1934, p. 248.
I am usually inclined to encourage the inquiry of the fundamental aspects of money and banking. This is because I tend to believe that only by going back to first principles is it possible to cut through the thicket of widely accepted but deeply flawed theories that dominate the current debate in mainstream media, politics and the financial industry. From my own experience in financial markets I can appreciate how convenient and tempting it is in a business context, where quick and easy communication is of the essence, to adopt a certain, widely shared set of paradigms, regardless of how flimsy their theoretical foundations. Fund managers, traders and financial journalists live in the immediate present, preoccupied as they are with what makes headlines today, and they work in intensely collaborative enterprises. They have neither the time nor inclination to question the body of theories – often no longer even perceived as ‘theories’ but considered accepted common wisdom – that shapes the way they view and talk about the outside world. Thus, erroneous concepts and even outright fallacies often remain unquestioned and, by virtue of constant repetition, live comfortably in the bloodstream of policy debates, economic analysis, and financial market reportage.
This goes a long way in explaining the undeserved survival of a number of persistent modern myths: deflation is the gravest economic danger we face; Japan has been crippled by deflation for years and would grow again if it only managed to create some inflation; lack of ‘aggregate demand’ explains recessions and must be countered with easy monetary policy; and money-printing, as long as it does not lead to higher inflation, is a free lunch, i.e. we can only expect good from it. None of these statements stand up to scrutiny. In fact, they are all utterly absurd. Yet, we can barely open a newspaper and not have this nonsense stare us in the face, if not quite as bluntly as stated above, than at least as the intellectual soil from which the analysis or commentary presented has sprung. Deep-rooted misconceptions can only be dismantled through dissection of their building blocs and a discussion of basic concepts.
The dangers of going back to basics
However, going back to basics and to first principles, analyzing critically the fundamental aspects of our financial system, is not free of danger. Here, too, lies a minefield of potentially grave intellectual error, and when things go wrong here, at the basic level, the results and policy recommendations derived from such analysis are bound to be nonsensical too, if not even more nonsensical than what the mainstream believes. In this and the following essays I am going to address some of the erroneous notions at the fundamental level of money and banking that seem to have gained currency in the public debate of late.
I get periodically confronted with these confusions through readers’ comments on my website. Some of the questions and suggestions expressed there reveal the same, or very similar, errors and misunderstandings, and these often seem to have their origin in other publications circulating elsewhere on the web. Among them are the following fallacies, in no particular order:
The idea that the charging of interest, or in particular the charging of interest on money, is a fundamental problem in our financial system.
The notion that there must be a systematic shortage of money in the economy because banks, through fractional-reserve banking, bring into circulation only amounts of money equivalent to the principal of the loans they create but not the necessary amount to pay the interest on these loans.
The notion that it is a problem that money-creation is tied to debt-creation (again, as a consequence of fractional-reserve banking) and that it would be possible and advantageous to have the state issue money directly (debt-free) rather than have the banks do it.
The idea that schemes are feasible that allow the painless shrinkage or even disappearance of the national debt.
All these ideas are nonsensical, based on bad economics and fundamental logical flaws, and to the extent that they entail policy proposals, these policies, if enacted, would not only not give us a stable and more prosperous economy but would surely lead to new instabilities or even outright chaos.
None of these misconceptions originate, or even resonate, as far as I can tell, with the ‘mainstream’. The mainstream – the financial market professionals, the central bankers, financial regulators, and the media – remain resolutely uninterested in dealing with fundamental questions of money and banking for the reasons given above. Here, the discussion continues to centre on how the economy can be ‘stimulated’ more, what ‘unconventional’ policies the central banks may still have up their sleeves, and if the central banks need new targets or better central bankers. Icebergs or no icebergs, these deckchairs need re-arranging.
But, outside the mainstream, among certain think tanks, ‘activists’, bloggers and some economists, even those at the IMF, the appetite for fundamental analysis has grown. In many cases this has led to utter confusion, as I will show in this set of essays.
I should declare a personal interest here. I feel the need to make my disagreements with these ideas and the resulting policy proposals as clear as I can as, on more than one occasion, casual readers of my website seemed to have assumed some sympathy on my part with the erroneous ideas put forward by others. The mere fact that somebody else also focuses his or her attention on the system’s same fault-lines, such as, for example, the instabilities created by fractional-reserve banking, has led them to believe that we must share considerable intellectual ground and arrive at similar conclusions and policy recommendations. Sometimes this confusion may be the result of a lack of familiarity with my work, sometimes with a lack of knowledge of or attention to the precise concepts articulated by others. In any case, this confusion needs to be cleared, partly because I do not want to be associated with what I consider economic nonsense, and partly because articulating the differences – and highlighting what, in my view, are the mistakes of the other side – should further clarify the issues and improve the debate. As I already said, the mix-up is usually greatest when the topic is fractional-reserve banking. So let me start right here:
Fallacy 1: As fractional-reserve banking is a source of economic instability, it would be better to force the banks to become fully-reserved banks with no ability to create money, and have the state create all money directly and inject it – wisely – into the economy. This would allow us to enjoy the benefits of more money without suffering the disadvantage of more debt. We may even use this process to reduce or eliminate existing debt.
This is the position of UK ‘think tank’ – or pressure group? – Positive Money, which has proposed legislative changes in the UK based on its analyses. Positive Money enjoys the support of the UK’s left-leaning ‘new economics foundation (nef)’ (so egalitarian and new age is nef that it doesn’t allow any capital letters undue dominance in the writing of its name) and of the Centre for Banking, Finance and Sustainable Development at the University of Southampton. Together these organizations have submitted a policy proposal to the Independent Commission on Banking.
The starting point of ‘Positive Money’s’ thesis – namely, that fractional-reserve banking is a source of economic instability – is essentially correct. But – as I will show in this essay – their analysis of fractional-reserve banking is incomplete, and their view lacks entirely any deeper understanding of money demand and of how changes in money demand are being met naturally in a market economy. Moreover, Positive Money has no perception of the necessary – and necessarily disruptive – effects of money-injections into the economy, regardless of who injects the money, and seems completely blind to the obvious disadvantages of channeling all new and free money through the state bureaucracy. Having shown – a bit flimsily and without resorting to any theories of capital or business cycles – that fractional-reserve banking is problematic, Positive Money seems to have exhausted its critical faculties and jumps hastily to the conclusion that the privilege of money-creation should be given to a wise, independent and benevolent state agency. The arguments of Positive Money are economically unsound and politically naïve and dangerous.
If these resolutely anti-banking and pro-government proposals sound familiar to readers of this website, it is because they resemble the ones put forward by economists Benes and Kumhof in their widely quoted, less widely read and apparently even less understood IMF working paper 12/202, which I attempted to dissect here. In the following I will not repeat my criticism of Benes/Kumhof. Neither Benes/Kumhof nor Positive Money provide a single economic argument to support the claim that the state is a superior guardian of the privilege of money creation. This is not surprising because there is no such argument. Yet, we have to be grateful to Positive Money for at least not resorting to the bizarre line of reasoning that Benes and Kumhof came up with, namely that in order to improve upon our modern monetary order we have to first discover the ‘true nature of money’, which is apparently not open to the theoretical investigation of economists but can only be unlocked by anthropologists who tell us how money came about in primitive society thousands of years ago, and by certain monetary historians who re-interpret the historical record to tell us that the privilege of money creation has always been safe – and thus, in a logical jump of breathtaking audacity, is assumed to always be safe in the future – in the hands of government. Such mysticism is an insult to any true historian and to any proper economist. Sometimes it may be better to have no explanation at all than to put forward such rubbish. So thank you, Positive Money, for sparing us this nonsense.
Some thoughts on fractional-reserve banking
Let us start by briefly sketching the key problems with fractional-reserve banking.
Most of what we use as ‘money’ today is deposit-money and thus an item on a balance sheet of a bank. This form of money has come into existence through the banking system’s lending activities, i.e. through fractional-reserve banking.
Banks, for as long as they have been around, have never only just channeled saved funds into investments, such as fund management companies do today. Banks have always also been in the business of creating money derivatives (or fiduciary media), that is, financial instruments that are treated as money proper by the public (usually because they were issued with a promise of instant redemption in money proper), and thus circulate in the economy next to money proper. This process allows banks to fund a portion (and potentially a large one) of their lending through their own issuance of money derivatives, although today hardly anybody even distinguishes any longer between money proper and bank-created money derivatives. In a way, it can be said that the banks extend loans by drawing cheques on themselves and having these cheques circulate in the economy as money (and in the hope that they won’t be cashed!). These ‘cheques’ used to be the banknotes of the olden days, when banks were still allowed to print them, today there are deposit money, items on a bank balance sheet, like your current account balance.
This form of banking has made a considerable expansion of money in the economy possible. Fractional-reserve banking has been conducted in some shape or form for 300 years, and its effects on the economy have been the focus of the attention of economists for about as long (Cantillon, Ricardo, Mises – to name just some of the most outstanding social scientists dealing with it). Economists have long suspected, and over time have become ever more successful in demonstrating, that this activity is the source of economic instability. Fractional-reserve banking – and the elasticity of the supply of money that it creates – helps explain business cycles.
In my book Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown– I explain in some detail why elastic money is so undesirable, making use of the seminal work of Ludwig von Mises, in particular. In order to understand the full range of problems with fractional-reserve banking in a modern economy we need some knowledge of the origin and role of interest rates, of the nature of what is called ‘money demand’, of investment and saving, and thus the rudimentary elements of a theory of capital. I cannot provide this in a blog post and I am not going to try. Let it suffice to say that the extra money created by banks lowers interest rates on credit markets and expands the supply of investible funds beyond the volume of available true savings. Thus, investment and saving get out of line, misallocations of capital ensue, and what appears like a solid economic expansion for a while is ultimately revealed as an artificial and unsustainable credit boom that will end in a recession. Sustainable growth requires investment funded by proper saving, i.e. by the voluntary reallocation of real resources from present consumption to future consumption (that is saving). Bank credit expansion creates a dangerous and fleeting illusion of the availability of more savings, which means more resources for investment projects that are in fact not there.
Should fractional-reserve banking be banned?
Do I have some sympathy for the proposal to ban fractional-reserve banking? Well, I do agree that an inelastic monetary system, for example a 100% gold standard, would be the most stable (least disruptive) monetary system. (Interestingly, this is not what Positive Money suggests, but more about that later.) But I do not believe that fractional-reserve banking should be and can realistically be banned. Not only because it has been around for so long but also because the exact definition of what is being used as money by the public in a dynamic monetary economy at any moment in time must remain fluid. Financial intermediaries will always succeed in periodically bringing ‘near-monies’ into circulation and thus become de facto money producers, at least for a while.
Furthermore, there is no legal case for banning fractional-reserve banking. It is, in my view, not fraudulent (as some modern Austrian School writers maintain) and there is no basis for banning it on standard property rights considerations. Moreover, there is also little need to ban it as we can, in my view, rely on market forces and the superior regulators of capitalism – profit and loss – to ultimately keep it in check. (Some economists dispute this but here is not the place to discuss this point in detail. I will argue my case below. However, it is not even essential for a critique of the ideas of Positive Money.)
I think that the most straightforward and most obvious solution to these problems is that we remove the extensive framework – erected and maintained by the state – to actively support and systematically subsidize fractional-reserve banking. This means removing the institutions – implemented through acts of politics and maintained through acts of politics- of unlimited fiat money, which means unlimited bank reserves, and of lender-of-last-resort central banks that have the power to issue such unlimited bank reserves. Unlimited state fiat money and central banks are today the indispensable backstops for large-scale fractional-reserve banking activities of the nominally ‘private’ banks.
If fractional-reserve banking is disruptive – and I agree with Positive Money that it is – should we not – as a first step and before we even consider such authoritarian measures as universal bans – take away the state-run support system for fractional-reserve banking by which the banks and their clients are systematically shielded from the consequences of their activities, and through which the true costs of fractional-reserve banking are persistently being socialized?
Fractional-reserve banking and the state
What the folks at Positive Money fail to appreciate is that in a free market the ability of banks to create money is severely restricted. A deposit at bank X is only considered ‘money’ by the public to the extent that this deposit can be used for transactions with potentially everybody else in the economy, that is, not just with other customers of bank X but also any non-customers of bank X, and this is only the case if the deposit remains instantly redeemable in money proper (let’s say, gold or, in today’s world, state paper money) or can be transferred to any other bank. Thus, bank X runs the constant risk that its customers demand redemption of the type of money it CAN create (the deposit that sits on its own balance sheet) in a form of money that it CANNOT create: gold, state paper money or deposits at the central bank that are required for transfers to other banks. (Hint: these are the ‘reserves’ from which fractional-reserve banking gets its name!)
In an entirely free market, in which the state does not interfere in the economy and in which there is no central bank and no fiat money but in which money proper is necessarily a commodity chosen by the market, one the supply of which is outside political control or anybody else’s control for that matter, such as is the case with gold, in such a system fractional-reserve banking is an inherently risky enterprise. The constant fear of requests for large redemptions will severely restrict the ability of private banks to lower their reserve ratios and fund large parts of their lending by issuing ever more money derivatives. Each additional bank deposit that is created out of thin air will increase the risk of a bank run, which, in a world without central banks, bailouts and state deposit insurance, must lead to the failure of the bank.
Sure, banks may still be tempted to issue more deposit money but it requires a somewhat strange view of human nature to expect that even after a number of bank runs, in which bank shareholders and most depositors were wiped out, financially speaking, fractional-reserve banking would merrily continue and could in total be conducted at anywhere near the scale it is today, when banks do not have to content themselves with strictly limited reserves and do not have to operate under the constant risk of business failure but can safely rely – or, at least rely to a much larger degree than in a free market and a hard currency system - on an unlimited and constantly expanding pool of fiat reserves provided by lender-of-last resort central banks, and where depositors need to pay no attention to the soundness of the various deposit-taking institutions as they simply rely on the blanket cover provided by the state.
Positive Money’s account of fractional-reserve banking makes it appear as if the state and its agencies were simply innocent and powerless bystanders in the business of money creation, rather than active promoters of and eager and indeed indispensable accomplices in the exercise. Positive Money creates the impression that bloated bank balance sheets, real estate bubbles and excessive debt levels had all been created by scheming and out-of-control private banks, entirely on their own accord and behind the back of an unwitting and clueless state, rather than constitute the inevitable consequences of an institutional framework built on the widespread belief that constant bank credit expansion is a boon to the economy.
The truth is that the state, beholden to the generally accepted fallacy that cheap money – and even artificially cheapened money- is a source of prosperity and that we should never allow credit contraction or deflation, has actively supported the gigantic money creation of recent decades. Without an essentially unlimited and ever cheaper supply of bank reserves from the state central banks, private banks could never have expanded their balance sheets so aggressively and issued such vast amounts of deposit money.
Or, to put this differently, had the state wanted to stop or restrict the creation of deposit money by the banks at any point, the state – in form of the central bank – could have done this at the drop of a hat. Restricting the availability of new bank reserves and/or making bank reserves more expensive would have instantly put the brakes on fractional-reserve banking. Not only did the state not choose to do this (at least not for the past few decades), to the contrary, whenever the banks had maneuvered themselves into a position where they thought it themselves prudent to stop or at least slow down their balance sheet expansion for a while in order to protect limited capital or their limited reserves, the central banks invariably cheapened bank reserves further, specifically to encourage further deposit money creation.
In the present context, any criticism of fractional-reserve banking must include, in order to be consistent and complete, a rebuttal of the false beliefs in the benefits of cheap money and criticism of the state’s systematic support for this activity. Positive Money evidently fails to appreciate the role of state institutions and government policy in the present process of money creation or it would argue much more simply and straightforwardly for the voluntary restriction or abandonment of these policies first, and it would be less eager to hand full control over monetary affairs to the state.
Money injections must result in resource reallocations and mis-allocations
Furthermore, a proper understanding of fractional-reserve banking, one that is based on monetary economics and that does not stop at the most apparent symptoms of bank credit expansion, reveals that its core problem is its disruption of the pricing process that would normally co-ordinate economic activity smoothly (in this case, the co-ordination through market interest rates of voluntary saving with investment activity). The problem with fractional-reserve banking is precisely that it leads to persistent misallocation of resources. Would it not be sensible to ask if money injections through the state bureaucracy would also result in very similar or maybe even larger misallocations of resources or misdirection of economic activity?
This seems indeed very likely. We all know that whenever the market is replaced with administrative decisions by a bureaucracy, the results will be suboptimal as the bureaucrat has to make his decisions without the help of market prices, for if he would allow market prices to guide resource use and economic activity there would be no reason for his intervention in the first place. He might then as well leave everything to the market. It is precisely the political decision that the market should not be allowed to allocate resources through market prices and the profit and loss calculations of private enterprises that is the excuse for state involvement in the economy. According to the proposal by Positive Money, a state agency would determine centrally how much money the economy needs and then give this money to other departments of the state, which would spend it according to how it sees fit.
Positive Money does not provide any mechanism for how the state agency might determine who in the economy experiences a higher demand for money, and how the money would get to where it is needed. This is not surprising because there can be no such process, as I will explain shortly. According to Positive Money, the state agency would simply make a macro-level decision as to the amount of new money supposedly needed and hand the necessary amount over to other departments of the state (without the standard process of double-entry bookkeeping that is used today, I might add, by money-creating central banks. According to Positive Money’s proposal, the money is simply created and handed over to the state bureaucracy as a gift.) By putting this money into the economy the state will, of course, exert a tremendous influence on the pricing and the allocation of resources and the direction of economic activity. This does not bother Positive Money. It is simply assumed that this must be better than having private banks do this via the credit market.
It is clear that Positive Money has not fully understood why fractional-reserve banking is harmful. For a functioning economy an uninhibited pricing process for all resources is required in order to direct the use of these scarce resources in accordance with the preferences and demands of consumers. Fractional-reserve banking systematically distorts the pricing process (it corrupts the coordinating properties of interest-rates) but Positive Money suggests to replace it with a process that does away with market prices altogether, and that consists of the arbitrary and politically motivated allocation of resources through a state bureaucracy (even if the central bank is, as Positive Money naively assumes, ‘politically independent’ the departments of the state that are the first recipients of the new money and that decide how the money gets injected into the economy are certainly not).
Apart from the well-established and justified reasons to be suspicious of substantial state control over any part of the economy, there are other reasons to reject this proposal. As I have shown in Paper Money Collapse, EVERY injection of new money into the economy, regardless by whom, has to occur at a specific point from where the new money will disperse through a number of transactions. This process must always – from the point of view of a smoothly functioning, uninhibited market economy – lead to disruptions. It can never be neutral and it can certainly never enhance the functioning of the economy, or lead to a better plan-coordination between economic actors. Money injections always lead to arbitrary changes in relative prices, reallocations of resources and redistribution of wealth and income, without ever enhancing the wealth-generating properties of the economy overall. Money injections never benefit everyone, they always create winners and losers. It does not matter who injects the money.
Is a money producer needed at all?
Given all these problems, is it really necessary that anybody in the economy has the privilege of creating and allocating new money? Once fractional-reserve banking has been banned and money-creation by the banks has ceased (or, in my scenario, once the support for fractional-reserve banking has stopped and money-creation by banks has been much reduced), why not leave the economy to operate with a given and stable quantity of money?
“But that doesn’t necessarily mean that the economy will run smoothly on a fixed amount of money – we may still need to increase the amount of money in the economy in line with rises in population, productivity or other fundamental changes in the economy.”
Positive Money does not explain why this should be the case, simply because there is no reason why this should be the case. The quote above reflects another widespread fallacy about money, namely that a growing economy somehow needs a growing supply of money. Many people will find intuitively that this makes sense. Yet, on further reflection anybody who thinks for a minute about the purpose of money and about how we all use money every day can see quickly that this statement is without any basis in fact and lacks any economic logic.
A growing economy does not need a growing supply of money and therefore does not need a money producer. On the basis of a stable and given supply of widely accepted money the public can satisfy ANY demand for money it may have.
The person who has demand for money never has demand for a specific quantity of money. Nobody who demands money has demand for a specific number of paper notes or a specific weight in gold coins or a certain quantity of bits on a computer hard drive (or whatever is used as money). We have demand for a certain quantity of money because of what we can buy with it, and this depends not on the quantity of the monetary asset as such but on its exchange ratio versus non-money goods. We always have demand for money’s exchange value, for what we can buy with it, for its REAL purchasing power. The value that money has for us, it has because of its purchasing power in trade. Money does not have direct use value, such as any other good or service.
Whether a certain quantity of cash is sufficient for me to carry with me for a good night out in London, depends on what that quantity of money can buy, that is, its real purchasing power. My demand for money is always a function of its exchange value, but money’s exchange value is necessarily subject to constant change as a result of the constant buying and selling of money versus non-money goods by the trading public.
If the public at large has an additional demand for money (i.e. an additional demand for purchasing power in the form of money) what will the public do? – Answer: the public will do what every individual does who wants to increase his or her holding of money, the public will reduce its present ongoing money-outlays on non-money goods (i.e. spend less and accumulate cash) and/or sell non-money goods for money (i.e. liquidate assets). This process will immediately exert a downward pressure on the money-prices of non-money goods and an upward pressure on the purchasing power of the monetary asset (the result is deflation, if you like, but in contrast to all the excited scaremongering about deflation in the media this is a normal market process and nothing to be scared of). By raising the exchange value of each unit of money this process will satisfy the additional demand for money naturally and automatically. The same physical amount of money is circulating in the economy but now this same amount can satisfy a larger demand for money.
Of course, the reverse will happen if the public lowers its demand for money. The purchasing power of money will drop (inflation) and the same amount of (physical) money will still be held but now at a lower exchange value per unit reflecting the lower demand for money.
These processes do not work for other goods or services. If the public has a higher demand for cars, somebody has to produce more cars. This is because the demand for cars is demand for the use-value that cars provide. Additional demand for cars cannot be satisfied simply by raising the prices of cars. But money is demanded for its exchange value, and additional demand for money can be satisfied (and is in fact satisfied) by a higher exchange value of money, i.e. lower money-prices of non-money goods.
Importantly, the processes described here would not just commence once we converted to a system of inelastic money. These processes are by necessity at work all the time – even now in our economy of constantly expanding fiat money and excessive fractional-reserve banking where they are, of course, usually overshadowed by the inflation from constant monetary expansion.
Money qua money has two characteristics: it is the most fungible good in the economy and it is demanded exclusively for its exchange value. From this follows that every individual can hold exactly the desired portion of his or her wealth in the form of money at any moment in time, and it equally follows that the public at large can hold exactly the desired portion of its wealth in the form of money at any time.
If more economic transactions are to occur in a given period of time money can circulate faster, and in fact, money then IS GOING TO circulate faster. If the demand for money holdings rises, this demand can be satisfied automatically and naturally by a rise in the purchasing power of the monetary unit, and in fact, the purchasing power of the monetary unit IS THEN GOING TO rise.
Via the constant buying and selling of money versus non-money goods the public automatically adjusts the velocity of money and the exchange value of the monetary unit, and thus the public is always in possession of precisely the amount of money purchasing power it needs. It is in the very nature of a medium of exchange that any quantity of it – within reasonable limits – is sufficient (and indeed optimal) to satisfy ANY demand for money.
There is no need to fear that this process would lead to undue volatility in money’s purchasing power, to constant fluctuations between inflation and deflation. If some people have a higher demand for money and start selling non-money goods for money, and this is beginning to lift the purchasing power of the monetary unit, then those who have an unchanged demand for money will readily sell some of their money for non-money goods in order to merely maintain the same real purchasing power in the form of money that they had before. Nobody can say that this process will lead to complete stability of money’s purchasing power. Such stability is unachievable in human affairs. But dramatic swings in money’s purchasing power can reasonably be expected to be rare.
Be that as it may, there is certainly no process available by which even the most dedicated, smartest and impartial monopolist money producer could anticipate the discretionary changes in the public’s desire for money balances and neutralize the resulting changes in money’s purchasing power through pre-emptive money injections or withdrawals. Once the changing demand for money has articulated itself in any statistical variables (and, in particular, in rising or falling prices) the public will already have satisfied its changed money demand through the processes described above. The whole idea of superior monetary stability through a central state monopolist is entirely absurd.
Equally absurd is the idea – this one not being advocated by Positive Money, I shall add – that fractional-reserve banks could play a role in satisfying the public’s demand for money. This is, I fear, another widespread fallacy, and it has its origin in a confusion of demand for loans with demand for money. Banks are not in the business of meeting their customer’s money demand (which they could not do even if they tried) but in the business of meeting their clients’ loan demand. Banks conduct fractional-reserve banking in order to extend more loans (on which they collect interest!), not in order to bring more money into circulation. The deposit money that is also created in the process (the ‘cheques’ the banks write to fund the loans) is simply a by-product of their expanded lending business (and this money is absorbed by the public through inflation).
By the same token, nobody (or at least hardly anybody) who has a higher demand for money will go to a bank, take out a loan and pay interest just to hold a higher money balance. Demand for money is not demand for loans. The people who take out loans do not have a high demand for money. To the contrary, they have a high demand for the goods and services that they quickly spend the borrowed money on. That is why they are willing to incur the extra expense of interest. As explained above, people who have a high demand for money cut back on spending or sell assets.
Positive Money starts with a correct observation, namely that today’s large-scale fractional-reserve banking is unnecessary and destabilizing for the economy. However, their suggestion of a ban on fractional-reserve banking strikes me as overly authoritarian, unnecessary and probably unpractical and unrealistic. Simply removing the state-run support infrastructure for fractional-reserve banking would be sufficient, in my view. Where the ideas of Positive Money become bizarre and dangerous is when they propose to install the state as an all-powerful central money creator. There is absolutely no justification whatsoever for such a function in a market economy. It is entirely unnecessary and would probably entail the same, if not worse, misallocations of capital that we suffer now. We would be guaranteed to stumble from one dysfunctional system into another dysfunctional one. The lessons from a proper understanding of fractional-reserve banking and of money demand are very different from what Positive Money suggests.
Luxury carmaker Rolls-Royce’s 2012 financial results must have brought new worries to those concerned with the growing wealth divide.
Rolls-Royce reported a third consecutive annual sales record, the best results in its 108-year history. Priced at £170,000 for its cheapest model, it is safe to say that these sales were reserved for a small subsection of the wealthiest, perhaps the 0.01 percent. While the ongoing recession has left the masses paying off their debts and enjoying less consumption than before, the so-called one percent continue reaching for new heights and excesses.
What explains this growing divide, especially concentrated in the hands of a very few?
One place to look could be in the successes of businessmen, earning large profits by serving customers especially well. While there may be a handful of entrepreneurs weathering the financial storm well, the recession is wearing on the majority of the business community. It also doesn’t appear that these lavish displays of wealth are being made by the astute business community.
Another place to look is whether there is a privileged position or relationship that is enabling some to succeed at the expense of others. Such a cause would have the markings of some people earning large profits with seemingly little conventional work at the expense of the well-being of the masses (in contrast to the normal way of earning profits – hard work aimed to make the masses better off).
Last year the Bank of England increased the supply of notes and coins by about 4%. This increase provided a buyer for UK gilts that might not otherwise exist, reducing borrowing costs for the government. Yet while some politicians might be living the high life, the real culprit is found within the banking system.
With that increase in base money, the banking system was able to increase its supply of credit – issued in the form of loans to borrowers against the deposit base. It was able to do this by a legal privilege bestowed on it by the government, in the form of fractional-reserve banking. By issuing loans in excess of the amount of their assets, banks are able to effectively create something from nothing. These loans are used by borrowers, and have the result of pushing up prices. Inflation harms savers – those whose hard work was rewarded in the past but is now compromised as rising prices reduce the purchasing power of these funds. On the other hand, borrowers are able to use these newly created funds for purchases. Since they gain access to funding at one set of prices and then, through their spending, raise these prices, borrowers of this fractional-reserve created money relatively impoverish the rest of us.
Instead of earning profits the old-fashioned way, it is now advantageous for people to borrow money from the banking system and spend it as quickly as possible. The only problem is that most of us cannot do this. Since the bank is concerned with getting paid back, it will only loan money to the credit-worthy, or connected. The one percent, relatively unaffected by the recession compared to Main Street, is able to gain access to new exclusive profits.
That these profits should be funneled into displays of wealth like luxury autos should come as no surprise.
Yet Rolls-Royce is not alone in this growing wealth divide. Last year I discussed how high-end art and real estate markets are flourishing. BMW (Rolls-Royce’s parent company), Audi, Mercedes-Benz and Jaguar Land Rover also all reported record luxury sales in 2012. Automotive research consultancy JATO Dynamics reports that premium and luxury car sales have grown by 13% over the past four years, despite talks of austerity and recession filling the financial press. Bently recently announced that its 2012 sales increased 22% compared to the year before.
The mass-market automotive brands are in a much starker position. Battling over price points to attract price-sensitive customers, high taxes and rising unemployment are endangering sales. Indeed, “[t]here is a disconnect between the mega-rich and the rest of us” according to Rim Urquhart, an analyst at IHS Automotive. With the forthcoming introduction of Roll-Royce’s ultra-luxury model, the trend shows no sign of abating. Aimed at just hundreds of units of sales instead of the thousands for its current model, Rolls-Royce is aiming clearly at a different segment of the market than it is accustomed to – one geared toward the one percent of the one percent.
For those upset at these ostentatious displays of wealth and the growing divide they signify, blame should be properly placed. In some cases these purchases and lifestyles are the result of hard work and the reward of sacrifice. For many, however, the growing divide is a “reward” for being in a privileged position within the financial industry. The fractional reserve system enables undue profits to some at the expense of others. Scrutiny over the Bank of England (and other central banks) and their continued inflationary gifts to the financial system would do much to rectify this growing imbalance.
You cannot escape an all-pervasive sense of crisis these days. Impending doom does not only announce itself in actual events but also via the proliferation of ever more hair-raising schemes that claim to solve our problems. Maybe it should not surprise us if, at a time when the world’s most powerful central banks keep interest rates at zero for years on end and keep printing quantities of money that are simply outside the facilities of human imagination (trillions? quadrillions?), bravely hoping it will end differently this time, people get the impression that economics holds no certainties, that it is merely an exercise in limitless creativity. In his excellent speech to the New York Fed, Jim Grant reminded us that when the Financial Times first explained to their readers what QE was, back in 2009, one of those readers wrote in a letter to the editor: “I can now understand the term ‘quantitative easing, but . . . realize I can no longer understand the meaning of the word ‘money’.” – This gentleman is not alone. The basics of monetary economics have been tossed out the window and a merry ‘anything goes’ of policy proposals has descended on us. Otherwise sane-looking men and women now propose that, although years of zero interest rates have not solved our problems, everything will change once interest rates are negative. We should all get checks from the central bank with free money to spend, and government bonds at the central bank should be cancelled. Grown men dream of money from helicopters and money buried in bottles in the ground. “Whom the gods would destroy, they first make mad.”
Just when you thought it could not get any madder there comes a policy proposal that sets a new low in monetary policy discussion. Of course, in the current climate it is being hailed as ‘epic’ and ‘revolutionary’. The easily excitable Ambrose Evans-Pritchard, a tireless campaigner for man’s exploration of the unknown in the field of money, could not believe his eyes: “So there is a magic wand after all,” he writes in the Daily Telegraph, “one could eliminate the net public debt of the US at a stroke and, by implication, do the same for Britain, Germany, Italy or Japan.” It gets better all the time. No longer are we confined to debating arduous strategies for crawling slowly back to sustainable growth, no, we can now simply wipe out all our debt.
Harry Potter meets Irving Fisher
The proposal under discussion is the IMF’s Working Paper 12/202 by Jaromir Benes and Michael Kumhof (a link to a PDF version is provided in this article). It is titled “The Chicago Plan Revisited” and presents itself as a restatement of the ideas of Irving Fisher and Henry Simons of the University of Chicago from the 1930s and 40s, and an application of these ideas to the present crisis. It suggests the following:
‘Private money’ creation is the root of all economic evil. Most money today is created by ‘private’ banks through fractional-reserve banking. This means money-creation is linked to loan creation and debt accumulation. A hundred-percent reserve system is to be established by the state and the state will forthwith crack down on any attempt by the private sector to issue liquid financial instruments – near monies – that could be accepted by the public as cash equivalents. Money creation is put under the full control of the state. The new system is to be implemented right away in one big swoop: the banks are forced to borrow the needed reserves from the government (Treasury) to achieve the new 100 percent reserve ratios instantly. The government creates these reserves – as is usual in a fiat money system – out of thin air. In the US, this plan would amount to new reserves to the tune of 184 percent of GDP, according to Benes/Kumhof, which means $27.6 trillion or 15 times the combined size of QE1 and QE2. With the new 100% reserve requirement, this money will not circulate and not allow for further bank credit creation, which – it is expected by the authors – makes this intervention not inflationary. (A portion of the new reserves will also be cancelled in the next step.) The new reserves allow the government/central bank to ultimately transfer ownership of the bank assets to itself.
Importantly, these new reserves are issued in a process very different from how reserves are issued and placed with the banks today, for example through ‘quantitative easing’, and how it was suggested by Irving Fisher in 1935 (“100% Money”), or Milton Friedman in 1960 (“A Program for Monetary Stability”). These more ‘conventional’ procedures do not allow for any large-scale elimination of debt. Central banks acquire bank assets by exchanging them for newly created reserve money, which they issue as a claim against themselves (a liability), and under normal accounting principles, any write-down of the new assets (debt ‘forgiveness’) would necessarily cause the extinction of the bank reserves as well. Writing down debt shortens the balance sheet of the central bank and thus reduces the central bank’s liabilities, which are the banking system’s reserves.
Benes and Kumhof circumvent this by simply claiming that the new fiat reserves are not just a new liability of the central bank but that they are assets as well, Treasury Credit or ‘commonwealth equity’. Through this accounting gimmick, the state can issue new assets, simply as an administrative act. Thus, the new reserve money lengthens the balance sheets of BOTH central bank and ‘private’ banks in a first step, that is, the new reserve money is simultaneously an asset AND a liability for both. This novel approach then allows balance sheet reduction later on and debt forgiveness without elimination of the new reserves that now back bank deposits by 100%. (See model balance sheets on pages 64 to 66 of the Benes/Kumhof paper and compare them to the model balance sheet presented by Irving Fisher on page 57 of “100% Money”, 1935, which is much more conventional.)
At the end of this process, not only has a lot of debt disappeared, the separation of the ‘credit’ and the ‘money’ sphere of the economy is now total, and so is the state’s control over the monetary economy. This, Benes and Kumhof, make perfectly clear, is the ultimately goal of the exercise, and they claim it is to our benefit. Why? Here (very differently from Fisher and Friedman or, for that matter, any monetary theorist) they do not argue as economists, but quote anthropologists and certain monetary historians who claim that 1) money originated not spontaneously from direct exchange but is a creation of the state, or rather the state’s early precursors, such as priests and religious masters of ceremony; this is deemed important because the origin of money determines the “nature of money” (page 12) and therefore determines who should best control its issuance. 2) They argue that thousands of years of monetary history confirm that the state can be trusted fully with the monetary privilege. (If you remember history somewhat differently, then according to Benes and Kumhof you have to rethink. The paper follows a select group of maverick anthropologists and monetary activists that have simply rewritten monetary history. Needless to say, none of this was ever claimed by Irving Fisher or Milton Friedman, and to my knowledge, not even Henry Simons.)
Finally, the paper presents an elaborate econometric model that shows that all of this will work in reality.
In this essay I will do four things: I will put the proposed paper in the context of ‘Austrian ’ and Monetarist monetary theory, and show that it is not only outside these intellectual traditions but that its main argument is not even economic in nature. I will show that the core problem Benes and Kumhof claim to have identified is bogus, and that they do not understand money creation in our economy. I will then look at the paper’s peculiar historical, and non-economic, justification of complete state control of money, and show that this argumentation is highly dubious but also irrelevant. I will then show that the proposal presented relies on unprecedented forms of state intervention and crucially advances the notion that the state can create vast new assets – commonwealth equity – by decree, which allows it to claim to have no net debt and thus engage in loan acquisition and ‘debt forgiveness’.
What this paper is not: it is neither ‘Austrian’ nor Monetarist
Benes and Kumhof, early in their paper, claim that fractional-reserve banking increases the risk of bank runs, causes boom-bust cycles, and that a 100 percent reserve system would ensure greater stability. These observations are, in principle, correct. But this is, sadly, where it stops. Benes and Kumhof do not build on these insights. In fact, for their further argument these insights are completely irrelevant. Their paper does not bother to investigate the full range of effects of bank credit expansion, and ask, for example, if the expansion of base money by the central bank under a 100%-reserve system could not have similar or even the same adverse effects that deposit-money expansion has in a fractional-reserve system.
The Austrian School has provided the most comprehensive analysis of the effects of bank credit expansion and has shown most conclusively why more inelastic (‘harder’) monetary systems offer greater stability. Expanding the money supply always has disruptive effects as the inflow of new money must distort interest rates, and interest rates are crucial for the coordination of investment activity with voluntary saving. The question the ‘Austrians’ ask is not, who should control money creation, but should anybody control money creation? Should anybody even create money on an ongoing basis? Once a commodity of reasonably inelastic supply, such as gold, is widely accepted as money, any quantity of this monetary asset – within reasonable limits – is sufficient, and indeed optimal, to satisfy any demand for money. Demand for money is demand for purchasing power in the form of money, and can always be met by allowing the market to adjust the price of the monetary asset relative to non-money goods. No money creation is needed, and any ongoing money creation is in fact disruptive.
‘Austrians’ tend to be critical of fractional-reserve banking but they are equally critical – in fact, even more critical – of fiat money and central banking. The problems they studied would also occur – and are even more likely to occur – if the fractional-reserve-banking system was replaced with one gigantic state central bank.
But Benes and Kumhof did not call their paper ‘The Austrian Plan Revisited’ but ‘The Chicago Plan Revisited’. The approach and the goals of the Chicago School were different. But it is still worth mentioning that in his 1935 book “100% Money” Irving Fisher suggested that his plan could be combined with the gold standard, something that is impossible with the Benes/Kumhof plan and that Benes and Kumhof show no interest in. Here is Fisher, page 16:
Furthermore, a return to the kind of gold standard we had prior to 1933 [before the domestic gold standard was abolished by Roosevelt and private gold confiscated, DS] could, if desired, be just as easily accomplished under the 100% system as now; in fact, under the 100% system, there would be a much better chance that the old-style gold standard, if restored, would operate as intended to operate.
This would indeed be the 100% gold standard that many ‘Austrians’ propose, and a system immeasurably more stable than what we have today. However, it was certainly not Fisher’s primary objective to restore the gold standard. Fisher wanted to maintain the fiat money system and consolidate the control of the central bank over the banking system by eliminating any remaining discretion by ‘private’ banks. Fisher was a big proponent of price index numbers. He believed the purchasing power of money could be measured accurately through statistics – a fallacy that is still widely believed today and still causes confusion and harm – and he was an early advocate of inflation-targeting. (For an Austrian School response to Fisher’s original plan see Ludwig von Mises, Human Action, 1949, Chapter XVII, 12. The Limitation on the Issuance of Fiduciary Media)
25 years later, Fisher’s fellow Chicagoan Milton Friedman also proposed a version of the 100% plan, this time with even less reference to boom-bust cycles or the potential for a gold standard. Friedman was an advocate of central banking because he believed that monetary and economic stability could be achieved by guaranteeing a stable, persistent and moderate expansion of the money supply, which is at the core of Friedman’s Monetarism. In a 100% system the state central bank – so he argued – can make sure that this would happen.
Importantly, both Fisher and Friedman had an asymmetrical view of monetary expansion. The ongoing expansion of the money supply – and therefore persistent injections of new money into the economy – were not considered harmful (quite to the contrary), as long as the money inflow remained moderate, but any contraction of the money supply (shrinking of bank balance sheets and destruction of money) was seen as a major problem and to be avoided at almost all cost. Their plans for full reserve banking was largely motivated by a desire to avoid the destruction of previously created deposit money. Of course, ‘Austrians’ see this very differently. The expansion of money – even if moderate and controlled – must already cause problems (capital misallocations), and when these problems come to the surface they cannot be suppressed with yet more money creation, at least not forever (although this is attempted under Friedman’s proposal for very easy monetary policy in crises).
It should now be clear why the Austrian School is enjoying a revival in the present crisis, not the Chicago School. Fisher and Friedman did not get their 100%- system with complete control over money creation for the central bank but whatever power central banks had in recent decades – and that power was formidable – was used in ways that were strongly influenced by the Chicago School. Fisher and Friedman have shaped modern central bank orthodoxy to this day. As long as inflation is moderate central bankers believe that no monetary problem exists, in line with Fisher. Even in the run-up to the present, spectacular financial crisis, inflation remained moderate in most major countries, at least in the common (and dangerously narrow) CPI definition. And for the past two decades, any crisis that, if left unchecked, could have caused bank balance sheet deleveraging and credit contractions was aggressively fought with low interest rates and base-money injections from the central bank, according to Friedman. In fact, the Bernanke Fed has repeatedly referred to Friedman’s policy descriptions as a blueprint for its own actions. However, none of this has prevented major financial imbalances to build, and these policies have even helped create these imbalances, as Austrian theory would suggest.
But I digress. None of this makes any impression on Benes and Kumhof. In fact, Benes and Kumhof seem decidedly uninterested in monetary theory, business cycle theory, or the Austrian School. There is no mention of Mises or Hayek, and only Carl Menger is mentioned – in a footnote and disapprovingly.
Instead, the paper sets up an entirely new and I believe bogus problem based on the premise that in our monetary system money is supposedly provided ‘privately’, that is, by ‘private’ banks, and ‘state-issued’ money only plays a minor role. From this rather confused observation, the paper derives its key allegation that ‘state-issued money’ ensures stability, while ‘privately-issued money’ leads to instability. This claim is not supported by economic theory and certainly not by anything in the Austrian School or, for that matter in Friedman’s Monetarism or Irving Fisher’s original plan. Monetary theory does not distinguish between ‘state-controlled money’ and ‘privately produced’ money, it is a nonsensical distinction for any monetary theorist. An attempt to give credence to this distinction and its alleged importance is made in a later chapter in the Benes/Kumhof paper but, tellingly, this attempt is not based on monetary theory but on an ambitious, if not to say bizarre, re-writing of the historical record.
Benes and Kumhof create an artificial problem
For any analysis of the present financial system a distinction between state-created money and privately created money is entirely artificial and of no help whatsoever, because in our system money is created in a process in which ‘private’ banks are intimately connected with the state central bank. Any distinction between ‘private’ and ‘state’ is thus arbitrary and for an analysis of the economic consequences of such a system meaningless. Yes, most money in circulation today is deposit money and sits on the balance sheets of nominally ‘private’ banks, but the reserves are state fiat money, only to be created by the state central bank, which the nominally private banks have to have an account with in order to receive a banking license. Fractional-reserve-banks rely crucially on state-sponsored and state-controlled central banks that have a lender-of-last-resort function and that can – in a fiat money system – create bank reserves at will, no cost, and without limit, and are, under normal circumstances willing to do so to backstop the banks. Without this crucial backstop fractional-reserve banking on the scale on which it has been practiced in recent years and decades would be inconceivable. In their description of the present system, Benes and Kumhof take no account of any of this. Frankly, they do not appear to understand it.
Here are two statements from the IMF paper that may at first appear sensible but that on closer inspection reveal the grave misunderstanding of our present system by Benes and Kumhof:
“In a financial system with little or no reserve backing for deposits, and with government-issued cash having a very small role relative to bank deposits, the creation of a nation’s broad monetary aggregates depends almost entirely on banks’ willingness to supply deposits.” (page 5)
But what determines the willingness of the banks to supply deposits? Fractional-reserve banking (supplying deposits) is lucrative but also risky for the banks as the public can demand redemption of deposits in cash or in transfers to other banks, and banks cannot create cash or the reserve money required to facilitate transfers. These forms of money remain the prerogative of the state central bank. It is the certainty, or high probability, under present institutional arrangements that the central bank will support the banks and continue to supply whatever amount of cash and reserves is needed, that allows the banks to supply – very profitably, of course – vast amounts of deposit money on the basis of small reserve money. Should the public demand payment in cash, the central bank can reasonably be expected to stand by the banks and supply the needed cash.
In recent decades, the global banking system found itself on numerous occasions in a position in which it felt that it had taken on too much financial risk and that a deleveraging and a shrinking of its balance sheet was advisable. I would suggest that this was the case in 1987, 1992/3, 1998, 2001/2, and certainly 2007/8. Yet, on each of these occasions, the broader economic fallout from such a de-risking strategy was deemed unwanted or even unacceptable for political reasons, and the central banks offered ample new bank reserves at very low cost in order to discourage money contraction and encourage further money expansion, i.e. additional fractional-reserve banking. It is any wonder that banks continued to produce vast amounts of deposit money – profitably, of course? Can the result really be blamed on ‘private’ initiative?
Fractional-reserve banking on today’s scale requires two things: 1) a state-sponsored central bank that has the monopoly of bank reserve-provision and that has a lender-of-last resort function for the banking industry; 2) the central bank must have complete control over bank reserves and be able to create them at no cost and without limit. In short, the precondition for large-scale fractional-reserve banking is a complete, unrestricted fiat money system. By contrast, the ability of the central bank to create reserves is fundamentally restricted under a gold standard.
The gold standard was abolished and replaced with a system of entirely unconstrained state fiat money through an act of politics. The state established monopolistic central banks that have a lender-of-last-resort function for the banking sector. The state thus created the infrastructure that allows banks to supply vast amounts of deposits, and over the decades has repeatedly subsidized this activity and socialized its risks.
Here is the second statement by Benes and Kumhof:
“The control of credit growth would become much more straightforward because banks would no longer be able, as they are today, to generate their own funding, deposits, in the act of lending, an extraordinary privilege that is not enjoyed by any other type of business.” (page 5)
But what exactly constitutes the privilege? – In a free society, you are, of course, free to issue your own fiduciary media – just issue checks against yourself and have them circulate as money surrogates. You will probably have to convince the public that you will convert these checks into money proper on demand in order to persuade the public to use the checks as money equivalents, and even then you may not succeed. But if the public believes you and your endeavor is successful, you have indeed become a money-producer and can fund your own lending with your checks. In fact, this is pretty much how fractional-reserve-banking originated. So far no privilege. It only becomes a privileged business, and possible on the scale we see it today, once the state supports it. The ‘Austrian’ solution is straightforward: remove the privilege! Without fiat money, central banks and state-sponsored deposit insurance, let us see how much ‘private’ money creation there really is!
No theory but revisionist history
Benes and Kumhof try to argue in a separate part of the paper that the distinction between ‘privately produced’ money and ‘state-produced’ money is meaningful and important. Here, they completely depart from any traditional analysis of money or even any that could still be called ‘economic’. An economic analysis of money understands money as a useful social institution and thus starts with an inquiry of what money is used for in general, including today by today’s money users (that includes you and me), and tries to explain, based on reasoning, what would therefore make for good money in a general context, including the present one. Benes and Kumhof, however, do not argue conceptually as economic theoreticians but as (re-)interpreters of history. History can tell us what is good money and how it comes about. The anthropologists and monetary historians Benes and Kumhof quote claim that because money originated – supposedly – with the state its issuance is best controlled by the state. Again, no economic – conceptual, logical, theoretical – explanation is given for why that should be the case and why this could be upheld as a general rule. Allegedly, history tells us that the state is a responsible issuer of money and the private sector an irresponsible one. And that’s that.
The interpretation of the historical record that is provided in support of this allegation ranges from the adventurous to the outright bizarre. Instances in which the redeemability of deposit money in gold and silver was abandoned by official decree and vast amounts of fiat money were created to fund wars, revolutions or other state expenditures, such as during the Revolutionary War in America, the Civil War in America, or 1920s Weimar Germany, are reinterpreted to show that the ensuing inflations and outright currency disasters cannot be blamed on the state but are entirely the result of the involvement of ‘private’ money issuers.
“Colonial paper monies issued by individual states were of the greatest economic advantage to the country…The Continental Currency issued during the revolutionary war was crucial for allowing the Continental Congress to finance the war effort. There was no over-issuance by the colonies,… The Greenbacks issued by Lincoln during the Civil War were again a crucial tool for financing the war effort, [Hooray! Another war courtesy of paper money! DS] … The one blemish on the record of government money issuance was deflationary rather than inflationary in nature.”
Really? – The ‘colonials’ that were issued to fund the war with Britain ended up worthless, and to this day there is the idiom “worthless as a continental” in the American language. The period of the Civil War, too, was one of unusually high inflation, and in 1879 the USA decided to go back on a gold standard, at which point a period of considerable growth and rising prosperity set in.
While the enthusiasm for paper-money-funded wars on the part of Benes and Kumhof is already a bit disturbing, what is particularly striking is that Benes and Kumhof, and the ‘historians’ they quote (in particular the activists David Graeber, an anthropologist and leading figure of the Occupy Wall Street movement, and Stephen Zarlenga, founder and director of the American Monetary Institute), try nothing short of a complete re-writing of economic history and suggest conclusions – not only in one instance but throughout ALL of monetary history – that not only fly in the face of the generally accepted historical record but also common sense. The state as a monopoly-issuer of money with no restriction whatsoever becomes a trusted guardian of the common weal – simply by being a state!
Their whole argument gets kooky in the extreme when they address more recent instances of fiat money currency disasters, for which we not only have ample documentation that supports the opposite interpretation but which some of the most distinguished monetary theorists actually lived through themselves and experienced first hand – and which they explained succinctly.
Ludwig von Mises wrote a seminal book on monetary theory in 1912 (Theories des Geldes und der Umlaufmittel), in which he laid the foundations for the Austrian Business Cycle Theory and in which he predicted (!) the European hyperinflations of the 1920s. He lived through the hyperinflation in Austria in 1923, and, as the chief economist of the Vienna Chamber of Commerce, was in direct contact with the key players in government and central bank. He later wrote his memoirs.
Benes and Kumhof now claim that all these accounts are simply wrong. The main culprit was not the state but the private sector. We only have to ask state officials (!) and they can tell us what really happened. Here is the IMF working paper, page 17:
“The Reichsbank president at the time, Hjalmar Schacht, put the record straight on the real causes of that episode in Schacht (1967).”
According to Benes/Kumhof, Schacht blames the inflation on aggressive money creation by the private sector but his account also suggests that this was only possible because the Reichsbank generously redeemed deposit money in Reichsmark, that is, the central bank provided essential support for money expansion. With a generous backstop from the state the private sector will, of course, create money. But does that mean the state had nothing to do with the whole debacle? Kumhof, Benes and their prime source, Zarlenga, seem to not understand the role of central banks and the essential ingredient of state-backing for large-scale fractional-reserve banking. Furthermore, Schacht is a source of a somewhat dubious reliability in this debate. Schacht became a Hitler supporter later on, introduced socialist New-Deal-type policies in Germany, and helped the Nazis with re-armament and plans for German autarky. I am not saying this to discredit Schacht as an economic observer, only to highlight that he had – and this is probably an understatement – a considerable pro-state bias in all his economic views and is hardly an objective observer on the question of whether the state can be trusted with money. (As an aside, all totalitarian ideologies are anti-gold and pro-paper money and central banks. The Socialists, the Communists, the National-Socialists, the Fascists – they all hated to see the state restrained in its manoeuvrability by a gold standard.)
Benes and Kumhof’s case simply ignores the numerous historical accounts that paint a very different picture, such as the work by English historian Adam Ferguson whose seminal book “When Money Dies” has recently found a wide new readership. It ignores the eye-witness reports of one of the most distinguished economists of the 20th century, Ludwig von Mises, or the work of Swiss monetary historian Peter Bernholz.
I am not a historian and I want to be careful in dismissing challenges to the established historical record out of hand, but the account presented here strikes me as simply ridiculous, unscientific, mystical pro-state propaganda. As a scientific argument it is without merit.
But almost the worst aspect of it is this: where are the economics, where is conceptual analysis and reasoning? Even if we accepted – simply for argument’s sake and contrary to the overwhelming evidence to the contrary – that the state has more often than not been a good guardian of the money privilege, what are the explanations for this, what are the theoretical and conceptual arguments that underpin this historical pattern? Could we rely on this always being the case? If it is in the “nature of money” (Benes/Kumhof) to be provided by the state, is it therefore in the “nature of the state” to always provide good money, or would we need specific institutional arrangements, legal frameworks, or some ‘good-money’-culture or tradition for this to be the case? Of course, Benes and Kumhof provide no answers.
This part of the paper is simply unscientific because the argument is essentially mystical. The whole idea that a socially useful institution such as money can only be understood if we understand its “nature”, which does not derive from how people use it (including you and me today) but from how it came into being thousands of years ago, is nothing if not rooted in mysticism.
Money is a tool, and so are hammers. If I asked you to tell me what a hammer is for, what makes for a good hammer and a bad hammer, and what type of hammer I need for a specific purpose, would you tell me that I first have to understand the “nature” of the hammer, and to do so I would have to ask anthropologists how the first hammers came into being and what the first hammers or hammer-like tools were used for?
Remember what I said above about circulating your own checks as fiduciary media? That is a pretty good description of paper money issuance. The newly circulated paper money is accounted for as a liability on the balance sheet of the paper money creator, and the things he acquires through issuing/spending this new paper money become the corresponding assets. By issuing paper money the money creator lengthens his balance sheet, while those who transact with the money-creator neither lengthen nor shorten their balance sheets but exchange positions on the asset side of their balance sheets, they replace other, previously held assets with new money.
This can also be observed in the creation of base money (extra bank reserves) by central banks today. When the Federal Reserve creates an extra $1 trillion as part of ‘quantitative easing’ and decides to buy mortgage-backed securities from its member-banks, then the Fed’s balance sheet expands by $1 trillion dollars. The new bank reserves are on the liability-side of its balance sheet, while the mortgage-backed securities are on the asset-side. The balance sheets of the banks do not expand as a result of the Fed operation. The banks simply replace mortgages with new reserves. Both are on the asset side of their balance sheets. Their asset-mix has changed. They now have more reserves.
This process could be extended until almost all bank assets have moved to the central bank and the banks are fully reserved and thus cease to be fractional-reserve banks. This was precisely the process that Irving Fisher had in mind when he wrote “100% Money” in 1935 (see page 57), and Milton Friedman when he wrote “A Program For Monetary Stability” in 1960.
At no point did any of these economists suggest, nor does any central bank today suggest, that the creation of new paper money enhances the overall wealth of society, that there is now more property in this society. It is also clear from this process that ‘debt forgiveness’ by the central bank is difficult. The central bank can issue enough reserve money to acquire all bank assets but whenever it writes down the book value of any of these assets it also has to shrink the liability side of its balance sheet, it has to destroy reserve money.
Benes and Kumhof now come up with an entirely novel approach. The state simply declares that its new reserve money is also an asset in its own right. Per decree the state creates wealth: Treasury Credit or commonwealth equity. The central bank books the new reserves on its liability side, just as in a conventional money creation process but now does not book existing assets against it that it acquires from whoever books the new reserves as assets (the banks). The corresponding asset is now ‘Treasury Credit’, which did not exist before but now comes into being per government decree. At this stage, the central bank’s balance sheet lengthens without any acquisition of new assets – the offsetting asset is created simultaneously with the reserve money liability!
The balance sheets of the banks now also lengthen: the banks book the new reserves on their asset side without (at this stage) transferring other assets to the money-issuer. The asset-side of their balance sheets lengthens. The corresponding lengthening of the liability side is achieved by booking ‘Treasury Credit’ as a liability.
It is this slight-of-hand that allows, in the following steps, various bank assets to get written off without a corresponding shrinking of reserve money. Only via the accounting gimmick of creating central bank assets out of thin air (and not just new central bank liabilities) and thus claiming that overall wealth – new assets – have been created administratively by the government can the large-scale debt write-off that is the paper’s allegedly strongest selling point, proceed.
All of this is state intervention in private contracts and property rights on a gigantic scale. The state may have the power to rewrite accounting rules and simply claim the existence of mysterious ‘government wealth’. Stranger things were claimed by governments in the 20th century. But what are the consequences? How will the public react? What confidence will it have in the new 100% state controlled monetary system?
Simply writing off all household debt is a mixed blessing. How would you feel if you worked hard and saved and did pay down your debt to give your family financial security, only to find out that your irresponsible and reckless neighbors, living high on the hog on credit cards, just saw all their debt wiped out by the Benes/Kumhof plan?
All power to the state!
This whole plan is nonsense on the greatest scale. Benes and Kumhof have thoroughly embarrassed themselves. Maybe we should simply look the other way and ignore this ill-conceived rubbish, maybe excuse it as the confused musings of two state-worshipping econometricians who fell under the spell of the New Age historicism of Graeber and Zarlenga, which they saw as a great opportunity for some fancy econometric modeling. But this comes with endorsement from the IMF, a major state-organization. Could it be that those who benefit from the accumulation of more state power feel that all the widespread banker-bashing and the erroneous but skillfully planted notion of the failure of capitalism can be turned even more to their advantage? Even the otherwise intervention-happy Ambrose Evans-Pritchard has his doubts:
Arguably, it would smother freedom and enthrone a Leviathan state. It might be even more irksome in the long run than rule by bankers.
Ambrose, for once I agree.
In the meantime, the debasement of paper money continues.
In a recent Mises Dailyarticle Mark Thornton has offered an excellent critique of why Krugman’s attack on the Austrian view of money market mutual funds (MMMF) is totally misplaced. I would like to add another angle as to why Krugman’s attack on the Austrian School of Economics is fundamentally flawed. According to Krugman as quoted in Thornton’s article:
How do the Austrians propose dealing with money market funds? I mean, it has always been a peculiarity of that school of thought that it praises markets and opposes government intervention — but that at the same time it demands that the government step in to prevent the free market from providing a certain kind of financial service. As I understand it, the intellectual trick here is to convince oneself that fractional reserve banking, in which banks don’t keep 100 percent of deposits in a vault, is somehow an artificial creation of the government. This is historically wrong, but maybe the actual history of banking is deep enough in the past for that wrongness to get missed.
But consider a more recent innovation: money market funds. Such funds are just a particular type of mutual fund — and surely the Austrians don’t want to ban financial intermediation (or do they?). Yet shares in a MMF are very clearly a form of money — you can even write checks on them — created out of thin air by financial institutions, with very few pieces of green paper behind them.
So are such funds illegitimate?
It seems that Krugman has a problem with the money supply definition. Once the definition is established even Krugman could see that the whole issue of the MMMF is irrelevant as far as the money supply issues are concerned.
The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify. A definition is to tell us what the fundamentals of a particular entity are. To establish the definition of money we have to ascertain how the money economy came about.
Money emerged because barter could not support the market economy. A butcher who wanted to exchange his meat for fruit might not have been able to find a fruit farmer who wanted his meat, while the fruit farmer who wanted to exchange his fruit for shoes might not have been able to find a shoemaker who wanted his fruit.
The distinguishing characteristic of money is that it is the general medium of exchange. It has evolved from the most marketable commodity.
Through an ongoing selection process over thousands of years, people have settled on gold as money. In other words, gold served as the standard money. In today’s monetary system, the core of the money supply is no longer gold but coins and notes issued by the government and the central bank.
Consequently, coins and notes constitute the standard money, known as cash, that is employed in transactions. In other words, goods and services are sold for cash.
At any point in time part of the stock of cash is stored, that is, deposited in banks. Once an individual places his money in a bank’s warehouse he is in fact engaging in a claim transaction.
In depositing his money, he never relinquishes his ownership. No one else is expected to make use of it. When Bob stores his money with a bank, he continues to have an unlimited claim against it and is entitled to take charge of it at any time. Consequently, these deposits, labeled demand deposits, are part of money.
Thus, if in an economy people hold $10,000 in cash, we would say that the money supply of this economy is $10,000. But, if some individuals have stored $2,000 in demand deposits, the total money supply will remain $10,000: $8,000 cash and $2,000 in demand deposits—that is, $2,000 cash is stored in bank warehouses. Finally, if individuals deposit their entire stock of cash, the total money supply will remain $10,000, all of it in demand deposits.
This must be contrasted with a credit transaction, in which the lender of money relinquishes his claim over the money for the duration of the loan. As a result, in a credit transaction, money is transferred from a lender to a borrower.
The distinction between a credit and a claim transaction serves as an important means of identifying the amount of money in an economy.
Following this approach, one could easily note that, notwithstanding popular practice, money invested with money market mutual funds (MMMF) must be excluded from the money supply definition. Investment in a money market mutual fund is in fact an investment in various money-market instruments.
The quantity of money is not altered as a result of this investment; only the ownership of money has temporarily changed. Including investment in MMMFs in the money definition will only lead to a double-counting thereof.
The fact that mutual funds offer their clients cheque facilities has prompted some analysts to suggest that deposits with mutual funds are similar to bank demand deposits.
However, when an individual writes a cheque against his account with the money market fund, he in fact instructs them to sell some of his money market certificates for cash. The buyer of these certificates parts with his money, which is then transferred to the writer of the cheque; money changes hands, but no new money is created.
Furthermore, the fact that MMMF cheques are employed in payments does not mean that they are money. Cheques are a particular way of employing existing money in transactions.
The crux in identifying what must be included in the money supply definition is to adhere to the distinction between a claim transaction and a credit transaction.
Contrary to Krugman, Austrians are in favor of a free market in financial markets. Austrians, however, oppose the creation of money out of “thin air”, which sets in motion the consumption of capital and economic impoverishment. Austrians hold that the key to true free financial markets is to close all the loopholes that enable the creation of money supply out of “thin air”. This means the closure of the Central Bank and passing a law that forbids fractional reserve banking .
UK Chancellor George Osborne and Bank of England Governor Mervin King last week announced another round of fiscal and monetary stimulus measures, including steps to ease the funding for banks and allow them to extend more loans.
If these measures were hoped to instil confidence they must be classified as a failure. We have lived through quite a few years of unprecedented and fairly persistent monetary accommodation and occasional rounds of QE by now, and I doubt that yet another dose of the same medicine will cause great excitement. Furthermore, observers must get confused as to what our most pressing problems really are. Have we not had a real banking crisis in the UK in 2008 because banks were over-extended and in desperate need of balance sheet repair? Is a period of deleveraging and a rebuilding of capital ratios not urgently required and unavoidable? Let’s not forget that the government is still a majority-owner of RBS and holds a large chunk of Lloyds-TSB. If banks are still on life-support from the taxpayer and the central bank, is it wise to already prod them to expand their balance sheets again and create more credit to ‘stimulate’ growth?
The same confusion exists on fiscal policy. Is the Greece crisis not a stark warning to all other sovereign borrowers out there, which are equally and without exception on a slippery slope toward fiscal Armageddon, that it is high time for drastic reduction in spending and fundamental fiscal reform? If the Bank of England or the government assume any of the risk of the latest additional credit measures, then the taxpayer is on the hook.
None of this will instil confidence, not in the economy and not in the banks, and certainly not in politics. UK newspaper ‘The Independent’ headlined: “King pushes the panic button”, which I consider a pretty apt description.
Banks are parastatal dinosaurs
One thing is now clear to even the most casual observer: banks are not capitalist businesses. In their present incarnation they have little to do with the free market and no place in it. They are constantly oscillating between two positions: One moment, they are a state protectorate, in desperate need of support from the state printing press or unlimited taxpayer funds, as, in the absence of such support, we are supposedly faced with the dreaded social fallout of complete financial collapse; the next moment they are a convenient tool for state policy, simply to be fed with ample bank reserves and enticed with low interest rates to create yet more cheap credit and help manufacture some artificial growth spurt. Either the banks are the permanent welfare queens of the fiat money systems, or convenient policy levers for the macro-economic central planners. In any case, capitalist businesses look different.
Central banks and modern fiat money banks are quite simply a blot on the capitalist system. In order for capitalism to operate smoothly they will ultimately have to be removed. I believe that the underlying logic of capitalism will work in that direction. Personally, I believe that trying to ‘reform’ the present system is a waste of time and energy. It is particularly unbecoming for libertarians as they run the risk of getting infected with the strains of statism that run through the system. Let’s replace this system with something better. With a market-based monetary system.
When and how exactly the present system will end, nobody can say. I believe we are in the final inning. Around the world, all major central banks have now established zero or near-zero interest rates and are using their own balance sheets in a desperate attempt to avoid their highly geared banking systems from contracting or potentially collapsing. If you think that this is all just temporary and that it will be smoothly unwound when the economy finally ‘recovers’, then you are probably on some strong medication, or have been listening for too long to the mainstream economists who are, in the majority, happy to function as apologists for the present system.
I still believe that chances are we will, at some point, get the full throttle, foot-on-the pedal monetary overkill, the ultimate uber-QE that will push the system over the edge. This will be the moment when central bankers discover – and discover the hard way – that their ability to print their fiat money may well be unlimited but that the public’s confidence in this fiat money certainly is not. The whole system will blow up in some hyperinflationary fireball, which has been the end of most previous experiments with complete fiat money systems, all others having ended with a voluntary return to commodity money before the public had lost complete faith in the system. And the prospect for a voluntary and official return to a gold standard seems slim at present. However, this is not the topic of this essay.
The future of money
I am often asked what will come next after the present system collapsed? Will we have to go back to barter? – No. Obviously, a modern capitalist economy needs a functioning monetary system. My hope is that from the ashes of the current system a new monetary system arises that is entirely private and not run by states – and that does not have the unholy state-bank alliance at its core, an alliance that exists in opposition to everything that the free market stands for. Nobody can say what this new system will look like precisely. Its shape and features will ultimately be decided by the market. In this field, as in others, there are few limits to human inventiveness and ingenuity. But we can already make a few conceptual points about such a system, and we should contemplate working on such a system now while the old system is in its death throes.
A private gold ‘standard’…
Free market monetary systems, in which the supply of money is outside political control, are likely to be systems in which money proper is a commodity of limited and fairly inelastic supply. It seems improbable that a completely free market would grant any private entity the right to produce (paper or electronic) money at will and without limit. The present system is unusual in this respect and it is evidently not a free market solution. Neither is it sustainable.
The obvious candidates are gold and silver, which have functioned as money for thousands of years. We could envision a modern system at whose centre are private companies that offer gold and silver storage, probably in a variety of jurisdictions (Zurich, London, Hong Kong, Vancouver). Around this core of stored monetary metal a financial system is built that uses the latest information and payment technology to facilitate the easy, secure and cheap transfer of ownership in this base money between whoever chooses to participate in this system (Yes, there would be credit cards and wire transfers, and internet or mobile phone payments. There would, however, be no FOMC meetings, no Bank of England governor writing letters to the Chancellor, and no monetary policy!).
Are these gold and silver storage companies banks? — Well, they could become banks. In fact, this is how our present banking system started out. But there are important differences about which I will say a few things later. In any case this would be hard, international, private and apolitical money. This would be capitalist money.
Another solution would be private virtual money, such as Bitcoin.
Bitcoin is immaterial money, internet money. It is software.
Bitcoin can be thought of as a cryptographic commodity. Individual Bitcoins can be created through a process that is called ‘mining’. It involves considerable computing power, and the complex algorithm at the core of Bitcoin makes the creation of additional Bitcons more difficult (and thus more expensive) the more Bitcoins are already in existence. The overall supply of Bitcoins is limited to 21 million units. Again, this is fixed by the algorithm at the core of it, which cannot be altered.
Thus, creating Bitcoin money is entirely private but not costless and not unlimited. Most people will, of course, never ‘mine’ Bitcoins, just as under the gold standard most people didn’t mine gold. People will acquire Bitcoins through trade, by exchanging goods and services for Bitcoins, then using the Bitcoins for other transactions.
Bitcoin is hard money. Its supply is inelastic and not under the control of any issuing authority. It is international and truly capitalist ‘money’ – of course this assumes that the public is willing to use it as money.
There are naturally a number of questions surrounding Bitcoin that cannot be covered in this essay: is it safe? Can the algorithm be changed or corrupted and Bitcoins thus be counterfeited? Are the virtual “wallets” in which the Bitcoins are stored safe? – These are questions for the computer security expert or cryptographer, and I am neither. My argument is conceptual. My goal is not to analyze Bitcoin as such but to speculate on the consequences of a virtual commodity currency, which I consider feasible in principle, and I simply assume – for the sake of the argument – that Bitcoin is already the solution. Whether that is indeed the case, I cannot say. And it is – again – for the market to decide.
There is one question for the economist, however: could Bitcoin become widely accepted as money? Would this not contradict Mises’ regression theorem, which states that no form of money can come into existence as a ready medium of exchange; that whatever the monetary substance (or non-substance), it must have had some other commodity-use prior to its first use as money. My counterargument here is the following: the analogy is to the banknote, which started life not as a commodity but as a payment device, i.e. a claim on money proper which was gold or silver at the time. Banknotes were initially used as a more convenient way to transfer ownership in gold or silver. Once banknotes circulated widely and were generally accepted as media of exchange in trade, the gold-backing could be dropped and banknotes still circulated as money. They had become money in their own right.
Similarly, Bitcoin can be thought of, initially, as payment technology, as a cheap and convenient device to transfer ownership in state paper money. (Bitcoins can presently be exchanged for paper money at various exchanges.) But as the supply of Bitcoins is restricted while the supply of state paper money constantly expands, the exchange-value of Bitcoins is bound to go up. And at some stage, Bitcoin could begin to trade as money proper.
A monetary system built on hard, international and apolitical money, whether in the form of a private gold system or Bitcoin, would be a truly capitalist system, a system that facilitates the free and voluntary exchange between private individuals and corporations within and across borders, a system that is stable and outside of political control. It would have many advantages for the money user but there would be little role for present-day banks, which goes to show to what extent banks have become a creature of the present state-fiat money system and all its inconsistencies.
Banks profit from money creation
Banks conduct fractional-reserve banking (FRB), which means they take deposits that are supposed to be safe and liquid and therefore pay the depositor little interest, and use them to fund loans that are illiquid and risky and thus pay the bank high interest. Through the process of fractional-reserve banking, banks expand the supply of money in the economy; they become money producers, which is, of course, profitable. Many mainstream economists welcome FRB as a way to expand money and credit and ‘stimulate’ extra growth but as the Currency School in Britain in the 19th century and in particular the Austrian School under Mises and Hayek in the early 20th century have argued convincingly (and as I explain in detail in Paper Money Collapse) this process is not only risky for the individual banks, it is destabilizing for the overall economy. It must cause boom-bust cycles.
It cannot be excluded that banks could conduct FRB even on the basis of a private system of gold-money or Bitcoin. However, in the absence of a backstop by way of a central bank that functions as a lender-of-last resort, the scope for FRB would be very limited indeed. It would be too dangerous for banks to lower their reserve ratios (at least to fairly low levels) as that would increase the risk of a bank-run.
I am sometimes told that I am too critical of the central banks and the state, and that I should direct my ire toward the ‘greedy’ ‘private’ banks, for it is the ‘private’ banks that create all the money out there through FRB. Of course they do. But FRB is only possible on the scale it has been conducted over recent decades because the banks are supported – and even actively encouraged – in their FRB activities by a lender-of-last resort central bank, in particular as the central bank today has full and unlimited control over fiat money bank reserves. Under a system of hard money (gold or Bitcoin), even if the banks themselves started their own lender-of-last resort central bank, that entity could not create more gold reserves or Bitcoin reserves and thus provide unlimited support to the banks.
FRB is particularly unlikely to develop in a Bitcoin economy, as there is no need for a depository, for safe-keeping and storage services, and for any services that involve the transfer of the monetary system’s raw material (be it gold or state paper tickets) into other, more convenient forms of media of exchange, such as electronic money that can facilitate transactions over great distances. The owner of Bitcoin has an account that is similar to his email account. He manages it himself and he stores his Bitcoin himself. And Bitcoin is money that is already readily usable for any transaction, anywhere in the world, simply via the internet. The bank as intermediary is being bypassed. The Bitcoin user takes direct control of his money. He can access his Bitcoins everywhere, simply via the SIM card in his smartphone.
The tremendous growth in FRB was made possible by the difficulty of transacting securely over long distances with physical gold or physical paper tickets. This created a powerful incentive to place the physical money with banks, and once the physical money was in the banks it became ‘reserves’ to be used for the creation of additional monetary assets.
Channelling true savings into investment is very important, but remember that FRB is something entirely different. It involves the creation of money and credit without any real, voluntary saving to back it. FRB is not only not needed, it is destabilizing for the overall economy. Under gold standard conditions, it created business cycles. Under the system of unlimited fiat money and lender-of-last-resort central banks, it created the super-cycle, which is now in its painful endgame.
Banks make money from payment systems
When I recently made arrangements for a trip to Africa I dealt directly with local tour operators there, which, today, can be done easily and cheaply with the help of email, websites, and Skype. Yet, when it came to paying the African tour operators I had to go through a process that has not changed much from the 1950s. Not only were British and African banks involved, but also correspondence banks in New York. This took time and, of course, cost money in form of additional fees.
Imagine if we could have used gold or Bitcoin! The payment would have been as easy and fast as all the email-communication that preceded it. There would have been no exchange rates and little fees (maybe in the case of gold) or no fees (in the case of Bitcoin).
Another example: Last year I gave a webinar at the Ludwig von Mises Institute (LvMI). The LvMI is located in Auburn, Alabama, I did the seminar from my home in London, the LvMI’s technology officer sat in Taiwan, and the seminar attendants were spread all over the world. All of this is now possible – cheaply, quickly and conveniently – thanks to technology. Yet, when the LvMI paid me a fee it had to go through a few banks – again, correspondence banks in New York – it took quite some time and it incurred additional costs. And the fee from LvMI was paid in a currency that I cannot use directly in my home country.
Banks make money from monetary nationalism
Future economic historians will pity us for having worked under a strange and inefficient global patchwork of local paper currencies – and for having naively believed that this represented the pinnacle of modern capitalism. Today, every government wants to have its own local paper money and its own local central bank, and run its own monetary policy (of course, on the basis of perfectly elastic local fiat money). This is naturally a great impediment to international trade and the free flow of capital.
If I want to spend the money I got from the LvMI where I live (in Britain), I have to exchange the LvMI’s dollars for pounds. I can only do that if I find someone who is willing to take the opposite side of that transaction, someone who is willing to sell pounds for dollars. The existence of numerous monies necessarily re-introduces an element of partial barter into money-based commerce. Sure, the 24-hour, multi-trillion-dollar a day fx market can accommodate me, and do so quickly and cheaply, but this market is only a second-best solution, a highly developed make-shift to cope as best as possible with the inefficiencies of monetary nationalism. The better, most efficient and capitalist solution would be to use the same medium of exchange around the world. The gold standard was a much superior monetary system in this respect. Moving from the international gold standard to a system of a multitude of state-managed paper currencies meant economic regression, not progress.
One hundred years ago, you could take the train from London to Moscow and use the same gold coins all along the way for payment. There was no need to change your money even once. (Incidentally, neither did you need a passport!)
The notion of the ‘national economy’ that needs a ‘national currency’ was always a fiction. So was the idea that economies work better if money, interest rates and exchange rates are carefully manipulated by local bureaucrats. (This fiction is still spread by many economists who make a living off this system.) The biggest problem with monetary policy is that there is such a thing as monetary policy. But in today’s increasingly globalized world, these fictions are entirely untenable. Capitalism transcends borders, and what it needs to flourish is simply hard, apolitical and thus international money. Money that is a proper tool for voluntary human interaction and cooperation and not a tool for politics.
Banks benefit from the present monetary segregation. They profit from constantly exchanging one paper money for another and from foreign exchange trading. Non-financial companies that operate internationally are inevitably forced to speculate in currency markets or to pay for expensive hedging strategies (again paying the banks for providing them).
Banks make money from speculation
There is, of course, nothing wrong with speculation in a free market. However, in a truly free market there would be few opportunities for speculation. Today the heavy involvement of the state in financial markets, the existence of numerous paper currencies, all managed for domestic political purposes, and the constant volatility that is generated by monetary and fiscal policy create outsized opportunities for speculation. Additionally, the easy money that central banks provide so generously to prop up their over-extended FRB-industry is used by many banks to speculate in financial assets themselves, often by anticipating and front-running the next move of the monetary authorities with which these banks have such close relationships. And to a considerable degree, banks pass the cheap money from the central banks on to their hedge fund clients.
Remember that immediately after the Lehman collapse, investment banks Goldman Sachs and Morgan Stanley, which previously had shunned deposit and retail banking but have always been heavily involved in securities trading, quickly obtained banking licenses in order to benefit from the safety-net the state provides its own fiat-money-deposit banks.
Banks channel savings into investment
Yes, to some degree they still do this, and this is indeed an important function of financial intermediaries. However, asset managers can do the same thing, and they do it without mixing this services with FRB and money-creation. In general, the asset management industry is much more transparent about how it allocates its clients’ assets, it has a clear fiduciary responsibility for these assets, and it cannot use them as ‘reserves’. In the gold or Bitcoin economy of the future, you will, of course, be free to allocate some of your money to asset managers who mange investments for you.
Have I been too harsh on the banks? – Maybe. The bankers, in their defence, will say that they are not the source of all these inefficiencies, that they simply help their clients deal with the inefficiencies of a state-designed and politicized monetary system – and that they reap legitimate rewards for the help they provide. – Fair enough. To some degree that may be true. But it is very clear that the size, the business models, the sources of profitability, and the problems of modern banks are uniquely and intimately linked to the present, fully elastic paper money system. As I tried to show, even if the paper money system was meant to last – and it certainly is not – the forces of capitalism, the constant search for better, more efficient and durable solutions, coupled with technological progress, would put enormous market pressures on the present banking industry in the years to come. But given that our present system is not the outcome of market forces to begin with, that a system of fully elastic, local state monies is not necessary, that it is suboptimal, inefficient, unstable, and unsustainable, and that it is already in its endgame, I have little doubt that modern banks will go the way of the dodo. They are to the next few decades what the steel and coal industries were to the decades from 1960 to 1990. They are parastatal dinosaurs, joined at the hip with the bureaucracy and politics, bloated and dependent on cheap money and state subsidy for survival. They are ripe for the taking.
The demise of the paper money system will offer great opportunities for a new breed of money entrepreneurs. In that role, I could see gold storage companies, payment technology companies, Bitcoin service providers and asset management companies. If some of these join forces, the opportunities should be great. The world is ready for an alternative monetary system, and when the present system collapses under the weight of its own inconsistencies, there would be something there to take its place.
The present fiat money economy is ripe for some Schumpeterian ‘creative destruction’.
In the meantime, the debasement of paper money continues.