Not meaning to gloat or anything but...

Mark Carney and other central bankers have been trying to persuade us that higher interest rates are coming any moment now - for years!

Not meaning to gloat or anything but, in my book (published July 2011) I did say: After "bursting of any asset bubble"... "Society can get locked in to low rates, painted into a corner."

MMT and The Problem with Government Bonds

Proponents of MMT are fond of arguing that the amount of government debt, i.e. the amount government bonds, that a government creates is not a problem. I have to take issue with this idea. The problem is that the interest on government bonds is paid by taxpayers in general, whereas the recipients of the interest are exclusively the bond holders. The greater the government debt, the greater the flow of money from the taxpayer in general to bondholders. This is clearly unfair to tax-paying-non-bond-holders... like me.

A possible counter argument is that the people that purchased government bonds are investing in the government and therefore the rest of us should be grateful for this service, and be happy to repay them with interest payments. The problem with this argument is that the money was not really investment at all. True investment is where you spend money on something that makes future production more efficient, like buying new machinery for a factory. But most of the money received from bond sales is simply spent on running costs, like wages. That's not investment at all.

Share prices with fractional reserve banking

The popular explanation of share prices is that its all determined by “supply and demand”. If the price of something has gone up it must mean that either its supply has diminished, or its demand has increased. It’s all part of a natural stable system. Wise investors are carefully evaluating companies and buying and selling shares accordingly. The government, who claim to believe in free markets, sit on the side-lines and let them get on with it.

IMHO the conventional view is badly wrong and here's why:

Most people would make two assumptions when considering this market:

1. People buy shares with their money.
2. If they spend say, £1000 on shares, they will have £1000 less money to spend on other things.

If both these things were true, then share prices may stand a chance of being well behaved and act in the way textbooks may have you believe. But many economists have observed that share prices behave in strange ways. At least part of the reason for this is the fact that neither of the two assumptions is correct. They are incorrect because shares are often purchased with borrowed money, or to be more accurate, part borrowed. Readers of this blog should know by now, that when £1000 is “borrowed” from a bank, that money is created on the out of nothing. There is nobody else in the economy that is deprived of £1000 of spending power. You should get the idea straight away that now something is screwy about the demand side of the supply and demand balance.

Textbooks say that the price of something is what you are willing to give up in order to get something, i.e. the amount of money you will pay for something equals the amount of money you are willing to have disappear from your spending power. But if you are going to buy that thing with 10% your money and 90% borrowed money (a process known as trading on margin) then the textbook concept is busted. Now the amount of money you are willing to pay for something is, instead, enormously sensitive to the interest rate you will be charged for the money you borrow to buy that something.

So now the role of government/central banks, becomes crucial in setting share prices! Instead of standing at the side-lines observing these wise investors analysing the companies, the government is now the dominating factor. If they lower interest rates, then the enthusiasm for borrowing to buy shares increases and their price will rise… and conversely If they raise interest rates, then the enthusiasm for borrowing to buy shares decreases and their price will fall.

By implementing super-low interest rates for such a long time, the government is now stuck in a situation, where returning to normalised interest rates would almost certainly cause a fall (or even crash) in the stock market. Note that I could have made almost exactly the same argument about the housing market too.

The near-zero interest rate policy is in force precisely because of fractional reserve banking and would be entirely unnecessary had we a full reserve system.

Changing to full reserve banking is a key ingredient for making our economy work properly.

What nobody is saying about the housing market...

Its seems incredible to me that amongst all the talk about the housing market by Mark Carney, George Osborne and the media, there is scarcely any mention of its connection with the money supply. As readers of this blog should know by now, new loans increase the money supply whist repayments of existing loans shrink it. In the UK, lending is dominated by the housing market. Far more money is lent for house purchasing than for business. Putting these facts together means that the total amount of money that circulates in the economy as a direct function of the state of the housing market. A housing boom corresponds to a growing money supply, whilst a bust would shrink the money supply, just like in 2008. We are now in a very unstable situation. If regulators succeed in bursting the current housing bubble it would either lead to an immediate recession (this is what a shrinking money supply does), or alternatively quantitative easing would have to start all over again.

With this precarious situation, why are the words "money supply" not on everybody's lips?

Does a switch to full reserve banking equate to “banning banks”?

Ever since Martin Wolf came out in favour of full reserve banking, there have been several follow-up articles (1,2,3) in which the authors describe a move to full reserves as “banning banks”. I take issue with this...

When Dave Fishwick, made famous by the television series Bank of Dave, wanted to start his own bank, he was surprised to discover that his proposed business of taking people’s savings and lending that money to people that wanted to borrow it, was not allowed to be called a “bank”. I can sympathise with Dave because by almost any definition of the word bank you may find in a dictionary, his institution was most definitely a bank. It’s just that the financial regulators have an unreasonably pedantic definition of the word. Its as if the word “car” had been defined as a Volkswagen Golf, and any “vehicle” that wasn’t a VW Golf was barred from calling itself a car, and had to be advertised as a “motorised people transportation device”.

There are many precedents for dictionary definitions of words being different from that which pedantic lawyers would insist upon. For example, take Champagne and Velcro. Champagne is simply sparkling white wine, but woe betide you if you make some white sparkling wine outside the Champagne region of France and label your drink Champagne. Similarly with Velcro. If your “hook and loop material” was not made by Velcro Corp. and you describe it in your sales material as velcro, you will have a letter from their lawyers soon after.

So if you are a pedantic lawyer type, then yes, full reserve banking is indeed banning banks. But if you are a normal human being, armed with a normal dictionary, then full reserve banking does not involve banning banks. It's merely switching to a different model of bank, like a different model of car.

Krugman's c**p argument against 100% reserve banking

A few days ago the FT's Martin Wolf  wrote an article supporting 100% reserve banking. Good! About time too.

Then Paul Krugman responded with a short article entitled "Is A Banking Ban The Answer?"

This article made an argument (that I've seen before) which suggests that under a 100% reserve system, anyone with spare cash that wanted to use their money to lend out and earn interest would be unable to use a "bank" and would therefore be forced to employ some dubious unregulated "shadow" institution. See for example this sentence from his article:

"First, Wolf’s omission is a big one. If we impose 100% reserve requirements on depository institutions, but stop there, we’ll just drive even more finance into shadow banking, and make the system even riskier."

First of all I suggest that even with 100% reserves, the institutions that manage saving and lending should be called banks. They will still take in people's savings and lend them out to borrowers. The only difference with today's banks being that the deposits will have to be properly enforced "time deposits" rather than "demand deposits".

Secondly, even if they are not given the name "banks" (lets call them alt-banks for now), a switch to 100% reserve banking would have to involve new regulation. This means that alt-banks could (and should) be regulated to whatever degree a government deemed necessary. So Krugman's argument is just drivel.

Fractional Reserve Banking on Wikipedia

The fractional reserve banking page on Wikipedia has long been a source of edit-warring. It has generally presented the, now thoroughly discredited, "money multiplier" theory as if it was gospel. But now in the light of this new Bank of England document, the money multiplier defenders on Wikipedia have few arguments left. Today I posted on the discussion page a new opening section (below) which I hope to have accepted.

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Fractional reserve banking is a monetary system in which there are two types of money with one type constituting a fraction of the total, hence the name. The first type is known as central bank money or base money which is created by the central bank. The second type, known as broad money or demand deposits, is both created and destroyed by private banks as they make loans, or their loans are repaid. Broad money is essentially an IOU, from the private bank, of central bank money.

Central bank money can be further subdivided into two components, reserves and cash. Reserves are electronic and do not circulate outside of the banking sector, whilst cash takes the form of notes and coins which may be used by the public.

Banks typically loan out IOUs totalling more central bank money than they posses. This makes them vulnerable to a phenomena known as a bank run. Governments often have guarantees and or other policies to protect bank's customers in such circumstances.

There are regulations that require that a bank holds a minimum amount of capital and or reserves for any given amount of IOUs it has loaned out. The exact nature of these regulations may be different between different countries and at different times.

Fractional-reserve banking is the current form of banking in all countries worldwide.