My book is now online for free

I have now completed an updated version of What Went Wrong with Economics and put it online for free.

Q.E… Just an “asset swap” as suggested by MMT supporters?

Following on from my last post What People Still Get Wrong About QE...

I have seen MMT proponents suggest that QE is just an “asset swap” with private banks and so no new money is created in the process. In the UK where the central bank purchases bonds mainly from non-banks it is very blatantly false. In order for a central bank to buy bonds from a pension fund the central bank has to give freshly created reserves to the private bank that the pension fund has an account with. That private bank has to then credit the pension fund with the same amount of freshly created demand deposits. These demand deposits did not exist before and constitute new (“cheque book”) money, spendable in the real economy.

In the US where the central bank may buy the majority of bonds from private banks the issue is more complicated because the money creation is more of a side effect of ongoing QE. I emphasize ongoing because in the very *first* instance there may not be any (“cheque book”) money creation. Let me tell it in “cartoon” form for the sake of simplicity. Imagine it’s November 2008 and Ben Bernanke wants to do some QE for the first time ever. He goes round to a private bank, knocks on the door and says “Have you got any government bonds in stock, I’d like to buy some”. The bank has a few and swaps those bonds for reserves and no new cheque book money is created. This is the “asset swap”, just as the MMTers suggest. But then, just as Ben is heading out the door, he turns round and says “it’s a shame you had so few bonds, I’d actually like to buy tons more next month and indeed every month for the foreseeable future”. So the bank manager says to himself, “gee, we’d better get out there and buy a ton of bonds from pension funds and the like so we can sell them to Ben the next time he calls round”… this is where it gets interesting...

The thing is that when private banks buy assets from non-banks, new money that never existed before is created... “WHAT!!??” I hear you ask. Yes, indeed. And this fact is not even controversial, it’s just very little known outside of banking. Just think about what a private bank can use to buy stuff. It cannot buy stuff from non-banks with reserves. Instead it simply creates demand deposits for the non-bank. It creates the demand deposits out of thin air, it does not get them from somebody else’s account. So QE does indeed create new cheque book money, but it’s indirect. The new money is created by the private banks when they are expecting to be able to sell bonds to the central bank as part of ongoing QE.

What people still get wrong about QE

The idea of QE has been widely discussed in the media since the crash of 2008 but even now, over a decade later, people’s understanding of it is very poor. And when I say people, I include politicians and even economists. The consequences of these misunderstandings are simply enormous. This article will explain what QE really is, what it does and whether or not it should stop.

But before we delve into the nitty-gritty of QE we should first check that we’re all agreed on how the monetary system works. Most people assume that there is a constant pool of money that circulates in the economy forever more and the quantity of it only changes when the government decide to print more of it. Some of the money we use does indeed work in this way but it only constitutes a tiny fraction of our money supply. The bulk of it is made up of what is known as “cheque book money” and it works in a completely different way. It has become increasingly well known that when a bank makes a loan, new cheque book money is created. What is less well known is that when the borrower repays the principal of the loan, it disappears back out of existence. If you’re finding this hard to believe then please read this document published by the Bank of England https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf. This paper contains the words "Just as taking out a new loan creates money, the repayment of bank loans destroys money." - I wish all explanations of our monetary system were this clear. 

So now we can see that the money supply can go up or down in accordance with two rates of flow – the rate of new money creation through new bank loans vs the rate of money destruction through loan repayments. The money supply is thus analogous to the amount of water in a bath where a tap is adding water (new loans) but the plug has been removed and water is flowing out of the bath (loan repayments). I shall refer to this analogy later on as the “bathtub dynamic”.

The prelude to QE

The next thing to consider is what circumstances would lead up to a situation where governments/central bankers might want to do QE in the first place. The answer is the upswing phase of a housing bubble. Millions of people borrowing as much money as they possibly could to buy houses, driven by the belief that house prices are likely to rise at a rate which makes them a good investment. This phase corresponds to a high rate of flow through the taps into the bath. At the same time there will be a high rate of flow out of the bath corresponding to all those mortgage repayments. At some point however, all housing bubbles come to an end. People become less certain that the rate of increase of house prices can be sustained and the enthusiasm for new mortgages takes a nosedive. So the flow of water into the bath will slow to a trickle. But what happens to the flow of water out of the bath? The answer is that it remains high. Mortgages last a long time, decades even. So now we have a situation where, in the absence of any intervention, the water level (i.e. money supply) will start to fall. A falling money supply is painful for an economy in all sorts of ways and central bankers want to avoid it if at all possible… enter QE.

Misconception 1: QE is just “printing money”

If QE was just “printing money” then it would be a permanent thing. I.e. you print the money and that money would remain in the economy forever more and that would be the end of it. QE does indeed create new money but with QE it is very much not the end of it. It is inherently a time limited thing, i.e. the money is created, added to the economy and then at a predefined future time will automatically disappear back out of the economy. The reason for this strange disappearance is all to do with the fact that QE involves the purchasing of bonds…

What is a bond?

A bond is a mechanism for borrowing money. Let us say that someone or some organisation wants to borrow a £1million for 5 years and they are willing to pay interest of say 7% each year for the privilege. What they can do is write out a special document called a bond, which says, “I promise to pay the holder of this document  1 million pounds in 5 years’ time and I will pay 7% (that’s £70,000 each year) along the way” and then hope they can find someone willing to buy that document for 1 million pounds. The person that buys the document will then receive £70,000 a year and at the end of five years the person borrowing the money will have to pay the purchaser the original £1million back. In this example 5 years is known as the “maturity” and the £70,000 per year interest payments are known as the “coupon”. If the organisation wanting to do the borrowing happens to be the government then the bond is referred to as a government bond or gilt. Bonds can be bought and sold like stocks and shares.

So the first step of QE is the central bank creating money out of thin air and using that freshly created money to buy pre-existing government bonds from the financial markets, for example from a pension fund. Say for example they purchased £10Billion worth of bonds that mature in 3 years’ time. When those bonds reach their maturity the original issuer of the bond (i.e. the government) will need to pay back the £10Billion to the holder of the bond (the central bank). One may ask what happens to that money upon repayment, and the answer is that it disappears back out of existence.

So the difference between simply printing money and QE is that with QE there is an automatic, baked in, process by which that money will be “un-printed” at some future date. And the un-printing will be painful for the government of the time – the government will have to deliberately destroy some of its own money, i.e. it would mean collecting £10billion from the taxpayer and instead of using that money to pay doctors, teachers, policemen etc., it will have to destroy that money. There is not only that pain however, there is also the economic effects of removing that money from the money supply – a double whammy of pain. This process is known as “unwinding QE”, and guess what, governments don’t like to do it! What they are much more likely to do instead is some more QE to counteract the expiring QE. I.e. at the moment that £10billion of bonds matures, the government can simultaneously borrow another £10billion by selling £10billion of freshly created government bonds to the private sector and getting the central bank to do £10billion of new QE, i.e. buy another £10billion of bonds from the private sector.

Misconception 2: QE increases the money supply.

Indeed QE can increase the money supply, but it is not guaranteed. If the rate of creation of new money via QE is less that the rate at which the money supply is falling (due to the burst housing bubble) then we could be in a state, where you add new money over some period but end up with less than you started with. Indeed if you watch the former Governor of the Bank of England speaking to a parliamentary committee in 2011: http://www.bbc.co.uk/news/business-15446545 you can see he explains that at that time the UK was in just such a state. He says "What we were doing was injecting money into the economy and what the banking system has been doing is destroying money". "What we were doing [QE] was to partially offset what would otherwise been an even bigger contraction."

Misconception : The money initially simply sits in the banks as reserves and no new money enters the economy until the banks lend it out.

This idea probably comes about because the central bank’s form of money, namely bank reserves, cannot be used directly by the public. So the assumption is that the only way for central bank money to get out into the economy is for banks to make loans. But in fact the central bank can purchase things from, say a pension fund, in a two-step process whereby they give reserves to the bank holding the pension fund’s bank account and instruct the bank to credit the pension fund’s account thereby getting money outside of the banks without a single loan having taken place.

Misconception : It’s failed so let’s stop

Many people (usually with no idea of the bathtub dynamic) have observed the rounds of QE, seen that there have not been great improvements in the economy and have declared things along the lines of “We’ve given QE a try and it didn’t work, let’s stop QE and never do it again”. Unfortunately because water gushing out of the bathtub’s plug hole, you have to have an alternative plan for preventing a contraction of the money supply. Simply stopping QE is not really an option.

Misconception : QE might lead to runaway inflation

If you don’t know about the bathtub dynamic then QE will appear to present a great risk of inflation. Indeed when it was being employed  around 2009 there were many economists warning of hyperinflation around the corner. Over a decade later it has still not materialised. This is not to say that it is completely impossible to create hyperinflation with QE, merely that when you “do the math” you have to take into account the (anti-inflationary) water flowing out of the bath.

The most critical issue of all

Let us consider the question of whether it would be possible to get the money supply stabilised again without relying on QE. This means getting the rate of flow of new money creation to rise up to a level which is at least as much as the rate of flow of money destruction. Unfortunately the high rate of money destruction has been baked in for years to come by the mortgage repayments set up just before the bubble burst. This rate was crazily and unsustainably high. Without QE, this rate cannot be matched again without there being a new bubble in place! Any long term solution to the QE problem has to bear this in mind.

A solution

What we need is to replace the money being lost through mortgage repayments with money that doesn’t disappear and won’t leave future governments burdened with horrible decisions about unwinding. This can be done with genuine (permanent) money printing. The government can, for a few years, spend more than it takes in from taxation and make up the difference with central bank money. They can pay government workers (doctors, teachers policemen etc.) with central bank reserves by handing those reserves to private banks and then instruct those banks to credit the accounts of the workers. The new money thus goes straight into the economy and there is no future unwinding required and no interest to pay.

An even better solution

All this crazy game that central bankers need to play in order to get a stable money supply is a direct consequence of our monetary system in which bank loans create money and repayments destroy it. The system we have, known as fractional reserve banking, was however not humanity’s only choice for a way of designing money. Indeed I would suggest that that our current system has come about more through historical accident than by design. If money was being introduced for the first time today, nobody in their right minds would select our current system. If you asked the man in the street how money worked, they would probably suggest that there was some pool of money that circulates in the economy forever unless a government decided to print more of it. This “naive” idea is in fact perfectly workable and is known as full reserve banking. No more bathtub dynamic. Under full reserve banking, the amount of money in the economy does not change when there is a boom or a bust so there would never be any need to stop the money supply falling. It simply cannot fall. Switching to full reserve banking would no doubt take a lot of preparation and re-education of bankers, so could not be done overnight but it’s something we should start investigating for the future.

How to Save the Economy from Coronavirus

 
Obviously the economy is going to shrink dramatically during this virus outbreak. This will be true whatever policies are put in place… So perhaps the more important question for policymakers is what steps can be taken to minimise the harm to the economy when the outbreak is over and try and ensure that perfectly viable companies are not lost through bankruptcy.

A powerful tool for solving complex problems is to first make a simplified model of the problem, solve that, and then start thinking about how the real-life complexities might alter that solution…. So what I’m going to do here is present a kind of cartoon version of the virus interacting with the economy and present a solution for that scenario. I will then propose that this “cartoon solution” could be a starting point for dealing with the real world coronavirus issue.

The cartoon: Imagine a world with a normal economy ticking over nicely. Then one day a kind of magic-freezing-virus fell from the sky and prevented all living things from moving a muscle – a bit like a game of musical statues. Nobody was killed, they were just put into a state of suspended animation. This state lasted for five whole years and then suddenly the effect wore off and everyone “woke up”. Now let’s consider what should happen with the post-suspended animation economy. You might imagine it should and could carry on from where it left off and life could get back to normal in an instant but there are some issues to be resolved.

Issue 1 Wages: The workers may go to their bosses and say “we’ve got contracts, you owe us five years wages!”. Obviously the companies will have earned zero during those five years and the bosses could say “but you did not work for us during all those years why should we pay you?” If the back pay was enforced then most companies would instantly be bankrupt and be forced into liquidation. Hopefully you will agree that the best thing to do is simply not enforce the back pay of all those wages.

Issue 2 Rent and/or Interest: Landlords and banks may demand five years of rent and interest payments. If this was enforced then again a huge proportion of business would be immediately bankrupt. Hopefully you will agree that the best thing to do is not enforce the back pay of rents and interest.

In conclusion, in the case of the magic-freezing-virus, the economy can continue unharmed from where it left off so long as wages, rent and interest were deemed non-applicable during the suspension and could not be recouped retrospectively.

Relation to the real world COVID-19:

Obviously the magic virus is not the same as COVID-19, but it does share some similarities. Around the world, otherwise viable companies are temporarily having to cease operating. Whether or not they will be able to restart again when the pandemic is over may depend critically on the decisions made by policymakers. What would be ideal is if companies could go into a kind of suspended animation and not have to pay any wages, rent or interest during any virus-enforced shut down. One difference between COVID-19 and the cartoon story is that during the COVID-19 outbreak people still need to pay for at least the bare necessities of life, food, water, gas, electricity. If they were getting no wages then how would they get the money to live? The answer is to pay everyone a citizen’s income. This would be enough to cover food, utilities and not much more. The money can just be created by the Bank of England. Now before you all scream “but what about the inflation!” don’t forget that this money would not need to cover mortgage or rental payments because these will all be non-applicable during any enforced shutdown. The total amount needed may be as little as say £100 per week per person. This corresponds to around £28 billion per month. Now consider that Rishi Sunak is talking about injecting £330 billion into the economy, this £30billion a month is a mild measure indeed.

What Sunak is proposing is that all rents and interest should be 100% applicable during any shutdown. Even if some of those things are not collectable during that time, they accrue and will be recoupable in the future. He wants Landlords and moneylenders to not lose a single penny in the long run – as if the pandemic never happened. Why should this group of the wealthiest people in society have the privilege of being so fully immune? It makes no sense. Under Sunak’s plans, the amount of debt businesses and families will be saddled with after the pandemic will have risen horribly.

In conclusion, the best thing to do in a shutdown is to properly cease all rent and interest payments and allow hibernating companies to cease paying wages. Add in a not too expensive citizen’s income and you have a recipe for both surviving the crisis and recovering afterwards.

How the Rich Steal From the Poor

A video about land and housing. Parts 1,2, and 3.

MMT seems to becoming ever more popular recently and I can't really see why. Whilst they do state one or two true things that perhaps some people did not realise - they also spout a lot of incredibly misleading and occasionally downright incorrect stuff. So here are a few examples I came across recently.

1. Randy Wray being very reluctant to say that demand deposits are money. Moneyness is a matter of degree, but if all the things that could conceivably be money were lined up in order of their moneyness, then demand deposits would sit right at the top of the list neck and neck with cash as a near rival. So to have such reluctance to call demand deposits money is just unhelpful.

2. Warren Mosler claiming that QE does not increase the money supply.
This is now the opposite of the Wray problem. Wray was too reluctant to call something money when it blatantly is money and now Mosler is too keen to label something as money when it has rather dubious moneyness - namely government bonds. What percentage of goods and services in our economy is purchased with government bonds? Close to nill I would guess.

3. Randy Wray saying of debt fee money: "it's a non sequitur, it's impossible"
This is simply false. Debt is an IOU. An IOU is a thing which literally or metaphorically has the following form:

I/we/organisation 'X' agree to give the bearer of this thing, some stuff 'Y' at some future time.

The holder of this thing can, at that future time, take the IOU to X and say "Now please can I exchange this IOU for Y". Indeed this exchange will probably be enforceable by law. Once the exchange has taken place the IOU has now done its job and will expire. X may as well destroy the IOU - it will be of no value to them.

So a reasonable test of whether something is an IOU or not is to ask: who is X and what is Y. If you can not answer that then the thing is not an IOU. In addition to that, if Y is simply the same as the thing in question then again that thing is not an IOU.

As an example let us consider demand deposits. Are they IOU's? Let's consider X and Y:

X is: your bank

Y is: cash

The test has been passed, so indeed demand deposits are an IOU.

Now consider coins - i.e. ordinary coins you can buy things with - obviously money. Can you identify X and Y?... Good luck, because I can't. Coins are money but they are not debt.

As another example, take bitcoins which are definitely not debt (Wray says they are not money). This is slightly messy because in recent years their moneyness has diminished but certainly around 5 years ago people were buying and selling goods and services in bitcoin. Unfortunately some design flaws meant that it was a little awkward to use and it tended to be reserved for people of a geeky disposition. But even today there are people (mostly criminals!) that will buy and sell things (mostly illegal things!) with bitcoin. So just as you can say cigarettes are money *in prisons* you can also say that today bitcoins are money *amongst criminals*.

A counter argument I have heard about bitcoin is along the lines of "their inherent value is zero therefore in the long run they will fail" - even if that were perfectly true, that statement is not an argument against bitcoin being money now. Plenty of currencies have ultimately failed due to excessive printing or other issues but that never stopped those same currencies functioning perfectly well as money for many years, perhaps many decades, before their ultimate failure.

MMT an intellectual slight of hand

Imagine you pour some water into a bucket at a rate of one litre per minute... a minute goes by... how much more water is there in the bucket compared to when you started? One litre more? I hear you say. Wrong! I forgot to mention that there was a hole in the bucket which leaked water at half a litre per minute. What kind of dirty trick is that! I hear you say... well its the same kind of trick used by MMT'ers when they tell you about their beloved "sectoral balances" graph:

The graph seems very compelling - if the government spend $1 billion more then they take in taxes then the private sector has 1 billion more dollars to use... right?... wrong! (hole in the bucket coming up)... the thing they forget to mention is that the private sector can make and destroy money independently of the government via the magic of fractional reserve banking. So the amount of money the private sector has to play with could have gone up by much more or much less than $1 billion. It could even have shrunk. Many people will assume that the vertical axes on the graph corresponds to "money", but it doesn't... instead it corresponds to a rather odd concept of "financial assets" which is not the same thing at all.

It may well be that if you read some MMT books in detail that the precise truth of what's going on in the sectoral balances graph is revealed, but I can't help feeling that the graph is being over-sold.

George Osborne guides UK on unsustainable trajectory

Ask yourself this question: When have house prices in the UK ever been higher?

According to the Halifax House Price Index, the only time prices have been higher, as a multiple of average earnings, was just in the run up to the crash of 2007/8. And as you can see from the graph below, we are now on course reach or exceed those levels all over again.

So, why should this matter I hear you ask... Maybe house prices will simply flatten out, at some high level and we can just carry on with our great economic recovery... The problem is that a sizeable constituent of the demand for houses is precisely the perception that they are on a rising trajectory. When the trajectory is no longer expected to continue, the enthusiasm for new mortgages drops dramatically and you have a crash in house prices and consequently a crash in demand for new mortgages.

So why should a crash in mortgage demand matter? Surely housing will just be cheaper and we'll all be happy? The problem is, that with our crazy fractional reserve monetary system, the amount of money in the economy is critically dependant on the amount of borrowing that goes on. So a slump in borrowing equals a slump in money. Economists and the media confusingly refer to this as a "credit crunch", but it is more accurately described as a money crunch. Money, quite literally, starts disappearing. As Mervyn King said just after the crash "What the banking system has been doing is destroying money". A shrinking money supply is painful for an economy, and George Osborne is setting us up for just that scenario.

There are ways out of this predicament. We don't actually need rising house prices forever to maintain the money supply. We could actually have normalised interest rates, non-looney house prices and a stable money supply... we just have to fix our crazy monetary system and switch to something sane like full reserve banking as supported by the FT's Martin Wolf.

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.

===================

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.

What's wrong with MMT

I'm writing this blog entry as a discussion point. Please don't take it as definitive.

I have long been dissatisfied by MMT'ers. Listening to them just hasn't rung true. And I've never quite been able to work out why... but now I have a hunch... its all to do with the difference between "base money" and "broad money", or as I like to think of it "everlasting tokens" and "spendable IOU's". If you are not familiar with these concepts, please watch this.

MMT'ers appear to believe that the world revolves around base money (everlasting tokens), despite the fact that over 95% of the money in the economy is broad money. The reason for this they would say is that when man A buys $1000 worth of stuff from man B, then the transaction is not complete until $1000 of base money is transferred from A's bank to B's bank. But this is (mostly) untrue. If for example A and B both are with the same bank, then no base money need get transferred anywhere. It would be purely the bank's spendable IOU's or broad money that would be transferred from A to B. Even if bank A and bank B were different, so long as they are reasonably large, then any base money settlement between the banks will be done at the end of the day and will involve a sum corresponding to the net balance of transfers between them. If there were thousands of transactions between bank A and bank B some in one direction and some in the other, then the net transfer of base money will likely be only a tiny fraction of the total amount exchanged.

People's propensity to spend money (and therefore the overall demand) depends critically on the amount of broad money that they earn and/or possess in the bank. Therefore, unlike what MMT'ers would have you believe, it is the amount of broad money that dominates the behaviour of the economy. And don't forget it is perfectly possible, at least in the short and medium term, for the amount of base money and the amount of broad money to be quite uncorrelated, one can rise as the other one falls and vice versa.

Feel free to leave comments. I will read them carefully and may write a followup blog addressing whatever comes up.

Georgism in 300 words.

Imagine that in the distant past, a ship ran into rocks off a desert island and started sinking.  Everyone jumped overboard and started swimming towards the nearest beach. Imagine a guy armed with a gun got to the island first, and then upon everyone else's arrival, the guy said, “I got here first, so this island is mine. You can't live here unless you pay me rent for using my land”. The swimmers have no choice and have to give the “landowner” part of their income forever more.  This situation obviously stinks. If you were one of the people having to pay rent you would be angry as hell, you’d protest at every opportunity. Who could possibly defend such system?

Now imagine that at some later time, a rich islander purchased the island from the gunman for a large sum of money. The rich man announced to the rest of the islanders, “That nasty gunman was evil and grabbed the island unjustly. He had no right to claim rent from you all. But I purchased the land with my own money and without violence. Therefore this island is rightfully mine, and now you should all quit protesting and pay me rent!”.

If you were an islander, would you be happy with the situation now?

By the way, this is essentially the way the world works today. How do you think the first owners of the land you're living on got to own the land? (Usual answer: they took it by force) Personally, I have no idea why people are not marching in the streets demanding a better system.

Is there a more just way of distributing land? Yes. An idea known as Georgism. The fact that houses get built on land makes the potential solutions more complex, but almost any system based on Georgist ideals would be better than what we have today… unless you’re a landlord that is.

Georgism:- look into it.

Share prices with fractional reserve banking

The textbook explanation of share prices revolves around basic “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.

Most people would make two assumptions when considering this market:

1.    People normally 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 be 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 prices appear so strange is the fact that neither assumption 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 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 on other stuff. 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 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 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. The wise investors are sitting watching the government! If they lower interest rates, then the enthusiasm for borrowing to buy shares increases, this increases demand 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 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. If I were in charge, I would ban the practice of trading on margin too. It serves no purpose that I can figure out for the economy as a whole.

Advertising Standards Authority condone bank's lies.

The idea that banks simply "lend" money in the normal sense of the word is actually false. I wrote about this before here. You may have noticed however, that banks are happy to use the word "loan" in their advertising. So I decided to write to the Advertising Standards Authority (ASA) to see what they had to say on the matter. According to their website, the ASA's mission is to "ensure that advertising in all media is legal, decent, honest and truthful". Let's see...

In their reply, they said...

"we acknowledge that the wording could be seen as being technically inaccurate"

...interesting. Note that "technically inaccurate" is a euphemism for lie. Reminds me of terminological inexactitude!

They went on to say...

"we consider that the ads are unlikely to mislead consumers into making a transactional decision with regard to the advertisers’ services that they would not have otherwise made"

I would dispute their claim, certainly in the long run. If more people, including economists, were aware of the true workings of our crazy monetary system, the entire course of our economic history would probably have been quite different and so many of the loans that were taking place in the run up to the credit crunch would never have taken place. Allowing banks to lie in their advertising is just one more contribution to the world's misunderstanding of money. Apart from anything, what are the ASA doing, allowing any lies in adverts at all? Sure, there are many adverts that have comedy lies, or unreal events that everyone knows are unreal. But lies where the viewer will probably believe the lie to be true? Surely that can't be allowed.

I strongly suspect the ASA is a sham organisation who's main purpose is to protect advertisers from genuine regulation, just like self-regulation by the British press. The ASA are gutless and toothless.

Peter Mandelson demonstrates his ignorance of our monetary system

When Peter Mandelson appeared on the Andrew Marr show on 22 Dec 2013, he was asked about the state of economy. He said "we've got to see people earning more and their personal indebtedness reduce". Unfortunately, under our current fractional reserve monetary system, most of the money supply is created by people's personal indebtedness; reducing that, will reduce the amount of money available for people to earn! Its impossible to achieve what he's asking for without changing our monetary system.