Money how to change it

7/30/2019 Money how to change it

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TOWARDSATWENTY-FIRSTCENTURY

BANKINGANDMONETARYSYSTEM

SUBMISSIONTOTHEINDEPENDENTCOMMISSIONONBANKING

byBenDyson,TonyGreenham,JoshRyan-CollinsandRichardA.Werner

Jointsubmissionbythe

CentreforBanking,FinanceandSustainableDevelopment

UniversityofSouthampton,SchoolofManagement(ProfessorRichardA.Werner)

nef(theneweconomicsfoundaon)(TonyGreenham&JoshRyan-Collins)

PosiveMoney(BenDyson)

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Aboutthesubmissionandorganizaons

TheisajointsubmissiontotheIndependentCommissiononBankingbythreeorganizaonswhosharea

broadconcernthatmuchofthedebateonbankingreformisfailingtoaddressoneofthekeyunderlying

causesoffinancialinstabilityintheUKeconomy:thesystembywhichcreditiscreatedandallocatedintothe

economy.Thisisanareawherethereisconsiderablepublicandacademicmisunderstandingandconfusion

andbothnef(theneweconomicsfoundaon)andPosi%veMoneyareoftheopinionthatakeyfirststep

towardssystemicreformistoprovideabeOerunderstandingofhowcreditiscreatedunderthefraconal

reservebankingsystem.BothnefandPosi%vemoneyhavebeenworkingforsomemewithProfessor

RichardWerner,oneofthemostrespectedandknowledgeableacademicsinthefieldofmonetaryreform

andbanking,todevelopalternavestothissystem.Theproposalbelowisbynomeansthefinishedarcle

andmanyareasrequirefurtherdetailedresearch.Butwedohopethatattheveryleastthisproposalopens

upaspacefortheICBmemberstoconsiderradicalalternavestothestatusquo.Wewould,ofcourse,

welcomefurtherdiscussionaboutanyaspectsofthesubmission.

ProfessorRichardA.Werner,DPhil(xon),BSc(Economics,LSE),beganhisacademiccareerasMarieCurie

FellowoftheEuropeanCommissionattheUniversityofxford.From1997to2004hewasAssistant

ProfessoratSophiaUniversity,Tokyo.Since2004hehasbeenattheUniversityofSouthampton,Schoolof

Management,whereheisChairinInternaonalBankingandfoundingdirectoroftheCentreforBanking,

FinanceandSustainableDevelopment.

ProfessorWernerhastwodecadesofexperienceinthefinancialsector,includingaschiefeconomistat

JardineFlemingSecuries(Asia)Ltd,SeniorManagingDirectoratBearStearnsAssetManagement,andas

seniorconsultantorvisingresearcherattheAsianDevelopmentBank,theJapaneseMinistryofFinance,the

BankofJapan,theJapanDevelopmentBankandtheNomuraResearchInstute.RichardservedasamemberoftheassetallocaonboardofaUS$6.5bnJapanesecorporatepensionfund,andhasbeenworkingasglobal

macrofundmanagerandproviderofforecasngservicesandeconomicpolicyadvicetoinvestorsand

governments.

HisbookPrincesoftheYenwasaNo.1bestsellerinJapanin2001.Inhis2005bookNewParadigmin

Macroeconomics,hewarnedaboutthedangersofrecurringbankingcrises,includingthependingfinancial

collapseintheUK,anddetailedtherequiredpolicyresponses.Richardhasbeenvotedoneofthetop

economistsbyinvestorsurveysandissoughtasacommentatorbythemedia.TheWorldEconomicForum,

Davos,selectedhimasGlobalLeaderforTomorrowin2003.

nef(theneweconomicsfoundaon)isonetheUKsleadingthinktanks,developingresearchand

campaigningforsocialjusce,ecologicalsustainabilityandwell-being.Wehavealongtrackrecordof

developinginnovaveandradicalalternavesintheareaoffinancialreform.nefwasoneofthepioneersof

theJubilee2000campaignwhichledtomanybillionsofdollarsofThirdWorlddebtbeingcancelled.ur

reportsinthisareaincludeCrea%ngNewMoney(2000)and,morerecentlyinreacontothefinancialcrisis,

TheGreenNewDeal(2008),TheEcologyofFinance(2009)andWhereDidourMoneyGo?(2010).ur

proposalforaGreenInvestmentBankhasbeenadoptedbythecoaliongovernment.

PosiveMoneywaslaunchedin2010toaddressthelowlevelofunderstandingoffraconalreservebanking

amongpolicians,themediaandtheauthories.Weworkwiththinktanks,NGsanduniversiestoraise

awarenessandunderstandingoftheflawsinthemodelofmoneyandbankingthatunderpinstheglobal

economy.

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Contents

..............................................................................................................................................ExecuveSummary 4

.............................................................................................................PartI:Full-reservebankingaproposal 7

..............................................................Step1:DivorcingthePaymentsSystemfromRiskyLendingAcvity 7

..................................................................................................................................TransaconAccounts 7

...................................................................................................................................InvestmentAccounts 8

.....................................................................ACommercialBanksBankAccountsattheBankofEngland 8

..............................................................................Step2:TheNewRoleoftheMonetaryPolicyCommiOee 9

.......................................................................................TheMPCWouldNotNeedtoSetInterestRates 10

...........................................BankofEnglandWouldChoosetoIncreaseorDecreasetheMoneySupply 10

..............................................HowFull-ReserveBankingWouldAddresstheConcernsoftheCommission: 12

..................................................................................AStableMoneySupplyLeadstoaStableEconomy 12.............................................................................................therKeyBenefitsofFull-ReserveBanking: 14

....................................................................................................DisadvantagesofFull-ReserveBanking: 16

......................................................................BenefitsofFull-ReserveBankingoverAlternaveReforms 17

............................PartII:ACriqueoftheCurrentBusinessModelofBanking(FraconalReserveBanking) 18

...............................................................................................TheRelevanceofFraconalReserveBanking 18

.....................................HowFraconal-ReserveBankingWorksAgainsttheConcernsoftheCommission: 19

..........................................................................................................................BankingSectorInstability 19

......................................RisktoEconomy-WideInstability,andtheImpactonLending&MoneySupply 20

.............................................................................................................HouseholdAffordabilityandDebt 21

.........................................................................................................................CreaonofAssetBubbles 21

.............................................................................................DragnEconomicGrowth&Development 21

.................................................................................................RiskToTheGovernmentsFiscalPosion 22................................................................................AddionalProblemsWithFraconalReserveBanking: 22

.............................................................Weaknessofinterestrateadjustmentasamacroeconomictool 22

........................................................................................Re-DistribuonfWealthUpwards&Inwards 23

...............................................................................................................TheNeedforDepositInsurance 23

.......................................................PartIII:AddressingCommonMisconceponsaboutFull-ReserveBanking 25

.....................................................................1.Full-reservebankingwouldleadtoashortageofcredit 25

2.[Full-reservebanks]eupbankdeposits,ratherthanallowingthemtobemadeavailabletofund

.......................................................................producveinvestmentthroughfinancialintermediaon. 25

...................................................................3.Allowingthestatetoissuemoneywouldbeinflaonary 26

...........................................4.Full-reservebankingwouldendtheprocessofmaturitytransformaon 27

5.TheMonetaryPolicyCommiOeewouldbeunabletojudgethecorrectlevelofmoneyneededbythe..................................................................................................................................................economy 28

....................................................................6.Full-reservebankingwouldforcebankstoleavetheUK 29

........................................................................................................................................................Appendices 30

.....................................................................APPENDIX1:HowWeGotHereThe1844BankCharterAct 31

.............................................APPENDIX2:HowFull-ReserveBankingIncreasesStabilityWithinEachBank 32

.............................................................................................APPENDIX3:InvestmentAccountGuarantees 33

......................................................................APPENDIX4:ImpactontheBankofEnglandsBalanceSheet 35

....................................................................................................................APPENDIX5:DealingWithCash 37

.........................................................................................................................................................References 38

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ExecuveSummary

Thissubmissionoutlinesaproposalforbankingreformthataddressesmostoftheconcernsofthe

Commission.TheproposalhassomesimilarieswithnarrowbankingandLimitedPurposeBankingbut

avoidssomeofitsmaindrawbacks(suchastheneedforretaildepositstobebackedbygovernmentbonds),

andoffersaddionaladvantagesoverandabovenarrowbanking.

Webelievethatthebankingsectorwouldbemorestableandrobustunderafull-reservebankingmodel,

wherethetransaconalfunconofbanking(thepaymentssystem)isseparatedfromthelendingfuncon,

thanunderthecurrentbusinessmodel,whichisoenlabeledfraconalreservebanking.

Wealsobelievethisreformwouldcreategreatercompeonwithinthebankingsector,byhugelyreducing

thebarrierstoentryintheretailsector.Inparcular,wewouldhopetoseeitmademucheasierfornew,

TransaconAccount-onlybankstoenterthemarkettoincreasecompeonintheprovisionofthiscore

paymentssystemservice.Wealsobelievethisreformwouldsupportthedevelopmentofamorediversefinancialservicessector,placinginstuonssuchascreditunionsandtradionalbuildingsocieesonalevel

playingfieldwithbanks.

Thekeyfeatureoffraconalreservebankingisthatthelendingacvityofbankseffecvelycreatesnew

money,intheformofnewbankdeposits.AstheBankofEnglands2007Q3QuarterlyBullenstates:When

banksmakeloans,theycreateaddional[bank]depositsforthosethathaveborrowedthemoney.Put

anotherway,themoneysupplyoftherealeconomydependsenrelyonthelendingdecisionsofthe

bankingsector.MervynKing,theGovernoroftheBankofEnglandrecentlyidenfiedthesechangesinthe

moneysupplyasbeingcentraltothefinancialcrisis:

"Attheheartofthiscrisiswastheexpansionandsubsequentcontrac%onofthebalancesheetofthe

bankingsystem."1

Incontrast,inafull-reservebankingsystem,theeffecvemoneysupply2isunaffectedbythelending

acviesofbanks.Aneconomyrunningonafoundaonoffull-reservebankingwillbelesspronetopro-

cyclicaltendenciesandlessinflaonarythananeconomybasedonfraconal-reservebanking.Theviewthat

separaonoftheacviesoflendingmoneyandcreangmoneywouldleadtobeOerstabilityinthe

financialsectorisalsosupportedbyGovernorKing:

Elimina%ngfrac%onalreservebankingexplicitlyrecognisesthatthepretencethatrisk-freedeposits

canbesupportedbyriskyassetsisalchemy.Ifthereisaneedforgenuinelysafedepositstheonlyway

theycanbeprovided,whileensuringcostsandbenefitsarefullyaligned,istoinsistsuchdepositsdonotcoexistwithriskyassets.3

urproposalforfull-reservebankingensuresthatrisk-freedepositsinthepaymentssystemdonotcoexist

withriskyassets.Theproposaltoachievethisissimple:werecommendtorequirebankstokeepsafethe

moneywhichcustomerswishtokeepsafe,andinvestonlythemoneythatcustomerswishtobeinvested.

4

1h:p//www.bankofengland.co.uk/publicaAons/speeches/2010/speech455.pdf

2Forthepurposesoffullreservebanking,wedefineeffecAvemoneysupplyasbeingcashpluspoundsterlingbankdepositsthatcan

bewithdrawnondemand,andthereforeexcludetermorAmedeposits,onwhichanoAceperiodmustbeservedoraspecified

maturitydatemustbereached.ThisdefiniAonofmoneysupplyreferstomoneyandbankdepositsthatcanbeusedtomake

paymentsimmediately.Incontrast,theBankofEnglandsM4measureofmoneysupplycurrentlyincludesAmedeposits.

3h:p//www.bankofengland.co.uk/publicaAons/speeches/2010/speech455.pdf


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AerafewminorchangestothereserveaccountsystemsusedbytheBankofEngland,theeconomywould

haveastablemoneysupply,regardlessoftheeconomicclimateandthewillingnessofthebankstolend.

Thesechangeswouldalsogivecustomersatrulyrisk-freemethodofholdingmoney,regardlessofthe

amountheld,andremovetheneedfortaxpayer-fundeddepositinsurance.

urproposalissimilarinspirittoandmodernizesthoseputforwardbytheleadingmonetaryeconomistsof

thetwenethcentury,namelyIrvingFisher(1936),MiltonFriedman(1960),andJamesTobin(1987).It

followsHuberandRobertson(publishedbynefin2000)inrecognizingthedigitalnatureofmodernmoney,

andisdesignedtocausetheminimumamountofdisrupontothefinancialsystemscomputernetworksand

ITinfrastructureinthetransionperiod.

Thisproposaldeservesseriousconsideraon.Itiseasyandinexpensivetoimplementcertainlymuch

cheaperthananewbailout,andlessdisrupvetotheCitythanbroaderregulaon,suchasanewGlass-

Steagal-typeAct.Itmerelymakesbanksoperateinthewaypeople(includingmanyeconomists)assumethey

operatealreadyastrueintermediariesbetweensaversandborrowers.Bydoingso,itremovesoneofthe

primarysourcesofeconomicinstability.

AdvantagesofFull-ReserveBankinginBrief:

Thebankingsystemandwidereconomywouldbecomeinherentlystable,ratherthaninherentlyunstable.Itwouldbecounter-cyclicalandself-liming,unliketheexisngpro-cyclicalsystem.

Thelikelihoodofsevererecessionsorcriseswouldbesignificantlyreduced,reducingtherisktothegovernmentsfiscalposion.

Compeoninthebankingsectorwouldbesignificantlyenhancedbyreducingbarrierstoentrytoretailbanking,promongamorediverseandresilientsectoroverall

Depositinsurancecouldberemoved,simultaneouslyremovingahugesourceofmoralhazardthat

distortsmanyfinancialmarketsandremovingtherisktotaxpayersandthegovernment. Poorlymanagedinstuonscouldbeallowedtofailwithoutthreattothewidereconomicsystem

orthepaymentssystem.

Thepaymentssystemandmoneysupplywouldbetechnicallyseparateandinsulatedfromthelendingbusiness,meaningthatcomponentfailureinthelendingbusinesswouldnotaffecttheusers

ofthepaymentssystem.

Therewouldbenoneedforfuturebailouts. Despitethewithdrawalofdepositinsurance,membersofthepublicwouldhaveaccesstoameansof

storingmoneythatis100%riskfree,whateverquantyofmoneyisstoredintheaccount.

Themoneysupplyandthewidereconomywouldceasetobedependentonthelendingacviesofthebankingsector.Acreditsqueezewouldnotcauseasevererecessionorriseingovernmentdebt.

Interestratescouldbesetbythemarket,viathesupplyanddemandforfunds,ratherthanbytheMonetaryPolicyCommiOee.Thiswouldreducetheimpactofrapidinterestratechangeson

vulnerablegroups.

Banklendingwouldbelesslikelytocauseasset-pricebubblesandresulnginstabilityandinequality.Inthecurrenteconomicsystem,risingmoneysupplygoeshandinhandwithrisingdebt,creang

greatervulnerabilitytoshocksandinmanycasesacrisis.Incontrast,full-reservebanking,withthe

statecreang,orwithdrawing,debt-freemoney,couldgraduallyreducedebtoverme,creanga

moreresilienteconomyandstrongerfiscalposion.

IncomparisontootherreformproposalsmenonedintheCommissionsIssuespaper,theproposalhasthe

followingadvantages:

Unlike(forexample)LimitedPurposeBanking,thechangesfromtheperspecveoftheconsumerwouldbeminimal.Theywouldsllbeabletoaccessallservicesfromthesamebankbranchor

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website.

Itwouldmakethecomplicatedseparaonofretailandinvestmentbankingunnecessary. Itwouldmakethelimitsonproprietarytradingandinvesngunnecessary.

Unlikenarrowbanking(asoutlinedbyJohnKay)andLimited-PurposeBanking,itdoesnotrequireretail(demand)depositstobebackedupbygovernmentdebt. Itdoesnotrequirethelegalseparaonofthedeposit-takingandinvestmentdepartments,whilstsll

achievingthesameeffectintermsofstructuralsafety.

ResponsetoCommonReacons&Misconcepons:

Wehaveaddressedsomeofthecommonconcernsregardingfull-reservebanking.Wefindthatconcernsthat

full-reservebankingwillcauseashortageofcreditarelikelytobeoverstatedwhenthewidereffectsof

implemenngfull-reservebankingaretakenintoaccount.Wealsoquesontheassumponthatleavingbank

depositsidleinanaccountisaninefficientuseofresources,arguingthattheprinciplesthatapplytoscarce

physicalcapitaldonotapplytointangibledigitalmoneythatcanbecreatedatnocost.

StructureoftheSubmission:

PartIoutlinesourparcularfull-reserveproposalandexplainsitsrelevancetotheCommissionsconcerns.

PartIIoffersacriqueoffraconalreservebanking,explaininghowthisbusinessmodelmakeseconomic

stabilityextremelyunlikely,whilstalsonecessitangbailouts,taxpayer-fundeddepositinsurance,andawide

rangeofmarketdistorons.

PartIIIaddressescommonmisconcepons,objeconsandreaconstothefull-reservebankingproposal.

Theappendicesofferaddionalbackgroundinformaon,suchastheimplementaonintheUKofasimilarreformin1844whichpreventedthecreaonofbanknotesbycommercialbanks.Wediscussthetechnical

changesthatwouldneedtobeimplementedbytheBankofEngland.

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PartI:Full-reservebankingaproposal

BriefOverview

Therearetwocoreelementsofourfullreserveproposal:

1.Thepaymentssystemisseparatedfromriskylendingacvity,sothatfailureofinvestmentsdoesnotposeanyrisktothepaymentssystemorothercrucialpartsofthefinancialinfrastructure.

2.TheMonetaryPolicyCommiOee(MPC),ratherthantryingtoindirectlyinfluencemoneysupplyviathesengofinterestrates,canleaveinterestratestobesetbythemarketandinsteaddirectly

influencesthemoneysupplythroughthecreaonofnewmoneywhennecessary,withinstrict

constraintstoavoidinflaonaryanddeflaonarypressure.(TheMPCcouldconnuetouseinflaon

targengtoguidetheirdecisions).

Step1:DivorcingthePaymentsSystemfromRiskyLendingAcvity

Westartbyclassifyingallaccountsusedbybankcustomersunderthenewstructureintooneoftwotypes:

TransaconAccounts,andInvestmentAccounts.TransaconAccountscollecvelymakeuptherisk-free

paymentssystem,whileInvestmentAccounts,ratherthanholdingmoney,actuallyrepresentarisk-bearing

investmentmadebyacustomer.Withtheoponofarisk-freemethodofsavingmoneyinTransacon

Accounts,theFinancialServicesCompensaonSchemeguarantee(depositinsurance)canberemoved.The

riskofrisk-bearingInvestmentAccountsissharedbetweenthebankandtheinvestor/saver,andisnotpassed

ontothetaxpayerthroughdepositinsurance.Furtherdetailsaregivenbelow.

TransaconAccounts

TransaconAccountswouldreplacepresent-daycurrentaccountsandwouldprovidethefullrangeof

paymentservices,suchascheques,debitcards,ATMcards,electronicfundtransfers,andreceivingmoney

(suchasamonthlysalary).HoldersofTransaconAccountswillhaveon-demandaccesstotheirfundsatall

mes.

However,abankwillnolongerbeabletousethemoneyinTransaconAccountsformakingloansorfunding

itsowninvestments.TheTransaconAccountswillallbeheldoffthebalancesheet,infiduciarytrust,and

notbeconsideredaliabilityofthebankasisthecaseincustodyaccountsofcustodianbanks.

ThemoneypaidintoTransaconAccountswillbeheldinfullwithinanaggregateaccountattheBankof

England.Thisaggregateaccount,labelledtheCustomerFundsAccount,wouldcontainrisk-free,centralbank

issueddigitalmoney.Thisrisk-freecentralbankdigitalmoney,whenheldinaTransaconAccount,willbe

ownedbythecustomer.

BecausethemoneyplacedinTransaconAccountswouldneverbelentorinvestedbythebankandwould

technicallyremainintheCustomerFundsAccountattheBankofEngland,thebankwouldbeabletorepayall

itsTransaconAccountholdersinfull,atanyme,withouthavinganyimpactonthebanksoverallfinancial

health.Itwouldbetechnicallyimpossibleforthemoneytobelost,andabankruptbankwouldsllbeableto

repayallitsTransaconAccountholdersinfull.(Seediscussionbelowonwindingdownafailedbankunder

full-reservebanking).

BecausethebankisunabletouseTransaconAccountfundsforinvestment,TransaconAccountswillnot

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payinterest,andwillverylikelyincurmonthlyorannualfees.Thesefeesareunlikelytobetoohigh,as

explainedlater.

InvestmentAccountsInvestmentAccountsreplacepresent-daysavingsaccounts.Underfull-reservebanking,thebankwould

needtoaOractthefundsthatitwantstouseforanyinvestmentpurpose(whetherforloans,creditcards,

mortgages,longterminvesnginstocksorshort-termproprietarytrading).Thesefundswouldbeprovided

bycustomers,viatheirInvestmentAccounts.

Atthepointofinvestment,customersloseaccesstotheirmoneyforapre-agreedperiodofme.Asalegal

requirement,therewouldnolongerbeanyformofInstantAccessSavingsAccounts.

Customerswouldagreetoeitheramaturitydateoranoceperiodthatwouldapplytotheiraccount.The

maturitydateisaspecificdateonwhichthecustomerwishestoberepaidthefullamountoftheinvestment.

Thenoceperiodreferstoanagreednumberofdaysorweeksnocethatthecustomerwillgivetothebank

beforedemandingrepayment.

UnliketheTransaconAccount,theInvestmentAccountwillnotactuallyholdmoneythatcanbereadily

withdrawn.AnymoneyplacedinanInvestmentAccountbyacustomerwillbetransferredtoacentral

InvestmentPoolheldbythebank,andthenbeusedformakingvariousinvestments.Ineffect,the

InvestmentAccountisacustomer-friendlymethodofrepresenngafixed-terminvestmentmadethrougha

bank.

ACommercialBanksBankAccountsattheBankofEngland

Underthecurrentsystem,eachlargebank(orbankinggroup)mustholdareservesaccountattheBankof

England.Thecomputersystemstomanagethesereserveaccountsalreadyexistandhandletensofmillions

oftransaconseachmonth.Thesesystemswouldbeadaptedslightlytoallowfull-reservebankingtobeimplemented.Specifically,thereservesaccountofeachbankwouldbereplacedbythreenewaccountsat

theBankofEngland:

1.TheCustomerFundsAccount

ThisistheaccountinwhichallofeachbanksaggregateTransaconAccountfundsareheld.This

accountismanagedbythecommercialbank,butthefundsinitbelongtotherelevantTransacon

Accountholders.WhenapaymentismadetoaTransaconAccountholderbysomeoneatanother

bank,thebalanceoftheCustomerFundsAccountwillincrease.WhenaTransaconAccountholder

makesapaymenttosomeonewhousesadifferentbank,thebalanceoftheCustomerFundsAccount

willdecrease.TheBankofEnglandscomputersystem(theRTGSprocessor)willonlyknowthe

aggregatetotalofthisaccount,andthebankwillberesponsibleforkeepingrecordsofthebalancesofeachindividualcustomer.

2.TheInvestmentPool

Thisistheaccountthatthebankusestoreceiveinvestmentsfromcustomers,makeloansto

borrowers,receiveloanrepaymentsfromborrowersandmakepaymentsbacktoInvestmentAccount

holders.Thefundsinthisaccountlegallybelongtothecommercialbank.

3.TheBanksOperaonalAccounts

Thisistheaccountwherethebankcanholdfundsforitsownpurposesretainedprofits,owncapital,

moneytopaystaffwages,etc.Thefundsinthisaccountlegallybelongtothecommercialbank.

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TheLoanMakingProcess:

Withintheframeworkofaccountsoutlinedabove,theprocessofmakingloansaerthereformisvery

mechanical.Cruciallyforeconomicstability,theissuingofaloanunderafull-reservesystemdoesnot

createnewmoneyornewpurchasingpower.Incontrast,money-andthereforepurchasingpower-istransferredfromoneperson(theinvestor/saver)toanother(theborrower).

Inthefull-reservebankingsystem,abankwouldonlybeabletomakeloansusingmoneyfromoneof

thefollowingsources:

a)themoneythatbankcustomershavegiventothebankforthepurposeofinvestment(specifically,

themoneythatbankcustomershaveusedtoopenInvestmentAccounts);

b)thebanksownfunds,forexamplefromshareholdersorretainedprofits;

c)anyborrowingsfromtheBankofEngland(whenpermiOed).

Incontrastwiththecurrentsystem,allmoneyinTransaconAccounts(whichwouldcurrentlybeheld

incurrentaccounts)isofflimitstothebanksloan-makingsideofthebusiness.Further,bankscannot

borrowfromotherbanksinaninter-bankmarket(therelianceonwhichwasthesourceofinstabilityin

manycases,suchasNorthernRock).

FillingUptheInvestmentPool

WhenacustomeropensanInvestmentAccount,thebehind-the-scenestransaconwillinvolvemoney

beingtakenfromthecustomersTransaconAccountandtransferredintothebanksownInvestment

Pool.

HowBanksWouldMakeLoans

Whenthebankwishestomakealoan,itwilleffecvelytransfertheamountoftheloanfromits

InvestmentPoolintotheborrowersTransaconAccount.Todothis,itwillneedtoinstructtheBankof

EnglandscomputersystemtotransfertheamountoftheloanfromthebanksInvestmentPoolinto

thebanksCustomerFundsAccount,andupdateitsinternalrecordsfortheborrowersTransacon

Account.

HowBorrowersWouldRepayLoans

Whenaborrowerwishestomakearepaymentonthewholeorpartofaloan(orwhenthebank

regularlytakestheregularloanrepaymentfromthecustomer),moneywillbetransferredfromthe

borrowersTransaconAccountbackintothebanksInvestmentPool.

HowaBankWouldRepayMaturingInvestmentAccounts

WhenanInvestmentAccountreachesitsmaturitydateornoceperiod,thebanktransfersthemoney

thatitowestoitscustomerfromitsInvestmentPoolintothecustomersTransaconAccount.

Step2:TheNewRoleoftheMonetaryPolicyCommiJee

Underfull-reservebanking,theMonetaryPolicyCommiOee(MPC)couldconnuetheircurrentapproachof

inflaontargengaimingtosteertheeconomytowardsatargetlevelofinflaon.

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TheMPCWouldNotNeedtoSetInterestRates

Atpresent,innormalmes,theMPCtriestoinfluencetherateofinflaonbysengtherateofinterestat

whichtheBankofEnglandlendstothecommercialbanks.Centralbanktargengofinterestratesmayhavea

rangeofeffectsontheeconomy,oneofwhichmaybetoincrease(ordecrease)borrowing,andthereforeaccelerate(ordecelerate)thecreaonofnewmoney.Ifinterestratesfall,morepeoplemaywishtoborrow,

andasbankscreatenewbankdepositswhentheyissueloans,alowerinterestratecouldundercertain

circumstancesleadtothemoneysupplygrowingmorequickly.4

However,thisisanimpreciseandindirectmethodofinfluencingthemoneysupplyandtheeconomy.Interest

ratesoenlageconomicacvity,andunderavarietyofcircumstanceshigherinterestratesdonotslowan

economy,andlowerinterestratesfailtosmulateaneconomy,asbankcreditmayfailtorecover(an

exampleofthelaOercaseisprovidedbytheJapaneseexperiencesince1991;seeBernanke,2000;Werner,

1997;2005:p49-57).

Itisnowwidelyacceptedthatrealeconomiesarecharacterisedbycondionsofimperfectinformaonand

thatundersuchcondionsmarketsdonotautomacallyclear.Marketsthatdonotclear,includingthe

marketformoneyandcredit,areraoned(SglitzandWeiss1981).Raonedmarketsaredeterminedby

quanes,notprices,accordingtotheshort-sideprinciple:whicheverquantyofdemandorsupplyis

smallerwilldeterminetheoutcome.Thelimitedliabilityofdirectorswithincorporaonsmeansthat

incenvesareskewedsuchthatentrepreneurswhoborrowmoneymaingaindisproporonatelycomparedto

theirpotenaldownside(SglitzandWeiss1992).Concerningthemarketformoneyandcredititmeansthat

demandislikelytooutstripsupply,sincelendingissupply-determined(Werner2005:195).Thismeansthat

(a)themarketforcreditisdeterminedbythequantyofcreditsuppliedbythecreatorsofcredit,and(b)

thosesuppliersmainlycommercialbanks-makeallocavedecisionsaboutwhowillobtainloansandwho

willnot(ibid:p195).

Underfull-reservebanking,ratherthanusingthisimpreciseandineffecvemethodofinterest-rate

adjustment,theBankofEnglandwouldbeabletodirectlycontrolthequantyofmoneyincirculaon,bydirectlyincreasingordecreasingthemoneysupplywhichwouldthenbeallocatedthroughgovernment

spending.Bankswouldconnuetoplayanallocatoryandmaturitytransformaonrolebutasgenuine

intermediariesthattransferexisngpurchasingpower,notascreditcrea%ngenesthatexpandthemoney

supply.Addionally,underthenewbankingstructure,thecentralbankcouldallowinterestratestobesetby

marketforces.

BankofEnglandWouldChoosetoIncreaseorDecreasetheMoneySupply

Ratherthansenginterestrates,theMPCwillinsteadmakeadecisiontoincreaseordecreasethemoney

supply.Ineffect,theBankofEnglandwillbetaskedwiththeresponsibilityforcreangnewmoney,or

withdrawingexisngmoneyfromcirculaon,inlinewiththeneedsoftheeconomy.Thisdirectcontrolisa

muchmoreprecisetoolthanthesengofinterestrates,andlikelytobemuchmoreeffecve.(WhethertheBankofEnglandshouldconnuetousethecurrentMPCforthiskeytaskisanotherqueson;mostlikelya

strengtheningoftheanalycalcapabiliesoftherelevantdecision-makingbodywithintheBankofEngland

willbedesirable;neverthelessthetasksathandwillnotbemoredifficultthancurrently.Tothecontrary,they

willbecomeeasier.Butduetotheirmoreimmediateimpactacentralbankwillbelessabletobrushoffpolicy

mistakesthaniscurrentlythecase.Thusthenewstructurealsoenhancestheaccountabilityofthecentral

bank).

10

4SeeTheTransmissionofMonetaryPolicy,bytheBankofEnglandsMonetaryPolicyCommi:ee.InparAcular,seepage6-7 Higher

interestratesgenerallyincreasethecostoffinancinghousepurchase,andsoreducedemand...;...housesareusedascollateralfor

loans,solowernetworthinhousingmakesithardertoborrow.;Monetarypolicyaffectsinterestrateschargedon[creditcardsand

bankloans],andhigherrateswilltendtodiscourageborrowingtofinanceconsumpAon.Evenforthosewithnodebts,higherinterestratesmaymakereturnsonsavingsproductsmorea:racAve,encouragingsomeindividualstosavemoreandsotospendless.

vailableath:p//www.bankofengland.co.uk/publicaAons/other/monetary/montrans.pdf


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MakingtheDecisiontoChangetheMoneySupply

Ashappenscurrently,theBankofEnglandwouldhaveaccesstoawiderangeofdataandinformaonto

guideitsdecisions.Itwouldsllbeaimingtomeetapre-determinedinflaontarget,suchas2%perannum.5

Atthesimplestlevelofanalysis,ifinflaonisbelowthetarget,forinstancetheMPCcouldincreasethe

moneysupply,whileifinflaonwasabovethetarget,theMPCwoulddecreasethemoneysupply.An

elementofjudgementandpaenceisrequiredbetweenanincreaseinthemoneysupplyandadecreasein

themoneysupplythereshouldbeadequateperiodsofnochange,inordertoallowtheeffectsoftherecent

increase/decreasetoplayoutintheeconomybeforefurtherchangesaremade.

TheMechanicsofCreangNewMoney

TheMPCwilllikelytakea12-monthor2-yearviewoftheeconomy,andthensmoothanyincreaseinthe

moneysupplyovereachmonth.TheMPCwillconnuetobepolicallyindependentandneutral.Thisisvery

important,asitpreventsharmfulpolicalnkeringwiththeeconomy.ItisimportantthattheMPCcannot

beoverruledbypolicians,whosedecisionswillbeswayedbypolicalmaOersratherthanthelong-termhealthoftheeconomy.ItisalsoimportantthattheMPCisshelteredfromconflictsofinterest,andfrom

lobbyistsforthefinancialsector.

TheMonetaryPolicyCommiOeewillalsosllbesubjecttoalltheexisngrulesregardingtransparencyofits

decisions,andtheamountoftheauthorisedincreaseinthemoneysupplywillbemadepubliclyknown.

DistribungNewlyCreatedMoney

AnymoneycreatedbytheMPCwouldneedtobedistributedintotheeconomytohaveanyeffecton

economicacvityandtheinflaonrate.Ratherthanlendingthismoneyintotheeconomyviathebanks

(whichdependsenrelyonthewillingnessofthebankstolend)werecommendthatthemoneyisspentinto

circulaonviathestate.

Inpracce,newly-createdmoneywouldbeaddedtogovernmentrevenuefromtaxes,andcouldbeusedina

rangeofways.Thereisafurtherimportantdifferencetothecurrentsystemofmoneysupplycreaonvia

banks.Sincethegovernmentwouldspendnewly-createdmoneyintocirculaon,itisdesirablethatthis

moneyisusedfortransaconsthatareproducveandcontributetoGDP.(Forfurtheranalysisonthese

issues,seeWerner,2005).

Thegovernmentcouldspendthemoneyintocirculaonby:

usingthenewly-createdmoneytocoverexisnginvestmentexpenditureandreducingtaxesbyacorrespondingamount;

increasinggovernmentspendingonpublicservices; distribungmoneydirectlytocizens.

Itshouldbenotedthatcentralbanksusedtomonitorthelevelofnon-producvecreditissuanceby

commercialbanksbut,followingthederegulaonadviceofneoclassicaleconomictheories,theychoseto

abolishtheircreditguidancepoliciesandinsteadallowedorencouragedunproducvebankcredit

expansions,typicallyintorealestateorfinancialspeculaon(Werner2002,2005:268-294).Followingthe

financialcrisis,ironically,theUK,French,andGermangovernmentsimposedrulesontheallocaonofnew

banklending(tosmallfirms),albeitinanineffecvemanner.

11

5WewouldsuggesttheBoEandMPCconsidermakingchangestothemeasureofinflaAonsothatitincorporatesassetpriceinflaAon.WerealisethisiscomplexandthereisnotroomtodiscussopAonsindepthherebutitwouldclearlyenhancetheeffecAvenessofthe

reformsweareproposing.


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Theexactmethodsbywhichthemoneywillbespentintocirculaonshouldbeformulatedaerapublicand

transparentconsultaonprocess,astheymakeexplicitthattheallocaonofmoneyisapolicalprocess.The

detailsofpossibleincenve-compableandme-consistentdecision-makingsystemsisoutsidethescopeof

thissubmission.Tobeclear,intheproposedsystemtheBankofEnglandwouldhavenoinvolvementindecidinghowthemoneyisspent,ensuringthatthereisacompleteseparaonbetweenthosewhoare

decidinghowmuchmoneytocreate,andthosewhoaredecidinghowtospendit.Thisisafurtheradvantage

ofourproposal:unlikeinthecurrentsystem,thereisaclearandtransparentseparaonoffiscal(allocaon)

andmonetary(moneycreaon)policy.

HowFull-ReserveBankingWouldAddresstheConcernsofthe

Commission:

AStableMoneySupplyLeadstoaStableEconomy

Lendinginafull-reservebankingmodelinvolvesthetransferofreal,risk-freecentralbank-issuedmoneyfrom

theinvestortotheborrower.Incontrasttofraconalreservebanking,thisprocessdoesnotincreasethe

quantyofbankdepositsthatcanbewithdrawnondemand.Asaresult,whilelendingunderafraconal

reservebankingsystemactuallycreatesnew,addionalpurchasingpower,lendingunderfull-reservebanking

wouldmerelytransferpurchasingpowerfromonepersontoanother.Thatistosay,lendingunderfull-

reservebankingwouldnotincreaseordecreasethebroadmoneysupply,andwouldthereforehavenoaffect

oninflaon.

Banksinthissystembecometrueintermediaries.Theybecomecreditbrokersratherthancreditcreators,and

theirlendingdecisionshavenopowertoswellorcontractthebroadmoneysupply.Webelievethatthis

wouldsignificantlyreducethepro-cyclicaltendencieswithinthefinancialsystemandwouldthereforeincreasethestabilityofthebankingsectorandthewidereconomy.

ImprovingStabilityWithinIndividualBanks

Full-reservebankswouldbesignificantlymorestablethanfraconalreservebanks.Instabilitywithin

fraconalreservebankscomesfromthefactthatthemajorityofthebankscustomerscandemand

repaymentatanymefromanyaccountsthatdonothavematuritydatesornoceperiods.Thiscouldresult

inthebankbeingrequiredtopaybackhugesumsofmoneyinashortperiodofme,makingthebank

effecvelyinsolvent.Thebankstrytoguardagainstthisbykeepingbackreserves,buttheyconnuallywalka

knife-edgebetweenkeepingreserveshighenoughtocoverthemaximumlikelynetwithdrawals,andkeeping

themaslowaspossibleinordertofreemoneyupformakingfurtherloans(tomaximiseprofits).

Thepost-reformsituaonismuchmorestable.Thestabilityarisesfromthefactthatthefundsabankusesto

makeloansarenowlockedincustomerscannolongerdemandthembackwhenevertheychoose.This

makesitmucheasierforthebanktopredicttheircashflowintothefuture,andtoprepareaccordingly,

meaningthatfull-reservebanksaremuchlesslikelytobecomeinsolvent.

ThisincreasedstabilityisexplainedinmoredetailinAppendix2.

ReducingMoralHazard:RiskStayswiththeBank&Investor

Underthecurrentsystem,theFinancialServicesCompensaonScheme(FSCS)guaranteesbankdepositsin

eligiblebanksupto50,000.Thismeansthatasavingsaccountwithabankisseentoberisk-free,even

thoughthemoneymaybeusedformortgagelending,personalloansorriskyproprietarytrading.Ineffect,

whilethepotenalupsideofaninvestmentgoestothebankandthesaver/investor,thepotenallossesfall

uponthetaxpayer.

12


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Incontrast,underfull-reservebanking,theriskofanyinvestmentnowstayswiththebankandtheinvestor,

ratherthanfallingonathirdparty(i.e.thetaxpayer).

Insomeaccounts,theriskwillfallenrelyuponthebank,whileonothersalargeproporonoftheriskwill

fallontheinvestor.TheexactbalanceofrisksharingwillbedeterminedbytheInvestmentAccount

GuaranteesoutlinedinAppendix3.AnyinvestoropeninganInvestmentAccountwillbefullyawareofthe

risksatthemeoftheinvestment,andthosewhodonotwishtotaketheminimumamountofriskwillbe

abletooptforan(almost)no-risk-andconsequentlylow-return-account.

AddressingtheToo-Big-To-Fail&Too-Systemic-To-FailProblems

Underfull-reservebanking,anybankcanbeallowedtofail,regardlessofitssize.Abankcanbewounddown

inthefollowingway:

TransaconAccounts,beingfullyfundedwithcentralbankmoneyandnotheldonthebalancesheet,wouldbetransferredtootherbanks(withthecustomernominangthenewbankthattheywantto

moveto).Inpraccaltermsandwithintelligentdesignofthecomputersystems,thisprocesscould

becompletedwithindaysofabankscollapseandTransaconAccountholdersshouldnotexperience

morethananhourwhentheyareunabletoaccesstheirmoney.

InvestmentAccountholderswouldbecomecreditorsofthebankandneedtowaittorecoverasmuchoftheirinvestmentaspossiblethroughnormalliquidaonproceedings.

Atnopointwouldtaxpayersmoneyneedtobespentoncompensaonorcoveringtheliabiliesofthebank.

Enhancingcompeonandreducingbarrierstoentryinretailbankingandpaymentservices

Underfull-reservebanking,anewbankenteringthebankingsystemshouldnotcreateanongoingaddional

workloadfortheBankofEngland,beyondtheinialsetupprocess.IftheBankofEnglandscomputersystemsaredesignedwellatthepointofmakingtheswitchtofull-reservebanking,itshouldbepossibleto

veryeasilyconnectanewbanktothosesystemsandnotrequireanyfurtherhumanintervenononthepart

oftheBankofEngland.

Thisplugandplayabilityforanewbanktobecomepartofthemainstreambankingsystemshouldreduce

thecoststotheBankofEnglandofdealingwithcommercialbanks.Thiswouldhelptoreducethebarriersto

entryfornewbanks,andwouldthereforehelptoincreasecompeoninthesector.Inparcular,wewould

hopetoseeitmademucheasierfornew,TransaconAccount-onlybankstoenterthemarkettoincrease

compeonintheprovisionofthiscorepaymentssystemservice.Aswellasnewlimitedcompanyretail

banks,thiscouldincludecreditunions,tradionalbuildingsociees,mutualsandCommunityDevelopment

FinanceInstuons(CDFIs)whichcurrentlystruggletocompeteforhighstreetretailcustombecausetheydonothavethesamecredit-creangpowersofbanksnortheabilitytocross-subsidizetheirretailoperaons

throughincomefrominvestmentbankingacvies(Werner2009).6AstheFSArecentlysuggested:

Currentaccountsareofcourseonlyonepartoftheservicesprovidedbybanks.Cross-subsidisaon

arisesintheretailbankingbusinessmodelnotjustthroughpackagedproducts,butinotherways.The

modelisbasedonprovidingarangeofservicessuchasdeposit-taking,savingsaccounts,homeloans,

unsecuredcredit,andinsurance.Cross-sellingandcross-subsidisaonareintegraltothismodel,and

theadvantagesofofferingaporolioofservicescanhavemajoreffectsonthescopeforentry.Itwould

beverychallengingforfirmstoenterandcompetesolelyasdeposit-takersagainstbanksprovidingan

integratedporolioofservices.Similarly,itwouldbedifficultforafirmtoentertheloanmarket

13

6Whileonlyabout0.5%oftheadultpopulaAonintheUKismemberofacreditunion,theequivalentfiguresforIreland,

theUS,ustraliaandCanadaare45%,30%,20%and16%,respecAvely(Werner2009)


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profitablyasitriskstakingonpoorerqualitycredit,asshownbytheexperienceoftheformerbuilding

socieeswhichcompetedaggressivelyinmortgagelending.verall,therearestrongdriversforcing

potenalnewentrantstoadoptanintegratedmodel,andthisactsasabarriertoentrytoanyfirms

withoutsubstanalresourcesandbankingexperse.7

ReducingRiskstotheGovernmentsFiscalPosion

Therearethreekeywaysinwhichfull-reservebankinghasaposiveimpactonthegovernmentsfiscal

posion,incomparisontofraconalreservebanking:

1. Thereducedriskofinstabilityinthebankingsector,andthestablemoneysupply,reducetheriskofarecession,andthereforereducestherisksofasuddenlargedrop-offintaxrevenue.Thisreducestherisk

ofthegovernmentneedingtoincreasegovernmentborrowingtocovernormalexpenditure.

2. Asoutlinedearlier,full-reservebankingmakestaxpayer-fundeddepositinsurancewhollyunnecessary,andensuresthatthetaxpayerhasabsolutelynoliabilityforthebankingsystem.

3. Becausenofull-reservebankwouldbetoobigtofail,thereisnoneedforanytaxpayer-fundedbailouts,potenallysavingthegovernmenttensofbillionsofpounds.

IncreasingthePaceoftheRecovery

BecauseanynewmoneycreatedbytheMonetaryPolicyCommiOeewouldbespentintotheeconomyrather

thanbeinglent,thisinjeconofnew,debt-freemoneycanhelptoreducetheoveralllevelofindebtedness

ofhouseholds.Thisisincontrasttothefraconalreservebankingsystem,inwhichtheonlywaytoinjectnew

moneyintotheeconomyistoincreasetheoveralllevelofdebtheldbythepublic(sincenewbankdeposits

areonlycreatedwhenloansaretakenout).

Webelievethatafallingoverallburdenofhouseholddebtislikelytohaveposiveeffectsoneconomic

growthandthepaceoftherecovery.

OtherKeyBenefitsofFull-ReserveBanking:

NoNeedforDepositInsurance

Depositinsurancecanbecompletelyremovedfromthebankingsystem,reducingtheriskstothetaxpayer

andalsoreducingthedistoronsandmoralhazardthatarisewhentherisksofaninvestmentfallonathird

party.

Full-ReserveBankingisNotPro-Cyclical

Fraconalreservebankingispro-cyclical,sincerisingdebtcreatesanincreasingmoneysupply,whichinturn

generatesacredit-fuelledboom.Thisseeminglybenigneconomicenvironmentencouragesotherstotakeon

furtherdebttotheextentthatinflaonbecomesaproblem,especiallyinassetprices(suchashousing).

Eventuallythecostofservicingthedebtstartstobecomeexcessiveforcertaingroups,whothendefault,

triggeringarecession.

Incontrast,lendingunderafull-reservebankingsystemdoesnotincreasethetotalpurchasingpower,and

thereforeshouldneverprovidesuchapro-cyclicalsmulustotheeconomy.Thisshouldresultingreater

economy-widestability,withmassivebenefitsforreal-economybusinesses,whowillbeabletoplanwithless

riskofasevererecession.

14

7FinancialServicesuthority,SubmissiontotheTreasurySelectCommi:eeEnquiryonCompeAAonandChoiceintheBankingSector,

September2010,h:p//www.publicaAons.parliament.uk/pa/cm201011/cmselect/cmtreasy/memo/banking/m26.htm
http://www.publications.parliament.uk/pa/cm201011/cmselect/cmtreasy/memo/banking/m26.htmhttp://www.publications.parliament.uk/pa/cm201011/cmselect/cmtreasy/memo/banking/m26.htm


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MinimumDisruponforMembersofthePublic

Formembersofthepublic,theserviceprovidedbyfull-reservebankswillappeartobealmostidencalto

fraconalreservebanking.Thetwokeydifferencesare:

1.TransaconAccountswillnolongerpayinterest,andmaychargelowfeesforsomeorallservices(dependingonthebankandspecificaccount).

2.Therewillnolongerbeanyinstantaccesssavingsaccounts,andinterestwillonlybeearnedonmoneythatcanbeedupforaperiodofme.

However,TransaconAccountscouldconnuetobelabelledcurrentaccountsandprovideallthesame

services(exceptforpayinginterest).TheswitchfromsavingsaccountstoInvestmentAccountsshouldcause

veryliOleconfusionformembersofthepublic(althoughwerecommendthatthenameInvestmentAccount

isusedtoclarifythattheseaccountsarenolongerrisk-freestorageaccounts).

NoNeedtoManipulateInterestRates

ThesengofinterestratesbytheBankofEnglandisarelavelyineffecvetoolinmanagingthemoney

supply.SharplyreducingtheBankofEnglandsrelianceon,orevenremovingthistool,andgivingthecentral

banktheabilitytodirectlyaffectthemoneysupplyinaquantavefashion,hastwosubstanalbenefits:

1.ThecreaonofnewmoneybytheBankofEngland,e.g.ontheauthorisaonoftheMPC,andthedistribuonofthismoneyintotheeconomyvianormalgovernmentspending,willhaveaquickerand

morepreciseimpactontheeconomythanthechangingofinterestrates.Itisthoughtthatinterest

ratechangestakeuptotwoyearstohavearealimpactintheeconomy,whereasthespendingof

newlycreatedmoneyintotheeconomyhasanimmediateimpact.

2.Byremovingtheneedtomanipulateinterestratesweminimisethecollateraldamageofmonetarypolicy.TheMPCcurrentlychangesinterestratestoencouragearelavelysmallgroupofpeopleto

eitherincreaseordecreasetheirborrowing.However,reducinginterestratesreducestheincomeofmillionsofpensionerswhorelyontheinterestontheirsavings.Whentheeconomyisinarecession,

interestratesarecuttoencouragepeopletoborrowmore,butthen,oncethosepeoplehave

borrowedandtheeconomyimproves,interestratesarepushedrightupagain,causingfinancial

hardshipforthosewhoborrowedtosmulatetheeconomy.

Full-ReserveBanksWouldBeExposedtoMarketDiscipline

Sincefull-reservebankscanbeallowedtofailandwouldnotbesupportedbythetaxpayer,bankswillbe

exposedtofreemarketdiscipline.Thisshouldaddresstheworstmarketdistoronscurrentlyevidentinthe

bankingsectorandremovemuchmoralhazardandmisalignedincenves.

Full-ReserveBankingHasNoSignificantImpactonCapitalMarkets

Unlikecommercialbanks,parcipantsinthecapitalmarketsneverhadtheabilitytocreatecredit(intheform

ofgovernment-guaranteedbankdeposits).Consequently,beyondchangesinthesupplyanddemandfor

creditinthelong-term(whichareaddressedinPart3),aswitchtofull-reservebankinghasveryliOleimpact

onthecapitalmarkets.Infact,thefactthataTransaconAccountatanyfull-reservebankwouldbeassecure

andrisk-freeasaCHAPSorreserveaccountattheBankofEnglandmeansthatcapitalmarketparcipants

whoarenotmembersoftheBankofEnglandsreservesorstandingfaciliesschemeswouldsllhaveaccess

toaninstantly-clearingrisk-freemeansofseOlement.Thiscouldactuallycontributetotheefficiencyof

capitalmarkets.

15


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DisadvantagesofFull-ReserveBanking:

CostofTransaconAccounts

BecausethebanksareunabletousethefundsplacedinTransaconAccountstoinvestorlend,theywillbeunabletoearnareturnonthesefunds.Astheywillsllincurthecostsofprovidingpaymentsservices

(chequebooks,ATMcards,cashhandling,etc.),theywillalmostcertainlyneedtoimplementaccountcharges

tocoverthesecosts.

However,itislikelythatthesefeeswillbekeptlowthankstomarketcompeon,evenmoresoifmeasures

aretakentoreducebarrierstoentryinthepaymentsservicessideofbanking.

Inaddion,anynewannualfeesonTransaconAccountsneedtobeseeninthelightofthesavingstothe

taxpayerthroughremovalofitsfinancialexposuretothebankingsystem,andtheotherbenefitsoffull-

reservebanking,suchasgreatereconomicstabilityandalowerlikelihoodofrecessions.

Inaddion,withthemodeloffull-reservebankingoutlinedhere,mul-lateralnetseOlementschemessuch

asBACS,FasterPayments,CreditCardclearing,VisaandMastercard,maybeunnecessary,andallpayments

couldberouteddirectlythroughtheBankofEnglandsRTGSProcessor.8Thiscouldsignificantlyreducethe

coststobanksofoperangvianumerousmiddlemenandmakeitcheaperoveralltoprovidepayments

services.WecanelaborateonthislastpointifitisofinteresttotheCommission.

LowerLiquidityforHouseholds

Full-reservebankingdoesundoubtedlyreducetheliquidityofhouseholdswhowanttoinvestandearna

return,sinceitrequiresthatsavers/investorsgiveupaccesstotheirmoneyfortheperiodofaninvestment.

Asaresult,afull-reserveInvestmentAccountislessliquidthananinstantaccesssavingsaccountcurrently

providedbyfraconalreservebanks.

However,thebenefitsoffraconalreservebankingintermsoftheincreasedliquidityforhouseholdsisfar

outweighedbythecostsofdepositinsurance,therisktothegovernmentsfiscalposion,andtheimpact

uponhouseholdsofrecurrentrecessions.Thereisarealtrade-offbetweenliquidityforinvestorsandstability

forthebankingsectorandtheeconomyasawhole.Itisworthaskingwhetherthepublicwouldhave

acceptedlowerliquidityinreturnforavoidingtherecentfinancialcrisisandtheresulngtaxrises,spending

cutsandhighernaonaldebt.

Ifreducedliquidityisthoughttobeaseriousconcern,onewayofaddressingthisconcernistoallow

InvestmentAccountholderstoreduceasmallproporonoftheirbalanceondemand.Thisdoesre-introduce

someinstabilitytothesystem(albeittoamuchlowerextentthanfraconalreservebanking).Wecan

elaborateonthisoponuponrequest.

TyingupofIdleDeposits

Thisissueisaddressedinpart3,AddressingCommonMisconceponsAboutFull-ReserveBanking.We

believethat,onanalysis,thisisnotavalidcricismoffull-reservebanking.

16

8TheRTGSProcessoristhesystemwhichhandlestransacAonsintoandoutofbanksreserveaccountsattheBankof

England.


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BenefitsofFull-ReserveBankingoverAlternaveReforms

NoNeedtoBackRetailDepositswithGovernmentDebt

Withourmodeloffull-reservebanking,membersofthepublicareabletouserisk-free,digitalcentralbankmoneyintheirTransaconAccounts.TransaconAccountsareheldoffthebalancesheet,andtherefore

thereisnoneedforabackingasset,meaningthatourfull-reservebankingproposaldoesnotrequireretail

depositstobebackedbygovernmentdebt.

Interesngly,backingretaildepositswithgovernmentdebtisillogicallycircular,sincegovernmentdebtis,in

effect,backedbythegovernmentsabilitytocollectretaildepositsfromthepublicviataxaon.Inother

words,underproposalsbyKayandKotlikoff,retaildepositswouldulmatelybebackedbyretaildeposits.

LackOfNeedForLimitsonProprietaryTradingandInvesng

WecanrequirethatbanksdisclosetheintendeduseofmoneyinvestedineachtypeofInvestmentAccount,andthattheyring-fencethismoneyappropriately.Doingsowouldmeanthatbanksthatwantedtoengagein

proprietarytradingandinvesngwouldbeabletodoso,butonlywithfundsthatinvestorsagreedtohave

usedinthisway.Inotherwords,savers/investorswhowerehappytoaccepttherisksthatcomewith

proprietarytradingorinvesng,andwerefullyawarethattherewouldbenogovernment-funded

compensaoniftheinvestmentslostmoney,wouldbeabletoprovidethefundsforsuchacvies.Banks

wouldbeabletoengageinproprietarytrading,butwouldneedtobidforthosefundsfrommembersofthe

publicataprice(interestrate)thatreflectstherisk.Thisfactwouldprobablyreducetheoverallamountof

fundsthatbankscanputintoproprietarytradingandthereforereduceinstabilityfromspeculavetrading.

Thissystemwouldmeanthatproprietarytradingandinvesngcouldconnuewithinthesameentyasa

normalretailbank,withoutexposingthepaymentssystemtoanyrisk.

LackofNeedforSeparaonofRetailandInvestmentBanking

Asoutlined,wecanrequirebankstodisclosetheintendeduseofmoneyinvestedineachtypeofInvestment

Account.Ifwedidthis,investmentbankingcouldconnuewithinthesamelegalentyasacommercialbank,

butonlywithfundsthatthesavers/investorswishtohaveusedforinvestmentbanking.

MinimumDisruponForMembersofthePublic

IncontrasttotheLimitedPurposeBankingproposal,whichrequiresallinvestmentstobemadethrough

mutualfunds,membersofthepublicwouldfinditveryeasytoadapttothenewTransaconAccountsand

InvestmentAccounts,whicharealmostidencaltopresent-daycurrentaccountsandsavingsaccounts.

NoLossofSynergiesBetweenDeposit-TakingandBankLending

Withourmodeloffull-reservebanking,thesamelegalentycanprovidepaymentservicesalongwith

investmentandlendingservices.Thesamebankbranchcouldthereforeprovidealltheservicesthatthe

averagememberofthepublicneeded,andthereforethesynergiesbetweenthesedifferentservicesare

preserved.

17


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PartII:ACriqueoftheCurrentBusinessModelofBanking(Fraconal

ReserveBanking)

eliminangfraconalreservebankingexplicitlyrecognizesthatthepretencethatrisk-freedepositscanbe

supportedbyriskyassetsisalchemy.

(MervynKing,2010,p17)

Theessenceofthecontemporarymonetarysystemiscreaonofmoney,outofnothing,byprivatebanks

oenfoolishlending.

(MarnWolf,FinancialTimes,9thNov2010)9

Wecontendthatalackofunderstandingofthewiderimpactsoffraconalreservebankingwillleadtoaninadequateresponsetothecrisisandinappropriaterecommendaonswithregardstotheshapethat

bankingreformshouldtake.Wehaveoutlinedsomeofthemainimpactsoffraconalreservebankingbelow.

WehavefirstlistedthosethataredirectlywithintheCommissionsremit,beforeaddingsomeaddional

issuesthatareoutsidetheremitbuthighlyrelevanttoanydiscussionofthelong-termhealthoftheeconomy

andthebankingsector.

Butbeforedetailingspecificconsequences,weclarifytherelevanceoffraconalreservebanking.

TheRelevanceofFraconalReserveBanking

Underfraconalreservebanking,theonlywaythatthepublic(householdsandbusinesses)asawholecan

getaddionalmoneyistoborrowitfromthebankingsector.RecallthatWhenbanksmakeloans,they

createaddional[bank]depositsforthosethathaveborrowedthemoney(BankofEnglandQuarterly

Bullen2007Q3).

Themissingpartofthisstatementisthatbankdepositsareonlycreatedwhenamemberofthepublic(ora

business)takesoutaloan.Inotherwords,thebankingsectorhasaneffecvemonopolyonthesupplyof

money(intheformofbankdeposits)tothepublicandtherealeconomy.Ineffect,theaggregatemoney

supplyinthehandsofthepublicisonloanfromthebankingsector.

Thefollowingstatement,fromtheCommissionsIssuespaper,parallyrecognizestheroleofbanksin

providingcredit(ormoney)tohouseholdsandbusinesses,butfailstorecognizetheirroleasthesolesupplier

ofmoneytothepublic:

TheUKbankingsectormakesakeycontribuontothewidereconomythroughtheprovisionof

credittohouseholdsandbusinesses.Thefinancialcrisisledtoareduconintheavailabilityofcredit,

andproducedasharpdeclineinUKGDP.(Point3.24oftheCommissionsIssuespaper)

Ifbankslend,newmoney(intheformofbankdeposits)iscreatedandtheeconomygrows(evenif

unsustainably).Iftheystoplending,theeconomyslowsdownandweapproacharecessionordepression.

Thelendingdecisionsofthebankingsectorasawholehavetheabilitytoswellorcontractthemoneysupply

18

9h:p//www..com/cms/s/0/93c4e11e-ec39-11df-9e11-00144feab49a.html#ixzz14yZBSY8z


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ofthenaon,withasignificantandoennegaveimpactonthewidereconomy.

AsecondstatementfromtheCommissionsIssuespaperalsohighlightshowpoorlytheeffectsoffraconal

reservebankingareunderstood:

neofthemostobvioustrendswastheexplosionofdebt.Inthetwentyyearperiodrunningupto

thecrisis,theaggregatedebtoftheUKfinancial,householdandcorporatesectorsasapercentageof

GDPincreasedmorethansixfold(Point2.5oftheCommissionsIssuespaper)

Whenbankdepositsareonlycreatedwhenanindividualorcompanytakesoutaloan,theninordertohavea

growingmoneysupply,thepublicmusthaveagrowingoverallburdenofdebt.Aslongastherealeconomys

moneysupplyisissuedbycommercialbanksviafraconalreservebanking,thenagrowingmoneysupply

mustbeaccompaniedbygrowingdebt.Thiscanbeseenintheredandgreenlinesinthechartbelow,which

representtotaldebtandtotal(broad)moneysupplyrespecvely10.

HowFraconal-ReserveBankingWorksAgainsttheConcernsoftheCommission:

BankingSectorInstability

Fraconalreservebanksareinherentlyunstablethankstotheirfundamentalbusinessmodel.Tomaximise

profits,afraconalreservebankneedstolendoutasmuchofthedepositsthatitreceivesasitcan,withthe

onlyconstraintsbeing:

19

10SourceBankofEnglandInteracAveStaAsAcalDatabase,figuresforM4andM4Lending.


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1. ItmustretainorbuyenoughTier1andTier2capitaltomeetBaselcapitaladequacyraos.2. ItmustretainenoughcentralbankreservestobeabletomakeseOlementpaymentstootherbanks,

eitherinrealmeorviamul-lateralnetseOlement.11

Ineffect,fraconalreservebankswalkaghtropebetween:

1. Havingmorecentralbankreservesthantheyneedandmissinglendingopportuniesasaresult,and

2. Havingfewercentralbankreservesthantheyneedandriskingbecomingilliquidandulmately,

insolvent.

Theexistenceofinter-banklending,theBankofEnglandsDiscountWindowFacility,andtheimplicit

assumponthatthegovernmentwillbailoutanybankthatrunsintofinancialdifficulesmakesitlikelythat

bankswilltendtowardsopon(2)above.Inotherwords,fraconalreservebankshaveacommercial

incenvetoruntheircentralbankreservestotheverylowestlevelthatallowsthemtomeetpaymentsona

day-to-daybasis.Anybankthatholdsthepraccalminimumlevelofreservesisveryvulnerableassoonas

economiccondionsormarketsenmentchanges.

Therearetwootherwaysinwhichinstabilityisinherenttofraconalreservebanking:

1.Everyloanthatthebankingsystemmakescreatesmoredeposits,andconsequentlyfundsmoreloans.Asa

result,aspeoplesfinancialposiongetsworseandtheytakeonmoredebt,theoverallavailabilityofloans

actuallyincreases.Thiscreatesaposivefeedbackloopaswegetfurtherandfurtherintodebt,banks

becomeincreasinglywillingtooffermoredebt.Parcularlywhentherearerelavelybenignmacroeconomic

condions,e.g.lowinterestratesandinflaonandsteadyorhighgrowth,thiscanleadtoever-higherlevels

ofpersonalandhouseholddebt,makingeconomiesmuchmorevulnerabletoexternalshocks.Aswesaw

withthefinancialcrisis,financialinnovaons,includingformsofderivavesandsecurisaon,allowbanksto

movedebtofftheirbalancesheets,creangevengreatercapacitytoissuedebt(credit).Eventually,thisledtoawaveofdefaults,suchasseeninthesub-primemortgagemarketinAmerica,whichinturntriggersa

dominoeffectthroughouttheglobaleconomy.Thismeansthattheloansthatbanksoriginallyexpectedtobe

repaidarenolongerlikelytoberepaid,creangahugeshorallintheirincomeandpotenallybankrupng

them.Inshort,thedesignofthecurrentbankingsystemcreatesafundamentaldistorontothematurity

transformaonroleofbanksandcreatessystemicvolality.

2.Themajorityofthebankscustomerscandemandrepaymentatanymefromanyaccountsthatdonot

havematuritydatesornoceperiods.Thiscouldresultinthebankbeingrequiredtopaybackhugesumsof

moneyinashortperiodofme,makingthebankeffecvelyinsolvent.Thebankstrytoguardagainstthisby

keepingbackreserves,buttheyconnuallywalkaknife-edgebetweenkeepingreserveshighenoughtocover

themaximumlikelynetwithdrawals,andkeepingthemaslowaspossibleinordertofreemoneyupfor

makingfurtherloans(tomaximiseprofits).

RisktoEconomy-WideInstability,andtheImpactonLending&MoneySupply

Asoutlinedabove,thebankingsectorhasaneffecvemonopolyonthesupplyofmoneytothepublic

(individuals,householdsandbusinesses).Theamountofmoneyinthehandsoftherealeconomyis

determinedbyanddependentuponthelendingdecisionsofthebankingsector.

Thismeansthattherealeconomydoesnothaveastablemoneysupply.Ifincenvestructuresforbankstaff

aresetinsuchawayastoencourageirresponsiblelending,thenthemoneysupply(andlevelofdebt)inthe

economywillsoar,ashappenedbetween2000and2007.Thiscreatestheillusionofaboomingeconomy,

20

11MulA-lateralnetse:lementinvolvesallthebankscollaAngthetransfersbetweenthem,cancellingoutoppositetransfersand

simplytransferringthenetbalanceattheendoftheday(orendoftheclearingcycle,wheneverthatis).


21/39

whichthenencouragespeopletotakeonevenmoredebt.Thecostofservicingthisdebteventuallystartsto

actasabrakeonthegrowthoftheeconomy,andassoonasthisplaysthroughintoaneconomicdownturn,

somedebtorsbecomeunabletoservicetheirdebts,triggeringdefaults.Thesedefaultsforcethebanksto

reininlending,causingacontraconinthemoneysupplyandexacerbangthedownturn.Ifthebanksconnuetorefusetolend,thenthemoneysupplycontractsevenfurther,causingafull-blownrecession.

Itseemsunlikelywewillachieveeconomicstabilitywhenthequantyofmoneyintheeconomydepends

enrelyonthesenmentsofabankingsectorthathashugeincenvestoover-issuecredit,shareholders

withlimitedliability,andisunderwriOenbyanimplicitpublicsubsidy.12Incontrast,full-reservebanking

woulddeliverastablemoneysupplyandismorelikelytodeliverastableleveloflending.

HouseholdAffordabilityandDebt

Between2000and2009,banklendingcreatedaround1.2trillionofnewmoney,intheformofbank

deposits.13Asignificantamountofthisnewmoneywascreatedviatheissuingofmortgages:whilelendingto

therealeconomyremainedrelavelyflatinthatperiod,lendingonpropertyincreased5-fold(nef2010:15).Thisundoubtedlycontributedtothehousepricebubble.

Ifhousepriceshadkeptinlinewithearningssince1950,theaveragehousepricewouldnowbe88,80714.

Therecenthousepriceboom,fueledbyexcessivelendingbythebankingsectoralongsidesecurizaon

(makingitpossibletomoverisksoffthebalancesheet),hasmorethandoubledthecostofhousingrelave

toincome.Wheninterestcostsarefactoredin,thiscouldadduptoanaddional300,000thateachyoung

householdwillhavetopaytothebankingsector,viamortgageinterest,overthelifemeofthemortgage.

CreaonofAssetBubbles

Whenbanksmakeloans,theycreatenewdeposits(i.e.newmoney)fortheborrowers.Asthesolecreatorsof

bankdeposits,thebankingsectorisabletocontroltheallocaonofcreditandinvestmentintheeconomy.Underthecurrentstructure,theyhavestrongcommercialincenvestodirecttheirlendingtowardshousing

andcommercialproperty,forthesimplereasonthatthereisatangibleassetthatcanberepossessedifthe

borrowerdoesnotkeepuprepayments,andthereforetheloanislessriskythanaloantosay,asmall

businessorstart-up,andduetotheeffecttheirbehaviourhasonthepriceofthecollateralisedassets.By

creangcreditforassettransacons,bankspushupassetprices.Thisposivefeedbackalsoworksinthe

oppositedireconassoonascreditcreaonslowsorstopsattheheightofanassetbubble.Sinceasset

transaconcreditisunsustainable,itwillturnintobaddebtsandbringthebankingsystemdownwithit

(Werner,1991,1992,1997,2005).WhilstoursuggestedreformswillnotchangetheaOracvenessof

mortgagelendingtobanksoverotherformsoflendingandwillnotdealwiththeproblemofbanksshiing

mortgagedebtofftheirbalancesheetsthroughResidenalMortgageBackedSecurisaon(RMBS),itshould

significantlyreducethequantyofcreditthatispushedintothehousingmarketandthusthepro-cyclicality

ofthehousingmarketmoregenerally.

DragOnEconomicGrowth&Development

Inaneconomybasedonfraconalreservebanking,arisingmoneysupplymustbeaccompaniedbyrising

debt(sincenewmoneyintheformofbankdepositsisonlycreatedifthepublicborrowfrombanks).The

costofservicingtherisingdebtreducesthedisposableincomesofmembersofthepublicandtherefore

reducesspendingintherealeconomy,whilstdiverngmoneybackintothefinancialsector.Ifthemoney

21

12SeeFinancialTimes,pril20th2010,TheChallengeofHalAngtheFinancialDoomsdayMachine,MarAnWolf

13SourceBankofEnglandInteracAveStaAsAcalDatabase,figuresforM4

14CalculatedfromLandRegistryHousePriceIndexandOfficeforNaAonalStaAsAcsnnualSurveyofHoursandEarnings(SHE)


22/39

paidininteresttothefinancialsectorisretainedwithinthefinancialsector,thenitresultsinthefinancial

sectorgrowingwhiletherealeconomyshrinksinrelaveproporon.Ifmuchoftheinterestisredistributed

tobankstaff,then,duetotheconcentraonofhighly-paidbankstaffintheCityofLondon,thiswouldresult

inincreasinginequalitybetweentheCityandtherestofthecountry,withtherestofthecountrybecomingpoorerwhiletheCitygrowsasapercentageofGDP.

Avarietyofstudiesshowthateconomicinequalityandtheconcentraonofwealthinthemannercausedby

thecurrentarrangementsofthebankingsystemisdetrimentaltoproducveeconomicgrowthandwell-

being(Werner,2005;WilkinsonandPickeO2009;Frank2007;Chang2010).

RiskToTheGovernmentsFiscalPosion

Fraconalreservebankingposesasignificantrisktothegovernmentsfiscalposionfortwomainreasons:

1.Asoutlinedabove,thepro-cyclicalityoffraconalreservebankingappearstobeamajorcontribungfactorintheboom-bustcycle.Inthebustphaseofthecycle,governmenttaxrevenuesfall

significantly,meaningthatthegovernmentisfacedwiththechoiceofeithera)rapidlycungpublic

servicesorraisingtaxes,orb)runningupasizeabledeficit.Rapidcutsofpublicservicesortaxrises

areusuallypolicallyunacceptable(andhavepotenallydamagingeconomicimpactsintermsof

reducingdemand)sothegovernmentisusuallyforcedtorunupadeficit,increasingthenaonal

debtandworseningthegovernmentsfiscalposion.

2.Theinherentinstabilityoffraconalreservebankingasabusinessmodelmeansthatgovernmentsareverylikelytobecalledonforfinancialsupportsoonerorlater.

AddionalProblemsWithFraconalReserveBanking:

Weaknessofinterestrateadjustmentasamacroeconomictool

WhentheBankofEnglandfeelsthatinflaonisgengtoohigh,ittriestoindirectlyreducethemoney

supplybyraisinginterestratestoreduceborrowing.Iftheeconomyisinarecession,itdoestheexact

opposite,loweringinterestratesinordertoencouragemoreborrowing,asanindirectwayofincreasingthe

moneysupply.

Thismethodofsteeringtheeconomyusinginterestratesisnecessaryunderfraconalreservebanking,and

isanothergreatcauseofinstability.ItisaliOlelikedrivingacarbysteppingonthebrakeandtheaccelerator

atthesameme.Whentheeconomyisoverheang,thebankingsectorhasitsfootontheaccelerator

(creangmoremoneyasdebt)whiletheBankofEnglandhasitsfootonthebrake(raisinginterestratestoslowdowntheborrowing).Whentheeconomysinksintoarecession,theyswappedals:thebankingsector

slamsonthebrakes(refusingtolend)andtheBankofEnglandstepsontheaccelerator(cunginterestrates

totheirlowestlevel).Thistypeofmanagementoftheeconomyappearsunlikelytoeverleadtoeconomic

stability.Indeed,manystudiesdemonstratetheweaknessofchangesininterestratesinaffecngthereal

economy(BlanchardandFisher1989;Werner2005).neofthemostwidelyusedexamplesisJapaninthe

1990s,wheninterestrateswereheldatzeroforanextendedperiodbuttherewasnotangibleimpacton

outputmainlybecausebanksweretooheavilyleveraged.AsimilarstorycanbeseentodayintheUK.

Interestratemanipulaonisalsoazero-sumgameintermsofthesocialcosttomanagingtheeconomy.

Wheninterestratesarecut,pensionersandothersaverswhowerelivingoffinterestincomefromtheir

savingsseetheirwealthandincomerapidlydeteriorate.Meanwhile,otherindividuals,especiallytheyoung,

aretemptedtoborrowbecausecreditischeap.Thisissupposedtosmulatetheeconomybyraisingthemoneysupply.Butiftheeconomydoespulloutofrecession,theBankimmediatelyincreasesinterestrates,

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reducingtheincomeandpurchasingpoweroftheverypeoplewhorescuedtheeconomybyborrowingwhen

interestrateswerelow.

Incontrast,full-reservebankingofferstheBankofEnglandandtheMonetaryPolicyCommiOeeawayofdirectlyincreasingordecreasingthemoneysupply,andthereforeavoidsthismanic-depressive

managementoftheeconomy.Italsoavoidstheneedtoshiinterestratesthataffecteveryexisngborrower

simplytoinfluencethesmallgroupofpeoplewhoareconsideringincreasingtheirborrowingatany

parcularmomentinme.Underfull-reservebanking,interestratescanbesetbysupplyanddemand

throughthemarkets,withthebanksacngasintermediariesbetweensaversandborrowers.

Re-DistribuonOfWealthUpwards&Inwards

Becausetheenremoneysupplyiscreatedasadebtbycommercialbanks,ineffectinterestmustbepaidto

thebanksoneverysinglepoundofbankdepositsthatexistsintheeconomy.Apartofthisinterestis

redistributedbacktodepositorsviainterestonsavingsaccounts,etc.,butbyfarthebulkofitisdistributedtotheworkersofthebanks,viasalariesandbonuses.Thiscreatesthreere-distribuoneffects:

1.FromthePoortotheRich:

Allmoneyiscreatedasdebtbythebankingsystem.Thisshisthebaselineofpovertydowntozero

ornegave,ratherthanalowbutposivebankbalance.Becauseitisthoseonbelow-average

incomesthatendupwithmuchofthedebt,theyenduppayinginteresttothebankingsector,in

effectmeaningthatthepoorsubsidisethemiddleclassorrich.

2.FromtheRealEconomytotheFinancialSector

Businessesarealsoinasimilarsituaon.Thereal(non-financial),producveeconomyneedsmoneytofuncon,butbecauseallmoneyiscreatedasdebt,thatsectorwillalsoenduppayinginterestto

thebanks.Thismeansthatreal-economybusinessesshops,offices,factories,etc.endup

subsidisingthebankingsector.

3.FromtheRestoftheUKtotheCityofLondonandtheSouthEast

Becausethisdebt-basedsystemreturnsmoneytothebankingsector,andthebulkofbankingsector

salarypaymentsareconcentratedwithintheCityofLondon,thismeansthatthereisatransferof

incomefromtherestoftheUKtotheCityofLondonandtheSouth-East.

Allofthesere-distribuoneffectsareinherenttothesystemandwillconnueyearaeryearaslongasthe

moneysupplyisissuedbycommercialbanksasdebt,viafraconalreservebanking.Furtherresearchneeds

tobedone,butitisverypossiblethattheupwards-and-inwardsredistribuonofincomecausedbythis

systemofissuingmoneycancelsoutanydownwards-and-outwardsredistribuonofincomethroughthe

welfarestate.Lookedatanotherway,thewelfarestatemayonlybenecessarybecauseofthedesignofthe

bankingsystem,andcouldbesignificantlyscaledbackifthemethodofcreangmoneywasreformed.This

shouldofferasignificantopportunitytoimprovethefiscalposionofthegovernment.

TheNeedforDepositInsurance

Underfraconalreservebanking,abankwillneverhavesufficientmoneyatanyonemetorepayallitsdemandliabilies(instantaccessaccounts)simultaneously.Thismeansthatarunonthebankcanvery

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quicklyforceabanktocloseitsdoorsandeffecvelybecomeinsolvent.ncepeoplerunononebank,other

membersofthepublicmayrunontheirownbank,triggeringthequickcollapseoftheenrebankingsystem.

Topreventthis,thegovernment,throughtheFinancialServicesCompensaonScheme(FSCS),guaranteesthatnocustomerwilleverlosemoneydepositedinanyaccountwithaneligiblebankupto50,000.

Whilstmakingthebankingsystemlesslikelytocollapse,thisdepositinsurancecausesahugeeconomic

distorontothekeyprocessofmaturitytransformaonthatbanksundertake,asMervynKingrecently

pointedout(King2010).Itmakestheinvestmentproductsofahigh-streetbankappeartoberisk-free,

makingthemeffecvelyassafeasgovernmentbondsorphysicalcash.Thisisdespitethefactthatthe

underlyingassetsbackingthosedepositsmayrangefromconservavemortgagestosub-primelendingto

riskyproprietarytrading.

Inshort,depositinsuranceensuresthatwhiletheprofitsofaninvestmentgotothebankandtotheinvestor/

saver,anyextremelosseswillfalluponthetaxpayer.Toputitanotherway,thisistheprivasaonofprofit

andthesocialisaonofrisk.Thisintroducestheproblemofmoralhazard.Savershavenoneedtotakeanyinterestintheacviesoftheirbank,becausetheyknowthatevenifthebankfails,theywillnotlosemoney.

Thismakessavingwithabankaone-waybet.

Consequently,depositinsurancemeansthattheleveloffundingprovidedtodifferentinvestmentsdoesnot

appropriatelyreflecttherealrisksofthoseinvestments.Banksareabletotakemoneyfromdepositorswho

believethattheirinvestmentsarerisk-free,andtheninvestthosefundsinriskyproprietarytradingor

invesng.Iftheoriginaldepositorswererequiredtoshoulderatleastsomeoftheriskofproprietarytrading,

thenitislikelythatfewerfundswouldbemadeavailableforthoseinvestments.

Thisdisconnectbetweentherisksandthepotenalgainsofaninvestmentcausedalmostenrelyby

depositinsuranceislikelytobearootcauseofamajorshitowardsshort-term,profit-seekingspeculaonoverthelastfewyears.

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PartIII:AddressingCommonMisconceponsaboutFull-ReserveBanking

1.Full-reservebankingwouldleadtoashortageofcredit

Thefirstissuetorecogniseisthatthecurrentlevelofdemandforcreditismoreaccuratelydescribedasa

dependenceondebt.Thisdependencearisesfortworeasons:

1.Theonlymethodbywhichthepublic,collecvely,cangetaccesstobankdeposits(money)isbytakingonloansfromabank.Therefore,iftheeconomyneedsmoremoney,thisnewmoneymustbe

borrowedfromabank.Thismeansthatthelackofanalternavemethodofinjecngmoneyintothe

economyensuresthatthedemandforcreditisarficiallyinflated.2.Thefactthateverybankloanissuedcreatesbrandnew,addionalpurchasingpowerisamajor

contribungfactorininflaon.The150%(1.2trillion)increaseinthemoneysupplyfrom2000to

2009wasundoubtedlysignificantinthe197%increaseinhouseprices15,giventhatthebulkofnew

moneycreatedasaresultoflendinggoesdirectlyintothehousingmarket.Thisimpliesthatthe

demandforcreditnowisarficiallyinflatedbytheabilityofbanklendingtoinflatehousepricesand

requiremembersofthepublictoborrowmoreinordertobuyahouse.

Asaresult,wewouldsaythatthefraconalreservebankingsystemarficiallyinflatestheneedforcredit,

andthatthedemandforcreditwillalwaysbehigherunderafraconalreservebankingsystemthanundera

full-reservebankingsystem.

Inotherwords,therewillbelessneedforcreditinafull-reservebankingsystem.

Inaddion,theintroduconofanewsourceofdebt-freemoneyviatheMonetaryPolicyCommiOeeand

governmentspending(ortaxreducons)willallowthepublictoreducetheiroveralllevelofdebt.Withlower

debt,householdswillhavehigherdisposableincomeandthereforelessneedtoborrow.

Theimplicaonisthat,followingaperiodoftransion,theneedforcreditwillbemuchlowerunderfull-

reservebankingthanunderafraconalreservebankingsystem.

Thetransionbetweenourcurrent,highlevelofdependencyoncredit,andalowerlevelofcreditunderfull-

reservebanking,canbemanagedsoastoavoidanyformofshort-termcreditcrunch.Therearevarious

methodsofeasingthistransion,suchastheBankofEnglandandMPCcreangaddionalnewmoneythatcanbelent-onbythebanks,inordertofillthetemporarygapbetweenthecurrentdemandforcreditandthe

currentlevelofrealsavings.Asthebenefitsoffull-reservebankingstarttoplayoutintheeconomy,this

temporaryprovisionofcreditmaybegraduallyphasedout.

2.[Full-reservebanks]eupbankdeposits,ratherthanallowingthemtobemadeavailableto

fundproducveinvestmentthroughfinancialintermediaon.

Thisstatement,adaptedfromtheCommissionsIssuespaper,hasanumberofproblems.

25

15SeeM4figuresfromtheBankofEnglandsinteracAvestaAsAcaldatabase,andNaAonwidesHousePriceIndex.


26/39

Firstly,thestatementimpliesthatintermediaonchannelsfundsintoproducveinvestment.Asthelastfew

yearshaveshown,banksgenerallyhaveacommercialincenvetofunnelmoreoftheirintermediatedfunds

intonon-producve,asset-pricespeculaon(suchashousingandcommercialrealestate;Werner,1997,

2005).nlyaroundonethirdofbanklendinggoesintoproducveinvestmentinbusinesses(nef2010:15).

Secondly,thestatementimpliesthatbanksactuallyundertakefinancialintermediaon.Whilethisisan

accuratedescriponwhenlookingattheflowsofcentralbankmoneybetweenreserveaccountsattheBank

ofEngland,itcertainlyisntaccuratewhendiscussingbankdeposits.Banksdonotintermediatebank

depositsbetweensaversandborrowersinstead,whenbanksmakeloans,theycreateaddional[bank]

depositsforthosethathaveborrowedthemoney(BankofEnglandQuarterlyBullen,2007Q3).

Thirdly,thestatementimpliesthatbankdepositsarescarceandthereforeneedtobeputtogooduse.This

kindofthinkingisappropriatewhendiscussinggoldcoinsorexpensivehospitalequipment,butitisnot

appropriatewhendiscussingdigitalmoneythatcanbecreatedatnocost.

Thestatementalsoimpliesthatmoneyshouldbeintermediatedandinvestedevenifthedepositorsdonotwishittobeinvested,throughthemechanismoffraconalreservebanking.Thispermanentintermediaon

ispossibleviafraconalreservebanking,butthecostistheinstabilityandexcessivedebtthatfraconal

reservebankinggenerates.

Forclarity,underourproposalforfull-reservebanking,itisinaccuratetothinkofmoneyasbeingineithera

TransaconAccountoranInvestmentAccount.Infact,allmoneywillbeheldinTransaconAccountsatall

mes,andanInvestmentAccountwilljustbearepresentaonoftheinvestmenti.e.atransferoffunds

fromaninvestorsTransaconAccounttotheTransaconAccountofaborrower.Thesamequantyoffunds

inTransaconAccountscouldsupporteitherahighorlowlevelofinvestment,sothereisnolossfromhaving

fundsinaTransaconAccountratherthanhavingthemonloanviafraconalreservebanking.

3.Allowingthestatetoissuemoneywouldbeinflaonary

Thecommonreacontothesuggesonthatthestate(oranypartofthestate)shouldberesponsiblefor

issuingnewmoneyisthatelectedpolicianswouldabusethispowertothedetrimentoftheeconomy.We

considerthataveryvalidconcern,andthereforewehaveproposedthattheMonetaryPolicyCommiOee,

insulatedfrompolicalinfluence,shouldberesponsibleforincreasingordecreasingthemoneysupply.They

wouldbespecificallychargedwiththetaskofcreangasmuchmoneyastheeconomyneedstomeetthe

inflaontarget.Anyexcesscreaonofmoneyunderthissystemwouldpushinflaonabovethetarget,in

whichcasetheMonetaryPolicyCommiOeewouldneedtostopincreasingthemoneysupplyorevenstartto

withdrawmoneyfromcirculaontodampeninflaonarypressures.

Thisseparaonofpowersbetweenthosedecidinghowmuchmoneyshouldbecreated(theMPC),and

thosedecidinghowtospendanynewly-createdmoney(thegovernment)shouldavoidthemisaligned

incenvesthatwouldresultifelectedpolicianshadtomakedecisionsoverthemoneysupply.

Thequeson,then,iswhetherinflaonislesslikelywhenthecommercialbankingsectorissuesmoney(by

creangnewbankdepositswhentheymakeloans)thanifmoneywerecreatedbyanagencyofthestate,

suchastheMonetaryPolicyCommiOee.

Thetrackrecordofthebankingsectorwithregardstomanagingthemoneysupplyandavoidinginflaonis

notgood.Between1990and2009,thelendingacviesofbanksincreasedthemoneysupplybyanaverage

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of8.2%p.a.(atotalincreaseoverthatmeof370%).16Inthisme,theRetailPriceIndexhasincreasedby

88.5%17(anannualaverageof3.15%)whiletotalhousepriceinflaoninthatmehasbeen180%.18From

thisitappearsthatremovingtheabilityofbanklendingtoswellthemoneysupplycouldgoalongwayto

reducinginflaonarypressuresintheeconomy.

Despitethislogicalanalysis,knee-jerkreaconsmayconnue.MarnWolfpointsouttheinconsistent

thoughwithregardstostate-issuedcurrencywhenhestates:

"Theessenceofthecontemporarymonetarysystemiscreaonofmoney,outofnothing,byprivate

banksoenfoolishlending.Whyissuchprivasaonofapublicfunconrightandproper,butaconby

thecentralbank,tomeetpressingpublicneed,aroadtocatastrophe?"19

Furthertothehistoricalevidence,theincenvesofbanksshouldbeconsidered.AMonetaryPolicy

CommiOeewiththeresponsibilityforcreangtherightquantyofnewmoneytomeetaparcularinflaon

targetwillstopcreangaddionalmoneyassoonastheinflaonraterisesabovethetargetrate.Incontrast,

bankswillconnuecreangmoneyaslongastheycanprofitablymakeloans,sinceeveryloantheyissuecreatesbrandnewbankdepositsandincomeforthebank.Itshouldbeobviousthatineverysituaonother

thanabankingcrisis,banksarelikelytoincreasethemoneysupply,creangapermanentupwardpressure

oninflaon.

Inconclusion,inflaonappearstobesignificantlylesslikelyinafull-reservebankingsysteminwhichthe

MonetaryPolicyCommiOeehasresponsibilityforincreasinganddecreasingthemoneysupplyinlinewith

theneedsoftheeconomy.Thegreatestlikelihoodofinflaoncomeswhencommercialbanksareableto

increasethemoneysupplythroughtheirlendingdecisions.

4.Full-reservebankingwouldendtheprocessofmaturitytransformaon

Acommonmisunderstandingisthatfull-reservebankingwouldendmaturitytransformaon-theprocessby

whichshort-terminvestmentsaretransformedintolong-termloans,suchasmortgages.Butitisimportant

torecognisethatunderfull-reservebanking,thereisnodirectmatchbetweenasaverandalender:full-

reservebankingisnotpeer-to-peerlending.

Underourproposalforfull-reservebanking,ascustomersopenInvestmentAccounts,themoneyis

transferredtothebanksInvestmentPool.WhentheInvestmentPoolissufficientlyfull,thebankisableto

makealoantoaborrower.Atallmes,therearemulplecashflowsinandoutoftheInvestmentPool:

CashflowsintotheInvestmentPool:

1. Themonthlyrepayments(principal+interest)frommulpleborrowers2. Newinvestmentfundsfromcustomersofthebank3. Newinvestmentfundsmadefromthebanksowncapital(whichwouldcomefromthebanks

27

16M4figuresfromBankofEngland

17OfficeofNaAonalStaAsAcsRPIIndex-availablefrom

h:p//www.staAsAcs.gov.uk/STTBSE/tsdataset.asp?vlnk=229&More=Y

18NaAonwideHousePriceIndex

19FinancialTimes,November9th2010.vailablefrom

h:p//www..com/cms/s/0/93c4e11e-ec39-11df-9e11-00144feab49a.html#axzz14sno2FXa


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peraonalAccount)

CashflowsoutoftheInvestmentPool:

4. Newmortgagesandloansissuedtoborrowers5. PaymentsofinteresttoInvestmentAccountholders6. RepaymentsinfullofmaturingInvestmentAccounts7. TransfersofprofitstothebanksperaonalAccount(inordertopaysalariesetc.)

Maturinginvestmentaccountsmayberepaidwiththemonthlyrepaymentsfromexisngborrowers,butthey

mayalsobepaidwiththefundsfromnewInvestmentAccounts.Whileatfirstglancethismayappeartobe

similartoPonzi-financing(newinvestmentspayingoffoldinvestors),itismoreaccuratetoseeitasanew

investorbuyingoutthepreviousinvestorsshareofanincomestream,withtheincomestreambeingthe

assetsofthecommercialbank.

Throughthisprocess,itisenrelypossibleformaturitytransformaontotakeplace.Throughoutthelifeofaparcularmortgage,someofthebanksInvestmentAccountholderswillwanttoreclaimtheirinvestmentat

thesamemeasothercustomerswishtoopennewInvestmentAccounts.Providingthebankmanagesits

investmentsandcashflowswell(andasoutlinedinPart1,thisisfareasierunderfull-reservebankingthan

underfraconalreservebanking),itisenrelypossibletotransformmulpleshort-terminvestmentsinto

mulplelong-termmortgages.

Inotherwords,maturitytransformaonunderfull-reservebankingoperatesinmuchthesamewayas

maturitytransformaonunderfraconalreservebanking.Themaindifferenceisthatunderfraconal

reservebanking,theshort-termfinancecanevaporaterapidlyascustomerswithdrawtheirmoneyon

demand,whilstinfull-reservebankingthisprocesscouldonlyhappenatamuchslowerrate,thankstothe

maturitydatesornoceperiodsthatapplytoInvestmentAccounts.Consequently,full-reservebankingallowsmuchmorerobustmaturitytransformaonthanfraconalreservebanking.

5.TheMonetaryPolicyCommieewouldbeunabletojudgethecorrectlevelofmoneyneeded

bytheeconomy

ThereisanargumentthatacommiOeesuchastheMonetaryPolicyCommiOeewouldfinditimpossibleto

correctlyesmatetheappropriatelevelofnewmoneyneededintheeconomy.Thisargumentimpliesthat

thebankingsectorwouldbemoreeffecveinmanagingthemoneysupply.However,onanalysisitbecomes

apparenthowunlikelyitisthatthefraconalreservebankingsystemwillgeneratetheappropriatelevelof

moneyfortheeconomy:

Everyloanissuedbyabankincreasesthemoneysupplyinthehandsofthepublic; Bankshaveacommercialincenvetolendwhenevertheycanfindacredit-worthyborrower; Mostbankstaffareunawarethatbanklendingcreatesnewmoney,andthereforedonotunderstand

themacro-economicimpactoftheirlendingdecisions;

Mostbankstaffareincenvisedtomaximisetheamountofloansthattheyissue.Theywillreceiveabonusorcommissionforanyloantheyissue,andgetnorewardiftheydonotissuealoan.

Consequently,underthefraconalreservebankingsystem,thedecisionoverhowmuchmoneytheeconomy

requiresistakenbythousandsofloanofficerswhoareincenvisedtomakeonlyonedecision:issuealoan

andincreasethemoneysupply.Thisnaturallyleadstoaconstantlyincreasingmoneysupply,regardlessofthe

needsoftherealeconomy.

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Thoseindividuals(bankstaff)andcompanies(banks)withcontroloverthemoneysupplyhavenooversight

ofthewholeeconomy.Incontrast,theMonetaryPolicyCommiOeewouldhavebig-pictureoversightofthe

economy,withtheremittoconsidertheneedsofthewidereconomybeforemakingadecisiononaltering

themoneysupply.

Inaddion,theMPCistheonlyinstuonwithnoconflictofinterestandanalignmentofincenveswiththe

needsoftheeconomy.ThemembersoftheMPCcouldberewardedforachievingatargetrateoflowand

steadyinflaon,andcreangtoomuchmoneywouldresultinthemlosingthispotenalreward.Incontrast,

bothbanksandelectedpolicianswouldgetarewardintheshort-termatleastbyincreasingthemoney

supplyexcessively,eveniftodosowasagainstthebestinterestsoftheeconomy.

6.Full-reservebankingwouldforcebankstoleavetheUK

Thefull-reservebankingrequirementswouldapplytoanybankthatdealsinpoundsterlingandwhich

thereforerequiresaccountsattheBankofEngland.Inotherwords,anybankwishingtodobusinessinpound

sterlingwouldneedtooperateunderthefull-reservebankingrules.Beingregisteredorlocatedabroadwould

nothelpthebankcircumventthechanges.

Inshort,full-reservebankingiscompletelyunlikechangessuchasbankleviesoraGlass-Steagal-typechange

thereisnowaytocircumventit,aslongasabankwantsaccesstothehugesterlinglendingmarket.

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Appendices

Thefollowingappendicesgivefurtherdetailsonspecificareasoftheproposal:

Appendix1:HowWeGotHere-The1844BankCharterAct Appendix2:HowFull-ReserveBankingIncreasesStabilityWithinEachBank Appendix3:InvestmentAccountGuarantees Appendix4:TheImpactofFull-ReserveBankingontheBankofEnglandsBalanceSheet Appendix5:DealingwithCashUnderFull-ReserveBanking

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APPENDIX1:HowWeGotHereThe1844BankCharterAct

Priorto1844,commercialbankswereallowedtoprinttheirownpoundsterlingbanknotes,whilecoinscould

onlybecreatedbythestate.verme,banksstartedtoissue(print)andlendoutsomanybanknotesthat

theycausedsignificantinflaonanddestabilisedtheenreeconomy.

Inresponse,thegovernmentofRobertPeelpassedthe1844BankCharterAct,whichmadeitillegalfor

anyoneotherthantheBankofEnglandtoprintpoundsterlingbanknotes.Intheory,thisshouldhave

returnedcontroloverthemoneysupplyofthenaonbacktothestate.

NumberMoney(BankDeposits)However,the1844BankCharterActdidnotmakeitillegalforbankstocreatebankdeposits-thenumbers

inyourbankaccount,andinthebankaccountsofanycizenorcompanyinthecountry.Withtheriseofthe

digitalage,thesebankdepositsarenowtheprimarymeansofpayment,usedin99.91%oftransacons.20

Thebanksareabletocreatebankdepositsthroughtheaccounngprocessthattheyusetomakeloans.

Ratherthantakingmoneyfromasaverandlendingittoaborrower(asperthecommonunderstandingof

banking),theysimplywritenewnumbersintothebankaccountofaborrower-effecvelycreangnew

money.Theironlyconstraintinthisprocessistheneedtohaveasmallpoolofcentralbankmoneyatthe

BankofEngland,butasmorein-depthbriefingscanexplain,inpraccethisdoesnotactasaconstraintupon

thelendingofbanks.

Withoutseeingtheprocessinacon,itcanbealiOlehardtobelieve.Acomprehensiveandfullyreferenced

explanaonofthismoneycreaonprocessisavailablefromPosiveMoneybutbelowareafewquotes

straightfromthehorsesmouthwhichconfirmthisamazingfact:

...byfarthelargestroleincreangbroadmoneyisplayedbythebankingsector...whenbanksmake

loanstheycreateaddionaldepositsforthosethathaveborrowedthemoney.

-BankofEnglandQuarterlyBullen,2007Q3

Subjectonlybutcruciallytoconfidenceintheirsoundness,banksextendcreditbysimplyincreasing

theborrowingcustomerscurrentaccount,whichcanbepaidawaytowherevertheborrowerwantsby

thebankwringachequeonitself.Thatis,banksextendcreditbycreangmoney.

-PaulTucker,DeputyGovernoroftheBankofEnglandandmemberoftheMonetaryPolicyCommiOee

"...changesinthemoneystockprimarilyreflectdevelopmentsinbanklendingasnewdepositsare

created."

-BankofEnglandQuarterlyBullen2007Q3,p378

"...thebankingsectorplayssuchanimportantroleinthecreaonofmoney.Changesinthetermsfor

depositswillaffectthedemandformoney,whilechangesinthetermsforloanswillaffecttheamount

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ofbanklendin

Money how to change it

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