Fractional reserve banking, Mr. Carswell and the double facepalm

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Yes, I\’m sorry, the double facepalm is indeed the appropriate response to this foolishness being promoted:

We now see that demand-deposits are created out of thin air. Indeed, these are just ledger-entries from one bank customer to another. The creation of this credit causes a credit-induced boom that then becomes a bust.

How can we stop this? Conventional wisdom says get banks to have more of a capital cushion and there is no harm in that. More regulation they cry.

But money is simply too important to be controlled by politicians. Today two brave insightful MP\’s, Douglas Carswell and Steven Baker, have helped show us the way by proposing a bill to end this.

What is needed is to let people own their own money, with the banks keeping it safe for those that want complete peace of mind. Let the depositor decide if the money should be lent and for what period, until it matures. Remove all political control from banking. And let\’s have more language of the fiduciary rather than the gambler from bankers.

There are two reasons, thus the double facepalm.

The first is that we already have an entirely reasonable and useful system whereby you can deposit your money with a bank, it remains your property and no one lends it on to anyone else.

It\’s called a safe deposit box.

The second reason delves a little deeper into fractional reserve banking. The thing being that, well, instead of all of your and my rainy day savings sitting around doing nothing….they might not be much individually but gross they\’re a hefty chunk…we\’d rather like that such savings go off and finance industry. Or other people, at least do something other than leave economic resources, capital, sitting doing sweet fuck all.

And this is what banks do. They engage in maturity transformation. They take our short term, on demand, deposits and turn them into term, long term, loans to peeps who want to build, buy or finance something. Might be that new grommet machine required to cure the country\’s kids of glue ear, that house desired to home that family or even the government borrowing necessary to keep the police service running until the income tax cheques come in at the end of the year.

This is what a banking system is for: and to insist that banking should stop being banking is, umm, well, it\’s dim actually. Facepalm, double facepalm type dim.

15 thoughts on “Fractional reserve banking, Mr. Carswell and the double facepalm”

  1. At the moment(and for the foreseeable future), bank interest is almost nothing, and so, expect many more ‘ideas’ like that.

    Also, it seems to me that banks no longer have much of a savings business anyway, as almost no-one has any savings and if they do, it’s in assets, not cash. So, it’s not surprising the banks got out of the savings business some time ago and only offer a limited virtual safety deposit box (up to £50k guaranteed by UK PLC)

    For the massive amounts of relatively small sums the banks shift around for the nation rather efficiently, banks are actually really good value.

    People just need to lose the old-fashioned idea that banks are for investing in and all is good.

    In other news, it’s been revealed that Father Christmas has never existed.

  2. As I see it, the main benefit of the Bill is that it will raise awareness of the issues:

    – How does FRB work? (most people are completely unaware that banks lend money that is held in current accounts, and that they expand the money supply in the process)

    – Do the benefits to society of Fractional Reserve Banking outweigh the costs?

    – Is it right that bankers should enjoy legal privileges? (in Irving Fisher’s words, to act as “so many irresponsible private mints”)

    – Why is storing money in a safe deposit box such an unreasonable idea? (Answer: because a deliberate government policy of inflation has led to a tenfold devaluation of our currency since 1970, and a hundredfold devaluation since 1899)

    – Does the presence of a central bank as lender of last resort do more harm than good? (think ‘moral hazard’)

    – If not 100% reserves, would we be better off with fractional reserve free banking?

    These are all interesting questions, which deserve to be debated. Though I don’t expect Carswell’s Bill to get through as-is, I hope it will stimulate discussion.

  3. Carswell and his colleagues are doing all free marketeers a favour here. In opening up the conversation and highlighting the corporatist nature of such much of our financial infrastructure, they will encourage mainstream commentators to recognise that the economic crisis is not about market failure. The discussion is fabulous news and should be very much welcomed in these terms.

  4. The usual Polyanna view of the present ideal world where “we’d rather like that(bank) savings
    go off and finance industry.” Funny that after an enormous binge of credit creation so many parts of the country are reliant on the public sector ,the financing of industry not having materialised.Meanwhile an enormous housing bubble seems to indicate where the created credit has gone instead.(The point of LVT being to block the cheap credit going out of the productive loop into land.)
    Meanwhile Treasury meatheads are running round complaining that everybody is paying 7o billion p.a. to service the National Debt.So why is the State paying the private sector to borrow,when it is a truth universally acknowledged that the private sector just creates
    the credit (does n’t borrow it off anybody) and lends it out at interest?
    We should have nationalised the banks when we had the chance.No doubt they will screw up again fairly soon, being given a licence to print money proving too much for them.

  5. I haven’t noticed Carswell adding that his depositors would never be paid any interest and would be charged for all banking services consumed.

    Adam Smith lived through the introduction of modern banking – and “fiat money”, the other obsession of Carswell and his pals. Here’s what Smith had to say about it:

    “I have heard it asserted, that the trade of the city of Glasgow doubled in about fifteen years after the first erection of the banks there; and that the trade of Scotland has more than quadrupled since the first erection of the two public banks at Edinburgh, of which the one, called the Bank of Scotland, was established by act of Parliament in 1695; the other, called the Royal Bank, by royal charter in 1727.*14 Whether the trade, either of Scotland in general, or the city of Glasgow in particular, has really increased in so great a proportion, during so short a period, I do not pretend to know. If either of them has increased in this proportion, it seems to be an effect too great to be accounted for by the sole operation of this cause. That the trade and industry of Scotland, however, have increased very considerably during this period, and that the banks have contributed a good deal to this increase, cannot be doubted.”

    Tim adds: To be fair to Carswell, “I haven’t noticed Carswell adding that his depositors would never be paid any interest and would be charged for all banking services consumed.” He has actually said that.

  6. Tim, for once I am actually going to disagree with you and even half-agree with DBC Reed (cough, splutter).

    First, the crack about a safe is silly: what happens in a cash-less economy?

    More importantly, you are, I think, ignoring a central point: people want to put money into a bank rather than a safe deposit box because safe deposit boxes are costly, you can easily forget the combination and they get broken into. That is why most people, for convenience, use a bank instead.

    As far as the issue of using deposits for investments, it is an issue of matching up the time-expectations of depositors and creditors. Money that is deposited for instant-access cash purposes should be 100 per cent covered by reserves, or insured. Money that is put on deposit for say, 3 months can be lent for 3 months, and so on. The balance sheet of a bank should reflect this, but the very fact that there are bank runs under fractional banking proves that there is an issue, which is why the MPs have brought this Bill forward.

    Take the very different case of hedge funds. In some funds, which invest in highly liquid strategies, such as long/short equities, the fund will only require investors to give say, 5 days notice before pulling their money out. Other funds, which employ long-term, illiquid strategies such as M&A arbitrage, etc, can insist on lockups of up to a year or more.

    It is all about time, really.

    Tim adds: “or insured”

    Quite. It’s called deposit insurance. Damn good thing to have as fractional reserve systems without it are prone to runs. As we just found out when we had a series of runs in the wholesale markets, which didn’t have deposit insurance. Banks should be charged a proper rate for this insurance, of course. But then that’s that problem dealt with.

    For, you see, we don’t just want banks to match borrowing and lending maturities. We want them to *transform* them. That’s what a bank is *for*. Borrowing short and lending long.

  7. FFS, Timmy, what if a customer — like me — wants all the cool stuff that comes with a current account; debit cards, direct debit etc. but would rather pay for it through a transaction charge rather than through letting them loan out my money?

    There ought to be a market for that shouldn’t there? However, there isn’t, because of a very odd ruling a hundred and fifty years ago legally asserting that all bank deposits into current accounts are loans to the bank. All this bill is supposed to do is reverse that odd ruling, and allow banks and customers to negotiate between them the status of the deposits. If — as you assert — FRB and Maturity Transformation is joyous and non-inflationary, then it will continue, however those of us who disagree will be able to opt out, without the inconvenience of having to operate with cash all the time.

    As to Maturity Transformation itself, you would do well to at least consider the arguments laid out — albeit in a highly verbose fashion, replete with archaic phrases and odd verb forms — here by everyone’s favourite Jacobite, the irascible Mencius Moldbug.

  8. Tim, the issue of disclosure is important; suppose that I don’t want the bank that is supposed to be protecting my cash that I keep for short-term purposes to lend it out to some borrower for say, 12 months? In a cashless economy – which is what is rapidly approaching – we won’t even have the chance to avoid this by putting money into a safe.

    Banking is about putting holders of capital in touch with those don’t have it but who have an interesting, profitable ways of using it, for terms agreeable to both sides.

    There is also another way of thinking about it; if I lend you a pound, then for the period that I have lent it, I don’t have it. It is like stock lending: if I lend you a share in BP (sucker!) then I tempoarily give up ownership of it, the right to vote its shares in AGMs, etc. I transfer the property right, in other words, in order to gain something (like a cash payment from the stock borrower).

    The fiction of FRB is the idea that it encourages people to believe that two people can spend the same £1 at the same time. Cash held on deposit in a no-notice account is, by definition, money to which the depositor wishes to obtain instantly; the fact that sometimes banks have not been able to do this shows that there is a problem.

    The only reason FRB has been able to continue as it has is due to lenders of last resort – surely a sign that there is something fishy about FRB; bailouts, and the fact that banks calculate that only a minority of their clients will want to redeem all their cash. The fact that banks need all these government “air bags” is surely a sign that there is something about FRB that does not quite fit.

    Tim adds: “Banking is about putting holders of capital in touch with those don’t have it but who have an interesting, profitable ways of using it, for terms agreeable to both sides. ”

    No, that is finance, not banking. Banking is about maturity transformation.

  9. @ukliberty: thanks for that, that looks really cool. I know Kiva does the peer-to-peer loans thing too. To start off with I couldn’t work out why the rates were so high — the answer is that the rates reflect the true time preference of the loaners.

    MT is not a problem in a free market economy; the free market, as always, prices it down to stability — the risk of default is never zero, so the value of a coin deposited into a demand account at a bank to be Fractionally Reserved is slightly less than the value of that coin in your hand, thus although the bank’s credit expands the money supply, this is counteracted by a contraction in the money available to the depositors, expressed as their expected withdrawl: (deposit * P(¬default)) + (equity-payout * P(default)).

    What formal State deposit insurance, or informal promise of a bail-out does, is effectively guaruntee these deposits using the State’s ability to print unlimited volumes of money. This forces the pound in the bank to trade at parity with the pound in your hand, suppressing the contraction of the money supply at the depositor’s end, but without suppressing the expansion in the bank loan’s end, making the system inflationary overall.

    Ugh. MM explains it better than me. Go Read.

  10. we’d rather like that such savings go off and finance industry.

    Tim, you have often pointed out the difference between industrial funding in the UK compared to Germany, namely that businesses here rely much more on directly issuing corporate bonds. This is inefficient for small businesses and individuals, so they should continue to borrow from a bank, but the bank can fund its loans by issuing corporate bonds.

    I would also support the end of FRB as we currently have it, moving instead to a clear separation of deposits (not lent out) and fixed term bonds that can only be cashed in early by trading in a secondary market. Benefits:
    1. The ownership, availability and risks associated with all money would be much more explicit, instead of the collective delusion we have now.
    2. The only guarantee needed from the government (taxpayer or central bank) would be for the deposit money, which is by definition only at risk from theft or incompetence of administration by the bank, thus moral hazard is reduced.
    3. Maturity transformation may still exist, e.g. a bank could issue a succession of 5 year bonds to fund a portfolio of 25 year mortgages, but the capital banks have to repay/rollover on the portfolio of bonds they have issued would be known at all times. Thus a bank could still go bankrupt but not through a sudden rush to withdraw deposits. BTW: Deposit insurance for FRB is flawed, as the system will always tend to err on the side of charging the banks too little for the insurance, due to regulatory capture, political pressure for low interest rates etc. Hence the fears over the solvency of FDIC last year.
    4. Inflation would probably be lower and interest rates higher. This is to be welcomed as it would help prevent asset price bubbles and the bad government decisions caused by too easy credit.
    5. Did I mention the reduction in moral hazard? You cannot have a free market while government backed moral hazard exists.

    the government borrowing necessary to keep the police service running until the income tax cheques come in at the end of the year.

    No-one needs to borrow to manage cashflow, at least not in the long term, if they run surpluses until such time as they have enough savings to smooth out their income and outgoings. Governments are also engaged in maturity transformation, creating long term problems for the people in exchange for short term gain for the politicians. I’d prefer we minimised such MT, which is why I think governments should be forbidden from borrowing money.

  11. You statist, Tim! 🙂 Deposit insurance is a joke. Deposits are not insurable. How would that work? Banks put aside some money into a big pot every year. This would have a gradual deflationary effect. (Presumably they would stop putting money aside once the pot was bigger than the remaining money supply in the whole economy.) Then there is a bank run and the money is released from the pot to pay off all depositors. This has an instant inflationary effect which exactly cancels out all the previous gradual deflation.

    Whatever that is, it isn’t insurance.

    And how is it different from the government just printing a load of money for “stimulus”? Presumably your system really would abolish bank runs because people wouldn’t panic because they would know that the banks would always be able to pay them off. (Presumably the government could abolish bank runs if people believed with absolute certainty that the government would always print money to cover the bank’s short-term liabilities.)

    Why do you support such a system, which would fill the time gaps created by maturity transformation, but not support just banning maturity transformation?

  12. Such a system would create moral hazard for the banks just as much as govt guarantees to print money to cover bank runs would.

  13. Back to Carswell’s proposal. (I’m not convinced that Carswell understands MT, but Steve Baker does.)

    sconzey’s comment about choice should be a clincher for you, Tim. We don’t have the choice at the moment. We should.

    Johnathan Pearce’s comment “In a cashless economy – which is what is rapidly approaching – we won’t even have the chance to avoid this by putting money into a safe” is extraordinarily insightful.

    The legalistic point about who owns the money is a red herring. The point is that if my money is lent out, then even though I don’t legally own it, I still have a claim to withdraw it without notice which the bank cannot possibly service, because it hasn’t got it.

    You have a bit of blind spot on this, Tim. Lending will still happen without maturity transformation. Us ban-MT-ers don’t want money just locked in boxes. We do want the banks to lend it out, we just want them to lend it out for fixed terms chosen by the depositor and for the depositor not to be able to withdraw it before then.

    Your language, “No, that is finance, not banking. Banking is about maturity transformation”, smacks of argument by definition. Your desire to claim the word “banking” for your side, “We want them to *transform* them. That’s what a bank is *for*.”, is not an argument at all. That’s just quibbling over definitions. It’s an attempt to avoid debate. Do we really want banks to do that? You do. I don’t.

    I think you should ponder this issue a bit more. Definitely read some Mencius Moldbug.

    Tim adds: Yup, it’s definitional. If you borrow short and lend long you’re a bank. If you don’t you’re not. There’s an entire universe of all sorts of finance out there and the bit of it that is banking is, by definition, the bit that borrows short and lends long, that does the maturity transformation.

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