Monday, 28 July 2014

Share prices with fractional reserve banking

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

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

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

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

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

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

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

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

Wednesday, 21 May 2014

What nobody is saying about the housing market...

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

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

Sunday, 4 May 2014

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

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

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

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

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

Monday, 28 April 2014

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

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

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

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

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

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

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

Friday, 14 March 2014

Fractional Reserve Banking on Wikipedia

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


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

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

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

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

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

Tuesday, 11 March 2014

What's wrong with MMT

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

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

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

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

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

Wednesday, 26 February 2014

Georgism in 300 words.

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

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

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

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

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

Georgism:- look into it.