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.

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

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

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

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

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

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.

Tuesday, 21 January 2014

Share prices with fractional reserve banking

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

Most people would make two assumptions when considering this market:

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

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

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

So now the role of government becomes crucial in setting share prices. Instead of standing at the side-lines observing these wise investors analysing the companies, the government is now the dominating factor. The wise investors are sitting watching the government! If they lower interest rates, then the enthusiasm for borrowing to buy shares increases, this increases demand and their price will rise… and conversely If they raise interest rates, then the enthusiasm for borrowing to buy shares decreases and their price will fall. By implementing super-low interest rates for such a long time, the government is now stuck in a situation, where returning to normalised interest rates would almost certainly cause a crash in the stock market. Note that I could have made almost exactly the same argument about the housing market too.

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

Changing to full reserve banking is a key ingredient for making our economy work properly. If I were in charge, I would ban the practice of trading on margin too. It serves no purpose that I can figure out for the economy as a whole.

Tuesday, 31 December 2013

Advertising Standards Authority condone bank's lies.

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

In their reply, they said...

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

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

They went on to say...

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

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

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

Monday, 23 December 2013

Peter Mandelson demonstrates his ignorance of our monetary system


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

Friday, 20 December 2013

An irritation with MMT'ers

The sectoral balance equation gives the *impression* that if the government runs a surplus of $X during one year then the money supply available to the private sector to use must be whatever it was at the start of the year minus $X.

But this is not true. Fractional reserve banking allows the private sector to increase or decrease the money supply independently of whatever the government does. So the *contribution* of the government's policy to the money supply may indeed be -X, but the size of the private sector's money supply could have changed by any amount.

Maybe an MMT'er would admit this if probed, but why don't they say it in the first place instead of misleading everyone?

PART II

After some back and forth on Twitter, and being directed to read this, I'd like to say some more...

A huge component of the current economic crisis is the size of the money supply and the amount of private debt (the two are closely related). But the debt is not debt *to* the government sector. It is debt to others within the private sector (I'll label this as internal borrowing). Note that MMT'ers favourite quantity, the "net financial assets" does not measure the private sector's internal borrowing, because it nets out as zero.

Having a conversation about what to do about the economic crisis and debts without talking about the private sector's internal debt is just leaving a huge elephant in the room. Where is an MMT article about the that? Where is the article "MMT'ers use sectoral balance equation to deduce policy to control internal private debt"?