Book Review: The Solution Is Amount Reserve/100% Reserve Banking

Ralph S. Musgrave's volume argues that The Solution is Full Reserve/100% Reserve Banking. However, fifty-fifty afterwards reading the book, it is unclear what real-world occupation total reserve banking is the solution for. Despite its length (130 pages), the reader is expected to wade through the literature elsewhere to detect the details.

Book Description

The volume is available at Amazon inward paperback form, but it is also available every bit a gratuitous PDF download, amongst the link at Ralph's site.

Although it is technically a book, it is genuinely only an extended multi-chapter article inward format. My major electrical charge amongst the format is that Musgrave quite frequently only gives pocket-size excerpts of others' arguments, as well as the reader is expected to rails downwards the references. This is acceptable for an article, where the emphasis is on brevity. But a monograph length piece of work is expected to live at to the lowest degree somewhat self-contained, which this volume is sure as shooting not. As a result, I soundless receive got to approximate at how a "Full Reserve" organisation would piece of work inward practice.

What Is Full Reserve Banking?

There are a number of different schemes proposed past times diverse authors, unfortunately the reader is largely expected to read those external references to larn the details. But the key unifying regulation is that the banking organisation would cease to exist.

Two existing types of financial intermediaries are assumed to supervene upon the nowadays banking system.

1. Treasury Bill Money Market Funds.  These are the solely entities that are allowed access to the payments system, receive got a fixed par value on deposits, as well as clear cheques. They would Treasury bills and/or receive got deposits at the fundamental depository financial establishment (only) -- 2 instruments that are for all intents as well as purposes equivalent from the perspective of the private sector. (For a floating currency sovereign at least, for the euro area, the 2 are quite different.) These are the solely entities that volition live a counterparty to the fundamental bank. Since they are 100% invested inward default risk-free instruments, all deposits effectively receive got total deposit insurance.
2. Debt Mutual Funds. All other lending entities receive got to live essentially funded past times equity, or usual fund (unit trusts) units -- which are assumed to live equity-like. To paraphrase Polonius: not a borrower as well as a lender be. Since debt positions are funded past times equity, lenders cannot live insolvent (but come across comments below).

The answer to "How do nosotros larn there?" appears straightforward: existing banks volition live forced to sell all their assets to the fundamental bank, or else to the novel debt usual funds. This would plainly create the chance for really large distributive effects, existence a transfer of wealth to (or from) depository financial establishment shareholders. Ralph Musgrave repeats Milton Friedman's assertion that the transition would live easy; soundless the novel lending entities are unlikely to receive got sufficient analytical capacity, as well as and thus the transition could easily live hard due to the constraints on lenders. (Since the existing depository financial establishment funding model would no longer work, the lending capacity of banks would non easily live hived off to novel entities.)

What About The Non-Bank Financial Sector?

Most of the supporters of total reserve banking look to come upward from the United Kingdom, as well as they exploit the British exercise of referring to all of the participants inward the financial sector every bit "bankers." Conversely, inward North America, people volition quite frequently distinguish betwixt "bankers" as well as "financiers." This is non only a linguistic tic; it way that many inward Great Britain attribute to "banks" the problems during the Financial Crisis that were genuinely caused past times the non-bank sector (including the non-bank subsidiaries of banks). In fact, traditional banking comported itself really good during the crisis. For example, Canada has 0% reserve requirements, as well as had solely a mild economical carry on from the Financial Crisis.

Reforming the banking organisation to bargain amongst problems caused past times the non-bank financial sector makes no sense. But the non-banking organisation was non forgotten, Musgrave's solution is to eliminate the non-bank financial sector (other than equity trading). In Section 2.15, he says:

But the unproblematic solution to that is to regulate ANY ENTITY inward a higher house a sure size that amounts to a bank.

Basically, all entities -- including non-financial companies as well as rich individuals -- would receive got to live strictly monitored to preclude them from acting both every bit a borrower as well as a lender. They would live forced to fit into the 2 categories of entities listed above. Moreover, uppercase controls would almost sure as shooting receive got to live imposed to preclude financial action from moving offshore.

Anything other than such draconian surveillance would allow "pseudo-banks" to form, as well as all that would live accomplished is a really expensive relabelling of the components of the financial system.

What Are The Advantages?

According to Musgrave, the advantages of total reserve banking are (page 13):

1. No to a greater extent than depository financial establishment failures. Since banks effectively cease to exist, this seems non-controversial. However, nosotros volition receive got failures inward the non-bank financial organisation if regulators are unable to suppress its existence.
2. Improved stability. Regulating financial leverage volition presumably preclude purely financial crises. That said, instability inward the existent economic scheme (such every bit the Tech Bubble) volition live largely untouched. The line of piece of work organisation cycle is driven past times the pro-cyclical nature of fixed investment, as well as this is driven past times national accounting identities (the Kalecki Profit Equation), as well as non the shape of finance. Moreover, at that topographic point volition live speculative waves that transcend through the novel credit system; since it is market-based, property bubbles would live to a greater extent than easily financed.
3. Bank subsidies vanish. This claim is repeated throughout the book, as well as is presumably the most of import point.
4. Depositor/Investors choose. Retail deposits are non used to finance risky assets. Most regulators who understand the banking organisation would sentiment this every bit a defect, non an advantage, every bit discussed below.
5. No trammel to deposit guarantees. Outside of the euro area, who cares?

He does cite inward other passages the thought that resources would live freed upward every bit nosotros would involve less depository financial establishment supervisors. Given that all commercial action would receive got to live tightly regulated every bit I discussed above, I seriously incertitude that at that topographic point would live whatever savings on bureaucrats' salaries.

The claim that "subsidies cut back GDP" is repeated throughout the book. The declaration is unproven as well as dubious.

The subsidy that is provided past times access to lender-of-last-resort operations is a structural characteristic of the economy, as well as cannot live measured inward terms of a financial cost. Since whatever realistic assessment of how capitalist economies business office shows that investment as well as financial action is pro-cyclical -- regardless of the shape of financing -- lender-of-last-resort operations volition e'er occur if the authorities aim to caput of a depression.

Also, i tin describe the analogy amongst or as well as thus other structural subsidy inward the carry sector. Trucking companies are subsidised versus railroads, every bit they are provided a route network past times the state, whereas railroads receive got to maintain their ain track. It seems probable that a province that prevented trucks from using public-owned roads would receive got lower growth than those next electrical current practices. In whatever event, since the construction of the economic scheme would live radically different, it is extremely hard to isolate the growth carry on of the "subsidy."

Pros And Cons Discussed Within The Book

The volume has a huge make of arguments both for as well as against a Full Reserve banking system. There are 45 wide complaints that Musgrave identifies, as well as which he addresses. Unfortunately, they are introduced past times cryptic partial quotes, as well as and thus the reader would receive got to rails downwards the references to come across whether the writer is accurately capturing the critiques.

Given the huge number of points, I cannot promise to fifty-fifty laid out to address them. I would annotation that I remember that most of the critiques (as Musgrave presents them) are inward fact weak. That said, I soundless remember a Full Reserve organisation would fail; my criticisms are non properly captured past times the 45 he lists.

Would It Work?

Although I believe such a organisation volition non work, that declaration should live qualified. Once the hard transition stage was completed, the economic scheme would live able to business office amongst a simplified financial system. It would live to a greater extent than hard for smaller firms to heighten uppercase (as discussed below), as well as and thus at that topographic point would live bias towards larger firms. In my view, this would live unwelcome, every bit the economic scheme would tend to locomote besides rigid. That said, it is unclear whether this would plainly harm economical performance.

However, the organisation would live nether continuous pressure level to evolve entities that are essentially banks, fifty-fifty if they are labelled differently.

1. Citizens as well as businesses volition receive got to obey the draconian financial regulations, as well as non detect ways to arbitrage them. Arbitrage as well as economical forces would otherwise drive the ascent of a novel organisation of entities that are for all intents as well as purposes banks.
2. Politicians would receive got to follow the strict dominion of watching their economies spiral downwards into depression instead of engaging inward lender-of-last-resort operations. Any such lender-of-last-resort operations would christen the recipients every bit becoming the core of a novel "banking" system.

Points Of Failure

The Treasury Bill fund based payment organisation would plainly function. The solely inquiry is whether the stock of authorities liabilities would live large plenty to back upward the need for base of operations money (or bills). That said, the authorities could monetise random assets to create base of operations money. (This would solely receive got the cost of redistributing wealth to the sellers of said assets. This is a subsidy, which nosotros are told reduces GDP.) An additional occupation is the inquiry why anyone other than an oligopoly would wishing to offering such a production to the public. It would live tightly regulated, require large investments inward the payment infrastructure, as well as turn a profit margins would live negligible. Banks brand such investments inward the payment infrastructure because deposits are a inexpensive root of funding, but that incentive would no longer exist.

The to a greater extent than serious problems volition occur inward the lending entities. They would receive got a hard fourth dimension extending finance to smaller firms.

The volume repeatedly argues from authority, citing economists such every bit Friedman, Fisher, Kotlikoff, as well as Cochrane, that at that topographic point volition live no problems. This sounds impressive until nosotros realise that these economists correspond a fringe that believes that market-based solutions solve all economical problems. As a Minsky-ite economist, I receive got serious doubts that this is the case. 

The economists he cites tend to assume that markets are perfect, continuously liquid, self-regulating as well as could never misprice whatever assets. Correspondingly, the analysis skips over the existent globe number that a slap-up bargain of private sector debt is illiquid as well as at that topographic point is effectively no toll for it. Loans to smaller firms is the most dominant shape of such illiquid assets. The types of private sector debts that tin plausibly live traded inward markets receive got been securitised or issued inward bond format a long fourth dimension ago. 

If at that topographic point is no market, at that topographic point is no way of assigning a toll to a loan (at to the lowest degree until it is paid dorsum or written off). Banks receive got developed practices over centuries to bargain amongst this problem. The best exercise is to fund such illiquid assets amongst "sticky" retail deposits, as well as non wholesale funding. The entire objective of total reserve banking is to preclude this optimal funding construction from occurring. On paper, long-term investors should live able to concur illiquid securities. But inward practical terms, most investors are chasing afterwards short-term performance metrics, as well as receive got solely express capacity to concur illiquid assets.

The inability to toll assets makes the repeated appeal to the Miller-Modigliani theorem irrelevant. Since nosotros cannot toll the property side of the depository financial establishment properly, nosotros cannot say besides much close the relative pricing of the liability side.

The inability to toll illiquid assets way that the "debt usual funds" discussed past times Musgrave volition non work.

• If the funds are "open" -- unit of measurement holders tin redeem units at calculated NAV -- they are soundless vulnerable to runs. The get-go people to redeem volition larn the proceeds of the liquidation of liquid assets, as well as the residue volition live stuck amongst units that are backed past times illiquid garbage that cannot live valued. And this is non a theoretical argument; this happens to hedge funds during crises. The run on funding units would drive a collapse inward existent activity, only every bit nosotros saw inward the Financial Crisis.
• If the fund units cannot live redeemed, at that topographic point is no way for unit of measurement holders to dependent miserable managers of funds. Moreover, the units would receive got to live traded inward the secondary market, at prices that may carry no resemblance to their NAV. It is hard to come across why whatever competent private would invest inward a non-redeemable fixed income production that has a marketplace seat value that is completely detached from fundamental valuations.

Investors who wishing to ain fixed income products amongst transparent pricing characteristics would live forced to lend direct to entities issuing bond-like products. Since i tin construction bonds to facial expression similar deposits (such every bit the failed Auction Rate Securities inward the United States), nosotros could only terminate upward amongst bank-like institutions.

Meanwhile, it is unclear that usual funds or similar market-value oriented investors are able to allocate credit inward an efficient fashion. Although or as well as thus investors may live disciplined, the volume of investing action tin live characterised every bit trend-following. Influenza A virus subtype H5N1 catamenia of uppercase into an surface area volition cut back spreads, raising the marketplace seat value of holdings. This volition validate the before inundation of investment, as well as heighten the investment capacity of those who wishing to maintain pouring uppercase into the sector. The financial sector accentuates the booms as well as busts that are a natural portion of capitalism. Admittedly, banks follow trends themselves, but those bubbles are quite frequently associated amongst regulatory failures (such every bit the Savings & Loan crisis inward the United States).

An additional occupation amongst this scheme is that it is essentially impossible to offering credit lines. (I come across no way of offering credit lines inward an economical fashion piece existence consistent amongst the objectives of Full Reserve banking.) Commercial newspaper as well as bond issuance are directly backed amongst credit lines to preclude "runs" on issuers. Pulling those credit lines volition hateful that "runs" are the rational response to whatever perceived illiquidity risk. Credit lines are non a pocket-size fry slice of financial trivia; they are a critical element of the private sectors' coping machinery to bargain amongst liquidity risk. (Lender-of-last-resort operations are essentially only credit lines offered past times the fundamental bank.) Fundamentalist efficient marketplace seat analysis that relies on all securities e'er having a well-defined toll (which tin live borrowed against inward perfectly liquid lending markets) ignores the importance of credit lines, as well as Musgrave's analysis inherits that flaw.

From a bigger moving painting perspective, mismatches betwixt the desired liability as well as property structures of the private sector implies the involve for "maturity transformation." Banks receive got been designed to provide that maturity transformation. Abolishing banks volition only create an economical strength that volition force other entities to convey over that role. The shape does non matter, solely function.

Connection With MMT?

Both Full Reserve Banking as well as Modern Monetary Theory (MMT) are good represented upon the internet. There are or as well as thus superficial similarities betwixt them, given the emphasis on fundamental depository financial establishment reserves. This similarity appears misleading, however.

The MMT sentiment is that the fundamental depository financial establishment as well as the Treasury should live consolidated, as well as that the authorities should halt issuing bonds. This would hateful that authorities liabilities would solely consist of non-interest bearing deposits at the fundamental bank, every bit good every bit government-issued notes as well as coin. Since at that topographic point is no distinction betwixt the Treasury as well as the fundamental bank, at that topographic point is no distinction betwixt financial as well as monetary policy; they are integrated.

Full Reserve Banking proponents believe that authorities liabilities would largely consist of deposits at the fundamental depository financial establishment ("reserves"). They seem to believe that a tertiary agency volition live able induce the economic scheme past times adjusting the amount of those reserves. This is seen every bit or as well as thus kind of independent agency, similar the Monetary Policy Committee of a fundamental bank.

This commission would live redundant. The amount of authorities liabilities is determined past times financial policy, as well as the mix betwixt reserves versus bonds/bills is determined past times private sector preferences as well as fundamental depository financial establishment policy. Correspondingly, the novel committee's decisions close the monetary base of operations are meaningless. As a result, the switch to total reserves would non create whatever novel policy space.

More generally, I receive got a hard fourth dimension seeing is whatever wages of a political alliance betwixt MMT as well as "Full Reserve" banking proponents. (Please annotation that I do non verbalize for anyone other than myself; others inward the MMT military camp may facial expression at things differently.)

Modern Monetary Theory proposes incremental changes to how governments finance themselves, every bit good every bit a reform of the Welfare State (a Job Guarantee). These are reforms that could plausibly live supported from across the political spectrum, as well as receive got at to the lowest degree a withdraw chances of improving economical performance.

The Full Reserve Banking reforms consist of regulating most of the financial organisation out of existence, as well as generate no corresponding tangible benefits (other than satisfying those who remember banking is unfair). Why utilization spectacular amounts of political uppercase on a programme that accomplishes almost nothing?

Concluding Remarks

There are obvious defects to the electrical current financial system. Simplification is in all probability the best way forward. Reverting dorsum to the pre-1980s financial system, which rigidly separated the types of financial firms, would in all probability live the optimal outcome. But at the same, the reforms that were set into house since the 1980s did non occur only because of "neoliberalism." Private sector balance sheets receive got grown, as well as the non-bank financial organisation has grown inward response. Bank regulations had to suit to the ascent of the shadow banks. Unless at that topographic point is a plausible way to cut back private sector balance sheets, reforms volition only alter details of the shape of the system, but non the substance.

As a result, I tin understand amongst or as well as thus of Ralph Musgrave's complaints close the construction of the banking system. But at the same time, I do non come across clearly how the proposed organisation could deal amongst the economical forces driving the financial system.

(c) Brian Romanchuk 2015