I was reading Frosti Sigurjonsson's proposal for monetary reform in Iceland. [Click on the document thingy halfway down the page.] His proposal is a variant on 100% reserve banking. I got stuck on page 72 and footnote 66, where he discusses overdrafts.
This post is just my attempt to get my own head clear on some of the questions this raises. My head is not 100% clear yet.
(Iceland's financial crisis was much worse than other countries', which concentrates their minds to consider radical reforms. But it would be wise for all countries, and that includes Canada, to keep at least one eye on the possibility of radical reforms. We don't really know why Canada has been relatively "lucky" so far.)
Suppose we stop keeping our money in our pockets. Instead we each have a box with our name on it at the Bank of Canada, where we keep our paper banknotes issued by the Bank of Canada. When I buy something from you, I send an email to the Bank of Canada, cc'ing you, instructing the Bank of Canada to take a $20 banknote out of my box and put it in your box. The Bank of Canada sends a reply-all email confirming it has done this. Then the boxes and paper banknotes all get destroyed in a fire. But it doesn't matter because the Bank of Canada has a computer record of how many notes are in each person's box, so everything carries on just as before. Paper money that we keep in our pockets is functionally equivalent to electronic money, except for convenience, muggers, etc.
100% reserve banking is exactly like that (all money is central bank money), except that there is limited decentralisation so that commercial banks manage some of the record-keeping and communications. Most proposals for 100% reserve banking require each commercial bank to keep a record of how much is in each customer's box, and the central bank to keep records of the totals for each commercial bank (with an occasional audit to check that the two sets of records match up). Frosti's proposal requires the central bank to keep records of how much is in each individual's box too (the commercial banks just handle the communication).
What happens when we introduce overdrafts into an economy with 100% reserve banking?
There are green notes worth +$1 each and red notes worth -$1 each. If you buy something for $20, you either have 20 green notes taken out of your box or 20 red notes put into your box. There is a limit to how many red notes you may have in your box, to prevent you buying unlimited amounts of goods, and accumulating an unlimited number of red notes. If you have only red notes in your box we call it an "overdraft".
Introducing red notes raises some interesting questions:
1. Who decides the limit on the number of red notes each individual may have in his box? Can it be decentralised so that commercial banks set those limits? If it is decentralised, is the commercial bank liable if the individual holding red notes becomes insolvent? If no, then commercial banks face moral hazard in setting that limit. If yes, then commercial banks can go bust despite 100% reserves, unless the commercial banks are required to hold green notes in their own boxes equal to their customers' holdings of red notes.
2. If the central bank: creates one green note plus one red note on demand; and destroys one green note plus one red note on demand, then the value of one red note will always be minus the value of one green note. (For the same reason that a $20 note will always be worth two $10 notes if the Bank of Canada swaps one $20 note for two $10 notes, or vice versa, on demand.) But then what particular monetary aggregate does the central bank control? Is it the the net stock of notes [the number of green notes minus the number of red notes]? (That is the direct equivalent of the Bank of Canada controlling [10 times the number of $10 notes plus 20 times the number of $20 notes].)
3. If the central bank controls the net stock of notes [green notes minus red notes], and commercial banks control the gross stock of notes [green notes plus red notes], then commercial banks do control the stock of money in one important sense, despite 100% reserve banking. Because red notes are media of exchange too. We can imagine an economy where the net stock of notes is zero, but the gross stock of notes is unlimited. (The simple New Keynesian model is like this.)
And that's as far as I've got.
Worthwhile Canadian Initiative 
If banking sector is liable and required to hold green notes against overdrafts (1. in the post):
Then overdrafts, I think, require banking sector as a whole to keep more equity (green notes). If we assume that the equity is expensive (and I think in the model equity-green-notes sit in banks’ boxes at the Central Bank) then banks’ profitability limits their ability to run overdrafts. Is it then fair to say that the Central Bank controls indirectly the gross stock of notes too? This is quite alike the system we already have, the banks can expands money aggregates if their profitability allows it but only the Central Bank can easy it further. In that sense the proposal might not be that radical (didn’t read it)?
Btw. I love these green/red posts/analogies, they are always insightful.
Cochrane also proposed a variant of this, except he argued that deposits be required to be backed by reserves or treasuries. Any quantity limit suffers from the same problem, namely it loses control of the interest rate and creates bank runs.
Either banks do not make loans in such a scheme (full 100% reserve banking) or they are allowed to make a few loans but are subject to bank runs should depositors withdraw their funds (so they fail and we are back to the no-loan scenario).
But there are many borrowers who cannot access the commercial funding markets except at extremely high rates, which are dominated by highly volatile risk premia. In such a world, the central bank can’t control interest rates at all.
But it has been decided that control over interest rates, and the corresponding ability of individual households to borrow at low rates is more important than any philosophical benefit accrued from X% reserve banking.
It’s interesting that in Cochrane’s speech outlining his proposal, as soon as someone asked “Well, what if the demand for deposits exceeds the quantity of available government bonds”, Cochrane immediately walked it back and started talking about risk taxes applied to banks — effectively the current system, rather than any type of quantity restrictions.
Quantity rationing of the financial sector is always too rigid. Price rationing (e.g. interest rates, capital requirements, etc) are the only workable option, regardless of the appeal of quantity rationing to those who like to think in terms of quantities rather than prices.
Reserve banks were created as institutions to allow banks to avoid quantity rationing in times of crisis. Only after this happened was it possible for reserve banks to set policy interest rates and target macro-economic stability once the problem of bank stability had been solved.
If we were to try to continue targeting macro-economic stability while abandoning bank stability, then the whole system would collapse. If we ban banks from making loans, then lending will occur with some new institutions, called Nanks, and then we’d need to invent a new Reserve Nank to bail out the Nanks in their time of crisis, and we are back to the current system. Quantity rationing only works in a rational expectations world.
Jussi: thanks. I think that what you say is correct.
rsj: you lost me. Consider a world with only green notes. What would a “run” look like?
Nick,
Contrary to the suggestions in the 2nd half of your post, overdrafts or “loans” having nothing to do with the central bank – at least under the full reserve system advocated by Milton Friedman and Laurence Kotlikoff. And more or less the same goes for Positive Money’s version.
Under full reserve, loans are made by entities or “banks” or bank departments which are funded just by shares or largely by shares. Thus contrary to your suggestion that “commercial banks can go bust despite 100% reserves”, those lending banks (or bank departments) cannot go insolvent: it’s near impossible for a bank funded just by shares to go insolvent. And that makes the banking system much more stable.
I ASSUME the Iceland model is similar to Friedman, Kotlikoff and Positive Money’s, and if so, that renders your final points “2” and “3” obsolete.
For Friedman, see Ch3 of his book “A program for monetary stability” under the heading “How 100% reserves would work”. As to Kotlikoff, Matthew Kline does a good introduction to K’s system here:
http://www.bloombergview.com/articles/2013-03-27/the-best-way-to-save-banking-is-to-kill-it
There’s also a good paper on this subject by Adam Levitin:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2532703
Rjs,
You are right: Cochrane proposed a variation on this system. See here:
http://www.hoover.org/news/daily-report/150171
The rules of full reserve are actually being imposed on money market mutual funds in the US. Good thing too in my view. See:
http://www.euromoney.com/Article/3426686/Money-markets-Short-term-bank-funding-costs-hit-by-Fidelity-move.html
Re your claim that under full reserve (FR) the central bank loses control of interest rates, I’m baffled. What’s to stop it printing base money and buying up government debt just like CBs do at present? Nothing that I can see. Or what’s to stop it wading into the market and offering to borrow at above the going rate for risk free loans, if the CB wants to raise interest rates? Nothing in principle.
Moreover, even if FR does reduce the CB’s ability to adjust interest rates, the reaction of one group of FR enthusiasts (Positive Money and Richard Werner) would be “we couldn’t care less”. Reason is that they specifically argue for fiscal measures rather than interest rate adjustments when trying to control AD. See:
Click to access NEF-Southampton-Positive-Money-ICB-Submission.pdf
Re your claim that FR “creates bank runs”, I’m baffled. As Cochrane specifically explains, when a bank is funded just by shares, runs just don’t happen.
Your 2nd para says “Either banks do not make loans in such a scheme (full 100% reserve banking) or they are allowed to make a few loans but are subject to bank runs should depositors withdraw their funds (so they fail and we are back to the no-loan scenario).” Nope. Depositors DO NOT fund loans under FR: its shareholders that do the funding. And shareholders can’t/don’t run.
I think in the model* the bank equity needs to match the amount of overdrafts. So there is no room for banks to expand effective gross stock of notes (effective as excluding green-notes-equity) without the Central Bank offering more liquidity.
*If banking sector is liable and required to hold green notes against overdrafts
Ralph: loans and overdrafts are different. I can give you a loan (I give you some of my green notes and you give me an IOU). If the bank gives you a $100 loan, in a 100% reserve system, the bank lends you 100 green notes, puts them in your box, and you give the bank an IOU. With an overdraft, you only owe what you actually spend. So if the bank gives you an overdraft limit of $100, but you only spend $20, you only have 20 red notes in your box, not 100.
Jussi: I think it depends on whether we count those green notes in bank’s equity box as money.
@Ralph
“Cochrane also proposed a variant of this, except he argued that deposits be required to be backed by reserves or treasuries”
Isn’t this just the heart of the 100% reserve banking? The additional/initial money/reserves/treasuries need to come from somewhere – the private part of the economy cannot expand money by itself at all (only velocity can change). So the government/Central Bank needs to limit or accommodate the expansion. How the proposals tackle this? What rules or who decides how much credit can be expanded in the proposals?
@Nick: exactly, that’s why I tried to introduce effective gross stock of notes. I think in practical terms we shouldn’t as green notes in the equity box don’t circulate anymore (they are kind of back in the Central Bank again).
“There is a limit to how many red notes ………..”
Try adding to your thinking that the limit is based on green notes. More exactly, any individual who holds green notes can exchange his green notes for red notes. His does this by emailing the bank (taking advantage of a bank service) instructing the bank to deduct green notes from his account in in favor of friend XXXXX with the stipulation that friend XXXXX will repay the green notes in the future at YYYYY date. Friend XXXXX signs a note payable to the bank acknowledging that he is accepting his friends generosity.
With this limitation, red notes are not overdrafts. Red notes are a link to green notes used by another player.
The exchange of green notes for red notes is a bank service. The bank may charge for the service.
If friend XXXXX fails to repay the green notes at future YYYYY date, something may happen (or not) to the linked red notes. The ‘something’ in case of loan failure is the next step in the green-red story.
Thus ends this suggestion for continued thinking on the green-red money analogy.
Hi Jussi,
Re “who decides how much credit can be expanded in the proposals” Positive Money and Richard Werner propose that the amount of additional base money spent into the economy in the next six months or whatever is decided by some sort of committee very much like the existing central bank committees that decide on interest rate adjustments and QE. As to the EXACT WAY that money is spent (which of course is a POLITICAL decision) that’s left to voters and politicians. See bottom of p.10-12 here:
Click to access NEF-Southampton-Positive-Money-ICB-Submission.pdf
In short, STIMULUS is decided by the above sort of committee just as it is at present.
As to “credit” in the “lending” sense of the word, that’s done by banks or bank departments which are funded by shares or funded largely by shares. Thus the total amount loaned is determined very much by market forces: how much shareholder money can banks attract and at what price versus what demand is there for borrowed funds and at what price.
Milton Friedman advocated the above sort of “create base money and spend it into the economy in whatever amounts are needed to maintain full employment” in a 1948 paper. See para starting “Under the proposal…” here:
Click to access AEA-AER.06.01.1948.pdf
Though far as I know he didn’t advocate that SPECIFICALLY in connection with his full reserve / 100% reserve proposals.
Nick:
Overdraft=loan
So you are asking what happens if a 100% reserve bank is not a 100% reserve bank.
And the number of red notes I can have in my box is limited by the amount of collateral I can give to the bank.
Jussi:
1. The commercial bank goes to the central bank and demands 100 green notes plus 100 red notes be put in its box. The central bank does this. (This is the equivalent to a commercial bank asking the central bank to swap one $20 for two $10 notes.)
2. The commercial bank then tells customer A he is allowed to have an overdraft of up to $100.
3. customer A spends $60 buying a bike from customer B. The bank transfers 60 red notes from its own box into customer A’s box, enters “$60” on customer A’s blank signed IOU to the bank, and transfers 60 green notes from its own box to customer B’s box.
4. So customer As box has 60 red notes, customer B’s box has 60 green notes, and the bank’s box has 40 green and 40 red notes.
The net money supply stays exactly the same throughout. But the sum of green+red notes in customers’ boxes has increased by 60+60=120.
@Ralph: thank you for explanation and pointers. Will read.
I see that there is the committee and upper limit (if/when the reserve ratio is binding) of private credit expansion already in the current banking system so it wouldn’t be that different. But the proposed system feels stricter as the money (reserve) multiplier is one and thus all the credit given needs to be met by additional reserves. But this is only a matter of degree and can be addressed.
I can see how spending in the existence vs. additional reserves against collateral/purchases might have a difference in terms of aggregate demand (at least in practice, I guess MM theory and Nick disagree) and thus employment.
This is probably already off-topic but would you say that pros of the proposals would be less/no moral hazards (no deposit guarantee), no bank runs and likely less instability? Cons might be at least slightly less growth as savings/investments are not subsidized anymore?
I think you can see the plan’s outline most clearly on page 82/85, “Availability of bank credit following the switchover.”
The main thrust of the plan is to demonetize savings. Funds made available for loan would be put into the bank’s “Investment Pool Account,” which is an aggregate of individual “Investment Accounts” (page 71/74), which are most emphatically not demand deposits. Demand deposits will be secure but not interest-bearing; investment accounts are on the other hand not guaranteed.
In terms of managing the money supply, the proposal permits the central bank to make loans to commercial banks to increase the supply of base money. However, it does a far longer job of selling MMT-like “money creation for public use” approaches.
In practice, I don’t see how well this will work. Either the system would be mananged for interest-rate stability (that is, explicitly reducing the risk of investment accounts), or it will lead to serious interest-rate volatility. If the latter happens, I don’t see any reason that more of the Icelandic economy would become euroized or dollarized.
“all money is central bank money”
all loaned money anyway
because is the government paid me money for services rendered and i put it in the back, they couldnt touch it to lend it out
with 100% reserve banking
but then again i guess i would have pay a portion to the bank for their services
ie interest rate would have to always be negative
an overdraft would have to be a loan and therefore come from ‘central bank money”
Mike Sproul said: “Overdraft=loan”
I agree that overdraft = “red money” = loan/bond. Out in the real world, there is only “green money” and bonds.
Jussi,
“I guess MM theory and Nick disagree”. I don’t see a big clash between MMT and full reserve. In fact there was an article on the Positive Money site a few days ago considering whether MMTers and the Pos Money lot could work together. MMTers (particularly Roger Erickson on Mike Norman’s site) tend to favour the idea of simply “creating fiat” (as they put it) and spending it in a recession.
Re your last para, there is less moral hazard in that deposits (or more broadly “stakes in banks”) which fund risky loans are no longer guaranteed by taxpayers. The only guarantee is for deposits where the relevant money is lodged in a near totally safe manner (e.g. at the central bank). So that guarantee should cost taxpayers little or nothing. Ergo there’s no subsidy of the banking system there.
Re your last sentence, you suggest that because money deposited at banks which is loaned on to mortgagors and businesses is no longer backed by taxpayers, that there’ll be less investment. Correct. But I don’t agree that that reduces growth. Reason is that ANY SUBSIDY (including investment subsidies) missallocate resources, unless a good reason is found for the subsidy (e.g. market failure or some sort of social reason). So… the initial effect of introducing full reserve is to cut investment and hence AD, but that’s easily compensated for by creating and spending new base money into the economy. The net effect is less loan / investment based activity and more non-loan and non-investment based activity.
So the net effect (in view of the removal of an unjustified subsidy) should be to INCREASE GDP, not reduce it.
also if every time the fed issues a credit “green” so the bank can loan then they would have hold a red at the fed
the banks could then send this money to the lendee since its “central bank money”
not deposit money
fed not being subject to 100% reserve
@TMF: “Out in the real world, there is only “green money” and bonds.”
What is the color of money on your credit (overdraft) card?
@Ralph:
Sorry the confusion and use of an acronym, my MM stood for “Market Monetarism”.
Yes, I agree with the misallocation part – thinking it more the reduced instability might also encourage more investments. But I’m not sure how GDP is necessarily up because it depends on which effect dominates. But I think in utility terms we would be better off as there would be less distortion towards non-optimal savings – I mean max growth comes by maximizing investments but that is hardly the best world to live in.
I think your analysis in point 1. is entirely accurate. My reading of footnote 72, however, indicates that any bank that authorizes an overdraft must indeed hold a green note (presumably in its operational account, p. 75) for every red note in a customer account. (That is, I think what Jussi is calling equity would under the proposal actually have to be held in the operational account.) I think this is what the authors mean when they write “When a customer with an approved overdraft draws down the overdraft, he is borrowing from pre-existing sovereign money owned by the bank.” These, after all, must be green notes, right?
You then posit in point 2 that the central bank stands ready to hand paired red/green notes on demand. But I think this presumption is precisely what the central bank is unwilling to do in a narrow banking framework — because it gives control of the money supply to the banks, which can then issue unlimited overdrafts. (Which roughly speaking is I think what Woodford’s “cashless” model seeks to do.) I think the idea is that the central bank controls the stock of green notes, and banks can create their own red notes to offer people, but for every red note created by a bank there must be a green note sitting in the bank’s reserve account at the central bank. In short, the bank can transfer control over the value of the green notes that it owns to customers, but cannot create money.
The footnote continues “From the customer’s point of view, the experience of using overdraft in the sovereign money system will be very similar to using an overdraft in the current system.” Which I think is only superficially correct. (I think your model is reading more into this statement than the authors of the proposal intended.) Functionally overdrafts will be similar. In practice, however, requiring banks to fund overdrafts will prevent them from creating money and undoubtedly have a significant effect on the availability of overdrafts.
On a related note, I try to explain simply in two posts why new monetarist models indicate that narrow banking proposals that eliminate expansion of money by banks through overdrafts are a bad idea.
Jussi said: “What is the color of money on your credit (overdraft) card?”
The color of the demand deposits that are borrowed is green.
The credit card itself is instructions to issue a “green” bond to the credit card issuer. The bond issued to the credit card issuer is not “money”.
Nick,
‘you lost me. Consider a world with only green notes. What would a “run” look like?’
A bank run is the failure of the bank to be able to borrow green notes against good collateral.
Banks on the one hand lend out green notes, and on the other hand they borrow green notes. A depositor depositing green notes is actually lending the notes to the bank. But banks do not need to be passive and sit around looking pretty hoping that a depositor will show up before they make a loan. They make loans to borrowers who are qualified and the bank itself goes to commercial (and interbank) funding markets to borrow the green notes that the bank needs to meet its regulatory requirement to hold green notes as well as to meet any actual green note outflows.
But the green notes that the bank borrows are shorter term than the duration of the loans (e.g. depositors can withdraw their money any time, and the bank borrows from short term funding markets). This is because the bank really only needs to borrow green notes on a short term basis, to meet fluctuations between outflows and inflows.
A run on the bank would be a situation in which the bank cannot borrow enough green notes to meet its regulatory requirement to hold notes or its actual requirement to provide notes to those who withdraw. This could happen because the short term market does not trust the bank while at the same time depositors are withdrawing. I.e. the lenders to the bank have lost confidence in that bank. In this type of situation, the bank needs to be able to turn to the Reserve Bank and be able to get whatever quantity of green notes it needs. And if the lenders to the bank know that the bank can get whatever quantity of green notes it needs, whenever it needs them, then they will not lose confidence in the bank as long as the collateral is sound. That prevents bank runs, but at a cost of the central bank losing control (or not having any credibility) over the quantity of reserves outstanding. It cannot tell a bank — no more green notes for you! — because then the bank is liable to bank runs again.
csissoko: “These, after all, must be green notes, right?”
Yes, I think so.
“(Which roughly speaking is I think what Woodford’s “cashless” model seeks to do.)”
I think so too. I read Woodford’s “cashless” model as having an equal number of green and red notes (so net money is zero), but an unlimited number of green+red notes. (The modeller enforces the no-Ponzi condition by assumption).
” I think the idea is that the central bank controls the stock of green notes, and banks can create their own red notes to offer people, but for every red note created by a bank there must be a green note sitting in the bank’s reserve account at the central bank.”
Maybe. But then red notes created by the Bank of Montreal and sitting in my bank account at BMO would be assets of BMO, and if BMO also has one Bank of Canada green note for every red note it creates, that seems like a 200% asset/liability ratio. (I’m not sure I’m right on that.)
Re Woodord’s “cashless” model. Not surprised you think so too. I’m pretty sure I got that understanding from you! Glad I didn’t mess it up.
I think the accounting for this is a little complicated. Once a red note has been issued by the bank, the corresponding green note becomes something similar to an encumbered asset. Probably collateral-type accounting would be needed, where it is necessary to note whether the asset that you nominally own has been pledged as collateral to someone else.
I think one of two accounting frameworks would have to be used:
(i) Bank holdings of green notes in a central bank account are counted as assets only on a net basis, that is, after subtracting off the number of outstanding red notes issued by a bank.
Or
(ii) Bank holdings of green notes in a central bank account are counted as assets on a gross basis. However, for every red note issued by the bank, three new entries are created:
Liability to recipient of overdraft
Asset due from recipient of overdraft
Liability to central bank (borrowing fully collateralized by green notes)
@TMF:
The credit card itself is instructions to issue a “green” bond to the credit card issuer.
The red money itself is instructions to issue a “green” bond to the red money issuer?
Ralph,
“The rules of full reserve are actually being imposed on money market mutual funds in the US.”
Huh? I can write checks against my stock holdings in brokerage account at this very moment. What you are talking about just adds more costs and fees, it doesn’t actually prevent banks from providing money-like services held against less liquid assets, as that’s kinda the whole point of banking.
“Re your claim that under full reserve (FR) the central bank loses control of interest rates, I’m baffled. What’s to stop it printing base money and buying up government debt just like CBs do at present? ”
That is not my claim. My claim is that if the CB tries to fix the quantity of reserves, it loses control of interest rates. Of course when you say that the CB can buy up X, you mean that it must abandon it’s previous quantity peg.
And in reality, the CB cannot control the quantity of reserves because banks need a certain amount of reserves, and if the CB does not make this amount available, then there will be a banking crisis. So in practice, the CB has a choice in setting the quantity to be greater than the minimum that banks need. But if the quantity is greater than what banks need, the rate drops to zero. So the CB, if it is to control rates, needs to set the quantity to be exactly what banks need. It doesn’t really have control over quantity.
Now it can choose to pay interest on reserves, but in this case there is no difference between CB and Treasury liabilities.
This is the kind of thing that gives full reserve banking a bad name. The paper proposes not to pay interest on deposits. So deposits will be “taxed” at some random fluctuating rate depending on prevailing interest rates. That’s dumb. (Yeah, that’s how currency works, but there’s an excuse: it’s tricky to pay interest on currency).
Nick,
“If the central bank controls the net stock of notes [green notes minus red notes], and commercial banks control the gross stock of notes [green notes plus red notes], then commercial banks do control the stock of money in one important sense, despite 100% reserve banking. Because red notes are media of exchange too. We can imagine an economy where the net stock of notes is zero, but the gross stock of notes is unlimited.”
I buy a widget for $20 green notes. Do I get the choice of either paying $20 green notes or accepting $20 red notes even if I have the $20 green notes?
This is not an obvious choice. My liquidity is improved if I accept the red notes assuming they are as liquid as the green notes. Meaning I later have an easier time selling a whatsit that I produce since my buyer does not need green notes to buy it from me, he just accepts the whatsit and the $20 red note that I give him.
The central bank may not want to give the commercial bank additional red notes if there are already too many in circulation relative to green notes.
And so the commercial bank trying to keep me as a customer deducts $19.95 in green notes from my account instead of crediting me with $20 in red notes.
The liquidity premium is born.
csissko: “I think the accounting for this is a little complicated. Once a red note has been issued by the bank, the corresponding green note becomes something similar to an encumbered asset.”
That sounds right to me.
If those are the rules needed to ensure that a bank that allows overdrafts can never go bust (which is the whole point of 100% reserve banking), I’m beginning to wonder if such a bank would ever allow its customers to have overdrafts. The customer seeking an overdraft with a $100 limit would simply borrow $100 instead, and put 100 green notes in his box. The non-payments half of the bank (that operates just like a non-bank financial intermediary) could just as easily lend the customer those 100 green notes.
I guess that the point of this post is that there’s some sort of contradiction between overdrafts and 100% reserve banking. Wish my head was clearer.
Max,
Not paying interest on deposits is not a huge change from the EXISTING system. E.g. I pay about £12/month fees to my bank for my current / checking account and get no interest. If I shopped around, I could probably find a better deal, but I can’t be bothered.
Second, whether interest is paid on deposits under full reserve banking depends on whether (as proposed by Milton Friedman) deposited money is invested in government debt (where it obviously earns interest) or whether deposited money can only be kept in the form of base money (which normally pays no interest). I favour the Friedman option.
Third, the ability of banks to pay interest on deposits under the existing system relies on a fraud, or on taxpayer backing for private banks. That is, there is no such thing as a totally safe set of loans or investments (made by a bank or anyone else). Thus the promise by banks to return $X to customers for every $X deposited AND PAY interest is a flagrant self-contradiction: it’s a fraudulent promise. It’s a promise that can only be made good 100% of the time if taxpayers stand behind private banks.
Under full reserve, depositors have to get real. If they want total safety, then their money is kept in a more or less totally safe manner, but that ipso facto means their money is not loaned out (except possibly to government) so the money earns little or no interest.
Alternatively, depositors can have their money loaned on, which means that interest or more interest is earned, but in that case depositors take a hair cut if the loans go wrong. That means that depositors effectively become shareholders: they are no longer depositors.
Rsj,
Re money market mutual funds, the change in the rules governing MMMFs don’t come into force for some time yet (I think it’s about 18 months time). So that explains why you can write cheques against a fund which invests in corporate bonds at the moment.
And even after the rules ARE CHANGED, it would be possible to have a system where people can write cheques against the above sort of fund without breaking the basic rules of the game. The basic rule is that only funds which invest in short term government debt or just boring old base money can promise to return $X to customers for every $X deposited. In contrast, funds which invest in anything more risky have to let the value of customers’ stakes in the fund vary with changes in the value of the underlying assets.
Whether it’s desirable to actually let customers write checks against the latter sort of fund, I’m not sure: the pros and cons are a bit complicated, seems to me.
Re interest rate adjustments under full reserve, I think you make some good points. I also think this issue is too complicated to be fully addressed in comments after a blog post. But I’ll throw in just one point, as follows.
I agree with the claim often made by MMTers that if the state issues more liabilities (“private sector net financial assets” (PSNFA)) than the private sector wants to hold, the state will have to pay interest to those holders to induce them to “hold”. Thus the state CAN push up interest rates by expanding the stock of PSNFA, and then paying interest on the latter. Put another way, governments can borrow, but doing so will tend to raise interest rates. Having done that, the state can then cut that interest rate by printing money and buying back some of that govt borrowing.
” I think the idea is that the central bank controls the stock of green notes, and banks can create their own red notes to offer people, but for every red note created by a bank there must be a green note sitting in the bank’s reserve account at the central bank.”
Maybe. But then red notes created by the Bank of Montreal and sitting in my bank account at BMO would be assets of BMO, and if BMO also has one Bank of Canada green note for every red note it creates, that seems like a 200% asset/liability ratio. (I’m not sure I’m right on that.)
I’m pretty certain that’s not right.
Firstly, notes created by the BMO are its liabilities, not its assets. So, in a 100% reserve environment, every green note created by a commercial bank has a corresponding red note created by the CB sitting on the opposite ledger on the commercial bank’s books. Secondly, the asset / liability ratio for every institution, including the CB, is always 1:1, per identity. Now, if one increases the requirement for one type of asset (reserves), one needs to first know how they get onto bank books and then one can decide what that might mean for the ability of the bank to make new loans.
From Wikipedia: A central bank may introduce new money (read = reserves) into the economy by purchasing financial assets or lending money to financial institutions.
Let’s assume that purchases are the norm (that’s true for the US, as far as I know). Bank A has made new loans during a period and created new red notes / demand deposits (which we’ll assume remain on its books) in the process. It now needs new green notes / reserves to cover the increase in red notes / demand deposits. Assuming it wants to keep banks from going bust / not force them into borrowing reserves, the central bank will purchase (or sell) other bank held assets, most notably government bonds, and exchange them for reserves at the end of a maintenance period in the exact amount required to keep the interbank lending rate of reserves on target. It can do this for 0%, 10% or 100% reserve requirements. But since reserves do not normally pay interest (as opposed to other assets such as government bonds) a higher reserve requirement makes deposit banking more expensive. Banks can circumvent this by swapping red notes for other types of liabilities, say time deposits (which tend to be more expensive than demand deposits, though). Central banks can also pay interest on its reserves. It also means there is a natural market for the types of securities that central banks buy / sell.
This is a simplified description of my understanding of a typical modern monetary system. But, even assuming I’m right, that of course does not mean it could’t be otherwise. What the 100% reserve folk seem to be getting at is that their proposed system would keep banks from making new loans above the amount of reserves already in the system. Assuming it is the expansion and not contraction of loans / deposits that they wish to control, that must be true for any non zero reserve requirement. If I limit the amount of reserves to $1’000 at 10& reserve requirement, I have de facto limited the maximum amount of credit money to $10’000. And even at 0%, the amount of new deposits could just be limited by decree.
But such limits could only be achieved if central banks closed their discount windows and gave up targeting lending rates. Apart from the fact that it is those two things that central banks were invented for, it is also my opinion that that would not actually work. A world with many different commercial banks that emit means of payment at par with the official medium of account but with no LOLR and interest rate targeting central bank is a nonsensical counterfactual. Interest rates would move so eratically that banks would either suffer constant runs or be forced to give up their peg to the official medium of account. It would be like the euro system on speed. I claim this is not an artefact of modern money, but an inherent trait of money as such. Homgenising the value of money across heterogenous agents requires giving up quantity targets.
I think I got it but now I’m not sure.
What is the actual distinction of green and red notes? Is it only about the hierarchy, I mean CB liabilities are green for banks and bank IOUs (deposits) are green for customers but red for the banks. Having 100% reserve banking means IMO then that the bottom red notes (e.g. bank deposits) have one-to-one correspondence to the top green notes (reserves) and they have the same (CB) credit qualities – the amounts are the same. But if that is true, I’m not sure why not circulating only green notes in the first place? What is the advantage to create a red note if there needs to be a corresponding green note locked up on an upper (operational?) account?
So is the proposed system the same than using central bank money (or accounts) only?
Did I miss something big?
Nick,
I haven’t had time to read that report or even the comments above, but I’ll go ahead and ask anyway: Why would we want to permit overdrafts in the first place in a 100% reserve banking system? If people need to borrow money, there’d be a separate credit market on which they could do so. That’s the idea behind separating money from credit.
David
David: I’m slowly coming to the same conclusion as you. The Report just discusses overdrafts in passing, but I thought that overdrafts seemed “problematic” in a 100% reserves system, so I wrote this post, trying to get my head around it.
Nick,
Does 100% reserve banking keep an individual commercial bank from failing (assuming there are many commercial banks)? I don’t think so. 100% reserve banking will not stop banks from competing with each other. At some point, a poorly run commercial bank will have an excess of red notes relative to green notes and could be considered insolvent / bankrupt.
I (as bank customer) would prefer to have red notes credited to me rather than green notes taken away when I purchase a good. Commercial bank would rather take green notes from me rather than issue red notes to me when I purchase a good. So, I shop around for commercial bank that has excess red notes they are willing to give me or for a commercial bank that will take fewer green notes from me when I purchase a good.
I (as bank customer) would prefer to have green notes credited to me rather than red notes taken away when I sell a good. Commercial bank would rather take red notes from me rather than issue green notes to me when I sell a good. So, I shop around for commercial bank that has excess green notes they are willing to give me or for a commercial bank that will take fewer red notes from me when I sell a good.
So there are really two liquidity premia – one for the seller of goods and one for the buyer of goods. Seller of goods prefers liquidity of receiving green notes, buyer of goods prefers liquidity of receiving red notes.
If there is only one bank (the central bank), then the liquidity premia should be exactly the same when the central bank maintains 100% reserves (equal green notes and red notes).
If there are multiple commercial banks all competing with each other for profits – then the liquidity premium for green notes shifts – they will be in higher demand by both sellers of goods AND commercial banks. And so green notes would trade at a premium to red notes even though the quantities are held to be the same by the central bank. If the difference in liquidity premia is sufficient – you could get a recession.
The central bank must be able to increase the quantity of green notes relative to red notes if it wants profit seeking commercial banks.
If people need to borrow money, there’d be a separate credit market on which they could do so. That’s the idea behind separating money from credit.
How does money initially enter the (non-bank) economy if not by somebody borrowing it? And isn’t it the aim of 100% reserve banking to have better or even complete control over credit growth?
I’ll rephrase that. How does money enter the non-bank economy without first being credit money?
“How does money enter the non-bank economy without first being credit money?”
By QE which buys assets from non-bank sector or fiscal stimulus?
“At some point, a poorly run commercial bank will have an excess of red notes relative to green notes”
This is not possible by the definition/rules, the bank needs to match red ones with green ones – one way or the other.
Nick: “The non-payments half of the bank (that operates just like a non-bank financial intermediary) could just as easily lend the customer those 100 green notes. I guess that the point of this post is that there’s some sort of contradiction between overdrafts and 100% reserve banking.”
I agree with you that overdrafts, even if permitted on a fully funded basis, are unlikely to take place in a 100% reserve banking framework.
I think though that the author’s desire to allow for overdrafts gets to the heart of why 100% reserve banking proposals are in the end unconvincing. These proposals are premised on the idea that banks are “just” intermediaries between savers and lenders, so nothing will be lost by forcing debt out of the payments system.
To the degree that the payments system only functions well, because it facilitates transactions by making debt more available to account holders, and that it does so easily because banks don’t need to source the funds from savers before they offer such credit to account holders, then the 100% reserve banking will reduce economic activity.
Jussi,
Under Nick’s #3, the commercial banking system as a whole can’t have more green notes than red notes (or vice versa) because of central bank intervention.
That does not mean that commercial banks competing against each other can’t individually have more of one and less of another.
Frank,
I assumed standard 100% reserve banking where all the banks individually are required to keep the reserves at 100%.
Jussi,
“I assumed standard 100% reserve banking where all the banks individually are required to keep the reserves at 100%.”
Next to impossible to do. I (as a bank customer) can buy goods through one bank using red notes. That bank would then need to match my purchase with another that uses green notes to balance it’s transactions.
If I am playing the liquidity game, I would keep my green notes at one bank and keep my red notes at another. When I sell something through my green bank, I would have no red notes to give up (preserving my liquidity) and when I buy something through my red bank, I would have no green notes to give up (again preserving my liquidity).
If enough people play this game, then there becomes two types of banks – all red banks used by consumers and all green banks used by producers. If profits / losses and the solvency of the bank is measured in net green notes versus red notes, then consumer banks (red banks) fail regularly while producer (green banks) live on.
Finally, if all commercial banks try to maintain 100% reserves, then the quantity of transactions may fall – I want to buy a $1 million airplane with red notes but my bank doesn’t have a matching green note transaction to offset it with.
Frank,
You cannot game it as customer if a bank is reserve constrained it will decline your loan – no more red notes and game over. Thus excess loans are not made; only the CB can expand credit – this might be good or bad.
Transactions are different though and won’t fail, you can transact with red notes as you wish but banks will always mirror the transactions with corresponding green notes (think like they would be paired) – all banks will always be at 100% reserves.
Jussi,
Suppose that at the end of each working day / week all of the commercial banks got together and tried to all balance their books by trading green notes and red notes. This situation would not be “real time” 100% reserves which is next to impossible, but rather fixed instant in time 100% reserves.
If all of the commercial banks are profit seeking and competing against each other, then a premium would develop for green notes versus red notes. The central bank could allow this premium to exist or could offset it by maintaining a floating reserve ratio.
Jussi,
Yes I can game the system – I and a bunch of my friends move all of our red notes to one bank and all of our green notes to another bank. The quantity of red and green notes has not changed, but the distribution has.
That change in distribution could negatively affect the bank that has accepted our red notes and positively affect the bank that has accepted our green notes.
Jussi:
By QE which buys assets from non-bank sector or fiscal stimulus?
No, because the CB can only buy in the secondary markets which means somebody else must have bought first. And if you start from scratch, that cannot happen with central bank money. My point: although CB money may be alpha in the sense that it is the bench mark, credit money is alpha in another sense, namely that it is logically prior. It is the original financial asset that precedes both private securities and CB money (in my admittedly not very humble opinion, that is).