100% reserve banking

And here’s eccentric Tory MP Douglas Carswell trying to explain how to abolish “fractional reserve banking”, ie to turn banks into safe deposits. Well, actually, he’s just proposing allowing people who deposit money in a bank to choose not to receive interest on it (coming out of the bank lending it) but to instead pay the bank for storing it for them. As if many would.

I know it’s boring but I think we do have to deal with the various arguments and misunderstandings about banking and money as they are so widespread these days amongst critics of society.The first point to be clear on is the definition of “money”.  Up to WW2 there was more or less agreement that money was “currency” (notes and coins). Since then “bank loans” have been regarded as money. This is ok as long as the same definition is kept to throughout the analysis. But it should be noted that, even today, conventional economics has felt the need to distinguish between M0 (mostly currency) and M1 (which is M0 + bank loans) (M2, M3 and M4 are M1 plus various other types of loan).So, when as in the New Economics Foundation video and in all economics textbooks, people say “banks create money” this is true (by definition) if money is defined as M1. But it wouldn’t mean that banks create all money, as M0 is created by governments and/or central banks. Having said this, it is true that only 3% of M1 is currency and 97% bank loans.The case against regarding both bank loans and currency as money is that they come into being and behave differently. Currency circulates. Bank loans don’t.  In fact, although M0 is only only about 3% of M1 it can be used to make payments, etc (including bank deposits and bank loans) of many times its face value.But even accepting that bank loans are money, banks do not create it out of thin air (as is often claimed, though not in economics textbooks). No bank can lend more than it has, either as deposits or what it has itself borrowed. In fact, because they have to keep some of what they have as cash, they can only lend less than they have. In the past, in Britain, they had to keep about 8% of their assets as cash. Now it’s down to about 3%. This is the “fraction” of assets they have to keep as a “reserve” against withdrawals. Hence the “fractional reserve banking” that currency cranks make such a fuss about. But all lending institutions do this (building societies, savings clubs and credit unions too). If they didn’t, all they would be would safe deposits. It’s what lending other people’s money involves.The first mistake that currency cranks make about this is that they assume that, with a fractional reserve of 10%, if someone deposits £100 in a bank this means that the bank can then lend out a sum of which this is 10% (less a £100), ie £900. In fact, it means only that the bank can lend out £90 as it has to keep 10% (£10) as cash.It is true that economics textbooks do teach that the banking system as a whole (but not a single bank on its own) can, with an initial deposit of £100, eventually make loans totalling £900. The assumption is that the first bank makes a loan of £90, which is then deposited in a second bank which can then lend 90% of this (£81), which is then deposited in a third bank which can then lend out 90% of £81, until eventually total loans of £900 will have been made.There is nothing wrong with this theoretical model as such, only with the claims that are made about it. Even the textbooks claim that the £900 has been created by the banks together, but in fact it depends on the money from loans being repeatedly re-deposited in the system. So, it could just as logically be claimed that it was the depositors that created the loans as they provided the banks with the money to lend. In fact this refutes the second mistake that currency cranks make: saying that all money (bank loans) comes into being as “debt”. They don’t. They come into being as previous deposits. What is happening is that money is circulating throughout the banking system, but there’s nothing mysterious about that as circulating is what money does.The currency cranks mistake what the economics textbooks say about the whole banking system as applying to an individual bank. Hence their mistaken conclusion that, if someone deposits £100 in a bank, that bank can then immediately lend out £900.There is one bank that can create money out of thin air and that is the government-owned or controlled central bank. It does so by mere decision, by creating more “fiat” (“let it be”) money and introduces it into circulation by using it to buy government bonds off commercial banks (“quantitative easing” is a variety of this).Ironically, one of the solutions proposed in the New Economics Foundation video, that the government itself should issue money, already happens, even if indirectly. It could do it directly of course as the video says it did during WW1 and as the US government did during the Civil War (as “greenbacks”) … or as the government of Zimbabwe has been doing.What we need to ask is why people today tend to blame banks rather than capitalism as a whole. In his 1935 pamphlet Economics for Beginners (which has an interesting section on the currency crank theories of his day, some of which have been revived today) John Keracher attributes funny money theories to indebted small farmers, shopkeepers and businessmen who want to monkey about with the currency to reduce the value of their debts. I don’t think this applies today. It seems to be rather that because money so dominates people’s lives and that they associate money with banks that people’s resentment at their money problems is aimed at banks.Of course no banking or monetary reform is going to stop money dominating people’s lives. This is where we come in.

Good to know data is still available. This series is the one that stopped in 2006, there is a slight difference in that the old series includes ‘banks operational deposits’. What theoretical problems this posses I’m not yet quite sure.

Actually the weekly returns do include these as “reserve balances”, ie interest-bearing deposits by commercial banks and building societies with the Bank of England. So, M0 could be reconstituted if it was wanted, but breaking it into its two components is more useful as “reserve balances” are not part of the currency that is actually in circulation, which is the more relevant statistic.

I have now checked the quote with how the Times of the time (26 January 1924) reported what he said. The passage in question is :

This passage is not in the Times report (maybe it was left out, as is possible) but this is:

Which gives a rather different interpretation as to what he meant than has been suggested.Another dodgy quote from the currency cranks hits the dust.