Can Full Reserve Banking actually even stop credit-money creation? The Chicago Plan v. Positive Money

[This is a comment from a previous post on Post Keynesianism, MMT, & 100% Reserves Project, Post No. 2. It is in answer to the question "Do Full Reserves actually even stop credit-money creation?" Scott Fullwiler at one point said full reserves could not, as well as some other commenters.]

Andrew Jackson, December 25th, 2012

“Does full reserve stop banks being able to create money out of thin air.

Quick disclaimer, I work for Positive Money.

It’s interesting that you mentioned us alongside the Chicago plan in the first post. The Positive Money (PM) proposals do indeed have the same goal as the Chicago plan/full reserve/100% reserve proposals, that is to stop banks creating money in the process of making loans (or buying assets),. However, the method is different. In the case of Chicago plan they do it by forcing banks to hold reserves against their deposits. As some people have pointed out, this doesn’t necessarily stop banks creating money – that is it is quite possible for there to be money creation by the banking sector with 100% reserves (incidentally for exactly for the same reasons a 10% reserve ratio doesn’t constrain deposit creation, although it does require the central bank to play along).

The PM proposal, on the other hand, does not suffer from this problem. Instead of backing deposits with reserves, we give people access to the state created means of payment itself. Thus, unlike in the current system where two types of money circulate separately – central bank created reserves which are only used by the banking sector, and commercial bank created deposit money which is used by everyone else – in the PM system there is no longer a split circulation of money, just one integrated quantity of money circulating among banks and non-banks alike.

This is achieved by removing the sight [on call] deposits from banks balance sheets and placing them onto the central bank’s balance sheet (which will be called transaction accounts). The private banks then obtain a new liability of the same size to the central bank, and correspondingly the central bank an asset from the banks. This banks’ liability to the Central Bank is to be repaid as their assets mature, with the money repaid in this way to be recycled back into the economy by the central bank granting money to government to be spent into circulation.

In effect, the central bank has ‘extinguished’ the banks’ demand liabilities to their customers by creating new state-issued electronic currency and transferring ownership of that currency to the customers in question. In a sense everyone starts baking at the central bank (although we would hire the banks to administer our accounts for us).

Lending occurs in this system when people move their money from their transaction account (held at the central bank) to an ‘investment account’. This will be broadly similar to a time deposit today – there will be minimum notice periods, however, unlike today they will also carry some risk (i.e. if the underlying assets go bad they may lose some of their money). The money transferred to the banks will then be transferred to a borrower. So in this system lending by banks merely transfers money around the system, no new money or purchasing power is created when loans are made. Because in this system because all money is held on the central bank’s balance sheet any bank can be allowed to fail, without any effect on the money supply.

So with the PM system it is possible to achieve the aims of the Chicago plan, whilst retaining double entry bookkeeping. The question is then not if it is possible, but if it is desirable. Obviously you have covered the boom bust cycle, financial crisis etc. and the unemployment and high house prices that go along with it. However there are also other issues, such as higher taxes, the effects on individual debt levels, inequality (interest transfers money upwards), subsidies and the too big to fail problem etc.”

[Andrew Jackson works for PositiveMoney, their homepage is here]

14 Responses to “Can Full Reserve Banking actually even stop credit-money creation? The Chicago Plan v. Positive Money”

  1.   Ralph Musgrave
    December 27th, 2012 | 04:04      Reply

    100% reserve (or any other reserve figure) won’t stop commercial banks creating money if we continue with the current system under which (in the words of Steve Keen) “the tail wags the dog”. In other words if central banks insist on a particular rate of interest as part of their misguided attempts to regulate economies, commercial banks can force central banks to issue more reserves during a boom, else central banks lose control of interest rates. (That’s actually just a classic example of a point made in the basic economics text books, namely that a monopolist can control price or volume, but not both. In this particular case, the monopolist is the central bank which has a monopoly on the supply of monetary base.)

    And that point ties up very nicely with one made in the Positive Money / Richard Werner / submission to Vickers, namely that adjusting interest rates is a daft way of regulating economies (a point I fully endorse). I’ve set out a whole string of reasons to back that point. And my reasons are incidentally very “MMT compliant”. See:

    http://ralphanomics.blogspot.co.uk/2012/03/sixteen-reasons-why-mmt-is-right-on.html

    For the above “submission”, see:

    http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf

    Re the rest of Andrew Jackson’s post I’m going to disagree on several niggling little points – though I fully support Positive Money and it’s full reserve policy.

    First Andrew says “we give people access to the state created means of payment itself…”. I suggest they’ve got such access anyway. E.g. suppose person X sells government debt to the central bank as part of the latter’s QE operation, X then holds base money – except they don’t actually have an account at the CB: a commercial bank acts as go-between.

    Next he says “This is achieved by removing the sight deposits from banks balance sheets…” Nope. Under both the Werner / Positive Money full reserve system and under Laurence Kotlikoff’s full reserve system, private sector banks (or in the case of Kotlikoff, other private sector “entities”) still offer sight deposits. I.e. you want to withdraw £500 in cash, you’ll get it “on sight” (assuming the funds are in your account).

    Next, the whole business of investment accounts and transaction accounts at the central bank strikes me being unnecessarily bureaucratic. (And if I’m right then that strengthens PM’s argument.) Reason is that IF YOU DO have those two accounts at the CB, you’re still going to have to do spot checks on commercial banks and their branches to make sure that sums that depositors believe to be “sight”, have not in fact been surreptitiously loaned on by the bank. And as long as commercial banks are not doing that (i.e. doing fractional reserve on the side), I don’t see the need for investment and transaction accounts at the CB.

    And if anyone who thinks those “checks” are a weakness in full reserve, they need to count the number of regulators who are now permanently installed in bank headquarters to control the current system: our fractional reserve system.

    Final point, Andrew says “So with the PM system it is possible to achieve the aims of the Chicago plan, whilst retaining double entry bookkeeping.” I don’t see why any of the versions of the Chicago plan make double-entry difficult or impossible.

  2.   Andrew Jackson
    December 28th, 2012 | 10:51      Reply

    Hi Ralph,

    Hope you had a Happy Christmas!

    In response to your points:

    Point 1: “First Andrew says “we give people access to the state created means of payment itself…”. I suggest they’ve got such access anyway. E.g. suppose person X sells government debt to the central bank as part of the latter’s QE operation, X then holds base money – except they don’t actually have an account at the CB: a commercial bank acts as go-between.”

    I disagree, in the current system they don’t have access to the state created means of payment, they have a claim on a bank. The bank can then use this base money for whatever it chooses.

    Point 2: “Next he says “This is achieved by removing the sight deposits from banks balance sheets…” Nope. Under both the Werner / Positive Money full reserve system and under Laurence Kotlikoff’s full reserve system, private sector banks (or in the case of Kotlikoff, other private sector “entities”) still offer sight deposits. I.e. you want to withdraw £500 in cash, you’ll get it “on sight” (assuming the funds are in your account).”

    I don’t want to talk about the Kotlikoff proposals, but I can categorically state that under the PM proposals sight deposits are removed from banks balance sheets. Now individuals will still be able to withdraw their money on sight, however the legal and accounting relationships will have fundamentally changed – essentially they wont be withdrawing this money from their bank, instead they will be withdrawing it from the central bank.

    For example, in the current system current accounts are merely promises from banks that they will use their own money at the central bank to settle payments on our behalf. These promises are only worth something as long as the bank is able to stay solvent and liquid. In contrast, Transaction Accounts will be actual money at the central bank, which banks will administer on their customers’ behalf. This means that funds placed into a Transaction Account remain the legal property of the account holder, rather than becoming the property of the bank (as happens in the current system). As such these deposits are removed from the private banks balance sheets.

    The customer is in a sense hiring the bank to act as a middleman, whose role is to relay instructions and information between the customer and the central bank. The bank never actually takes possession of the money, and is not allowed to instruct to the central bank to transfer it without the customer’s express permission.

    This is why the positive money system is not a full reserve system – people don’t own bank deposits which are then backed 100% by central bank reserves, instead they actually own the ‘reserves’ themselves (obviously under a reformed system these reserves would just be money).

    Point 3: “Next, the whole business of investment accounts and transaction accounts at the central bank strikes me being unnecessarily bureaucratic. (And if I’m right then that strengthens PM’s argument.) Reason is that IF YOU DO have those two accounts at the CB, you’re still going to have to do spot checks on commercial banks and their branches to make sure that sums that depositors believe to be “sight”, have not in fact been surreptitiously loaned on by the bank. And as long as commercial banks are not doing that (i.e. doing fractional reserve on the side), I don’t see the need for investment and transaction accounts at the CB.”

    Transaction accounts are the only accounts held at the central bank and are essentially digital versions of cash. Banks, individuals, the government and businesses would all hold their own transaction accounts at the central bank and have full legal ownership over the money in them, as outlined above.

    On the other hand, Investment Accounts are not money and are not held on the central bank’s balance sheet (but are assets on private banks balance sheets. Any money ‘placed in’ an Investment Account by a customer will actually be immediately transferred from the customer’s Transaction Account (which represents electronic money held at the Bank of England) to the bank’s account (also held at the Bank of England). At this point, the money will belong to the bank, rather than the Investment Account holder, and the bank will record that it owes the Investment Account holder the amount of money that they invested as a liability to the customer. In effect, Investment Accounts are simply records of investments made by customers through a bank, equivalent to a savings certificate. When the money is then lent to a borrower, it will be transferred from the bank’s account (held at the Bank of England) to the borrower’s Transaction Account (also held at the Bank of England)

    Point 4: “Andrew says “So with the PM system it is possible to achieve the aims of the Chicago plan, whilst retaining double entry bookkeeping.” I don’t see why any of the versions of the Chicago plan make double-entry difficult or impossible.”

    I didn’t mean the Chicago plan did this, merely that some monetary reform proposals with the same aims as the Chicago plan promote a kind of ‘single entry’ accounting system, as in those systems money is considered a token that is an asset of the holder and a liability of no one (and so ‘debt free’).

    In fact whichever system of accounting is used is mainly a matter of taste and is largely immaterial. Accountancy is after all not the reality, rather it is the recording of the reality – it is a bunch of conventions thought up by men to help record financial positions, they are not laws of nature! The American Institute of Certified Public Accountants (AICPA) defines accountancy as:

    “the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof.”

  3.   clintballinger
    December 28th, 2012 | 16:24      Reply
  4.   Kyle
    December 29th, 2012 | 05:47      Reply

    How about this: Screw banks. Join credit unions and keep money in our communities. What can a banks do that credit unions can’t? Lower loan interest rates? No. Higher savings interest rates? No.

  5.   Kyle
    December 29th, 2012 | 05:55      Reply

    I wish we could use PM’s method, while eliminating banks altogether. Have a Federal Reserve and community-established, non-profit credit unions to manage the loans.

  6.   scepticalh
    January 11th, 2013 | 05:38      Reply

    Currently credit unions (in the UK) aren’t allowed accounts at the Bank of England but must use one of the high street banks to handle their members’ deposits, withdrawals and loans. Senior staff at the Bank of England (including Andrew Haldane) are very interested in proposals to open up access to the Bank’s payments settlement processes through the provision of generic connectivity, breaking the monopoly of the high street banks. The PM system will give credit unions central bank accounts along with everyone else. If generic settlement access is also provided, banks will operate just like credit unions, and not-for-profit credit unions should be able to out-compete profit-chasing banks for the administration of customer accounts.

    (incidently, I also work with Andrew Jackson at Positive Money)

  7.   scepticalh
    January 11th, 2013 | 07:22      Reply

    To enlarge on how Full Reserve Banking (under which customer accounts remain as liabilities of banks) leaves banks able to create loans almost at will, the following cyclical process will be possible:

    1. government makes payments to holders of bank deposits, transferring reserves to banks in settlement following receipt of which banks credit recipients’ deposits. Deposits increase and reserves increase. Deposits = reserves.
    2. government issues bonds which deposit holders buy. Banks transfer reserves to government in settlement and debit deposit holders’ accounts. Deposits decrease and reserves decrease. Deposits = reserves.
    3. banks issue shares/bonds which deposit holders buy. Deposits decrease and bank capital increases. Deposits < reserves.
    4. banks buy government bonds from depositors to the extent permitted by surplus reserves, paying for them by crediting deposit holders' accounts. Deposits increase and banks' eligible securities increase. Deposits = reserves.
    5. banks repo eligible securities with the central bank as collateral for additional reserves. Repo liabilities increase and reserves increase. Securities, now hypothecated, remain as banks' assets under repo accounting principles. Deposits < reserves.
    6. banks make loans creating new deposits to the extent permitted by the additional reserves. Loans increase and deposits increase. Deposits = reserves.

    Repeat ad lib.

    The overall result is that the maximum rate at which deposits will rise will be the rate at which the availability of eligible securities increases, a function of government fiscal policy, whilst the maximum rate at which loans can rise will be limited only by the ability of banks to raise more capital. Under the current system, the same process operates but at step 6 new loans, and therefore new deposits can be up to a multiple of new reserves, the size of the multiple being set by whether statutory/prudential reserve targets or Basle capital adequacy ratios are the limiting factor. Under both systems, the availability of loan finance through the banks depends directly on the banks' ability to raise capital through retention of fees and interest revenue and through the public's appetite for bank share and bond issues.

    Under the PM proposals, in contrast, the aggregate of the balances in the accounts of government, the banks and the public will respond only to the decisions of the Monetary Authority, while lending will be financed directly by the public, without regard to their appetite for bank capital.

    •   clintballinger
      January 11th, 2013 | 09:48      Reply

      I have heard a simple description of this: Most people (even otherwsise smart economists such as Paul Krugman) believe the “loanable funds model” holds now, when it very much doesn’t.
      PM’s plan would basically make this model actually hold. So with the PM model we actually would have a loanable funds system.
      I think another way to say is that instead of almost no constraints that we actually have, or fractional reserve/deposit limited system that some think we have (even though we really don’t) – we would have a system based on capital assets – Banks would be constricted in their loaning based on their capital (not reserves or deposits).
      Anything you would change, subtract or add to that?

      •   scepticalh
        January 11th, 2013 | 20:03      Reply

        It’s not true to say that we have no constraints at present. There are prudential constraints that individual banks operate under. Banks actively manage their liquidity requirements through forward inter-bank lending commitments and the cost of these affects their willingness to take on additional deposit liabilities by creating loans, whilst provisions for bad debt does have the effect of tying lending to bank capital (or vice versa) in the manner intended by Basel. But when banks are optimistic they underprovide and overcommit and when pessimistic they overprovide and undercommit. Neither bears any necessary relation to prevailing economic conditions but both are self-fulfilling in the medium-term.

        The six-step process I outlined above would limit the growth in lending under full reserve banking to the growth in capital (equivalent to at least 100% provision against bad debts) and the growth in capital would be financed by a transfer from depositors in the form of account management charges, fees, interest and other bank revenue plus the proceeds from bond and share issues net of total bank spending, including capital spending, in the domestic currency. The overall effect, therefore, is equivalent to a flow from depositors to borrowers via the banks, but there is no flow of loan repayments by borrowers back to depositors. Loan repayments simply reduce deposits, which will only be replenished if the banks extend further loans. So this isn’t a loanable funds model either, but a system based on capital(not capital _assets_ which are the assets funded by capital) and surplus reserves.

        The PM system _is_ a loanable funds model but is not constricted by bank capital. Every economic agent, including banks and government, has its own stock of money – true payments settlement assets independent of the liquidity of any other agent. Any agent may transfer money from its own stock into a collective fund owned and administered by a bank, from which the bank will pay out loans to borrowers, augmenting the stocks of the latter and from which stocks loan repayments will replenish the collective fund, completing the circuit. Bank capital will be involved only in connection with the necessary prudential provision by banks against their share of the exposure to loan default risk. Investors in the banks’ loanable funds will make their own provisions against the share of the exposure that they bear. Bank liquidity will be an issue only with regards to demands by investors to cash in their shares in the loanable funds. Payments between agents will settle directly between their respective stocks of settlement assets (money) and will not involve bank liquidity at all.

        •   clintballinger
          January 11th, 2013 | 21:20      Reply

          Thanks for the details! Still digesting them. You might (to get your explanation out there) want to put similar comments on this discussion of FullRB, MMT and related topics: http://mikenormaneconomics.blogspot.co.uk/2012/12/clint-ballinger-post-keynesianism-mmt_22.html

          In response to this comment:
          “geerussell said…
          Assuming for the sake of discussion some practical scheme for eliminating endogenous money creation I think it comes down to a pretty basic set of trade-offs.

          You can have an economy with low risk of financial shenanigans but a deflationary bias from having made real the loanable funds model. It relies heavily on the government policy to exercise prior, timely good judgement on the money supply to avoid stifling private growth impulses.

          Or you can have a growth-biased economy that allows the private sector to fund its own growth through endogenous credit creation with the government following behind to ratify and stabilize that growth through fiscal injections. It relies heavily on the deployment of smart policy and regulation to filter unproductive, rent seeking financialization to avoid bubble-bust debt deflation while still accommodating productive investment.

          For me it’s an easy choice. I’ll always prefer to place my bets on endogenously driven private sector growth leading the way and accept the challenge of deploying smart government policy and regulation to keep it from eating itself. As opposed to a private sector on rails able to go no further or faster than the government lays down track in front of it.”

          http://mikenormaneconomics.blogspot.com/2012/12/clint-ballinger-post-keynesianism-mmt_22.html?showComment=1356197019135#c7073661014802151296

          I would love to know both yours and Andrew Jackson’s response to this (again, perhaps useful to put them on mikenormanecon)

          •   scepticalh
            January 14th, 2013 | 05:09      Reply

            I’ve posted a response on mikenormanecon (as Graham Hodgson, I can’t seem to get Edublogs to display my name here). geeRussell starts off by assuming no credit money, and proceeds from there to offer endogenous credit creation as a preferred route for funding growth. I can only assume he is referring to trade credit, with which we have no problems at all. Money and payments are used for avoiding or terminating credit relations. Bank money makes this impossible. Banks have no business in our affairs and yet we are forced to become bank creditors in order to transact with third parties.

        •   clintballinger
          January 12th, 2013 | 12:49      Reply

          Scepticalh – I think it is absolutely crucial to get some other intelligent bank reformers and PM on the same side.

          It seems to me many of the proposals here (for the US system, adapt the details to the UK system if you like) accomplish basic goals of PM.

          It would be extremely useful to highlight where PM and this overlap.
          Proposals for the Banking System http://www.huffingtonpost.com/warren-mosler/proposals-for-the-banking_b_432105.html

          •   scepticalh
            January 12th, 2013 | 21:29      Reply

            Warren Mosler concludes from his brief review of monetary history “The hard lesson of banking history is that the liability side of banking is not the place for market discipline.” This is precisely the point of focus for Positive Money. Our proposals remove the “mission critical” aspect of the monetary system – people’s money – from the liability side of banking and the vagaries of the market, isolating the payments system from the questionable liquidity and ultimate solvency of banking institutions. And that is all we seek to do. We do not propose any changes to the management of banks’ assets, which is where Warren directs his proposals, because we feel that is the wrong place to start. Getting the liabilities side right will eliminate the systemic significance of current concerns – securitisation and inter-bank lending are at present primarily liquidity management practices. Only once the balance between financial stability and profitability has been realigned by this will it be apparent whether and how asset management practices should be regulated.

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