Accounting regulations can change

One of the oft-heard criticisms of Modern Monetary Theory (MMT) is that the original developers (including myself) say one thing but know another. We say – there are no financial constraints on a currency issuing government but then, as if as an afterthought, admit that in the real world there are lots of constraints on government spending. On Christmas Day 2009 I wrote the following blog – On voluntary constraints that undermine public purpose. It renders such criticisms redundant. But in the light of the Cyprus schemozzle (putting it mildly), it is interesting to reflect on what could have been done to avoid the ugly consequences that will follow the “Bail-in” package. Even within the constraint of keeping Cyprus in the Eurozone, the authorities (in particular, the ECB) has the capacity to save that nation’s banking system and avoid destroying the nation’s economy. The fact they chose not to use that capacity is telling given the consequences that will now follow. They might have followed their American counterparts who in 2011 clearly knew how to reduce the damage of the crisis and operate as a central bank rather than as part of a vicious syndicate of unelected and unaccountable socio-paths (aka the Troika).

As a warm-up, there is an interesting technical and legal debate going on in Sweden at present that illustrates how rigid administrative constraints can easily be circumvented. You can find background to this discussion provided by the Swedish National Debt Office (Riksgälden) (January 22, 2013) – Borrowing to satisfy the Riksbank’s need for foreign exchange reserves.

The issue arose in 2008-2009 when the central bank (Riksbank) sought foreign currency to bolster their diminishing reserves so that it could maintain financial stability by providing the domestic banks’ foreign currency funding needs. The Debt Office is constrained by the Budget Act, given that all its dealings show up one way or another in the national budget.

The Debt Office concluded that while it was not explicitly detailed, the request from the central bank was “implied in the assignment we have under the Budget Act.” However, they soon realised that the wording of the Act in this relation was ambiguous. There was a discussion about how to interpret the word “may” in terms of the criteria for borrowing.

The Budget Act specifies the purposes for which the Debt Office may borrow. One of those purposes is to “satisfy the Riksbank’s need for foreign exchange reserves”.

But the Debt Office concluded that:

it is not evident that the Debt Office has a duty – or even a right – to borrow unlimited large amounts in order to increase the foreign exchange reserves at the request of the Riksbank. Such borrowing is not necessary for the state’s on-going activities in the same way as borrowing to finance budget deficits. At the same time, it is unclear on what grounds the Riksbank’s need for foreign exchange reserves should be determined.

A ruling was sought from the Government’s Committee on the Constitution, which said that the Riksbank should not expect unlimited funding. But the generality of the Budget Act, that the Debt Office will “meet the Riksbank’s need for foreign exchange reserves” means that:

In practice, this grants the Riksbank extensive discretion in specifying the size of the foreign exchange reserves.

I could cite many examples like this.

Further, in many countries (Sweden included) laws were changed during the crisis to ensure that previously constrained governmental institutions (such as central banks) could act more freely to get cash where it was needed.

Now what did the US Federal Reserve Bank do in 2011 that is relevant to this story? On January 6, 2011, they issued this very opaque statement – Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.

I say opaque because only those in the know would have a clue what it meant. At the time, hardly any financial journalists picked it up and when they did the Austrian schoolers (gold bugs) went crazy – for they thought it confirmed all their worst fears. The fact is that the decision did confirm their worst fears but then advanced paranoia is a state that can be treated with appropriate care so things will turn out alright for them once the sedatives take over and the counselling begins.

The financial journalists, who also didn’t really have a clue what the press release meant, didn’t really respond for nigh on 2 weeks. This was the first response I recorded at the time – Accounting tweak could save Fed from losses – which came out on my Reuters feed on January 21, 2011. Then all hell broke loose in the financial press, for a day or two, until the next big impending (apparent) meltdown occupied their typewriters and blogs.

The “accounting change” was also mentioned in the – Monthly Report on Credit and Liquidity Programs and the Balance Sheet – under “recent developments” (page 1) – the relevant paragraph being:

Effective January 1, 2011, as a result of an accounting policy change, on a daily basis each Federal Reserve Bank will adjust the balance in its surplus account to equate surplus with capital paid-in and, in addition, will adjust its liability for the distribution of residual earnings to the Treasury.

What did this January 6, 2011 Statistical Release mean? Start with this: negative capital.

Ring a bell? Try Cyprus and think about the ECB. The whole Cyprus mess could have been solved with an accounting change or two and some legal changes.

Back to the US to clarify.

The Release began with this statement:

The Board’s H.4.1 statistical release, “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks,” has been modified to reflect an accounting policy change that will result in a more transparent presentation of each Federal Reserve Bank’s capital accounts and distribution of residual earnings to the U.S. Treasury.

In other words, they didn’t think there was much in it. A meagre accounting change to make things clearer.

This accounting change “does not affect the amount of residual earnings that the Federal Reserve Banks distribute to the U.S. Treasury” (under the Federal Reserve Act), the Release tells us that “it may affect the timing of the distributions”.

That is, the change allows the parties to manipulate when things occur.

Prior to the change, the Bank gave the Treasury any earnings that exceeded the sum of its operational costs, dividend payments and “the amount necessary to equate surplus with capital paid-in”. That last quoted reference refers to maintaining its capital, which in an accounting sense defines solvency.

For a private firm, of-course, negative capital means it is insolvent. For a central bank in a currency-issuing nation it means accounting insolvency but nothing other than that. Maintaining bank capital for a central bank is just a charade. The comparison with private balance sheet practices fails. There is no relevant meaning to “negative capital” for an institution that has the monopoly capacity to create its own liabilities at will (that is, issue currency).

The January 6, 2011 accounting change amounts to a sleight of hand – another layer of the voluntary smokescreen designed to obfuscate the fact that there is no intrinsic financial constraints faced by the consolidated US government. Any constraints that exist are voluntary and can be manipulated in one way or another at will. In this case, by some accounting changes.

That means, where the accountant puts numbers in accounts. Smoke and Mirrors sort of stuff. The underlying substance remains – the imagery changes.

So, after the January 6, 2011 accounting change, as noted in the quote above, the Federal Reserve would consolidate the member bank accounts and place any losses as a liability to the Treasury in some account – “Interest on Federal Reserve notes due to U.S. Treasury” – and not write the losses against its capital held on the balance sheet.

At some future time – recall “may affect the timing” – it would then write residual earnings (over the costs etc) off against this liability.

It is more transparent because it tells the public: (a) that it can make losses in the financial markets if it purchases assets at one price and sells them lower or cannot sell them at all; and (b) that it can never go broke because ultimately it is the US consolidated government that issues the US dollar currency.

So if it was to lose amounts equivalent to all or more than its current paid-up capital nothing would happen. Liabilities would get some bigger numbers recorded and life would go on as usual.

It also means that the Federal Reserve is under no compunction to transfer cash to the Treasury on a regular basis. It can put that on hold until the accounting profits improve to wipe out any past losses.

A private company could not do this because it doesn’t issue the currency.

As it happened the Federal Reserve Governor told the – US Senate Committee on the Budget the day after the accounting change was announced during his regular testimony that it could not go broke.

The former Chairperson of that Committee – Kent Conrad – asked the Governor whether there would be losses incurred by the Federal Reserves as part of the “extension of credit that was made during the downturn”.

Dr Bernanke replied:

As a practical matter, what matters is not losses, because those are paper losses. What matters is the amount of funds, remittances we send back to the Treasury. Under most scenarios, because our cost of funding is so low, we will continue to remit back to the Treasury significant amounts of money. Under a scenario in which short-term interest rates rise very significantly, it is possible that there might come a period where we do not remit anything to the Treasury for a couple of years. That would be, I think, the worst-case scenario.

That should have been the end of the story. But the gold bugs know no bounds – they clearly have no reason or, for that matter, comprehension. So the accounting change was seen as a diabolically heinous act of sabotage of US freedom and would send the nation broke with hyperinflation being recorded just moments before the entire staff of the US Bureau of Labor Statistics, which assembles the inflation data in the US, was sacked because the US had run out of money. Its a fun world out there in the denizons!

The Reuters story, that I linked to above, claimed that many financial market commentators were:

… at once surprised that the Fed can set its own guidelines, and also relieved that the remote but dangerous possibility that the world’s most powerful central bank might need to ask the U.S. Treasury or its member banks for money is now more likely to be averted.

Which is amusing in itself. On both counts there is total ignorance. First, of-course governments and the related institutions such as the central bank can alter laws and regulations to suit the current need. Governments are not always stupid and place a fair majority of the operational detail of their institutions in rules and regulations or by-laws, which can be changed, by stealth, without the need to go back to the legislature for approval.

Otherwise, the operation of the government sector would become more cumbersome. This practice does raise questions about the transparency of the democracy. But the reality is that there are a lot of wriggle-room rules that are codified and can be easily changed.

Second, anyone who for a second thinks that the Federal Reserve Bank or, for that matter, any central bank (in a currency-issuing nation) can go broke hasn’t understood the basis of the monetary system they are commenting about.

Please read my blogs – The US Federal Reserve is on the brink of insolvency (not!) and The ECB cannot go broke – get over it – for more discussion on this point.

Why did we just take this little historical diversion?

Think about the options for Cyprus. I am clearly not in favour of the Eurozone continuing. It cannot operate as an effective monetary system under its current structure and there is no political will to change the structure to make the single currency work.

But assume that issue away for the moment.

The Troika’s response was captured in the leaked document I mentioned yesterday, which was published in the Cypriot press on Monday (April 1, 2013) – Memorandum of Understanding on Specific Economic Policy Conditionality.

It is a staggering document. The Troika’s demands amount to a full-scale frontal attack on the well-being of the Cypriot people by a body who are unelected by those people and are not accountable to those people.

The extent of the attack on the well-being of Cyprus, and the fact that the Bail-In will effectively force the nation to endure a Depression for the extended future suggests to me that the decision-makers are socio-paths.

They could not possibly be interested in promoting prosperity in that little nation.

What was the alternative within the Euro structure? Think Federal Reserve accounting rules. The ECB is just a creature of laws and regulations as well. Its intrinsic monetary capacity is that it can never go broke because it issues the currency.

However, its outlook is dominated by the Bundesbank mentality. It is obsessed with the 1920s and fails to even understand that the 1930s wiped what happened in the 1920s away. It also doesn’t seem to understand that it can create Euro liabilities on its balance sheet to whatever size it might choose. That is, in unlimited quantity (please don’t write in and tell me that money cannot be infinite. I understand calculus).

The alternative ECB action which could have avoided the Bail-In would have be as follows:

1. Declare the private Cypriot banks insolvent.

2. Nationalise them under Cypriot law.

3. Guarantee all deposits held by the new state banks.

4. Issue enough Euros to itself and the new state bank(s) to ensure they satisfy the capital adequacy

5. If they are worried about having negative capital themselves, then manipulate some accounting rule or another. As I explained in these blogs – The US Federal Reserve is on the brink of insolvency (not!) and The ECB cannot go broke – get over it – negative capital for a central bank is a meaningless concept. It only has meaning if the institution cannot issue its own liabilities in the currency being used.

Relatedly, the comic book for this week is the latest edition of the Time Magazine which has a headline story “Can this Woman Save Europe?” – the focus being Ms Lagarde. The same Ms just – told Cyprus – that they have to:

… achieve a 4 percent of GDP primary surplus by 2018, which is required to put debt on a firmly downward path.

… and push the real economy on a very sharp downward path and unemployment on a very sharp upward path. The priorities of the socio-paths are all based on anti-people measures – they design policy interventions that they know will cause harm to people over long periods of time (5 years in this case).

They take massive salaries themselves and flit around the place staying at the best hotels, eating the finest cuisine and scoffing the finest wines. Then when the blood is dripping of their hands, they retire on massive superannuation benefits.

I get a lot of E-mails asking me about these so-called fiscal consolidation formulas. The full paragraph that the previous quote is taken from in the latest IMF statement says:

In addition to the fiscal consolidation already underway-estimated at about 5 percent of GDP- an additional 2 percent of GDP in measures will be implemented during the program period, including by raising the corporate income tax rate from 10 to 12 ½ percent and the tax rate on interest income from 15 to 30 percent. An additional 4½ percent of GDP in measures will be needed over the medium term to achieve a 4 percent of GDP primary surplus by 2018, which is required to put debt on a firmly downward path.

The comprehension gap appears to be what does, for example, cutting net spending “at about 5 per cent of GDP” mean. It is very simple.

Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. It is also equal to total spending and total income over the same period.

Cutting government spending by 5 per cent of GDP means initially that GDP falls by 5 per cent. But the multipliers will ensure that the overall contraction is more than 5 per cent.

Add all the “equivalent of X per cent of GDPs” in the program that has been forced on the Cypriot people and you will find they are going to contract the economy by some amount more than 15 odd percent.

Why the hell is that necessary when the simple solution was to nationalise the banks and the ECB to manipulate the accounting to ensure the new state banks had enough capital to satisfy the Basel capital adequacy rules?

And recall that a significant component of the Cypriot banks’ problems were there exposure to Greek government debt, the value of which was reduced because the Troika, themselves engineered an unconscionable “hair cut” as part of their destructive Greek bail out.


Pretty depressing really.

But the point is that these voluntary constraints allow socio-paths and conservatives (both of whom might be in the same set) to fool the public into believing there are no alternatives but to inflict massive damage on the economy and the citizens (avoiding any collateral damage being borne by themselves of-course).

They can typically be changed with a stroke of a pen (an “accounting change”). Sometimes they need a change in the relevant legislation.

They should all be scrapped and replaced with clear statements of the role of government in terms of achieving and sustaining full employment and price stability. The two are not trade-offs in a properly constructed policy mix.

I also thought I was being positively generous in not concluding that all conservatives were socio-paths! Just most of them.

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.

This Post Has 40 Comments

  1. Bill,

    Essentially you are saying, “The ECB should print enough Euros to bail out the Cypriot banks and depositors who put their money into daft loans to Greece”. I think the average German taxpayer will see thru that.

    If a group of people set up an economy with a central bank, and incompetents / the unlucky are bailed out by the central bank, that just amounts to responsible or lucky people in the economy subsidising the irresponsible or unlucky.

    The above idea would work in a country or common currency area with sufficient political cohesion: e.g. some states in the U.S. subsidise others. U.S. citizens are happy with that. But that situation doesn’t exist in the EU.

    A much better solution would have been full reserve banking. Under full reserve, depositors have to choose between having their money lodged in a 100% safe manner, in which case they get no interest, or secondly having their money loaned on or invested, in which case they get interest but they take a hair cut if things go wrong.

    Under the latter system depositors in Cyprus would have had nothing to complain about. No one would have lost anything on safe accounts. As to others, they’d have taken a hair cut, but that would have been nothing more than they signed up for when first lodging their money.

    Moreover, interest rates prior to the recent problems in Cyprus were suspiciously generous. That generosity would have compensated at least to some extent for the haircuts.

  2. “A much better solution would have been full reserve banking”

    Which would involve the ECB issuing enough Euros to bail out the banks in Cyprus and Greece and all other banks in the Eurozone.

    Otherwise you can’t turn a fractional system into a full reserve system – which always involves the central bank taking the place of depositors that are moved to ‘the other place’ (wherever in the ‘off-balance sheet’ plane of existence that happens to be).

  3. Dear Ralph (at 2013/04/04 at 19:16)

    You said:

    If a group of people set up an economy with a central bank, and incompetents / the unlucky are bailed out by the central bank, that just amounts to responsible or lucky people in the economy subsidising the irresponsible or unlucky.

    Except I don’t think the depositors should be treated as unlucky. They have rights. They did nothing wrong. My suggestion punishes the owners (shareholders) and would see the management replaced without bonuses.

    Further, no-one subsidises anyone when the ECB engineers some accounting adjustments. There are no real resources being taken off anyone.

    Here is a recent interview – – where an “adviser” from the ECB explains the current crisis in Cyprus.

    Australians will identify the adviser and the interviewer immediately.

    Wait for the end and that sound of Russian money leaving the Cypriot banking system!!!

    best wishes

  4. Neil,

    I’m baffled. You say “Which would involve the ECB issuing enough Euros to bail out the banks in Cyprus..”. On the contrary: one of the beauties of full reserve is that neither banks nor depositors who have decided to put their money at risk get bailed out. Banks don’t go bust because the latter depositors foot the bill for daft loans or investments made by a bank.

    And why does the central bank “take the place of depositors”? Obviously the money frittered away by the above “daft loans” ends up somewhere: for example, initially some ends up in the accounts of corrupt Greek politicians. But that’s no concern of the central bank.

    If I buy a house without having it properly surveyed and it turns out to be worthless, I lose money and the person selling it to me gains money. Again, that’s no concern of the central bank. If I go bust, then under full reserve, the risk taking depositors at the bank where I borrowed money would take a hair cut. Again, that’s of no interest to the central bank.

  5. Ralph, what are the Germans going to see? The truth? You are looking at this from an individualistic perspective, which is what we are all used to. But what is needed is a solution generated by a system perspective.

    Think of the justice system. If working properly (I am assuming this ex hypothesis), some intelligently guilty and even stupidly guilty will inevitably get off. Does that mean that if we notice this, we are looking at some kind of scam? If we truly believe that it is better for 9 guilty men to go free than it is for 1 innocent man to be jailed, we may well see, as it were, a goodly number of economic incompetents get saved from their own perfidy. That is unfortunate, but it will constitute a kind of economic justice overall, looked at from a system perspective.

    We need to get away from an individualistic way of interpreting this crisis and begin to think systemically, as it IS a systemic crisis, not a crisis created by a host of independent individual failures.

    Let me use an analogy invented by Phil Zimbardo. We have bad apples, bad apple barrels, and bad barrel makers. Some want to look at the bad apples. But the most insightful place to look is at the bad apple barrels and, indeed, the bad barrel makers (members of the elite, related organizations and institutions, and political helpmates). I think it is also necessary to accept that not all bad apple barrels are bad by design. They may be by-products of another process designed to do good, but through accident or incompetence, failed to live up to expectations.

  6. Addendum:

    I inadvertently left out one of the major contributors to bad apple barrel design, members of the economics profession, in particular, the neoclassical branch.

  7. “If I buy a house without having it properly surveyed and it turns out to be worthless, I lose money and the person selling it to me gains money. Again, that’s no concern of the central bank. If I go bust, then under full reserve, the risk taking depositors at the bank where I borrowed money would take a hair cut. Again, that’s of no interest to the central bank.”

    Bank would take a loss under current system if it makes a bad loan, would it not? If bank makes enough bad loans then what? Do you want to get rid of deposit insurance? That doesn’t require full reserve banking.

  8. Bill,

    I fully accept that Cyprus depositors just prior to the recent crisis had rights. In particular they deposited money on the understanding that their money was 100% safe. That agreement has been broken. And that is wrong.

    However, the point made by full reservers is that the contract between depositors and banks under the existing system is defective. I.e. the rights and obligations need re-arranging. And under such a “re-arranged” system, Cyprus would have been a storm in a tea cup.

    Re your idea that bank shareholders should have footed the bill, my understanding is that even wiping out shareholders in Cyprus would not have solved the problem. (In that connection, the 3% capital ratio suggested by Basel III is hilarious. As Mervyn King pointed out, Basel III will not stop the next crisis.)

  9. Larry,

    Far as I can see, you’re arguing that the refusal by Euro core countries to donate as much to south European countries as the latter would like has damaging macro or systemic consequences. That is true if there is no other macro or systemic solution.

    But my point is that there is in fact an alternative “systemic” solution. It involves making depositors who decide to let their bank lend on their money take a stake on those loans. In effect, banks no longer promise to return any SPECIFIC SUM of money to those depositors. Instead, depositors hold shares in a collection of loans or investments made by a bank. (Under the full reserve system advocated by Laurence Kotlikoff, depositors are just given mutual fund units.)

    That way, those shares / units in the case of Cyprus would have drifted downwards in value over the last two or three years. The whole failure would have been much more gradual. A bit more gradual given core country generosity, and a bit less gradual given core country stinginess.

    Instead, under the current system, banks PRETEND (until the pretence cannot be maintained any longer) that they are able to return SPECIFIC sums of money to depositors. Then woomph! The system collapses within 24 hours. Queues appear outside Northern Rock, Cyprus banks, and the long list of banks that have failed thru history.

  10. Cyprus depositors also had the right to expect their deposits to be paid in Euros.

  11. ralph
    i am forced to have a current account to get paid
    as is just about eveyone else
    and pay bills
    why should i pay for the privalege
    as no doubt basic current accounts would oblige me
    are you in favour of nationalised non profit making current accounts to avoid this?

  12. Kristjan,

    If a bank makes a SMALL loss under the existing system, then as you say, the bank (i.e. shareholders) absorb the loss. But if the losses are serious, then the question arises as to who bears the loss. If you have deposit insurance in the form of FDIC (which deals very well with small banks), that’s OK by me: no taxpayer subsidy is involved.

    But in the case of large banks, FDIC cannot cope: only the state, i.e. taxpayer can carry that loss, and that equals a subsidy of banking which is an obvious misallocation of resources.

    The latter problem can be solved with much better capital ratios: i.e. increasing the number of loss absorbers. Basel III wants 3%. Martin Wolf advocates something more like 25% here:

    STRICTLY SPEAKING, all bank creditors must be loss absorbers if a bank is to be 100% safe. And if all depositors are loss absorbers (i.e. effectively become shareholders) then commercial banks can no longer create money, and that equals full reserve. Reason they can no longer create money is that a commercial bank creates money when $X it receives from a depositor is loaned on: both the borrower and depositor then have $X. $X has been turned into $2X.

    If, in contrast, depositors get shares when they let their bank lend their money on, then no money creation takes place, any more than it does when you buy shares in General Motors.

    You could well argue that the above “strictly speaking” point is a bit unrealistic: that is, if the capital ratio is 25% then a bank is about 99.99% safe, and commercial banks can do a bit of money creation.

    However, full reservers point out that commercial banks do not use their freedom to create money in a constructive way: they lend money into existence like there’s no tomorrow just when they shouldn’t, e.g. in the run up to crunch. And they fail to create money just when they should: in a recession. Ergo their freedom to create money should be removed, with just the central bank / government creating money. And that means full reserve and it means turning all depositors who want their money loaned on effectively into shareholders.

  13. Ralph, any bank that tells its depositors that it can pay more than the central bank guarantees is perpetrating a fraud, unless it can make good on this promise, which virtually no bank now can as they are insolvent. In practice, banks could never make good on such a promise as their reserves could never be sufficient for this.

    Anything that Kotlikoff advocates is inherently dangerous for the average person. I certainly wouldn’t agree to have any money of mine placed in a mutual fund, as this may render it susceptible to casino banking practices.

    No bank I have ever banked with has ever asked me whether I wanted my deposits/savings used for loans. They just engaged in the practice or not as the case may be. And no one I know has ever been asked this question. The only time I was asked this question was when my pension fund wanted to know whether I would consent to have my contributions “invested”. I said, no. This was some time before the crash but I didn’t like the look of the market and certainly didn’t like the look of Japan where a lot of Western money was being invested. First, Japan crashed and then, the Western banking system.

    The alternative that you sketch doesn’t look attractive to me and I would certainly reject anything suggested by Kotlikoff.

  14. Full reserve alters nothing other than the price of loans.

    All it is is paying out the deposit insurance ahead of schedule and giving it to the wealthy in the form of unwarranted tax cuts brought about by the collapse in private borrowing.

    I’d rather they pay out the deposit insurance and have the central bank own most of the deposits in the banks – cutting out the wealthy asset owning middleman and their fee.

    Then the small entrepreneur can still borrow money at a reasonable rate and keep his equity. Which helps the supposedly capitalist system nibble at the heels of the oligopolistic cartels.

  15. The problem is they think the Cypriot deficit is to big where it is actually to small.The trokia ,like all drug addicts ,have lost all sense of humanity and would sell their grandmothers [all grandmothers],down the toilet for their next hit

  16. “I also thought I was being positively generous in not concluding that all conservatives were socio-paths! Just most of them.”

    Or to paraphrase J.S.Mill:

    “Whilst not all conservatives are sociopaths, most sociopaths are conservatives”

  17. It seems to me the world banking system is headed for a very severe crisis. There is too much private debt out there realative to earning capacity and real assets. This is debt that can never be paid down and thus will be defaulted upon. The defaults process will have knock-on effects throughout the financial system. Individuals and banks will lose vast amounts of capital and become insolvent. An MMT approach (MMT prescriptions) would be the right approach but I question if even this would go far enough.

    The current system has forced everyone into the private and very unstable banking system. A poster above alluded to this. Most workers are no longer paid in cash just as most businesses small and large are no longer paid in cash. All of them operate accounts for deposits and withdrawals to keep living and running. A bank crash, the freezing of operating accounts and so on brings the entire economy to a halt. People cannot live day to day with no access to funds. Businesses (many of them) will soon be in dire straights.

    If the government guarantees the private banking system in some comprehensive way sufficient to avert major crises then this introduces moral hazard. The only solution left, which I advocate, is that national governments which are currency sovereign (issue fiat currency) must establish or re-establish a nationalised retail bank (like Australia’s Commonwealth Bank used to be). This government owned Bank should guarantee its deposits 100%. It should offer low interest rates for deposits equal to or just slightly better than inflation. On the other hand, the government should offer no deposit guarantees for money in private banks.

    Further controls and strategems should be put in place but detailing them would make this post too long and most will not read it through. Suffice it to say that the above strategem would give people a safe haven if they do not want to take risks with the private banking system.

    Where does a person park money now if they don’t want to take risks? There is really absolutely nowhere now except perhaps AAA government bonds from a stable government with its own fiat currency. Where does a person now operate a day to day account safe from being frozen? The answer is that there is nowhere safe at all. Not anywhere. More and more governments appear to be readying legislation (like Canada) to normalise so called bail-ins where ordinary depositors have funds frozen and take haircuts. This is a very dangerous state of affairs.

    Starving, deseprate people = violence and revolution. I hope the authorities remember that. I always remember as a somewhat politicised teenager asking my father “How will we know when real (political) change is coming?” His answer was “When you see politicians hanging from lamp posts.”

  18. Ralph, how would absorbing a nationalized Cyprus bank balance sheet into the ECB balance sheet and guaranteeing the deposits impact German taxpayers. The taxpayers don’t have to pay anything.

    Of course those taxpayers might be worried about inflation, not higher taxes. But what German citizens might learn as a result of the kind of rescue Bill is suggesting is that in a depression with 12% unemployment, you can expand the central bank’s liabilities sheet dramatically without causing inflation.

  19. The biggest asset anyone can have in the event of a banking collapse is not a lockbox of gold, but rather a network of trust wherein exchange can take place without the mediation of bank credit. This tends to favour smaller, close-knit communities with a history of mutual trust and cohesion. People expecting the government to rescue them from an environment of counterparty risk aversion may do better to reacquaint themselves with their neighbours and redevelop social bonds that our economic system has helped to erode. Ultimately, only our social capital is what will survive.

  20. Ralph Musgrave: “However, full reservers point out that commercial banks do not use their freedom to create money in a constructive way: they lend money into existence like there’s no tomorrow just when they shouldn’t, e.g. in the run up to crunch. And they fail to create money just when they should: in a recession. Ergo their freedom to create money should be removed.”

    Hear, hear!

  21. Kevin,

    You ask why you should be forced to pay to have a current account. The answer is that it’s generally accepted in economics that customers or consumers to pay for the real costs of whatever they consume (except where we decide that social considerations should override the latter point, as is the case with health and education for children). The real cost of processing a cheque is about £1. Someone has to pay for that. Who do you suggest?

    Moreover, plenty of people have to pay for the privilege of having a current account under the EXISTING SYSTEM: me for example (at Lloyds Bank). And my current account pays no interest.


    I’m baffled by your claim that under full reserve banks would tell “its depositors that it can pay more than the central bank guarantees…”. Under full reserve, banks SPECIFICALLY DO NOT guarantee to repay depositors any specific sum of money (except depositors who opt for safe accounts). It’s under the EXISTING SYSTEM that banks promise to return depositors money: a promise which is quite clearly a farce, in view of Northern Rock, Cyprus and the hundreds of bank failures thru history.

    Re your dislike of mutual funds, you are fully entitled to your views, and you’d be fully entitled to lodge your spare money any way you like under full reserve (as indeed you are under the existing system). In fact mutual funds are relatively safe, with the safest (money market mutual funds) investing just in government debt. The latter are 99.99% safe (at least in well run countries). Greece and Zimbabwe are a different matter.


    You claim that “with 12% unemployment, you can expand the central bank’s liabilities sheet dramatically without causing inflation.” I’m all in favour of doing that within a monetarily sovereign country given high unemployment. I’m also all in favour of doing that in a common currency area given roughly the same high unemployment throughout the area.

    But the problem comes where you use freshly printed central bank money to bail out incompetently run firms in a monetarily sovereign country, or incompetently run countries or banking systems within specific countries in a common currency area. Plus the same problem applies where freshly printed money is used to subsidise countries in the EZ that have become uncompetitive. That amounts to a subsidy of the incompetent or uncompetitive by the competent or competitive, even though, as you rightly say, there would be no specific payment by Germans to bail out Cyprus as under Bill’s proposal.

    Worse still, that subsidy will be ongoing and never ending, till the disparity in competitiveness is dealt with.

  22. Ralph, I didn’t say that banks would tell customers that they would pay more than the central bank guarantees. I thought you were saying that.

  23. In the context of a full-reserve (or its equivalent) banking system, the problem of making deposits absolutely secure may be easily solved by setting up an effficient public national depository. One could name such an entity the National Deposit Bank (NDB). It would neither borrow nor lend, such activities being relegated to commercial financial institutions. Its main functions would be to safely store transaction money and to act as a facilitator in the payments system. Commercial financial institutions and post offices could act as agents of the NDP, providing only that there is full demarcation of the depository function from the intermediary function.

    In a full (100%) reserve banking system, all commercial financial institutions, as well as individuals, businesses and governments, would use the National Deposit Bank for storing their money and authorising transactions. And no interest-bearing accounts would be offered by the NDB. Moreover, in a full reserve system there would little or no incentive for commercial financial institutions to offer interest-bearing accounts either. In place of term deposits and certificates of deposit, the government could offer investors requiring a risk-free return the alternative of government infrastructure bonds.

  24. Ralph, If I wished to invest in mutual funds I would do that myself. I do not want the bank to engage in that activity for me with money that has not been set aside for this purpose. And I certainly don’t wnat it done sub rosa by the bank.

  25. Isn’t the simplest route just to nationalise the retail banking system. (Let the casinos go and play their games and if they go down they take everyone involved with them.)
    Given private bank’s penchant for acting pro-cyclically (as per Ralph Musgrave above) wouldn’t having them under government control help to prevent this? No need for full-reserve either. How hard is it to run a vanilla banking operation – it’s basically just interest rate arbitrage after all.
    I don’t see the advantages of competition between banks as outweighing the systemic risks a private banking system brings.
    Also, how hard would it be to attract people with the ability to assess credit risk into a public banking service? Not very, I suspect.

  26. For “banking”, it seems to me that there are two completely separable functions. One is the payments system. That could potentially be a “full reserve system” just like paypal. The other is the lending system. Where we run into trouble is that we mix them up. We have a system where the payments system uses the debt from lending as the medium of exchange. That entails all of the hazards of maturity transformation and liquidity risks. It means that the payment system (a vital utility for the entire economy) is held hostage by the lending system. That creates a slippery slope towards bailing out an irresponsible lending system so as to keep the payment system intact.

    If the payment system was just by something such as paypal and the lending system were separate; THEN it wouldn’t matter if systemic credit defaults led to defaults on the bonds sold to fund loans. That would not impact on the vital role of the payment system. It would simply be irresponsible lenders getting what they had coming to them.

    Lending could potentially be by loan companies that did no maturity transformation and simply sold bonds with the same maturity profile as the loans made. Retail savers could hold savings in the form of ETFs that were made up of thousands of such bonds (just like current bond ETFs). Customers could sell their ETF holding whenever they needed to draw down savings.

    I think it is worth remembering that half of all the credit provided in the USA is already by shadow banks (ie lenders that don’t hold deposits) and we already have a non-bank payment system in the form of paypal.

  27. “In the context of a full-reserve (or its equivalent) banking system”

    You can separate out the transaction system in any banking structure, or you can maintain it in a distributed fashion as it is now.

    Either works and there is no structural difference between the two – as long as you have documented resolution procedures on how to deal with regulated financial institutions.

    A centralised system is probably better if you believe that your regulators are too meek to shut banks down since that removes a hostage.

    The question is whether vastly increasing the cost of private lending is sensible – by introducing unnecessary middlemen into the backfilling of loans from the central bank.

  28. “That entails all of the hazards of maturity transformation and liquidity risks.”

    It doesn’t really. In any other system all you do is issue central fiat ahead of schedule. In an insured system that only happens after an event and the issuing is ‘delegated’ to the private banks.

    So centralised issuing or decentralised issuing. Rigidity and control or more loose and flexible.

  29. “The real cost of processing a cheque is about £1. Someone has to pay for that. Who do you suggest?”

    The central bank back should be the sole depositor in the private banks in return for running the transaction system. That lowers the cost of lending, maintains control and keeps free banking.

    So the central transaction system is built as a common good so that granny doesn’t have to pay to draw out her pension from the bank account she is required to have to receive that pension.

    Much the same as we don’t pay for receiving and transferring cash.

    It is inconsistent to charge for electronic money, but not for paper money – given that both represent the same liabilities at the central bank.

    Which means that there has to be an ulterior motive somewhere.

  30. Neil Wilson, the set up I described would be totally protected against bank runs. There is enough as bank reserves at the moment for it to work now. If lenders had to match the maturity profile of their liabilities to the loans on their books then that would entail the banks selling lots of bonds. That would drain bank deposits so there would be no need to convert bank deposits into monetary base or anything like that. The central bank wouldn’t have much left to do. It would simply be the guardian of the computer that held bank reserves and oversee the interconversion of those with paper currency as requested by the ATM providers. It could leave treasury interest rates to fall to zero and not conduct monetary policy. I don’t see what is wrong with having the transaction system conducted by paypal type companies. Why have that as a nationalized system rather than say having railways nationalized. To my mind the case for nationalizing railways and having rail travel as a free service is much stronger than the case for nationalizing the payment system and having that as a free service. Payment systems could be suited to competition that drove costs down. Look at the astonishing lowering of costs that have occurred with mobile phone provision in much of the world as compared to previous nationalized telephone systems.

  31. Neil Wilson, I think shops now do have to pay banks a charge when they pay in paper currency. That is why supermarkets offer a cash back service at the tills so as to get the paper money off their hands. My guess is that if we had a transaction system that was entirely privately run and separate from lenders, then the direct costs would be seen at the point of the shop keepers just as is now the case with credit cards (and as I said paper money). To my mind the paper system and the non-bank electronic system could compete on the basis of convenience and cost with no problem.

  32. Bill, would you be in favour of re-nationalising the Commonwealth Bank in Australia? I certainly support it. The nation needs one retail bank that is government guaranteed. Let it pay low-ish interest but be 100% government guaranteed. Let the private, commercial and merchant banks have no government guarantees. Let the people decide where they want to put their money.

    If the private banks bleat on about unfair competition tell them to “pipe down or we will nationalise you too.” It’s about time our democraticaly elected politicians stood up to the oligarchs and governed for all the people not just the rich end of town.

  33. @larry,
    Check out the wikipeadia page for “Communications in India”.
    I think much of Africa has also seen a similar transformation.
    I’m not some fanatically enthusiast for privatization of all of the economy. I was serious about thinking that rail transport might best be nationalized; I just think the payment system might be more akin to mobile telephone provision where competitors can compete head to head rather than rail where they can’t. Monopolies need to be public; where head to head competition can occur, that is a good sphere for private competition.

  34. The issue we are discussing is tied up with the fact that the monetary system is the framework within which the entire apparatus of the economic system must operate. Arguably the monetary system must be absolutely stable, as a prerequisite to implementing any form of economic sustainability. This implies that all money should be created by the state (and desirably in an endogenous manner). Money should not be created by the private financial sector — in the process of creating interest-bearing debt.

  35. “This implies that all money should be created by the state”

    Private commercial banks are licensed and regulated by the state and can only create money by virtue of the convertibility peg that license implies.

    So all money is created by the state. It’s just that they’ve chosen to use an outsourcing model.

  36. ” Private commercial banks are licensed and regulated by the state and can only create money by virtue of the convertibility peg that license implies. So all money is created by the state. It’s just that they’ve chosen to use an outsourcing model. ”

    This is an incorrect perception of how money is created. In the modern world, money is created endogenously — i.e. not exogenously. This means that banks create bank credit money whenever they see a viable business opportunity which would justify them in doing so. Thus money creation is driven by the willingness of banks to create credit money as well as by the desire of the non-bank private sector to acquire bank credit money.

    The state (more specifically the central bank) creates fiat money, which is intended to underpin the creation of bank credit money, irrespective of whether there exists a statutory reserve requirement or not. It is essential to recognise however that in an endogenously operated monetary system the creation of bank credit money comes first, whether or not the bank possesses a sufficient volume of reserves (state fiat money possessed by the bank) in support of that new credit money creation. Banks look for the reserves that they require subsequently. This poses no problem whatsoever, because in a normally operated monetary system there is never a shortage of state fiat money in the possession of the banking system. The central bank operates monetary policy in a manner (i.e. via open market operations) which always ensures that this is so.

  37. John,

    The banks can only create liabilities that are worth anything because of the peg they maintain with the central bank and the central bank backing that via the reserve account.

    The limits on what commercial banks can create is down to the capital requirements dictated by regulation and licence.

    They are currently licensed on a ratio basis. That could be changed to a fixed amount (balance sheets no bigger than $x million) and the banks would have to comply or find their access to the central bank closed down.

    Perhaps less reading of propaganda and more understanding of the process? Plenty of blog articles here to aid that.

  38. It is arguable whether bank credit money is ever exchanged (or exchangeable) with base money (state fiat money). When a bank customer makes a withdrawal and demands payment in the form of currency, the monetary mechanics is quite clear: (a) currency is exchanged between the bank and the customer, (b) the bank’s stock of reserves is reduced by that amount, and (c) bank credit money is destroyed – by the same amount. Neither base money nor the money supply are affected by the overall transaction. There has been no exchange between bank credit money and base money in this transaction. The word exchange can be taken to imply that something was destroyed in one form and created in the other form. In this case, bank credit money was destroyed but base money was unaffected. And the reverse argument applies in the scenario where a customer takes currency into a bank branch and requests a deposit.

    The counter-argument is that the scenario described above is not complete. When a bank customer withdraws currency against an account, the depository loses reserves. Other things being equal, that would cause a shortage of reserves in the banking system and thus an increase in the interest rate on central bank funds. To maintain control of that interest rate, the central bank would feel obliged to inject additional base money into the system to replenish the lost reserves. As a result, this argument goes, base money normally would increase when currency is withdrawn from a bank, and conversely.

    However I don’t believe that the operation of monetary policy is a good argument in favor of the viewpoint that bank credit money is inter-convertible with base money. For a financial system which embraces the use of base money in the form of currency, one may argue that

    (a) although the operation of monetary policy is a possible reaction to any (actual or likely) loss or gain of reserves by the financial system, it has no direct connection with the transaction mechanics of deposits and withdrawals;
    (b) the gross withdrawal of currency is roughly counterbalanced by the gross return of currency to the banking system, even if there is a net growth or decline in currency over time (which I would expect to be a small fraction of gross turnover) due to other factors such as population growth and seasonal preferences; and
    (c) currency may be viewed as an intermediary, or catalyst, which facilitates the ultimate movement of bank credit money between different accounts (with a time delay) – so there is an association between currency and bank credit money — rather than an inter-conversion.

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