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Socially Useful Banking – Open Letter to Andrew Haldane

October 30, 2012

Mr Andrew Haldane

Executive Director, Financial Stability

Bank of England

30 Oct 2012

Dear Mr Haldane

Socially Useful Banking

I was very sorry not to be able to attend the meeting organised by Occupy Economics on 29 October. I am responding to your speech as published on the Bank of England website.

I was very pleased that you are prepared to engage with the Occupy movement and that you acknowledge their attempts to address the issues in a constructive and analytical way.

I entirely agree with you that the problem is the system rather than particular individuals, though I would argue that the system has encouraged greed.

However, whilst I agree that the problems have been fairly well diagnosed, there is no generally accepted solution to address one key issue, namely how to control the total amount of money-as-credit issued, and the purposes to which it is directed. It is this issue that is the subject of the rest of this letter.

You acknowledge that “once bank assets exceed annual GDP in size, they begin to act as a drag on growth.” Turner reports that by 2007 UK bank balance sheets had risen to five times GDP [1]. You also mention J.K.Galbraith’s claim that the asset price boom has been a major cause of rising inequality in the US. These two facts in conjunction suggest that if banking is to be socially useful, the total (as opposed to net) assets of banks have to be drastically reduced. This conclusion will not commend itself to bankers. Though banks could remain solvent their profits and share valuations would (over time) be drastically reduced. How much does this matter from a national point of view? Politicians assume that it matters greatly, but I am not aware of any objective study of the net value of the financial sector over the business cycle.

The financial sector is close to a zero sum game. This was acknowledged by Turner when he wrote,

“There is no clear evidence that the growth in the scale and complexity of the

financial system in the rich developed world over the last 20 to 30 years has driven increased growth or stability, and it is possible for financial activity to extract rents from the real economy rather than to deliver economy value…” [2].

If the UK were a closed economy the net value of the financial sector would be small. Its net value depends surely on the exploitation of developing economies. For how much longer can Britain get away with this?

Turner also quotes Reinhart and Rogoff who identify the period between 1945 and the early 1970s as one of ‘financial repression’, and goes on to write, “… and in the more developed economies – the US, Europe, and Japan – this period of financial repression was one of significant and relatively stable growth, comparing well with the subsequent 30 years of increased financial activity and financial liberalisation.”[3]

As Turner acknowledges [4], excessive credit used to finance purchase of existing assets (whether via securitisation or not) is especially likely to lead to bubbles. All the incentives are for banks to lend for this purpose. I do not believe that Basel style capital controls (even if time varying) can control this adequately.

All this suggests to me that we need tight controls over the money supply using instruments that have not been in vogue in the West for some decades. Two such schemes were outlined in evidence to the Independent Commission on Banking (ICB).

  • The first of these is to revert to what Prof. Richard Werner refers to as Direct Credit Guidance as practised in the West during the Bretton Woods era, and even now in some Asian countries. Whereas the Bank of Japan’s guidance proved to be misguided, elsewhere this plan seems to have worked well. Werner especially stresses the importance of limiting the issue of credit to finance purchase of existing assets. True this could lead to a return to mortgage queues, but is this any worse than saddling people with unaffordable mortgages as a result of excessive house price inflation? We need more housing.
  • The second proposal was the adoption of Full Reserve banking as first proposed by Irving Fisher et. al. in the 1930s. This involves giving an organ of the state a monopoly of credit creation. Either the Treasury would issue money by fiat (as the US issued Greenbacks during the Civil War), or the Bank of England would create the money and issue to the government in return for a zero interest loan. This is not the same as the way the Bank now issues banknotes or conducts Quantitative Easing as now interpreted.

Although both submissions were persuasively argued, the ICB’s interim report dismissed them. Full Reserve Banking was woefully misunderstood and Werner’s proposal (in spite of its track record) was not even mentioned. This appears typical of the establishment reaction. For me, this completely destroyed the credibility of the ICB. Freedom of Information requests to the Treasury, which now holds the records of the ICB, have failed to elicit any analysis of these proposals.

I realise that even if the Bank and the FPC were in support of either of these proposals they would experience strong political pressure to leave them alone. However, somewhat to the surprise of those who support Full Reserve Banking, in August the IMF published a working paper by Jaromir Benes and Michael Kumhof, entitled ‘The Chicago Plan Revisited’ (Working Paper No. 12/202). The authors summarise their paper as follows:

“At the height of the Great Depression a number of leading U.S. economists advanced a proposal for monetary reform that became known as the Chicago Plan. It envisaged the separation of the monetary and credit functions of the banking system, by requiring 100% reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this plan: (1) Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money. (2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt. (4) Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. We study these claims by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy. We find support for all four of Fisher’s claims. Furthermore, output gains approach 10 percent, and steady state inflation can drop to zero without posing problems for the conduct of monetary policy.”

If the authors’ conclusions are correct the implications are huge, and I believe this work should be taken very seriously. Opponents of such a scheme would argue that state authorities cannot be trusted to get it right. Benes and Kumhof’s summary of the historical evidence suggests otherwise. I do not claim that any single academic study is a sufficient basis for action, but we believe the paper has made a strong prima facie case and ought to be followed up as a matter of urgency.

Surely the Bank could now work with the IMF to increase awareness of the potential benefits of Full Reserve Banking, and to carry out further studies.

yours sincerely

David H Smith

PS References

[1] Turner in ‘The Future of Finance: The LSE Report’, ed. Layard, authors Turner et. al., LSE 2010, Fig 1.10

[2] ibid. , Introduction, page 5 of printed edition

[3] ibid. page 16 of printed edition

[4] ibid. Fig 1.30

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One Comment
  1. Very nice article. I absolutely love this website. Thanks!

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