Economists Calling for Full Reserve Banking

Written by Mira Tekelova on . Posted in Economic Analysis, Theory

It may appear that Positive Money’s proposal for banking reform is somehow too radical or too marginal, since mainstream media are rather silent about it and even the Independent Commission on Banking in the UK is so immersed in conventional thinking that it doesn’t see a need to ask a fundamental question: “Who should create the national money supply, and in what form?”

But despite the fact that this information rarely makes it into current news, the fact is that many very well-known, important, respected and famous economists were or are calling for a full reserve banking system. Their proposals differ from each other, however the 100% reserve requirements is common to all of them.

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Let’s start from the old tradition established by some members of the Chicago School.

They suggested monetary reforms, including a call to end the fractional reserve banking and impose 100% reserves on demand deposits in a memorandum that came to be known as the “Chicago plan”. The Chicago plan was a proposal to radically change the structure of the financial system.

Supporters of the plan were: F H Knight, L W Mints, Henry Schultz, H C Simons, G V Cox, Aaron Director, Paul Douglas, and A G Hart.

The memorandum generated much interest and discussion among lawmakers but the suggested reforms were set aside and replaced by watered down alternative measures.

After the Great Depression that began in 1929, there was an apparent recovery in the mid-1930s, but by 1939 the US was again in recession and economists circulated a draft proposal titled  “A Program for Monetary Reform” calling once more for an end to fractional-reserve banking. It resurrected proposals for banking and monetary reform from the Chicago plan.

The program was sent to the most complete list of academic economists available at the time. General approval of the program was expressed by 235 economists from 157 universities and colleges; another 40 economists approved of it with some reservations; only 43 economists expressed disapproval.

A Program for Monetary Reform was coauthored by six notable economists: Paul H. Douglas, Frank D. Graham, Earl J. Hamilton, Willford I. King, Charles R. Whittlesey and  Irving Fisher, who was a celebrated American economist and professor of economics who is best known for his work on the quantity theory of money. Fisher was a true celebrity and one of the major influences on Milton Friedman’s monetarism. Friedman called Fisher “the greatest economist the United States has ever produced”.

——————-

On the other side of political spectrum there is the Austrian school of economics, which is associated with libertarian political perspectives. While with different theoretical roots and with totally different objectives, they came to the same conclusion – and called for the abolition of fractional reserve banking.

The Austrian theorists argue for an extremely limited role for government and the smallest possible amount of government intervention in the economy. They see the 100-percent reserve requirement as an imperative which is vital for the correct functioning of a market economy. (Economists of the Chicago school proposed a 100-percent reserve requirement to make government monetary policy more effective and predictable – to assist governments in administering a stable monetary policy by preventing the elastic, distorting credit expansion which all fractional reserve banking systems generate from nothing.)

Ludwig von Mises was the first twentieth-century economist to propose the establishment of a banking system with a 100-percent reserve requirement on demand deposits.

Nobel Laureate Friedrich.A. Hayek also speaks of establishing a banking system based on a 100-percent reserve requirement.

Professor Murray N. Rothbard (in 1962) developed his proposal for a pure gold standard based on a free-banking system with a 100-percent reserve requirement. Rothbard compared the banker who operates with a fractional reserve with the criminal who commits the crime of misappropriation.

In Europe, the French economist Maurice Allais, who received the Nobel Prize for Economics in 1988, has championed the proposal of a banking system subject to a 100-percent reserve requirement.

Jesus Huerta de Soto is today’s leading Austrian school economist, and in his book “Money, Bank Credit and Economic Cycles” published a proposal for a reform of the banking system. He suggests: “a 100-percent reserve requirement would be established for private banks. This step would necessitate certain legislative modifications to the commercial and penal codes. These changes would allow us to eradicate most of the current administrative legislation …”

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Strong criticism of fractional reserve banking comes also from Frederick Soddy (a winner of the Nobel Prize for Chemistry). He could not accept the comfortable view that scientists have no responsibility for the uses to which their work is put. The world’s real problem was faulty economics, not faulty chemistry, and for the second half of his nearly eighty years economics replaced chemistry as the centre of his intellectual life.

There is one more outstanding economist who has backed monetary reform. Milton Friedman, a Nobel Prize winner - known now as one of the most influential economists of the 20th century, wrote a book in 1960 called, A Program For Monetary Stability. On page 65 he stated that he was in favour of what Henry Simons and Lloyd Mints were advocating, that is, 100% reserve. In other words, he advocated that governments, rather than private banks, should issue the money supply. Dr. Friedman also praised the American Monetary Reform Act  (See his comments here).

 

In more recent years more and more economists have been advocating a sound and stable monetary system based on 100% reserves. They include Laurence Kotlikoff, Josef Huber, James Robertson, James Tobin (who received the Nobel Prize for Economics in 1981 and has proposed a “deposit currency” system which incorporates many aspects of the Chicago Plan for a 100-percent reserve requirement), and Herman Daly, former Senior Economist at the World Bank, who strongly endorses full reserve banking, saying “I think we can really do a whole lot for our economy if we would just move away from fractional reserve banking and go back in the direction of 100% reserve requirement.” (See the video here)

Finally, let’s conclude with the quote of the governor of the Bank of England Sir Mervyn King himself  which hints that full reserve banking is not such a bad idea after all:

“Another avenue of reform is some form of functional separation. The Volcker Rule is one example. Another, more fundamental, example would be to divorce the payment system from risky lending activity – that is to prevent fractional reserve banking”. 

 

 

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  • RJ

    What would PM include as bank reserves

    BoE reserves held as a commercial bank asset would be

    But what about

    Bank vault held notes and coins
    Govt bonds. Either UK or overseas treasury bonds.

    Is there anything else that would be classified as reserves

    • Ben Dyson (Positive Money)

      RJ – are you getting confused between central bank reserves and capital reserves? Central bank reserves are numbers in commercial banks’ accounts at the central bank.

      • RJ

        So when PM refers to reserves (as in full reserve banking) what is meant by this term.

        Is it capital reserves or BoE reserves (a bank asset). And if it is capital reserves what does PM mean by this term and how does a bank generate these reserves.

        Based on this I assume PM means BoE reserves (or notes and coins?).

        “The Bank of England would then take over the role of creating the new money that the economy requires each year to run smoothly”

        • João Granchinho

          Full reserve banking means the bank has notes and coins as reserve against every unit of digital money that its customers have in their accounts. None of it is used to make new loans. Under that system, in order to lend, a bank has to have its own pool of funds, separate from the depositors’ money. This would mean, among other things, that when a bank goes bust, the depositors’ money is safe, and thus no bailout is needed – no finantial crisis – no public services cuts – no increased taxes.

        • João Granchinho

          One more thing, I see this safeguarding of money as a basic service we should all have access to, for free, and not subject to any kind of risk. A service provided and guarateed by the government. Why let private banks “keep your money safe” at all? Why not have banks with the sole function of lending money at their own expense? This would truly separate the lending function from the deposit keeping function.

        • Ben Dyson (Positive Money)

          Full reserve banking refers to having 100% liquidity on your demand liabilities (to use the jargon). In plain English it means all the customers who can ask for their money back with no notice, can be paid by the bank.

          The term is a bit confusing and ideally we should look for an alternative.

  • John Morrison

    JoO – you have described it nice and simple.

    There still seems to be a question about what bank reserves are:

    As I understand it bank reserves are the reserve accounts that banks hold at the Bank of England. This is electronic cash, not bank credit. It is a record of cash deposited at the Bank of England. It is pure national currency which banks use as a basis for credit multiplication.

    There are two outstanding things about these electronic currency accounts:

    They are only available to banks. The rest of us have to either hold our money as currency in the form of notes and coins or surrender it to a bank and trust its credit.

    Although we the citizens have to trust bank credit and the nation as a whole trusts it by receiving it as payment of taxes, the banks themselves DO NOT trust each others credit. They insist that the accumulation of all credit transfers between them is completed by transfer of currency reserves at the B of E by the end of each day.

    I think every citizen should be entitled to an electronic currency account. This would enable real currency to be held and flow in greater quantities than is possible with just notes and coins. It would also enable a distinction between currency and credit to be made with larger electronically held sums of money, This is of course the same as Positive Money demand deposits but looked at in a different way, more from the perspective of where we are now.

    • RJ

      The central bank is the bank for

      The treasury (Govt) and
      The commercial banks

      The treasury and commercial banks have an account at the BoE that operates in the same way as our bank account operates at a commercial bank.

      If we have a positive balance at a commercial bank
      -Its our asset (a cash deposit at the bank)
      -Its the commercial banks liability
      -We use bank deposits to settle with other parties

      If a commercial bank has a positive balance at the BoE
      -Its the commercial banks asset (deposit at the BoE)
      -Its the BoE liability
      -Commercial banks use BoE reserves to settle with other banks, AND TO SETTLE WITH THE TREASURY. (For example when people pay tax using a bank deposit. Or the bank or their customers buy treasury bonds). And the commercial bank use BoE reserves (the commercial banks asset) to obtain notes or coins (another commercial bank asset).

      How do commercial banks in total initially obtain BoE reserves
      -Mainly from Govt spending. Whenever the Govt spends money the commercial bank receives BoE reserves (the banks asset). The party the Govt is paying receives cash – depsoit at the commercial bank (a bank liability to offset the BoE reserves received).
      - Later the commercial bank can gain or lose reserves from treasury settlements, from other banks or from a BoE overdraft. But the initial supply of reserves mostly come from Govt deficit spending.

      • John Morrison

        RJ – I was wondering if the Treasury has a reserve account at the B of E and you appear to have answered this.

        Are you sure that the Treasury has a reserve account at the B of E ?

        If so then there is no sane reason why the Treasury should accept bank credit as payment of taxes (as some claim is the case) because it is in position to insist on a transfer of reserves (pure currency) into its own reserve account at the B of E just as the banks do.

        Or have I completely misunderstood how the whole thing works ? I have a tendency so simplify things down to a level that I can understand, as any mathematician would do. I don’t apologise for this because it is often a great revealer of hidden truths but I expect to be corrected if I am wrong.

        On the issue of the asset and liability equation of reserve accounts: As reserve accounts are pure currency (not bank credit) then surely these accounts have the asset and liability equation of the national currency; it is issued by the nation as an asset to whoever holds it and a liability to the nation as whole which is obliged to receive it in exchange for goods and services. Currency issued by the B of E is not a liability of the B of E nor of the Treasury it is a liability of the people of the nation. Fortunately it is a flexible liability. If the currency issued (asset to whoever holds it) gets too big and the liability to the nation to exchange it for goods and services becomes unsustainable then both assets and liabilities are automatically reduced by inflation.

        Oh for the days of steady inflation and indexed linked wages ! That was the best way to game the existing system and remains the only way to deal with over inflated house prices without leaving recent buyers in negative equity.

        • John Morrison

          Oh for the days of steady inflation and indexed linked wages ! Those were good times, ordinary people never had it better. It felt good getting an increase each year, price rises felt like part of progress and we used to amuse ourselves with how much less things cost only a few years before when people had less money. There wasn’t much point in hoarding money for future use because it would be worth less and that kept it flowing in the economy. Of course it does need indexed linked wages and pensions too. If as in my case your my rent is index linked but your salary is not – that is not so good.

        • RJ

          “If so then there is no sane reason why the Treasury should accept bank credit as payment of taxes (as some claim is the case) because it is in position to insist on a transfer of reserves (pure currency) into its own reserve account at the B of E just as the banks do.”

          The Govt does accept bank credit.

          The treasuries bank is the BoE. So if I want to pay my £10,000 tax bill

          I write a cheque using my bank credit (deposit) to the treasury (or transfer money). The Govt in effect banks this cheque with the BoE (rather than say HSBC or another commercial bank).

          Say my bank is Lloyds. Lloyds journal entry from the cheque is

          Debits RJs cheque account £10,000 (reduces my bank balance)
          Credit Interbank settlement account £10,000

          The BoE journal entry from this cheque is

          Credits Treasury bank account £10,000 (bank balance increases)
          Debits Interbank settlement account

          Lloyds settles with the BoE (£10,000) using BoE reserves

          NB The whole banking system starts from the BoE. This is the banks and treasuries bank. The next level is THE commercial banks.

          If there was only one commercial bank. Then there would be no need for a central bank. Central banks are needed to allow bank to settle with each other and with the treasury.

          • John Morrison

            Thanks RJ – That makes it very clear, including the mechanism by which it works.

  • Steve

    John,

    RJ is correct that the Government has a reserve account with the Bank of England and all payments to the Government involve a transfer of central bank reserves from the commercial banks reserve accounts to the Government’s reserve account.
    Government will never accept bank credit in the same way as all banking transactions are settled by central bank reserves.

    The transfer between Commercial bank reserves and Government reserve accounts is the primary reason that the BoE carries out open market operations to maintain a stable level of reserves in the banking system. The flow of money into and out of Government accounts is not smooth and so when there are large net inflows to Government accounts the BoE will provide short term reserve boosts to the banking system and will drain these when there are net outflows from Goverment accounts.

    • John Morrison

      Steve – thanks for the clarification over the Treasury’s reserve account at the B of E.

      I am still a long way from understanding open market operations. I think there are some other things I need to understand first.

      I still don’t understand why the government ever has to borrow the money used to measure and record trade between its own citizens when it can simply issue it itself. There may be a need for constitutionalised and transparent controls over how a government issues money but to subject a nation and its people to a kind of artificial debt servitude doesn’t seem like the best solution and it isn’t going very well.

      When the government borrows money, what does it borrow ?
      Its own currency or bank credit denominated in its own currency ?

      I guess that if it is currency then it would be paid into its reserve account at the B of E and if it is bank credit then it would have to be held on deposit at a commercial bank, probably the bank that issues it.

      • RJ

        [EDITED BY POSITIVE MONEY: The following comment is factually inaccurate, so please do not be confused by it. The book Where Does Money Come From? gives an accurate and fully researched explanation of how the UK government borrows money from the markets.]

        The UK Govt NEVER borrows money from the market to pay expenses as the UK like the US and Aust etc are still monetary sovereign (Euro countries have given up the most value asset any country can own – their monetary sovereignty. Google it.)

        The Uk and all monetary sovereign countries pay all their expenses using central bank reserves (this is called Govt debt although it isn’t in some ways as it never has to be paid back and can attract zero interest. The Govt decides the interest rate.)

        Govt bonds are only issued after the spending occurs to drain excess bank held BoE reserves. Otherwise banks are left holding excess reserves attracting very low or zero interest.

        So Govt spending to create excess BoE reserves must always come first (otherwise banks will not have the required reserves to settle with the treasury for bond purchases). Then after the event bonds are issued to drain excess reserves as noted by Steve above.

        NB 1 If banks buy Govt bonds only reserves are drained. If non banks buy bonds then reserves and bank deposits are both drained (or decreased as drained means decreased).

        NB 2 In the US today banks hold over $1 trillion of excess reserves. That’s why the US is now paying a small amount (well under 1%) of interest on these reserves.

        • Ben Dyson (Positive Money)

          RJ – this is factually untrue. The UK government borrows money from the markets via the Debt Management Office. Regardless of how they could operate if they wanted to, the reality is that the government currently believes that it has to tax or borrow every pound that it spends. What you described sound logical in theory but it’s just not the way that the UK government operates, so please be careful about adding to the confusion about how the UK monetary system works.

          Anyone who wants to know how it actually works would be well advised to read Where Does Money Come From? which has been compiled from research covering over 500 documents from the Bank of England, Treasury, Debt Management Office etc.

          • Steve

            Ben you are quite correct.

            RJ, you are referring to a view of what could happen not what does happen. The government pre-funds all spending through taxes and the issuance of Govt bonds via the Debt Management Office.

            When you say the following..
            “Govt bonds are only issued after the spending occurs to drain excess bank held BoE reserves. Otherwise banks are left holding excess reserves attracting very low or zero interest.”

            This is untrue – it is a description of open market operations (OMOs) but these involve the trading by the BoE of EXISTING govt bonds not the issuance of new bonds – buying to add liquidity and selling to drain liquidity and this is to smooth the level of reserves in the system.

            New issues of government bonds are a seperate process and unrelated to draining of liquidity – they are done by the DMO to advance fund government expenditure when required.

    • Ben Dyson (Positive Money)

      Steve – spot on. The Bank of England does try to keep the level of reserves available to the banking system fairly constant, and when there’s a big inflow of reserves to the government’s account, it requires some Open Market Operations to balance this out. See Where Does Money Come From? for more details.

      • John Morrison

        Ben – I feel a bit short changed. If you are so alarmed that someone’s post could mislead that you have to insert a disclaimer then you should make some sort of statement about the true state of affairs that the post in is danger of obscuring.

        Saying that it is in the book is not good enough. I am not saying I won’t buy it or that I won’t find time to read it. If the authors have a good narrative style that keeps you engaged while they take you through all the complexities then that is certainly something worth paying for but the truth itself is nobody’s property and it should not be hidden behind a credit card payment.

        A paragraph giving just a basic idea of what is happening when a government borrows money, who they borrow it from, what they get and where they put it and how they use it would be very welcome.

        RJ’s description is of course coherent and what a rational monetary sovereign nation should do. The mystery is what the hell is happening instead.

        OK. I´ll buy the book but don’t wait for that, tell us something now!

        • RJ

          Its a chicken and egg situation. What comes first

          Borrowing or spending. But note that the banks need BoE reserves to settle with the treasury when bonds are purchased.

          The UK Govt is not (legally) allowed to have a overdrawn balance at the BoE. But this is a self imposed restriction.

          So in theory Govt (treasuries) MUST borrow (or tax) first to top up their BoE account. They then spend which decreases the treasuries BoE account balance. This spending then generates bank reserves (and bank deposits) which are then used to buy bonds (or pay taxes).

          Its a loop. Some say borrowing comes first. Other spending. Ben is right but seeing the chicken and egg situation helped me to tie everything together.

        • Ben Dyson (Positive Money)

          John – the government borrows every pound that it doesn’t collect in taxes or fees, by selling new bonds to the market, via the Debt Management Office. It requires that all buyers of bonds ‘settle’ by making a transfer of central bank reserves into their account at the Bank of England. It then makes payments to other bank accounts, by transferring central bank reserves away to the recipient banks.

          The knowledge isn’t private property, but it did take 3 weeks of solid research to map out exactly how the government operates with regards to its borrowing alone. I doubt many people have the time to do that, so £14.99 for 8 months of full-time research (in total) seems a fair deal! If someone hadn’t put up the funding initially then it still wouldn’t be public knowledge (it would still be buried in over 500 documents).

          • RJ

            I’m waiting for the kindle version. Hopefully this will be available before too long.

          • John Morrison

            Thanks Ben. You have given the clarification I was looking for.

            I agree that the book is a fair deal and that extensive efforts for the common good require the support of all who benefit. That is after all what money is for.

            Nobody should be shy though of freely disseminating insights, analysis and conclusions that derive from the book. I’m sure it is the intention of the authors that this should happen.

      • Rick

        Any chance of accepting an alternative payment method for book ?? Cheque for example.

        • Ben Dyson (Positive Money)

          Hi Rick – sure, you can send a cheque to Positive Money, 205 Davina House, 137-149 Goswell Road, London, EC1V 7ET with your postal address and we’ll ship the book out to you. (It’s £17.49 including shipping in the UK).

    • Drew Jackson

      Hi Steve,

      I am afraid this is incorrect, although it used to be the case prior to the existence of the Debt management office (DMO). At the end of every day any funds (reserves) in any government account which have not been spent are ‘swept up’ into the DMOs account, where they are lent short term into the UK money market. Because of this the BoE does not need to use open market operations to adjust the level of reserves due to ‘lumpy’ taxes/spending.

      • RJ

        Thanks

        This makes sense. Otherwise there would be a shortage of reserves held in total by banks

        As a treasury credit balance at the BoE means banks in total must have a debit balance at the Boe (so that the BoE in total has a balanced balance sheet).

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  • Dismayed

    Only the lunatic fringe is promoting full-reserve banking. Fractional reserve banking has worked well, but that was before deregulation.

    • http://www.facebook.com/sigurvin.sigurjonsson Sigurvin Bardur Sigurjonsson

      Well, the morse code also served us well. That doesn’t mean more effective alternative was available.

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