We Don’t Have To Be In Financial Crisis
In the article below, Herman Daly, a University of Maryland and former World Bank economist, makes the case for 100% reserves. This reform, once a principle goal of important economists, would terminate the ability of the banking system to create credit to finance its own speculations and return the power over money to the government from private banks.
Herman Daly is one of the few economists who are capable of thinking outside the box and who can devise reforms that benefit the people rather than the vested interests.
Nationalize Money, Not Banks
Emeritus Professor University of Maryland School of Public Policy
If our present banking system, in addition to fraudulent and corrupt, also seems “screwy” to you, it should. Why should money, a public utility (serving the public as medium of exchange, store of value, and unit of account), be largely the by-product of private lending and borrowing? Is that really an improvement over being a by-product of private gold mining, as it was under the gold standard? The best way to sabotage a system is hobble it by tying together two of its separate parts, creating an unnecessary and obstructive connection. Why should the public pay interest to the private banking sector to provide a medium of exchange that the government can provide at little or no cost? Why should seigniorage (profit to the issuer of fiat money) go largely to the private sector rather than entirely to the government (the commonwealth)?
Is there not a better away? Yes, there is. We need not go back to the gold standard. Keep fiat money, but move from fractional reserve banking to a system of 100% reserve requirements. The change need not be abrupt—we could gradually raise the reserve requirement to 100%. Already the Fed has the authority to change reserve requirements but seldom uses it. This would put control of the money supply and seigniorage entirely with the government rather than largely with private banks. Banks would no longer be able to live the alchemist’s dream by creating money out of nothing and lending it at interest. All quasi-bank financial institutions should be brought under this rule, regulated as commercial banks subject to 100% reserve requirements.
Banks cannot create money under 100% reserves (the reserve deposit multiplier would be unity), and banks would earn their profit by financial intermediation only, lending savers’ money for them (charging a loan rate higher than the rate paid to savings or “time-account” depositors) and charging for checking, safekeeping, and other services. With 100% reserves every dollar loaned to a borrower would be a dollar previously saved by a depositor (and not available to the depositor during the period of the loan), thereby re-establishing the classical balance between abstinence and investment. With credit limited by saving (abstinence from consumption) there will be less lending and borrowing and it will be done more carefully—no more easy credit to finance the leveraged purchase of “assets” that are nothing but bets on dodgy debts.
To make up for the decline and eventual elimination of bank- created, interest-bearing money, the government can pay some of its expenses by issuing more non interest-bearing fiat money. However, it can only do this up to a strict limit imposed by inflation. If the government issues more money than the public voluntarily wants to hold, the public will trade it for goods, driving the price level up. As soon as the price index begins to rise the government must print less. Thus a policy of maintaining a constant price index would govern the internal value of the dollar. The external value of the dollar could be left to freely fluctuating exchange rates.
Alternatively, if we instituted John M. Keynes’ international clearing union, the external value of the dollar, along with that of all other currencies, could be set relative to the “bancor,” a common denominator accounting unit used by the payments union. The bancor would serve as an international reserve currency for settling trade imbalances—a kind of “gold substitute”.
The United States opposed Keynes’ plan at Bretton Woods precisely because under it the dollar would not function as the world’s reserve currency, and the US would lose the enormous international subsidy that results from all countries having to hold large transaction balances in dollars.
The payments union would settle trade balances multilaterally. Each country would have a net trade balance with the rest of the world (with the payments union) in bancor units. Any country running a persistent deficit would be charged a penalty, and if continued would have its currency devalued relative to the bancor. But persistent surplus countries would also be charged a penalty, and if the surplus persisted their currency would suffer an appreciation relative to the bancor.
Keynes’ goal was balanced trade, and both surplus and deficit nations would be expected to take measures to bring their trade into balance. With trade in near balance there would be little need for a world reserve currency, and what need there was could be met by the bancor. Freely fluctuating exchange rates would also in theory keep trade balanced and reduce or eliminate the need for a world reserve currency. Which system would be better is a complicated issue not pursued here. In either case the IMF could be abolished since there would be little need for financing trade imbalances (the IMF’s main purpose) in a regime whose goal is to eliminate trade imbalances.
Returning to domestic institutions, the Treasury would replace the Fed (which is owned by and operated in the interests of the commercial banks). The interest rate would no longer be a target policy variable, but rather left to market forces. The target variables of the Treasury would be the money supply and the price index. The treasury would print and spend into circulation for public purposes as much money as the public voluntarily wants to hold. When the price index begins to rise it must cease printing money and finance any additional public expenditures by taxing or borrowing from the public (not from itself). The policy of maintaining a constant price index effectively gives the fiat currency the “backing” of the basket of commodities in the price index.
In the 1920s the leading academic economists, Frank Knight of Chicago and Irving Fisher of Yale, along with others including underground economist and Nobel Laureate in Chemistry, Frederick Soddy, strongly advocated a policy of 100% reserves for commercial banks. Why did this suggestion for financial reform disappear from discussion? The best answer I have received is that the great depression and subsequent Keynesian emphasis on growth swept it aside because limiting bank lending to actual savings was too restrictive on growth, which became the big panacea. Also there is the obvious vested interest of commercial banks in retaining the privilege of creating money and lending it at interest.
Now suppose for a moment that aggregate growth has begun to increase environmental and social costs faster than production benefits, thus becoming uneconomic growth. There is much evidence that this is the case. Then a financial constraint on growth (balancing investment with abstinence) would be much needed, and 100% reserves would be a good way to accomplish it. If, however, growth remains the summum bonum of the economy, then we will inevitably borrow against our hoped for larger future income to finance the investments needed to produce it.
Financing investment by saving would require less present consumption, which many will deem to be an unacceptable drag on growth. But real growth has encountered the biophysical and social limits of a “full world.” Financial growth is being stimulated ever more in the hope that it will pull real growth behind it, but it is in fact pushing uneconomic growth- — growth of ”illth.” Since illth is negative wealth it can hardly redeem the growing debt that is financing it.
The original 100% reserve proponents mentioned above were in favor of aggregate growth, but wanted it to be steady growth in wealth, not speculative boom and bust cycles. Soddy was especially cautious about uncontrolled physical growth, but his main concern was with the symbolic financial system and its disconnect from the real system that it was supposed to symbolize. The result was confusion between wealth and debt. One need not advocate a steady-state economy to favor 100% reserves, but if one does favor a steady state the attractions of 100% reserves are increased.
How would the 100% reserve system serve the steady-state economy?
First, as just mentioned it would restrict borrowing for new investment to existing savings, greatly reducing speculative growth ventures—for example the leveraging of stock purchases with huge amounts of borrowed money (created by banks ex nihilo rather than saved out of past earnings) would be severely limited. Down payment on houses would be much higher, and consumer credit would be greatly diminished. Credit cards would become debit cards. Long term lending would have to be financed by long term time deposits, or by carefully sequenced rolling over of shorter term deposits. Growth economists will scream, but a steady-state economy does not aim to grow, for the very good reason that growth has become uneconomic.
Second, the money supply no longer has to grow in order for people to pay back the principal plus the interest required by the loan responsible for the money’s very existence in the first place. The repayment of old loans with interest continually threatens to diminish the money supply unless new loans compensate. With 100% reserves money becomes neutral with respect to growth rather than biasing the system toward growth by requiring more loans just to keep the money supply from shrinking.
Third, the financial sector will no longer be able to capture such a large share of the nation’s profits (around 40%!), freeing some smart people for more productive, less parasitic, activity.
Fourth, the money supply would no longer expand during a boom, when banks like to loan lots of money, and contract during a recession, when banks try to collect outstanding debts, thereby reinforcing the cyclical tendency of the economy.
Fifth, with 100% reserves there is no danger of a run on a bank leading to a cascading collapse of the credit pyramid, and the FDIC could be abolished, along with its consequent moral hazard. The danger of collapse of the whole payment system due to the failure of one or two “too big to fail” banks would be eliminated. Congress then could not be frightened into giving huge bailouts to some banks to avoid the “contagion” of failure, because the money supply is no longer controlled by the private banks. Any given bank could fail by making imprudent loans, but its failure, even if a large bank, would not disrupt the public utility function of money. The club that the banks used to beat Congress into giving bailouts would have been taken away.
Sixth, the explicit policy of a constant price index would reduce fears of inflation and the resultant quest to accumulate more as a protection against inflation. Also it in effect provides a multi-commodity backing to our fiat money.
Keynes bancor scheme or a regime of fluctuating exchange rates would automatically balance international trade accounts, eliminating large surpluses and deficits. Thus, there would no longer be any need for the International Monetary Fund and the austerity its “conditionality” imposes on weaker economies.
To dismiss such sound policies as “extreme” in the face of the repeatedly demonstrated failure and fraud of our current financial system is quite absurd. The idea is not to nationalize banks, but to nationalize money, which is a natural public utility in the first place. The fact that this idea is hardly discussed today, in spite of its distinguished intellectual ancestry and common sense, is testimony to the power of vested interests over good ideas. It is also testimony to the veto power that our growth fetish exercises over the thinking of economists today.