Robert P. Murphy does not understand banking

In his article Banks Can Perform Their Two Functions With 100% Reserves, Robert P. Murphy writes:

Let’s start with the basics: There are two functions that banks serve:

(1) They act as credit intermediaries, in which the banks take funds from savers and channel them to borrowers.

(2) They act as warehouses, in which the banks store their customers’ deposits in huge vaults and provide services such as check-clearing and ATMs.

Murphy does not get the basics of banking right. Actually banks perform two main functions: payment managers and financial intermediaries (debt or credit intermediaries). Banks are not money warehouses; deposit contracts are not warehousing contracts. Banks perform their payment management function by issuing their own liabilities (bank notes and demand deposits) and ideally backing them with very short term and very low risk assets. Only a small part of those assets is money proper, therefore banks naturally operate with fractional reserves. Bank liabilities are not money in the strict sense (outside money, probably some commodity) but money substitutes, promises to pay money, fiduciary media (inside money). They are used by their clients because they can be more convenient than using only money. The problem with banks is not fractional reserves, but maturity and risk mismatch between their liabilities and assets (borrowing short and low risk and lending long and high risk).

According to Murphy:

100% reserve banking is possible in a market economy.

It is possible in the same sense that less efficient and competitive agents are possible: in principle they are not impossible, but competition tends to expel them from the market.

100% banking could work, yes: badly.

Liquidity mismatch does not create social value

Mainstream economists do not understand the problems with maturity and risk mismatch, also named liquidity mismatch:

The IGM forum responses to this statement “There is a social value to having institutions that issue liquid liabilities that are backed by illiquid assets” are depressing.

The problem is that illiquid assets do not actually properly “back” the liquid liabilities, or they back them badly and unsafely.

The quality of the liabilities depends on the quality of the assets: illiquid assets imply illiquid liabilities. People may wrongly believe they are liquid, but in fact they are not, as banking and financial crises show.

It is like selling security services, making people think they are safe, and then providing the service poorly, so that risk is actually much higher than people think it is.

Martin Wolf and money

Money and banking are relatively complex issues and can be misunderstood in multiple different and sometimes complementary ways: different people understand and misunderstand different parts and then contradict each other. Many intellectuals are right when they criticize the misunderstandings of others, but they are wrong when defending their own views. They seem to think that because they know some cases of how others misunderstand money and the current monetary system, which is often correct, they do actually fully understand money and banking, which is most often not correct. They see errors in others but not their own ones.

Martin Wolf’s latest article (Strip private banks of their power to create money) about money and banking is a good example of how intellectuals and professional economists misunderstand money, banking, finance and the State.

The title is already wrong, as Wolf himself seems to recognize in the article:

Some people object that deposits are not money but only transferable private debts. Yet the public views the banks’ imitation money as electronic cash: a safe source of purchasing power.

Banks do not create money. They create money substitutes, private liabilities or IOUs that are often (almost always) accepted as means of payment, but they are not money in a strict sense. If the public mistakes them for completely safe money, that is the public’s problem: maybe some monetary education would help. That education will hardly come from Wolf.

Banking is therefore not a normal market activity, because it provides two linked public goods: money and the payments network.

Again, banking does not provide money.

Banking is a peculiar market activity, but in the market every activity is not normal in the sense that it is different from every other activity in some aspect.

Wolf seems to be logical and rigorous: he uses words like “therefore” and “because”. In reality he is rather clumsy in his arguments.

Money is not a public good. Money is a social institution and a network good. They are not the same thing, and mistaking them is a serious and disqualifying intellectual error. Money is easily excludable and its consumption is clearly rival. What money is today is a politicized good, highly intervened by the State. And that is why it works so badly.

On one side of banks’ balance sheets lie risky assets; on the other lie liabilities the public thinks safe. This is why central banks act as lenders of last resort and governments provide deposit insurance and equity injections. It is also why banking is heavily regulated. Yet credit cycles are still hugely destabilising.

The first sentence is true and very important: it is risk mismatch, which, although Wolf does not mention it, probably because he believes it is not important, goes together with maturity mismatch. The rest of the paragraph is completely upside down. Credit cycles happen and are hugely destabilising because banks perform maturity and risk mismatch; but they do it because central banks act as lenders of last resort and provide them with cheap refinancing when the market does not, because deposits are theoretically (not really) insured and therefore depositors do not keep an eye on their banks and discipline them, because the State injects equity (bail-outs) instead of having creditors assume losses (bail-ins) or letting imprudent insolvent banks fail, and because banks are heavily and clumsily regulated and supervised by the State.

Wolf compares creating private money (again, this is not the case) with printing counterfeit banknotes: one is legal, the other illegal. Wolf does not see that the counterfeiter is committing fraud; the bank is offering its liabilities as monetary substitutes which in principle nobody should be obligated to accept; unless the State forces them as legal tender, but this would be a problem caused by the State.

Wolf thinks that “the interdependence between the state and the businesses that can do this is the source of much of the instability of our economies”. He never considers eliminating State intervention and letting banks do their job and fail if they do it poorly. And he does not mention one side of the financial interdependence between banks and the State: how the banks buy State debt so that it can obtain cheap financing for its ever growing unsustainable spending.

Wolf understands that “banks create deposits as a byproduct of their lending. In the UK, such deposits make up about 97 per cent of the money supply”. And he thinks this should be terminated.

He does not mention that the problem is the maturity and risk mismatch caused by creating (short term) demand deposits as a byproduct of long term lending. There is no problem in the fact that most means of payment are not actually money but money substitutes: this is what happens when people pay each other with promises to pay, most of which will compensate each other and cancel out, and actual money is only exchanged in order to settle debts that cannot be compensated.

Wolf analyses possible minimal changes to the banking system: tighter regulation and more bank equity or loss-absorbing debt. The problem with this approach is that nobody really knows what regulation is adequate and how much capital is necessary; technocrats think they know, but actually only the market process can partially discover the solutions via trial and error.

Wolf then proposes a maximum response: give the state a monopoly on money creation. The problem is that this already exists: only the central bank can create base money. Base money is not a very good money as gold or silver used to be, but this is what the State has produced. There is no external money, all money is internal to some bank, private or public.

Wolf explores the proposal of the requirement for 100 per cent reserves against deposits (Chicago Plan and other modern versions): but he does not explain what he means with “reserves”, what their nature must be.

Under this proposal the State, not banks, would create all transactions money. Money would not be a free market good. It would be fully based on State coercion. Some people neither mind nor see the problems with this. Maybe they think the State is wise and non-coercive.

Customers would own the money in transaction accounts, and would pay the banks a fee for managing them.

Why should these accounts be in banks? If we are going to nationalize money, why not also the entities that hold those money accounts? What will the fee be? Aren’t there any opportunity costs in holding cash balances?

Banks could offer investment accounts, which would provide loans. But they could only loan money actually invested by customers. They would be stopped from creating such accounts out of thin air and so would become the intermediaries that many wrongly believe they now are. Holdings in such accounts could not be reassigned as a means of payment. Holders of investment accounts would be vulnerable to losses. Regulators might impose equity requirements and other prudential rules against such accounts.

This part seems great: saving and investment seem to be matched. They seem to be because Wolf does not explore the possibility of borrowing short and lending long, or borrowing low risk and lending high risk, which is still open. At least the payments system and the financial intermediation system do not interfere destructively as they do now.

Wolf insists that banks right now are not financial intermediaries and that many wrongly believe them to be so. Wolf is wrong: banks are financial intermediaries; the problem is that they are not only financial intermediaries and that they are imprudent financial intermediaries. Demand depositors are not the only creditors banks have. Yes, banks create deposits when giving loans, but banks also look for other longer term creditors to borrow from them: maybe they sell them the loans they created, or use them as collateral to borrow funds.

How will the money be created, according to this system? Easy:

The central bank would create new money as needed to promote non-inflationary growth. Decisions on money creation would, as now, be taken by a committee independent of government.

Finally, the new money would be injected into the economy in four possible ways: to finance government spending, in place of taxes or borrowing; to make direct payments to citizens; to redeem outstanding debts, public or private; or to make new loans through banks or other intermediaries. All such mechanisms could (and should) be made as transparent as one might wish.

This assumes that the central bank can promote non-inflationary growth. Good luck with that. The independent committees and the transparency sound very well: wish they could be real and competent.

The State is supposed to be all-knowing and good, caring for the welfare of all. It will never abuse its powers to create more money and cause some inflation. It will never make loans to benefit some at the expense of others. It will never devalue its currency competitively against other nations.

Wolf sees the advantage of increasing the money supply without encouraging people to borrow too much, and of ending “too big to fail”. But in order to achieve this all you need is truly free markets in money production (probably gold and silver) and banking. The State is unnecessary and the State is dangerous, specially if it controls money fully.

Our financial system is so unstable because the state first allowed it to create almost all the money in the economy and was then forced to insure it when performing that function.

Again, that story is completely backwards. The State is not “forced” to do anything. The State, incompetent as it is, does what it wants: it protects and saves its allies.

This is a giant hole at the heart of our market economies. It could be closed by separating the provision of money, rightly a function of the state, from the provision of finance, a function of the private sector.

We do not have market economies. At least not free market economies, by a very wide margin. Some people seem unable to notice the difference, and that explains a lot.

Yes, there is a hole in them. Actually, there are many holes in them. But they will not be plugged with wrong advice.

Separating payments management from finance is an important and a good idea. Uniting money and the State even more than they are now is a very bad idea. The provision of money is not rightly a function of the State, but a free market institution. Wolf wants to play the moralist: he knows what is right and wrong; he also fails here.

One last question that comes to my mind: for international trade and investment, what state provided money are we going to use? Or do we need a world government for that?

More on Arnold Kling and banking

He writes:

I would like to see this whole issue analyzed in terms of signaling. With free banking, I suspect that we would get cyclical movements in the perceived soundness of banks. People would grow to trust the signals of at least some banks more and more, until those banks abuse that trust. Then, when people lose money, the trust will drop way off.

The same thing happens under regulated banking, of course. Which is where those government guarantees come in.

The question I have is whether a system of government guarantees produces an overall higher level of economic growth. It could do so by giving people more confidence in financial intermediaries on average through time.

It could be that putting the symbol “FDIC insured” on the door of banks is a very inexpensive signaling mechanism with a lot of social benefits. It could be argued that without that signaling mechanism, financial intermediation would be much more costly than it is today.

I am not saying that this is definitely true. However, I do think that it is the key issue in banking theory. It is all about the costs and benefits, including moral hazard and regulatory costs, of different signaling mechanisms.

Signaling is an important issue in the evolution of cooperation. Signals that work by providing accurate information are hard to fake, usually by being expensive: inexpensive signals do not work well. The best signals are simple and sincere ones: if a bank wants to signal financial soundness it can do so by being financially sound and proving it with good and clear accounting. Trust is hard to gain, and entities like corporations with long lives and stable, continuous and repetitive relationships cannot risk jeopardizing their reputation: abusing trust is not a long term successful strategy; signaling is an investment in trademark.

The possibility of cheating always exists, but government regulation is not only not a good solution, but probably the worst possible one.  The best way to minimize cheating is to make people responsible for their own dealings, so that they stay alert and can at least learn from their mistakes. Having many decentralized motivated cheater detectors is far more powerful that having a few technocrats in charge of a rating bureaucracy. Confidence is not necessarily a good thing: trust is useful when the trusted entities work efficiently; simply promoting confidence creates an environment of naive trust ideal for cheaters to prosper. Those people not interested in investigating the true situation of the entities they deal with can use the services of professional raters, but there is no guarantee that the raters will be completely honest or impartial. Guarantees are never perfect or final, but government guarantees create an illusion of safety. Free competition is necessary in the provision and supervision of all goods and services: government insurance not only socializes the cost; what is more problematic is that is establishes unique official standards of conduct that are not known with certainty to be adequate (and most certainly are not), but are generally and wrongly perceived to be so (there are no alternatives to compare with).

Regarding cyclical movements, they are probably a feature of systems with a strong dependence on a single important entity, and this is the case with government regulation: since it cannot be perfect maladjustments will tend to accumulate until they are no longer sustainable and the system breaks down. A monopolistic regulator trying to stabilize the system it controls will probably destabilize it even more by failing in the intensity and the timing of its interventions.

A system with many competitive elements and interactions can compensate the fluctuations of some elements with the opposite fluctuations in other elements. Complex adaptive systems are like homeostatic organisms: too complex to be purposefully designed or controlled, they adapt by means of multiple decentralized interactions. Banks are not only controlled by their depositors and shareholders: they are also limited by the competition of other banks which can inform potential customers of the dangers associated with the risky behaviors of the least trustworthy firms (and of course companies can lie about their competition). The distributed information of market watchers can be gathered in the secondary markets of private bank notes where all people are free to prove their knowledge by means of their financial bets.

Arnold Kling on bank regulation

Arnold Kling is always very interesting and informative.

But he writes:

We want to provide consumers with bank deposits that are insured. To protect taxpayers, we want to prevent insured banks from taking significant risks. Therefore, banks should be very closely regulated.

Who is that “we”? How does he know what “we” want? What if insuring bank deposits turned out to be expensive and in itself risky (moral hazard)? I do not want to provide consumers with bank deposits that are insured: I want depositors to look after the safety of their own deposits, and in this way control the banks. Taxpayers and the state need not be involved in insuring or regulating banks. Functional and legitimate regulation comes from below, from competitive and evolving contractual arrangements between interested parties, not from far away and detached bureaucrats.

And of course the state should be separated from money production and management.