Bureaucrat Worried About His Job

Here

By observation and logic regulationism was at the heart of the events leading up to the 2008 credit crisis.  It was the predictable, abject and unremitting failure of governments and their bureaucratic Satraps engaging in credit expansion and niaive and incompetent (based on their ignorance and their own self regarding arrogance) bank regulation especially as regards the quantity and quality of their capital requirements that encouraged Banks in their own (and ultimately unsustainable) monetary expansion.  The result being an absolutely text book Austrian Business Cycle theory failure.

In fact the sheer quantity of regulationism has made Banking a de facto nationalised industry: a state sanctioned specially privileged cartelised supplier of a monopoly product engaged in couterfeiting.

So then we get self serving bureaucrats like Randall clamouring for more regulation post Brexit. One might have thought he was worried about his job.

Janet Yellen

Central bank interest rates cuts vs commercial bank profits

From today's Daily Mail:

Australia's wealthy banks are set to hang on to $917 million by not passing on the Reserve Bank's record interest rate cut. The big four banks - ANZ, Commonwealth Bank, National Australia Bank and Westpac - made only modest reductions to their standard variable mortgage rates and gave customers about half of the Reserve Bank's reduction of 0.25 per cent...

It comes after Prime Minister Malcolm Turnbull was left unimpressed and demanded an explanation from the bosses of the big banks for not passing the official rate cut on in full.

"They operate with a very substantial social licence," he said, "They owe it to the Australian people and their customers to explain fully and comprehensively why they have not passed on the full rate cut."

I like his emphasis on "social licence" i.e. government granted privileges.

Also from today's Daily Mail/This Is Money:

Britain's big banks are facing a £1.3billion hit to their profits if, as expected, the Bank of England cuts interest rates on Thursday.

There are fears that the banks could attempt to contain the damage by not passing on the benefit of lower rates to borrowers – risking fury from customers and regulators. Very low interest rates squeeze bank profit margins, so there will be further losses if the 0.25 percentage point cut is passed on to customers.

It's either one or t'other, surely? Unless UK banks are net depositors with the central bank and Australian banks are net borrowers from the central bank?

Economic Myths: Debt free money

Lots of people who refuse to accept basic principles believe there is such a thing as "debt free money". If you Google it and follow a couple of links you end in a sea of raving gibberish like this from zerohedge:

This organization (Committee On Monetary/Economic Reform) is demanding that our corrupt government and the nefarious central bank which rules above it return Canada’s monetary system to the issuance of debt-free money.

In turn, the phrase “debt-free money” is relatively easy to define: issuing currency from our central bank, into the economy, without (literally) “borrowing it” into existence – i.e. attaching debt to every unit of currency.

Again, some readers not familiar with our current monetary system may require some additional clarification (as they discover the horror/insanity of our present system)… However, at roughly the same time our (now) now corrupt governments began corrupting our economies, they also totally corrupted our monetary system. 

The gold standard was abolished (assassinated by Paul Volcker), and our governments began creating their so-called “money” from debt – i.e. our governments forced themselves to “borrow” our own currencies, from these corrupt central banks, as the mechanism for our money-printing.

As an aside, this person doesn't understand that the government doesn't and can't borrow from the central bank because the central bank is part of the government. You can't borrow from yourself or lend yourself money. He contrasts this with the central bank issuing currency without borrowing it. That is impossible. Whoever issues currency, be that coins and notes, money, bonds, IOUs or numbers on a computer screen is borrowing. He contrasts two scenarios which are exactly the same.

"But it's not borrowing!" squeal the nutters, "The government doesn't ever have to repay its debts, they can just mount up for ever."

Yes, fair point, in practice, governments don't ever repay most of their debts, they just get rolled forward again and again. But if interest is payable on those debts, that't a teeny tiny bit of a bit of a hint of a cluesy-woozy that it's borrowing.

Next argument, "But in today's world, government don't need to pay interest any more, or are even paying negative interest" (which is like a bank charging you an account fee even when your deposit account is in credit, which is not that unusual). That is also true, although this is an unusual situation and we don't know how long it will continue.

Nonetheless, even if the debts are interest-free and will never be repaid, it is still borrowing and that borrowing is debt. The flip side of money is always debt (physical gold is not money for these purposes).

Consider the simple question, everything else being equal, which government is "richer", Government A which has absolutely no public debt or Government B which is drowning in debt (or has issued endless paper money with nothing to back it up like Zimbabwe or Weimar Germany)?

It's not difficult is it? Government A is 'richer'. Why? Because it has no liabilities. Even if Government B never pays interest on its debts or repays those debts, then it has less scope for manoeuvre. If Government A were temporarily strapped for cash, it could issue extra coins and notes, or bonds or whatever and people would accept those as valid, so Government A can procure the services it needs.

Government B no longer has this option, it has already used up its credit line by, er, borrowing. If the absence of something makes Government A richer, the something that is absent is debt or borrowings or liabilities.

Here endeth.

Golden rule: the first person to use the meaningless word 'reserves' has lost the argument. I will delete all comments which include that word.

So, the Truth is Out - Finally

Headline from the Telegraph:

How central banks have lost control of the world

Positive Money

A few people have asked me what I think about the proposals put forward by Positive Money:

Positive Money believes that the root cause of many of our current social, economic and environmental problems lies in the way that we allow money to be created. We campaign for fundamental reform of a system that is fueling debt, poverty and our economic and environmental crises.

Good start, agreed so far.
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They have a good page explaining how the banking system works in general, the nub of which is this:

A customer, who we shall call Robert, walks into RBS and asks to borrow £10,000 to buy a new car. Robert signs a contract with the back confirming that he will repay £10,000 over a period of five years, plus interest. This legally enforceable contract represents a future income stream for the bank, and when the bank comes to draw up its balance sheet it will be included as an additional asset worth £10,000.

Robert, having committed to pay the bank £10,000, wants to receive his ‘loan’. So RBS opens up [a deposit] account for him, and types in £10,000. This is recorded as a liability on RBS’s balance.

Notice that no money was transferred or taken from any other account, the bank simply updated a computer database. A bank does not ‘lend money’ – to lend one must have money to lend in the first place. In reality a bank creates credit – money – when it advances loans.

A process which we can refer to as 'splitting the zero'. At least with a car loan, the bank is oiling the wheels of commerce a bit. Robert gets his car earlier than otherwise, the manufacturer can sell an extra car and the bank assumes the risk of non-payment by Robert (instead of the manufacturer having its own leasing-finance division, which many of them do).

Apply the same process to buying land, and the bank isn't actually providing anything (it does nothing to create the land rental values), it's just merrily splitting the zero, paying 2% on the deposit side and collecting 5% on the loan/mortgage side, so ultimately it is collecting land rent. If prices are high enough and interest rates are high enough, the bank is collecting more than the total rental value - from buyers who reckon that it is worth taking a small extra net monthly outlay on the chin (mortgage interest exceeds rental value) in order to make capital gains (and there are hundreds of thousands, if not millions, of such people at the moment).
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They point out that the bulk of bank lending is for purely speculative purposes and address the housing bubble:

If you allow banks to create money when they make loans, and you allow them to pump the bulk of this newly money into a housing market with relatively limited supply, then house prices will go up...

A rising house price was treated like an unexpectedly sunny bank holiday; everyone was expected to rush to take advantage of the opportunity before it was over. I don’t recall seeing any decent analysis explaining that overall, constantly rising house prices simply benefit banks and the few individuals who plan to sell up and move into an old folks’ home or a caravan.

Again, completely agreed. If you minus off bricks and mortar from house prices, what you are left with is land speculation. Land prices are the product of about four variables:
+ the actual rental value of any site
- recurring taxes thereon
x availability of credit
+/- bubble/hope/despair element.

To choke this off you just need to bring the end value down to zero. Gross land rental values are A Good Thing of course, but if we taxed away those rental values, there'd be nothing left to speculate on. And the big bonus is that we can then phase out all the bad taxes on earned income, output and profits. Or a government could credibly threaten to do something which would cause land prices to plunge in the near future so that the negative 'despair' element brought selling prices down to nothing.
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Positive Money are mildly sympathetic to Land Value Tax, but their preferred method is to reduce the amount of credit which commercial banks can create, which they explain here (pdf).

Briefly and broadly speaking, there will be two kinds of deposit account:

* Transaction accounts, which will be backed 100% by government bonds or deposits at the Bank of England, which will pay little or no interest and which will bear charges. So the government can limit the total amount of money in these accounts by reducing the amount of government bonds in issue or the BoE refusing to accept any more deposits.

* Investment accounts... In order to lend money after the reform is implemented, banks will need to find customers who are willing to give up access to their money for a certain period of time. In practice, this means that the customer will need to invest their money for a defined time period (1 month, 6 months, 2 years, for example) or set a minimum notice period that must be given before the money can be withdrawn (e.g. 7 days, 30 days, 60 days, 6 months).

Banks will then operate in the way that most people think they currently do - by taking money from savers and lending it to borrowers (rather than creating new money (deposits) whenever they make a loan, and walking a tightrope between maximizing profit and becoming insolvent).
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Well, no.

On a purely practical level it will be easy to circumvent this and banks will be able to merrily continue splitting the zero so that people can speculate on rising land values.

i. Wadsworth Bank plc holds some spare government bonds, not matched by and in excess of WB's transaction accounts.

ii. Robert wants to take out a mortgage. WB can only make this loan by lending him some bonds. WB records this as a financial asset (it doesn't matter whether WB gives him notes and coins, a cheque or a number on a computer screen, the loan is always recorded as an asset in £-s-d in WB's books).

iii. Robert gives those bonds to the vendor, who turns up a few minutes later at WB (or any other bank, doesn't matter as banks are a closed loop) to deposit his bonds safely.

iv. WB's counter staff explain to the vendor that they are happy to open a transaction account to hold his bonds, but point out that if he leaves his money there, he will earn zero interest. Would the vendor not like to transfer money from his transaction account to an investment account paying a few per cent interest?

v. So the vendor does so. This means that WB no longer has to hold those bonds in a matched account on the vendor's behalf; WB now holds them as spare bonds on its own account again, which is can lend to the next would-be purchaser who walks through the door. Rinse and repeat.

vi. The end result of this is that while the total value of transaction accounts at WB and all other banks is fixed and constant, the total value of its assets (money lent to purchasers) and the total value of its investment accounts (money taken from vendors) is unlimited, and WB is still 'splitting the zero' into ever increasing amounts of mortgages and investment accounts.

vii. So we get the house price bubble going again nicely, until it all goes wrong again, at which stage the government steps in to guarantee investment accounts again.

For sure, we can think up all sorts of extra measures to stop banks from circumventing this, for example by making loans to acquire land (in excess of the rebuild cost/value of buildings thereon) unenforceable, not registering them at HM Land Registry etc.

But the land rents will still be collected privately; if current land owners can't sell to mortgage borrowers then vendors will just sell them to real Estate Investment Trusts in exchange for shares, and then the vendors can sell the shares for cash, or something, and if the REIT wants to sell residential land, it will do so with Islamic mortgages (where the borrower is legally a tenant for a fixed rent for a long fixed period, and ends up repaying exactly the same amount as if he'd taken out a mortgage at interest).
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Finally, Positive Money make the assumption that the UK government actually wants to do anything about banking and land speculation. (The idea of taxing the rental value of land instead of taxing earned income faces the same problem, of course, but at least with that you can make it immediately clear that there would be far more winners than losers, hoping to grab the votes of the winners, and that the overall gains to society or to the economy would vastly outweigh any short-term collateral damage.)

The UK government has no intention of doing anything to cut the banking sector down to size or to end the house price bubble. Not only does this ensure them the continuing support of the vested interests and the promise of cushy well-paid jobs once they are booted out of office, in a perverse sort of way, rising house prices have shown themselves to be electoral gold.
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And even if we the UK government were entirely benevolent and motivated by the overall interests of its citizens, how will they know what the correct total level of transaction accounts is?

What's the point of that then? (2)

Anon alerted me to this in The Daily Telegraph:

Fearful banks parked a record €411bn (£344bn) with the European Central Bank (ECB) last night in a further sign that Europe's financial institutions are becoming increasingly wary of lending to each other.

The record amount was deposited just a week after the ECB lent 523 eurozone banks a total of €489bn in cheap loans in an attempt to keep credit flowing through the economy and prevent a full-scale credit crunch. Banks borrowed the money at the ECB's benchmark rate of 1pc, but receive an overnight rate of just 0.25pc, well below what they could earn in wholesale markets.

This means lenders are depositing any new cash back with the ECB at a loss in order to guarantee safety.

There's not much I can add to that, except to note that maybe this is how the ECB borrowed the money which they lent out a week or two ago, and the ECB is taking a 0.75% cut as insurance for guaranteeing inter-bank lending between banks with spare cash and banks with not enough cash, which seems perfectly fair to me.

The other possible explanation is that there are banks so stupid that they borrow money from the ECB with the sole purpose of depositing it back with the ECB.

What's the point of that then?

From the BBC:

Eurozone banks have rushed to take out cheap three-year loans offered by the European Central Bank, borrowing 489bn euros ($643bn; £375bn). The central bank had hoped to lend up to 450bn euros to stop another credit crunch crippling the banking system. When the plan was announced, French President Nicholas Sarkozy said banks could use the money to invest in eurozone sovereign debt.

Right, so the ECB, which is explicitly or implicitly backed by EU member state governments, has borrowed money from sources unknown the German central bank* (it has no real money of its own) and lent this to commercial banks cheaply, in the hope that the self-same commercial banks will then lend the money back to EU member states, thereby presumably generating a profit for themselves?

Yes, I know Article 123 of the Lisbon Treaty the EU Constitution says that member states aren't supposed to lend directly or indirectly to other member states** (since when have they ever cared about their own rules?), so they can't just brazenly cut out the middleman, but isn't the transaction entirely circular anyway?

If you strip out the commercial banks as middlemen, all that is happening is that member states have clubbed together to create their own supra-national central bank, the ECB and are not only financing this but also borrowing from it.
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* UPDATE: Ralph Musgrave emailed me that bit.

** UPDATE, Denis Cooper has emailed me to say this:

It's Article 125 which prohibits member states from becoming liable for or assuming the commitments of other member states, while Art 123 prohibits the ECB from direct purchases of debt instruments, but there's also Art 124 preventing
"Any measure ... establishing privileged access by ... central governments ... to financial institutions ... " and if the ECB is lending money to banks specifically to lend on to governments then that seems to me to be "privileged access".

Then there are articles about "the principle of an open market economy with free competition, favouring an efficient allocation of resources" and the ECB conducting "credit operations with credit institutions and other market participants, with lending being based on adequate collateral", and it seems that all of that is being disregarded so it's hardly worth reciting all the details.

Not true; true; missing the point completely.

Allister Heath rants on in today's City AM:

If anything, today’s problem is even greater than that: it is clear from the global government debt crisis that fiat money – currencies entirely detached from any commodity or anchor and produced entirely at the discretion of government agencies – has failed. (1)

Its adoption has abolished all restraints on governments and has meant that currencies keep being devalued and inflated away.(2) Eventually, we will need a new monetary system more in tune with the principles of capitalism and sound money – until then, expect tensions between central bankers and governments to rise and rise.(3)

1) Not true. Although superficially a government cannot finance itself by handing out bits of paper, on the facts it works surprisingly well.

Sometimes governments introduce paper currencies by accident, and people work out how to use them: for example, food rationing vouchers. Ignoring undeclared production and the grey market, we know that each household or each person has different preferences, so those people who don't need to redeem the full value of their vouchers can sell them to those people who want more than their state-allocated ration. So the former group sells their surplus vouchers to the latter group.

You can see handing out the vouchers as a universal benefit/Citizen's Income as well as a tax on buying food; if you want more, you have to pay somebody for their surplus vouchers.

2) True. So although the physical vouchers have no intrinsic value, the fact that the government does not just create them but also taxes them away again gives them value. And the same basic principle applies to any paper currency: as long as the government is not running a deficit (i.e. it is printing/spending at the same rate as it is taxing/collecting them) the value of the vouchers is largely stable.

It is only when the government prints more vouchers/bank notes/government bonds than it is collecting back in again (as taxes) that the value of vouchers is diluted.

3) Missing the point completely. I'm no big fan of deficit spending as a long term plan, and would prefer UK government spending to be reduced by about a quarter*, down to the level of taxes it currently collects (easily do-able if you chuck out all the theft and waste).

But government deficits (to which there is always an equal and opposite asset, such as money deposited with National Savings & Investments or held in the form of government bonds or even bank notes and coins) are not the largest debts of all; the total value of outstanding debts secured on land and buildings (and the corresponding assets) are about twice as much* by volume.

As illustrated above, government debts are secured on publicly collected taxes and mortgage debts are secured on privately collected taxes, i.e. ground rents. The total value of UK ground rents has barely increased over the last ten or fifteen years*, so how come the total value of mortgage debts has doubled or trebled*? That's where the bulk of your [monetary] inflation comes in.

* Don't quote me on the exact fractions and percentages, I'm talking ball park figures here.

This whole central banking lark is trichier than it looks

Short Lists

Mike W aced the last one - the three most famous admirals ending in "-itz" are of course Tirp, Dön and Nim.

Right. Our next Short List is "Countries which have never devalued their currency; 'restructured' or defaulted on their national debt; taken a bridging loan from the IMF; accepted soft loans/grants under Lend/Lease, Marshall Plan, or from World Bank or EU; received overseas aid; nationalised foreign-owned assets etc."

"Posen: We need QE to start again"

From City AM:

QUANTITATIVE EASING (QE) must be restarted if Britain's bankers are to avoid persistent high unemployment and economic stagnation, Bank of England Monetary Policy Committee (MPC) member Adam Posen said yesterday.

In a speech delivered in Hull yesterday, Posen was the first MPC member to call explicitly for a second round of QE, which he described as "The Royal Mint issuing 502 pence in coins and exchanging them for five pound notes held by commercial banks". His comments put him on a collision course with fellow policymaker Andrew Sentance, who has been calling for slightly lower subsidies to the banking system since June.

Posen argued: "It is right for both long-term stability in the City and short-term performance for banker's bonuses."

He warned that policymakers’ well founded fears of inflation should not lead them to settle for weak growth in the banking sector or in house prices: "The risks that I believe that we - bankers, land owners and politicians alike - face are the far more serious ones of sustained low house prices turning into a self-fulfilling prophecy, and/or inducing a political reaction that could undermine the commercial banks' long-run stability and prosperity.”

Posen has not yet voted for further monetary loosening but said that his vote at the next meeting was pretty much a foregone conclusion.

"Although we find Mr Posen’s analysis sobering and plausible, the reactions to Charlie Bean's 'Spend, spend, spend!' speech suggest that we are losing the propaganda war, and that it will take further back scratching and palm-greasing before a majority of MPC members is to support a QE extension," said Barclays Capital’s Simon Hayes.

Eagle-eyed Pedant Of The Week

The Bank of England have tee'd up a short video to explain how they are going to try and keep the Home-Owner-Ist bubble going at your expense (I will return to the substance of this later on). If you watch the text at the bottom of the screen carefully, you'll notice an awful typo at about 14 seconds in (click to enlarge):

Spotter's badge, Devo (comment 5 here).

Spend, spend, spend!!

Killer arguments against LVT, not (68)

I've just rediscovered this brief exchange over at HPC (comments 20 and 21):

Capitalist: I don't go for this land tax Georgist nonsense. Nor taxing wealth*. Two wrongs don't make a right. The real problem lies with having interest rates set by a group of bureaucrats and government support for fractional reserve. Remove those problems and the rest disappear. The market would have solved the asset pricing problems had interests risen, as you would expect them to do in a credit crunch.

Drewster: Not true. The American writer Henry George wrote his treatise on Land Value Tax in 1879; but the Federal Reserve was only founded in 1913. Land value bubbles existed long before central banking**.

Yup. LVT opponents will resort to any lie, any distortion and any generalisation; and to be able to counter this stuff, you really have to know your stuff and be on your toes, which Drewster clearly does and is.

* The Home-Owner-Ists are keen to portray land 'ownership' as just the same as any other form of 'wealth' (which it quite patently isn't) just to muddy the picture.

** See here for a reprint of an article from 1902 which mentions the bubbles/busts in the USA in 1837, 1857, 1875 and 1893, i.e. the good old eighteen year boom-bust cycle.

Reader's Letter Of The Day

From the FT:

Sir, In the hubbub over the current budgetary situation one frequently hears that the UK has a recent history of effective default by unilaterally reducing the coupon on government debt. Indeed, Carmen Reinhart and Kenneth Rogoff, in their recent book on financial folly, list the war loan conversion of 1932 in their table of examples of domestic default or restructuring and, perhaps as a result, this example has gained wide currency.

The pre-1932 stock, 5 per cent war loan was repayable at three months’ notice between 1929 and 1947. In late 1931 market interest rates had fallen, so that it was in the taxpayers’ interest for the government to redeem the debt and to issue new stock at a lower interest rate. This became 3½ per cent war loan repayable in 1952 or afterwards.

This was in no sense a default or a unilateral rescheduling but was entirely in accordance with the prospectus of the 5 per cent stock, as the chancellor of the time explained to the House of Commons. I imagine that the same was true of the 19th century conversions, also listed by Reinhart and Rogoff as default or restructuring.

M.R. Weale,National Institute of Economic and Social Research, London SW1.

Being accused of having said things I never said

DBC Reed left a comment on Are central bankers really this stupid..?:

As I have said: your views that bankers are middlemen and are unjustly maligned is so unusual that you really need to adduce some evidence, quotations from other people, books and standard works of reference to back them. That is to satisfy the normal terms of written debate or academic discourse.

I never said they were unjustly maligned, they deserve all the kicking that they can get IHMO, but whichever way you look at it, they are middlemen between borrowers on one side; and depositors, bondholders and shareholders on the other (the precise distinction being a legal rather than an economic matter). The bank's net assets/shareholders' capital as a percentage of total assets/total liabilities is absolutely tiny - I believe that DBC himself mentioned the figure of three per cent, which sounds about right.

There is little point quoting people, banking is a very mechanical thing, let's understand the mechanics before we worry about polemics, or what the 'solution' might be, if any exists.

It is quite clear how everybody but you is using the term reserves as in the quote from The Times: they clearly mean bank money not loaned out or possibly on quick call (Libor money).

OK, we hereby agree to use common parlance - "reserves" now refers to liquid assets, that's fine.

"In the course of issuing money the commercial banks actually create it by expanding their deposits,but they are not not at liberty to create money all they may wish, whenever they wish, for the total is limited by the volume of bank reserves and by the prevailing ratio between these reserves and bank deposits - a ratio that is set by law, regulation or custom."

Yes, I agree with that statement and have said so myself often enough*, although the more modern approach (which I loosely refer to as Basel capital ratios) is to look at the ratio between shareholders funds and total deposits.

Kitty Ussher then at the Treasury: "By far the largest role in creating money is played by the banking system itself... When banks make loans they at the same time create a new deposit.."

That is saying the same thing, and again, I agree. However, once the dust has settled, the bank ends up with an asset (the loan to the borrower) and a liability (the new deposit it has created), and henceforth, it is a middleman between the two parties.

Remember that pecunia non olet: once the loan and deposit have been created, what happens after that is exactly the same as what would happen were the system to work the other way round, i.e. the bank waits patiently until people make deposits and keeps putting the cash received into "reserves" (as defined above) until it has enough to make a new loan.

Of all the money I have in bank accounts, it is impossible to tell which of it is my hard-earned net salary, and which of it is the easy money I made from selling flats and houses or my capital gains. The bank simply does not care, and the person who ultimately borrows the money will never find out, it all gets mixed up.

Even in a non-technical way, bankers are primarily middlemen in creating credit and asset price bubbles - they prey on the gullible who think that house prices or share prices can only go up by lending them money; and the more cynical people exchange what they think are overvalued houses or shares into a deposit at the bank (but not that cynical that they don't even trust banks!). The fact that the new loans and new deposits are created more-or-less out of thin air is a separate topic - the bank (i.e. the shareholders as a body) still only own three percent of the whole shooting match.

You could also argue that politicians, Home-Owner-Ists, estate agents and property pornstars like Phil & Kirsty are only middlemen in creating bubbles - they do not in themselves buy and sell every single house, but they con people into thinking that house prices can only go up - this makes them just as deserving of a good kicking as the banks are.

* See for example here: "The point is that building bank reserves [i.e. giving them more capital, the accounting meaning of the word 'reserves'] will not increase the bank’s capacity to lend. Loans create deposits which generate reserves."

Are central bankers really this stupid or was he just badly reported?

From The Times:

Everyone needs a guru, even the Governor of the Bank of England. When Mervyn King mentioned him by name three times during evidence on the future of Britain's banking sector, MPs were left scratching their heads over the identity of a little-known American economist who, it appears, has been bending the Governor's ear. The owlish Mr King, it emerges, has become a keen advocate of the radical ideas of Laurence Kotlikoff, an American professor of economics at Boston University...

The Harvard-educated economist wants to ban banks from lending money that is not matched in cash reserves (1). He also wants the banking regulator to approve every single mortgage sold (2) and to force banks to turn their vastly lucrative investment arms into separate consultancies.

Modern bankers keep only small amounts, relative to the loans they make, in reserve in case of crisis (3). Under Professor Kotlikoff's plans, which he calls Limited Purpose Banking, banks would be turned into mutual funds that would take no risk and lend out only what they had taken in deposits from savers (4).

1) Cretinous comment. Let's imagine that a new bank starts on Day One with £1 million in coins and notes in its safe - the minute you take some money out of the safe and lend it to a borrower then it can no longer be matched by cash reserves! Unless he means that a bank can only lend out half of its total cash, which would be hyper-cautious, to which see 3)a).

2) Yeah right. In the UK, but especially in the USA, politicians were putting pressure on banks to approve all sorts of sub-prime or self-certified mortgage loans - politicians like rising house prices to keep the Home-Owner-Ists* happy - so sticking in another layer of regulators, accountable to the self-same politicians, will either make no difference or just lead to the whole system grinding to a halt.

3) Anybody who uses the word "reserve" is usually waffling and probably a moron. There is a mismatch between common parlance and the technical accounting term - it can mean two entirely opposite things:

a) If you are referring to the "assets" side, it means stuff which highly liquid, nigh 100% safe and which can't fluctuate in sterling terms - in other words, coins and notes in a safe; balances with the Bank of England; and short term UK government bonds.

b) If you are referring to the "financed by" side, it means shareholders' funds generally, i.e. non-repayable liabilities. These are not assets.

To explain the misunderstanding, in terms of a typical household, your house is an asset and your mortgage is a liability (the words have the same meaning in common parlance and in accounting).

However, if the household also has a couple of thousand quid tucked away in a rainy day account, the common man sees these as "reserves" but in accounting terms the rainy day money is also included as "assets" (albeit current rather than fixed). Conversely, in common parlance, the value of your house minus the outstanding mortgage is called "equity" but in accounting terms, it is analogous to "reserves".

As it happens, a higher ratio of either type of "reserve" compared to the balance sheet total will lead to "safer" banking, but the question is "safe for whom?". More highly liquid safe assets makes the bank safer for depositors and shareholders; a higher amount of shareholders' funds means it's safer for depositors, but not safer for shareholders, as they have more of their own capital at risk).

4) Yup. The good old-fashioned building society model. Firstly, even a well-run and cautious building society can and does create matching loans and deposits out of thin air, as I explained for the umpteenth time yesterday**; and secondly, a building society can and does fail as well if it makes reckless loans on overvalued properties, see e.g. Dunfermline BS. The depositors in a building society bear exactly the same total risk as do shareholders and bondholders in a bank.

The main reason why building societies were seen as "safe" and why they have become riskier is because from the 1980s onwards, they were allowed to issue bonds, borrow on the money markets etc - so it's a purely behavioural thing: if you are funded by short term deposits you tend to be much more cautious with lending decisions, so I'll give him half a mark for that, I suppose.

* Disclaimer - not all homeowners are Home-Owner-Ists. Only the NIMBYs and people who prefer taxation of incomes to taxation of property are Home-Owner-Ists.

** This is only a bad thing if the loans are taken out to acquire overvalued assets, i.e. in practice most of the time.

The money-go-round: QE in practice

The UK's Debt Management Office issued £4.3 billion of new gilts last week, i.e. investors were willing to lend the government £4.3 billion, which, multiplied up would indeed support a budget deficit of £200 billion this year. On the other hand, the Bank of England bought back £6.5 billion of previously issued gilts last week.

So, last week the Bank has actually bought back £2.2 billion more gilts than the Treasury issued, bringing total purchases to £45.5 billion - gilts which have removed from the market and taken out of circulation as part of the Bank's programme of "quantitative easing", aka "rigging the gilts market".

Can this game carry on forever? Either investors will tire of being bribed to take part, but more likely the crunch will come when the Bank of England refuses to co-operate. Officially this is being done as part of "monetary policy", to ward off deflation. But if the next Inflation Report suggests that deflation is no longer a danger, then the brown stuff could start to impact the rotating vanes.

Thanks to Denis Cooper for researching and emailing me this.

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