A bank , building society that uses factional reserves, lends long and pays out short is only going to exist should confidence be kept in it. The “Run on the Rock” in the summer of 2007 saw people queuing to get their cash out of the Northern Rock which resulted in the first systematic run on a bank since the 1866 run on the Overend, Gurney & Company bank in the UK.
Readers of this site will know that a bank can only exist with the legal and accounting privilege that allows them to use current creditors – i.e. the depositors of the Presbyterian Mutual Society (PMS) – to lend out a multiple number of times to property loans and other entrepreneurial loans. Readers will also know that when they deposit money they in effect lend it to the bank and become a creditor to the bank. A deposit of cash into a bank/Mutual means you as the depositee lend money to the bank/Mutual That is, to be very clear, when you deposit, you cease to own the money – the bank does. This was established by law in 1811 in Carr V Carr and reaffirmed in Foley V Hill 1846.
The History
The Society’s audited accounts for the year ended 31st March 2008 showed £305m of loans and £5m of liquid assets to pay up to £310m on demand deposits. So one can deduce that there was only £5m of cash supporting £310m IOUs to its creditors, the depositors. This means that the PMS multiplied its credit creation to the tune of 62 times! This is nearly twice the average of all the banks licensed by the Bank of England. In fairness to the Society, they did pay out £21m before they were left with only £5m of cash, so £26m of cash was in their vaults when the run happened. Thus a more conservative 12 x credit was created out of thin air or a leverage ratio of 1 part cash to 12 parts credit existed in this Society.
A quick refresher on how the banking system allows this creation of credit out of thin air can be found here https://www.cobdencentre.org/2010/02/a-day-of-reckoning/ where I say, “ It is often forgotten but when you place £1m in a savings account (in cash) in say the Royal Bank of Scotland, which has no legal reserve requirement, they then lend £970k (in credit) , keeping on average 3% of cash back in reserves, to an entrepreneur in say HSBC, who then deposits that money in HSBC. We now have one claim to the original £1m and one claim to the £970k. The money supply has moved from £1m to £1.97m – just like magic! This is credit expansion.
The reality is that across all the banks in the United Kingdom licensed by the Bank of England, we have for every £1 of money (in cash), £34 in claims to money (credit)!”
The Administrators’ report tells the sorry story of events in summary which I list underneath, but one glaring fact is omitted. This is that the very Government of the UK actually triggered the loss of confidence in this Bank. When our Prime Minister in his own words was “saving the world” he ordered a full guarantee , government backed, on all deposits. The PMS, which had 10,000 members, went into administration following a rush by savers to withdraw their money at the height of the banking crisis in October 2008. People withdrew their money as they learned the Society was not covered by the government’s bank deposit guarantee scheme. Previously they were content to leave their money in the Society. For the purposes of this article, it is not needed to debate the point: was it or was it not a bank that should have been supported by this guarantee? The salient point being that not being guaranteed scared people into making withdrawals where little existed before.
From the Administrators’ report of the12th January 2009 that can be down loaded here http://www.presbyterianmutualsociety.co.uk/files/Administrator’s%20Proposals%2012.1.09.pdf the Society was placed into Administration by the Directors on 17th November 2008. The following are selected quotes from this report which speak for themselves:
“the demand for withdrawals by members of their investments exceeded its cash reserves;”
“the members’ investments were historically withdrawable on demand but the cash was invested by the Society in longer term investments such as property and loans.”
“For the Society to allow members to withdraw their investments on demand and invest members’ money in longer term investments, the Society required a high degree of confidence among its members that their investments were secure. However this confidence has been severely tested by the current economic climate and eventually the demand by members for withdrawals exceeded the Society’s cash reserves. …I believe it will be difficult for the Society in its current form to continue as a going concern.”
“loan capital will be treated as creditors and will therefore be paid in preference to members’ shares.”
“Government Guarantee
As you will be aware the Society does not benefit from the deposit guarantee scheme.
During the month of October 2008 the Society experienced an unprecedented increase in the number of requests for repayment of members’ investments. It was common practice for the Society to repay investments on receipt of a request, and payments of £21 million were made up to Friday 24th October 2008, leaving £4 million in the Society’s bank account.
An emergency meeting of the Society’s Board of Directors was convened on 25th October 2008 and it was resolved that:
…the 21 day notice period for the repayment of members’ investments be invoked in respect of requests received from members as at that date and any new requests received from members.
On 6th November 2008 the Society’s Board of Directors met again and it was reported that the demand among the Society’s members to withdraw their investments had increased which further exacerbated the Society’s liquidity. It was also reported at this meeting that legal proceedings had been commenced by three members seeking repayment of their investments. It was resolved by the Society’s Board of Directors on 6th November 2008 that the Society should be placed into Administration so that its assets could be protected, subject to enabling legislation being passed to permit the Society to go into administration.
During the period 27th October 2008 to 17th November 2008, the Society had received requests for withdrawals in excess of £50 million but the Society had cash reserves of only £4 million to meet such requests.”
Now this would have been the story of every bank in the UK if the government had not acted as it did as we were ‘panicking’ as a nation. We should also note that all banks are in the same precarious situation as the PMS was with regard to lending long and paying out short still, to this day. Do we need to live like this?
The Future Safe Way to Run Banks and Provide Interest for Savers and Lending to the needs of Trade.
If banks were mandated to hold 100% reserves of cash in their vaults, they could issue their bank statements saying what they owe you each month and you would know that you actually had cash in the vault to support your deposit that is represented by your bank statement. The bank statement after all is only a thing that would more accurately be called a “bank IOU statement.” Should you want interest you could ask for the cash you have deposited to be placed in a highly liquid government bond that could be converted into cash when you need it, paying you a rate of interest. Should you want a higher rate of interest, you can lend your money i.e. cease ownership and place in a bond that has in turn been lent to an entrepreneur for 6 months, 1 year, 2 years, 3 years, 5 years etc with the highest rate of interest being given for the longer term locked away and lent to somebody.
The Solution for Paying Out 100% of the PMS Depositors’ Lost Money- £310m – Now, Today
Following the work of 5 Nobel Prize winners and the founder of the American Chicago School, I would suggest the following written about in the Day of Reckoning article;
The Bank of England immediately issues notes to cover all the deposits i.e. redeem all the depositors for 100% cash notes and coins to be placed in their accounts. Please note, this costs the Bank of England the price of paper and the ink and nothing else and IS NOT INFLATIONARY and generates no liability to the UK taxpayer – see next point.
At the same time, get the administrator of the PMS to delete all current creditors (the depositors) as these have now been redeemed from the bank’s books by the Bank of England. The deleting of these bank obligations means that the money the depositors did lend on deposit to the PSM no longer exists, so for the sake of argument, if there was £310m of deposits, these have been redeemed in cash by the Bank of England and the equivalent amount of deposits have been removed from the money supply. Cost to the Bank of England = zero and cost to the UK tax payer = zero. Money supply stays the same.
The PMS in administration now has only assets i.e. loans from entrepreneurs /people who are repaying the loans or mortgages. These can now continue to get repaid, but instead of paying the creditors of the PMS, there are now none, so these loans can go into paying off the National Debt.
This way all parties win.
A courageous politician in Northern Ireland or in mainland GB could well put forward a Private Members’ bill which could be the first legislative move to establishing Honest Money.
The Day of Reckoning article linked to above provides the start of the legislative solution to the whole UK wide banking system whose model is sadly no different to that of the little PMS.
How on earth is converting a debt that will never be repaid (and therefore worthless) into a debt that is guaranteed to be paid in cash (and therefore worth the full value) not inflationary? How does this differ in practice from simply nationalising PMS and printing money to cover the government’s new liabilities?
As for the 100% cash reserves idea, surely this would cause a credit contraction the likes of which hasn’t been seen since 1990s Japan?
It is not inflationary in any way.
If the money supply was made up of 100 units of money, of which 5 units were cash and 95 units were demand deposits and we changed those 95 demand deposits into 95 units of cash, we would still have 100 units of money right?
So with the PMS , we take the £300m of demand deposits and change them into cash from the demand deposits that they currently are, thus the money supply stays the same.
Note, cash is the stuff you have in your pocket. A demand deposit is a bank saying it owes you a claim on demand to a certain amount of cash. The problem being the bank does not always have that cash as it is lending it out and cash can not be in two places at once. You can not own it and the property developer who has been loaned it can not both own it. It can not be in two places at once, only in one. Your bank statement is an IOU from yoor bank as in all cases, they have lent it out to another party.
So the depositors in the PMS have £300m of demand deposits that the PMS can not pay out to its depositors in cash, hence a run on the PMS has happened. Let the Bank of England have the demand deposits, there are worthless. It can then put in £300m of cash. Like the 100 money unit example above, we still have the same amount of money , therefore no inflation.
The Bank of England can then get back the loans of approx £200m they think that can be wased to chip off a bit of the national debt.
See the works of Hayek, Soddy, Buchannan, Freidman ,Tobin and Allais on this, all of them Nobel Winners. See here for more information.
https://www.cobdencentre.org/2010/02/a-day-of-reckoning/
Like the 100 money unit example above, we still have the same amount of money , therefore no inflation.
For argument, let’s take that definition of zero inflation. Then all the likely alternatives (a government guarantee backed by tax revenues, or allowing the depositors to take the hit) reduce the money supply, and are thus deflationary. Government action of this kind is therefore inflationary compared to the effects of the alternatives, which is the only relevant measure.
And you still haven’t explained how this differs from nationalisation and printing money to fill the holes in the government balance sheet.
I recommend this article:
https://www.cobdencentre.org/2010/01/what-is-money/
From an Austrian perspective, money is:
– Cash.
– Demand deposits with commercial banks and thrift institutions.
– Government deposits with banks and the central bank.
If I understand correctly, Toby is proposing directly exchanging demand deposits (backed by nothing) for physical cash, so the money supply is unaltered at the time of the reform. The monetary inflation took place already, when the bank loaned out demand deposits.
There are, perhaps obviously, other issues at work here, including the legal status of demand deposits:
https://www.cobdencentre.org/2009/12/banking-part-1/
See also my precis of Fisher’s “100% money”
https://www.cobdencentre.org/fisher/
Certainly, communicating such a plan is fraught!
The monetary inflation took place already, when the bank loaned out demand deposits.
Using this definition of money, yes. And under normal circumstances, this inflation would be partly reversed by the deflationary effect of defaulting on the demand deposits. By printing cash, you bypass this correction, so long-term inflation is higher than it would have been otherwise. You can’t use a particular definition of money in one place and fail to take note of the effects of that definition elsewhere in your model.
Toby and I are not neglecting the inflation caused by credit expansion unbacked by real savings. We are both advocates of 100% money and sound property rights.
The flaw that needs correcting is in the whole banking system: a systematic breach of sound property rights. See for example, my article:
https://www.cobdencentre.org/2009/12/banking-part-1/
For a full explanation, I recommend Huerta de Soto.
Andrew the loans will recover £200m to £250m according to the Administrators.
At the moment the demand deposits of £300m still exist in the UK money supply M4 definition which is not only money, but money and other near money substitutes. With our definition of Actual Money Supply, this is still the same.
Once the PMS has been wound down and all loans collected, there will be a shrink of the money supply to the exact tune of this loss. So anywhere between £50m and £100m. This is deflationary and will happen in some years time. We could let this happen and the creditors will take a hair cut in the normal way we have become accustomed to.
Or we could print £300m of cash now and give to the demand deposit owners, the savers of the PMS and at the same time delete the demand deposits. M4 and our measure Actual Money Supply does stay the same.
For doing this, the State could get the one off windfall gain of all the loans being paid back to it to pay off part of the national debt as it has allowed all the depositors to remain exclusively whole.
I would think this is a unique and brilliant solution to a very real problem to totally innocent people who have deposited under the misguided belief that “their” money would be safe!
Once the PMS has been wound down and all loans collected, there will be a shrink of the money supply to the exact tune of this loss.
Only if the money is not released back into the economy in other ways. If, as you suggest, this money is used to repay the national debt, then the state no longer needs to raise taxes for that purpose. Again, money is now in the economy that would otherwise have been removed, and the deflationary correction has not happened. You have effectively printed money to pay off the national debt, via the scenic route.
This is no better than a perpetual motion machine. There’s no such thing as a free lunch, but if you make the process obfuscated enough it can be made to look very convincing, so long as you don’t look too closely.
On rereading my last comment, I should clarify. I quoted the wrong part of Toby’s comment and unfortunately added to the confusion.
Toby admits that a) under normal circumstances there would be a deflationary haircut of (say) £100M and b) by printing £300M he avoids that deflation. What he fails to take account of is that the other £200M of the printed money is also inflationary in that the recovered assets will be used to pay the national debt in lieu of £200M of taxation, as I (inadequately) tried to explain above. Therefore the entire £300M is indeed inflationary.
Let’s calculate both scenarios. In both cases, we start with:
M4(before) = 300M demand deposits + 200M recoverable assets + 100M unrecoverable assets + 200M tax revenues + (rest of economy) = 600M + rest
Scenario A (money is not printed, investors redeem demand deposits taking haircut, taxation used to pay national debt)
M4(after) = 0 demand deposits + 200M recovered assets + 100M unrecoverable assets + 0 tax revenue + (rest of economy) = 300M + rest
Scenario B (money is printed, state redeems demand deposits taking haircut, recoverable assets used to pay debt)
M4(after) = 0 demand deposits + 300M newly printed money + 100M unrecoverable assets + 200M tax revenues + (rest of economy) = 600M + rest
The difference between the two “after” scenarios is 300M, the exact amount of cash printed.
Andrew, just had a quick look. Will revert on the weekend, got to keep the day job going selling fish!
Note, a demand deposit is created out of thin air, so when the money gets paid back i.e. the £200m or £250m recovered, it goes back to thin air, that is why it is not inflationary!
Note in Administrators report how much cash actually existed in the PMS. The rest are bank IOU’s or call it a bank statement or call it a demand depoit. NOT CASH. All the former do count as money.
Banks keep saying they are lending like mad, but their lending is going down. Are they telling porky pies? No, people are paying back credit faster than it is being lent out, the worst situation for a bank. Salient point, when credit is paid back, it does not sit in a bank vault, so you will not have £300m plus £200m. It goes back into thin air.
Note, a demand deposit is created out of thin air, so when the money gets paid back i.e. the £200m or £250m recovered, it goes back to thin air, that is why it is not inflationary!
That’s why credit expansion is normally not inflationary. But in your scheme, the demand deposits don’t go back into thin air – they’re converted into newly-printed cash.
Andrew, to be clear, today, the money supply is what it is , inclusive of the PMS bank deposits. In the next couple of years, there will be a collect out and this may be say £200m. £100m demand deposits will then cease to exist i.e. there will be a money deflation to the tune of £200m . the PSM creditors lost £100m.
Under my scheme, £300m of demand deposits get swapred for £300m of cash. As those demand deposits came from thin air, they go back to thin air i.e. no change in the money supply. The £200m of loans then get repaid v the national debt account. No inflation, no deflation.
Credit expansion is always inflationary if not backed by real savings. Credit inflation also distorts the capital structure and causes boom and bust. Two articles for you that might be of interst.
The second section of this link is the part to look at
https://www.cobdencentre.org/2009/09/is-a-liquidity-trap-possible-beware-of-those-who-do-not-understand-the-structure-of-production/
This is the best little PDF that will show you why credit creation , not back by savings is inflationary and will always cause boom and bust.
http://mises.org/tradcycl.asp