Reforming fractional reserve banking

This article was included as an expert submission to Ron Paul’s Monetary Policy Anthology.

“When you’re one step ahead of the crowd you’re a genius. When you’re two steps ahead, you’re a crackpot.”[1]

-Rabbi Shlomo Riskin

Lincoln Square Synagogue, February 1998

“I hold all idea of regulating the currency to be an absurdity; the very terms of regulating the currency and managing the currency I look upon to be an absurdity; the currency should regulate itself; it must be regulated by the trade and commerce of the world; I would neither allow the Bank of England nor any private banks to have what is called the management of the currency.

…

I should never contemplate any remedial measure, which left to the discretion of individuals to regulate the amount of currency by any principle or standard whatever… I should be sorry to trust the Bank of England again, having violated their principle [the Palmer rule]; for I never trust the same parties twice on an affair of such magnitude.”[2]

-Richard Cobden

Report from the Select Committee on Banks of Issue

British Parliament, April 1840

Introduction

It is a great privilege to write this essay on money and banking reform to mark the retirement of Dr. Paul from Congress. We in the United Kingdom have much to thank Dr. Paul for his tireless campaigning on these issues, especially those raised in the full public glare of two Presidential campaigns, making money and banking reform resonate here as well more than it otherwise would have.

At the Cobden Centre, we have two great parliamentarians, like Dr. Paul also inspired by the Austrian School of Economics: Steve Baker, Member of Parliament (MP) for High Wycombe (my co-founder of the Cobden Centre); and Douglas Carswell, MP for Clacton. Taking the idea of full-reserve free banking, currency competition, honest accounting, and full open liability for bankers, they have produced four bills in Parliament which we will discuss next in summary.

The Financial Services (Deposit and Lending) Bill – 2010

Carswell describes the Deposit and Lending bill as follows:

My bill would give account holders legal ownership of their deposits, unless they indicated otherwise when opening the account. In other words, there would henceforth be two categories of bank account: deposit-taking accounts for investment purposes, and deposit-taking accounts for storage purposes. Banks would remain at liberty to lend on money deposited in the investment accounts, but not on money deposited in the storage accounts. As such, the idea is not a million miles away from the idea of 100% gilt-backed storage accounts proposed by other hon. Members and the Governor of the Bank of England.[3]

Currency and Banknotes (Amendment) – 2011

Carswell describes the Currency and Banknotes Amendment as follows:

That leave be given to bring in a Bill to amend the Currency and Banknotes Act 1954 to allow banknotes in addition to those issued by the Bank of England to be legal tender; and for connected purposes. … My Bill would amend the Currency and Banknotes Act 1954 to enable a range of different currencies to be used as legal tender in Britain. The idea comes from a 1989 Treasury paper from when John Major was Chancellor. What the Treasury proposed as theoretically possible 22 years ago, the internet now makes practically achievable.

The internet has given people unprecedented choice. We have access to a greater range of music, financial services, groceries and books than ever before, so why do we have legal tender laws that create a monopoly currency?[4]

In an email to me, Carswell expressed the influence Congressman Paul has had on his work:

Reading Ron Paul’s End the Fed gave me the confidence to speak out.  I suddenly realised it wasn’t just a few of us Brits who doubted the whole fiat money/candy floss currency scam.  He has given hope to those of us throughout the West.

Financial Services (Regulation of Derivatives) Bill

Steve Baker compiled the Regulation of Derivatives Bill with the help of Gordon Kerr, Tim Bush, and Kevin Dowd. [5] When he introduced the legislation on 15 March 2011, he described the Bill as requiring “certain financial institutions to prepare parallel accounts on the basis of the lower of historic cost and mark to market for their exposure to derivatives; and for connected purposes.”[6] Baker explained how the accounting rules for banks incentivize trading in derivatives by enabling unrealized profits to be booked up-front, leading to large but unjustified bonuses and dividends.

More broadly, banks are producing accounts that grossly inflate their profits and capital in three ways:

(1)     Using mark-to-market and mark-to-model accounting, banks record unrealized gains in investments as profits.

(2)     International Financial Reporting Standards (IFRS) prevent banks from making prudent provision for expected loan losses by allowing recognition only of incurred losses.

(3)     IFRS encourages banks not to deduct staff compensation from profits.

Taken together, these flaws mean that banks’ accounts under IFRS are at once rule-compliant and dangerously misleading. The Regulation of Derivatives Bill[7] deals with this broad problem. For much more detail, see Gordon Kerr’s Adam Smith Institute pamphlet, “The Law of Opposites.”[8]

Financial Institutions (Reform) Bill[9]

Baker compiled the Financial Institutions Reform Bill with the help of Gordon Kerr and Kevin Dowd. The bill was introduced on Wednesday, 29 February 2012. The key provisions of the bill would:

(1)     Enforce strict liability on directors of financial institutions;

(2)     Enforce unlimited personal liability on directors of financial institutions;

(3)     Require directors of financial institutions to post personal bonds as additional bank capital;

(4)     Require personal bonds and bonuses to be treated as additional bank capital;

(5)     Make provision for the insolvency of financial institutions; and

(6)     Establish a financial crimes investigation unit.

The purpose of this Bill is to minimise moral hazard within the financial system by ensuring that those who take risks are held personally liable for the consequences.  Since rules can usually be gamed by financial institutions, a principle underlying this Bill is to minimise scope for evasion.

Baker said,

The public are rightly incensed at the injustices we see across the financial system but our economy must have responsible, innovative and enterprising financial services.  It is essential that commercial freedom is maintained while creating a system in which remuneration is a just reward for success, not the unjust product of unrealised profits and bailouts.

My Bill would make directors of financial institutions personally liable for losses.  It would ensure that losses came first out of institutions’ bonus pools then directors’ personal bonds before hitting equity.  Directors would also be exposed to unlimited personal liability long before any suggestion of taxpayer bailout.

With key decision makers’ own wealth at risk, they would take responsible decisions instead of expecting rewards for failure.

It’s time to tell bankers, “Yes, innovate. By all means earn large rewards for providing valuable financial services. But bear your own commercial risks. Don’t expect the rest of us to bail you out.”[10]

Public Attitudes to Banking: A Survey Commissioned by the Cobden Centre (2010)[11]

When we started the Cobden Centre, we all thought we knew about money and banking and all thought we knew what our fellow Brits thought about it all. To the great credit of Prof. Anthony Evans, he said let’s do some empirical testing. And so the Cobden Centre commissioned a survey. This research formed the basis of much of the work our parliamentary friends have embarked upon.

The survey was conducted by the market research company ICM with 2,000 participants.  The results offer us a rather confusing array of views as to what people think banking is about.

• 74% of respondents thought that they were the legal owner of the money in their current account, as opposed to the bank being the legal owner.
• 66% of respondents answered “don’t know” when asked what proportion of their current account was used in various ways by their bank.
• 15% wanted safe-keeping services.
• 67% wanted convenient access.
• 8% knew correctly that they had lent money to the bank.
• 33% think it is wrong that the bank lends out what they view as their money.
• 61% said they would not mind the bank lending if it was done safely.
• 26% wanted reserves to match deposits.

It would seem a sizeable minority percentage would want some form of safe-keeping services.  Most would want easy access, which would imply short-term borrowing matched with short-term lending, so as to avoid runs, rather than the current practice of lending long and borrowing short.

The needs of savers and borrowers would be better aligned by requiring depositors to choose, at the time of making a deposit, how much money they wished to put into plain saving (i.e., savings set aside for safe/precautionary holding as opposed to investment purposes — a distinction made by the Austrian scholar Ludwig von Mises) and how much into capitalist saving (i.e., savings set aside for investment gain as opposed to safe/precautionary savings). This would provide the setting for, and lead to, much more stable and substantial growth.

In a modern setting, the ability for banks to distinguish between plain savings, those savings that people want for safe keeping, and savings for capitalistic investment via the normal savings bonds, time deposit accounts, and so on and so forth, would allow the banking system to mediate more accurately the diverse time preferences of all savers and borrowers.  (The Manchester/Lancashire system of full reserve banking and private money creation that we will discuss in the last part of this essay is a good historical example of how mediating only capitalistic savings, and not plain savings, created a system of safe credit—until it was interfered with by the Stamp Act.)

The ICM survey showed all of us that there is a need to sort out what people actually think happens with their money and banking and what actually does happen—as the two things are very different.

The Jesus Huerta De Soto Monetary Reform Proposal in Summary

Some three years ago I was fortunate enough to introduce both of our Parliamentarian friends to the greatest of all the living Austrian School economists in the full reserve tradition, Professor Jesus Huerta De Soto.  His 1998 book, translated into English in 2006 as Money, Bank Credit, and Economic Cycles, is the seminal treatise on the matter.

In chapter nine, he outlines his reform proposal. (All quotes in this section are taken from chapter nine and the full book can be downloaded at https://www.cobdencentre.org/tag/downloads/.) The aims of the reform, as summarized by Prof. Huerta De Soto himself, are as follows:

[O]ur proposal is based on privatizing money in its current form by replacing it with its metallic equivalent in gold and allowing the market to resume its free development from the time of the transition, either by confirming gold as the generally accepted form of money, or by permitting the spontaneous and gradual entrance of other monetary standards.

This second element of our proposal refers to the necessity of revoking banking legislation and eliminating central banks and in general any government agency devoted to controlling and intervening in the financial or banking market. It should be possible to set up any number of private banks with complete freedom, both in terms of corporate purpose and legal form. …

Nevertheless the defense of free banking does not imply permission for banks to operate with a fractional reserve. At this point it should be perfectly clear that banking should be subject to traditional legal principles and that these demand the maintenance at all times of a 100 percent reserve with respect to demand deposits at banks. Hence free banking must not be viewed as a license to infringe this rule, since its infringement not only constitutes a violation of a traditional legal principle, but it also triggers a chain of consequences which are highly damaging to the economy. [12]

The crux of his reform proposal is as follows (the description is mine and made UK-specific by me — read chapter nine in full for the complete version in the Professor’s own words):

(1)     All demand deposits are immaterial money, and are not the depositor’s money but a liability from the bank they deposit with to pay them back money in the same amount as deposited, on demand.

(2)     Let the government back all these demand deposits for physical cash and place them as reserves against the existing demand deposits. This is virtually a costless activity on behalf of the state. It is also not inflationary, as the backing, the physical cash, cannot be spent, as it sits in reserves.

(3)     The money supply can neither expand nor contract at this specific point.

(4)     The banks, where they had current liabilities, now no longer have them as they are fully reserved.

(5)     This generates a one-off gain to the banks in terms of their net worth. In short, so much as they had these current demand liabilities, now they have these backed with paper notes for the same value, so their net worth has gone up by the equivalent amount.

(6)     The asset side of the balance sheet, their loan portfolio, stays intact.

(7)     As there are over £1 trillion of demand deposits in the UK banking system, the banking system’s net worth would have risen by £1 trillion.

(8)     Why give this one-off gift of largesse to the shareholders and bonus-hungry bankers? Well, don’t. Form special purpose vehicles to hold the asset side of the balance sheets of the banks to collect on these outstanding loans and you can contract out the management of this to the existing banks.

(9)     By doing this, the banks’ net worth on the day after the reform is still the same as the day before the reform, but the £1 trillion loan repayments are now paying off our national debt obligations. This is a unique one-off gain and is a byproduct of this reform.

(10)     The gold price would need to rise to back all the deposits with gold and then you fix all money in one of its historic anchors: gold (you could also use silver or other successful monies). Since gold increases in physical supply at the rate of approximately 2% per year, if productivity gains run at about this rate you will have stable prices; if productivity rates are greater, then a benign price deflation.

(11)     Let the people spontaneously discover what their most favoured money actually is.

I have suggested my own reform proposal along this line of reasoning here: https://www.cobdencentre.org/2010/05/the-emperors-new-clothes-how-to-pay-off-the-national-debt-give-a-28-5-tax-cut/.

In short, I would have no-reserve banking, not 100% reserve. By this, I have suggested that all demand deposits should actually be swapped out for physical cash and the current liability of the bank just rubbed out. Then the people would actually own their own money on deposit and not be current creditors, thus I would question the need to perform point number two and substitute along the lines of what I just suggested.

Would 100% Reserve Free Banking be the End of Lending and the End of Commerce as We Know It?

This is the question that gets asked when most people have understood that 100% reserve banking would be the end of bank-created credit. Many credible and distinguished people attribute the creation of bank credit as the source of the Industrial Revolution itself. Such a powerful thing is alleged.  The noted Daily Telegraph writer Ambrose Evans-Pritchard says in his 21 October 2012 column:

One might equally say that this opened the way to England’s agricultural revolution in the early 18th Century, the industrial revolution soon after, and the greatest economic and technological leap ever seen. But let us not quibble.[13]

For those followers of Dr. Paul and those generally interested in monetary reform in this tradition, I did some research into the genesis of the Industrial Revolution to see if this assertion held any merit. I have focused my research into the County of Lancashire and what became the first industrial city of the world, Manchester.[14] In this concluding historical section, I will show that in the first third of the Industrial Revolution, private credit, bills of exchange, backed by the goods and services that were being traded for and by gold and silver, was the preferred modus operandi. The taxation of this private money by the 1815 Stamp Act led to their slow decline in favour of the privileged note issue of, in particular, the Bank of England. However, by late 1874 some 45%[15] of all credit was still private credit in the form of bills of exchange. Private credit was the preferred medium of the Industrial Revolution, and not bank-created fiduciary credit.

Early Banking in Manchester

The historian Arthur Redford in his book about merchants and foreign trade in Manchester described the early bankers of the town:

The first Manchester Bank, that of Byron, Sedgwick, Allen, and Place, was opened in 1771, in combination with an insurance office, and the Mercury welcomed it with the comment that “from the general Approbation the Scheme has met with amongst all Ranks of People, it is not questioned that it will be of infinite Utility to the Trading Part of the Town, and to the County in general.” …. It was not the only Manchester banking business, for in 1772 John Jones and Co. were “Bankers and Tea Dealers” and within thirteen years were to have offices in London from which Jones Lloyds sprang. In Liverpool also most of the early bankers, says their historian, “arose out of general merchants, some few from tea dealers, and one from linen merchants.” Even after declaring themselves bankers, the banking business was usually continued along with trading. But the use of the term banker was late, and until almost the end of our period the commerce of Liverpool, with its complex dealings in foreign exchange, and the internal trade of Lancashire seem to have been carried on mainly through the bill discounting side of the merchants’ and traders’ businesses. In Liverpool marine insurance broking was closely allied.”[16]

The key thing I observe here is that in the first part of the Industrial Revolution the issue of notes (which were the chief means of bank fiduciary credit) was a side issue and bills of exchange were the main mechanism to facilitate this massive explosion in trade. Also, this first bank in the UK’s main industrial area was nearly 100 years behind the establishment of the Bank of England and the Scottish public banks.

Data supplied by Prof. Angus Maddison shows us that from 1700 to 1820 there is 338.38% growth in measured economic activity. The next 130 years saw 960.06% growth when the Industrial Revolution was in full flow.[17] Nevertheless, with the initial explosion of activity in the mid- to late-1700s, to the early 1820s, we see the prime industrial county in the world exist with few or no banks and banks not providing credit services as we know them today, and clearly not to its detriment.

Economic historian T. S. Ashton quotes William Langton (a driving force behind the founding of the Manchester Statistical Society in 1833) writing later in the 19^th century:

“It is exceedingly natural,” said Langton, “that those banks which still retain the privilege of issuing their own notes should desire to retain it, since it naturally adds to their profits; but it has always been recognised in the great industrial district of Lancashire that it is no essential condition to the wielding of manufacturing and commercial enterprise, and that the banks not possessing this privilege have not stinted their customers of any legitimate accommodation.”[18]

Langton also notes their usefulness vis-a-vis other modes of money:

My personal memory of trade only extends back to the year 1820; but at that time the Liverpool merchants received nothing but bills in payment from Manchester of their cotton invoices; every such payment, if in what was called promiscuous paper, requiring a calculation of interest to make a settlement per appoint. This practice gradually disappeared with the resumption of cash payments by the Bank of England and the lowering of the standard rate of interest; but if economy of interest of money is to be taken as the special recommendation of any particular kind of circulating medium, this one surely ought to bear the palm![19]

W.T. Crick and J.E. Wadsworth note the significance of Manchester and the nearby City of Liverpool by observing:

Yet, in spite of Lancashire’s advanced industrial organization, banking was rather later to develop than in some other areas. No banks are recorded in Manchester until 1771 or in Liverpool until 1774, and when eventually they were formed, they do not appear to have acquired note circulations except in a few unimportant instances.[20]

Ashton describes the special preference for bills of exchange over notes:

These are reasons explaining the ubiquity of bills of exchange at this period. The special preference of Lancashire for bills rather than notes is a matter deserving of research. It arose, no doubt, out of a high degree of commercial confidence, no less than out of a low degree of trust in note-issuers, and the fact that Lancashire bought raw material from distant places and sold products in distant markets must also have engendered a preference for a document the circulation of which was not confined to the sphere of operations of a local bank. As time went on the domestic bill came to play a smaller part in commercial transactions: the increase of the stamp duties after the Napoleonic War dealt a blow to the system; and the growth of large banks of deposits with many branches, together with the shortening of the customary terms of credit, led to a substitution of cheques for bills in inland trade during the later decades of the nineteenth century. But in the period with which we are concerned cheques were in their infancy and the bill had no serious rival as a medium of exchange between traders.[21]

Ashton also gives us clues as to why they have almost vanished today from the commercial idiom as the stamp duty applied to them was less advantageous vis-a-vis note or chequebook issue as the latter provided quicker redemption in money possibilities.

If we dig a bit further into the historical record we see that these bills arose spontaneously to fulfill a need to be able to facilitate the smooth transmission of trade. A wonderful book written by Alfred P. Wadsworth & Julia De Lacy Mann, The Cotton Trade and Industrial Lancashire 1600-1780, documents this history quite thoroughly:

We have seen Marsden as a manufacturer, putting out cotton and yarn through his agent and debiting the materials and wages against the value of the finished goods. On the other side he maintained a London house, through which he bought his raw materials and sold his fustians, and in connection with which he conducted extensive operations as a bill discounter. Between 1688 and 1690 he was involved in a maze of lawsuits, from which some account of his business may be constructed

^….

Having “constantly great and considerable sums of money in his hands” [Marsden] lent money to other dealers in return for their bills on London; or he “furnished them with bills of exchange for payment of considerable sums of money at London to them or their order, or to such persons as they appointed to receive the same,” either receiving cash, or, generally, giving them credit at an agreed rate of interest. When they failed to pay him for the bills he had given them, he would take an assignment of their goods at Liverpool —cotton or linen yarn, promissory notes, or bills drawn on their London debtors. But apart from his own trading credit, he had “for many years past been intrusted or employed with greate parte of the monies retorned out of the county of Lancaster to London.”[22]

Marsden the industrialist had become the banker as well as the chief remitter of revenues back to Lancashire and the principal collector of taxes. Daniel Defoe, trader, writer, and journalist, remarked in 1727, that:

[A] very great part of the bills drawn out of the several counties in England upon the tradesmen in London, such as factors and warehousekeepers, are made payable to the General Receivers of the several taxes and duties, customs and excise, which are levied in the country in specie, and the money is remitted by those collectors and receivers on account of those duties; this generally appears by the bills or endorsements, which often mention it in these words for his Majesty’s use.[23]

Thus credit was granted and discounted bills accepted and paid with specie, not with notes or other such fiduciary credit. The Crown accepted these bills!

In commenting upon the various inaccuracies with traders being bankers, after an extensive investigation into the disputes listed in the court records, Wadsworth and Mann conclude:

Much might be said of the use of the bill in the general system of credit, but enough, perhaps, has been suggested in earlier pages to indicate its importance. The bill on London, then as a century later the dominant form, entered at every stage, and into every form of transaction, ran from the smallest to the largest sums, and passed even more freely than cash. The financial mechanism which turned on the bill, the promissory note, and other credit instruments, and has here been summarily illustrated, bulks large in all the commercial manuals of the time. … It is apt to be forgotten that the credit machinery of industries like the textile trades was hardly less extensive before the foundation of the country banks than it became after.[24]

Unwin, Hulme, and Taylor did a fantastic investigation into the affairs of Samuel Oldknow and his mill at Mellor. There is also some evidence to show why Lancashire rejected bills vs. notes:

Enough has been said to show the almost desperate condition of Oldknow’s affairs at the beginning of 1793. He had invested an immense capital—for those days—in the fixed forms of land, buildings, and machinery which could not yield any return without the assistance of commercial credit—and owing to the outbreak of war commercial credit had almost ceased for the time being to exist. No fewer than 872 bankruptcies were recorded between November 1792 and July 1793. The problem of credit currency became acute. The country banks, which had multiplied greatly during the previous decade, had produced an over-issue of notes, some of them for such small amounts as to provoke the derisive issue by a Newcastle cobbler of a note for two-pence. But the notes even of the sounder banks were now returned on their hands and many were obliged to close their doors.[25]

The instability that these free banks issuing fiduciary credit afforded the industrialist in the times of crises was very destabilising, as you did not want to become a creditor to a bankrupt banker. This is one way to accelerate your own potential to become bankrupt. So commercial credit, or bills backed by real goods, was sought in preference.

Why did these Lancashire Bills Decline?

Henry Thornton, an economist, banker, and Parliamentarian, commented on the demise of bills to the favour of notes in 1802: “Some Bank of England notes have also been recently employed in the place of small bills on London, the use of which has been discouraged by the late additional duty on bills and notes.”[26]

Redford discusses the response of Manchester merchants to the duties and taxes imposed on bills of exchange:

A much more protracted struggle, extending throughout the second quarter of the nineteenth century, was waged by the Manchester merchants against excessive stamp duties on various kinds of legal documents. … Bills of exchange and promissory notes were first subjected to stamp duties in 1782; a general Stamp Act of 1815 had increased the duties, which thenceforth discriminated between short-dated and long-dated bills. In the post-war period the average duty on all bills of less than £50 was 1/2 per cent.; but this charge was felt to be prohibitive, and had in Manchester caused bills to be almost completely replaced by bank notes. Bank notes, however, were considered to be a much more inconvenient and risky means of payment, since they were payable “to bearer” and not “to order.” The Manchester Chamber of Commerce therefore moved in 1822 for the reduction of the duties, and sent up several petitions on the subject, to the Prime Minister, the Chancellor of the Exchequer, and the Houses of Parliament. The petitioners described the serious inconvenience to business which had resulted from the virtual extinction of “a description of currency of great convenience and security”; they suggested a greatly reduced scale of duties, and argued that, if this were adopted, not only the business community but also the revenue would benefit greatly, because of the increased use of bills of exchange.[27]

The Bank of England (BoE) was still a private bank at the time. However, as the government’s favoured bank it had certain privileges and was always lobbying for more. The 1815 Stamp Act made the reissue of bills of exchange virtually impossible. Some were taxed up to 460% higher than Bank of England note issue, or subject to great penalty that made the issue of private credit by other banks more expensive than BoE note issue. In 1825 the Bank of England set up a branch in Manchester specifically to take advantage of the terrible taxation placed on private bill issue and make sure that those pioneers of the Industrial Revolution had to take BoE credit.

The significance of Manchester as the prime industrial area of the world at the time does make it a meaningful and worthy study area from which we can extrapolate, hopefully, our findings to the wider canvas of today and I submit that in the absence of bank-created credit we, like our ancestors, have nothing to fear. Indeed, like the pioneers of the Industrial Revolution, we should embrace private money solutions such as bills of exchange and rely on the lending of real savings to provide real capital to entrepreneurs and not bank credit created out of nowhere. Full-reserve systems are not only stable, but growth enhancing. Lending does not die as many advocates of fractional reserve banking dread.