http://www.businessweek.com/articles/2013-01-25/why-well-still-never-see-a-100-percent-reserve-economy

U.S. Economy

Why We'll Still Never See a 100% Reserve Economy


Blinder: Leave credit creation to the banks

Photograph by Joshua Roberts/Bloomberg

Blinder: Leave credit creation to the banks

“I’m going to start with a model of a perfectly safe 100 percent reserve economy,” said Robert Lucas, “…which looks better and better to me.” Lucas, a Nobel Prize-winning economist at the University of Chicago, was speaking two weeks ago at a panel in San Diego to mark the 100th anniversary of the Federal Reserve. It’s a fairly radical place to start.

Monetary economists distinguish between “inside” and “outside” money. Outside money is what you might think of as “money,” a volume of dollars managed by the Federal Reserve and backed by the full faith and credit of the United States Treasury. But that’s not the only money in the economy. Private banks, too, create money through leverage. They lend more than they have, keeping only a percentage as a reserve. The credit this creates functions as real money: A business can spend the dollars it takes out via a loan. This money—credit—is called “inside” money. The Federal Reserve manages the supply of outside money in attempting to spur the economy or keep inflation in check. Private banks manage the supply of inside money—again, credit—by lowering their reserves (increasing the credit they can offer and consequently, their profits) or raising their reserves, which reduces their risk. When politicians complain that banks aren’t offering credit, they’re asking, essentially, for banks to goose the economy by expanding the supply of inside money.

When Lucas casually starts a discussion by assuming a 100 percent reserve economy, then, he’s assuming a world in which banks are required to keep 100 percent of their capital on reserve. (As a point of reference, the latest Basel rules for banks require them to keep reserves equal to 7 percent of their risk-weighted assets.) There would be no bank leverage at all. There would be no inside money. Banking would become boring, predictable, utterly safe, and only as profitable as the interest that banks could charge on their reserves. All money would be outside money, a supply controlled exclusively by the Federal Reserve. Lucas does not, ultimately, support this model. That he’s willing to entertain it as a hypothetical, however, shows how low trust is among academics that banks can behave responsibly with what is essentially a privilege: creating money.

Historically, there has always been tension between banks and governments over who gets to create money. In their 2012 book Economists and the Powerful, Norbert Haring and Niall Douglas run briefly through the history of the conflict. Marco Polo reported back to Europe on what he found in China, a paper money supply completely controlled by the government. Government land banks and private merchant banks in post-revolutionary America clashed over whether money should be kept loose, to help debtors, or tight, to help creditors. In the 1930s, Irving Fisher and a young Milton Friedman at the University of Chicago proposed a “100 percent money” system, all outside money. Fisher wanted an independent commission to increase money supply every year in keeping with the needs of the economy. It’s not an accident that 80 years later, after another trough that followed an asset bubble inflated with bank leverage and inside money, Robert Lucas is looking back to Irving Fisher.

In their book, Haring and Douglas point to a 2009 paper by Moritz Schularick and Alan Taylor. Shularick and Taylor assembled a new database of both money and credit supply—outside and inside money—from 1870 to 2008. Until 1939, they found, money and credit “maintained a roughly stable relationship to each other and to the size of the overall economy.” Since 1970, however, credit “started to decouple from broad money and grew rapidly, via a combination of increased leverage and augmented funding via the nonmonetary liabilities of banks.” In other words, inside money increased more than the size of the economy merited. Central banks can create price inflation by printing outside money. Private banks create asset inflation by leveraging up and printing inside money.

Alan Blinder, a Princeton economist, responded to Lucas’s paper in San Diego by pondering the value of a stable 100 percent reserve system. “Every time, I want to get up to a podium and say we should do it,” he said, “and I’ve been sorely tempted, I started thinking about who would do the banking.” His point is not that bankers should be trusted with inside money, but that someone’s going to create credit, and he worries that someone—read: shadow bankers—would be worse than the banks. “I’m thinking of the guys who would fill those gaps,” he said, “and they’re all guys, and I’d rather leave it to the banks.”

Banks complain that regulatory actions such as raising capital requirements would prevent them from lending. They are suggesting that we continue trusting them to contribute their appropriate share of inside money—credit—to the economy. The 100 percent reserve will never happen; banks don’t want to be boring, and they find this solution so unpalatable that no one on Capitol Hill is even willing to utter it. So they will continue to create inside money. As they argue in favor of holding on to their leverage, however, it’s useful to look back at the history of inside money and point out, as Blinder does, that it’s no longer trust that prevents us from taking away the privilege of inside money. It’s fear of something worse than a bank. Shudder.

Greeley-brendan-190
Greeley is a staff writer for Bloomberg Businessweek in New York.

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