Economic Reform Australia Blog

Two different models for monetary reform

By ‘monetary reform’ I mean implementing a new monetary system in which no commercial financial institutions are able to practice fractional reserve deposit expansion. There is nothing new about this idea; it was around in the early part of the 20th century – notably in the economic reform proposals of Frederick Soddy – and later during the 1930s in the writings of the great American economist Irving Fisher. Towards the latter end of the 20th century the idea also was revived by the Chicago school economist Milton Friedman. Also by economists attached to the Canadian based Committee on Monetary and Economic Reform (COMER) — notably John Hotson, Henry Pope and William Hixson.  And more recently the idea has been advocated by a range of other organisations, including in particular the American Monetary Institute.

There is no universally accepted version of monetary reform. The basic proposal to abolish fractional reserve banking is often described as ‘Full Reserve’ banking.  However this description can refer to a system in which every loan advanced is matched by reserves on a one for one basis, or alternatively to a system in which there are no reserves at all and money is exclusively created by a central monetary authority – with financial institutions disempowered from creating bank credit money (and thus only capable of acting in a truly intermediary capacity). A variant of the latter system has been proposed by Ellen Brown — namely, that only publicly-owned banks should be allowed to practice fractional reserve deposit expansion, but operating in parallel with private sector financial institutions who are disempowered from doing so.  Her basis for trusting public banks to behave with due prudence, and for believing them incapable of falling into the mode of reckless lending behaviour displayed by many private banks in recent times, is that they are controlled by civil servants who presumably have no incentives for supporting Ponzi schemes or the casino.  However in my opinion such a split system would open up a hornet’s nest of tricky operational (not to mention political) problems.

One of the primary criticisms of ‘full reserve’ banking is that it is more difficult for capital accumulation to occur, making it difficult for entrepreneurs to raise start-up capital for large projects. However there are ways of addressing the issue of capital accumulation in the context of a “full reserve” financial system, such as appropriately structured investment trusts, without the sort of leverage that characterises fractional reserve banking.  The leverage currently placed in the hands of the large banks is often misused.  Far too much lending goes to support purely speculative activity in the financial markets, which distorts the markets, inflates asset prices, encourages financial fraud, increases the fragility of the banking system, and serves no useful purpose in the real economy.

I intend to restrict this discussion to an alternative ‘full reserve’ monetary system in which all money is created by the central bank (or a central monetary authority) and there are no reserves. Indeed, under such a system the concept and use of the word “reserves” would disappear from the economic lexicon.

The AMI model

The first type is the exogenous route, in which new money created by a central monetary authority is spent into the economy.  This is the basis for the monetary reform proposals put forward by the American Monetary Institute (AMI), and also form the basis of the recent bill introduced  into the US House of Representatives by Congressman Dennis Kucinich.

In expositions of the exogenous model there is usually a recognition that taxation will be necessary as a tool for exerting some control over aggregate demand and inflation (and secondarily as a tool for manipulating the distribution of wealth and income). However there seems to be less tolerance of the idea that central governments can issue public debt instruments, and that running a budget deficit via the issue of public debt would serve the purpose of authorising the government to spend newly created money into the private sector.

The Hummel model

The second type of monetary reform model embraces the endogenous route.

Australian economists Steve Keen and Bill Mitchell have both expressed a lack of enthusiasm for ‘full reserve’ banking, not because it is not technically possible, but because they are sceptical about the capacity of government agencies to get the creation of money right at all times. However this belief seems to imply that the expansion of the money supply, under such a scheme, would change from being endogenously driven to exogenously driven. Clearly in an endogenously driven system the government is not in the driving seat when it comes to the creation of new money, even if technically the mechanics of money creation involves the government spending newly created money into the economy. Thus it is the demand for new loans (in a debt-driven economic system) in line with the perceived needs of the overall economy, that drives monetary expansion. The central bank merely creates new reserves and introduces them into the banking system in response to those pressures, via the mechanism of achieving the interest rate targets which it perceives to be necessary for attaining an acceptable rate of inflation.

For a monetary system in which all money is fiat money created by a central monetary authority, I see no reason for assuming that monetary expansion would no longer be endogenously controlled. The mechanics of how such a system can be made to work in an endogenous manner has been worked out by William Hummel (see his website:  The Hummel model would work in much the same way that the current banking system operates, involving the implementation of monetary policy via the manipulation of interest rates,  with the important difference that there would be no reserves and no bank credit money.

Since all financial institutions in a ‘full reserve’ system would be obliged to behave as true intermediaries, Hummel has proposed – as a central feature of his approach – the creation of a single national depository.  Such a depository institution would neither borrow nor lend, but would simply exist to facilitate monetary transactions. Commercial financial institutions and post offices could act as agencies of this single national depository. It seems obvious to me that such an arrangement would be the most efficient way of ensuring the absolutely necessary demarcation between intermediary and depository functions.

Demarcation of the intermediary and depository functions

In both the endogenous and exogenous models, since banking institutions would be transformed into acting as true intermediaries, a mechanism would need to be found for demarcating the intermediary function from the retail depository function. This is because any workable payments system requires that a true intermediary (an institution which borrows and re-lends, making a profit from the interest margin) cannot simultaneously operate as a retail depository. And that is the basis for the introduction of a single national depository in Hummel’s scheme.

In order to better understand the nature of this imperative, we need to have a clear grasp of what a banking deposit consists of. The first thing I would mention about retail banking deposits is that they are a very special form of bank liability, and different from a borrowing.  The jurisprudential term is ‘bailment’, meaning that they are a form of money (albeit bank credit money, under a fractional reserve system) which must be held by the bank in trust and safekeeping.  And this is what gives the payments system its stability. The public needs to have confidence that their cheques will be cleared efficiently and without undue delay.

I am aware of various isolated legal rulings to the contrary, which have determined that bank deposits do not have special status and are mere borrowings.  However IMHO these instances merely reflect the economic ignorance of the judges concerned.  Moreover it is interesting that in practice no retail deposits are ever loaned out.  If they were merely borrowings then this would not be the case at all.

The second relevant thing about retail banking deposits is that they are always accounted – by central banks – as being part of the ‘money supply’.  The money supply is simply money which is accessible to, recognized by, and used by — the general public.  That is why reserves have never been seen as part of the money supply (nor are inter-bank deposits, nor are bank operating accounts, nor are central government deposits in holding accounts with commercial banks, nor is Treasury’s deposit account with the central bank).  Thus it is important to differentiate between the public’s banking deposits (which I designate ‘retail deposits’) from all other types of deposit.

The third thing I would say about retail deposits is that commercial banks have no need for retail deposits as useful assets.  Fundamentally this is because the commercial banking system both creates and destroys bank credit money as it deems appropriate.  Banks are only interested in acquiring the reserves which tag along in principle after all retail deposits, and have no interest in acquiring bank credit money itself.  This explains why any payments to a commercial bank – for any purpose whatsoever – entail the destruction of bank credit money and a temporary reduction in the money supply.  Only the associated reserves are retained intact.

All of this background will help to place into a proper perspective the Hummel proposal to create a single national depository – which is basically incompatible with a fractional reserve system.  Such a national depository would contain deposits of government-created money only, and would be unable to operate in parallel with existing banks issuing credit money deposits.  If banks were to become transformed into true intermediaries (like finance companies) then they would lose the power to create credit money, and the basic reason for their acting as depositories for the nation’s money would also cease to exist.  In these circumstances, a single national depository, which neither borrows nor lends, begins to make sense — as the most efficient way of carrying out the necessary depository function.

John Hermann