Fixing the Banks
Mervyn King, the former governor of The Bank of England, has written a very readable book on the interaction of money and banking on the global economy. He offers his insights as a practical banker and a serious economist for the way forward from the financial crisis of 2007-09 that we are still reeling from.
Although he discusses a host of topics relating to how people make decisions in practice compared to how economic theory suggests they behave, the problems of the fixed exchange rate regime within the European Union, and the difficulties of making policy within a framework of competing nations; I will focus on two issues that he raised.
The first is his suggested reform for the banking system. His reform is a modified “Chicago Plan” of the 1930s which called for 100% reserves. Under that regime bank deposits would be matched with cash and short term government securities. Hence no risk and no potential for bank runs. In contrast the current system is based on fractional reserves where banks hold a small portion of their deposits in reserves and lend out the balance. This process is King’s alchemy where short maturity deposits are transformed into long term assets. In the jargon of economists this process is called “maturity transformation.”
This system is inherently unstable because the cash is not there to pay off depositors if they want all of their money at once. To deal with this contradiction the central bank acts as a lender of last resort to meet the demands of anxious depositors. This gives rise to the issue of “too big to fail.” King’s compromise is to turn the central bank into a “pawnbroker for all seasons.” Under his proposed system banks must hold sufficient reserves, liquid assets and discounted long term assets to meet all deposit and short term borrowing liabilities. The discounted assets would be valued at a “normal times” value with an appropriate “hair-cut” to allow for risk and those asset could be pawned at the central bank should the need arise. Any lending above this threshold would have to be funded by additional equity and long term liabilities. Thus depositors would feel secure that their money be there when they needed it.
All this is fine and good, except there would be very little incentive for banks to make risky loans. Why is that bad? It is bad because new businesses, new ideas and new construction have to be funded if the economy is going to achieve the growth that most of us desire. To undertake King’s reforms we would need new institutions to undertake those risks. King is silent on this question.
The other issue that King raises that I would like to discuss is that the universal answer to all financial crises is to throw central bank money at it. We have been doing this for nine years. The problem that King rightly raises is that if the problem is structural rather than liquidity, throwing money at the crisis will delay solving the structural imbalances. To King’s mind central bankers in this environment may set interest rates too high to permit growth, but too low to allow for a structural adjustment.
The issue in the West is that savings are too low, while in the East consumption is too low. For example in order for the U.S. to cure its chronic trade deficit the savings rate has to rise and consumption has to fall, while China’s huge trade surplus has to be cured by higher consumption and lower savings. Politically asking people to reduce consumption is a hard sell so the easy way out is to keep interest rates low that works to keep consumption up.
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