A Better Monetary System?

[William F Hummel <wfhummel@xxxxxxxxx>]

With the banking industry so deeply involved in the financial
misdeeds of the late 90s bubble, I thought it would be worth
taking another look at a 100 percent reserve system.  The
following on my website is a complete revision of the article I
posted on PKT in November 1998.  Comments and criticisms are
solicited.

                          A Better Monetary System?

Some economists object to the fractional reserve banking system
because it seems to permit private enterprise to ?create money
out of thin air.?  They propose instead a system in which banks
are required to maintain 100 percent reserves against all demand
deposits.  No modern nation has actually operated such a system,
so we cannot know with certainty how well it might work.  The
following describes some of the key issues that must be addressed
and proposes a particular solution.

The Money Supply

In a fractional reserve system, the money supply consists of the
monetary base created by the central bank (CB) and credit money
created by the lending of private banks.  This system relies on
the promise that credit money can be converted on demand into
base money at par.  Base money consists of currency plus deposits
at the CB.  Credit money consists mainly of bank deposits, and is
by far the largest part of the money supply.

In a fully backed system, banks cannot issue credit money.  Thus
the entire money supply consists of currency and deposits at the
CB.  Currency, which is used mainly in retail transactions, can
be acquired on demand in exchange for CB deposits.  The bulk of
the money supply is CB deposits, which are used mainly in
wholesale transactions by financial intermediaries (FIs) such as
banks, security dealers, finance companies, and insurance
companies.

FIs that accept demand deposits are known as banks.  Their
depository role is monitored and regulated separately from their
other financial operations.  Demand deposits in banks are
actually proxies for money they must hold on deposit at the CB.

Monetary Policy Options

The basic goal of monetary policy is to provide the financial
liquidity needed for a growing economy while limiting consumer
price inflation to some small positive value.  Monetary policy
can be implemented in two different ways: (1) selection and
control of the money supply growth rate, leaving the money market
interest rate as a dependent variable, or (2) selection and
control of the money market interest rate, leaving the money
supply as a dependent variable.

The first option is feasible only if the CB has direct control of
the money supply, as in a fully backed system.  Some economists,
notably Milton Friedman, advocate a fully backed system with a
fixed money supply growth rate at about 4% per year, consistent
with the potential growth rate of the real economy plus a small
inflation rate.  A key objection to this option is its
inflexibility.  There are certain to be significant external
shocks to the economy from time to time.  The damage could be
ameliorated with temporary changes in interest rates that a fixed
money growth rate policy would not allow.

The second option is adopted here because it provides the
flexibility to deal with special circumstances.  While mistakes
have been made in the past by the CB in the selection of the
target interest rate, a great deal of experience now exists in
many different economies that supports the effectiveness of the
interest rate targeting option.

Monetary Policy Implementation

The money market rate is the interest rate at which deposits can
be borrowed overnight within the private sector.  The target rate
is that rate at which the CB intends to control the market rate.
When the market rate rises above the target rate, the CB
purchases bonds for its own portfolio to increase the aggregate
supply of deposits.  When the market rate falls below the target,
the CB sells bonds.  In this way the CB continually adjusts the
supply of loanable funds to steer the market rate toward its
target rate.

Authorized FIs in good standing may unconditionally borrow
deposits overnight from the CB at its lending rate.  The loan
must be collateralized with Treasury securities, and may be
rolled over indefinitely as long as the borrower has sufficient
funds on deposit to pay the interest and to cover any change in
the market value of the collateral.   The lending rate is set 50
basis point above the target rate.  This spread means that FIs
will use the lending facility mainly to cover short term cash
flow problems.

Total deposits at the CB consist of reserve deposits and working
deposits.  Reserve deposits are those that back demand deposits.
Working deposits are unrestricted.  The CB pays no interest on
working deposits, but does remunerate reserve deposits.  The
interest rate paid is known as the deposit rate, and is set 50
basis points below the target rate.

Banking Operations

FIs that offer banking services must keep a reserve account at
the CB in addition to any working accounts. When a depositor
transfers funds to or from another bank, those banks settle
between themselves with transfers between their reserve accounts.
Creditors of a failed FI have no legal recourse to reserve
accounts.  Thus deposit insurance is unnecessary.

The interest received on its reserve account will normally cover
the cost of an FI's banking service, including some interest on
customer deposits.  Banks will likely compete on the basis of the
interest rate they can offer their depositors, while still making
a profit on the service.

CB -- Treasury Relationship

The CB buys bonds from the Treasury only to roll over the
maturing securities in its portfolio.  The Treasury sells new
bonds directly to the public in order to ensure that the yields
reflect true market value.

The principal source of income for the CB is the interest it
earns on the Treasury securities in its portfolio.  Periodically,
the CB pays any income in excess of its operating costs to the
Treasury.  All Treasury balances are all held on deposit at the
CB, which acts as its banker.  Treasury deposits earn  interest
at the deposit rate.

The Treasury remains responsible for managing its cash flow to
keep its average balance at the CB at a fixed level.  The purpose
is to minimize variations in the private sector money supply
caused by short term imbalances between government revenues and
spending.  A Treasury balance in excess of the fixed level is
auctioned to FIs as short term loans by the CB.

Minimizing the Risk of Systemic Failure

FIs borrow to lend at a profit, but with wide variations in cash
flow risks due to maturity mismatching of assets and liabilities.
There is little about a fully backed system that would eliminate
excessive risk taking by FIs.

To minimize the danger of systemic failure, capital adequacy
requirements should be imposed on all FIs who significantly
mismatch the maturities of their liabilities and assets.  That
applies to most FIs, but not to the depository function of banks.
The required capital-to-asset ratio should be an increasing
function of the mismatch.  Details of the formula will require
careful study to ensure its effectiveness and practicability.

Potential Advantages

A fully backed deposit system should be more robust than the
fractional reserve system.  When only the CB can create money,
and the recipient must sell or pledge collateral to acquire it,
the use made of the money should be more carefully considered.

Other advantages include: elimination of the need for government
insurance on deposits; elimination of overnight sweeps and
similar sterile games that banks play to increase their lending
power.

Transition to a Fully-Backed System

If this system were working today in the US, the amount of
currency outstanding would be about the same as it is now, $600
billion.  The deposits at the CB can be roughly estimated as the
current amount of transaction deposits plus perhaps half of
savings deposits (both in banks and thrifts), for a total of
about $1,500 billion.  The combined total of $2,100 billion
represents the face amount of Treasury securities the CB would
have in its portfolio backing that money.  While that?s only
about two-thirds of the securities outstanding, it represents a
substantial addition to the CB's current portfolio, now about
$600 billion.

The transition will not be easy.  It would have to be carefully
planned and phased in to give all parties adequate time to make
the necessary adjustments.  Banks and thrifts would have to close
out their existing loans, since they represent credit money that
is no longer legal under a fully backed system.  At the same
time, the CB would have to purchase outstanding Treasury
securities to finance the loans being redeemed.  A logical way to
proceed would be to gradually increase the reserve ratio
requirement on existing depositories until it reached 100
percent.  In the process it is likely that many bank loans would
be purchased by FIs as investments.

William F Hummel