Sovereign Money: Responding to the Bundesbank

100%-reserve versus single-circuit sovereign money

To begin with, we need to be clear about the subject of the Bundesbank text. It is about a reform approach from the 1930s, that is, 100%-banking (Chicago Plan) or 100%-money according to Fisher. This approach basically keeps the split between the public circuit among nonbanks on the basis of bankmoney (deposits) and the interbank circuit on the basis of central bank reserves. In order to stop bankmoney creation, the minimum reserve requirement (today 1% in the euro area) is to be raised up to 100%.That approach comes with a number of counter-intentional results, even though not always of the kind the Bundesbank assumes.

What can be endorsed is the Bundesbank’s conclusion that even a 100%-reserve does not prevent banks from pro-actively creating additional bankmoney, which indeed applies in any reserve system with pro-active primary bankmoney creation through extending bank credit. Independently, the need to refinance 100% of the bankmoney would improve the effectiveness of base rate policy.

Today’s monetary reform proposals, by contrast, such as for example represented by the initiatives in the International Movement for Monetary Reform, go beyond reserve banking in favour of a sovereign money system or central bank money system. The proposals aim at substituting central bank money for bankmoney in order to create a single-circuit system on the basis of central bank money only, the money circulating among nonbanks and banks alike, be it solid cash, money-on-account, or central bank digital currency.

100%-reserve banking and sovereign money pursue comparable goals, such as for example control over the stock of money by preventing banks from private bankmoney creation; enabling effective and crisis-preventive monetary policies; and full gain from money creation to the benefit of the public purse. Concerning technical aspects, however, the two approaches are fundamentally different, and equating them leads to confusion and wrong conclusions.

The heading of the Bundesbank article correctly indicates that it is just about 100% reserves, but incorrectly states that critical money system analysts today were looking back to 100%-reserve approaches for restraining otherwise overshooting bankmoney, credit and debt creation. The press and blogosphere have subsequently covered the Bundesbank article as a statement on a sovereign money system (i.e. the German Vollgeld or Positive Money), and as a rejection of respective reform initiatives. It is difficult to say whether the confusion is due to a lack of proper understanding or whether in some quarters there may be method behind equating 100%-reserve with sovereign money beyond reserve banking*.

Tighter Basel rules on bank equity versus monetary reform

At the beginning of the Bundesbank text it is said that critics of the present monetary system explain boom and bust cycles by unrestrained bankmoney creation feeding into credit and debt bubbles. This explanatory approach is not contradicted, but is in fact implicitly endorsed, as it is maintained that, rather than calling for a full reserve requirement, the better alternative in dealing with the problem is tighter Basel rules on bank equity and liquidity (a higher equity-to-credit ratio, or credit-to-equity ceiling respectively).

On the surface of it, higher equity buffers appear to be desirable. The question arises, nonetheless, as to why a higher dose of a remedy would be promising if it has proved to be completely ineffective in previous smaller doses? Within the frame of the bankmoney regime, Basel rules III and thereafter maybe IV are not likely to be very effective after implementation. The reason is that securities and equity on a bank balance sheet, as far as when acquired from nonbanks, are paid for with bankmoney created by the banking sector itself. Basel rules thus might decelerate bankmoney creation a little in the short run, but will not prevent banks in the longer run from creating an overshooting primary supply of bankmoney for funding credit and debt bubbles (secondarily also funded by on-lending of bankmoney among nonbanks, further money surrogates such as money market fund shares, and private digital currencies). Banks have always gone bust, even at equity ratios of 30–50 percent as was the case in the 19th century. Rather than caring too much, and ultimately in vain, about the banks’ health, of primary importance is to make sure the money is safe beyond a bank’s balance sheet and under the control of an authority independent of banks and treasuries.

Irrespective of the scope and extent to which tighter Basel rules may make sense, it is misleading to depict Basel rules and sovereign money reform as mutually exclusive alternatives. Banking regulation relating to specific objectives can be advisable in both a bankmoney regime and a sovereign money system. Besides, Basel rules and sovereign money essentially refer to different things. Basel rules are about hopes for enhanced stability of banks in the fractional reserve system by higher loss-absorbing buffers. Considered as a credit-to-equity ceiling this is hoped to act as a brake to overly runaway credit expansion, or bankmoney creation respectively. Sovereign money, by contrast, is about regaining control of the stock of money in the first place, as a prerequisite for achieving monetary safety and financial stability in a much wider sense, including bank stability.

Some people have difficulty drawing the functional distinction between money creation and credit extension due to today’s ostensible identity of money and bank credit. Questions of credit risk, collateral requirements and bank equity are thus mixed with the question of monetary safety and the reliability of cashless payments (which today depend on the banks’ solvability and liquidity in terms of fractional amounts of cash and reserves with the central bank).

The money system today is a state-backed private bankmoney regime, with the bankmoney determining the entire money supply, pro-actively led by the banking sector, re-actively accommodated by the central banks as lenders and dealers of last resort, and warranted by government as the guarantor of last instance. In this system, the safety of the money stands and falls with the (in-)stability of the banks. Economic and financial developments, however, are generally exposed to different degrees of uncertainty. The banking business is unavoidably exposed to different levels of risk, and the banks’ balance-sheet positions, including the bankmoney (liabilities to customers), are latently always at stake, which largely explains the arm-twisting ability of the banking industry to get its way.

Weakness of conventional monetary policy instruments

The Bundesbank article confirms that under today’s monetary conditions central banks always accommodate the banks’ fractional demand for reserves, including an automated intraday overdraft in the ECB payment system Target2. The article, however, fails to conclude that this is tantamount to saying that there is no effective monetary quantity policy. Independently, the article concedes that the effectiveness of base rate policy has weakened, too. This is explained by the presently low or even no cost of refinancing. This certainly applies, but blinds out a more fundamental fact, that is, the fractionality of reserves which is next to irrelevant: 1.4% cash and 0.1–0.5% excess reserves on 100% of the sight deposits (the liquid part of bankmoney), and, in the eurozone, an additional 1% obsolete minimum reserve requirement also on savings and time deposits (the inactive part of the bankmoney). The article nevertheless continues to assume a degree of effectiveness of short-term base rate policy. This is inconsistent with the otherwise accurate description of important features of the present split-circuit monetary system.

Liquidity and credit shortage?

A standing criticism of 100%-banking, also applied to single-circuit sovereign money, warns against liquidity and credit shortages. Apparently, it is assumed that banks, if stripped of the privilege of creating bankmoney on a small reserve of central bank money, ‘have no more money’ and could only finance further lending and investment by expanding their equity base. This is plucked from thin air. Similarly, other critics have claimed that funds for bank lending and investment could only be obtained from the central bank (which may be an echo of the IMF’s 2012 special version of the Chicago Plan Revisited, according to which banks would have to apply for additional credit funding from the central bank. This, however, is very special and not a feature in any other plan for 100%-banking, less so in a sovereign money system).

In actual fact, under a 100%-reserve or in a single-circuit sovereign money system there is no reason at all why banks would not be able to obtain sufficient funding at a reasonable level of interest. Available sources include the money continually flowing back to the banks in repayment of earlier loans and investments, taking up money from customers as well as on the open money and capital markets (which of course can and must exist), and finally also short-term borrowing from the central bank. A central bank can always provide any amount of additional money denominated in its own currency, literally overnight if need be. No expansion of bank equity is needed for this; unless the critics inadequately project an exhaustion of the potential of the Basel rules on a 100%-reserve or a sovereign money system, as critics often inadequately project today’s false identity of money and credit onto a sovereign money system in which money creation and the banking business would be separate.

Considering the present system, by contrast, cyclical shortages of bank credit and money in various actor groups are widespread despite the central banks’ preparedness to provide very large quantities of reserves. If banks at times are not willing to lend or invest, central banks are not in the position to do much about it, because there is no effective transmission from the supply and price of central bank money to the creation of bank credit and bankmoney. If the banks are interested in accommodating the market demand for credit, they can easily do so anytime without needing huge quantities of excess reserves.

In any case, in a 100%-reserve system as much as in a pure sovereign money system it can easily be ensured there is always enough money and never a harmful shortage of money. Whether, however, there would at times or in certain cases be a credit crunch, continues not to be depending on the monetary system, but on the financial institutions, including the banks, and the financial markets. In today’s bankmoney regime with its false identity of money credit, of course, the one is automatically tied to and confounded with the other.

Maturity transformation and financial intermediation

Another standing criticism concerns maturity transformation, a favourite issue of orthodox banking theory to which the Bundesbank article refers at some length. This too contradicts the otherwise correct description of the bankmoney regime. The theory of maturity transformation considers banks to be financial intermediaries by taking up money short-term and lending that money long-term. This is definitely wrong as modern banks are not and cannot be financial intermediaries like nonbank financial institutions (e.g. funds). A modern bank is not a savings and loan association.

Banks have become monetary institutions, bankmoney creators whenever they make payments to nonbanks, and bankmoney transferers, say monetary intermediaries, when they carry out payments on behalf of nonbank customers to other nonbank customers.

Nevertheless, even though there is no maturity transformation in the banking sector, there are mismatches, to a greater or lesser extent, regarding maturities of various banking assets and liabilities. Equally, there are balance sheet positions with different degrees of (dis-)advantageous liquidability. In a way, this violates the golden banking rule of bygone times, but, given the prevailing general liquidity preference, such mismatches are unavoidable in maintaining the banking business.

The Bundesbank article posits, as other critics have done before, that under a 100%- reserve rule maturity transformation is no longer possible. As explained, such transformation does not exist (it exists in nonbank financial intermediaries), and assuming the banks under a 100%-reserve rule or in a sovereign money system not to be able to run their business on the basis of a tolerable degree of maturity and liquidability mismatch is again plucked from thin air. In a sovereign money system, banks are no longer monetary institutions; instead, they would again be financial intermediaries, taking up money short- or long-term as suits them, and lending or investing that money short- or long-term in a somewhat different composition of maturities and liquidability.

Maturity and liquidability mismatches were necessary in former cash economies as well as under the gold standard; they are common in today’s bankmoney regime, and would continue to exist with a 100%-reserve requirement as well as in a sovereign money system. Supervisory authorities and specific regulation of financial institutions will not become redundant. But a monetary system with effective control of the money will rest on safe money, will thus be able to make redundant various parts of the regulation, and will reduce the number and severity of instabilities and crises that haunt banking and finance today.

— source positivemoney.org by Joseph Huber

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