Alex Tabarrok points out that Switzerland will have a referendum on a 100% reserve banking system. The details are kind of vague, as is the motivation. It’s also odd that this is occurring in Switzerland, which supposedly has a “problem” with a bloated monetary base. As far as I can see this would lead to an even larger base, much larger.

In the 1930s, Irving Fisher and Henry Simons advocated a plan where bank deposits would be 100% backed by reserves, and in that case the motivation was clear. The idea was to prevent the sort of big drop in the broader money supply that occurred in 1929-33, due to a falling money multiplier. Under 100% reserve banking, the money supply would be roughly equally to the monetary base, and hence the multiplier would be approximately one. But multiplier instability is not a problem today, under our current fiat money regime. The Fed can offset any fall in the multiplier, keeping the money supply unchanged.

Alex links to an article by Martin Wolf, which provides a different motivation for 100% money:

Banking is therefore not a normal market activity, because it provides two linked public goods: money and the payments network. On one side of banks’ balance sheets lie risky assets; on the other lie liabilities the public thinks safe. This is why central banks act as lenders of last resort and governments provide deposit insurance and equity injections. It is also why banking is heavily regulated. Yet credit cycles are still hugely destabilising.

I believe that most people underestimate the role that moral hazard plays in banking instability. Thus I am sympathetic to Wolf’s proposal. But how is the plan to be implemented?

First, the state, not banks, would create all transactions money, just as it creates cash today. Customers would own the money in transaction accounts, and would pay the banks a fee for managing them.

Second, banks could offer investment accounts, which would provide loans. But they could only loan money actually invested by customers. They would be stopped from creating such accounts out of thin air and so would become the intermediaries that many wrongly believe they now are. Holdings in such accounts could not be reassigned as a means of payment. Holders of investment accounts would be vulnerable to losses. Regulators might impose equity requirements and other prudential rules against such accounts.

Third, the central bank would create new money as needed to promote non-inflationary growth. Decisions on money creation would, as now, be taken by a committee independent of government.

Finally, the new money would be injected into the economy in four possible ways: to finance government spending, in place of taxes or borrowing; to make direct payments to citizens; to redeem outstanding debts, public or private; or to make new loans through banks or other intermediaries. All such mechanisms could (and should) be made as transparent as one might wish.

The third point is uncontroversial, it’s how things are done today, and the last point needlessly complicates the system—they should just buy Treasury bonds. The first two points are the key.

Wolf is not really proposing true 100% reserve banking, as the investment accounts would not be backed by reserves. And I don’t understand the point about “creating such accounts out of thin air”. The whole subject of “money creation” and the “money multiplier” is surrounded by confusion, and quite frankly, stupidity. All well-informed observers understand what banks do. Whether you prefer to call that money creation, a money multiplier, or something else depends on how you prefer to define terms. I prefer to define ‘money’ as the monetary base, but most economists prefer a broader definition of money—cash plus bank deposits. No one claims that banks create base money out of thin air. I happen to think the term ‘money multiplier’ should be dropped as it causes more confusion than it is worth. The more interesting multiplier is NGDP/base, also known as base velocity.

Under Wolf’s proposal, banks would be creating deposits “out of thin air” just as much as today. You could deposit $1000 in a bank investment account. Someone might borrow $900 of that money. The borrower might then deposit that $900 in another bank, which then loans out $810, etc., etc. As long as you have bank accounts not backed by reserves (i.e. investment accounts), banks will be creating deposits in pretty much the same way they do today. Whether you want to call that “out of thin air” is an aesthetic choice, not a substantive issue.

Nonetheless, I am attracted to Wolf’s proposal because it allows us to remove moral hazard from the banking system. The risky investment accounts would not be insured by the government, and demand deposits that would be insured would be 100% safe, thus shifting no risk to the taxpayer. (Of course you’d still have to address too big to fail, and I’ll do a post on that soon.)

But if the goal is to get rid of moral hazard, there are more efficient ways of doing so. Why not require 100% backing of demand deposits with base money or interest-bearing government bonds? Then perhaps you would not have to charge a fee to depositors for their checking accounts. Or at least there would be a smaller fee. Yes, there is some risk of a fall in bond prices, but there are two reasons why that risk would be trivial:

1. T-bond prices tend to rise during banking panics.
2. Banks would almost certainly have enough assets backing investment accounts to at least cover the shortfall produced by a fall in T-bond prices that back checking accounts.

And of course you could periodically require banks to “mark to market” the T-bond portfolio. I’m quite confident that deposits backed by T-bonds would be virtually 100% safe.

I’ve advocated removing banks as much as possible from the monetary system. I’d like to see no reserve requirements, so that during normal times when interest rates are positive, the monetary base would be 99% currency. Then the central bank would control monetary policy by adjusting the stock of currency and coins. Everything in the banking system would then be “endogenous.”

So in a sense we are moving in the opposite direction from what I’d prefer. We are moving toward a system with a much larger share of the monetary base being held by banks, due to interest on reserves (IOR), whereas I’d prefer to remove banks from the monetary system as much as possible. Preferably with a monetary policy that leads to positive interest rates, and a system of zero IOR and no reserve requirements.