Forced to take risk – The ideal monetary system, part 2

Man is like that – we don’t like to think until we’re in trouble. We rather tend to figure out what went wrong only after a crash. For example, the multiple waves of bankruptcies hitting American banks during the great world economic crisis could have been much softer under more prudential banking regulations. A bank is a dangerous operation, with $90 worth of deposits on the liabilities side against a mere $10 (or less) worth of equity. That is, if the bank were to lose more than $10 on the loans granted against the deposits taken, it will no longer be able to repay the deposits and will go bankrupt. This was happening on a mass scale in those days.

Of course, in the ensuing chaos people started to ponder over how a safer banking system could be set up. Indeed, the most hip economists of the 1930s, professors at the Chicago University tabled a solution that came to be known as the Chicago Plan. They proposed the division of the banking system into banks responsible for lending and those arranging payments, the latter being relevant for our purposes. These would require full reserves, i.e. they wouldn’t be allowed to lend the money deposited with them. Consequently they couldn’t lose it either, and would be absolutely safe. They would function as a kind of money warehouse so that people don’t have to keep cash at home. They would charge a fee for account keeping and the arrangement of payments.

The plan would have required radical changes to the monetary system and the banking lobby managed to prevent its implementation. Instead, the system was divided on the basis of other principles into commercial and investment banks. This at least stops banks from squandering depositors’ money on the stock exchange. That’s something. However, although perhaps to a smaller extent, the banking business has remained a dangerous operation to this day.

As we have seen during the latest credit crisis. But what, indeed, is the fundamental problem with banks? It is the fact that in order to arrange for the management of my money to meet today’s minimum requirements (easy and quick transfers rather than bothering with physical cash), I need to deposit it with a bank. Even if I don’t trust them, and worry that they might not be clever lenders and then they won’t be able to repay, I must give them my dough. I have no other choice. The monetary system forces me to take counterparty risk.

Generally, this risk doesn’t appear to be severe as in normal times, most banks don’t go bankrupt, and even if they do, I’m covered by deposit guarantee. However, as the events of recent years have shown, this is not always enough: money deposited with a bank may not only disappear in a third-world dictatorship but also in developed markets and the EU. British depositors with Icelandic banks and Russian depositors with Cypriot banks know this very well. True, trouble is rare but it’s big when it comes – depositing money with a bank does indeed carry a risk.

The resurfacing problems have again sent folks wracking their brains about what went wrong and how to do it better. Down one path, serious theoretical work was carried out. A 2010 paper by the IMF (The Chicago Plan Revisited) dusted off the Chicago Plant, thoroughly examining and modelling what would happen in a world of full-reserve banking systems. The findings suggest that economic growth would be less cyclical, more stable and stronger, smaller debts would be accumulated, and inflation risks would also be lower. This may be too good to be true, but the question does deserve more consideration. However, no such consideration is given at all: motivation is lacking because no-one seriously believes that fundamental changes could be brought about in the banking system.

Down another path, a specific and practical experiment was launched. In 2009, a person of ambiguous identity created bitcoin, a new kind of virtual money. As I discussed it in a previous post, I wouldn’t bore the reader with its details and mechanism.

Although not according to the original concepts, bitcoin in effect puts into practice the full-reserve banking model proposed in the Chicago Plan. And in doing so, it doesn’t require separate banks to arrange for payments: this service is provided to us by the monetary system itself. We can keep bitcoins in our virtual wallets without having to take counterparty risk (i.e. deposit money with a bank), while we can send or receive payments in a simple, quick and cheap manner. It’s no wonder that the banking system is not amused – bitcoin threatens its existence.

Obviously, bitcoin is not an ultimate solution to anything, as in its present form, it cannot successfully challenge banks in the long run. However, it is a working and viable alternative, which may provide incentives to make banks more secure, or point towards the reform of the monetary system.

Next in the series: Growth forever

Previous part of the series: Monetary Chernobyl