Home > Uncategorized > Bundesbank rejects 100%-money based on sophistry and false claims

Bundesbank rejects 100%-money based on sophistry and false claims

from Norbert Häring

In its April monthly report, Deutsche Bundesbank explains that banks create money ex-nihilo and rejects the proposal of 100%-money. The full English version is now online. The arguments employed to discredit 100%-money are a mix of sophistry and misleading or false statements.

With some delay, Bundesbank has joined the Bank of England in explicitly stating that the treatment of banks and money creation in most textbooks is wrong and that banks are not intermediaries, transferring money from savers to investors, but rather creators of money.

A key statement is this:

Sight deposits are created when a bank grants a credit or purchases an asset and credits the corresponding amount to the customer’s bank account in return. This means that banks can create book money just by making an accounting entry. This refutes a popular misconception that banks act simply as intermediaries at the time of lending – ie that banks can only grant credit using funds placed with them previously as deposits by other customers.

All the explanations are impeccable, albeit framed in a way that is very friendly toward the interests of commercial banks. The Bundesbank is stressing the “services” that banks provide. It does not even mention the benefits, which banks derive from their extraordinary privilege of having their short-term debt instruments treated as money.

Still, overall the article is a welcome attempt to bring knowledge and sanity back into the treatment of money.

The Annex titled “Remarks on a 100% reserve requirement for sight deposits”, however, is quite disappointing.  

First, the Bundesbank correctly states that proponents of 100%-money view commercial banks’ ability to create money to be a major cause of damaging credit cycles, aka boom-bust cycles. Reforms aimed at making the banking system more stable should therefore, in their opinion, limit money creation by commercial banks. This is how Irving Fisher reasoned more than 80 years ago in his proposal for 100%-money.

For an example of a fatal boom-bust credit-cycle (which the Bundesbank does not give) one does not have to go back to the great depression, which influenced Fisher and other proponents of 100%-money and related concepts. About 15 years ago, banks in the US and parts of Europe started to increase real estate lending with increasing rates. The new money flooding into real estate markets and the economy pushed up real estate valuations and boosted the economy. Banks felt ever more comfortable lending, and borrowers felt more comfortable borrowing; until at some point not enough new borrowers could be found any more to increase the flow of new money. Real estate prices stopped rising and finally turned negative. The whole Ponzi scheme, which relied on ever increasing rates of credit growth, collapsed into a debt crisis. In Europe it turned into a government debt crisis, which continues to this day.

Always at our service

The Bundesbank reminds us, that banks do us a favor by giving credit and buying stuff with money they can create out of thin air:

As the main text already states in detail, one central service provided by profit-maximizing commercial banks is that they make sight deposits (book money) available by extending loans.

Honestly, I would pay quite a lot to be allowed to provide the service of buying staff or lending money against interest by giving out short term debt obligations (IOUs) that I will not have to repay. The Bundesbank continues by explaining how maturity transformation by banks creates liquidity for the economy, another very lucrative (for them) service they provide:

Although banks invest in comparatively illiquid projects or assets, they provide liquid and – in principle – interest bearing assets (from the banks’ viewpoint, these are liabilities) in the form of sight deposits, which promise smoother patterns of return than other investment forms. By making sight deposits available while “simultaneously” investing in illiquid projects, banks provide a maturity transformation service. They create liquidity and give depositors the ability to consume intertemporally, whenever they want to.

Translation: Banks buy high-yielding (long-term) assets in exchange for giving out very low-yielding (short-term) IOUs. This works because the IOUs are not really short-term. Due to their functioning as money, very few of them are every repaid. The vast majority circulates in the banking sector continuously. The function of the strange insertion that bank IOUs serving as money are “in principle interest bearing” and “promise smoother patterns of return that other investment”, is hard to understand other than as an attempt to deflect from the fact that providing this service is so lucrative After all, interest on sight deposits is usually very near zero, which is the reason, why the return of depositors promises to be quite stable (near zero). The flipside is simply: banks make a lot of money that way.

The fact that banks make promises, which they can only heed in good times – this awkward fact, which causes these terrible busts at the end of the booms – is cast as another favor they do us:

As long as the liquidity risks of the individual depositors holding sight deposits with banks do not correlate perfectly, banks can bundle resources (and risks) such that, on balance, they only need to maintain a comparatively small fraction of liquid funds as a reserve and can invest the greater part of the available funds in illiquid and therefore higher-yielding assets. Thus, the banks can offer depositors short- term sight deposits so that depositors faced with an unexpected need for liquidity are not compelled to sell illiquid assets or long- term investment projects at a loss. From the depositors’ viewpoint, this is equivalent to insurance against illiquidity which can be implemented by a banking system maintaining a fractional (ie not a 100%) reserve.

I will argue later that it is very easy to provide this liquidity insurance for depositors in a different, much safer way.

The admission that the banks’ fair-weather-promises can cause a problem, does come, but in an idiosyncratic way:

However, this advantage is offset by the risk of a liquidity problem arising in the event that a bank cannot meet demands to repay deposits. If more depositors than anticipated withdraw their sight deposits – not because they need liquidity unexpectedly but because they fear that other depositors may withdraw their money and cause the bank to collapse – this form of coordination among consumers can trigger a run on banks.

Note that in this explanation, the problem is caused (triggered) by (somewhat irrational) depositors not by the usual reason for a bank run: news or rumors that a bank is in trouble because of losses and that customers need to run, to preserve their hard-earned money. The bank has made the promises it cannot keep. The bank doled out the extra profits it made that way in the form of dividends and above-average salaries and bonuses for their top brass. The bank has gone too deep into risk to reach the next level of return on capital – and then ran into trouble at some point, but has no reserves. But still, for the Bundesbank, it is the unruly, irrational depositors who are to blame, if the bank goes under.

After this idiosyncratic but generally correct way of laying out the problem, the Bundesbank spends many paragraphs on distracting sophistry. The authors claim that a 100% reseerve requirement would not stop banks from creating money because:

The level of the reserve ratio in itself would have little impact on the banks’ lending capacity. This finding, which may seem surprising at first glance, is owed to the fact that central banks do not steer credit dynamics through the central bank money stock but by how they set the key interest rates. Central banks use their liquidity management to accommodate higher minimum reserve requirements. (…) Since the reserves are factored into the banks’ optimisation calculation as a cost factor, the amount of the reserve ratio could in principle narrow the profit margin and thus indirectly affect lending and the provision of sight deposits. However, this indirect influence on the margin is essentially irrelevant, as central banks worldwide now pay interest on the required minimum reserve holdings in the amount of the refinancing costs (rate for making central bank money available). Taken in isolation, with regard to the payment of interest on reserves, lending and thus the provision of liquidity are not constrained by already existing sight deposits or by reserve holdings.

Translation: Banks give credit first and look for reserves later; and they can trust that the central bank will supply these reserves later. Better still: central banks provide these reserves for free, as they pay as much interest on required reserves as banks have to pay to get these reserves. If this arrangement were kept in place, hiking reserves even to 100% would not impede money creation by banks.

The arrangement does describe the current – exceedingly favorable policy towards commercial banks – that central banks have put in place. There is a “reserve period” in which banks have to fulfil their reserve requirements on average. In Europe, this is a month-long period. Banks thus have plenty of time to “look for reserves later” after making a loan and they can get these required reserves for free.

However, it would be absurd to continue with an arrangement, which is designed to make money creation as easy as possible, after introducing 100%-money, which aims precisely at preventing banks from creating money. All it takes to stop money creation under 100% money is to make sure that banks can access central bank funds only at the beginning, but not toward the end of the reserve period, except maybe at penalty rates. If this change is made, banks can only intermediate existing money, but not create new money. New money would only be inserted into the system by the central bank.

It gets worse: After their distracting sophistry, the Bundesbank’s economists say something that is plain wrong:

Under such a system, the credit department could grant additional loans only if it increased its capital, generated income from its lending activities or acquired liabilities in the form of savings, the maturities of which largely matched those of the loans on the asset side of the bank’s balance sheet. Consequently, the credit department would not, as it were, engage in maturity transformation and therefore could not perform a key function of the banking sector. Such a financial system without maturity transformation would likely lead to considerable welfare losses.

The 100%-money-proposal makes it necessary to distinguish accounts that can be used to make payments from savings accounts. Only the former would have to be backed by reserves.

Money in a savings account, which fulfils the requirements of not being usable for payents, does not have to backed by reserves. It would be treated as a loan to the bank. Thus, there is nothing inherent in the 100%-money proposal that prevents banks from making a ten year loan out money that depositors have given them for, say, six months.

Banks could run into problems because of that, and their customers with them. However, the potential for this to affect the whole payment system and the whole banking system, is much more limited, as banks cannot create new money in this system and depositors cannot run on the bank within days or even hours.

As an aside: There would be an incentive to provide savings accounts with features, which make them usable for payments or which can be very quickly and easily transferred into payment accounts. Thus, there would need to be a regulation to prevent that.

The Bundesbank goes on:

It would be more difficult in a system without the maturity transformation function to reconcile the preferences of long-term-oriented investors with any short-term liquidity needs they might have.

Not much more difficult, though. The regulation to separate savings accounts from payment accounts could impose a moderate penalty if a customer withdraws savings before the contract expires and banks could commit to accepting such withdrawal requests. To prevent bank runs, any such repayments before maturity could be made conditional on some competent authority not having issued a general hold on them or a hold for a certain bank or a group of banks.

Maturity transformation still possible, but less necessary

The Bundesbank also fails to mention that the central bank could and probably would provide enough long-term liquidity to make maturity transformation by commercial banks largely unnecessary or at least much less important. To understand, let us briefly look at to possible ways in which the central bank could add new liquidity.

  1. They could continue to go through banks and provide these with new liquidity by either buying asset from them, or by giving them reserves on credit. In the first case, banks receive reserves with infinite maturity. They never have to pay the money back. In the second case, the central bank can decide on the term-profile of the money they give to banks. They could easily continue the current practice of giving long-term or longish-term credit to commercial banks.
  2. They could also gift the regular installments of new money either to the government or to citizens directly. If the government pays a bill with that money, by transferring it to a business partner with an account at a commercial bank, the account of that commercial bank at the central bank would be credited with indefinite maturity reserves.

Thus, the need for the maturity-transformation-service of banks is artificially created and could be taken away at any time.

After a short discussion of macro-modelling exercises of 100%-money, the Bundesbank concludes:

A reserve ratio increase to 100% would not necessarily bring about a stabilization of macroeconomic growth. It would be wrong to assume that restricting money creation for a part of the financial system (“sight deposits” sector) would in itself be sufficient to make the entire financial system resilient. This would continue to require effective regulation, supervision of banking.

That is true. 100%-money will not solve all the problems at once. However, a Porsche is still a better car for most people than a little Hyundai, even though it cannot fly any better.

Moreover, there is a risk of evasive action being taken in that new, non- regulated institutions could be set up to fill the gap. There is no a priori reason why these new intermediaries should be more resilient (or even immune) to a run than the banks that exist at present.

The individual instituions might not be immune, but their problems would not be everybody else’s problems any more. Shadow banks cannot pump new money into the economy and thus it is much harder for them to blow up a big self-inflating bubble. In the past, they have caused the trouble they caused in concert with banks creating too much money. Under inadequate regulation they might be able to create near-money that floats around in the financial sector. But there would not be a boom in the economy in general and if these financial institutions went under, while the payment system was safe, there would be less damage to people and the economy than in the current system.

From the present perspective, the strengthening of the resilience of the financial system as a whole needs to be achieved by other means, notably by boosting its capital base as well as developing and expanding an effective macroprudential toolkit.

Boosting banks’ capital base would be helpful under 100%-money. In the current system, however, a banking system that can print money can print all the capital it needs. This does not make this banking system any safer. All it does is enabling an even bigger bubble, which will finally burst with even more disastrous consequences. One Swiss bank reportedly increased its capital during the banking crisis by giving a loan to a Sheikh, who would use the money to put in additional “capital” into the bank. Usually, this is done in a more roundabout way. However, it remains true that if banks create money, they also providecreate the money that is used to increase bank capital. Remember the failure of the bank-capital based rule-books Basel I, Basel II, Basel III and soon Basel IV. This is no coincidence.

The macroprudential regulation that the Bundesbank is alluding to, would still be a step in the right direction, if it was done properly, which it is not (inter alia, because of international competition of banks and regulators). But it is not nearly the panacea that the Bundesbank wants it to be. It consists in regulators demanding more capital from banks in a credit upswing and becoming more lenient in a downswing. However, the extra capital demanded is modest. Once the upper limit is reached, i.e. exactly when the credit boom goes really wild, this regulation seizes to be effective.

In conclusion, the Bundesbank has to come up with better arguments, to convince people outside the banking sector that withdrawing a lucrative and very dangerous privilege from the banking sector would harm anybody but the banking sector. The banking sector would be harmed, though. The basis for far-above average remuneration in this sector would go away. This would be an additional bonus for the rest of the economy, as talent could go into more productive sectors again.

This article appeared first at norberthaering.de

German version

  1. antireifier
    May 16, 2017 at 3:24 pm

    Do you think this will impact the Swiss referendum? In what way? If not, why not?

  2. May 16, 2017 at 3:37 pm

    We can safely assume that it is meant to influence the Swiss referendum on “Vollgeld”, which is a variant of 100%-money. How much it will do that, is anybody’s guess. Had the Bundesbank come out in support of 100%-money, it would certainly have been a big issue in the campaign. A rejection will have some influence, but less than the rejection by the Swiss central bank.

  3. May 18, 2017 at 9:58 am

    In the US banks and banking have often been problematic. Andrew Jackson said this about the 2nd US Bank in a speech in 1832,

    Is there no danger to our liberty and independence in a Bank that in its nature has so little to bind it to our country. The president of the Bank has told us that most of the State banks exist by its forbearance. Should its influence become concentered, as it may under the operation of such an act as this, in the hands of a self-elected directory, whose interests are identified with those of the foreign stockholders, will there not be cause to tremble for the purity of our elections in peace, and for the independence of our country in war. Their power would be great whenever they might choose to exert it; but if this monopoly were regularly renewed every fifteen or twenty years, on terms proposed by themselves, they might seldom in peace put forth their strength to influence elections or control the affairs of the nation. But if any private citizen or public functionary should interpose to curtail its powers, or prevent a renewal of its privileges, it cannot be doubted that he would be made to feel its influence.

    • May 19, 2017 at 6:08 pm

      Quote Frederick Soddy (The Role Of Money,1934), “… every monetary system must at long last conform, if it is to fulfill its proper role as the distributive mechanism of society. To allow it to become a source of revenue to private issuers is to create, first, a secret and illicit arm of the government and, last, a rival power strong enough ultimately to overthrow all other forms of government.”
      ******Excerpt from http://en.wikipedia.org/wiki/Frederick_Soddy
      “In four books written from 1921 to 1934, Soddy carried on a “quixotic campaign for a radical restructuring of global monetary relationships”[this quote needs a citation], offering a perspective on economics rooted in physics—the laws of thermodynamics, in particular—and was “roundly dismissed as a crank”[this quote needs a citation]. While most of his proposals – “to abandon the gold standard, let international exchange rates float, use federal surpluses and deficits as macroeconomic policy tools that could counter cyclical trends, and establish bureaus of economic statistics (including a consumer price index) in order to facilitate this effort” – are now conventional practice, his critique of fractional-reserve banking still “remains outside the bounds of conventional wisdom”[this quote needs a citation]. Soddy wrote that financial debts grew exponentially at compound interest…”
      Free download-

      ‘The Truth Shall Set You Free’; You need only to seek it.

      • May 20, 2017 at 1:02 pm

        Jackson would worry these changes might hurt those too poor or lacking political power to influence exchange rates or the use of surpluses and deficits. Ending the gold standard is anathema for Jackson. But Jackson was not a professional economist and certainly not an engineer or scientist.

  4. November 6, 2017 at 8:16 pm

    It’s important to understand the difference between “100% reserve banking” (a-la “The Chicago Plan”) which entails the continuance of a “dual-circuit” (two kinds of “money” – “inside” money and “outside” money and its variations) with that of a full sovereign, single-circuit one-money system. This distinction is substantial and crucial.

    The “reserve” system is essentially an anachronism of gold-standard days which permitted the ex-nihilo creation of “deposits” in multiples of the amount of government debt and gold possessed (held on “reserve” either in one’s own vault pre-FED or at the FED from 1914). Under a pure sovereign money system, the “money” issue could actually be considered an equity stake in the State, rather than viewed as “liability” created from debt. The State would issue the “money” ex-nihilo, indeed, but without a corresponding debt – the money would be debt-free at source.

    This is not to say that the essential credit-creation function of banks (acting under this scenario as they would have us believe they are now – as pure intermediaries of loanable State monies) and other institutions would end. Quite the contrary – this function would continue in its importance. However, the “funding” of loans would no longer take place ex-nihilo within the commercial banking cartel. Rather, banks would compete for sources of funding, now without the backing of cartel supports such as deposit-insurance and the like, in the open market. And nothing would stop the banks, or other individuals and institutions from issuing their own liabilities (near-money) just as occurs everyday at present in the commercial paper markets. The only difference is, they would not be able to call these instruments “Dollars” (or Euros etc.). These would be Chase credits, or HSBC credits, and these would have to be funded from existing wealth claims, not claims created from thin air de-novo. The “Dollar” (or Euro) issued in this manner would be the “Coca-Cola* of brands” (*James Grant) – and infringement of the brand would not be permitted. Naturally, the built-in functioning of an unrestrained interest-rate market together with the risk of market reflux (redemption or non-rollover of credits) would contain credit growth to a more normal scale. Improper allocation of “money” and credit to loss making enterprises or consumption would be penalized as it should be – with losses!

    Most importantly, a single-circuit sovereign money system (in conjunction with multiple competing alternate, and complementary media of payment) would REMOVE your money from the banks’ balance sheets and put it into a pure equity investment in the State. Taxpayers would no-longer be held hostage to “too-big-to-fail” banks seeking government bail-outs – bail-outs that are always forthcoming because “the peoples’ money” is at risk. When you invest in a Unit Trust or a similar Fiduciary, do your funds go onto THEIR balance sheet? Of course not. Your money-denominated investment is segregated under the strictest of circumstances. But a (grossly mis-named) “deposit” at a bank is taken onto the bank’s own balance sheet. Legally these monies are treated as a loan from you to the bank. And you have no say in how the bank “uses” those “funds”. Bad idea.

    In the sovereign money system I envision, one may have an account directly with the State (the Treasury – NOT the Central Bank). The Central Bank’s functions would be limited to regulatory supervision and enforcement of the banks. The State would create money, designated as Legal Tender only for the reflux of payments of taxes, fees, excises etc with the State, but would not be forcibly treated as legal tender vis-a-vis other debts and agreements of deferred payments (unless voluntarily so chosen by freely agreeing counter-parties in a contract). Deficit spending by the State would increase the amount of money in circulation (with the inherent risk of debasement, just as now). Every singe unit of State-issued money in existence would be uniquely identifiable, and “possessed” by only one entity at a time (just as cash has serial numbers and can only be held by one). Accounting for the State-issued money in this model could and should be accomplished with Single-entry bookkeeping methods (Dollars don’t rust). A given unique unit of Sovereign “Dollars” of this variety (the only valid type) can only be on one entity’s balance sheet at a time. A payment would shift a Dollar from payor-to-payee, in the same manner that Bitcoin digital ledger entries cannot be “double-spent”. Only the energy costs of running such a system would be vastly diminished.

    My monetary reform proposals entail additional crucial steps to ensure a resilient and equitable new monetary paradigm, but space is limited. How do we get there from here is what I’m writing about…


  5. November 7, 2017 at 12:21 pm

    It is good to see Norbert, Lucky and Wes actually discussing alternatives to what we have instead of just whingeing about it. What I don’t see is how 100% money systems can work given the global problems addressed recently by David Ruccio (follow his reference to United Nations Conference on Trade and Development). The globalisation of digital money makes it virtually impossible for national governments to control the movement of “hot” money at the convenience of self-serving speculators, and even UNCTD is advocating more growth rather than more genuine economy, i.e. ecological renewal and inter-social redistribution of wealth. There is a problem too with making States the central bankers: as Wes says:

    “But a (grossly mis-named) “deposit” at a bank [a profit or a tax payment] is taken onto the bank’s own balance sheet. Legally these monies are treated as a loan from you to the bank. And you have no say in how the bank [or government] “uses” those “funds”. Bad idea”.

    Hence my own arguments for what the Bundesbank admissions are making quite clear, that money is not wealth but credit. This is justified by our earning it by using it for what it was intended to facilitate, i.e. caring for ourselves, the world we live in, our communities and our worthwhile projects (which include arts as well as necessities, i.e. the development and expression of our own capabilities). Given real wealth that we happen to have, we can avoid Wes’s “bad idea” by making it available (conveniently via the monetary system) to others who are doing what we cannot do. Even as things stand, one can often choose to invest between saleable and common user goods, opting out of government taxes likely to be mis-spent on armaments etc by covenanted giving from one’s surplus to causes one deems worthy: as of old, building and supporting local schools, hospitals, railways and other infrastructure. Where I live volunteers are rebuilding railways demolished by myopic governments, with the price of resources being met as needed by “crowd funding”.

    Relative to what Wes is saying above bank credits: “… These would be Chase credits, or HSBC credits, and these would have to be funded from existing wealth claims, not claims created from thin air de-novo”, my “credit-card” concept goes further. It makes any credit used ours, not the banks, with what is FUNDED from existing wealth claims needing to be REFUNDED by future work or return of goods. With this to support us we need neither profits nor taxes to pay our wages. We need local banks plus central accounting to keep our credit card accounts for us, issuing only credit limits earned by our credit worthiness; but we also need governments to keep account of what we have and inform us of what needs doing.

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