In Praise of the Pawnbroker

On Mervyn King: The End of Alchemy. Money, Banking and the Future of the Global Economy, London: Little, Brown, 2016, 431 pages

by Joseph Huber


In 2010, King seemed to make fun of his peers when he portrayed them as 'misconceived men of très haute banque' and said: 'Of all the many ways of organising banking, the worst is the one we have today'. For the then Governor of the Bank of England that sounded rather radical and roused expectations among those who actually think the money and banking system is in need of overhaul. In vain. Lord King simply loves to crack a joke now and then. For the rest he is quintessentially a conventional central banker.

His book is about the alchemy of making trusted money out of thin air. Like other scholars he identifies much too low interest rates that recurrently result in various credit and debt binges as the major cause of recent financial crises and as the major continued problem, likely to result in another major crisis. For decades now, too low interest rates and overshooting money supply have been reinforcing each other, and the central banks have trapped themselves in a constraint of ever looser money and ever lower interest rates, down even into negative terrain. Returning to tighter money and historically normal interest rates would be necessary, but must also be expected to ruin many a debtor, thus also many a creditor, and including many a government and bank in both functions. Before recovering, the economy would surely go into depression.

King talks much about money but says remarkably little about the functioning and dysfunctions of the present money system which the central bankers are supposed to run and be in control of. Instead, and still his own central-banker's self, he is fixated on the liquidity and solvency of banks.

Most noticeable is King's ambiguity about the loanable funds model of banking. He occasionally mentions the banks' ability of deposit creation whenever a bank extends credit, that is, the creation of sight deposits in current bank accounts, the bankmoney we use for cashless payment. For the most part, however, rather than seeing banks as the primary and pro-active money creators today, he considers banks to be financial intermediaries between savers in a bank and borrowers from a bank. He thinks in terms of 'customer deposits funding bank loans' rather than 'bank loans creating customer deposits'. The latter is correct, and asserting both together is not possible as any payment from a nonbank to a bank results in the deletion of bankmoney. Banks can pay with cash and reserves only, not with their liabilities to customers. Moreover, King does not bother at all with who or what has the lead in money creation, the bankmoney created by the banking sector or the reserve positions created by a central bank.

This has a bearing on King's monetary reform perspective. In his opinion, the official banking reformssuch as the Dodd-Frank-Act (including, among other things, mandatory insolvency plans sparing third parties) or the Basel rules on higher bank equity and liquidityare insufficient and not truly changing the system in place; which is one of a number of views and assessments I am happy to share with the author.

On the other hand, he deems 'more radical reforms' such as 100%-banking (customer deposits fully backed up by central-bank reserves) too disruptive. He assumes that the advantage of the safety of money, pre-empting bank runs, would come with disadvantages regarding the availability of money and the flexibility of the money supply. One is left with the impression that much of what he says on those 'radical' approaches might be ill-informed. The fact that he misperceives today's approaches to a single-circuit sovereign money system as further 'variations on the same theme' fits that impression.  

Apparently, mentioning these reform approaches is but argumentative tactics to present King's own proposal as the golden middle course between official conservatism and alleged disruptive radicalism. King's proposal is the central bank as 'the pawnbroker for all seasons', replacing the model of central banks as the banks' lender of last resort. The idea is for banks to have to position at the central bank much more asset value than there are deposits and short-term debt on a bank's balance sheet. The amount of admissible deposits in a bank would result, for example, from a bank's liquid central-bank reserves, plus its liquid securities minus a calculated haircut of 10%, and its illiquid loans minus a haircut of 50%. More generally speaking, 'the regulatory requirement on banks and other financial intermediaries would be that their effective liquid assets should exceed their effective liquid liabilities' – which is typical for thinking in terms of the outdated loanable funds model.

King's pawnbroker approach represents a combination of narrow banking with a leverage ratio. The narrow-banking element includes securities and loans in addition to sub-par reserves. The leverage ratio builds on these components rather than on a bank's equity as is the case with the new Basel rules.   

King expects his approach to prevent future banking and debt crises. This, however, is bound to substitute one delusion for another.
Within the present bankmoney regime that operates on a fractional base of reserves, a bank cannot fully and wilfully decide on the customer liabilities it happens to have on its balance sheet. Credit and deposit creation is a co-operative act among different banks, in that a bank that extends a loan is different from the banks that happen to be the recipients of the deposits created in that act.  
The banking industry has the lead in money creation and will thus easily be able to create itself the assets which it takes to comply with the pawnbroker rule and the calculated haircuts; certainly not overnight, but in a certain period of time.
Assets and debt thus would continue to rise in disproportion to GDP. Beyond critical thresholds, and irrespective of any pawnbroker rule, such disproportionate growth is by itself a problem and cause of crisis.    
In a banking crisis, the value of many assets are declining rather than remaining stable.

King's pawnbroker model turns out to be too close to those conservative measures to make a real difference. In a banking crisis, the more so in a systemic crisis, central banks would still be likely to overthrow their rules and conditions of 'très haute banque' and fall back to being 'unreserved' lenders of last resort, resorting to basically unlimited quantitative easing and to refinancing banks and zombie banks at very low or no cost.

In actual fact, hardly any measure will make a significant difference as long as there is the split between interbank circulation on reserves and public circulation on bankmoney, and as long as the bankmoney in public circulation is but a customer claim on the banks and a bank liability to its customers; or put differently, as long as money and credit creation represent a false one-act identity rather than keeping monetary powers and banking functions separate from each other.

 
Lord King promising stable money

Lord King promising stable money

 
Charlie Chaplin in his pawnbroker's shop

Charlie Chaplin in his pawnbroker's shop