In Part 2 of this series I explored some of the reasons why Ed Miliband’s market share cap banking reform idea, while it may lead to more competition, would not solve the problem of easy credit creation leading to bad investment and ‘boom and bust’. While it may create a form of second rate banking sector, competition only works when it’s true competition, not corporatism {see Allister Heath writing in the Telegraph this morning – ed}. In this part we shall examine backbench Conservative MP Douglas Carswell’s idea expressed in his paper ‘After Osbrown’.

Carswell’s paper is a far more in depth examination of the problem than Miliband’s speech, and it is easy to see why he remains on the backbenches. As the title of the paper implies, he is not a fan of Chancellor Osborne who, while preaching austerity, is accused of overseeing the “greatest Keynsian stimulus in our history”. Nor is he a fan of the creation of money by Central Banks (QE) and accuses Osborne of merely continuing where Brown left off on monetary policy.

He charts the four periods of UK money creation followed by four ‘busts’ from 1968-2007, and notes the current growth in money supply. Nor is he is an admirer of the Bank of England’s (BoE) independence:

“‘Now’ wrote Mervyn King about independence ‘we really did have a chance to show what the Bank of England and price stability could do for this country’. And they did. Unaccountable central bankers presided over an even greater monetary policy disaster than the ERM debacle… Once independent, the central bank’s monetary policy has been consistently loose.”

The argument is that, in consistently setting interest rates too low, Central Banks have encouraged ‘normal banks’ (responsible for creating 95% of money) to create too much money which has been badly invested. When interest rates rise (as they are expected to do this year) businesses and individuals who have invested unwisely cannot repay their loans leading to the ‘boom bust cycle’.

While Carswell’s critique of Osborne’s fiscal policy – that the deficit remains around £100bn per year – is widely accepted, his critique of UK monetary policy is very much of the Austrian School. He demonstrates that our current Government has really changed nothing; the same mistakes that caused the problem are being repeated. Likewise he rejects bank leverage ratio reform, dismissively saying

“technocrats who could not set the right interest rates are hardly likely to be able to know how much credit each bank should be allowed to issue.”

I think most advocates of free market economics should welcome this critique.

His ‘free market’ suggestion relates to ownersip of bank deposits and is based on his attempt to introduce his Financial Services (Deposits and Lending) Bill in 2010. One of the greatest fictions of common thinking is that people own the money their bank accounts; they don’t. The answer to the question “how much money do you own?” is whatever you have in your pocket/purse/wallet/under your mattress. Once in the bank, your money is theirs and is spent almost immediately – ask the Cypriots!

Carswell’s idea is that two types of deposits be created; one owned by the depositor that could not loaned on or ‘gambled’ in the fractional/leverage system, and one that is owned by by the bank (as now) and is used create more money/credit. This, it is hoped, would curtail what some consider the ‘excessive’ credit creation that leads to bubble booms and subsequent busts – without the need for ‘technocratic’ or top down arbitrary intervention which by it’s nature can never be exactly right. It might be argued that the supposed ‘firewall’ in the Governments Financial Services (Banking Reform) 2013 due to be passed this year is another attempt at such ‘top down’ intervention.

One obvious response is “why don’t all accounts belong to the depositors?” and the equally obvious response is because banks also make loans which are used for the investment that makes the economy grow. They lend your money on and pay you part of the interest. Without this ability to create money/credit, economic growth would stop. One might ask if under such a two-type despositor system, with less money available for credit creation, whether economic growth might not be unnecessarily inhibited?

Another question that Carswell’s two-type despositor system doesn’t answer remains the leverage ratio issue discussed in Part 1. If a bank still only has to keep 3% of the value of it’s loans and investments in the vault, then as soon as more than 3% of those loans/investments go bad the bank is in trouble. Presumably there would be less money to loan on as some deposits would be protected, so it is possible that the real leveraging ratio would be decreased even further, making banks even more at risk of going broke or having to be bailed out by tax payers. We can also assume that, rather than reigning themselves in, when banks required more money to create loans they would raise the interest rates, leading onto the second problem…

While Carswell notes the effects of Central Banks keeping their interest rates too low for too long (in other words, being “consistently loose”), it is unclear how the two-type despositor system would help curb the influence of ‘loose’ Central Bank interest rates on the credit creation cycle of ‘normal banks’. When the Central Bank keeps its interest rates too low it encourages and allows other banks to create ‘cheap money’, since the banks themselves can always borrow cheaply.

There is a further problem with the ‘Carswell system’; how do you know your ‘safe’ deposit is not being loaned out? Is the bank’s assurance sufficient? Presumably not if you doubt them even once. Similar problems to these have been encountered in the scandal of US COMEX trading companies, who charged customers ‘storage fees’ for gold that had already been sold on! No storage, no gold, and the deceived customer still paying.

While Mr Carswells critique excellently charts the liturgy of errors of UK monetary policy past and present his proposed reform in itself does not solve the all problems his criticism raises.

In the concluding Part 4 of this series I shall discuss some alternative ways of approaching these problems.

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