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Daring, ambitious and fun, but fatally flawed
on 13 October 2014
I loved reading this book. It was a breath of fresh air. Despite the young age of the authors (or perhaps because of it) the first four chapters (pages 1 to 154) are as good a primer on the history, purpose, inner workings and current failings of banking as I've ever read. Perhaps it's the best I've read. If a friend asked me for one book to read about money and one book only, I'd order this book, tear out the first four chapters and give them to him.
There are ideas there that had never occurred to me and I've spent 23 years in banking. Example: kings who minted new coins made sure the new currency became "legal tender" by only accepting payment of tax in the new coins. Example: the 1974 oil embargo was mainly about reacting to the fact that the dollars the Arab states had accumulated over the years were no longer convertible into gold, much as these days we ascribe the formation of OPEC to political events in the Middle East.
The book is chock full of insights of this nature. A bit like Tarantino's first proper movie had every funky piece of dialogue he'd ever dreamt of, "Modernizing Money" is packed with everything the authors know, from an appendix on the recent economic history of Zimbabwe to a fantastic description of how an economy will react to fiscal and monetary measures and an unmissable extension to Irving Fischer's MV=PX that goes a long way toward explaining how QE is only really pushing up assets (p.119 onwards) . It's great stuff.
From chapter 5 onward, however, it gets very naïve.
Scandalized by the discovery that most money is created by banks (coming ten years after their parents told them how babies are made, give or take) the authors next attempt to design a banking system that will end boom and bust. Their main idea is that the general public will have two choices when it goes to the bank. Either (i) stick the money in a 100% safe piggybank that the bank gives up to the central bank, while retaining (and charging for) its basic administration, such as giving its clients access to a debit card, cash machines etc. or (ii) stick it in fixed time deposits that pay an interest because the bank can lean on the time deposits to make loans to the real economy. These accounts would not be guaranteed by any type of deposit insurance and would be the only source of "bank credit" to the economy. No time deposits, no loans.
The authors do brilliant work in terms of taking the reader through the intricate accounting repercussions of moving to such a system and provide a step-by-step sketch of how we'd move from the current system to the new one. Much as I was shaking my head throughout this bit, it was a fantastic mental exercise. I truly enjoyed going through it.
Bottom line, however, the authors fail to recognize that what we have here is a problem with human nature rather with the banking system. This is not to say our banking system is flawless. Far from it! If you had to design the banking system from scratch you probably would not design it the way it looks now. With no doubt, today's banking system evolved from a set of historical circumstances that are no longer relevant. But the problems we face are of our own doing. The banking system is not where I'd start, especially if there was a twenty year transition period to be negotiated.
So the authors mention somewhere that fully 69% of UK households own their dwellings. But they think it's the fault of the banking system that there is a housing bubble. Erm, no! In a system called democracy the majority will attempt to elect itself rich, impossible as that sounds. And it will use the banking system to enforce its will. The counterfactual can be observed in countries where ownership is below 50% (Germany and Switzerland spring to mind) where there is no housing bubble, because no politician thinks he'll benefit from hare-brained ideas like "help to buy."
The authors also mention Hyman Minsky's favorite aphorism that the "fundamental instability of capitalism is upwards," but have the arrogance to think they can design a system that works around this problem. It can't be done. Whatever system we design will next be watered down by politicians as they succumb to the will of the electorate.
The US, for example, did once have a system with separate banking and investment banking, current accounts that paid no interest, capped interest on time accounts, banks that could only operate in a single state and thus never become too big to fail, a Fed that wilfully brought about a double dip recession in 1980 and 1982 to fight inflation, a system, in short, with more than half of the things the authors would like to see. My BayBank card did not work in New York and my Citicard did not work in Boston and neither bank would grant me credit, let alone allow me to punt stocks.
But Don Regan (Ronald Reagan's treasury secretary and former CEO of Merrill Lynch) gave us the right to bank out of our stockbroking account, Bob Rubin (Bill Clinton's Treasury secretary and former CEO of Goldman Sachs) helped us get rid of that annoying Glass Steagall act, Angelo Mozilo singlehandedly changed everybody's home into an ATM, Alan Greenspan underwrote the value of the stock market and so on and so forth until a short thirty years later the entire legal, regulatory, operational and business landscape has become totally unrecognizable. To say nothing of the shadow banking system, which has grown to be larger than the banking system.
So to say that there is something we can do to change everything shows naivete of the highest order. The way this gets fixed is through a proper crash of the kind nobody can contain. Then we'll get serious, make all the necessary reforms, perhaps even adopt some of the authors' ideas, and of course get back on track toward instability. That's how it works.
There are some further technical points I feel need to be made here:
1. The authors assert that money is not a means of exchange, a unit of account and a store of value as per all economics texts out there, but is first and foremost a number that appears in your bank account when you get a loan. They mention at least ten times in the book and on the back cover and on their website than 97% of all money arises in this fashion from loans banks make; they make this sound like some sort of betrayal. Does not bother me, personally, one bit, provided somebody out there is counting all this money, keeps an eye on the total and tells them to cease and desist when they have hit some type of limit. Call it a leverage limit, call it a reserve ratio, call it what you like. If this failsafe is in place and if it's enforced, you're cool. And if it's not being enforced, more importantly, don't blame the system. Blame human nature.
2. The authors don't like the fact that the central bank holds government bonds against the money it issues. Why not? Government bonds are a claim on future tax. Indeed, a claim on future tax that can only be paid in the currency of the state in question. I cannot think of a better asset for a central bank to hold. If the government is in charge it will collect tax. Unlike gold, whose quantity is exogenously determined, the tax a government can collect is a straight function of GDP. That's what I call full faith and credit. Moreover, if a country has its budget under control and invests for the future it will find that it's exporting goods and services that make its currency desirable relative to other currencies, further underpinning the value of this debt. And vice versa, obviously, but that's a good thing!
3. Others have pointed out to the authors (and they admit as much on page 197) that banking is about maturity transformation: we all stick our overnight cash in the bank, but since my purchase of a car from the car dealer merely moves deposits from my account with Megabank to his account with Microbank, the banking system as a whole is A-OK and they can sort out their imbalances with interbank loans. Therefore, the banking system as a whole can turn around and lend this money for term. Why we would ever want to restrict this miracle to the amounts people specifically allocate to risky time deposits is totally beyond me. It really sounds like an unnatural distinction. Once upon a time, when the system was healthy, we had vigilant central banks that kept the lenders on the straight and narrow via (i) enforcement of reserve ratios (ii) the threat of higher interest rates that would move old loans into the red (iii) restrictions on risky activities. These and other measures meant depositors enjoyed deposit insurance without imposing a risk on society and could go about their daily business without the whole population being mini credit officers. It's called division of labor and it's a very good idea.
Despite these criticisms, I will repeat that I thoroughly enjoyed the book. It was written with passion. It kept me entertained, it taught me lots and it made me think. But the main argument is far too flawed and regrettably I can't recommend that you lend it to a gullible friend, lest he reads past page 154. And that's a shame.