How to emulate plain money within a 100%-reserve system

Joseph Huber

Introduction
The following five-point-plan sets forth how to emulate a single-circuit plain money
system within the framework of a double-circuit reserve system, i.e. a system like the
present one of fractional reserves in which cashless money circulation is split between
the circulation of bank money (demand deposits) among nonbanks and the circulation
of central-bank money (reserves) in interbank dealings.
ost supporters of !""#-reserve tend to think that the differences between the two
approaches are insignificant and that it is easier to retain split circulation rather than
to integrate the two circuits into $ust one. %ommon sense alone, however, tells us that
a split two-circuit system must be more complicated and effortful than a single one.
&oth a !""#-reserve approach and a single-circuit plain money system claim to
operate on sovereign money, which is to say that the means of payment are
e'clusively issued by the central bank (in (urope) or the Treasury (in the )*). +n actual
fact, however, a !""#-reserve system, that would do nothing more than bulking up
the e'isting !# minimum reserve (!"# in the )*) to !""#, remains a mi'ed system of
central-bank money (reserves created by the central bank) and bank money (deposits
created by the banks), whereby the pro-active lead in money creation is with the
banks, while the central banks react by refinancing the ensuing bank demand for
reserves.
+n the following, + will discuss the five changes that have to be implemented for a
!""#-reserve system to emulate a plain money system , which remains an emulation
nonetheless as will become clear from the pros and cons related to the different
changes involved-
!. .edefine the purpose of reserves
/. +ncrease fractional minimum reserves up to the level of !""# deposit reserves and
ensure !""# proprietary reserves on banks0 payments for own account
1. ('clude deposits in /21 from reserve re3uirements
4. Treat reserves as if they were the property of customers
5. *ynchroni6e demand deposits and !""# deposit reserves.
1. Redefine the purpose of reserves
Today, minimum reserve re3uirements are intended as a monetary policy instrument
aimed at restricting the money or credit multiplier of banks. That multiplier, however,
does not correspond to a real process but is a purely computational variable. The
reality is one of pro-active primary credit creation, thus, deposit creation, by the banks
followed by the re-active provision of needed fractional reserves by the central bank.
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inimum reserves are normally calculated in arrears of over one month for the ne't
month, irrespective of the additional amount of money banks are creating during the
time span involved. This gives banks any leeway they wish to have , and a !""#
reserve re3uirement is basically not different (e'cept that banks and their customers
have to bear the additional costs of !""# reserves). inimum reserves are lying idle.
They are not meant to be a safety net for deposits. The reserves are not available to
the banks under any circumstance.
7or emulating plain money, reserves will have to be redefined and accordingly treated
in a different way, that is, as li3uid central-bank money that mirrors the storage and
the transfer of demand deposits at precisely !""# without the slightest deviation.
8s a result, e'cess reserves will no longer be what they are today, i.e. reserves for the
fractional settlement of payments among banks. +nstead, they will represent a bank0s
proprietary means of payment. These are not used for carrying out payments from or
between customers (deposit holders) but for payments made by a bank itself, no
matter whether the addressees are customers, other banks or a central bank.
9ifferent terms may help to maintain clarity. .ather than continue to speak of
minimum or coverage reserves and e'cess or settlement reserves, which corresponds
to a traditional reserve system, it would be more appropriate to speak of proprietary
bank reserves and customer deposit reserves.
8s for accounting and balance sheets, the two types of reserves can be managed in
one and the same account. +t might, however, contribute to establishing transparency
if they are managed in two different accounts with automated transfer between the
two.
2. Increase fractional minimum reserves up to the level of 100% deposit reserves and
ensure 100% proprietary reserves on banks payments for own account
8ny !""#-reserve system includes raising the fractional or 6ero minimum reserve
percentage up to an amount of reserves that represents !""# of e'isting deposits. This
is not as trivial as it may sound. +t has to be decided whether this shall refer to all
deposits in !,1 or $ust to deposits available anytime in !2/ as preferred in this
place and as necessary in order to become compatible with a plain money system. +t
also has to be decided whether raising the reserves shall be done in one big step or
gradually in smaller steps over a couple of years. 7urthermore, raising the reserves up
to !""# will be costly. %entral-bank lending interest on the !""#-reserve will have to
be paid in addition to the deposit interest banks already pay to the customers.
8 plain money system is different. 9emand deposits are closed out of a bank0s balance
sheet and transferred to a new customer money account (thus conclusively settling
customer claims and bank liabilities). The previous overnight liability to customers is
replaced with a liability of the same amount to the central bank. This liability has to be
redeemed preferentially, or according to some negotiated plan, but is not interest-
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bearing. +n a plain sovereign money system, banks have to deal with additional funding
costs only to the e'tent to which they have to take up additional means for financing
additional business , financing to !""#, as everybody else in the economy has to.
8chieving this in a comparable way within a !""#-reserve system re3uires providing
the banks with !""# reserves at low cost or no cost at all. The current practice of the
(%& is actually not that far from this. +t lends the re3uired reserves to banks at, say, 4
or ! per cent and pays banks deposit interest of 1 or ".:5 per cent on the same
reserves. The actual interest, thus, is $ust ! or "./5 per cent. This is obviously
undermining the purpose of reserve positions under the fractional reserve system, but
that mechanism is ill conceived anyway.
However, there may be a little problem of political acceptance. ;ot everybody will
agree with giving reserves to banks nearly 0for free0, taking into account that everybody
else in the economy has to finance all activities in full.
!. "#clude deposits in $2%$! from reserve re&uirements
8s mentioned above, non-available deposits in /21 ought to be e'empted from
any reserve re3uirement. <therwise, the amounts of money involved , savings, time
contracts, certificates of deposits, and others , would continue to represent an idle
stock of inactivated money (bank money today) rather than serving as li3uid means of
payment for funding current bank activities.
Today, immobili6ation of bank money at low deposit interest makes sense for the
banking sector because it allows banks to e'tend additional primary credit at much
higher lending interest rates without running a li3uidity risk, even if $ust a fractional
one. +f, however, in a !""#-reserve system, savings and similar items could not be
made available to banks, thus blocking the conversion of corresponding deposit
reserves into proprietary reserves, that would create an enormous e'tra demand for
money, again resulting in enormous e'tra funding costs. /21-deposits would
certainly be safe, but the cost would be high and uncompetitive , unless the re3uired
reserves were given to the banks 0for free0. Here, the same considerations apply as
with regard to the funding costs of !2/-deposits.
oreover, including /21-deposits in a !""#-reserve re3uirement represents a
greater latent potential for inflation and asset inflation. +n normal times this does not
become virulent, but may do so in times of crisis or some other state of e'ception.
!""# reserves emulate plain money only if savings are no longer seen as 0deposited0
money but instead as customer loans to a bank, thus representing short-term capital.
The transfer of money involved will be emulated by swapping the corresponding
customer deposit reserves into proprietary bank reserves. *avings as short-term
customer capital carry some risk, even if normally a low one. 7or this reason, they are
interest-bearing, while li3uid reserves are risk-free money-on-account that can $ust as
little be e'pected to be interest bearing as banknotes and coins in the pocket.
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'. (reat reserves as if they were the property of the customers
+n a plain money system, there is no 3uestion that the money in a customer money
account is the property of the customer. %ustomers are in safe possession of their
money, which cannot 0disappear0 if the bank that manages the account runs into
trouble. +n any reserve system, by contrast, the reserves, no matter whether minimum,
full or e'cess reserves, deposit or proprietary reserves, are the property of banks= with
the central bank retaining a prior claim on the reserves in a bank0s central-bank
accounts.
8 bank, though, has a respective money liability to the customers, as the customers
have a money claim on the bank. 8s a conse3uence, in a reserve system customers are
not in possession of their money. +n the event of a crisis or insolvency of a bank, the
claims of the customers on the bank threaten to fall under the terms of a bankruptcy
agreement. This is now even going to be enshrined in new bank resolution laws where
customers are treated as creditors of a bank who, in a bail-in, if necessary, have to
bear their share of the burden.
Therefore, in order to emulate plain money within a reserve system, legal and
regulatory changes regarding monetary property rights and insolvency procedures
would have to be enacted, making sure that all reserves backing customer demand
deposits are treated as if they were the property of the respective customers and do
not fall under the terms of bankruptcy in case of insolvency. +t is open to legal
e'amination whether prior customer claims on reserves that override any other claims
can be implemented within a reserve system. +f the answer is negative, the e'isting
property rights regarding the ownership of reserves represent a serious obstacle.
). *ynchroni+e demand deposits and 100% reserves
8nother point that is pivotal in emulating plain money within a reserve system is
synchroni6ation of demand deposits and !""# deposit reserves in a real-time process.
This results in all payments of customers being carried out as a !-! transfer of deposit
reserves and customer demand deposits, and the payments of a bank being carried
out as a full transfer of proprietary reserves.
+f demand deposits and deposit reserves are synchroni6ed, a lack of reserves in the
payment process can actually not occur. >hen a bank grants a loan to a customer, the
bank0s proprietary reserves are debited and its deposit reserves are credited in the
same amount. <therwise, there cannot be a loan. %onversely, when customers want to
lend some of their money to their bank as a 0savings investment0, the bank0s deposit
reserves are debited and its proprietary reserves are credited in the same amount. +n
other words, when banks lend money, this is no longer about e'panding the bank0s
balance sheet but about a swap of assets (of reserves), and, of course, a parallel swap
of liabilities, from overnight liabilities into liabilities with time limitations, or the
reverse. >hen banks want to purchase securities or other assets, the process is
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basically the same, in that they swap proprietary reserves into securities or other
assets.
*uch synchroni6ation may best be achieved in a real-time gross-settlement system,
where payment orders are not cleared but immediately settled with no delay. The
important technical detail would be how to synchroni6e stocks and flows of demand
deposits with stocks and flows of deposit reserves. This might involve some e'tensive
technical measures, the more so as bank accountancy systems and the central-bank
payment system would also have to be synchroni6ed in this respect. (very change in
customer deposits would have to result in an immediate and even change of a bank0s
deposit reserves and2or proprietary reserves. This may in turn raise 3uestions
concerning the differentiation between the banks0 accountancy systems and the
central bank0s payment system.
aking sure that there is no delay between debiting and crediting of accounts, while
maintaining absolute synchroni6ation between deposit reserves and demand deposits,
is important for making sure that banks cannot create demand deposits 0out of thin air0
but instead have to ensure immediate full coverage by deposit reserves. +n other
words, deposit reserves amounting to less than !""# of demand deposits must be
absolutely e'cluded in such a system so that no bank is capable of crediting accounts
0out of nothing0.
This re3uirement cannot be met in a net settlement system, i.e. a payment system of
continued clearing of payment orders with deferred settlement or without settlement.
The re3uirement can be met, however, in a real-time gross-settlement system that
fulfills two additional criteria-
- The central bank rather than the banks has the pro-active lead in determining the
3uantity of reserves and, thus, the 3uantity of money available among banks and
nonbanks.
- There is no more automatic overdraft in the payment system= which, however, does
not e'clude a limited amount of ways and means advance.
Today, intraday overdraft is always granted. issing reserves are automatically
provided by the (%&0s marginal lending facility. *hort-term borrowing of reserves has
to be re3uested on a weekly or longer time basis and is also routinely granted. This
means nothing less than to give banks the greatest leeway for their pro-active creation
of primary credit and deposits. +n order to regain control of the money supply, the
routine of automatically accommodating banks0 demand for reserves has to be
reverted. .outinely provided re-financing would not e'ist anymore. 8ll activities would
have to be pre-financed, by the banks as much as by everybody else , e'cept the
central bank that would e'ercise the e'clusive sovereign right of money creation
(while deciding on the use of the money is left to banks and other financial institutions,
companies and households, and government bodies within the framework of their
fiscal competencies).
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8t this point, it is often assumed that this would result in an infle'ible system with a
recurrent standstill of the flow of payments when there is not enough money in a
bank0s reserve account. To e'pect something like this has no real grounds. The
e'pectation would certainly come true if, in the present system, the central bank
suddenly stopped re-financing the monetary facts that the banks have been creating in
advance. +f, however, demand deposits have to be mirrored by !""# deposit reserves
and proprietary dealings of the banks must be carried out on the basis of !""#
proprietary reserves, reserves cannot be missing.
&ut how or from where do the banks obtain the !""# reserves they need to have
available@ >ithout e'plaining this in much detail here, the sources and channels are
obvious- customer loans to banks as well as loans from financial institutions such as
funds, insurance companies and other institutional investors, the interbank market for
reserves, issuance of bonds and shares, and in the last resort also central-bank credit
to the e'tent to which it is offered.
The bigger, long-term portion of additions to the money supply can and should be
issued as genuine seigniorage, spent into circulation by way of government
e'penditure or per-capita dividend. The smaller, short-term portion can be loaned
directly to banks, thus generating interest-borne seigniorage. The important task is for
the central bank to provide, with a certain time lead, the 3uantity of money it deems
necessary according to its statutory goals and to market indicators, and to continually
read$ust the money supply by using its monetary policy instruments.
8ll this can be done in a discretionary and fle'ible way. The banks will have no problem
dealing with the new conditions. Aublic and private households and small enterprises,
as well as large industrial and financial corporations, 3uite naturally have to plan their
finances and current e'penditures , which basically is not a problem. The analogy with
banks is the way they manage cash. <ne has never heard of difficulties faced by banks
in providing the right amount of cash and handing it out with the help of today0s 8Ts.
+t is a well-run system that works well. >ith non-cash money-on-account it is even
easier to take up, provide and transfer money.
<f course, banks will have to finance everything they do at !""#, as they have to fund
cash at !""# today. &ecause of the high cost of financing cash in comparison to
fractionally re-financing demand deposits, and because of the high cost of managing
cash, the banking industry would prefer to get rid of cash sooner rather than later.
>hy not. 7ull funding, however, cannot be spared them. !""#-funding of cash has to
be replaced or complemented with !""#-funding of money-on-account and e-cash. +n
a sovereign money system, banks are free enterprises, but no longer have the privilege
of creating themselves the money on which they operate.


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,onclusion
+t has been shown in the previous sections how a !""#-reserve system can actually be
structured in way that emulates a plain money system.
8t the same time, it is apparent that such emulation is not a simple affair. +n actual
fact, it is complicated and re3uires considerable technical and legal effort-
- .aising a !# or !"# minimum reserve up to !""# creates important costs in
addition to the deposit interest banks already pay= or else, the reserves would have
to be given to the banks 3uasi 0for free0, which might be controversial.
- .eserves in a bank account with the central bank are the property of the banks,
with a prior claim of the central bank on these reserves. 8scribing reserves to
customers would include tricky legal disputes, the more so as current bank
resolution and insolvency procedures steer in the opposite direction.
- *ynchroni6ation of demand deposits and !""# reserves in an absolutely real-time
and gapless way may basically be feasible, but would involve e'tensive technical
restructuring with regard to the accountancy systems of banks and the payment
system of the central bank. This may include some awkward 3uestions of
delimitation between the two.
Biven these considerations and conditions, it definitely appears to be easier to 3uit the
two-circuit reserve system altogether in favour of a single-circuit plain money system.
;o more reserves, no additional funding costs for reserves, unambiguous ownership of
money, no complicated synchroni6ation of deposits and reserves= $ust one integrated
money supply , circulating among banks and nonbanks alike as a li3uid asset on any
balance sheet. +f there is a barrier to the transition from bank money and reserves to
plain sovereign money, it is more of a cognitive-routine barrier than one to do with the
technicalities of accounting and payment systems.