Full Reserve Banking: The Wrong Cure for the Wrong Disease

Back to the original purpose of this blog – education about money and economics – Critical Finance has the article Full Reserve Banking: The Wrong Cure for the Wrong Disease.

As J. K. Galbraith famously observed: ‘The process by which banks create money is so simple the mind is repelled. With something so important, a deeper mystery seems only decent.’

I’ll use this article as an excuse to put forward a related idea that I have had recently.

One of the limitations on Quantitative Easing (QE) is that the Fed only buys paper assets. This is the closest the Fed thinks it can get legally to fiscal policy maneuvers. However, this is like pushing on the proverbial string. They can put money back into the hands of the banks, but if there is nothing to invest in, then it just creates asset bubbles, and puts very few people back to work. If instead the Fed could buy infrastructure, they could put people to work, and this would be real fiscal policy.

Imagine if the new QE had the Fed buying state and local infrastructure bonds. The money would have to be used to build the infrastructure for which the states and localities issued the bonds. This would put people to work, replace the lost consumer demand in the economy, and get the economy moving again with a fairer distribution of wealth and income. It would eliminate the legislative and executive branches of the federal government from interfering with the growth of the economy.

What if states and localities were able to have reserve accounts at the Fed, so that they could borrow directly at the same interest rates as the banks do? My idea of the Fed buying state and local bonds is one step removed from the direct access. What would happen if we did away with the one step removal? The states would not have to issue bonds and the banks and other private financial institutions would not be raking off profits from running this bond trading system.

Yes, I am only talking about the good aspects of this change in policy. Of course there are some bad aspects that would have to be controlled. I am just not featuring that aspect in what I have written here. I fully admit that. You can nitpick away with all these other issues, but first, I would like you to examine the idea for its positive possibilities.

If you don’t like the idea of the Fed having control of part of the fiscal policy, there is the idea of creating an infrastructure bank to handle it. The trouble with that is that we would have two federal entities creating high-power money, and that would not be good. If the Infrastructure Bank could borrow from the Fed to fund its operations, then that might be a good way to handle it.

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