How to emulate plain money (single-circuit sovereign money) within a 100%-reserve system


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.

Most supporters of 100%-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 just one. Common sense alone, however, tells us that a split two-circuit system must be more complicated and effortful than a single one.

Both a 100%-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 exclusively issued by the central bank (in Europe) or the Treasury (in the US). In actual fact, however, a 100%-reserve system, that would do nothing more than bulking up the existing 1% minimum reserve (10% in the US) to 100%, remains a mixed 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. 

In the following, I will discuss the five changes that would have to be implemented for a 100%-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:
1. Redefine the purpose of reserves
2.  Increase fractional minimum reserves up to the level of 100% deposit reserves and ensure 100% proprietary reserves on banks' payments for own account
3. Exclude deposits in M2/M3 from reserve requirements
4. Treat reserves as if they were the property of customers
5. Synchronize demand deposits and 100% deposit reserves.

1. Redefine the purpose of reserves
Today, minimum reserve requirements 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. Minimum reserves are normally calculated in arrears of over one month for the next 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 100% reserve requirement is basically not different (except that banks and their customers have to bear the additional costs of 100% reserves). Minimum reserves are lying idle. They are not meant to be a safety net for deposits. The reserves are not, or only marginally, available to the banks.

For emulating plain money, reserves will have to be redefined and accordingly treated in a different way, that is, as liquid central-bank money that mirrors the storage and the transfer of demand deposits at precisely 100% without the slightest deviation.

As a result, excess reserves will no longer be what they are today, i.e. reserves for the fractional settlement of payments among banks. Instead, they will represent a bank's 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. 

Different terms may help to maintain clarity. Rather than continue to speak of minimum or coverage reserves and excess 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.

As for accounting and balance sheets, the two types of reserves can be managed in one and the same account. It 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  
Any 100%-reserve system includes raising the fractional or zero minimum reserve percentage up to an amount of reserves that represents 100% of existing deposits. This is not as trivial as it may sound. It has to be decided whether this shall refer to all deposits in M1–M3 or just to deposits available anytime in M1/M2 as preferred in this place and as necessary in order to become compatible with a plain money system. It 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. Furthermore, raising the reserves up to 100% will be costly. Central-bank lending interest on the 100%-reserve will have to be paid in addition to the deposit interest banks already pay to the customers.

A plain money system is different. Demand deposits are closed out of a bank's 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-bearing. In a plain sovereign money system, banks have to deal with additional funding costs only to the extent to which they have to take up additional means for financing additional business – financing to 100%, as everybody else in the economy has to.

Achieving this in a comparable way within a 100%-reserve system requires providing the banks with 100% reserves at low cost or no cost at all. The current practice of the ECB is actually not that far from this. It lends the required reserves to banks at, say, 4 or 1 per cent and pays banks deposit interest of 3 or 0.75 per cent on the same reserves. The actual interest, thus, is just 1 or 0.25 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. Not everybody will agree with giving reserves to banks nearly 'for free', taking into account that everybody else in the economy has to finance all activities in full.

3. Exclude deposits in M2/M3 from reserve requirements
As mentioned above, non-available deposits in M2/M3 ought to be exempted from any reserve requirement. Otherwise, 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 liquid means of payment for funding current bank activities.

Today, immobilization of bank money at low deposit interest makes sense for the banking sector because it allows banks to extend additional primary credit at much higher lending interest rates without running a liquidity risk, even if just a fractional one. If, however, in a 100%-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 extra demand for money, again resulting in enormous extra funding costs. M2/M3-deposits would certainly be safe, but the cost would be high and uncompetitive – unless the required reserves were given to the banks 'for free'. Here, the same considerations apply as with regard to the funding costs of M1/M2-deposits.

Moreover, including M2/M3-deposits in the 100%-reserve requirement represents a greater latent potential for inflation and asset inflation. In normal times this does not become virulent, but may do so in times of crisis or some other state of exception. 

100% reserves emulate plain money only if savings are no longer seen as 'deposited' 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. Savings as short-term customer capital carry some risk, even if normally a low one. For this reason, they are interest-bearing, while liquid reserves are risk-free money-on-account that can just as little be expected to be interest bearing as banknotes and coins in the pocket.

4. Treat reserves as if they were the property of the customers
In a plain money system, there is no question that the money in a customer money account is the property of the customer. Customers are in safe possession of their money, which cannot 'disappear' if the bank that manages the account runs into trouble. In any reserve system, by contrast, the reserves, no matter whether minimum, full or excess reserves, deposit or proprietary reserves, are the property of banks; with the central bank retaining a prior claim on the reserves in a bank's central-bank accounts.

A bank, though, has a respective money liability to the customers, as the customers have a money claim on the bank. As a consequence, in a reserve system customers are not in possession of their money. In 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. It is open to legal examination whether prior customer claims on reserves that override any other claims can be implemented within a reserve system. If the answer is negative, the existing property rights regarding the ownership of reserves represent a serious obstacle.

5. Synchronize demand deposits and 100% reserves
Another point that is pivotal in emulating plain money within a reserve system is synchronization of demand deposits and 100% deposit reserves in a real-time process. This results in all payments of customers being carried out as a 1:1 transfer of deposit reserves and customer demand deposits, and the payments of a bank being carried out as a full transfer of proprietary reserves.

If demand deposits and deposit reserves are synchronized, a lack of reserves in the payment process can actually not occur. When a bank grants a loan to a customer, the bank's proprietary reserves are debited and its deposit reserves are credited in the same amount. Otherwise, there cannot be a loan. Conversely, when customers want to lend some of their money to their bank as a 'savings investment', the bank's deposit reserves are debited and its proprietary reserves are credited in the same amount. In other words, when banks lend money, this is no longer about expanding the bank's 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. When banks want to purchase securities or other assets, the process is basically the same, in that they swap proprietary reserves into securities or other assets.

Such synchronization 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 synchronize stocks and flows of demand deposits with stocks and flows of deposit reserves. This might involve some extensive technical measures, the more so as bank accountancy systems and the central-bank payment system would also have to be synchronized in this respect. Every change in customer deposits would have to result in an immediate and even change of a bank's deposit reserves and/or proprietary reserves. This may in turn raise questions concerning the differentiation between the banks' accountancy systems and the central bank's payment system.

Making sure that there is no delay between debiting and crediting of accounts, while maintaining absolute synchronization between deposit reserves and demand deposits, is important for making sure that banks cannot create demand deposits 'out of thin air' but instead have to ensure immediate full coverage by deposit reserves. In other words, deposit reserves amounting to less than 100% of demand deposits must be absolutely excluded in such a system so that no bank is capable of crediting accounts 'out of nothing'.

This requirement 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 requirement 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 quantity of reserves and, thus, the quantity of money available among banks and nonbanks.
- There is no more automatic overdraft in the payment system; which, however, does not exclude a limited amount of ways and means advance.

Today, intraday overdraft is always granted. Missing reserves are automatically provided by the ECB's marginal lending facility. Short-term borrowing of reserves has to be requested 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. In order to regain control of the money supply, the routine of automatically accommodating banks' demand for reserves has to be reverted. Routinely provided re-financing would not exist anymore. All activities would have to be pre-financed, by the banks as much as by everybody else – except the central bank that would exercise the exclusive 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).

At this point, it is often assumed that this would result in an inflexible system with a recurrent standstill of the flow of payments when there is not enough money in a bank's reserve account. To expect something like this has no real grounds. The expectation 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. If, however, demand deposits have to be mirrored by 100% deposit reserves and proprietary dealings of the banks must be carried out on the basis of 100% proprietary reserves, reserves cannot be missing.

But how or from where do the banks obtain the 100% reserves they need to have available? Without explaining 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 extent 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 expenditure 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 quantity of money it deems necessary according to its statutory goals and to market indicators, and to continually readjust the money supply by using its monetary policy instruments.

All this can be done in a discretionary and flexible way. The banks will have no problem dealing with the new conditions. Public and private households and small enterprises, as well as large industrial and financial corporations, quite naturally have to plan their finances and current expenditures – which basically is not a problem. The analogy with banks is the way they manage cash. One has never heard of difficulties faced by banks in providing the right amount of cash and handing it out with the help of today's ATMs. It is a well-run system that works well. With non-cash money-on-account it is even easier to take up, provide and transfer money.

Of course, banks will have to finance everything they do at 100%, as they have to fund cash at 100% today. Because 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. Why not. Full funding, however, cannot be spared them. 100%-funding of cash has to be replaced or complemented with 100%-funding of money-on-account and e-cash. In a sovereign money system, banks are free enterprises, but no longer have the privilege of creating themselves the money on which they operate.

It has been shown in the previous sections how a 100%-reserve system can actually be structured in way that emulates a plain money system.

At the same time, it is apparent that such emulation is not a simple affair. In actual fact, it is complicated and requires considerable technical and legal effort:
- Raising a 1% or 10% minimum reserve up to 100% creates important costs in addition to the deposit interest banks already pay; or else, the reserves would have to be given to the banks quasi 'for free', which might be controversial.
- Reserves 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. Ascribing reserves to customers would include tricky legal disputes, the more so as current bank resolution and insolvency procedures steer in the opposite direction.

- Synchronization of demand deposits and 100% reserves in an absolutely real-time and gapless way may basically be feasible, but would involve extensive technical restructuring with regard to the accountancy systems of banks and the payment system of the central bank. This may include some awkward questions of delimitation between the two.

Given these considerations and conditions, it definitely appears to be easier to quit the two-circuit reserve system altogether in favour of a single-circuit plain money system. No more reserves, no additional funding costs for reserves, unambiguous ownership of money, no complicated synchronization of deposits and reserves; just one integrated money supply M, circulating among banks and nonbanks alike as a liquid asset on any balance sheet. If 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.



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