Adair Turner on the causes of the financial crisis

The people at Positive Money have every reason to feel vindicated. As Mira Teklova reports on their website, "Adair Turner, the chairman of the UK’s Financial Services Authority, member of the BoE’s Financial Policy Committee,  set out the fundamental cause of the financial crisis in his speech to the South African Reserve Bank on Friday 2nd Nov 2012:

 “The financial crisis of 2007/08 occurred because we failed to constrain the private financial system’s creation of private credit and money.”

The speech (which can be downloaded here) is quite remarkable, and could well be the clearest admission that one of the major causes of the financial crisis stems from the fractional reserve banking system that gives commercial banks the right to create money out of thin air, to make loans, and then charge interest on those loans. For example, Turner states that :

“The impact of fractional reserve banks is thus to make the financial system and the overall economy inherently more vulnerable to instability, creating risks which have to be balanced against the economic advantages which can arise from the risk pooling and maturity transformation which banks perform.”

“Banks which can create credit and money to finance asset price booms are thus inherently dangerous institutions.“

"... it is clear that the financial sector – to a far greater extent than other sectors of the economy – has the potential and the incentives to create forms and volumes of activity which are optimal for the private agents involved, but sub-optimal at the social level."

He gives a remarkable clear statement of how the fractional reserve banking system works.

"The banking system can thus create credit and create spending power  – a reality not well captured by many apparently common sense descriptions of the functions which banks perform.  Banks it is often said take deposits from savers (for instance households) and lend it to borrowers (for instance businesses).  But in fact they don’t just allocate pre-existing savings; collectively they create both credit and the deposit money which appears to finance that credit.

Thus banks can create credit and private money."  

Turner also discusses the "Chicago Plan", orinally proposed in the the 1930s and which argued for a switch to full reserve banking.

"The answer the early Chicago’s theorists gave us was ‘very radical’– so radical indeed as effectively to abolish leveraged maturity transforming, fractional reserve banks.
Thus in the Chicago Plan and other variants of 100% money banks no private money is created since no private credit is extended, but instead all money in circulation derives from public debt or money issuance.
Essentially this would mean that banks which provided money services would face a 100% liquid assets requirement: while any institutions which made loans would face a 100% capital requirement, and could hold no deposits a set of prudential requirements which certainly makes Basel 3 look a pretty weak package."

He also comments on the recent report by two IMF economists ("The Chicago Plan Revisted") 

"But extreme though it is, there are modern economists who believe that the Chicago Plan is a feasible model for real world policy. Indeed in an IMF working paper published in august this year, entitled ‘The Chicago Plan Revisited’ Jaromir Benes and Michael Kumhof have argued that a transition to a 100% money banking system is both desirable and possible, and that it could and should be accompanied by a dramatic write-down of existing household debts, removing in one fell swoop the vulnerability to financial and macroeconomic instability created by high levels of household leverage."

Turner doesn't go as far as to recommend implementing the Chicago Plan. Indeed, he specifically argues that it would be best to leave the fractional reserve mechanism in place. But it is very refreshing to hear someone so close to the heart of the financial system actually raising the question of whether the system has to work in the way it does.