I’ve argued over the years that inside money must, by necessity, take precedent in our monetary system over outside money. That is, bank money (which is created INSIDE the private sector by banks as deposits) exists as the dominant form of money in the monetary system and OUTSIDE money (which is created outside the private sector by the Central Bank and Treasury as reserves and cash) is a facilitating form of money. This is crucial to understand because it means that outside money does not necessarily “drive” the economic impact of inside money. The most glaring proof of this has been the collapse of the money multiplier theory in recent years as the financial crisis proved that there is no causal relationship between the quantity of reserves and the amount of lending that banks do.
I am revisiting this topic thanks to an excellent piece by Frances Coppola at Forbes. Frances is a former banker and she thinks about the monetary system in a way that is very similar to the way I think about it. She doesn’t just theorize about what is. Frances thinks about the way things actually are. And if reality conflicts with theory then Frances is always very quick to call someone out for their theoretical nonsense.
In this new piece Frances says that Swiss banks have eliminated the zero lower bound. That is, they’ve restricted cash withdrawals which means that the theoretical view about the cost of holding negative interest bearing deposits is bunk. In theory, no one would hold negative interest deposits because you can simply move to cash. But this theoretical view isn’t consistent with reality because banks, in the aggregate, cannot allow you to withdrawal all of the deposits in the system. There is a very real limit to how much banks would allow us to withdrawal because widespread withdrawals are essentially runs on banks and banks can’t exist if no one uses their payments system. So, naturally, they limit how much users can actually remove from the system. And those limits are quite open ended.
For instance, you might not know this, but when you opened your bank account you signed a lengthy deposit agreement. Here’s one small part of such an agreement which outlines your right to withdraw funds:
The Bank can also refuse to permit a withdrawal from your account if:
• The withdrawal would consist of funds deposited to your account in the form of a check or other instrument and the proceeds for the check or instrument have not been received by us. Please refer to Section 6 (Funds Availability Disclosure) for withdrawal availability times.
• There is a dispute about the account of such a nature that were the Bank to permit you to withdraw from it, we might be exposed to legal liability.
• Someone whose name is on the account or otherwise asserts an ownership interest in the account tells us in writing not to permit the withdrawal.
• The account is pledged as collateral for a debt.
• The withdrawal would consist of money or items we have lawfully taken to pay a debt due the Bank, by way of setoff or otherwise.
• We have been directed by court order (or other legal process or law or regulation) not to permit the withdrawal of all or part of the funds in the account.
• The requested withdrawal amount would exceed the amount permitted by the account agreement or term. Specific withdrawal restrictions and penalties (where applicable) for your account are outlined in the Guide to Your Account.
• You have failed to present to us any document (for personal customers, this includes, but is not limited to, a passbook), credential, evidence or identification we require, or the law requires, in connection with the withdrawal. If the Bank does not feel that it has enough proof of who someone is, it can ask for as much proof as it needs. In certain cases, the Bank may ask for a bond from an insurance company which guarantees the right of the person to the funds.
• You have reached your Card withdrawal limit (applicable only to ATM/pointof-sale transactions). For personal customers, specific Card withdrawal limits are set forth in the Guide to Your Account. For business customers, specific Card withdrawal limits are set forth in the business cardholder agreement. Not all business customers are eligible for a Card.
• A problem with our equipment prevents us from knowing your account balance.
• Your request for withdrawal is in a format or requires Bank action that is not permitted by the conditions applicable to the account.
• Other circumstances exist which do not permit the Bank to make the withdrawal.
That’s 12 relatively vague bullets in case you’re counting. But there’s a more basic understanding here. In fact, the term “demand deposit” is a big fat lie because banks will not and CANNOT give you all of your cash on demand. If banks allowed us all to demand our deposits at once then the banking system would essentially collapse in on itself. Given that the economy operates almost entirely through the inside money payment system, it is not in the best interest of the economy for this to happen. So it’s not surprising to see that the Swiss National Bank is actually encouraging banks to disallow large withdrawals. Central Banks, after all, exist to make sure that the banking system is stable. So Central Banks will almost certainly try to avoid widespread cash withdrawals because that would be destabilizing to the broader economy.
We reside in a monetary system in which inside money necessarily takes precedent over outside money. And that means a lot of the economic theory that has dominated crisis thinking needs to be reworked based on the operational realities of the banking system. This just goes to show how illogical it is when some theoreticians say silly things like “keep banks out of macro” – you can’t understand macro if you don’t understand banking….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.