Why does the Fed oppose narrow banking? By Scott Sumner

John Cochrane has an excellent new post on narrow banking, the best post I’ve read in a long time. Cochrane discusses the Fed’s opposition to a new business structure called “narrow banking”. A narrow bank takes deposits and invests the money in interest-bearing reserves deposited at the Fed. Because that’s all these banks would do, they would be very low cost and hence could pass along to depositors the interest earned on reserves, minus a small fee. Narrow banks could attract many large depositors, who currently receive much lower interest rates on their deposits at ordinary commercial banks. Here I’ll offer a few preliminary comments, but you really should read his entire post.

Cochrane is exasperated by the weak and unpersuasive explanations being offered by the Fed. You might argue, “What else is new? Government bureaucracies often do this sort of thing.” Actually, this is sort of new. Yes, government agencies often present obviously weak arguments to buttress decisions being made, especially when the “real reason” would be politically unpopular. But that’s not generally been the case for the Fed. You or I may disagree with a certain Fed action, but it’s usually justified with arguments that even independent experts find to be fairly persuasive. The Fed is a semi-independent branch of government, which has traditionally taken the high road in policy formation. Thus it’s dismaying to see such a weak defense of their opposition to narrow banking. Here’s Cochrane:

The Fed is acting as a classic captured regulator, defending the oligopoly position of big banks against unwelcome competition, its ability to thereby coerce banks to do its bidding, and to run a grand regulatory bureaucracy, against competitive upstarts that will provide better products for the economy, threaten the systemically dangerous big bank oligopoly, and reduce the need for a large staff of Fed regulators. I state that carefully, “acting as.” It is my firm practice never to allege motives, a habit I find particularly annoying among a few other economics bloggers. Everyone I know at the Fed is a thoughtful and devoted public servant and I have never witnessed a whiff of such overt motives among them. Yet institutions can act in ways that people in them do not perceive. And certainly if one had such an impression of the Fed, which a wide swath of observers from the Elizabeth Warren left to Cato Institute anti-crony capitalism libertarians do, nothing in these documents will dissuade them from such a malign view of the institution’s motives, and much will reinforce it.

Like Cochrane, I have a relatively high opinion of Fed officials as individuals. So as I continued reading his post, I kept asking myself, “What’s this really all about?” I began to wonder if this wasn’t actually about “cross-subsidization”, the federal government’s longstanding practice of banning certain forms of competition, in order that existing firms would earn enough profits in one area to subsidize loss-making service to another sector. Thus the Post Office bans competitors from delivering first class mail in New York City, so that they can earn enough profit to provide costly service to remote towns in Alaska, at the exact same price. They don’t want competitors skimming the cream off their most profitable markets.

Sure enough, as I kept reading I found that Cochrane had reached that conclusion even before I did:

Now we’re getting somewhere. Here it is boldface: The Fed is subsidizing commercial banks by paying interest on reserves, allowing the banks to pay horrible rates on deposits, because the Fed thinks out of banks’ generosity — or regulatory pressure — banks will turn around and cross-subsidize lending to households and businesses rather than just pocket the spread themselves. Regulators forever have stifled competition to try to create cross-subsidies. Airline regulators thought upstart airlines would skim the cream of New York to Chicago flights and undermine cross-subsidies to smaller cities. Telephone regulators thought competitive long-distance would undermine cross-subsidies to residential landlines. The long-learned lesson elsewhere is that regulation should not try to enforce cross-subsidies, especially by banning competition. You and I should not be forced to earn low deposit rates, and innovative businesses stopped from serving us, if the Fed wants to subsidize lending.