A man of astounding economic prescience
Although Soddy was largely dismissed as a crank during his lifetime, many of his policy prescriptions were later adopted into the mainstream. He was, for example, a great critic of the gold standard and argued strongly that exchange rates be allowed to float; he also argued in favour of using the government budget balance as a tool of macroeconomic policy and called for the establishment of independent statistical agencies to compile economic data (particularly to measure the price level). In the event, the idea of using fiscal policy as a policy tool was one of the cornerstones of the post-1945 Keynesian revolution whilst the suspension of dollar convertibility into gold in the early 1970s ushered in the era of floating exchange rates which has prevailed ever since. Moreover the UK established a Central Statistical Office seven years after Soddy first mooted the idea in 1934.
Economics as science
Soddy’s approach was rooted in physics, viewing the economy as a machine which requires inputs to derive outputs. Whilst there is a lot wrong with this way of thinking it was not out of tune with the mainstream views adopted in the post-1945 era, the echoes of which still persist today. But it is appropriate in one sense: A system which relies on such inputs will soon grind to a halt unless there is an infinite supply of them. Accordingly, Soddy’s ideas have been adopted by the modern-day ecological school of economics which views the economy less as a machine and more as a biological system.
The original motivation for his thinking was the recognition that a fractional banking system requires perpetual growth in order that the debt acquired in the process of generating today’s consumption can be repaid. As a scientist, Soddy understood that an economy based on the consumption of finite resources cannot continue to grow indefinitely since this would violate the laws of thermodynamics which prevent machines creating energy out of nothing or recycling it forever – an idea he set out in his 1926 book Wealth, Virtual Wealth, and Debt.
Soddy recognised the fact that private sector banks create money simply by creating deposits thus inherently increasing the leverage in the system – in his memorable phrase: “Money now is the NOTHING you get for SOMETHING before you can get ANYTHING”. He further recognised that this exacerbated the swings in the credit cycle since banks were prone to call in loans when borrowers were least able to repay whilst they were most willing to grant credit when times were good and therefore when credit was least needed. Accordingly, one of Soddy’s main proposals was that the creation of money be taken out of private hands and should instead be fully backed by government created money.
Father of the Chicago Plan
Although Soddy’s ideas were generally ignored in the UK they did find support in the US. In a review of Soddy’s 1926 work, the great American economist Frank Knight noted that “it is absurd and monstrous for society to pay the commercial banking system “interest” for multiplying several fold the quantity of medium of exchange when a public agency could do it at negligible cost” particularly where there are huge costs associated with the booms and busts of the credit cycle. Influential US economists led by Henry Simons and Irving Fisher went on to formulate the Chicago Plan which advocated wholesale reform of the banking sector, notably the separation of the monetary and credit functions of the banking system, “by requiring 100% backing of deposits by government-issued money, and by ensuring that the financing of new bank credit only took place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks.”
Needless to say the Chicago Plan did not find favour in the 1930s. However in the wake of the 2008 financial crisis the idea of full-reserve (or narrow) banking did come back onto the agenda. Institutions such as the IMF have recently given serious thought to the idea, with an influential working paper in 2012 conducting quantitative analysis which concluded that “the Chicago Plan could significantly reduce business cycle volatility caused by rapid changes in banks’ attitudes towards credit risk, it would eliminate bank runs, and it would lead to an instantaneous and large reduction in the levels of both government and private debt.” The FT’s chief economics commentator, Martin Wolf, who sat on the UK’s Independent Commission on Banking, came to a similar conclusion (although he did not credit Soddy with the original insight).
Rethinking narrow banking
In recent years the debate has taken a step further with the advent of digital currencies. In theory the likes of Bitcoin represent a form of narrow banking given that its supply is fixed. However, to the extent that each Bitcoin unit is divisible into sub-units of 100,000,000 it is possible to imagine a world in which value can be destroyed by division, in which case we are no better off. But the concept of a central bank digital currency (CBDC) may be a different story. The Bank of England’s illustrative model for a Sterling CBDC utilises a two-tier intermediation model, whereby Payment Interface Providers (PIPs) would keep all CBDC reserves at the central bank. These PIPs may be pure payment intermediaries or may be commercial banks processing transactions but the key point is that these CBDC deposits would not be used for lending. Such a policy is not without risks (as I discussed in this post a year ago) and I retain some scepticism that a CBDC does many of the things that are claimed for it. Nonetheless, their introduction may take us a long way closer towards realising Soddy’s idea.
One of the reasons why economists remain sceptical of narrow
banking is the conventional view that it will reduce banks’ lending activity which
will in turn act as a brake on economic growth[1].
But a lot of modern macro theory increasingly calls this view into question. This paper published in September
2020 by Hugo Rodríguez Mendizábal makes the case that a “fully
reserve-backed monetary system does not necessarily have to reduce the amount
of liquidity produced by depository institutions.” Space considerations
mean that we cannot do justice to the full implications of the case for narrow
banking and it is clearly a topic for another time. Suffice to say that it is a very active research area these days.
Last word
For a man who was regarded as a crank operating at the margins of respectable economics, many of Frederick Soddy’s “crazy” ideas have subsequently found a surprising degree of mainstream acceptance. Almost a century after he sowed the seeds, the idea of a full reserve-backed banking system refuses to die and has now become a respectable topic of research. It is perhaps not surprising that many of his ideas have such modern day resonance since many of today’s global economic problems echo those of the 1920s and 1930s. Indeed, as he wrote in 1934: “There is a growing exasperation that an age so splendid and full of the noblest promise of generous life should be in such ill-informed and incompetent hands.”
[1] Diamond, D. W., and P. H. Dybvig. 1983. ‘Bank Runs, Deposit Insurance, and Liquidity.’ Journal of Political Economy 91(3) pp401-19
Soddy's Law" is a brilliant observation encapsulated concisely. Physical Properties Presented Its witty take on unintended consequences in technology and society prompts both laughter and reflection.
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