Thursday 5 February 2015

Private banks do not charge interest on the money they create.


Richard Werner claims they do in this article. As he puts it, “It is not a law of nature that profit-driven private enterprises can be relied on to responsibly create and allocate the money supply . . . while being in the privileged position of being able to charge interest for this task. The private banks do not have a particularly good track record in this regard. Furthermore, it is possible to create the money supply without attaching interest payments to it. This can be done if the money supply is produced by the community…”.

Positive Money often makes the same claim. So let’s examine this claim.

First, a definition of “interest” is in order. The definition I’ll use is “a payment made by a debtor to a creditor that compensates the creditor for abstaining from consumption so that the debtor CAN CONSUME resources.” In contrast, I won’t include the ADMINISTRATION COSTS that are involved in creating and distributing a form of money, like checking up on the value of any collateral supplied by those who want to be supplied with money. The reasons for not including administration costs are as follows.

First, administration costs are perfectly legitimate costs, assuming the basic activity concerned is legitimate: which is the case with most businesses. In contrast, I assume that those, like Werner, who object to the alleged interest that private banks charge on the money they create are onto some sort of free lunch and thus that interest is ILLEGITIMATE. That is, the allegation is presumably that private banks simply do a book-keeping entry for say £10k and then watch interest on £10k roll in.

Incidentally, that is not to say that those administration costs are irrelevant to the broader argument namely: should money be supplied by private or central banks, or both? Certainly given that private banks have to incur the cost of checking up on the value of collateral, whereas central banks don’t need to, is a strong point against private money creation.


Do private banks really create a form of money?

Some readers may have doubts as to whether private banks create a form of money. A good publication that explains how private banks do in fact create a form of money is this Bank of England publication. As the publication explains, banks create money when they grant loans. And it is all too easy to deduce from that (as Werner seems to) that since debtors pay interest on loans, banks must be charging interest on the money they create. I’ll argue below that money creation and second, intermediating between lenders and borrowers are in fact SEPARATE activities, and that interst is involved in intermediating, but not in money creation.

The reason why banks in fact do NOT NECESSARILY create money when they grant loans is as follows.

There is no sharp dividing line between money and other liquid assets. But a common way to draw the line between the two is to classify money in an account to which the account holder has access in less than about two months as real money. In contrast, so called money in an account where access takes longer than two or three months is often not classified as money. Indeed that’s very much how Positive Money itself distinguishes between money and non-money.

So, if a bank grants a loan for £X, and after the borrower has spent the money, the recipient/s of that new money put the £X into a term account where the term is more than about two months, then arguably no money is created. Plus the depositor will expect interest on the “money”, which the bank will pass on to the borrower. In short, interest is involved where a bank intermediates between lender and borrower.

In contrast, if after granting the £X loan, the money ends up in a current account (or “checking account” to use US parlance), and the account holder intends spending the money fairly quickly, then money IS CREATED. But in that case the depositor will get little or no interest, so the borrower won’t have to pay interest.

Of course the bank will still charge the borrower SOMETHING, and they’ll doubtless CALL THAT interest. But the charge will actually be for administration costs and something to cover bad debts etc. Strictly speaking, no interest is charged.


Cross subsidisation.

The latter claim that banks do not charge interest where they simply create money as opposed to grant loans assumes that banks do their costing 100% perfectly: i.e. that there is no cross-subsidisation between different types of borrower and depositor. That of course is unrealistic. I.e. plenty of cross-subsidisation takes place, thus in practice in many cases, banks WILL CHARGE INTEREST even where  they are creating money rather than organising loans.

However, it would be perfectly possible for a bank to supply a customer with money and not charge interest. Bank and customer would agree that $X was credited to the customer’s account, and that over the period of year or so, the AVERAGE balance on the account remained at $X. For all I know such accounts do actually exist, and assuming  the relevant banks do their costing correctly, they’d charge for administration costs and something in respect of bad debts, but would NOT CHARGE interest. In that sort of account, the bank would be supplying the customer with LIQUIDITY, not a loan.


What about negative interest rates?

In the last year or two negative interest rates have become increasingly common. So it’s reasonable to ask how this affects the argument here. I think the answer is “not much”. Reason is that any payment made by a debtor to a creditor (or vice-versa) is a number that results from two other numbers. First there is the charge made by  creditors to debtors for abstaining from consuming resources (as per the above definition of interest). Second, there is the amount that owners of wealth are prepared to pay someone to look after or “warehouse” their spare wealth. And of course if the latter second number is larger than the first, the the result is a negative interest rate.

Thus the existence of negative rates does not alter the fact that creditors charge debtors. It just happens that at the moment, that number is currently and in a few cases exceeded by another number: the “warehouse charge”.


Conclusion. 


Private banks do not charge interest on the money they create where they do their costing properly, i.e. avoid cross subsidisation between different types of customer. In contrast, THEY DO charge interest when intermediating between lenders and borrowers, but in that case the tendency is for no money to be created.

Ergo, basically banks do not charge interest on the money they create.







5 comments:

  1. Ralph, can you clarify this point from your blog:

    > if a bank grants a loan for £X, and after the borrower has spent the money, the recipient/s of that new money put the £X into a term account where the term is more than about two months, then arguably no money is created. Plus the depositor will expect interest on the “money”, which the bank will pass on to the borrower. In short, interest is involved where a bank intermediates between lender and borrower.

    To restate the above: Alice borrows £X from Bank1, pays it all to Charlie, who deposits it in a term account at Bank2. What's puzzling me is your assertion that Charlie "expects interest", but the bank (Bank2) passes this on to "the borrower", which is Alice. Surely Bank2 pays interest to Charlie, whereas Alice pays interest to Bank1? Bank2 does not have any dealings with Alice, but even even if it did, the interest rates from the two banks aren't likely to coincide.

    You continue:
    > In contrast, if after granting the £X loan, the money ends up in a current account (or “checking account” to use US parlance), and the account holder intends spending the money fairly quickly, then money IS CREATED. But in that case the depositor will get little or no interest, so the borrower won’t have to pay interest.

    Restating again: Alice borrows £X from Bank1, pays it all to Charlie except now he deposits it in a current account, and then spends it. Charlie gets no interest to speak of. But Alice is still paying exactly the same amount of interest to Bank1 as before, no? Just because Charlie isn't getting interest from Bank2, I can't see how you can conclude "the borrower won't have to pay interest".

    Thanks,
    - Nick

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    Replies
    1. Nick,

      I think you (with the assistance of Charlie and Alice) have spotted a weakness in my argument. I’ve actually been uneasy about the above post for some time, and started re-writing it before getting your comment. So watch out for the improved version.

      For the moment, I’ll just reiterate what I’m trying to say, which is this.

      In that the private bank system is simply into supplying money, holders of that money will have the money in current / checking accounts, thus they’ll get little or no interest. Ergo banks don’t charge interest on the money they create and supply.

      In contrast, in that banks intermediate between long term lenders and long term borrowers, the lenders will tend to have their money in term accounts, and thus WILL GET interest, which banks will pass on to long term borrowers (e.g. mortgagors).

      Obviously the latter point of mine is made more complicated by maturity transformation, but I think my basic point holds, more or less.

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    2. Even so - when Alice takes a loan from Bank1, it imposes an interest rate which I believe is independent of whatever Alice does with it next, such as spend it or put it into a current account. The latter is entirely not a concern of the bank. This is certainly true of my mortgage - I definitely pay interest! Therefore I can't see any other conclusion except that banks *are* charging interest on the money created when loaning.

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    3. Nick,

      I think I’ve spotted the flaw in your argument (after much head scratching). It’s as follows.

      Let’s assume, first, that the economy is at capacity. (I’ll deal with the economy NOT BEING at capacity below). So, say the economy is at capacity, and Alice borrows £X from Bank 1 and Charlie deposits the money in Bank 2 and puts it into a current account (which means Charlie intends spending the money fairly quickly). The result is an increase in aggregate demand because Alice spends her £X and so does Charlie. And an increase in AD just aint possible when the economy is at capacity: excess inflation will ensue.

      Of course it’s absurd to suggest that the latter scenario (which involves just two individuals) increases inflation to any measurable extent in an economy the size of the UK’s. But the important point here is the MACROECONOMICS, not the MICRO. That is, if there are lots of Alices and Charlies doing the above, then the central bank would need to raise interest rates or do something else to curb AD. And that will result in less spending by Alices, and/or more saving by Charlies.

      Put another way, looking at the economy AS A WHOLE, i.e. as far as macro is concerned, where a collection of people borrow money and spend it (which increases AD), another lot have to abstain from spending, i.e. they have to deposit money in banks and just leave it there.

      As to where the economy is NOT AT capacity, then obviously an increase in AD is permissible. So the Alices and Charlies can go on a wild spending spree. Unfortunately, that’s not a very realistic scenario in that private banks just don’t get us out of recessions very well. That is, far from increasing loans in a recession and curbing them in a boom, they do the opposite, e.g. lend too much in booms and fail to increase lending in recessions. I.e. they tend to act “pro –cyclically”.


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  2. This is a fairly complicated argument, so it has taken me a while to think it through.

    What you seem to be saying is that, although Alice is borrowing from Bank 1, and paying interest so long as she does (which in some fundamental sense means banks *do* charge interest), in an economy with many Alices borrowing from various banks, the money supply would expand (because bank loans create money so long as they exist). Given enough of this expansion, it *may* cause inflation (if the economy is at capacity). Inflation tends to be countered by the Central Bank by (say) increasing interest rates. This is intended to discourage future Alices from borrowing and the indebted ones pay back faster, so that the money supply stabilises. Or if no inflation, then no tweaking necessary, the Alice sector continues as it was. (I don't see why there needs to be a Charlie in this argument, so I left him out).

    The suggestion being, I think, that all the later abstention cancels out the interest charged in the former borrowing bonanza. Is that correct? If so I don't see how, can you reference this argument anywhere?

    I just see banks charging interest at varying rates, and no way for any Alice to offset her payments. Even if she pays back her loans in full, the interest payments are a done deal and unreclaimable. The only potential reverse flows I can think of is if a) Alice is a beneficiary of the banking sector, or b) interest goes negative, or perhaps c) if some sort of asymmetric inflation renders the banks' assets worthless faster than Alice's.

    None of those seem to be generally applicable to our economy, even with QE creating inflation in the bond market more than elsewhere I don't believe this results in a loss for banks, quite the reverse.

    What I do find credible would be if Alice makes up for her interest payments by passing the cost on to her customers. Or perhaps she loans her loan out, and charges more interest. Assuming she has the means - if not the buck stops there. Then the hidden interest costs would transfer wealth up the commercial food-chain from Alice and her customers to the banks who created the original loan. But this is another topic.

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