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.
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”.
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.