Why do we let private banks produce counterfeit money?

Summary. When a commercial or “private” bank grants a loan, it doesn't need to get the relevant money from anywhere: it can just credit the borrowers account with money produced from thin air, as explained in this Bank of England publication. That money creation or “printing” is to some extent exactly what backstreet counterfeiters do with their printing presses when turning out $100 bills or £20 notes.

However, it’s certainly not true to say that every time a private bank grants an $X loan that the bank effectively prints $X. The extent to which new money is printed when that $X loan is granted is a bit complicated and the paragraphs below are an attempt to sort out the complexity. However the fact remains that what private banks do is to some extent exactly what back  street counterfeiters so, and it’s plain bizarre that we allow that “legal counterfeiting” to continue.


Where counterfeiting occurs.
 
Where counterfeiting takes place, obviously it takes place when the counterfeit notes are FIRST PRINTED and first used to purchase goods and services. That is the point at which harm is done. I.e., when those notes SUBSEQUENTLY passed from hand to hand, no further harm is done.

A similar point applies to “legal counterfeiting” as done by private banks.

That is, the money supply normally increases year after year, but in a recession, private banks tend to rein in their loans and cut down on new loans. Thus in a recession there is sometimes no monthly or annual increase in the money supply. In that scenario, banks grant new loans at the same speed with which old loans are repaid. And in that case, clearly no new money creation takes place, counterfeit or honest.

In short, legal counterfeiting if it takes place at all, only takes place when the money supply is increasing.


The basic money creation process.

When a bank accepts an £X deposit and the deposit is loaned on, both the depositor and borrower are in effect holders of £X. So £X has been turned into £2X. However, there is no sharp dividing line between money and other fairly liquid assets: in particular, money in a term account where the term still has more than about two to four months to run is often not counted as money.

So… if in the above £X scenario those who RECEIVE the £X spent by the borrower put the money into a term account where the term is say 6 months, then on most definitions of the word money, no money is created on balance. Put another way, money is only created where the £X is put into a CURRENT account (checking account to use US parlance), or into a short term term account (say less than about two months). I’ll refer to those two types of account from now on as checking accounts.

To summarise so far, we need to concentrate on money spent by borrowers which goes into checking accounts. Plus we need to concentrate on the INCREASE in the TOTAL AMOUNT in such accounts for the country as a whole.

That amount clearly increases most years and for two reasons. First one would expect households to want the amount of money at their disposal to increase along with real economic growth. Second, inflation eats away at the value of money, thus households will presumably want to add to their stock of checking money every year so as to compensate for inflation.

And as explained above, the origin of that increased stock is money produced out of thin air by private banks when they grant loans. So what’s going on here is that private banks create money out of thin air, give it to borrowers who in turn use the thin air money to purchase goods and services from various other people or firms, who in turn place the money in their checking accounts and leave it there.

Now the latter people and firms have in a sense been diddled: they sweated their guts out supplying real goods and services and return all they get is in effect a book keeping entry  - or if you like a “number” on their bank statements.

Of course, the latter people and firms who have been diddled aren’t TOO BOTHERED: in return for their hard work they get what might be called “magic numbers” which enable them to purchase goods and services. But remember we’re talking about the INCREASED STOCK of money in checking accounts, thus those magic numbers in the aggregate are in fact never spent: that is, on average over the year, the stock of money in checking accounts rises: it never declines.


Illegal printing presses.

The latter phenomenon is EXACTLY THE SAME as where someone with an illegal printing press turns out counterfeit £20 notes, and (out of the kindness of their heart) brings about an increase in the nation’s stock of current / checking account money. That is, the printing press owner acquires real goods and services in exchange for what might be called thin air money.

Now you might think that because borrowers eventually pay loans back to banks that that somehow makes commercial bank counterfeiting OK. Well it’s true that INDIVIDUAL borrowers repay banks. But IN THE AGGREGATE they don’t. That is the total amount loaned out increases nearly every year, just like the money supply increases every year.

So, in the aggregate, borrowers acquire real goods and services from those with checking accounts for free and of course banks take their cut. Put another way, people who want more money in their checking accounts have to provide $X of goods and services for every $X of additional money they acquire to stock up their accounts. And those goods and services flow to borrowers and private banks.


What about central bank created money?

Now as distinct from private bank created money, there’s another widely used form of money, namely central bank (CB) created money or if you like “government created” money. (That’s using the word “government” in a very broad sense, i.e. it involves regarding CBs as part of the overall government machine).

That CB money comes in the form of paper notes and coins ($100 bills etc), plus there’s a small amount of CB money which comes in book-keeping form just like PRIVATE BANK money comes in book-keeping form. (Incidentally the TOTAL AMOUNT of that CB book-keeping money is normally ROUGHLY equal to the amount of paper note money, though the amount of that book-keeping money has actually expanded enormously in recently years as a result of QE).


The big choice.

Now we have a choice here. It would be perfectly possible to have a system under which money production is done just by the state and private money creation is outlawed. Indeed, that’s exactly what Abraham Lincoln wanted. As he put it, “The Government should create, issue, and circulate all the currency and credits needed to satisfy the spending power of the Government and the buying power of consumers.”

Under such a system, there would be two ways of distributing state created money. First, the state could simply distribute for free a suitable amount of money to every household and firm. As to what constitutes a “suitable” amount, that’s easy: the best amount to distribute is whatever keeps households spending at a rate that gives us full employment, that is as high a level of employment as is possible without bringing excess inflation. That distribution system is often referred to as a “helicopter drop”.

That distribution system does however have a problem which is that one can get bogged down in arguments over how much “free money” should go to particular types of household.

The second and probably better way to distribute new money would be to have government simply use the new money to fund a proportion of its usual spending: on education, defence, roads and so on. Alternatively, a right of centre government might choose to leave public spending constant and use the new money to cut taxes.


Conclusion.

So let’s summarise. You want some more money for your checking account. The way you go about that under the existing system is to do some extra work or cut down on your consumption of goods and services for a month or two. That is, you “save money”.

Put another way, you sweat your guts out and supply real goods and services to someone somewhere, and in exchange get some extra magic numbers on your bank statement. Now whoever supplies those magic numbers is onto a good thing, aren’t they? I mean – supply magic numbers and get real goods and services in return? That’s nice work if you can get it. It’s extremely profitable. In fact there’s a name for that profit: seigniorage.

Now given that someone somewhere makes a seigniorage profit out of you when they supply you with extra money, who do you want that to be? Do you want it to be some collection of borrowers and banks unknown to you? Or do you want it to be the community as a whole, i.e. government? I prefer the latter.

When a private bank and those borrowing from it grab seigniorage profit they’re doing exactly what back street counterfeiters do. If there was no central bank, then private banks WOULD BE PERFORMING a useful service there: providing the country with money. But we DO HAVE central banks nowadays, and I suggest it’s central banks (in cooperation with government) that ought to provide our money supply.