Money creation by private banks involves an element of counterfeiting.

The free market or GDP maximising rate of interest is achieved in the same way as the free market or GDP maximising price of apples is achieved:  potential buyers of the commodity (borrowed funds or apples) bid for the commodity,  and producers produce whatever quantity they want or find profitable. Buyers and sellers reach a compromise known as the “market price”.

In a simple economy where just gold coins were used as money, there is no reason to think gold coin money would prevent the optimum rate of interest and debt being achieved.

Moreover, (and keeping it simple – at least to start with) if private banks operated in this hypothetical simple economy, and those banks confined themselves to intermediating between borrowers and lenders, there is again no reason to think the optimum rate of interest and debt would not be achieved.

However, in the real world, commercial banks do something else apart from simply intermediating: when worthwhile looking potential borrowers apply for loans, banks can simply credit borrowers’ accounts with money produced from thin air. (London goldsmiths 300 years ago issued receipts for non-existent gold). Indeed, if the prevailing rate of interest for a near risk free loan is say 5%, and a potential borrower can pay only 4%, that’s no problem for the bank.  The bank can just lend at 4% instead of 5%. After all, it costs the bank nothing to do a simple book keeping entry: credit the account of the borrower with £X.

As Joseph Huber and James Robertson put it in their publication “Creating Money”, “Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves.”


Term accounts.

It’s arguable that when a bank creates $Y and lends it out that the money supply does not necessarily rise by $Y: reason is that the RECIPIENTS of that money (once the borrower has spent it) may put it into term accounts where access takes longer than two or three months. And standard practice around the world is not to count so called money is such term accounts as money.

That doesn’t actually make much difference to the basic argument here. For example even if all of that money goes into term accounts, there will still be an inflationary effect when the money is initially spent. Plus chances are that while SOME OF the new money goes into term accounts, some will also go into current accounts (“checking accounts” in US parlance).


There’s no free lunch.

The process via which banks lend out money produced from thin air sounds too good to be true, and it is. That is, there might seem to be a free lunch here, but there isn't.

Assuming the economy is already at capacity, money which is effectively printed by private banks and loaned out will be spent. And that’s inflationary.

That in turn means government or the central bank has to rein in aggregate demand somehow, e.g. by raising taxes or cutting public spending. Thus the bank and borrower who has been supplied with money produced from thin air effectively steal from taxpayers and/or those who benefit from the latter government spending (e.g. road users, teachers, doctors, their patients, etc).


Counterfeiting.

The money printing activities of private banks are not EXACTLY the same as backstreet counterfeiters who print illicit $100 bills or £50 notes, and then spend that on smart cars, houses, holidays etc. That would be too obviously a form of fraud or theft, and banks have to be MODERATELY subtle when it comes to skulduggery.

However, the money produced by private banks goes into general circulation just like the money produced by backstreet counterfeiters and both types of money are inflationary for reasons given above. Thus state produced money has to be withdrawn to make room for counterfeiter’s money. So there is SOME SIMILARITY between what backstreet counterfeiters do and what private banks do. Plus their activities result in a rate of interest which is below the GDP maximising rate, and an amount of debt which is ABOVE the GDP maximising or optimum amount.


George Selgin.

Another explanation as to how private money displaces public money is set out by George Selgin in this article, which is not to suggest he would agree with everything in this article of mine. Indeed he argues that privately created money IS NOT inflationary, which might seem to contradict this article of mine.

What Selgin actually says is that given a “public money only” system (like the gold coin economy above) and assuming a private bank or banks set up in business, the result will be inflation: inflation which will continue till the value of the stock of public issued money has been reduced to near nothing.

That’s not much different to my point above namely that the appearance of private banks has an inflationary effect: I just assumed that the state deals with that by withdrawing public money rather than by letting inflation rip, which is what Selgin assumes. Thus my portrayal of how private money displaces public money is not actually much different to Prof Selgin’s.


Private bank created money is inefficient.

Another fundamental flaw with privately created money is that it is inherently expensive to produce compared to central bank or state issued money, and for the following reasons.

In a hypothetical economy where people (understandably) want a form of money, but did not want to borrow, private banks could easily issue whatever amount of money people wanted: people would just deposit suitable amounts of security, and banks would credit peoples’ accounts as required. But checking up on the value of security (and houses are much the most common form of security) does require several hours work by skilled bank staff, and that costs.

In contrast, simply having the state create and spend money into the private sector whatever amount of money is needed to keep the economy ticking over at capacity or “full employment” costs next to nothing.

As Milton Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.” (That’s from Ch3 of his book, “A Program for Monetary Stability”.)

Thus even though privately issued money is inherently inefficient compared to state issued money, privately issued money manages to displace publically created money.