Saturday, 14 November 2015

Base money is free. So why do we have privately created money which we have to rent?

The idea that we rent our (privately created) money supply could be questioned on the following grounds.

People who want to borrow from banks certainly pay what might be called a “rent”. That is, they pay interest plus they pay for the administration costs involved in setting up a loan (e.g. checking up on the value of the collateral deposited in exchange for the loan).

But it could be argued that that rent is simply what any borrower would pay to any lender, including those who borrow from a non-bank entity of some sort. Moreover, what might be called the “outright owners of money”, i.e. those with a positive balance at their bank, don’t pay any rent. Indeed, if anything it’s the reverse: the bank pays interest to the depositor.

The answer to the above criticisms of the “we rent our money” argument is as follows.

In the real world (as intimated above) LENDING gets very mixed up with money creation. But in order to separate the two, let’s assume a hypothetical country where no one wanted to borrow or lend, but people DID WANT a money supply.

In that scenario, everyone or most people would, 1, deposit collateral at some bank, 2, have the bank open accounts, and 3, have those banks credit each person’s account with whatever float or day to day spending money each person thought they needed to tide them over from one payday to the next. Or perhaps most people would want a bit more money than that, but that’s a minor technicality.
Now people would clearly have to pay for the administration costs incurred by banks in supplying that above money. So the conclusion is that we do in fact hire the money supplied by private banks, irrespective of any lending that those banks do.

In contrast, supplying the economy with base money is almost costless.

How private money displaces base money.

If base money is costless and privately issued money does cost a significant amount to produce, it is legitimate to ask why about 95% of our money is private rather than public / base money. Put another way, how does private money manage to displace public money?

George Selgin provides an explanation here (see in particualar his 5th paragraph). It’s an explanation which I think is “the truth, but not the whole truth”. I.e. he misses out a step in the argument. (Incidentally, Selgin does not favour a “base money only” system)

After assuming a base money only economy, he says:

“Suppose next that fractional reserve banking is legalized and that…. it becomes so popular that all the old warehouse banks embrace it. Will inflation result? Of course it will—but only for a time. As fractionally-backed notes (or deposit credits) take the place of their 100-percent reserve predecessors, the demand for monetary gold, and hence the demand for gold in general, declines, causing the value of gold to decline with it. Because prices are expressed in terms of an (unchanged) gold unit, the price level has to rise.”

My explanation, for what it’s worth, is thus.

Assume a fractional reserve bank or banks set up in an FR or “base money only” economy, and the bank wants to lend. It could of course attract deposits and pay interest to depositors. But why bother? The bank can simply create money out of thin air and charge interest to those borrowing that freshly produced money.

The result (as Selgin points out) is inflation. But why would those new fractional reserve banks be bothered by that inflation? If you can effectively print money, and hire it out at interest, the fact that that money loses value at a significant rate won’t bother you.

Thus the conclusion is that even though privately issued money is inherently more expensive to produce than publicly issued money, the interest that private banks get from the money they print and hire out more than compensates.

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