An anomaly in the existing bank system.

If you lend direct to a corporation, i.e. buy its bonds, there is no taxpayer support for you if it goes wrong, and quite right. In contrast, if you lend to a bank (i.e. make a deposit at a bank) and the bank lends to the same corporation, government guarantees you’ll get your money back.

So if you lend DIRECTLY to a corporation, you’re on your own. But if you lend via a bank, the taxpayer rescues you if it all goes wrong. That is an obvious anomaly. So what’s the explanation?

Well the authorities’ motive for maintaining that anomaly is the idea that “money should be used”. I.e. the idea is that money deposited at banks should as far as possible be put to good use. (See for example the Vickers report, sections 3.20-24) That is, if deposits were not loaned on, that money would stand idle, plus total amounts loaned would decline, which would first, cut demand, and second raise interest rates.

As to the “cut demand” point, that is easily dealt with by raising demand (surprise surprise). That is, for example, the state can simply create new money and spend it, and/or cut taxes, with a view to keeping demand at the full employment level, or NAIRU if you like acronyms.

As to the interest rate rise point, the crucial question there is whether the free market rate of interest is attained under the above “anomalous” regime, or under a regime where money which is supposed to be safe is not loaned on. And the answer is that the free market rate of interest (i.e. the GDP maximising rate) is achieved under a “not loaned on” regime.

Reason is that the only way of making loaned on money is safe is to have the taxpayer stand behind that arrangement, i.e. subsidise the arrangement. And subsidies, unless they are for good social reasons, result in GDP not being maximised.

And finally you may have noticed that the above “idle money should be used” argument is just one of dozens of examples of one of the most common mistakes in economics, namely applying microeconomic rules at the macroeconomic level. That is, it makes sense for a microeconomic entity like a firm or household to put its stock of money to good use as far as possible. But from the point of view of the economy as a whole, that argument doesn’t hold. That is, if a proportion of the population decide to hoard large quantities of money, that matters not one iota: the deflationary effect of that can easily be dealt with by having the state simply create and spend whatever amount of money is needed to keep the economy at capacity.