Tuesday, 22 March 2016

Taxpayers subsidise private money creation.

The above is the title of a paper I’ve just published – about 6,000 words. This is an 800 word summary.

Money can be divided into two basic forms. First there is publicly created money (created by central banks and often referred to as “base money”). Second, as the opening sentences of this Bank of England publication make clear, private banks also issue a form of money. And in fact that privately issued money makes up the vast majority of money in circulation.

Base money, costs much less to produce than privately created money because private banks have to check up on the credit worthiness of borrowers before supplying them with money.  In contrast governments and central banks (aka “the state”) does not need to do those checks when creating and spending base money into the economy.

It might be claimed that the cost of private money creation is the cost of organising loans and hence that the cost of private money creation as such is not particularly high. The flaw in that argument can be illustrated by a hypothetical economy where people want a form of money, but no one wants a loan, particularly a long term loan.

Commercial banks in that scenario would simply credit money to people’s accounts as desired, after taking collateral in most cases no doubt. At that stage, all banks have done is make book-keeping entries: no transfer of REAL RESOURCES has taken place. So there’s no real debt.

Thereafter, as long as the balance on everyone’s account was ABOVE the original balance as often as it was BELOW, no one would be indebted to a bank or anyone else on average over the year. And remember that where someone’s balance goes $X “below”, some else’s must go $X above because money leaving one account must enter another (if we ignore physical cash).

Moreover,  there’s no question but that when people or firms in the real world get so called loans from a bank, they are not actually after a long term loan at all: in many cases, all they want is a float or stock of money to enable them to do day to day business. Thus the idea that the cost of private money creation is simply the cost of organising loans is flawed.

So if you were setting up an economy from scratch, or converting from a barter to a money based economy , the GDP maximising option would be publicly created money, not private money. Plus there is no reason why that regime would not produce a genuine free market or GDP maximising rate of interest.

However, despite the high cost of private money, it nevertheless manages to drive public money to near extinction (except in the current very low interest scenario).  George Selgin describes that “drive to extinction” process, which is not to suggest he’d agree with the arguments here.

The reason for the “drive to extinction” is that private banks can create and lend out money at below the going rate of interest because they are not burdened with one of the main costs normally involved in lending, namely earning money and abstaining from consumption (so that borrowers can consume.) Joseph Huber makes very much that point (2nd para, Ch 4).

When an economy is at capacity, the result of that extra lending is inflationary, so government has to withdraw base money from the economy, i.e. rob taxpayers,  in order to counteract the inflation, for example by cutting the deficit / raising the surplus or by raising interest rates. In short, private money printing is subsidised by taxpayers, and subsidies reduce GDP, unless there is a good reason for a subsidy.

The net result of letting private money displace base money is an artificially low rate of interest and an artificially high level of debt, plus GDP is reduced. So if you wondered why interest rates are now at very low levels, and why debts are arguably too high, you now have part of the answer.

GDP would thus be increased if privately issued money was banned, though its complete elimination is not necessary. For example local currencies are a form of privately issued money. They do little harm and they’re a bit of fun.

Also shadow banks, particularly the smaller ones, would doubtless try to circumvent attempts to ban private money. That is, they’d try to issue money-like liabilities. However, while those liabilities may be readily accepted in the World’s financial centres, they are not much use for 99% of other transactions: buying a house or car or doing the weekly shop for groceries.

Bearing in mind that the normal definition of money is something like, “anything widely accepted in payment for goods and services”, it’s debatable as to how money-like the liabilities of small shadow banks can ever be.


  1. "When an economy is at capacity" - Just like every other mainstream economist, you too trivialize this and assume this is the everyday reality. In the recent decades, when has any of the nations been at full capacity?
    Why can't you make your argument stick with the economy not being at capacity. Try that next time.

    1. 99.9% of economists have tumbled to the blindingly obvious fact that the economy is never at full capacity in the sense that everyone who wants a job is able to find one. Had you studied economics you'd have discovered that what is normally meant by "at capacity" or "full employment" is that numbers employed are as high as it is feasible to get them, without excess inflation kicking in.


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