Note: this article also appears on the Seeking Alpha site.
Summary: Letting private banks create money leads to an artificially low or “non GDP maximising” rate of interest and an artificially large amount of lending, borrowing and debt.
One of the basic jobs of commercial banks is to lend. So with a view to trying to determine the optimum or GDP maximising amount of lending and associated rate of interest, let’s start with the simplest possible economy, namely a barter economy, and gradually introduce the alleged improvements that result in a 2016 real world bank system.
Borrowing and lending take place in barter economies: it’s just that it’s actual goods and services that are loaned rather than money. For example, Robinson Crusoe might lend a fishing rod to Man Friday and might demand fish by way of interest.
So the first question for supporters of the existing bank system is this. Ignoring the inefficiencies of barter, is there any particular reason why the amount of borrowing in a barter economy would not be the optimum amount, and is there any reason to think the rate of interest would not be the optimum or GDP maximising rate? Well not that I can see. That is, Crusoes are free to demand any rate of interest they like. And Man Fridays are free to pay that rate, or suggest a lower rate. Some sort of genuine free market rate will emerge.
Also (and this is important for reasons which will become apparent below) note that Crusoe loses access to the rod while Man Friday is using it. Second, if Man Friday fails to return the rod, then Crusoe loses his rod. At least in barter economies I imagine that it’s difficult for lenders to get insurance for the loans they make.
A simple money based economy.
Next, assume a barter economy decides to implement a simple money based system.
Citizens agree on what the money unit will be and agree to set up a central bank or government department which issues the right amount of money: that’s an amount that induces all and sundry to spend at a rate that brings full employment, or put another way, “keeps the economy at capacity”, without excess inflation. Also, assume that banks come into existence, and accept deposits and make loans.
Assuming that (as per Crusoe and Man Friday loans) depositors who want their money loaned on by their bank lose access to that money as long as it is loaned out, we are talking about a full reserve bank system here. Also note that losing access to money while it is loaned out PROBABLY DOES NOT involve losing access for very long even where loans are on a long term basis, e.g. for mortgages. Reason is that for every person wanting their loaned out money back, there’s probably someone else who want their money loaned out.
Next question for supporters of the existing bank system is this. Is there any reason why interest rates under the above “state money only” system would not settle down to some sort of genuine free market rate? Well not that I can see.
Enter fractional reserve, stage left.
The next stage in our increasingly sophisticated(?) hypothetical economy is that private banks are allowed to engage in the money creation trick that they indulge in in the real world. That is, when $X is deposited at a bank, the bank can lend on the $X (or most of it) while telling the depositors they still have instant access to their $X. So relevant borrowers have $X to play with, as do depositors: lo and behold, $X has been turned into about $2X.
In contrast to the above relatively simple economies, I definitely can see why, if private banks are allowed to create or “print” money, interest rates would fall to a SUB-OPTIMUM rate: i.e. an artificially LOW rate. Reasons are thus.
As George Selgin explained in an article entitled “Is Fractional-Reserve Banking Inflationary?” (published by Capitalism Magazine), if one starts from a “state money only” system, and then allows private banks to create or print money, private banks will fire ahead and do just that. (Start at the 3rd para of Selgin’s article if you like).
Incidentally, that is not to suggest that Selgin would agree with this article of mine.
As to EXACTLY HOW private banks ease their way into the money creation process, that’s not difficult: essentially they just offer loans at marginally below the going or free market rate of interest. And that’s easy for them to do because they don’t have to pay for the money they lend out: they just create it from thin air. (See para starting “Allowing banks to create new money…” in Messers Huber and Robertson’s work “Creating New Money” for more on that.)
That is, unlike Crusoe who loses access to his fishing rod while it is loaned out, and unlike lenders in the above “state money only” system who also lose access to money when they lend it, depositors in 2016 “sophisticated” real world economies can have their money loaned out AT THE SAME TIME AS retaining instant access to it. And if that isn't a sleight of hand, I don’t know what is. Indeed, as the governor of the Bank of England in the 1920s, Josiah Stamp put it, in reference to private money creation, “The process is, perhaps, the most astounding piece of sleight of hand that was ever invented.”
But that extra lending means extra SPENDING, which is inflationary assuming the economy is already at capacity. Moreover, as the saying goes, “loans create deposits”, thus people would find themselves with more deposits than they want at the going rate of interest. Thus they’ll try to spend away the excess, which will also be inflationary.
The net effect is a serious bout of inflation, as Selgin explains (though he doesn’t spell out all the details that I’ve spelled out in the latter two or three paragraphs). And as Selgin also explains, that inflation whittles away the REAL VALUE of the monetary base, plus that inflation would continue till the base had been reduced to the point where banks had only just enough of it to settle up with each other.
An alternative possibility is that government clamps down on that inflation by raising taxes, i.e. confiscating some of the private sector’s stock of base money. But the end result is the same: the stock of base money eventually declines to the point where banks have only just enough of the stuff to settle up with each other.
Incidentally another possibility is that the relevant country imposes some sort of legal minimum reserve ratio like 10%, a rule that has actually been in operation in various countries over the last century. In that case, reserves would continue to shrink in real terms till they had reached that legal minimum, instead of the above mentioned “settle up” minimum.
To summarise this section, the net effect of private banks lending money into existence is that the amount of lending and borrowing is artificially boosted, as a result of which government has to cut down on everyone’s stock of base money, which in turn causes an artificial reduction in spending which is not “lending / borrowing” based.
Put another way, a genuine free market is one where suppliers of any commodity bear the full costs of supplying the commodity. E.g. in a genuine free market for apples or steel, apple or steel suppliers have to bear the full costs of apple or steel production: not produce apples or steel by some underhand method, like popping across the border to some neighbouring country and stealing apples or steel.
Likewise, in a genuine free market for funds which owners of those funds want to lend, each supplier of funds takes a conscious decision to abstain from using a specific sum of money for some period. But in the existing real world, while depositors do take a conscious decision to put some money in term accounts and some in current or “checking” accounts, the money in checking accounts is loaned out, whether depositors like it or not.
Thus the normal process via which a market price is reached via the interaction between suppliers and buyer/consumers that operates in the market for apples or steel does not apply when it comes to the supply and demand for borrowed money.
The result is that governments, instead of pitching the quantity of money at a level that brings full employment or “capacity” as mentioned at the outset above, control demand by adjusting interest rates.
But that’s a wholly illogical way of controlling demand: there is no reason to assume, come a recession, that the cause is inadequate borrowing, lending and investment any more than there is reason to assume there’s a lack of one of the other constituents of aggregate demand, like exports or consumer spending.
In short, the whole process of letting private banks print money leads to a complete mess: it leads to a dog’s dinner.
To summarise, under the existing or fractional reserve system, money lenders, i.e. banks (unlike other corporations) can obtain some of the money they need simply by creating it out of thin air, rather than by earning it or borrowing it, which is what other corporations have to do. That is quite obviously not a level playing field. It quite clearly involves a distortion of the market: a mis-allocation of resources.
Isn't central bank money “artificial”?
It might be tempting to claim a weakness in the above arguments is that central bank issued money is just as artificial, if not more artificial, than privately issued money.
Well the first answer to that is that no form of money is possible unless there is general agreement as to what the monetary unit shall be. Or as the saying goes, “money is a social construct”. E.g. in some societies it is generally agreed that some specific weight of a rare metal like gold shall be the monetary unit. So to that extent, ALL MONEY is artificial.
Indeed, the historical evidence is that money does NOT NORMALLY arise of its own accord in a free market: rather, it has more often been the case that money is introduced by rulers trying to find a more convenient method of collecting taxes.
Moreover, having government increase the amount of state issued money in a recession is not an entirely artificial contrivance, and for the following reasons.
Given a recession and a totally free and perfectly functioning free market, wages and prices would fall. That equals a rise in the real value of money. I.e. the value of the TOTAL STOCK of money rises. (That phenomenon is sometimes called the “Pigou effect” after the economist, Arthur Pigou.)
But in the real world, it is extremely difficult to bring about a rapid fall in wages: you just get strikes, riots and the like organized by trade unions (not that non-union labour is entirely happy when wages fall either). Or as Keynes put it, “wages are sticky downwards”. So as an alternative (as I think Keynes pointed out in his General Theory) one can increase the value of the total stock of money by increasing the number of money units rather than by increasing the value of each unit. The effect is the same.
Aren’t interest rate falls “natural”?
It might also be tempting to question the basic argument in this article by pointing out that given a recession, interest rates tend to fall, so what’s wrong with the conventional method of dealing with recessions, namely interest rate cuts?
Well the answer is that, unlike in the case of wages where there is an obvious obstruction to falling “prices”, there is nothing to stop the “price” of borrowed money falling, far as I know. Banks and other lenders compete with each other. And if they have spare funds to lend, they’ll tend to cut the price charged for hiring out those funds, won’t they?
Unfortunately, as is pretty obvious, falling interest rates alone do not cure recessions. And that’s hardly surprising since falling interest rates are not the only “natural” or free market cure for recessions: there’s also the above mentioned rise in the real value of the stock of money.