The fact that stricter bank regulations raise interest rates does not mean GDP is reduced as a result.

It’s obviously tempting to think that if stricter bank regulations raise interest rates, that’s an additional cost for mortgagors and businesses which need to borrow. Thus it would seem we’re all worse off. The UK’s  “Vickers Commission” fell hook,  line and sinker for that argument. So too does Congressman Keith Rothfus: see the second para of this recent “Money and Banking” article (entitled “Money Funds – The Empire Strikes Back”).

Of course I’m aware that Rothfus’s motives for wanting to get back to the old “heads the banks win and tails the taxpayer loses” arrangement is possibly not entirely altruistic: he may have had wads of $100 stuffed into his back pocket by banks. But corruption is not the central issue I’m addressing here.

I’ve been thru the flaws in the above “higher interest rates makes us worse off” argument at least once before in this blog, but I’ll run thru them again.

The first obvious flaw in that argument is that every additional pound or dollar of interest paid is an additional pound or dollar for creditors, thus to that extent interest rate changes have no effect on GDP.

However it is widely accepted that a rise in interest rates does have a deflationary effect: indeed interest rate adjustments are one of the main weapons used to regulate aggregate demand. Thus a rise in rates stemming from stricter bank regulations would indeed cut demand and thus GDP. But that effect is very easily countered by standard stimulatory measures, monetary and/or fiscal and the latter measures cost nothing in real terms. As Milton Friedman and others have pointed out ad nausiam (figuratively), having the state print money and spend it and/or cut taxes costs nothing.

To summarise so far, the fact that stricter bank regulation cuts GDP via the above “higher interest rates cuts GDP” channel is completely irrelevant.

The really important question is whether the higher rates that stem from stricter regulations give us something nearer the genuine free market rate of interest. If they do, then GDP will rise: reason being that, as is widely accepted in economics, GDP is maximised when prices are at free market prices, unless there are good social reasons for thinking free market prices should not prevail: i.e. where there is “market failure” to use the jargon.

Now it might seem that conventional or “fractional reserve” banking under which loans are largely funded via deposits and under which those deposits are insured by government (with banks being charged an insurance premium by government) is very much a free market system: at least it seems to be free market in that all costs, in particular the cost of insuring banks seem to charged to banks.

But there’s just one problem: the only reason government can afford to insure dozens of banks with assets and liabilities running to hundreds of billions is that government has access to two near infinitely large sources of cash: first the taxpayer and second the right to print money. Normal, or “free market / commercial” insurers do not enjoy the latter two luxuries.

Indeed, in the US, large banks are not insured via FDIC: what happened during the crisis was that the Fed rescued large banks with loans totaling billions at derisory rates of interest: an obvious subsidy or “non free market” ploy.

In contrast, a system under which bank loans are funded via equity or “floating net asset value” stakes in banks is entirely subsidy free: if a bank makes silly loans, all that happens is the value of its shares or “net asset value stakes” falls. There is no danger of the bank collapsing and no need for taxpayer funded rescues.

And a further point is that funding private banks via deposits actually enables private banks to create or “print” money. That is, private banks can use the profits of seigniorage to subsidise the lending process, as I explained here recently.*

And finally, if the widespread belief that there is  too much debt is valid, then a rise in interest rates would cut the total amount of lending and debt, which according to the latter “too much debt” theory would be beneficial.


* Article title:  "Why private banks are counterfeiters in 300 words."