Why private banks are counterfeiters in 300 words.

Take a country which switches from barter to using money for the first time. It has the choice between state issued money, which I’ll call base money, and money issued by commercial / private banks. Base money is cheaper – indeed it’s costless as Milton Friedman and others pointed out. In contrast, when a private bank supplies money to a customer, the bank has to check up on the customer’s creditworthiness, perhaps take security off the customer, allow for bad debts, etc etc. Those are very real costs.

Having supplied the economy with enough base money to ensure full employment, people and employers would lend to each other, either direct (person to person) or via commercial banks. However, there is then a trick which private banks can pull: supply money to customers WITHOUT first having obtained necessary funds from saver / depositors. I.e. private banks could (as in the real world) in effect just print money. And printing money is clearly a cheaper way of obtaining money than borrowing or earning it. Thus private banks in our hypothetical economy are able to undercut the free market rate of interest. And that would reduce GDP because the GDP maximizing price for anything, including the price of borrowed money, is the free market rate (absent what economists call “market failure”).

But that extra lending would raise demand to above the above mentioned full employment level: excess inflation would ensue. Thus government would have to impose some sort of deflationary measure, like raising taxes and confiscating base money from citizens.

Now that’s exactly what happens when traditional backstreet counterfeiters print and spend $Xmillion of forged dollar bills: government has to confiscate about $Xmillion from citizens. QED.