Tuesday, 3 December 2013

Money creation by commercial banks produces sub-optimum interest rates.


Under fractional reserve banking, commercial banks lend money into existence. To make a profit, those banks and those they lend to do not need to cover or match the free market rate of interest: they only need cover other costs, e.g. administration costs. Thus commercial banks tend to depress interest rates to a sub optimum or sub free market level.


Let us start with a full reserve bank system. That’s a system where the only form of money is monetary base: and that could be some commodity, like gold, or a fiat monetary base. And let’s assume full employment, that is, we’ll assume the economy is at capacity, and that the going rate of interest for a near risk free loan is X%.

Next, let’s assume commercial banks start making loans not only by lending on money deposited with them, but also (as per the existing fractional reserve system) by simply crediting the accounts of credit worthy customers.

Now do those customers and their banks need to get an X% return on capital (assuming, to keep things simple, that the loan and investment are near risk free)? Well of course not! All they need to is to get a return which covers costs. In the case of the bank, that would be enough to cover administration costs. And as to the borrower, they only need to cover the costs normally involved in any investment or business: e.g. the costs of labour, energy, depreciation and so on.

As to where loans involved significant risk, banks would have to make a significant additional charge: for bad debts.


Of course the additional spending involved in the latter loan and investment means that aggregate demand rises, which would be inflationary. But that’s of no concern to the bank or borrower.

As to the bank, when the loan is repaid the REAL VALUE of the dollars repaid will be less than when the loan was first made. But what of it? It didn’t cost the bank anything to create the money it loaned out (administration costs apart).

As to borrowers, if the real value of the money they eventually repay is less than what that money was worth when first borrowed, then they’re quids in!!!

The above lending strategy where banks aim to effectively tell depositors to shove off because banks have no intention of paying interest to anyone will be called the “just cover costs” strategy.

Note that the “just cover costs” strategy will not lead to PERMANENT EXCESSIVE inflation. The inflation only continues until the total of loans made by banks has risen to the point where the costs of lending by banks just covers administration costs and return on investments just covers the costs of labour, energy, etc.

So why do banks pay interest to depositors?

The above argument effectively says that banks do not need to pay interest to depositors because when making a loan, banks can simply create the money they want to lend out of thin air. So why does any bank pay interest to depositors?

One answer is that they don’t!!  At least not in REAL TERMS. That is, the real or inflation adjusted interest on bank deposits has hovered around zero for a long time: since well before the recent crisis.

Second, there is an important distinction between an INDIVIDUAL bank and the commercial banking SYSTEM as a whole, and as follows. An individual bank cannot expand the amount it lends willy nilly even when it spots viable lending opportunities: if it does expand its loan book faster than other banks, it becomes indebted those other banks.

Thus the extent to which banks go for the above “just cover costs” policy depends amongst other things on the extent to which commercial banks act as one as against acting in competition with each other. And it’s not obvious to what extent those alternative policies are adopted by banks.

But even if they tend to go for the “act in competition” option, there will still always be a bank or banks which are flush with reserves, and which are thus more willing to lend that banks which are short of reserves.

This is getting complicated isn't it? Don’t worry: the complexity will be cut short a few paragraphs hence.

Central banks artificially raise interest rates.

Another factor that muddies the picture is that governments borrow huge amounts, which will probably artificially raise interest rates.

And yet another factor is that central banks sometimes artificially starve commercial banks of reserves so as to raise interest rates.

There is actually a limit to how far central banks can take that policy since commercial banks do not absolutely have to have reserves in order to settle up with each other. That is they could use almost anything: shares, real estate, you name it.  In fact commercial banks already by-pass the central bank settling up system in that commercial banks run up significant debts to each other.


Now this is all getting a bit complicated. But hopefully I’ve established that there is a TENDENCY for interest rates to be artificially low in fractional reserve system. 


Afterthought (5th Dec 2013): Messers Huber and Robertson have slightly different ideas as to how commercial banks exploit fractional reserve. They claim (p.31) that banks’ ability to create and lend out money at no cost to themselves enables them (in the words of H&R) to “cream off a special profit”: they charge borrowers the full rate of interest, while not themselves having to borrow that money from anyone.

Strikes me the problem with that idea is that you don’t get extra customers or sales by selling at the standard or existing rate, however big your profit might be. That is, any business that finds a cheaper way of producing something can certainly profit from that, but it can only do so by dropping its price: i.e. sharing the bonanza so to speak with customers. And that’s the sort of scenario set out above: that is, on introducing fractional reserve, banks will charge borrowers less than the rate of interest that would prevail under full reserve.



  1. You say:- "do those customers and their banks need to get an X% return on capital...? Well of course not! All they need to is to get a return which covers costs. In the case of the bank, that would be enough to cover administration costs"
    This seems to forget that banks also have to cover the costs of borrowing funds from the money market (interbank loan rate) and/or the Central Bank (discount rate).
    Interest rates are not set by banks or the admin costs. They are set by the Government's monetary policy, effected through the Central Bank.

    1. My central point above is that in a free market (i.e. absent central bank or government interference) fractional reserve banking will depress interest rates to below the optimum or free market rate. And the passage you quote is from the start of the above post where I assume free markets. Later on I introduce governments and central banks. And obviously once the government / central bank machine enters the fray and starts manipulating interest rates, then as you say the “machine” has a big say in or perhaps complete control of interest rates.


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