Tuesday, 17 February 2015

Why do we let private banks produce counterfeit money?

Summary. When a commercial or “private” bank grants a loan, it doesn't need to get the relevant money from anywhere: it can just credit the borrowers account with money produced from thin air, as explained in this Bank of England publication. That money creation or “printing” is to some extent exactly what backstreet counterfeiters do with their printing presses when turning out $100 bills or £20 notes.

However, it’s certainly not true to say that every time a private bank grants an $X loan that the bank effectively prints $X. The extent to which new money is printed when that $X loan is granted is a bit complicated and the paragraphs below are an attempt to sort out the complexity. However the fact remains that what private banks do is to some extent exactly what back  street counterfeiters so, and it’s plain bizarre that we allow that “legal counterfeiting” to continue.

Where counterfeiting occurs.
Where counterfeiting takes place, obviously it takes place when the counterfeit notes are FIRST PRINTED and first used to purchase goods and services. That is the point at which harm is done. I.e., when those notes SUBSEQUENTLY passed from hand to hand, no further harm is done.

A similar point applies to “legal counterfeiting” as done by private banks.

That is, the money supply normally increases year after year, but in a recession, private banks tend to rein in their loans and cut down on new loans. Thus in a recession there is sometimes no monthly or annual increase in the money supply. In that scenario, banks grant new loans at the same speed with which old loans are repaid. And in that case, clearly no new money creation takes place, counterfeit or honest.

In short, legal counterfeiting if it takes place at all, only takes place when the money supply is increasing.

The basic money creation process.

When a bank accepts an £X deposit and the deposit is loaned on, both the depositor and borrower are in effect holders of £X. So £X has been turned into £2X. However, there is no sharp dividing line between money and other fairly liquid assets: in particular, money in a term account where the term still has more than about two to four months to run is often not counted as money.

So… if in the above £X scenario those who RECEIVE the £X spent by the borrower put the money into a term account where the term is say 6 months, then on most definitions of the word money, no money is created on balance. Put another way, money is only created where the £X is put into a CURRENT account (checking account to use US parlance), or into a short term term account (say less than about two months). I’ll refer to those two types of account from now on as checking accounts.

To summarise so far, we need to concentrate on money spent by borrowers which goes into checking accounts. Plus we need to concentrate on the INCREASE in the TOTAL AMOUNT in such accounts for the country as a whole.

That amount clearly increases most years and for two reasons. First one would expect households to want the amount of money at their disposal to increase along with real economic growth. Second, inflation eats away at the value of money, thus households will presumably want to add to their stock of checking money every year so as to compensate for inflation.

And as explained above, the origin of that increased stock is money produced out of thin air by private banks when they grant loans. So what’s going on here is that private banks create money out of thin air, give it to borrowers who in turn use the thin air money to purchase goods and services from various other people or firms, who in turn place the money in their checking accounts and leave it there.

Now the latter people and firms have in a sense been diddled: they sweated their guts out supplying real goods and services and return all they get is in effect a book keeping entry  - or if you like a “number” on their bank statements.

Of course, the latter people and firms who have been diddled aren’t TOO BOTHERED: in return for their hard work they get what might be called “magic numbers” which enable them to purchase goods and services. But remember we’re talking about the INCREASED STOCK of money in checking accounts, thus those magic numbers in the aggregate are in fact never spent: that is, on average over the year, the stock of money in checking accounts rises: it never declines.

Illegal printing presses.

The latter phenomenon is EXACTLY THE SAME as where someone with an illegal printing press turns out counterfeit £20 notes, and (out of the kindness of their heart) brings about an increase in the nation’s stock of current / checking account money. That is, the printing press owner acquires real goods and services in exchange for what might be called thin air money.

Now you might think that because borrowers eventually pay loans back to banks that that somehow makes commercial bank counterfeiting OK. Well it’s true that INDIVIDUAL borrowers repay banks. But IN THE AGGREGATE they don’t. That is the total amount loaned out increases nearly every year, just like the money supply increases every year.

So, in the aggregate, borrowers acquire real goods and services from those with checking accounts for free and of course banks take their cut. Put another way, people who want more money in their checking accounts have to provide $X of goods and services for every $X of additional money they acquire to stock up their accounts. And those goods and services flow to borrowers and private banks.

What about central bank created money?

Now as distinct from private bank created money, there’s another widely used form of money, namely central bank (CB) created money or if you like “government created” money. (That’s using the word “government” in a very broad sense, i.e. it involves regarding CBs as part of the overall government machine).

That CB money comes in the form of paper notes and coins ($100 bills etc), plus there’s a small amount of CB money which comes in book-keeping form just like PRIVATE BANK money comes in book-keeping form. (Incidentally the TOTAL AMOUNT of that CB book-keeping money is normally ROUGHLY equal to the amount of paper note money, though the amount of that book-keeping money has actually expanded enormously in recently years as a result of QE).

The big choice.

Now we have a choice here. It would be perfectly possible to have a system under which money production is done just by the state and private money creation is outlawed. Indeed, that’s exactly what Abraham Lincoln wanted. As he put it, “The Government should create, issue, and circulate all the currency and credits needed to satisfy the spending power of the Government and the buying power of consumers.”

Under such a system, there would be two ways of distributing state created money. First, the state could simply distribute for free a suitable amount of money to every household and firm. As to what constitutes a “suitable” amount, that’s easy: the best amount to distribute is whatever keeps households spending at a rate that gives us full employment, that is as high a level of employment as is possible without bringing excess inflation. That distribution system is often referred to as a “helicopter drop”.

That distribution system does however have a problem which is that one can get bogged down in arguments over how much “free money” should go to particular types of household.

The second and probably better way to distribute new money would be to have government simply use the new money to fund a proportion of its usual spending: on education, defence, roads and so on. Alternatively, a right of centre government might choose to leave public spending constant and use the new money to cut taxes.


So let’s summarise. You want some more money for your checking account. The way you go about that under the existing system is to do some extra work or cut down on your consumption of goods and services for a month or two. That is, you “save money”.

Put another way, you sweat your guts out and supply real goods and services to someone somewhere, and in exchange get some extra magic numbers on your bank statement. Now whoever supplies those magic numbers is onto a good thing, aren’t they? I mean – supply magic numbers and get real goods and services in return? That’s nice work if you can get it. It’s extremely profitable. In fact there’s a name for that profit: seigniorage.

Now given that someone somewhere makes a seigniorage profit out of you when they supply you with extra money, who do you want that to be? Do you want it to be some collection of borrowers and banks unknown to you? Or do you want it to be the community as a whole, i.e. government? I prefer the latter.

When a private bank and those borrowing from it grab seigniorage profit they’re doing exactly what back street counterfeiters do. If there was no central bank, then private banks WOULD BE PERFORMING a useful service there: providing the country with money. But we DO HAVE central banks nowadays, and I suggest it’s central banks (in cooperation with government) that ought to provide our money supply.


  1. Ralph, I must disagree with the notion that the proper way for the government to expand the money supply is either helicopter money or fiscal expansion. Decoupling monetary expansion from fiscal expansion is very important. When there is a positive demand shock for money (2008), the monetary authority may need to dramatically expand the money supply to prevent the money demand shock from depressing aggregate demand for goods and services (NGDP). The problem with fiscal expansion is that it ties the monetary expansion to a specific government spending decision. Government spending decisions should be made based on whether the spending produces a surplus in public goods, not based on the economy's need for monetary expansion. Also, it takes time to get a big new fiscal program going, and time is on short supply when there is a sudden positive money demand shock. Helicopter money can be done quickly, of course, but the problem with helicopter money is that if there is excessive monetary expansion, helicopter money is hard to reverse (suddenly raising taxes to prevent inflation will not be popular).

    By far the better approach is what we already do. The Fed worries about the money supply, swapping cash for financial securities, and the fiscal authority worries about creating public goods.

    There may (or may not) be a special case at the ZLB where swapping money for securities fails to stimulate aggregate demand, and in that case, fiscal expansion (whether helicopter or otherwise) may be needed. Obviously the Keynesians think this is all too real, whereas market monetarists disagree. But that is not the normal case, at least not between 1940 and 2008.

    FWIW, I agree with your other comments about commercial banks undertaking their own monetary expansion. While I think your "counterfeiting" positioning is extreme to the point of being inaccurate, I must agree with the conclusion, that the central bank should control the money supply, not commercial banks. Some argue that the central bank ultimately controls the supply (because it can set reserve requirements, pay IOR, etc) but I don't see the benefit from all of this extra complexity.

    Kenneth Duda
    Menlo Park, CA

    1. Hi Kenneth,

      “Government spending decisions should be made based on whether the spending produces a surplus in public goods, not based on the economy's need for monetary expansion.” I agree – at least I think I do. I.e. I assume you’re saying that there is some optimum proportion of GDP that should be allocated to public spending, and it’s not the job of what might be called the “monetary expansion authorities” to interfere with that proportion.

      That proportion can actually be maintained when doing monetary expansion by implementing the right mix of public spending increases and tax cuts. Positive Money and co-authors achieve that “non interference” a slightly different way. They propose having some sort of central bank committee decide on the AMOUNT of monetary expansion, while the exact way the expansion is done is left to politicians. See bottom of p.10-12 here:


      Re the time needed go get fiscal stimulus going, that varies greatly on exactly what form the stimulus takes. Re infrastructure projects, they can take YEARS to get going, thus they are very unsuited to dealing with recessions. At the other extreme, the UK changed its sales tax (VAT) twice (down and then up) in the recent crises at the flick of a switch.

      Re your “Far better approach..”, the crucial points are how QUICKLY different forms of stimulus work, and second (as you mention) reversability. Re the speed at which monetary policy works, it’s not brilliant. Interest rate adjustments take about a year to fully work as I understand it. As to the reversability of fiscal, the above mentioned VAT rise didn’t cause problems in the UK.

      Re your last para, I agree that my points about counterfeiting are “extreme”. To some extent I’m flying a kite: I want to see if anyone can produce convincing counter-arguments. On the other hand I’m not the first to make the “counterfeit” accusation. See passage starting “The cost to the state…” (p.iii) here:


  2. I'm sorry Ralph, but this is incredibly irresponsible stuff. There is all manner of theory and evidence showing that a commercial bank in a competitive system faces strict limits on money creation, where these are in essence dictated by the willingness of the public to hold the banks' IOU's and its access to liquid reserves. Central banks, in contrast, really can create money willy nilly if they so choose. Even James Tobin got this right in a classic essay on the topic. Talking of bankers "counterfeiting" may appeal to anti-bank sentiment, which has a long history and got a big fillip from the recent crisis (in which most off the offenders weren't ordinary banks at all). But it is bad economics, both because it misleadingly suggests ordinary banks rather than central ones are the most likely source of irresponsible money creation and because it suggests that commercial bank intermediation contributes nothing to economic prosperity. Showing that such claims are false is child's play. Look up any empirical study of hyperinflation. Look up Cameron's work on money and development. Look up...well, at least look deeper than Abe Lincoln's speeches! Your readers may not want to hear it, but the fact is that, as between the commercial bank kettle and the central bank pot, the pot is the blacker!

    Saying these things isn't exonerating the likes of Citycorp. But there are good banks even today, despite all the distortions of TBTF etc. And there would be better more in the absence of implicit support for bad bankers' behavior.

    1. George,

      I’ll take your points in turn. First, I fully accept your point that “a commercial bank in a competitive system faces strict limits on money creation..”. That doesn’t invalidate my basic point which is that we can have either commercial banks or central banks issue the money we use, and that where the former expands, that can be at the expense of the latter. Plus in that scenario, commercial banks will grab seigniorage profits formerly reaped by the central bank, i.e. reaped by the community as a whole. (You yourself actually invited your readers to consider a hypothetical situation where commercial banks take over money creation from a central bank in your Capital Magazine article “Is Fractional Reserve Banking Inflationary?”)

      Re the possibility that central banks can be irresponsible and issue too much money, that’s certainly possible. Zimbabwe was a classic example. But in European and North American countries that sort of irresponsibility is rare. Moreover, if we bar central banks from ever implementing stimulus so as to prevent them ever being irresponsible, that bars them from implementing stimulus in a recession.

      Next, suggesting that private banks are involved in counterfeiting certainly does not suggest that their intermediation activities are worthless. Indeed, others who accuse private banks of counterfeiting (e.g. Positive Money, Jospeh Huber, James Robertson etc) are very clear that if private banks are barred from issuing money, they should very definitely continue with their intermediation activites. Plus the latter authors are very clear on exactly how intermediation would work in a full reserve system.

  3. A brief follow up. Perhaps you will agree with me that, in the U.S., the most offensive of commercial banks, or commercial bank holding companies rather, was Citycorp. I grant you it was a notoriously irresponsible firm (though "counterfeiting" hardly gets to the nature of its many offenses).

    Very well. Now tell me: where would Citycorp be if it weren't for the Fed? It would have failed a half-dozen times. "Thin air" my foot: show me a bank that survives and prospers despite reckless lending and investments, and I will show you a bank propped up by a central monetary authority abusing its own vast money-creating powers.

    1. George,

      I quite agree with you (and other advocates of free banking) that all forms of support for private banks should be withdrawn, including lender of last resort. (Though in contrast to advocates of free banking, I think that having withdrawn that support, 100% safe state backed accounts should be made available for those who want that.)

      However, there’s a distinction between saying (as above) that no central bank money should be available for failed private banks, and in contrast saying that central banks should not supply the money used by every household and firm in the land. I.e. using taxpayers money to rescue incompetent private banks is totally different to supplying households with the money they need. Stopping the former does not mean the latter has to be outlawed.

      Incidentally I’ve long been aware that Citycorp has been one huge farce, and for decades. But I can’t find an article which sets out all the gory details. If you know of such an article or paper I’d be grateful if you could give me the link.

  4. I second Ralph's call for 100% safe banks. Look, there is money I want to invest, where I expect to bear risk in exchange for return, and there's money I want in the US payment system, where I intend to use it to make payments. I do not want to gamble with my money in the payment system and I do not understand why it's good for anyone to have a payment system where there's some small chance that I lose all of my money, so if I think that might happen, I better pull it out, and voila, bank runs. The notion that I and 200 million other depositors would be able to assess the stability of a massive commercial bank is ridiculous. I have no clue and shouldn't have to know. So I need a monetary authority guarantee on the money in the payment system. Which of course we have today through FDIC+TBTF. But then what sense does it make to allow payment system operators (commercial banks) to gamble with that guaranteed money? This is what I've never been able to understand.

    George, I am all for the benefits of intermediation, and to get them, investors should invest funds into an investment company that provides intermediation in exchange for payments from the borrowers, and it should make payments to the lenders based on its return, and it should not participate in the payment system. Then, investors understand they are taking risk, TBTF + "systemically important" is gone, the investment company can reduce runs by issuing long-duration liabilities, and the whole thing would actually make sense.

    Kenneth Duda
    Menlo Park, CA

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