Why do we let loan sharks create our money supply?

Why do we have a form of money which is dependent for its value and its very existence on the success of a collection of loan sharks, commonly known as “private banks”? That’s what the existing monetary and banking system involves.

Of course the phrase “loan shark” may be a bit perjorative. On the the other hand, given the HUNDRED BILLION or so dollars worth of fines that banks have had to pay over the last two or three years for laundering Mexican drug money, fiddling Libor and God knows what else, the description “loan shark” isn't entirely unjustified.

But that’s not important. The important point is that even if banks were all reasonably honest (and some doubtless are) why do we have a form of money which vanishes into thin air when one or more of those private banks fail? After all: even businesses which are run in an ENTIRELY HONEST way make bad mistakes from time to time.

In the 1930s, governments were NOT IN THE HABIT of rescuing private banks, and as Irving Fisher put it in his book “100% Money and the Public Debt”: “The most outstanding fact of the last depression is the destruction of eight billion dollars-over a third-of our "check-book money"-demand deposits.”


How much of our money is “loan shark” money?

As to the exact proportion of our money supply which is created / printed by private banks rather than central banks, the ratio of those two forms of money is normally around 95%:5%. (Though those percentages have varied significantly since the 2007/8 crisis. But the AVERAGE ratio over the last twenty years is around 95:5.)

Actually 97% is one of the most commonly quoted figures. Just Google 97% and the word “money” for more information on that.


The printing press.

Of course there’s a solution to the above “disappearing money” problem which is to have the central bank crank up the printing press and rescue private banks when they’re in trouble. In the recent crisis a total of THIRTEEN TRILLION DOLLARS was loaned by the Fed (at sweetheart rates of interest) to private banks. $13tn by the way is almost as much as the GDP and the United States of America.

Must be nice to be in an industry where Uncle Sam is willing at the drop of a hat to come to your rescue with container-loads of $100 bills. Or perhaps that should be “entire ship loads”.

Assuming you haven’t died laughing (or crying) you will doubtless have worked out that an industry which periodically gets loans on the above scale gratis the central bank is being SUBSIDISED. And it’s widely accepted that subsidies do not make economic sense.


The flexibility argument.

It COULD BE argued that giving private banks the right to print and lend out money at gives them flexibility. That is it might seem that if a commercial bank spots a larger than normal number of viable borrowers, it’s beneficial for the bank to be able to lend IMMEDIATELY rather than wait for months till the bank can attract funds somehow or other: e.g. attract more depositors or sell bonds or shares.

Well the answer to that is that if under a “no private money” system, Bank X spots a larger than normal number of viable borrowers, it is free to borrow from other banks to obtain funds needed to enable it to lend straight away. Indeed, inter-bank lending takes place on a HUGE SCALE every day ANYWAY! And that inter bank lending should tide Bank X over till it gets a more permanent source of funds.

Alternatively, Bank X could “sell” the viable borrowers to some other bank: i.e. let some other bank know who the viable borrowers are, for a consideration, and let other banks do the lending.


Macro arguments.

Another plausible but flawed argument for private money printing is a macroeconomic one, namely that if the private bank system AS A WHOLE spots a larger than normal collection of viable borrowers, it should be able create and lend out money immediately.

Well the answer to that is that when the private bank industry as a whole DOES significantly expand its lending, that’s more likely to be an instance of lemming like behavior, i.e. an asset price bubble, than an increase in the number of GENUINELY VIABLE borrowers.

Was the expansion in NINJA mortgages before the credit crunch an example of an expansion in GENUINELY VIABLE borrowers? Certainly not: those NINJA mortgagors turned out to be duds (as predicted by a few individuals who make a killing out the house price collapse).

In general terms, it is widely recognised that private banks behave in a pro-cyclical manner: they stoke booms and exacerbate recessions. Thus it is right to be wary of claims by private banks that they’ve spotted a more than normal number of viable borrowers.


Interest rates.

Another weakness in the above macro argument is thus. If an economy is at capacity and private banks spot a more than normal number of GENUINELY VIABLE borrowers, and they create new money and lend, the effect will be excess inflation. That is, spending that new money will represent extra aggregate demand. And the reaction of the central bank to that excess demand / inflation will almost certainly be to raise interest rates, which in turn will choke off some of the extra lending.

Now suppose that private banks CAN’T create or “print” money. That is, suppose the only form of money allowed is base money, and that the volume or amount of that money is fixed or expands only a small amount every year.

If private banks suddenly want more money to lend out, they’ll have to raise the interest paid to depositors and other “bank funders” (e.g. shareholders and bondholders).

Same result! Interest rates rise.


Otherwise private banks are OK.

Finally, I’m not attacking private banks AS SUCH. They perform all sorts of useful functions. It’s just their money creation activity which is questionable. To quote Irving Fisher again, “We could leave the banks free . . . . to lend money as they pleased, provided we no longer allow them to manufacture the money which they lend.”



Afterthought.

I spelled out above a couple of ways that private banks could deal with VARIATIONS in demand for loans in a system where privately created money is banned. There is actually a THIRD way, and that is for private banks to have a stock of base money in reserve to deal with sudden increases in demand for loans. The creation and storage of that additional base money would not cost anything in real terms. As Milton Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”