The vast majority of money in circulation is issued or created by private banks rather than central banks. And it is often claimed that “loans create deposits”, i.e. that private banks when they grant a loan simply create the relevant money out of thin air and give it to the borrower. Thus, so the story goes, privately created money necessarily involves debt creation, or quote a popular phrase, “Without debt there’d be no money”.
That all gives rise to the phrase “debt based money”. And in view of the negative overtones of the word debt, that leads many to argue that there is something wrong with so called debt based money.
L.Randall Wray (professor of Economics at the University of Missouri-Kansas City) has written a few articles recently criticising the “debt based money” concept and on the grounds that the alternative form of money, i.e. central bank issued money (base money), is also a debt of sorts.
Wray’s articles produced several responses e.g. from Eric Lonegran, Brian Romanchuk and from me. I argued among other things that central bank / government issued money, if it is a debt, is so different in nature to a normal debt that basically it is not a debt at all. For example the so called debtor (i.e. central bank / government) can simply wipe out any amount of the so called debt it wants whenever it wants via tax. That is, when the government machine says “We’re raising taxes by $X, and you households and corporations better pay up else you go to prison”, then government is essentially wiping out $X of the so called “debt” it owes the private sector. And that’s clearly very different to the debt you owe your bank in respect of your mortgage: there is absolutely no way you can wipe out that debt by simply announcing the debt no longer exists – and the bank manager goes to prison if he objects.
So to summarise, Wray’s argument that base money is also a debt isn't brilliant. Now for a better argument (hopefully).
The real flaw in “debt based money”.
One problem with the debt based money idea is that at the moment when a private bank grants a loan of $Y, no net debt is created. Reason is that the bank sets up two equal and opposite debts. First there is the $Y the bank owes the borrower and that’s called “money”, and the bank undertakes to become indebted to anyone the borrower chooses when the debtor says so (using his/her cheque book, debit card or whatever). Money is debt owed by a bank to a bank customer. Second, the equal and opposite debt is the obligation on the borrower to repay the first debt at some point.
Next, there is a crucial distinction between bank customers who simply want a supply of money, and bank customers who want loans. Suppose a private bank were to set up in an economy where money previously didn’t exist, and it offered some wondrous new stuff called “money” to anyone wanting to dispose of the inconvenience of barter. Also assume the bank announced that each unit of money was equal to the value of a gram of gold or some other rare metal. That would not of itself create long term debts.
The bank would simply credit money to the accounts of those wanting money (maybe after collateral was deposited); then, any money paid out of one account would necessarily arrive in someone else’s account (assuming for the sake of simplicity that there was no physical cash).
In short, everyone’s account would bob up and down above and below the original amount credited to their account, thus there’d be no long term debts.
Would the bank charge interest to those whose balance was below the original amount credited? Well it could, but assuming everyone’s account is ABOVE the amount originally credited as often as it was BELOW, then account holders would be equally justified in charging the bank interest. All in all, the charging of interest would be a waste of time.
It would make sense for the bank to charge for ADMINISTRATION COSTS, but that’s not the same as genuine interest (indeed, that’s one of the weaknesses in debt based money: it’s inherently expensive to create compared to base money).
To summarise, where a private bank simply creates money as distinct from granting a long term loan, bank customers don't incur net debts over a full 12 month period. Plus the charging of interest wouldn’t make much sense.
In contrast there are long term loans, e.g. for mortgages which often last decades.
A long term loan necessarily involves the transfer of REAL RESOURCES for an extended period, and interest is what is charged for borrowing those real resources. For example where someone gets a mortgage for $100k, that enables them to acquired a big lump of valuable real resources or wealth, commonly known as a “house”.
Now there is absolutely no way a bank can produce real wealth / resources. That is, a bank is simply a collection of offices, full of computers, bank staff, etc. Banks don’t produce bricks, concrete, timber joists and the other stuff needed to build a house.
Banks simply issue bits of paper or book-keeping entries that enable one set of people and firms to purchase stuff off other people and firms in a more convenient way than occurs under barter. Thus when a bank grants a loan for an extended period, the real stuff that the borrower comes by is not produced by the bank: it’s produced (in the case of houses) by those who run and work in brick kilns, saw mills and so on.
Put another way, when a bank grants loans to a set of borrowers, and assuming the economy is at capacity, some other set of people must save, i.e. produce more than they consume, else the economy overheats: inflation becomes excessive. And those savers normally demand interest.
In short, when interest is charged by a bank, the bank is simply passing on the interest that the bank itself has had to pay to savers. Of course banks charge borrowers significantly more than banks have to pay to savers, but to repeat, that’s for administration costs of one sort or another: salaries paid to bank staff, something to cover bad debts, upkeep of bank buildings and so on.
In short, the idea that there is something wrong with privately issued money because a debt arises whenever such money is issued is nonsense. Also the popular claim that we, the people, have to pay interest on the money supplied to us by private banks is nonsense. Banks DO CHARGE for administration costs involved in creating money, but they do not charge what might be called “genuine interest” on that money. In fact banks don’t even charge genuine interest on loans: what they do is PASS ON the interest they have to pay to savers, and then add something to allow for administration type costs and of course something for profit (i.e. a reward for one particular type of saver, namely shareholders).
So is privately issued money without fault?
Having argued that the alleged debt element in privately issued money is non-existent or not a problem, that’s not to say that privately issued money is without fault. For example, private banks act in a pro-cyclical way: that is, they create and lend out money like there’s no tomorrow in a boom. Then come the bust, their money creating and lending activities grind to a halt. That’s the exact opposite of what we’d like them to do.
So should we prohibit privately issued money? Well that’s a big question: not one I’ll deal with here.
P.S. (25th Feb). There's a new article just out by Eric Lonergan which also criticises Wray.