Tuesday, 8 March 2016

The bank subsidy no one has spotted.


Private banks create money. That activity is subsidized by taxpayers. Reason is as follows. Assume an economy where the only form of money is base money and assume there’s enough of that money to bring full employment. If private banks then start creating and lending out their own money, government would have to confiscate base money off taxpayers so as to forestall inflation. Ergo taxpayers subsidize the creation / printing of money by private banks. Ergo privately issued money printing mis-allocates resources and reduces GDP.

At about 3,000 words, this article is much longer than most articles I produce. However, the basic ideas are set out in the first third of the article. The rest considers possible weaknesses in the arguments in that first third.


 Private banks enjoy at least three different subsidies, as follows.

1. The too big to fail subsidy which enables large banks to borrow at preferential rates of interest.

2. What might be called the “bail out” subsidy: the fact that the Fed for example loaned private banks around $600bn for about 18 months at the height of the crisis at a derisory rate of interest.

3. Governments in some countries have provided deposit insurance for private banks (and depositors) for free for decades. (In contrast, in the US, the FDIC actually charges banks for deposit insurance, and quite right).

However, there’s a fourth subsidy. I’ll explain it by reference to a very simple economy where the only form of money, at least initially, is base money. Let’s assume that that base money comes in fiat form (as it does throughout the World nowadays) rather than in the form of gold.

Assume that the quantity of money is enough to bring full employment: that is, the stock of money held by households and firms is enough to induce them to spend at a rate that keeps as many people employed as is possible without causing excess inflation. Also, assume that initially commercial banks are confined to lending money which depositors, bond-holders etc have deposited: i.e. banks don’t CREATE and lend out money as happens at the moment. (I.e. "deposits" would have to be in the form of bonds or at least long term deposits, or something that didn't count as money.)

There is no obvious reason why in that scenario interest rates would not settle down to some sort of genuine free market rate. In particular, a free market is one where the producers of each commodity bear the full cost of production, and in the case of loans, that means (first) that lenders take a hit when loans go wrong. Though let’s assume lenders are free to insure against those losses. Second, it means that lenders forego consumption in order to enable borrowers to consume.

Commercial banks create money.

Then one day, commercial banks (just like goldsmiths in London 300 years ago) realize that where they wish to lend, but don’t have the necessary funds, that’s no problem. Like the goldsmiths in London 300 years ago who loaned out receipts for gold that didn’t exist, commercial banks can simply print their own money, or issue IOUs. Whether those IOUs come in physical paper form (e.g. £10 notes) or whether commercial banks are confined to issuing IOUs in book-keeping form (as has been the case in Britain since 1844) doesn’t matter.

Now there are a couple of problems with lending out privately created money. The first is that on the above assumptions (full employment equilibrium, etc) all those who want to borrow at the prevailing rate of interest will already have done so. Thus there would seem to be no market for commercial banks’ funny money.

Well there’s a simple solution to that problem. The solution stems from the fact that it costs nothing for private banks to create money – just as it costs counterfeiters almost nothing to print money. That is, a money printing private bank does not need to endure one of the above mentioned costs that lenders normally endure, namely foregoing consumption. I.e. if you can, in effect, print $100 bills and lend them out, well that’s nice work if you can get it. And private banks can indeed “get it”. (For more on that, see 2nd para of Ch 4 (p.31) here).

But that in turn gives rise to a problem, namely that people borrow money to SPEND IT, and that additional spending will be inflationary (given the above starting assumptions). Moreover, whoever receives that money will then have an excess stock of money and will try to spend it away, which adds to the inflationary pressure. Thus government has to implement some sort of compensating DEFLATIONARY measure. For example it could raise taxes and rather than spend the money it collects, and simply extinguish that money. (That’s actually the opposite of what governments have done in recent years, namely implement fiscal stimulus followed by QE – see the end of this article under the heading “Grab and extinguish” for more details on that)

An alternative deflationary measure would be for government to remove base money from circulation by borrowing money off the private sector. But to pay interest, government would have to grab money off the private sector via tax, and tax is not a free market phenomenon (which is not to suggest that tax is never justified). Either way, to counteract the inflationary effect of the money created by private banks, government has to rob taxpayers.

Let inflation rip?

Re dealing with the above mentioned inflationary effect of private money printing, there is actually an alternative to grabbing money off taxpayers, and that is simply to let inflation rip until the real value of base money has been reduced to near nothing and is almost totally replaced with privately issued money. George Selgin actually describes that process.

In that case it is existing holders of base money who are robbed or who subsidise private money creation, rather than taxpayers. But that robbery / subsidy is of course equally unjustified.

So the net effect is that taxpayers or savers subsidise private banks’ “print and lend out money” activity. And subsidies misallocate resources: they reduce GDP. So the conclusion is that we’d be better off if private money printing / creation was outlawed.

And that’s it. The rest of this article deals with possible weaknesses in the above argument plus there’s the “Grab and extinguish” section mentioned above and set out below.

An alternative free market scenario.

It could be argued that there’s a flaw in the initial assumptions above. That is, it was assumed that our hypothetical economy has a fiat style monetary base and that in turn assumes the existence of some sort of government and central bank to organise the monetary base, and governments and central banks are arguably not free market phenomena. OK, let’s consider what happens where there is no government apart from just enough “government” to maintain law and order.

In that scenario if private banks are free to print money units and lend them out, there’d be no constraint on inflation. Banks would just print away and when anyone entered a bank demanding something (like base money) in exchange for the bank’s “100 unit” notes, the bank would simply say: “There’s no base money. Go away.”

So that scenario is just chaos.

A gold monetary base.

Another and more realistic scenario is an economy where the accepted form of money is gold or some other rare metal. That was situation in Britain about 300 years ago when goldsmiths started hiring out gold receipts for non-existent gold.

To explain what’s wrong with those receipts, I’ll make some simplifying assumptions. First, assume no economic growth. Also most of the costs involved in running a business (cost of labour, fuel etc) are irrelevant to the argument here. I.e. the RELEVANT items are, 1, the sum borrowed, 2, the interest paid and 3, the asset bought with that borrowed money.

So let’s assume a private bank prints money and lends it to a business which simply buys an asset, say a house, and sits on that asset: it doesn’t even rent out the house.

The effect of that additional money (given the same starting assumptions as at the start of this article above) is inflation: i.e. the price of gold rises in terms of other goods.

Next, the holder of the bank’s funny money (probably the person who sold the house to our entrepreneur) turns up at the bank and asks for gold in exchange. But there’s a problem: the price of gold has risen in terms of other goods. Thus the bank has a problem: the value of its liability (gold) has risen in terms of the ultimate asset which underpins that liability, namely the house. Too much of that sort of thing would lead to the bank going insolvent. So I suggest that under a gold standard regime, commercial banks just wouldn’t go in for money creation. And certainly banks in the 1700s and 1800s when the gold standard prevailed, didn’t deliberately print money and lend it to borrowers to fund projects that produced a ludicrously low return on capital.

So under our “gold standard free market” scenario, private money printing just won’t take place.

The actual history.

However, in the 1700s and 1800s, the amount of privately issued money expanded by leaps and bounds. So how come?
Well I suggest the explanation is that the 1700s and 1800s were periods of unprecedented economic growth – at least in Europe and North America. And growing economies need a growing money supply. Enter private banks with their money printing activities stage left.

The alternative would have been to bar privately created money, which in turn would have meant deflation and falling prices, which in turn would have made it economic to expand the monetary base by digging up more gold.

But a gold monetary base suffers from a defect: the high real costs of producing gold. Thus private money printers in the 1700s and 1800s did perform a useful service: they obviated those “high costs”.

But that doesn’t mean that the best way of increasing the country’s money supply, given economic growth, is to have private banks print and lend out money. Reason is as follows.

The purpose of economic activity is to produce what people want, both by way of publicly produced items (roads, education, etc) and items people buy out of their disposable income (beer, cars, clothes, etc).

Thus when more money is required, there is no obvious reason to feed that extra money into the economy exclusively via more borrowing to fund investment than there is to feed it in via subsidies for cars, ice cream or lollipops, or just via spending more on education. Given that the basic purpose of the economy is to produce what people want (to repeat) and assuming there is scope for letting them have more of what they want, the logical course of action is give people more of what they want (in the case of publicaly produced items) or plain old cash (e.g. tax cuts) when it comes it items purchased out of disposable income. Moreover, employers will AUTOMATICALLY invest more when they see the additional demand stemming from tax cuts and more public spending. There’s no need for any artificial encouragement to invest.  As Jamie Galbraith put it, “Firms invest when they can make money, not when interest rates are low.”

To summarise and recap, while the private money printing that took place in the 1700s and 1800s did serve a purpose (obviating the cost of digging up gold), that doesn’t justify the printing of money by private banks.

Private money costs more to produce than public money.

A further weakness in the idea that an economy with a powerful government and central bank is not a free market economy is thus.

A free market is one in which the most efficient producers remain in business, while the less efficient go out of business. And private money creation is inherently costly compared to publicly created money. That’s because if a private bank is going to supply a customer with a stock of money, the bank has to check up on the credit-worthiness of the customer and quite probably take collateral off the customer. Then it has to check up on the value of the collateral.

And there are significant costs there. In fact the only reason banks charge borrowers more interest than the interest that banks pay those who fund them (depositors, bond-holders etc) is precisely those costs – plus something for profit. Those costs come to very roughly 2% pa of the relevant capital sum.

In contrast, the real costs involved in having the state print money are near zero. That is, if it is decided that stimulus is needed say in the form of QE, then creating the money to do that simply involves pressing a few buttons on a computer keyboard at the central bank. There’s no need to check up on anyone’s credit-worthiness.

To repeat, a free market is one in which the most efficient producers win, and the least efficient are driven out of business. Whether those producers are public sector or private sector is irrelevant. And it’s clear that money creation can be done more cheaply by the public sector than the private sector.

And if you want to know why, in that case, there is so much privately created money in circulation, the answer is that as soon as commercial banks have more base money than they need to settle up with each other they are then in a position to print and lend out money at below the going or free market rate of interest, as explained above. Indeed that’s exactly how central banks cut interest rates: by increasing the stock of base money.

Alternatively, if the economy is at capacity and private banks create and lend out money, that (to repeat) causes excess inflation, which forces the state to grab base money off the private sector. Indeed that’s exactly what happens when counterfeiters produce money: if there were no counterfeit money and counterfeiters managed to print and put their own money into circulation to the tune of X% of the money supply, then government would have to grab money off the private sector to the tune of roughly X% of the money supply to forestall inflation.

Private money as a by-product of lending.

Another potential flaw in the first third of this article is that money creation by private banks is arguably a free by-product of lending. Indeed there’s that popular phrase: “loans create deposits”. Put another way, it could be argued that the costs of private money creation (checking up on credit-worthiness etc) are costs involved in making a loan, not costs involved in creating money.

The answer to that is that’s impossible to say (without some detailed research) exactly how far borrowers are simply after a stock of money with which to do day to day business, and in contrast, how far they are after long term loans, e.g. mortgages. Certainly a significant proportion of the population has no desire to borrow, but obviously DOES WANT a stock of money. Thus attributing the costs of money creation JUST TO lending is not realistic.

For more details on the point that no long term debt to a bank is involved where the bank simply supplies a customer with money for day to day transactions, see here.

A low interest rate scenario.

Having said above that private money creation enables private banks to make loans by undercutting the going rate of interest, an exception to that comes where the free market rate of interest has dropped to very low levels, as seems to have happened recently. Indeed, interest rates have been falling for twenty years or so. In that case the scope that private banks have for undercutting the going rate of interest is much diminished. And that helps explain why in recent years there has been a huge increase in the amount of base money, but very little inflation as a result.

“Grab and extinguish”.

I claimed above that where the state grabs money off the private sector via tax and extinguishes that money, that’s the opposite of the fiscal stimulus combined with QE that has been implemented in recent years. The reason for that is quite simple and is thus.

Fiscal stimulus consists of government borrowing $X, spending that back into the economy and giving $X of bonds to those it has borrowed from. QE consists of the state printing money and buying back those bonds. So the net effect is: “the state prints money and spends it”.

“Grab and extinguish” is the opposite of that. I.e. the state, instead of spending money into the economy, takes money AWAY FROM the economy and “unprints” it, i.e. extinguishes it.


Letting any private sector entity print or create money is a subsidy of that entity because taxpayers have to be robbed to prevent the inflation that would otherwise occur. That point applies both to respectable private banks and backstreet counterfeiters.  In other words it doesn’t matter whether the private sector money creator LENDS OUT the money created or whether it simply spends it (which is what counterfeiters do): in both cases taxpayers subsidise the private money creator.

Subsidies mis-allocate resources and thus reduce GDP. Ergo private money creation / printing should be abolished.


  1. This article is confusing and fundamentally mistaken because misuses the term "subsidy".
    A subsidy is negative tax, i.e. a payment by the government to a firm or household.
    Raising taxes to manage the economy is not a subsidy to anybody.

    My consumption is not subsidised even though it may cause the government to raise taxes (or take other deflationary action). This is so irrespective of whether I finance my consumption by reduced saving or by borrowing.

    Note that it is my spending that may require macroeconomic adjustments by the government. Banks may facilitate that spending, but neither they nor myself is being subsidised.
    Note also that retailers and wholesalers, like banks, also facilitate my spending. However, neither these, nor banks nor myself is being subsidised when I decide to spend.

    1. As usual, getting to grips with your comment involved me in a fair amount of head scratching and additional caffeine intake.

      Re the definition of the word subsidy, your definition (a payment by government etc) is the standard definition. But I suggest that a failure by government to charge a firm for something it ought to be charged for amounts to a subsidy as well. E.g. if firms in a particular industry emit a lot of pollution, and government charges them for that externality, except in the case of one firm which has good political connections, that amounts to a subsidy of the latter firm.

      In the case of private banks which create and lend out money, they can only do that (as explained above) by “cheating” so to speak: that is, no one needs, at least initially, to endure the main cost involved in making a loan, namely abstaining from consumption. Instead, abstinence from consumption is forced on taxpayers. That strikes me as a simple straightforward case of an externality: i.e. cost imposed on the community at large by the relevant firm. And the fact that those firms (private banks) are not charged for that externality equals a subsidy in my books.

      Re your second and third paragraphs, where you increase your spending, I agree that forces government to take some deflationary measure like raising taxes. But that’s different: you’ve acquired the means to spend (i.e. money) by legitimate means. I.e. you haven’t engaged in an activity where somehow or other you’ve managed to avoid the normal costs involved in making widgets, making loans or whatever.

  2. Ralph> Subsidies mis-allocate resources and thus reduce GDP.

    This is not a universal law.

    With some internet search, I found two econometric case studies where subsidies actually -increased- GDP.

    1. Yes: where there is market failure, i.e. market forces are not working properly, subsidies can increase GDP. Same goes for taxes: e.g. tax on alcohol probably cuts alcohol consumption, and sober workers are more productive workers. But before implementing a subsidy or tax, you first have to prove market failure, i.e. prove that the market price doesn’t maximise GDP. The normal assumption made by 90% of economists is that the market price for a commodity is the best price or the GDP maximising price.

  3. Well I am always one for having a reason to gripe at the highly privileged and cosseted banking sector .They are without doubt given kid glove treatment all the way by governments and central banks.As a business person myself I do look on with envy.The last crisis did without doubt cause inflation in house prices,which we as taxpayers are undoubtedly having to pay for,as well as suffering government cut backs in certain services too...eg they just stopped collecting my green refuse bins...so thanks banking sector, way to go!

    So I agree this is a another subsidy to our wonderfully inept fools running our private banking sector.

    I am off to tip my refuse at the local branch of RBS.


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