Sunday, 23 December 2018

Why should money lenders be backed by taxpayers?

Under the existing deposit insurance system, people who deposit money at banks with a view to having their money loaned out by their bank are guaranteed against loss by taxpayers. With a view to explaining the flaws in that system, let’s start by considering money and banks from first principles.

1. “Money is a creature of the state” as the saying goes. That is, there has to be general agreement in any country as to what the country’s basic form of currency will be. Plus there has to be some sort of state controlled organisation to issue that currency. Reason is that if too much is issued, excess inflation ensues and if too little is  issued, there is  excess unemployment. (I’m assuming the currency comes in fiat form as is normal nowadays and let’s assume the currently unit is a “dollar”. Plus I’ll assume that the “state controlled organisation is a “central bank”).

2. Assume a hypothetical economy which is switching from barter to money for the first time and that at least initially, commercial banks are barred from issuing money. In that scenario, people and firms will borrow from and lend to each other, sometimes direct person to person (or firm to firm etc) and sometimes via commercial banks.

3. Where depositors choose to have their money loaned on by commercial banks it would be fraudulent of banks to promise those depositors they are guaranteed to get their money back and for the simple reason that loaned out money is never totally safe (although that sort of promise was common prior to WWII: in the 1920s and 30s the fraudulent nature of that promise became blatantly obvious when ordinary depositors lost billions as a result of the hundreds of banks collapsing in the US. So given that those depositors stand to make a loss, they are not actually depositors: they are more in the nature of shareholders in relevant banks.


4. A possible optional extra to the above arrangement is to let commercial banks create and lend out their own home made money, as occurs in the real world at present. Those DIY dollars take the form of promises by relevant banks to pay money to whoever.

5. However, that DIY money does not really comply with normal definitions of the word money unless it is guaranteed by taxpayer / government backed deposit insurance. That is, if that DIY money is NOT BACKED in that way, then such “money” is in effect equity / shares as explained above.

6. Now what’s wrong with depositors wanting to have their money loaned on with the risk being carried by some sort of deposit insurance, particularly if that insurance system is run on commercial lines, i.e. assuming it pays for itself? Well the problem is that if people who deposit money at banks with a view to the bank lending on their money are entitled to deposit insurance, what about those who deposit money at any other investment intermediary like a stockbroker or unit trust (“mutual funds” in the US) with the same end in view, i.e. earning interest or dividends?

7. Another popular excuse for deposit insurance is that such insurance boosts the banking industry. Indeed that was the excuse given by the UK’s Independent Commission on Banking (sections 3.20 to 3.24). They claimed deposit insurance encouraged borrowing, lending and investment. (Actually the way the ICB put that point was to say that if deposit insurance WAS WITHDRAWN “the economic costs would be very high.” But that’s the same as saying deposit insurance boosts the economy and withdrawing it harms the economy.)

8. Moreover, the ICB were vague on exactly what form the alleged “costs” would take. For example, if they were trying to suggest the decline in borrowing due to a withdrawal of deposit insurance would raise interest rates and thus cut demand, that is not much of an argument: reason is that any fall in demand can be countered simply by having government and central bank create more base money and spend it into the economy (and/or cut taxes).

Plus current very low interest rates are not an unmixed blessing: they are often cited as a contributory cause of excess debts and asset price bubbles.

9. The next problem is that both the above “stockbroker and mutual fund” point and the latter “ICB / boosts the economy” point can be extended to yet further sectors of the economy. For example, taxpayer backed insurance for ships would probably be popular: if you’re a shipowner, being insured by an insurance company that cannot possibly fail has distinct attractions. So such insurance would “boost” the shipping industry and hence the economy as a whole, if the ICB argument is valid.

10. This is clearly getting silly: i.e. what is needed here is some form  of natural dividing line between valid forms of state interference or assistance for banking, shipping and so on, and on the other hand, INVALID  forms of assistance.

11. Well there is actually a natural dividing line which is that it is widely accepted that it is not the job of taxpayers or governments to back COMMERCIAL activity, unless there are obvious reasons for doing so, e.g. social reasons. (I actually argue that point in more detail in an article entitled “A New Justification for Full Reserve Banking”).

To illustrate, long ago in Europe, education and health care were commercial activities: people had to pay for tutors and medical treatment. It was then decided that for social reasons, governments should take over much of that work. But that sort of social reason hardly applies to money lending, i.e. banking, or shipping.

12. Now anyone who deposits money at a bank with a view to having their money loaned out so as to earn interest is clearly into commerce just as much as where they deposit money with a stockbroker with the same aim in view.

In contrast, there is a clear social case for everyone having a totally safe method of storing and transferring money where their motives are not commercial, i.e. where they do not aim to have their money loaned out. Indeed the latter “totally safe” facility is a basic human right.


The advocates of full reserve banking are right: the bank system should offer totally safe accounts for those who want them, while those who want their money loaned out so as to earn interest should bear relevant risks, just as they do when they deposit money with a stockbroker or unit trust.

And of course a consequence of that arrangement is that it is impossible for banks to fail: that is, if a bank makes silly loans, all that happens is that the value of the above mentioned shares / equity falls in value.


  1. The reasoning behind the state backing bank deposits is that it supports the nations payments system,whih is fundamental to the economy. And thus they have to do it.

    Of course if we take away that problem by doing what you suggest,separating safe accounts from investmnet accounts,then this "payments system" problem magicially disappears.

    1. Yes: it was a particularly clever move by banksters to mix up lending with the payments system. That means that if banks make silly loans and go bust, they can go running to politicians with the story that if they are not rescued with taxpayers' money, the payments system collapses. Politicians and bank regulators fall for it every time.


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