Banks have been a part of our society for so long that we have forgotten what exactly they do. We think of them as bastions of security and stability. They hate Bitcoin because of it's inherent instability, right? Wrong. There is more to this than meets the eye.
Economists are now asking the question: Do we need banks? The answers they are coming up with is somewhat surprising. There is a misunderstanding out there, of the role of banks today and, in particular, where all the money they loan out, comes from. The Bank of England recently published a paper called Money Creation in the Modern Economy that shows Banks are, in fact, not in the business of being an intermediary between people who have surplus of money and people who have a shortage of money (e.i. depositors and borrowers). A bank is, rather, in the business of creating money.
[dropcap size=small]L[/dropcap]et me explain. When a Bank, we will call it, The Fool's Mutual Bank, gives someone a loan of $1,000, what they do is create a deposit of $1,000 in the deposit account of the person that gets the loan, and this creates a sum of $1,000. The bank will continue to create money, by creating deposits, and the only time that this will fail to occur would be in the event that a consumer borrows a sum of money and uses it to pay off a debt to another bank, thereby creating nothing.
Banks, in their task of creating money, need to be managed, as it would be unacceptable to create an unlimited supply of money. (Look up Weimar Republic or Zimbabwe inflation). Banks are controlled in how much money they can create by Central Banks and Financial Regulators. A policy of careful regulation of the activities of banks ensures financial stability and, in particular, ensures that the volume of money created by commercial banks, is in line with the monetary policy that the central bank has decided upon. Central banks want stable economic performance and one of the tools available to them is the management of money creation; they carry out this function by the control of bank's interest rates.
Essentially, states have outsourced the creation of money to commercial banks and the central banks control them in carrying out this function.
Here is my question: "Why do we need commercial banks to carry out money creation when money creation is, in fact, a function of the State?"
The Financial Times columnist, Martin Wolf, has shown how giving banks the power to create money can lead to credit bubbles and squeezes. Banks carry out the function of the creation of money, but commercial considerations can mean that they are not efficient in carrying out this task.
Banks need to return a profit, and to ensure this need is met, they lend money. Low risk loans return low rates of interest and high risk loans return high rates of interest. If they loan too much money to poor risks, they become exposed and the State must step in to save them. Wolf argues that banks should just be clearing houses for payments and deposits and that the power to create money should be taken from them. The economist, John Cochrane, recently advanced the same idea in the work 100% Reserve Banking.
Banks will still be able to give loans of money, but we must ensure that the assets held, by the bank, are no greater than the loans out. This also means that depositors will not have 100% access to their funds; they may have to wait, as their money has probably been loaned out. Will this work? Yes. Will it avoid a future financial banking crisis, yes it will. Will we do it? Probably not. At least, it won't be seriously considered until the next crisis hits us. Many of us are of the opinion that the previous, or current recession (Matter of opinion) is still killing us economically.
Joseph Stiglitz, when he was asked if we will learn from the past financial crisis, answered that, in the short-term, we will learn a great deal, in the medium-term, we will learn a certain amount, in the long-term, we will learn absolutely nothing. Banks have controlled the supply of money for so long that they won't give it up easily. Imposing a 100% capital requirement on banks will simply kill most banks and although it has merits for society's future financial security, and has been considered by the IMF in 2012, the banks will not currently countenance it. Bitcoin is a decentralized cryptocurrency, not in the control of banks, and people are wondering why banks hate Bitcoin. Now you know.
Image by Shutterstock.
This post was last modified on (Eastern Time): 01/05/2014 00:46