|In Defense of
There are some who have heartburn over the fact that banks, which are
private enterprises, are able to create money out of thin air when by
What's worse, they can actually earn interest on their loans, which
surely be a free lunch. So why do we allow it to continue?
No Free Lunch
When a bank grants a loan,
it credits the borrower's account with a new deposit which will soon be
spent, usually by
check. As the check clears, the bank's reserve account at the
central bank is debited by the amount of the check and credited to the
payee bank's reserve account.
If the borrower defaults on
the loan, the lending bank may never see the money again. Thus
the bank would not grant the loan without charging a fee sufficient to
cover the risk and earn a reasonable profit. We use the
term "interest" if the fee is paid at regular intervals but it is
basically a service charge.
Financial Needs of a Growing
Every nation needs a mechanism to expand its money
with the growth rate potential of the economy. In fact the money
must be available in advance to support new capital investment.
takes time for a firm to produce capital goods, and people need to be
while they are doing the work.
The necessary funds might be acquired from the sale of
shares, but more
often they are borrowed. Non-bank lenders such as finance
provide the bulk of those funds. However non-banks cannot expand
the money supply. Their lending simply transfers the ownership of
existing bank deposits. Only depositories such as banks and
have the ability to expand the money supply through lending.
A System without Private Banks
In principle, there is no absolute need for private
of their functions could be performed by the government’s own central
The central bank could accept deposits of individuals and firms, pay
on term deposits, and manage the transfer of funds between transaction
accounts as part of the payment system.
Equally important, the central bank could provide for
the entire growth
of the money supply by issuing loans and monetizing the debt through
purchase of Treasury securities. However operating in this way
managing the growth of the economy from a central bureaucracy. It
doesn't usually work well, as the example of the failed Soviet Union
Why Private Banking Makes Sense
Private banks operating in the community they serve, and
the incentive of the profit motive, can do a much better job of
funds based on their knowledge of local needs and credit risks.
no less than non-banks, need to earn interest or fees on their
Without such earnings, they could not cover their costs and would have
no reason to be in business.
Some banks do a good job, earn a good return, and grow
their own capital
along with the economy they support. Others lend poorly, become
and drag their investor-owners down with them. On average the
of the banking industry is comparable to that of the economy at
In the long run, banks can only grow apace with the growth of the real
Another View of the Banking
Private banks in effect act as the lending agents of the
using its credit and operating under its supervision. They are
and none may lend more than a prescribed multiple of its own capital at
risk. Their profits depend on the efficiency and care with which
they manage their business. Any bank that doesn't play according
to the rules can be disciplined or even have its license removed.
Some Problems with Private
While the banking system today generally works well,
need to be curbed. One is the tendency toward procyclical
i.e. lending too much during the up-phase and too little during
of the business cycle, thus amplifying the cycle itself. Also
lend much too freely to financial institutions engaged in speculative
that offer no real economic benefit. The central bank needs to do
a better job in its regulatory role and be more aggressive in curbing
excesses in which banks often play a significant part.
Finally, banks have too much political power because of
role and their close ties with Congress through the money
Seen from a different perspective, the political influence of banks is
the natural result of the corruption in Congress. Banks are just
one of many working the system.