The Bank Subsidy No One Mentions

by: Ralph Musgrave


The right that commercial banks have to create or "print" money amounts to a subsidy of those banks. Subsidies are not justified: a subsidy results in reduced GDP unless there is a good social case for it. Ergo the above right that commercial banks have should be withdrawn.


The large majority of money in circulation was created by commercial banks with a relatively small proportion being created by central banks, as the opening sentences of this Bank of England article confirm.

Numerous economists over the years have objected to commercial banks creating money. For example the economics Nobel laureate Maurice Allais claimed that money creation or money "printing" by commercial banks amounts to counterfeiting, an argument which does actually stand inspection, as I show here.

However the main point of this article is to consider whether that "right to print" amounts to a subsidy of commercial banks. Joseph Huber and James Robertson in their work "Creating New Money" claimed that a subsidy is indeed involved there (see their p.31, para starting "Allowing banks…"). Briefly their point was that commercial banks have to pay interest to those who fund the bank (e.g. depositors), but banks do not need to pay interest on the money they produce from thin air. And that equals a subsidy of those banks. In a sort of way, the profits from seigniorage subsidize the lending process.

A hypothetical scenario

Let's examine that argument more closely, and we'll start with a hypothetical scenario where the only form of money is central bank money (i.e. a full reserve system) and commercial banks are then allowed to enter the fray. That hypothetical scenario was actually considered by George Selgin - start at his third paragraph if you like. And as Selgin rightly says, commercial banks in that scenario will be able to get their home made money to drive central bank money (often called "base money") to near extinction. So how do they do it?

Well I suggest the reason is thus. Under a central bank money only system, a commercial bank can only obtain money to lend out the same way every household and non-bank corporation gets hold of money: earn it or borrow it. In contrast, if commercial banks are allowed to create and lend out their own home made money, that costs them nothing! Thus commercial banks can undercut existing lenders. (Of course commercial banks still have to check the credit-worthiness of borrowers, but they face that cost under a central bank money only system also.)

But assuming the state (i.e. government and central bank) has supplied the private sector with whatever stock of central bank money is needed to keep the economy at capacity or "full employment", then there won't be any room for the additional demand that stems from those extra loans made by commercial banks. Thus the state will have to impose some sort of deflationary measure, like raising taxes (i.e. confiscating money from the private sector). Alternatively the state can artificially raise interest rates, but that too involves confiscation: central banks raise interest rates by in effect wading into the market and offering to borrow at above the going rate of interest, which of course reduces the private sector's stock of cash.

In short, to enable the creation of commercial bank money, central bank money has to be confiscated from the private sector. Now if that's not a subsidy of commercial banks, I don't know what is. (Incidentally Selgin assumed that the state does not implement those deflationary measures, in which case the result is excess inflation: but the end result is the same in that inflation robs existing holders of central bank money of their savings.)

Is full reserve feasible?

Having hopefully established that commercial bank created money is not justified, the next obvious question is whether a central bank money only system is feasible. Well the answer to that is that numerous leading economists have considered that question over the years and have concluded that there is no big problem.

Full reserve banking was advocated for example by Irving Fisher in the 1930s and by Milton Friedman in the 1940s (see his section I, and Ch3 of his book "A Program for Monetary Stability"). More recently it has been advocated for example by Adam Levitin, Lawrence Kotlikoff and John Cochrane.

As to how full reserve banking works, that's simple, and as follows. Where depositors want a tranche of their money to be totally safe, then that money is just that: totally safe. E.g. it is simply lodged at the central bank where it earns little or no interest. Indeed central banks are actively considering making accounts available to all at the time of writing, though that "central bank accounts for all" system is not necessary for full reserve to work: existing commercial banks could act as agents for the central bank and do the detailed administration work, while periodically remitting net deposits in safe accounts to the central bank.

In contrast, where anyone wants significant interest on their money, i.e. where they want their money loaned out, they themselves bear the risks, not taxpayers. And that is fair enough: if you want to be a money lender, you've entered the world of commerce, and it is not the job of taxpayers to rescue those engaged in commerce when things go wrong. If you lend money to a corporation by buying its bonds on the stock exchange, you are on your own. Why should there be any taxpayer funded support for you where you do exactly the same thing via an institution which happens to be called a "bank"?

Note that since the latter "depositor / money lenders" are not guaranteed their money back under full reserve, the stake they have in the bank where their money is deposited is essentially equity rather than a deposit. I.e. on the liability side of the relevant bank's balance sheet there is no money: only equity. Thus the bank cannot create money (as pointed out by Milton Friedman).

Is full reserve practical?

As for whether full reserve would actually work, well a type of quasi bank in the US which holds billions of dollars of savers' money has recently switched to full reserve: that's money market mutual funds. The sky has not fallen in as a result. And MMMFs illustrate another important point about full reserve, namely that under full reserve depositors have a choice as to what sort of borrower their money is loaned to. MMMFs only invest in very safe corporate and municipal bonds. The result is that over the decades, investors have got 100% of their money back about 99.9% of the time. But there'd be nothing to stop a bank offering investors something more risky like a fund that specializes in NINJA mortgages. Of course there might be very few takers, which would mean that funds for those mortgages might largely dry up: arguably an entirely beneficial outcome.

As for why banks cannot fail under full reserve, the totally safe accounts cannot fail. And as to the "loans funded by equity" accounts, if silly loans are made, and the value of those loans drops to say half of book value, then all that happens is that the value of the above equity falls to roughly half its original value. The bank itself cannot fail.

Note that assuming the arguments in the above paragraphs are correct, and assuming full reserve is adopted, that saves hundreds of thousands of person-hours of time spent arguing about exactly how far bank capital ratios must be raised in order to make banks reasonably safe. The reason for that saving is that under full reserve, capital ratios are 100% rather than the approximately 5% that existed both before and after the 2007/8 bank crisis. To illustrate, Dodd-Frank runs to at least ten thousand pages.

Moreover, if the approximately 5% capital ratio system is adopted, the arguments over exactly what the ratio should be will go on till the end of time, and create work for armies of lawyers.

Also, under the approximately 5% ratio system (the existing system) there is ample scope for banks to do what they arguably do best: bribe and cajole politicians into passing bank favorable legislation. In contrast, the rules of full reserve are simple: there is little scope for argument. For example under full reserve, 100% means 100%. In contrast, under the existing system, banks will always try to whittle 5% down to 4.5%, and then to some even lower figure.

And finally, there are a large number of objections that have been raised to full reserve banking. I deal with about forty of them in a book I wrote a year or two ago. So if you think you've thought of a good objection to full reserve, chances are that I've already dealt with it. Hope you don't mind me saying that!