The Socialist Myth of the Greedy Banker and of Economic Monopoly
by Iakovos Alhadeff
Most people are convinced that private banks are responsible, or at least mostly responsible, for the current economic crisis. The truth is that the crisis is the outcome of the policies followed by the political systems of the U.S.A., the E.U. and China. But I describe the major causes of the crisis in my essay “The causes of the economic crisis”, and therefore the purpose of this document is not to explore them, but rather to explain in very simple words, why private banks are not at all responsible for the crisis, since they cannot “create” money. Even though I have postgraduate studies in economics I am not a specialist, and this document is the knowledge I gathered in an attempt to answer my own questions. Moreover English is not my first language and you will have to excuse my syntax.
To show that private banks cannot “create” money, is very important since excessive money creation in the U.S.A., the E.U. and China, was one of the main causes of the current crisis. Equally important is to explain why excessive money creation is always and everywhere a government act. What happened in reality is that excessive money creation was simply used to accommodate the unsustainable fiscal policies followed for years by many countries. Unfortunately it is much easier to notice the private banks credit expansion with the abundance of cheap credit, and the resulting bubbles, and much harder to realize that it was state policies and laws that dictated such expansions and led to bubble creation.
Since the average person is well aware of the credit expansion and the inflationary money of the pre-crisis era, it is not unreasonable for him to assume that the cause of the crisis is the “uncontrollable” and “unstable” private banking sector. But if a person is mistakenly convinced that the private banking sector is responsible for the crisis, a very reasonable response would be to ask for more government regulation. Wouldn’t that be the most natural response? I therefore believe that it is of great importance for the general public to realize that private banks cannot create inflationary money. Only governments can do so by introducing relevant laws as I explain below.
In order to do so, I use various economic examples to show that private banks cannot “create” money. First I use an example where private banks issue their own bank notes and there is no central bank. In the second example private banks still issue their own bank notes, but there is also central bank that only keeps the private banks’ gold at its vault, and clears their transaction. In the final example which is very realistic, there is a central bank that issues bank notes, which keeps at its vault all the gold, and that clears the transactions between private banks. But the bank notes it creates are still backed by gold. I show that in all cases private banks cannot create money. Then I explain why it is only the government that can create money, and I show how and why it does so. At the final part of the document I explain why conspiracy theories about central banks are not true.
But first of all, what do we mean by “inflationary money”? What do we mean by “excessive money creation”? The best description in my opinion is the following: “Inflationary money refers to an increase in the supply of money that is not matched by an increase of equal value in production”. For example there is an economy with 2 tomatoes and 2 dollars, and each tomato costs 1 dollar. A third dollar is now created, that is not matched by the production of a third tomato. Therefore the price of each tomato increases to 1.5 dollars, which means that the new dollar was inflationary. This is actually a way for the issuer of the third dollar to tax the 2 existing tomatoes.
In my document “Central Banks for non-Economists Part 1: Inflation and Taxation”, I explain the relationship between money creation and taxation, and therefore in this document I will not elaborate on the relationship of inflation and taxation. I will only say what is necessary for the purpose of this essay. I will therefore show with this document that in a free market system, private bankers cannot create money and tax the current wealth. A free market banking system is exactly the opposite from the banking system we know. And I am not saying that when the state follows an aggressive monetary policy, private bankers do not make big profits. They do make big profits at such times. But this has nothing to do with the evil private banking sector. When there is lots of money around, they make big profits because their job is to buy and sell money. In the same way that someone who sells nails makes lots of money if huge amounts of nails are bought and sold. This does not change the fact, that paper money is the most important state monopoly. But before I explain why private banks can not create inflationary money in a free market economy, I would like to say a few words about why it is good for an economic system to have a form of “money” (a medium of exchange), and a banking sector. After all, this document is written for non economists.
In a barter economy without any generally accepted medium of exchange, that is without a good that everybody accepts as a means of payment, a person wishing to sell his tomatoes and buy oranges, would have to find someone who sells oranges and wants tomatoes. This can be a very difficult and time consuming task. On the other hand if everybody accepts a good as a means of payment, i.e. gold, olive oil, paper money etc, this problem ceases to exist. If I want to sell tomatoes I simply have to find someone looking for tomatoes, and with the medium of exchange that I will receive, I will buy the oranges I want. This is a much more efficient way to trade, and it leads to much higher levels of productivity and welfare.
Moreover, the orange producer needs a way to store the value of his production surpluses. If he needs 100 oranges per year but he produces 200 oranges, he must somehow store the value of his surplus i.e. the 100 oranges. He therefore needs a non perishable good, that everybody accepts as a medium of exchange, in order to store his surplus of 100 oranges. This can be a good that can last for a long time i.e. olive oil, but silver, golden and other metal coins, or paper money, are much more suited to serve as mediums of exchange. There are more reasons why an economy needs a medium of exchange, but the above will suffice for my purposes.
Now I want to say why an economy needs a banking system. The farmer of the previous example had a surplus of 100 oranges. There is another farmer that is willing to pay 110 oranges in a year’s time if he borrows these 100 oranges today. But the other farmer is reluctant. He does not know if the borrower is capable of repaying the 100 oranges, and he does not want to risk his surplus. But if there is a specialist who can evaluate the borrowers’ creditworthiness, this problem ceases to exist. This specialist is called a bank. It could be called a money merchant or anything else. But these experts are called banks. There is no difference between a real estate agent and a money agent. One is an intermediary in transactions involving property and the other is an intermediary in transactions involving money. The above explanations of the usefulness of a common medium of exchange and of a banking system are enough for this document. After all nobody disagrees.
My starting point will be an economy with no money and no banking system. There are only farmers producing oranges. Farmers producing more oranges than they consume, worry about their surpluses. They are afraid that someone might steal them when they are absent. There is therefore demand for places to deposit these surpluses for greater security. New companies are created then, with huge vaults, where farmers can store their oranges. Let’s call these companies banks. Farmers store their surpluses in their vaults, and can go whenever they want to take oranges for personal consumption or commercial purposes. I assume for a minute that oranges do not perish, and therefore they can serve as a store of value.
When farmers deposit oranges at the banks, they receive paper receipts. An orange and the number “1” are stamped on each receipt. All receipts are identical, except that each one carries the name of the issuing bank. Gradually farmers start to use these receipts as money. They find it more convenient to do so, instead of carrying oranges around. We now have a monetary economy with a banking system. People do not exchange oranges but paper representing oranges. However citizens want a medium of exchange that is more convenient than oranges. They therefore start using gold, which is much better suited to serve as a medium of exchange than oranges. Now gold is not only used for jewellery but as a means of payment too. In the same way that some people work to produce oranges, some others work to extract and process gold. One should not confuse gold with paper money. Gold is a good like all other goods. Someone has to work hard to extract and polish it, and it has real value. Paper money on the other hand has no intrinsic value. Its value derives from a governmental law establishing as the legal and only means of payment.
The price of gold is affected by the same factors that affect the prices of all other goods in the economy i.e. its availability, demand and supply for gold, improvements in mining techniques, changes in tastes etc. Gold is a good like all other goods (oranges, wood, wine etc). It is not like paper money that has no intrinsic value. Gold simply possesses some special characteristics that make its use as a medium of exchange ideal. Therefore economic agents trade their goods for gold, and deposit their gold at the bank, which in turn issues and gives them a paper ticket (bank note). Let’s call these bank notes “1 gram of gold” notes. All bank notes are “1 gram of gold” notes, and the issuing bank’s name is written on these notes. Banks are obliged to redeem these notes for 1 gram of gold, if the bearer wishes so.
These papers are exactly the same with 1 dollar notes, except that “1 gram of gold” is written on them instead of “1 dollar”. Actually the main difference is that you cannot redeem dollars or euros for gold, while you can do so for the bank notes of my example. The bank notes of my example have real value. They do not derive their value from a law, but from the gram of gold that backs them (or from the oranges that backed them before I introduced gold into my example). And for simplicity I assume that there are only “1 gram of gold” bank notes, and the economy is only producing oranges and gold, and that oranges exchange for 1 gram of gold, and the price is fixed. All very unrealistic assumptions but they enhance intuition which is my aim.
Why private banks cannot create inflationary money
Now I turn my attention to the private banker, to whom all socialists attribute the crisis. As expected, the private banker wants to sell as much of the medium of exchange as he can, whether the medium of exchange is olive oil, whether it is golden coins, or paper money or whatever, because this is his job. This is what he does. In the same way that someone selling nails wants to buy and sell as many nails as he can, the banker wants to buy and sell as much money as he can. The more he buys and sells the more profit he makes, exactly like the nails merchant. If the interest on deposits is 5% and interest on loans is 10%, and the private banker lends 100.000 dollars, he will make 5.000, if he lends 1.000.000 he will make 50.000 dollars, if he lends 10.000.000 dollars he will make 500.000. The same principle applies whether you buy and sell nails or money. The more you buy and sell the more profit you make, assuming of course that each sale carries a profit mark up. Therefore it is very normal and very healthy that the private banker wants to lend as much as he can, given of course his customers are creditworthy.
We now have to think whether a private bank can “create” inflationary money if it wishes to do so. And the answer is of course no. Let’s imagine a private bank, in which farmers have deposited 1.000 grams of gold, and which has issued 1.000 “1 gram of gold” notes, with its name on them. Therefore the issued bank notes are 100% covered by gold, which means that each bank note issued corresponds to 1 gram of gold in the bank’s vault. This bank now wishes to issue another 9.000 bank notes in order to lend them and make more profit. But the bank does not have another 9.000 grams of gold. Therefore these new notes will be inflationary notes. They will be money creation from thin air. Can the bank do so? No, it cannot as I already said. If X Bank attempts to do so, it will go bankrupt very soon. And here is why.
Imagine that the bank issues another 9.000 bank notes, and lends them to some customers in order to charge interest. The customers that will receive the “fresh” notes will use them to finance their activities, thus giving them to other economic agents, who in turn will deposit them to their domestic or foreign banks. The domestic and foreign banks that will receive the new bank notes will send them to the issuing bank to redeem them for gold, as the issuing bank is obliged to do. And more specifically they will require 1 gram of gold for each bank note. But the issuing bank has only 1.000 grams of gold in its vault, and therefore will not be able to redeem the banknotes. Therefore the issuing bank will go bankrupt shortly after the credit expansion.
In the banking system I just described, banks have to send loads of gold to each other every day, in order to clear their customers’ transactions. This is very inconvenient, and I will therefore introduce a central bank in my example. The private banks will continue to issue their own bank notes, and the central bank will simply hold their gold and clear their transactions. For instance when X Bank receives a bank note from Y Bank, it will send it to the central bank. The central bank will take a gram of gold from Y Bank’s box, and put it in X Bank’s box. Once the transfer of gold has taken place, the central bank will return the bank note to Y Bank, since the debt was fully paid. In a banking system like the one I describe, bank notes resemble bank checks, since the bank’s names are written on them.
The inclusion of a central bank into my example does not change much though. The private banks cannot create money for the reasons I described before. If Y Bank has “created” inflationary money, which means it issued more bank notes than the grams of gold it has at the central bank’s vault, it will go bankrupt. Assume farmers deposited 1.000 grams of gold at Y Bank, and Y Bank issued 1.000 bank notes of 1 gram of gold each. Now the bank issues another 9.000 bank notes not covered by gold i.e. inflationary money, and lends it to a customer. The customer buys something and the new bank notes end at X Bank. X Bank sends these bank notes to the central bank, and the central bank finds in the box of Y Bank only 1.000 grams of gold instead of 9.000 grams. The central bank therefore does not clear the transaction. Therefore the introduction of the central bank did not change anything.
Now let’s examine what happens when the central bank not only holds the private banks gold and clears their transactions, but in addition is the issuer of the economy’s paper money. But each bank note issued by the central bank issues is still covered by 1 gram of gold, as was the case in the previous examples. Can private banks now create inflationary money? No they cannot. For the central bank to issue a new bank note, someone will have to deposit in its vault 1 gram of gold, that someone being the government or a private bank (on its behalf or on behalf of a customer). Each private bank receives a bank note from the central bank, for each gram of gold it sells to the central bank. In other words, for each gram of gold that goes in the state’s box of gold at the central bank. Not for each gram of gold that the private banks deposit in their own box at the central bank’s vault. Bank notes are only issued when a gram of gold goes to the state’s box of gold. Therefore the country’s bank notes are real bank notes. For each one of these notes there is one gram of gold (at least) in the state’s box of gold at the central bank’s vault. They are “golden” paper notes.
I will use a full transaction as an example. I sell 1 orange to a person that extracted 1 gram of gold. Remember that I assumed oranges sell for 1 gram of gold. I then deposit this gram of gold at X Bank. X Bank has two choices. One is to buy the gold for itself and send it to the central bank for the latter to deposit it in X bank’s box of gold. Alternatively X Bank can send the gram to the central bank for sale. The central bank will then issue a “fresh” bank note, and send it to X Bank. The central bank will then put the gold in the state’s box of gold (and not in X Bank’s box). I, the seller of the orange, will take a bank note of 1 gram of gold in both cases. In the first case an existing bank note and in the second case a “fresh” one. I can give this bank note back to X Bank and open a deposit account or take it and leave. I use this example to emphasize that for a “fresh” bank note to be created someone has to put a gram of gold into the state’s box of gold. This is very important. And it is a very reasonable, since each bank note created represents for the country a debt of 1 gram of gold, whether this bank note is held by a local or a foreign citizen. And in order for the country to be able to redeem all the bank notes issued for 1 gram of gold, there must be (at least) 1 gram of gold for each bank note issued, in the state’s box of gold. That is why I call the banknotes “golden” notes. If these bank notes are not backed by gold they are not “golden”, they are simply paper deriving their value from a relevant law. Issuing “golden” bank notes is very healthy, since they represent real production surpluses and savings and not inflationary paper.
So, can a private bank in this environment “create” money if it wishes to do so? The answer is again no. If X Bank issues new loans, and gives let’s say bank checks to some customers (remember that now it is the central bank that issues the paper money), the customers will give these checks to other economic agents, these other economic agents will deposited these checks in foreign and domestic private banks, and eventually they will end up at the local central bank to be cleared. The central bank will not find enough gold in X bank’s box, and it will not clear the transactions.
We therefore see that private banks cannot create inflationary money under any circumstances. I hope it is now clear why the document is titled “the myth of the greedy banker”. Only the state through governmental laws, and through its monopoly as an issuer of paper money, can create inflationary money. Inflationary money is as I already said, money not covered by production surpluses. It is money that does not represent citizens’ savings, but it is rather a new government claim on the citizens’ savings. I must also say that a country does not have to produce gold. It can produce other goods and exchange some of them for gold. Gold is simply a good like all other goods.
Creation of money by the government
I hope that it is clear by now that private banks cannot create inflationary money. The problem for a political system with a banking system as described is that the government cannot create money either. And governments have only 3 ways to finance their deficits. The first one is taxation, the second one is domestic and foreign borrowing, and the third one is by printing new inflationary money. As I explain extensively in my other document, printing money is taxation through inflation. Inflation is a way of taxation that most governments very often prefer to use. Taxation is very unpopular, borrowing requires confidence on behalf of the lender that you will honor your obligations and carries the cost of interest, while printing money does not require a third party’s confidence in the government’s policies, it does not carry interest, and it is not as unpopular as taxation. Of course increasing the money supply increases inflation, but most people do not realize that inflation is taxation. Therefore taxation is more unpopular than inflation. If a government goes too far with the printing press though, it can cause very high levels of inflation, or even hyperinflation, with catastrophic consequences for the economy. But in the short run political parties tend to overlook the long run consequences.
I now want to describe the difficulties that a government faces under the gold standard, in its effort to finance deficits by printing money. To make things simpler, let’s start from day 0. Citizens have no savings in gold or oranges yet. They now start producing oranges and gold. Some of them produce oranges and some produce gold, and it is gold that serves as a medium of exchange and a store of value. Producers of oranges, exchange their surpluses with gold, and deposit gold at the bank. Similarly, gold miners exchange their gold for oranges, and deposit whatever quantity of gold is left at the bank. Note that the deposited gold does not represent only the past surpluses-savings of gold in the economy. It represents the surpluses-savings of all goods and services in an economy. When I exchange my extra orange for 1 gram of gold, and I deposit that gold at the bank, that gold represents a surplus of 1 orange that was stored in gold. I mean that the deposited gold at the banks represents all surpluses, all savings in the economy. Surpluses in oranges, surpluses in haircuts, surpluses in gold, surpluses in cleaning services etc, that are all converted and stored in the common store of value, which in my example happens to be gold. In my example gold is the only way to store value, but in reality this is not the case.
The private banks now deposit the citizens’ gold at the central bank, and the central bank issues new “1 gram of gold” bank notes. These notes could be called something else. They could be called dollar notes, or euro notes or whatever. I prefer to use the name “1 gram of gold” notes to emphasize that these notes are “made” of gold, they are backed by gold. Let’s assume now that there is 1.000.000 grams of gold deposited at the state’s box of gold in the central bank, and 1.000.000 “1 gram of gold” notes circulating in the economy.
Even though it makes no difference for my analysis, in order to be a bit more accurate, I have to add that the price of orange and gold would not be fixed in reality. The banknotes are indeed backed and redeemable for 1 gram of gold, but that does not mean that they will always buy 1 orange. The relative price of gold and oranges will vary according to weather, demand and supply, changes in tastes etc. In other words bank notes will always be redeemed for 1 gram of gold, but that gold might buy 1 orange, or 2 oranges, or half orange, depending on the prices prevailing at the market. But this should not be confused with a general increase of the price level that arises as a result of inflationary money creation. Relative prices must change when market conditions change.
So, we have 1.000.000 grams of gold in the state’s box at the central bank, and 1.000.000 “1 gram of gold” notes circulating in the economy. Let’s suppose that the government wants to issue some more “1 gram of gold” notes, to finance its deficits and avoid taxing its citizens. Can the government do that? Well for a while it can. I assumed that the total gold of the economy is 1.000.000 grams, and let’s say that 100.000 of these grams belong to the state. But the government decides to host the Olympic Games that cost 200.000 grams of gold. The treasury issues a check of 200.000 grams of gold, and gives it to the contractor. The contractor deposits the check at X Bank, in order for the latter to clear it. X Bank in turn sends the check to the central bank for the latter to clear it. The thing is that in reality, the gold is not kept in separate boxes with a bank name written on each box. It is placed all together at the central bank’s vault, and the central bank holds electronic information about the owners of that gold.
Therefore when the central bank receives the check issued by the treasury, it sees that the state’s gold of 100.000 grams is not enough to cover the expenses. However, contrary to what it would do for a private bank, it credits X Bank’s account with 200.000 grams of gold and says that everything is ok. X Bank then credits the contractor’s account, and the contractor starts preparations for the Olympics. The country now owes 100.000 grams of gold. In accounting terms this appears as a debt of the government to the central bank, but in reality it is a debt of the government to its citizens. Except that the citizens do not know that the just lent their government 100.000 grams of gold. Alternatively, instead of a check by the treasury, the government could have ordered the central bank to create 100.000 new notes. The central bank would create these notes pass them to the treasury, and write in the central bank’s books a government debt of 100.000 “1 gram of gold” notes. The treasury would pay the contractor, who would deposit these notes at X bank. X bank would open a deposit in his name and send the bank notes to the central bank in order for the latter to transfer 100.000 grams of gold in its box. The central bank would credit X bank’s gold account which would match the debt created by the government. I think the case with the check is better for illustration purposes. So you better think of this transaction in terms of the treasury check. But both cases are exactly the same. In both cases what happened is that the central bank owes a private bank 100.000 grams of gold, and the government owes the central bank 100.000 grams of gold. In reality, it is of course the government owing to its citizens 100.000 grams of gold, since the central bank is only a governmental institution.
The government just created money. But it did not created new wealth. It simply used its citizens’ accumulated wealth to finance the Olympics. This will of course appear as a debt of 100.000 grams of gold when the government prepares its financial statements at year end, but who notices? Everybody is happy. Everybody got their money. And the government did not have to tax anybody, and did not have to borrow any money. Only inflation was affected. But who cares when inflation is low? The problem for the government under the gold standard is that this artificial money expansion increases demand, it increases the price level, the country becomes more expensive and starts losing its competitiveness, imports start rising and exports start declining. The economic agents abroad that receive the country’s bank notes as a payment for their sales send these bank notes through their central banks, to the domestic central bank, in order for the latter to redeem it for gold.
Therefore if the government is very active in creating inflationary money, the country’s gold reserves will start declining. People will start doubting that the government will be able to redeem its bank notes for gold, and there will be a confidence crisis. Even domestic citizens might start redeeming their bank notes for gold. But there is not enough gold to pay for all bank notes in circulation, since the government used much of it for its expenditures. At some point the government will have to either abandon the gold standard all together i.e. stop redeeming the bank notes for gold, or change the exchange rate between bank notes and gold i.e. say that it will exchange each bank note for half instead of 1 gram of gold. Thus the gold standard imposes much more discipline on a government’s fiscal policies. On the contrary if the government passes a law, as is the case in all countries, imposing its paper money as the legal means of payment without promising to redeem it in gold, there is no limitation on the creation of inflationary money.
Now the bank notes do not derive their value from gold but from the law, and the government can create as much money as it wants. Well, almost as much, because excessive use of inflationary money as a means of taxation can lead to catastrophic hyperinflation. The point is that the gold standard imposes much more discipline on a government, and it is no surprise that governments do not like such regimes. It is no surprise either, that socialists hate the gold standard and libertarians love it. Because it is socialists that like excessive taxation, and since direct taxation is unpopular, they prefer to use the indirect taxation of monetary expansion. Libertarians do not favor big public sector and excessive taxes and they therefore love the gold standard as a barrier to socialist policies.
To make things simpler, think about it in the following. If society’s savings are a pile of gold, and the government takes some of this gold without taxing, it will have to pay back with gold. But the government does not have gold. But if, as it happens in all countries, the government passes a law that imposes paper money as the legal and only means of payment it is in effect forcing its citizens to save their surpluses in paper money. Now if the government can take some of the savings without taxing the citizens. If the citizens ever ask for their money back,