Tuesday, July 17, 2012

The Necessity of Private Banking

Yesterday, Rodger Malcolm Mitchell offered a second part to his view that private banking should be ended. He begins by accurately acknowledging the difficulty in writing and enforcing sufficient regulation, along with the bankers’ success in using the government system to bolster profits. The apparent impossibility of eradicating rent-seeking from bankers leads Mitchell to conclude:
When private individuals control vast amounts of money, and when they are compensated according to their control of this money, even the saints among us would be tempted. Bottom line, private banking is, and always has been, crooked, the bigger the bank, the greater the temptation, the more crooked.
In banking, the profit motive corrupts. And combining the profit motive with short-termism corrupts absolutely. Always has; always will.
All banks should be federally owned.
Although I agree that the profit motive “corrupts” (though not absolutely), it dawns on me that this view can easily be extended to the entire private sector and holds a strong parallel in the public sector if one alters profits with power. All individuals, at some point, are tempted to work the system in their favor. Banking, whether done through the private or public sector, will therefore always be subject to some level of corruption.

Apart from the reasoning on corruption, there are two other discrepancies I brought up in the comments. First, removing the profit motive from banking effectively eliminates the market (price system) for credit/lending. Government agents will therefore have full discretion over who receives a loan, as well as the size and price, without an incentive to determine the borrower's ability to repay. As many economists in the Austrian tradition have previously explained, without knowledge from a market (i.e. prices), the allocation of resources will be highly inefficient.

Second, Mitchell’s usage of the term “money” to include credit obscures an important distinction between money and credit. Kurt Schuler of Free Banking recently addressed this confusion:
Money in the narrow sense is the monetary base, which, at least from the standpoint of the domestic monetary system, is a pure asset and not somebody's IOU. Payment with the monetary base extinguishes IOUs.“Money” in the looser, broader sense includes IOUs, particularly those issued by banks, that are readily convertible at 1:1 into the monetary base.
Private banks are the majority supplier of credit (IOUs)*, which acts as a money-like instrument. The Arthurian explains the significant difference:
The cost of interest is an "extra" cost, a largely unnecessary cost in our economy. Yes of course we need to use credit. But we don't need to use credit for everything. But we do. So, we have this extra cost to deal with, the factor cost of money. And it creates cost-push conditions. And cost-push conditions cause inflation. Inflation, or decline.
Further, the added interest cost transfers wealth from borrowers to lenders. This increasing reliance on credit in the past three decades, supported and subsidized by government, is largely behind the enormous rise of profits in the financial sector and current economic struggles. Considering the public support for use of credit, making banks publicly owned is unlikely to address this issue.
I entirely agree that the financial sector is a source of corruption and prime example of problems with rent-seeking. However, turning over the role of banking to the government will not reduce corruption or the country’s reliance on credit and will be significantly more inefficient.

*Ralph Musgrave, who also got involved with comments on Mitchell’s post followed up with a post of his own seeking clarity on the proportion of the money supply (broad version) created by private banks. Presumably, since loans create deposits:
to get at the proportion of money created by central bank it strikes me we need take physical cash add total deposits and subtract total loans.
This site gives the deposit to loan ratio of U.S. FDIC insured banks as 79%. (loans are $7.28 trillion while total deposits are $9.22 trillion).
From that I deduce that about 20% of money in the U.S. is central bank created.

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