I’ll illustrate how by reference to some hypothetical economies.
Assume an economy with a full reserve banking system, i.e. private banks don’t create money or credit. Let’s say money consists of gold coins, and citizens can deposit surplus coins at banks for safe-keeping. Plus banks issue cheque books and debit cards to customers. The advantage of the latter two is of course that it obviates carrying gold coins around, which might get stolen. Plus for large transactions, wheel barrows loaded with good coins are obviously impractical.
The total stock of gold coins is enough to induce the private sector to spend at a rate that brings full employment.
The rate of interest for safe loans is X% with spreads over X% for riskier loans.
Private banks in that scenario would soon discover that they can make loans at less than X%. After all, lending such money into existence costs banks nothing, administration costs apart: it’s not as costly as digging up gold. And as long as decent collateral is offered to back the loans (e.g. houses), the banks cannot lose. And that is exactly what the goldsmiths of London did in the 1600s and 1700s.
In our hypothetical economy, the result of the latter activity is an increase in demand, which in turn means inflation (given the above full employment assumption). However, while TEMPORARY bouts of inflation are possible under the gold standard, longer term or permanent inflation is not possible, assuming the cost of digging gold out of the ground stays constant.
And wouldn’t you know it: in Britain in the 1800s (when Britain was on the gold standard) the cost of bread at the end of the 1800s was much same as at the beginning. Actually it was a bit LOWER in 1912 than in 1798. Scroll half way down to the table here.
Having said that allowing private banks to lend money into existence is inflationary, THERE IS an alternative, which is for government to raise taxes, withdraw gold coins from circulation and just store them – perhaps in the central bank vaults. But notice what is going on here: the CONFISCATION of purchasing power from citizens at large in order to enable privately produced money to be spent. Put another way, the monetary base is being replaced with privately produced money.
Now suppose that our hypothetical economy has a fiat currency instead of using gold. A fiat currency is much like a game of Monopoly. In Monopoly, the money initially distributed is of value, because players are agreed that it shall be of value, and because the money is needed to play the game / engage in “economic” activity. Likewise, in our hypothetical economy, ANYTHING which is declared by some authoritative body like government to be money is likely to BECOME money and to RETAIN its function as money, simply because SOME FORM OF MONEY is useful.
Another popular explanation for why fiat money has value is that government demands such money for taxes due. So let’s say our hypothetical economy has a government that collects tax.
Now in a fiat money system, gold is not there to stop long term inflation.
Thus when private banks start “lending money into existence” as the saying goes, inflation ensues, but that inflation does not need to be reversed by periodic severe recessions, as occurs under the gold standard.
Moreover, banks and those they lend to are not greatly concerned about the inflation. Reason is that in making a loan, BOTH bank and borrower become creditor AND debtor. I.e the agreement (at least initially) is: 1. The borrower owes the bank £Y till the loan is repaid, and 2, the bank owes the borrower £Y, which obligation the bank undertakes to transfer to anyone that the borrower chooses – using his/her cheque book. Initially, to repeat, both bank and borrower are both debtor and creditor, so neither are bothered by inflation.
In contrast, once the borrower has spent the money allotted to them by the bank, the situation is SLIGHTLY different – thought the new situation is still one where banker and borrower are not bothered about inflation.
That is, once the borrower spends the money borrowed, i.e. transfers the money to entity Z, the bank then owes entity Z, and has to pay entity Z (or entity Z’s bank). However, assuming all commercial banks expand their loan books at about the same rate, the amount of money created out of thin air by entity Z’s bank which is deposited at our original bank will approximately equal the amount of money flowing the other way. Thus to all intents and purposes, the above “initial” set up does not change: neither bank nor borrower are bothered about inflation.
There is no free lunch.
Now there is no such thing as a free lunch. If bank and borrower gain, then someone has to lose, and of course it’s the person paid by the borrower. That person or entity is left holding a permanently depreciating asset (which in most cases they will pass on to other entities).
Apart from not being bothered by inflation, the bank of course, gets some interest. So the net effect, to repeat, is that bank and borrower steal purchasing power from the rest of the population. Nice work if you can get it.
In addition, the rate of interest is reduced to an artificially low level. That is, in a genuine free market, the rate of interest is determined by borrowers and GENUINE SAVERS: that’s people who abstain from consumption in order to enable those they lend to to engage in consumption.
In contrast, private banks can create savings from thin air, i.e. at no cost (administration costs apart).