The phrase “credit creation” is NOT used here to refer to one of the services performed by commercial banks, namely intermediating between borrowers and lenders. The phrase refers to something else that the commercial bank system does, namely the creation of what is essentially new money out of thin air (much in the same way as central banks do).
That is, the commercial bank system can and does extend loans even where there is so to speak no depositors’ money in the piggy bank to “intermediate”. Those loans of course quickly end up as deposits.
The reason why the latter practice is undesirable is as follows.
A simple economy.
Assume a simple economy where there is a central bank (CB) but no commercial banks. I.e. everyone banks at the CB.
The CB issues just enough fiat money to induce households, firms, etc to spend at a rate that brings full employment.
Households, firms, etc lend direct to each other, as in the real world, and the going rate for a near risk free loan is X%. Plus the central bank lends, i.e. “intermediates”. And to keep things simple, let’s ignore the CB’s administration costs, plus we’ll assume the CB makes no profit. Those assumptions are relaxed later.
The above assumptions on costs and profit would mean the CB also charges X% for near risk free loans. Plus anyone depositing money for a significant period in a term account at the CB would get X%.
Obviously there’s a spread (above X%) for riskier loans, as in the real world.
The $64k question.
Now for the big question: is there any reason to suppose the above scenario would not lead to an optimum allocation of resources? Put another way, is there any reason to suppose GDP is not being maximised? Not that I can see.
Commercial banks enter the stage.
Then commercial banks enter the stage. We’ll assume commercial banks also have zero administration costs.
Now comes a crucial and very important point: a commercial bank and those it lends to do not need to obtain a commercial return on capital, that is X% for a near risk free investment. In fact any return above zero will do. A commercial bank can simply produce money from thin air and lend it out. Of course that money is liable to be deposited at other commercial banks, which means the first commercial bank is indebted to the other commercial banks.
But let’s assume that each commercial bank extends loans in proportion to its size. That would mean that no commercial bank becomes indebted to any other.
The net effect is that money is being created and loaned out at below the optimum X% rate. Or as Huber and Robertson in their work“Creating New Money” put it, “Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves.”
However, Huber and Robertson seem to miss the point that competitive forces would sooner or later whittle away that “special profit”, with the result that borrowers would get loans at below X%.
Moreover, the extra demand stemming from spending that “below optimum” money would be inflationary.
Indeed George Selgin describes the latter inflationary process: introducing commercial banks to a hypothetical economy where there is initially just a CB. That’s in an articleentitled “Is Fractional-Reserve Banking Inflationary?” He comes the same conclusion, namely that the effect is inflationary, at least initially.
He actually argues that that inflation ceases when commercial banks have reduced the real value of the monetary base to just enough to enable them to settle up between themselves. Personally I don’t agree: reason is that commercial banks do not need base money to settle up. They can and do use anything: property, shares, jewellery, bonds, you name it to settle up. Thus it strikes me that an economy dominated by commercial banks would suffer constant and excess inflation. But that’s a minor technical disagreement between me and Selgin.
To summarise so far, the introduction of commercial banks means, first that lending and borrowing takes place at a below optimum rate, and second, inflation ensues. In fact (and relaxing the assumption about banks having zero costs and making no profit) commercial banks will lend at rate that just covers administration costs and gives the bank a commercial return on capital. And as to the inflation caused by that, why should commercial banks or those to whom they lend care? Inflation suits borrowers down to the ground.
Now the scenario set out above (loans at below the optimum X% rate and inflation) doesn’t sound to me like an optimum allocation of resources: i.e. it’s hard to argue that GDP will be maximised in that scenario.
Why no hyperinflation in the 1800s?
Having claimed that commercial banking has inflation written into it, it’s legitimate to ask why there was no hyperinflation in the 1800s and earlier. Simple: the gold standard. And since abandonment of the gold standard, governments and CBs have had a difficult job controlling inflation.
The real world.
Anyway, let’s be generous to the obviously defective commercial bank system and consider whether, having introduced commercial banks and having government and CBs attempt to control the resulting inflation, the net result is something better than the “CB only” scenario with which we started above.
CBs and governments control inflation by using legal means to make the state’s money (base money) the dominant form of money. That is, the law states for example that taxes can only be paid in base money, and base money is the only form of legal tender.
That means that a commercial bank issuing units that it claims to be worth a dollar each or a pound each has to ensure that they actually trade for par with CB money: that is, anyone with a hundred units of “Barclays bank money” can swap it at any time for CB money (e.g. in the form of physical cash).
That means CBs and governments can control inflation by limiting the supply of CB money.
But wait a moment . . . That’s exactly what they’d do in the “CB only” scenario we started with above. So letting commercial banks issue money is one big farce.
In effect it simply amounts to the CB letting commercial banks in on the money creation business, a privilege which commercial banks abuse (offering loans at a sub-optimum rate plus tending to cause inflation). Then the CB and government have to try to minimise those harmful effects by doing what they’d do anyway: limit the supply of CB money.
It’s a farce.
The commercial bank money creation process is in check mate.