Updated: 1/13/20
Christian Economics: Teacher's Edition
But his master answered him, ‘You wicked and slothful servant! You knew that I reap where I have not sown and gather where I scattered no seed? Then you ought to have invested my money with the bankers, and at my coming I should have received what was my own with interest (Matthew 25:26–28).
Banking is a legitimate business. Jesus’ parable of the three stewards makes this clear. The owner is a metaphor of God, who delegates wealth to stewards for them to manage. Two stewards multiplied the coins he had given to them. The third steward buried his coin. The owner is outraged. He deserved at least some positive rate of return on his investment. A banker could have provided this.
There are critics of banking who come in the name of the Bible. They misinterpret Mosaic statutes prohibiting lending at interest in charitable loans. These laws did not forbid interest-bearing commercial loans. Then the critics say that the Bible opposes all lending at interest. They never comment on this passage, where the opposite is taught.
Banking has a legitimate function. Bankers serve as intermediaries between people with money to lend and people who want to borrow. The bank locates borrowers it believes will repay the money on time, plus a rate of interest. It charges a fee to the borrowers. It pays interest to depositors. It makes money on the difference between what the borrowers pay and what it pays depositors. This activity is not inflationary. No new money is created by the banking system.
A problem arises when banks make this offer to depositors. “If you deposit your money in our bank, we will pay you a rate of interest. But you can withdraw your money at any time.” This offer is inherently dishonest. If someone earns a rate of interest from money in a bank, then the money has to be lent to a borrower who will pay an even higher rate of interest. But this means that the money will not stay in the bank’s vault. “You can’t get something for nothing.” You cannot earn interest from money sitting in a bank’s vault. On the contrary, you will have to pay the bank for the service of storing your money in its vault. Vaults are not free resources. Neither are bank guards. So, how can the bank offer to let the depositor withdraw currency at any time? Only by using other depositors’ money to pay off the depositor who asks for his money back. The banker assumes that everyone will not want his money back on the same day. Sometimes this assumption is incorrect: during banking panics.
Here is how the offer should be revised. “If you deposit your money in our bank for a year, we will pay you a rate of interest. We will put your money in a lending pool. We will lend this pooled money to borrowers for one year. If you need your money in less than a year, we will lend it to you at the prevailing rate of interest.” This arrangement protects the bank and its depositors from a mismatch: borrowing short-term from depositors (withdrawal on demand) and lending long-term to borrowers.
Another problem arises when a bank makes loans for more money than it receives from depositors. How is this possible? The money it issues is in the form of drafts: IOU’s on the bank. They serve as money in society. Someone can take a bank draft or check to the bank and demand currency. But there is not an equal amount of currency in reserve in the bank’s vault. There may be only 10%. There may be less than 10%. So, the bank pays interest on the currency that people have deposited, but it collects interest from all of the borrowers. It therefore makes a far higher rate of return. The economic effect in the economy is the same as if the bank had counterfeited currency and lent it, which would be illegal. But the government does not pass laws against banks that issue more bank drafts than there is currency in the vault. Banks become legal counterfeiters.
When all banks do this, the effect multiplies. If the average reserve is 10%, whenever a depositor deposits $1,000 in currency, his bank keeps $100 and lends $900. The borrower takes $900 to his bank, which keeps 10% ($90), and lends $810. That borrower takes the check to his bank, which keeps 10% ($81) and lends $729. The process continues. At the end of the process, the banking system issues $9,000 of money from the initial deposit of $1,000. The lower the rate of reserves, the more money it creates. This is inflationary. It has a name: fractional reserve banking.
As prices rise, people who own money or IOU’s to money see the market value of their assets fall. Each unit of currency purchases less than it did before the multiplication of deposits in the banking system. This is a form of theft. Although these people did not agree to become counterfeiters, their banks did this for them. They now suffer a negative sanction: reduced wealth.
There is another effect. The multiplication of bank deposits creates a boom. People borrow more money, since interest rates are low as a result of the new money flowing into the economy. They spend this new money. This creates demand. The economy booms. But then the artificial boom turns into a real bust when the increase in the number of deposits slows or even stops. Businesses go bankrupt. Banks go bankrupt. More people lose their jobs than before the boom.
This is a system of multiple indebtedness. The banking system creates enormous debts. The banks also promise that every depositor can withdraw currency at any time. So, in a banking panic, people go to their banks and demand payment in currency (or gold coins prior to World War I). The process then moves from multiplying money to contracting money. If the original depositor demands his $1,000 in currency, his bank must call in the loan of $900. The borrower must come up with the money. He goes to his bank and asks for $900. The whole system implodes as it goes into repayment mode. The $9,000 becomes $1,000 again. This is deflationary. Some banks go bankrupt (bankrupt = bank + rupture). They cannot honor their promises. So, the banks that lent to the depositors of these bankrupt banks are unable to pay their depositors. The pyramid of debt topples. This is what happened around the world in the early 1930s. It caused the Great Depression, the worst economic downturn in the West since the process of compound economic growth began in 1800.
Banking is a cartel in every nation. It is a closed industry. Governments limit the number of banks that can be created. This becomes highly profitable for banks. But they still are at risk in a banking panic. If one bank goes bankrupt, fear of more bankruptcies can spread. More depositors go to their banks and demand payment. So, the cartel of banks wants a way to secure the system from the depositors. They petition the government to create a central bank. This bank is a government-created monopoly. It has the legal authority to create money out of nothing. It can buy government bonds with this counterfeit money. It can make loans to banks that are suffering a bank run. In practice, it lends money to the largest banks. It does not lend to small banks. The large banks then buy the assets—deposits—of small failed banks. They buy these assets at a huge discount. Now they can use these reserve assets to issue lots of counterfeit money.
The central bank sets rules for member banks. It becomes the enforcer of rules for banks inside the cartel. The central bank is the enforcing agency of the bank cartel. It offers benefits for this loss of individual bank sovereignty. It protects the largest banks. It becomes the insurance policy for the biggest banks in the economy. The politicians want this protection for large banks. A banking panic threatens the entire economy. It can create a recession or a depression. A depression leads to new politicians in office. Incumbents want to avoid this outcome. In the United States in the Great Depression, 9,000 out of 24,000 banks went bankrupt, 1930–33. These were small-town banks and rural banks. Not one large bank went bankrupt. They were protected by the Federal Reserve System, the central bank.
Fractional reserve banking violates a specific biblical law governing loans.
If ever you take your neighbor's cloak in pledge, you shall return it to him before the sun goes down, for that is his only covering, and it is his cloak for his body; in what else shall he sleep? And if he cries to me, I will hear, for I am compassionate (Exodus 22:26–27).
Why would a lender take a cloak as collateral for a loan? What good is it to the lender if he has to go to the trouble of giving it back at night? It does a great deal of good. The borrower cannot use the same collateral for two or more loans. This restricts his indebtedness to one piece of collateral per loan. In short, it restricts multiple indebtedness. Multiple indebtedness is the basis of fractional reserve banking: one piece of collateral (currency in a vault or gold coins in a vault) that sustains loans greater than the value of the collateral. The banking system cannot pyramid loans on the basis of minimal collateral.
Without government authorization of fractional reserves, a bank could not safely create fiat money out of nothing. Even if there were no law prohibiting fractional reserves, meaning 100% reserve banking, financially conservative bankers could police the entire banking system. They could present IOU’s to currency issued by any bank suspected of having made too many bad loans. The threat of withdrawals by other banks would reduce the amount of counterfeiting by banks. Also, without a government-created central bank to protect favored big banks, there would be far less counterfeiting. This system is called free banking. Here is its legal premise. First, anyone may start a bank. This means no banking cartel could develop that is based on legal barriers to entry. Second, there is no protection by the government of bankrupt banks, either directly (government-subsidized banking insurance) or indirectly by a central bank.
In the field of banking, the buyer is a potential depositor in a specific bank. But the money he will deposit is already in a bank account. He has the decision as to what bank should issue a receipt for his deposit, but for the vast majority of depositors, they cannot withdraw currency. They do not have enough money in the bank. The huge depositors are investment organizations: mutual funds, hedge funds, etc. They cannot go to a bank and withdraw tens of millions of whatever the national currency is. So, the buyer of banking services is trapped in the banking system as a whole.
In some nations, there is deposit insurance issued by the government. The depositor is protected if his bank fails. So, he pays no attention to his bank’s solvency. Rich people and managers of investment funds must pay close attention. The insurance is not extended to large depositors. So, they monitor bank solvency. But they have few choices. A handful of banks contain most deposits. In the United States, five banks out of 7,000 have about 40% of the deposits and half of all banking assets. The top 15 banks hold over 50% of deposits. This means that large buyers of banking services have a limited number of choices for their money.
The buyer shops for a bank. He wants safety for his deposit. If the government guarantees his deposit, other issues besides safety become his concern. The government’s guarantee of the return of his money is a major advantage of the national banking system. People who worry about the return of their money will deposit it in banks, sometimes at little or zero interest. They are in effect paying for deposit insurance, which is a valuable service. In such circumstances, price inflation erodes their net worth.
The most important service for most people is a bank credit card or smartphone digits. People in developed societies buy most of what they buy with credit cards. The other major service is free checking. Whatever people do not buy with a credit card they buy with a paper check. This ease of payments has extended the division of labor, thereby increasing specialization and output. This benefits buyers and sellers.
By increasing the security of banking, the government has reduced individual responsibility. It has also transferred responsibility to the central bank. The problem here is that the central bank is an agent of the largest commercial banks. The central bank will always defend the interests of the largest commercial banks. This has led to what is called “moral hazard.” The bankers at the largest banks take enormous risks with depositors’ money, confident that the central bank will intervene to save them if they get into financial difficulty. This produces above-market rates of return, but then, in a crisis, the central bank and the government intervene.
This reduction of responsibility by depositors has led to a banking system that is vulnerable to failure if the assets they invest in fall in price. This leads to bigger booms and bigger busts. The banking system seems secure, but it rests on the taxpayers as insurers. So, a banking system whose government-guaranteed safety features were cobbled together piecemeal by politicians and bureaucrats for over a century has produced a banking system that places millions of taxpayers at risk.
Banks sell banking services. In a free banking system, bankers would earn income by providing lending services and paying interest to depositors. They would look into the risk and uncertainty posed by lending to specific borrowers, probably local borrowers. They would pool depositors’ assets so as to reduce the risk of loss to any single depositor. The risk of default would be shared with multiple borrowers. The law of large numbers would protect depositors from the risks of borrowers’ default. This is an important service. It enables lenders who seek a positive return on their money to find a way to be paid interest. It enables borrowers who think they have ways to live better by taking on debt to do so.
Basically, the banker puts future-oriented people together with present-oriented people in order to reap a rate of return for this service. People who are willing to lend money at low rates of interest achieve their goal. Consumers who are willing to borrow money at higher rates of interest achieve their goals. So do businessmen who think they have a way to earn more than the rate of interest. The banking system is the primary means of allocating risk to those who are willing to accept risk for a specific rate of return. This is a valuable service. It has to do with transferring risk to those who are willing to accept responsibility at some price. People pay for the degree of responsibility that they are willing to accept at some price.
When bankers gain special favors from the government, such as barriers to entry, they become a cartel. They seek their financial goals at the expense of depositors, who earn a lower rate of return because of reduced competition: fewer bankers bidding to gain depositors’ money. They seek other favors, such as government-funded insurance for depositors’ accounts. A government-created central bank reinforces the cartel for the largest banks. The banking system becomes immune to most depositors’ demand to redeem their accounts for paper money. Investment funds cannot do this. Risk is steadily transferred from commercial banks to the central bank and the government, meaning taxpayers. Profits go mostly to the largest banks. The financial sector of the economy grows at the expense of other sectors.
Banking helped develop the pencil industry. Companies could borrow money for expansion. This led to more efficient ways to produce pencils. Quality improved. Prices fell. This is the effect of banking wherever it operates. It has to do with the extension of the division of labor. Banking makes capital available to manufacturers.
Banking is biblically legitimate when it is confined to serving as an intermediary between lenders/depositors and borrowers. It enables people with complementary goals to cooperate with each other. Banking therefore favors the coordination of plans. The means of coordination is the interest rate. Another service is the screening that bankers provide to identify and recruit reliable borrowers. These services must be paid for. Bankers earn this on the spread between what borrowers pay to banks and banks pay to depositors. This is called free banking.
The problem with banking has to do with government regulation. First, local governments create barriers to entry against new banks. This creates a bank cartel: reducing competition. Second, rules and regulations favor large banks that can afford to hire lawyers to interpret the rules. Third, fractional reserve banking replaces free banking because of the government’s creation of a central bank. This leads to legalized counterfeiting, price inflation, and the boom-bust cycle.
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