If Bank Creation of Money Lowered Interest Rates What does it Tell Us About the Causes of Interest?

Anne Pettifor has an interesting article criticizing positive  money/full reserve banking. I don’t wish to dwell on that – I have published similar criticisms here.  But one passage made me slap myself for missing something obvious.

As Douglas Coe and I explain in a recent PRIME report,[4] the UK monetary system – complete with the power to create money ‘out of thin air’ – was established back in 1694 with the goal, among others, of facilitating commercial transactions and the financing of the king’s wars. But there was an additional and just as important goal: to mimic the Dutch in reducing the rate of interest facing commercial interests. British firms, households and individuals were keen to bring rates down and into line with those that prevailed in the financially more advanced Netherlands.

Of course it did,the Amsterdamsche Wisselbank (Bank of Amsterdam) though starting off as a pure full reserve bank only for bills of exchange, and as an alternative to Italian credit based fractional reserve banking, soon found it could leverage its vault to lend money to the Dutch East India Company at much lower interest rates than full reserve ‘loanable funds’ type lending.

There were complex reasons for this. In part because specie was often clipped and depreciated and cost money to transport and insure against loss at sea.  Therefore paper money attracted an ‘agio’ over specie – a premium on price.  But researchers have found this premium is less than the interest rate differential.  There has to be another cause of ‘agio’.

What this shows very starkly is that the pure-time preference theory of interest, favored by Austrians, cannot be a full and complete theory of interest.  There has to be an additional cause.  One which Bohm Bawerk , adopting the term, called Agio.

That cause is that creating money ‘out of thin air’ finances real economic activity – potentially real growth – potentially asset speculation – than in turns finances the amortiziation of loans and increases the profits of banks.  Bank lending is profit constrained not reserve constrained.  This is the ‘banking agio’ the additional real production created by the fractional reserve system.

Therefore the pure time preference theory of interest is false, it cannot explain this lower interest rate under the fractional reserve system.  It is a partial not a pure theory of interest.  For those that argue that even physical productivity increases must have a subjective expression where is the cause and effect?  It is not like the 17th C Dutch woke up one day and simultaneously changed there subjective preferences, rather it reflected a deep structural change in capitalism.

Put more formally the supply of ‘lending power’ increased through the factional reserve system, lowering the equilibrium price of lending (interest) see my paper here.


One thought on “If Bank Creation of Money Lowered Interest Rates What does it Tell Us About the Causes of Interest?

  1. Steve Keen has been dancing around the Social Credit solution for quite some time now. He’s getting closer and closer to it, Whether or not he will have the courage and/or the ability to throw off the final chains of conditioned education in economics that is nothing less than the blinders of orthodoxy remains to be seen. Now you are inching closer to it also. Production itself, the commercial process…creates a rate of flow of prices that is higher than the rate of flow of individual incomes. THAT is the missing insight economists are seeking, but they have all of the orthodoxies that have built up over the years in economics to wade through in order to see that. The act of production itself is price inflationary by cost accounting convention and currently the only way that this can be “remedied” is to continually inject more and more debt into the economy. This palliates the problem but does not solve it. The only way it can be truly solved is to GIVE INDIVIDUALS money…to all 18 yrs old and over and in addition to what they make make as work for pay. In addition to production being price inflationary modern technologically advanced economies are acceleratingly reducing the rational need for human input, i.e. employment. It’s a game that economies and the individuals within them cannot possibly win…without cogniting on the Social Credit insight and solution.

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