State Banking Principle

Economy is not zero sum. People create and consume property. It is of course possible for the amount of capital to grow and to shrink. Each voluntary trade objectively improves the position of both people in the trade, as otherwise it would not happen. Consequently, the ability to trade freely increases accumulated capital. Assuming no change in time preference, this increase of a person’s savings increases the amount invested and hoarded capital. Increased investment results in increased production, in a compounding cycle. It is essential to recognize that money merely facilitates trade, it is not a source of production, and therefore not the source of wealth.

State money is however an effective form of taxation, an anti-market force. State banking is often conflated with free banking, leading to a general distrust of bank lending. In free banking a bank is simply an investment fund. It may offer demand withdrawal of customer accounts, which creates risk for customers of, and investors in, the bank. Free banking manages this risk through the possibility of failure. Yet this scenario is not limited to banking.

Any person (including banks and other businesses) who underestimates or overestimates liquidity requirements is subject to failure. Insufficient liquidity (liquidity crisis) requires the person to borrow again, and excess liquidity produces lower returns (cash drag), an opportunity cost. State banking compels the taxpayer to act as a “lender of last resort” to member banks that underestimate liquidity requirements. This facility would serve no purpose unless the taxpayer offered such loans at a discount to the bank’s market cost of capital, as otherwise the bank would simply rely on capital markets. This is why the interest rate offered to member banks is called the “discount rate” and why the loans are theoretically considered a “last resort”.

The current discount rate in the United States is 3% whereas the historical real market rate of return is between 5.4 and 10% depending on time horizon. A state bank that can borrow at 3% and earn 5.4-10% by lending pockets a 2.4-7% return on taxpayer money. Typically the discounted money is not actually extracted through direct taxation but indirectly through seigniorage. The latter is monetary expansion, which then undergoes necessary market credit expansion. The resulting credit expansion, most visible through bank lending, tends to receive unwarranted blame for what is actually a consequence of seigniorage.

A member bank has a strong financial incentive to underestimate its liquidity requirements as it can profit by borrowing from the taxpayer. This is known as “moral hazard” and is why state banking regulators set minimum “reserve” (hoarding) requirements for its members. However, the state as well has a strong incentive for member banks to utilize this facility, as it creates revenue for the treasury. As such reserve requirements are typically insufficient and the discount window is used in the everyday course of business, not as a last resort. When a member repays the loan principle with interest to the state (taxpayer), and the state subsequently destroys the principle, the expanded money supply and associated credit expansion both contract. However, both the state and its member banks have profited, at the rate of 3% and 2.4-7% respectively, at the expense of the taxpayer. The taxpayer was without the principle during the time of the discounted loan, while the member bank was able to invest it for the shared benefit of itself and the state. It matters not whether the taxpayer was taxed directly or indirectly during this process.

No new capital is created through state banking, it is simply a means of taxation. The capital lent by member banks is available only to the extent it is not available to the free market (taxpayer). Furthermore, this capital is directed by the state through its member banks, instead of by the free market. There is a strong political incentive to direct member bank capital in ways that the free market might not, such as toward “affordable housing” and “small business”. Similarly, a member bank will accept much higher risk in its investments than its hoard can support. These forces produce the “malinvestment” that manifests as the boom-and-bust phenomenon known as the “business cycle”. When economy is booming the state and its member banks profit and when busting the taxpayer covers the debt through the discount window.