Why is bank credit so destructive?

Jan 16, 2020·Alasdair Macleod

“Because your question searches for deep meaning, I shall explain in simple words.”

 – Dante, Inferno

Periodic economic destruction by bank credit is not new. It has been a problem for millennia. The basis of it, the ownership of bank deposits which should be safely held as assets in custody and not taken into ownership by the banks, goes back even to ancient Greece.

The Romans ruled that the practice was fraudulent in the third century, and empirical evidence ever since has shown that banks taking into their ownership depositors’ assets usually end up in crisis both for themselves and their borrowing customers.

This article looks briefly at the history of bank credit from ancient Greece, through the 1844 Bank Charter Act, the debate of the Currency and Bullion Schools, to modern economic interpretations.

The conclusion is that neo-Keynesian economists are ignorant about the moral and legal dimensions of deposit-taking. Without a proper understanding of these basics, policy makers will be managing symptoms and not addressing the cause. Any supposed monetary reset is bound to fail.


At the outset it should be understood that a cycle of bank credit leads to alternate booms and slumps and much debate has occurred over the years as to how to deal with it. This topic is becoming important again, since there are growing signs that the expansion of bank credit is faltering, a tendency for it to contract will follow and a business recession, or even worse, is now increasingly certain.

For many neo-Keynesians, the issue comes down to unpredictable private sector bank credit behaviour compared with more certain central banking control over base money. Some, such as the supporters of the 1935 Chicago plan, have argued that the way to deal with it is to introduce 100% reserve banking and to hand a monopoly of monetary creation to the central banks, targeting price stability, or simply managing a steady growth rate for money supply.

The Chicago plan was cooked up during the great depression, which was blamed by the inflationists on the gold standard. In the context of the controversy in the nineteenth century between the currency and banking schools the Chicago Plan was something of a hybrid, leaning towards the currency school but without the discipline of gold upon which the currency school based its proposition. Anyway, banking interests ensured the plan lay dead in the water.

It was also naïve, assuming that the relationship between the quantity of money and the general level of prices was simply mathematical, when we should know through empirical evidence and reasoned economic theory that it is not. There is enormous subjectivity in the general level of prices, reflected in relative preferences between the public’s desire for consumption relative to holding money. Furthermore, following the great depression, in debating these issues there was, and still remains, an unquestioned assumption that leaving any form of money at the mercy of free markets is dangerous and that it should be under the control of the state.

Aide-memoire: How bank credit is created

When a bank takes deposits onto its own balance sheet, it acquires possession of them and owes a debt to its depositors. Its balance sheet liabilities consist of the bank’s capital and what is owed to depositors and other creditors. Matching these liabilities are the bank’s total assets. The ratio between the bank’s own capital and its depositor liabilities is easily varied by the bank’s management. Technically, this can be done in one of two ways. Either a loan account with a matching deposit are created for a customer, so that the loan is offset by the deposit. Alternatively, a loan facility is made available, creating deposits as it is drawn down. Any imbalances at an individual bank are made up by deposits drawn from payments by other banks, or by borrowing from other banks through wholesale money markets.

Therefore, a bank can use possession of customer deposits to extend credit of its own creation. By expanding its balance sheet in this way, the gross income arising from the difference between loan charges and interest paid on deposits increases the ratio of earnings to the bank’s capital.

Equally, borrowers and depositors can cause the bank’s balance sheet to contract by the simple expedient of paying down their obligations, reducing their deposits. If a bank is to maintain an expanded balance sheet, it must repetitively find new business. Consequently, there is an inbuilt bias in favour of continual expansion of bank balance sheets and therefore of bank credit. But the expansion of credit distorts the price structure in the economy, lowering the cost of borrowing and discouraging savers from saving by reducing the time preference value of money.

Over time, an economy driven by bank credit expansion will move from being savings-driven, where investment capital for the wider economy is funded out of past profits and earnings retained as savings, to being driven by the creation of debt and matching deposits.

Putting aside the wishful thinking that bank credit can continue to expand on an even course in perpetuity, we should note that once an expansionary course is under way demand for bank credit starts off being less than the banks are prepared to finance. Spurred on by increasing banker confidence and growing bank competition for loan business, rates are then reduced to below where they would otherwise be in a savings-driven economy. This leads to an artificial boom that eventually generates more demand for credit than the banks are willing to provide, or are restricted from doing so by bank regulation.

When the banks call a halt to further credit expansion, borrowers can no longer fund their incomplete plans, and banks will want to protect themselves from the fallout by reducing loans and deposits to protect their own capital. The urgency of this change of course is due to the catastrophic impact on a bank’s own capital of an oversized balance sheet when bank credit expansion slows, stops and threatens to contract.

The consequence is a repetitive cycle of boom and sudden bust. (See here for a video further explaining the phenomenon).

The only way this can be prevented is to disallow the creation of bank credit in the first place, a solution so alien to today’s bankers and inflationist economists alike, that it is readily dismissed. The progression of successive cycles in Britain since the Napoleonic Wars, adopted increasingly by other jurisdictions has, for modern times, led to an end point in bank credit creation, where consumers have little or no savings left and the majority live on tick between salary payments. Having abandoned all forms of sound money in favour of fiat currency inflation, the creation of base money is now being accelerated in a final attempt by central banks to buy off the consequences of not just the current cycle of bank credit inflation, but all those leading up to it.

Nothing goes on for ever, so sooner or later the system that has flourished on the possession of depositors’ bank balances will end. A new system of banking will then be devised, and its success will require a return to sound money, money that cannot be created out of thin air on the whim of a commercial or central banker.

In the wider context of history, the current debate about the role and behaviour of banks has occurred in a moral and legal vacuum, ignoring issues which have been debated since ancient history. And it was the Romans who resolved it in the third century AD, differently from our modern assumptions.

The legal position

Throughout history, the taking in of deposits on a custodial basis only for them to be redeployed for the benefit of the custodian has from time to time become common. It was not for nothing that the ancients sought temples, such as that to Apollo in Delphi, to conduct their banking business. Not only did they hold depositors’ money for safekeeping, but temples loaned their own money and that of others for interest.

In about 393BC, Passio an Athenian banker, was accused of fraudulently deploying deposits. He had used gold entrusted to him for safekeeping to finance his own business deals and was unable to return it to the depositor when requested. This was probably the first documented instance of a banker ending up in court accused of taking in someone’s property as custodian only to use it for his own purposes without the owner’s permission. But it has been repeated from time to time ever since, leading to financial crises and occasionally a return to deposit banking as a custodial function. The fraudulent use of deposits is assisted by the fungibility of money, making definite ownership other than by book entry impossible to establish.

There have been variations on this theme. In Saville, Charles V of Spain (1516-1558) robbed bankers of their gold, leaving obligations to their depositors uncovered. The king’s mismanagement of his own affairs together with the disappearance of specie from bank vaults ended in a crisis for Seville’s banks.

Scholars at the School of Salamanca correctly identified the problem on the lines of Roman law concerning the ownership of deposits. In this case, it was the state that confiscated the deposits from the banks leaving them with potentially some explaining to their depositors. The banks even tried to forestall confiscation by loaning hard specie to third parties to keep it out of the king’s hands. Nevertheless, Spanish banks appear to have continued to ignore their custodial obligations for as long as they managed to stave off bankruptcy.

John Law in 1715-20 roped in the state to support his inflationary scheme, which deployed customer deposits to leverage the share price of his Mississippi company. Richard Cantillion, famous for his essay on economics, benefited from the fraudulent use of customers’ assets and successfully sued three clients in London for £70,000 owed to his bank, having already profited by selling the collateral they had deposited in Mississippi shares. Shares were in unnumbered bearer form, which allowed him to successfully argue that shares deposited at his bank were fungible and could not be positively identified as a depositor’s property. The custodial function of both deposits and other forms of property had been completely ignored by the London court, and Cantillon profited twice over.

We should think about the implications, ignoring for a moment the licence given to banks. If you entrusted a friend, who you regard as competent and trustworthy, to look after your interests in your absence, and on your return find he has taken them into his own possession and used them, refusing  or unable to return your money, you would regard it as fraudulent, and so would any court. Whether your friend describes himself as a banker is immaterial. If he builds an important temple-like edifice to elevate his status of business respectability by copying the ancient Greeks, taking in someone else’s money under false pretences is common fraud, pure and simple.

Admittedly, the ordinary person does not think deeply about the relationship with his bank in these terms. But clearly, he regards his bank deposit as his own money. It is naïve in one respect, and that is if a bank pays interest on his deposit, then it is reasonable to assume it is being deployed for both his and his banker’s benefit.

A depositor’s belief that the deposit remains his property is stronger if he is not paid interest. But if the test is whether the deposit is an exchange for future goods then we must differentiate between time deposits and deposits that can be demanded without notice. If a banker pays interest on a no-notice deposit, it does not mean he has a claim on the deposit to do with it what he would like, because the crucial element of future goods does not apply.

We are debating this in the context of natural justice, embodied in Roman law, which defined a deposit as something given to another for safekeeping. It is so-called because a good is posited or placed. The preposition de intensifies the meaning, which reflects that all obligations corresponding to the custody of the good belonging to the safekeeper.[i]

Thus, it was held by the Roman jurist Ulpian in the third century AD. The determining case in English law was of Foley v. Hill and others in 1848 when Judge Lord Cottenham ruled differently, as follows:

“Money, when paid into a bank, ceases altogether to be the money of the principal; it is by then the money of the banker, who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it. The money paid into a banker’s is money known by the principal to be placed there for the purpose of being under the control of the banker; it is then the banker’s money; he is known to deal with it as his own; he makes what profit of it he can, which profit he retains to himself, paying back only the principal, according to the custom of bankers in some places, or the principal and a small rate of interest, according to the custom of bankers in other places. The money placed in custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted, having received that money, to repay to the principal, when demanded, a sum equivalent to that paid into his hands.

“That has been the subject of discussion in various cases, and that has been established to be the relative situation of banker and customer. That being established to be the relative situations of banker and customer, the banker is not an agent or factor, but he is a debtor.”

As a landmark ruling in English law, it ignored the ruling of Ulpian in Roman law, codified by Justinian in the sixth century. It had followed on from the Bank Charter Act of 1844 four years earlier, which set the future terms for the banking system in England and Wales, whereby the note issuing facility was to become the preserve of the Bank of England and backed by gold. The objective of the Act was to contain inflation through the gold standard but failed to address the issue of bank credit. Foley v. Hill legitimised the inflationary expansion of bank credit, and since English banking law became the global standard, the possession of deposits has permitted banks everywhere to profit accordingly.

In legal terms the treatment of bank deposits is therefore conflicted. The fact that modern law has created an exception tells us that it recognises that the banks’ treatment of its customers is otherwise illegal and requires an exception to be made. Bankers are effectively placed in a privileged position, above the law. With the constraint of property rights removed, a banking licence then becomes a licence to create money out of thin air, the implications of which were not fully understood following the 1844 Bank Charter Act, despite the debate that had raged since 1810, when the Bullion Committee was formed.

The currency and banking school debate

In the nineteenth century, opinions on money, including the status of bank deposits, coalesced into two groups. The currency school argued for sound money in the form of gold and gold substitutes, while the banking school argued for unrestricted banking. The debate is often misrepresented today by economists who lack a grounding in classical economics and are immersed in modern macroeconomics instead.

The debate is interpreted by post-Keynesians as one between the state control of money (the currency position) and free markets (the banking position). This is the theme of a paper by Charles Goodhart and Meinhard Jensen (Currency School versus Banking School) published by the London School of Economics and echoed in other papers on the subject.[ii] A key passage in the paper is the following:

“One of the reasons sometimes put forward by Currency School advocates for this separation… is the claim that money creation should be a State monopoly, so that having much of such creation done by private sector banks is, in some senses, an inappropriate transfer of seigniorage from the public sector to private sector bodies. A problem with this position is that many of these same economists would probably also endorse the (invalid) Karl Menger theory of the creation of money as a private sector market response to the constraints of bartering, in which story the government only plays a subsidiary role. Holding both positions simultaneously would seem to be logically inconsistent.”

Any classically trained economist will tell you that the Currency School did not see money as a state monopoly, but that money was always gold. The state’s function was to produce gold substitutes on a rules basis, that allowed no room for monetary policy. The description of the arrangement as a state monopoly is pure deception, confirmed by the concealed denial of gold as money by interposing the authors’ opinion as if it were fact on Menger’s “theory of the creation of money”.

Equally, the description of the banking school as a free-market option is flawed. Instead, it supported a licenced monopoly to take custodial deposits and create further deposits out of thin air by issuing bank credit. That is the true monopoly, one which is legitimised by Foley v. Hill, riding roughshod over Ulpian’s factual judgement. The paper quoted is an extraordinary but unfortunately frequent and typical distortion of facts designed to support modern macroeconomic fallacies.

It is therefore hardly surprising that today the ownership status of deposits is assumed in favour of the bankers without question, but it is the most important aspect of the argument. Without it, there would have been no banking school and no debate.


The controversy over the role of banks taking in deposits to do what they wish with has a history from ancient times. Natural justice and Roman law say it is fraudulent, but the English law ruling of Foley v Hill from which modern banking practise derives its legitimacy ruled to the contrary. It has had a profound effect on how modern economists view the role of money in an economy.

They seem unaware that the taking in of deposits and adding them to bank balance sheets is at base, fraudulent. The creation of a government licence to permit banks to operate in this manner admits the fraud but does not resolve the issue. Instead of understanding how sound money works, establishment economists blame the private sector for destabilising the economy and can hardly wait for central banks to take full control of monetary expansion.

The correct way to resolve this issue is not to give central banks more powers, but to abolish them entirely. Only by bringing back sound money in the form of gold and fully backed gold substitutes (the issue of which does not require a central bank) coupled with a division of banking into custodial and investment functions can there be a lasting solution. Banking licences, granting banks legal exemption from activities that are plainly fraudulent, must be abolished.

With the establishment not on the same page, a descent into the purgatory of a fiat money collapse is all but guaranteed, before as Dante put it, “From there we came outside and saw the stars”. And the true solution, respecting the people’s property and the natural laws which in all decency must be respected, can then be implemented.

[i] The definition is Ulpian’s, a jurist at the time of Alexander Severus (Roman Emperor 222-225 AD). His ruling was later recorded in Justinian’s Digest. See De Soto’s Money, Bank Credit, and Economic Cycles, pp 27-28.

[ii] See http://eprints.lse.ac.uk/64068/1/Currency%20School%20versus%20Banking%20School.pdf


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