Who needs a bank?

Should we make banks better, or just make them redundant? Peer-to-peer currency schemes like offer the possibility of networked money without banks. Should democrats embrace the possibilities?
Peter Johnson
9 June 2011

A lot of people are busy trying to figure out how to make banks better. There is anger about what has gone on and puzzlement about the apparent inability of anyone to start doing something about it. Instead of rioting for change, we seem to be frozen in a technical discussion of bank separation, capital adequacy, product authorisation, remuneration and incentives, or taxation. All worthwhile subjects in their way, but guaranteed to keep the sans-culottes at home.

So let’s ask another question. Why do we need banks – what are they for?

This is less about what banks get up to, than about money. How should we think about the institutions that deal with our and other people’s money? What does it mean for you or me to have money?

Loosely speaking, banks make money. Banks are not the only entities that do this, but they are the ones whose purpose it is to do this. By creating credit they expand the ‘money supply’ to meet demand. And by taking and charging interest and fees, they pay themselves too, often very nicely. More strictly, however, banks don’t produce money: they only replicate money that already exists. Sometimes they annihilate it. They expand and contract the monetary balloon, but they don’t make the air that fills it. That is the function of central banks, those public bodies that provide banks with the materials and props for their financial conjuring tricks, encourage them to be careful with the knives, and then mop up the mess when things go wrong and the lady is sawn in half.

The conventional view is that money is (1) a unit of account, (2) a medium of exchange, and (3) a store of value. These are said to be the necessary features of anything that serves as money. Further reflection should make it clear that these are characteristics of what is already money, and reflect its ‘money-ness’. They aren’t and can’t be built in to a design because – to put it very simply – the characteristics of money arise from its acceptance as money by persons. Money is not created by either commercial or central banks. Money is what money does.

The other thing that banks (but again, not only banks) do, is to record and execute monetary transactions. In return for transaction fees, they hold and manipulate the data relating to people’s accounts with them. We are all either debtors or creditors of banks and we need to have accounts at banks because the trust system that banks represent is the required medium for nearly all financial transactions. When I transfer a sum of money to you, I simply instruct my bank to initiate a sequence of entries in its books and those of your bank.

In 1976 F.A. Hayek published a short book called Denationalisation of Money. It can be downloaded free from the link. Hayek conceived the essay as a response to the endemic debasement of currency by states addicted to inflation. He argued that legal tender laws should be abolished and that private institutions should be allowed to issue currencies in their own name.

With sufficient public information these independent currency-issuing banks could be held financially accountable for the prudence with which they manage the quantity of currency circulating in their name. They would have the strongest possible incentive to keep the amount of credit they create within sensible bounds. If they did not, they risked an early and devastating run on the bank. Gresham’s Law (not really his: the effect was known in ancient Greece) would be reversed, since no state would be in a position to cause money to be accepted at anything other than its underlying value.

Hayek understood that technology existed or would soon exist to price and complete even small everyday transactions real-time in several currencies at once and he expected that data on bank capital and money issuance could be gathered and disseminated without trouble.

But back in 1976 there was no alternative technical model of how monetary transactions might be carried out, and so whilst Hayek foresaw a world without central banks, it was impossible to conceive of one without banks. Nevertheless, it’s an elegant and in some ways compelling idea that addresses the problem of monetary discipline where states or central banks may be unwilling or unable to exercise control and private credit creators have every incentive to issue as much of this publicly guaranteed money as they can.

Precisely because of the opportunity legal tender offers to commercial banks to extract profits with negligible risk, Hayek’s proposal was not going to be popular there. Nor did it gain political traction in a Europe slowly moving to amalgamate national currencies in the Euro. The sound-money argument for the Euro and ECB was that only a politically embedded technocratic international institution could be trusted to manage the currency properly over the long term – a belief that the record of the German Bundesbank, in many respects the archetype for the ECB, suggested was realistic. Hayek would have argued for exactly the opposite: to abolish the national central banks and to allow economic agents in areas not defined by administrative boundaries to adopt the independent currency or currencies that suited their needs at the time.

Without going further into the details of the argument, the instructive point here is the attempt to think through what it would mean to take the ownership of currency away from sovereign states. As it turns out, the real problem may now be that currencies are no longer owned by sovereign states with at least some residue of democratic accountability, but by a financial sector of a size inconceivable in the 1970s that is intent on removing all traces of democratic accountability, and aims to coerce states to honour public debt burdens that can never be repaid without entirely impoverishing the general public. The implacable calls for Greece, Portugal and Ireland to cut spending and reduce wages in order to increase wealth, and the horror aroused by mention of debt rescheduling or reduction suggest that the citizens of these countries are indeed doomed to be the sharecroppers of today.

This view is trenchantly argued by Professor Michael Hudson of the University of Missouri, Kansas City. It is a long and fascinating read.

Which brings us to Bitcoin. Launched a couple of years ago and still in its infancy, it calls itself a peer-to-peer virtual currency. This means that instead of a bank, the collective network of users maintains a complete encrypted record of bitcoin (“BTC”) transactions and how many BTC each user has. Payments involve a public-private key exchange so that only valid identities can participate and each BTC can only be transmitted once. Because both parties have the complete data set, no external trust system is required. It’s a mechanism that removes the need for us to transact through banks.

At a macro level, the total number of BTCs in issue will approach a known fixed limit at a geometrically reducing rate (as in Zeno’s paradox, never quite reaching it) and expansion of the money supply takes place through the collective computation of the network. The advantages are claimed to be resilience, safety, absence of transaction costs, decentralisation, international acceptance, and no debasement. Because no physical currency is involved, arbitrarily small decimal units of BTC are possible. If convenient, BTC units could be subdivided or consolidated merely by a network-agreed software change. The monetary authority is therefore the network of users and their machines, which once it has reached a reasonable size becomes hard for even a super-computer user to dominate.

Even if we no longer need banks to store and handle our money, the BTC system, like any other currency, allows credit creation through fractional reserve banking. The BTC money supply could therefore exceed the number of BTCs in issue. However, without a BTC central bank, the imprudent lender may well go bust. It will be interesting to see how regulators deal with mainstream banks that acquire significant assets and liabilities in BTC. They might outlaw the BTC operations of regulated entities, but could they really close down an unregulated global user network?

It remains to be seen whether this is an advance of democratic self-determination. At this stage I would be optimistic, especially if Bitcoin’s proof-of-concept encourages others to develop distinct, communicating architectures that would create not just a digital currency but a digital currency exchange. There are some fascinating possibilities here:

  1. We may soon not need banks to carry out monetary transactions or keep our money. The benefit in terms of near-zero transaction costs, nearly immediate confirmation of payment (are you still waiting 4 days for your cheque?), reduced credit risk, security and resilience would be immense.

  2. Credit creation becomes an activity not linked to the transaction-handling franchise. It is also no longer underwritten by taxpayers. Inflationary behaviour requires public consent – not the taxpayer or voter public but the public that uses the particular currency.

  3. Because all transactions are peer-to-peer, people can switch their currency holdings at will and costlessly. How much people trade, if at all, depends only their beliefs about the riskiness of the currencies on offer.

  4. If peer-to-peer currency becomes mainstream, governments will have to decide whether to accept it and put the banks out of business, or refuse it and drive it underground. Either way, the relation of state and citizen in economic management is likely to be radically changed.

And in this kind of world, which may be not that far off, what is a good banker to do?


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