Banks use Other People’s Money — So What?
Banks provide fairly invaluable services to a monetary economy, many of which the economics literature has long been discussing: under division of labor, banks specialize in amassing savings and putting them to use. Bankers, partly due to non-public information, are in a better position to monitor and screen borrowers than would the rest of us be individually and they provide risk-smoothing features by assuming the default risk of their investments.1
But they also attract a lot of attention when things go wrong — spectacularly so during financial crises. Moneylenders of ages past became bankers the moment they accepted “other people’s money” and used those funds to supercharge their lending business. Turner (2014: 6) writes that modern banking is an “intrinsically risky business, and the reason is simple: bankers lend other people’s money, not their own.”
For centuries banks and employers of “other people’s money” have been denigrated and treated with hostility. Allegedly, there's something deeply immoral about money begotten by money, a moral accusation extended to all financial markets. What arcane things bankers do to the money you've entrusted with them simply have to be filthy, criminal, immoral or any combination thereof. Thus, the Western tradition has treated banks with skepticism, ban or restrict ‘usury’ — the lending of money against interest — and vilified its owners.
Note that my concern here is not primarily about the legal status of depositor funds — which is a much bigger dispute within the Austrian and libertarian community — or the consequences of credit creation at commercial banks, but rather the public’s often visceral reaction to the business of banking (for the purposes of this discussion, we can think of bankers’ funds as maturity-matched ‘time deposits’ so as to satisfy a 100% reserve regime). It seems unlikely that most people’s objections turn on whether bankers had legal recourse to lending their fungible deposits or were merely warehousing a bailment.
While the quip of "other people's money" is invoked with the utmost disdain on the left, it is hardly unfamiliar among the right: from Forbes to Alan Greenspan and even fairly free market friendly economists like Russ Roberts has been known to invoke it (not to mention a 1991 movie of a unscrupulous fund manager named after it).2 Is it really, as the objection intends to imply, such a grand crime to take financial risks and speculate" with other people’s money? Moving beyond such housekeeping, there are — predictably — a number of confused positions tangled up in the hatred of bankers using others’ money.
First of all, strictly speaking, all bankers’ funds are “someone else’s money.” Other than deposits, debt and wholesale funding, banks’ liabilities include equity — the residual funds belonging to the bank’s stockholders. By this account, anything a bank does with its funds amounts to taking risks with “other people’s money.”
There's Nothing Wrong with "Speculation"
Secondly, the issue of “speculation” is a familiar brain-twister, where the understanding of the unaffectionate critic (“vicious gambling with high stakes”) differs remarkably from everyday dictionaries (“investments in stocks, property, etc. in the hope of gain but with the risk of loss”) and the more technical definitions. For instance, the famous fund manager and investment guru Benjamin Graham considered in his Security Analysis the oft-repeated “cynical view” that speculation was merely an unsuccessful investment before ultimately settling on the following as a workable definition:
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” (Graham 2009: 106)
More convincingly, in what amounts to a more consistent and sound approach – perhaps at the expense of applicability – Ludwig von Mises defined ‘speculation’ more broadly:
dealing with the uncertain conditions of the unknown future— that is, speculation—is inherent in every action, and that profit and loss are necessary features of acting which cannot be conjured away by any wishful thinking. ( Human Action, p. 251)
In this Misesian line of thinking, any action – including business ventures and financial transactions – amounts to speculation since none of us live under perfect certainty. In this sense there is of course nothing objectionable with banks speculating with other people’s money – that is what they’re supposed to do. By buying low and selling high — occasionally with a value-added production process in between — banks finance entrepreneurial speculators under competitive market pressures in such a way that pricing of society’s resources is improved, ultimately in accordance with the will of consumers. The efforts of speculators, in Mises’ take (1953: 253) are “directed to correctly estimating future price-situations […] to diminish the gap between the highest and the lowest prices,” ameliorating rather than aggravating price fluctuations. We might very well say that the speculator, by alleviating price differentials, is benefiting society by correcting false prices .
Thirdly, the valuable screening and credit evaluation activities is performed by banks through the advancing of funds. Yale economist William Goetzmann writes in his 2017 book Money Changes Everything:
The business of a bank is to take in deposits and make loans; the true assets are not a stockpile of currency, a grand edifice, or a legion of clerks. Instead it is the business acumen of the banker, the eye for opportunities, the canny assessment of risk, and the reputation for integrity. (Goetzmann 2017: 83)
The business tool of a banker — his equipment, if you like — is the amassed funds of other people, and he adds value to society’s production by more effectively channeling savings to promising entrepreneurial projects than all of us could have done on our own. A bank uses those very funds as input into that production or intermediation.
Imagine how preposterous the "other people’s money" objection would be in another industry, where someone else’s asset is used in that production line: a bakery renting some piece of equipment used in making bread, a courier company leasing another company's truck, or effectively any other store or business renting space that do not originally belong to them in order to perform their services to their customers. Would anybody object to bakers risking other people’s ovens in order to speculate on your taste for freshly made organic bread? To insurance companies insuring other people’s risks? To truckers moving other people’s goods?
Yes, temporarily giving someone else — with superior knowledge and specialized skills — the control over some part of your assets is what defines a service. Everybody gets this. But for some reason, as soon as banks, finance or Wall Street is brought up, common sense goes out the window. We know they’re all criminals. Denounce them. Vilify them.
Finally, the confusion isn’t solved by invoking lack of knowledge in the “arcane arts” of what the banker is doing. In other words, it doesn’t have to do with understanding the business. I don’t understand what my plumber does when he's fixing my pipes, or the realtor does when she successfully markets, administers and sells my house, but I don't draw the malevolent conclusion that they must be ripping me off — or be taking undue risks with other people's pipes and other people’s houses. What is so different about banks that they’re despised in a way entirely unthinkable for plumbers and tax accountants?
- 1. In Theory of Money and Credit, Mises (1953: 263) writes that a bank “derives its profits and incurs its losses” from the acceptance of this investment risk when acting as an intermediary “between the granter of credit and the grantee”
- 2. Mises himself uses the expression in Theory of Money and Credit (1953: 261, 262), but as far as I can tell without the pejorative meaning usually attached.