Banking activity plays a key role in inflation. When credit is not dedicated to the productive economy, with the generation of new products or services, it artificially increases purchasing power, which breaks the balance between supply and demand and drives up prices.

The banking business does not work exactly as most people think it does. We tend to think of banks as mere financial intermediaries that receive money from their customers in the form of deposits to lend to other customers in the form of loans. And their profits are supposed to come from the spread between the interest they pay on the money they deposit and the interest they charge on the money they lend.

The reality is much more complex. What we call “deposits” are not deposits because they are not held in custody, but should be considered loans we make to the bank. At the same time, credits granted by a bank are not really loans as we understand them.

When we sign a loan, what the bank does is to buy our commitment to repay the nominal amount granted, which would be a promissory note. There is not necessarily a physical transfer of money from the bank to our account because what we call a “deposit” is nothing more than a book entry of an amount that the bank owes to the holder of that account.

This is how commercial banks artificially create money, as the Bank of Spain explains. In fact, the vast majority of deposits are generated out of thin air when banks grant credit, without being backed by real money. 

Productive or unproductive credit?

When this fictitious creation of money serves to finance the productive economy, making possible investments that generate new goods and services, the balance between supply and demand is maintained. There is more nominal money, but also more goods and services that can be purchased, so inflation does not increase.

However, if the bank artificially generates money for consumption and this is not followed by an increase in the volume of goods and services available on the market, the supply-demand equilibrium is broken. With more money available to buy the same volume of goods and services, inflation is generated. And, unfortunately, most lending is not productive, but rather is engaged in financial transactions that simply allow the transfer of property rights.

Hence, the desirability for regulation to provide for the categorisation of credit in order to avoid excessive speculative lending that triggers inflation. If most bank credits were used for productive purposes, we would have a more stable financial system and a healthy economy without inflation.

The current regulatory framework is flawed because it is based on the premise that banks are simply financial intermediaries, when in fact they artificially create money and cause an inflationary spiral, which often ends in the bursting of logical financial bubbles. 

A possible solution

Some countries have managed to avoid this problem thanks to financial systems dominated by community banks, which do not prioritise financial speculation but productive credit. In Germany, for example, such small banks dominate the market and allocate most of their lending to SMEs.

Undoubtedly, much of Germany’s economic success over the last 200 years is due to its financial system, which has never needed public money to bail out any of its banks, nor has it ever made its customers lose deposits. 

In order to stabilise and improve our economy, it would be advisable to break with the current logic of our financial system and promote the creation of community banks that prioritise the financing of the productive economy.

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