There has been a huge media furore this week about bonus payments to leaders of failed banks. The biggest firestorm centred around the former CEO of the Royal Bank of Scotland, Sir Fred Goodwin, who has apparently received a pension worth £16 million despite the fact that his bank now requires massive taxpayer support.

People are right to feel angry about injustices like this, and to ask for the deeper causes. However, we need to be careful to avoid knee-jerk responses and put the blame in the right place.

It is widely believed that the way to prevent future situations like this is to increase the regulatory oversight of the banks, including the way they pay their staff. I see it differently. The main problem with the UK banking system today (and that of every other highly-developed country) is that banks cannot be allowed to fail when they make bad decisions.

In our current financial system, banks actually create money when making loans, and if a bank fails, the money it has created winks instantly out of existence. Such sharp drops in the money supply are very dangerous: this is what politicians refer to as “systemic risk” and they are right to want to avoid such contractions. Many have argued that since banks cannot be allowed to fail, regulatory oversight is needed to make sure they do not exploit this fact by engaging in excessively risky behaviour in the knowledge that they will not have to assume the full consequences.

However, this analysis fails to recognise that the current banking system is not a creation of the free market but a product of government intervention. It is the state which grants banks the power to create money, and the state which forces us to use this money instead of a form of currency of our own choice. (more…)