Some people think that the way to eliminate the unjust and destructive practice of credit creation by private banks is to require them to loan out depositors' money when they make a loan. In practice, this would mean that depositors cannot access some of their deposits in an on-call manner for the simple reason that their deposits have been loaned out. This will make people - potential depositors - reluctant to place their money in a bank; and then the banks would have to pay a fairly high interest in order to attract depositors in order to loan it out at an even higher interest.
Credit creation allows borrowers to spend and invest money in certain things (such as a business or a house) in the present; and which they will pay off from a future income stream. If our banking system does not allow for credit creation, this stymies the flow of loans, and the economy will stagnate very rapidly as a consequence. The process can be explained with a simple example in which credit creation is not practised.
Imagine someone lives in a town and sees the need for a hotel - not necessarily the first one in the town. He sees correctly that with the building of a hotel, the town as a whole will benefit from the extra influx of tourists and people using it as a stopover; and that the extra work created in the building and running of the hotel would attract people to live in the town, and so on. He could save for years and years - perhaps as many as twenty years - before he has the money to pay for such a hotel with his own money. He could also borrow money in which the lenders - whether it be a financial institution or individuals - are out of pocket when they loan him their money (i.e. the lenders are using their own money). In the first case, the entrepreneur will have lost the impetus to start a hotel by the time he has saved enough for the building of a hotel. In the second case, he has to pay interest on his loan to lenders who then make unearned income. The interest on his loan becomes a burden on his business and he has to pass on this cost to his customers.
Credit creation allows for the money supply to temporarily increase in order to facilitate his need for capital. With credit creation, no-one is out of pocket. In reality, and in direct contradiction to what is taught in economics courses, credit creation is not dependent on people depositing money into the the banking system to happen. This is true even in the current banking system - this article shows that banks create money with the issuing of a loan first; then the deposits happen consequent to the loan issuance. As the entrepreneur above pays off his loan from the future hotel revenue, the money supply contracts back to the original point before he took his loan. At the retirement of the loan, the town's infrastructure (as well as the general economy's) has improved; many people will have found better employment, or income, than they would otherwise have; and so on. In the meantime, no-one needed to be out of pocket (i.e. unable to spend their money) on account of the loan. People and businesses can use their money to buy, among other things, the goods and services created by borrowers because the latter are not using, or tying up, the former's money.
Private banks have their origin in a time when banks were taking depositors money and then lending the depositors' money to the bank's borrowers. In that role private banks were totally justified and necessary; and they could still justifiably exist on that condition. When credit creation was discovered the community, or commons, should have realised that this practice, or right, should be the reserve of the commons. It is a dark and dispiriting marvel that the private banks have managed to hoodwink the public/commons for so many centuries as to what really happens in bank lending.. As Henry Ford said "It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning".
To sum up, credit creation is a necessity in order to have a vibrant and productive economy. The relevant point is that as a society we should not allow private entities to have a licence for credit creation.