Why Not Every Credit Expansion is Good for Economic Growth

In their various statements, central bank policy makers have said that the key to economic growth is a smooth flow of credit. For them, it is credit that provides the foundation for rising living standards. So from this perspective whenever credit dries up, it makes a lot of sense for the central bank to ensure it flows again.

Following the teachings of Friedman and Keynes, it is almost the unanimous view of most experts that if lenders are unwilling to lend, then it is the duty of the government and the central bank to keep the flow of lending going.

For instance, if in the commercial paper market lenders are not there, then the Fed should step in and replace these lenders. The important thing, it is held, is that various businesses that rely on the commercial paper market to keep their daily operations going should be able to secure the necessary funding.

Now, it is true that credit is a key to economic growth. However, one must make a distinction in this regard between good and false credit. It is good credit that makes real economic growth possible and thus improves people’s lives and well being. False credit, however, is an agent of economic destruction and leads to economic impoverishment.

Good credit versus false credit

There are two kinds of credit: that which would be offered in a market economy with sound money and banking (good credit), and that which is made possible only through a system of central banking, artificially low interest rates, and fractional reserves (false credit).

Banks cannot expand good credit as such. All that they can do in reality is to facilitate the transfer of a given pool of savings from savers (lenders) to borrowers. To understand why, we must first understand how good credit comes to be and the function it serves.

Consider the case of a baker who bakes ten loaves of bread. Out of his stock of real wealth (ten loaves of bread), the baker consumes two loaves and saves eight. He lends his eight remaining loaves to the shoemaker in return for a pair of shoes in one-week’s time. Note that credit here is the transfer of ‘real stuff’, i.e. eight saved loaves of bread from the baker to the shoemaker in exchange for a future pair of shoes.

Also, observe that the amount of real savings determines the amount of available credit. If the baker had saved only four loaves of bread, the amount of credit would have only been four loaves instead of eight.

Note that the saved loaves of bread provide support to the shoemaker, i.e. it sustains him while he is busy making shoes. Credit thereby gives rise to the production of shoes, and therefore to the formation of more real wealth. This is a path to real economic growth.

Money and credit

The introduction of money does not alter the essence of what credit is. Instead of lending his eight loaves of bread to the shoemaker, the baker can now exchange his saved eight loaves of bread for eight dollars and then lend them to shoemaker. With eight dollars the shoemaker can secure either eight loaves of bread or other goods to support him while he is engaged in the making of shoes. The baker is supplying the shoemaker with the facility to access the pool of real savings, which among other things also has eight loaves of bread that the baker has produced. Also note that without real savings, the lending of money is an exercise in futility.

Money fulfils the role of a medium of exchange. Thus when the baker exchanges his eight loaves for eight dollars he retains his real savings so to speak by means of the eight dollars. The money in his possession will enable him, when he deems it necessary, to reclaim his eight loaves of bread or to secure any other goods and services. There is one provision here that the flow of production of goods continues. Without the existence of goods, the money in the baker’s possession will be useless.

The existence of banks does not alter the essence of credit. Instead of the baker lending his money directly to the shoemaker, the baker lends his money to the bank, which in turn lends it to the shoemaker.

In the process the baker earns interest for his loan, while the bank earns a commission for facilitating the transfer of money between the baker and the shoemaker. The benefit that the shoemaker receives is that he can now secure real resources in order to be able to engage in his making of shoes.

Despite the apparent complexity that the banking system introduces, the essence of credit remains the transfer of saved real stuff from lender to borrower. Without an increase in the pool of real savings, banks cannot create more credit. At the heart of the expansion of good credit by the banking system is an expansion of real savings.

Now, when the baker lends his eight dollars we must remember that he has exchanged for these dollars eight saved loaves of bread. In other words, he has exchanged something for eight dollars. So when a bank lends those eight dollars to the shoemaker, the bank lends fully ‘backed-up’ dollars so to speak.

False credit – an agent of economic destruction

Trouble emerges, however, if instead of lending fully backed-up money, a bank engages in issuing empty money (fractional reserve banking) — money backed-up by nothing.

When unbacked money is created, it masquerades as genuine money that is supposedly supported by a real stuff. In reality however, nothing has been saved. So when such money is issued, it cannot help the shoemaker since the pieces of empty paper cannot support him in producing shoes — what he needs instead is bread.

Since the printed money masquerades as proper money it can be used to “steal ” bread from some other activities and thereby weaken those activities. This is what the diversion of real wealth by means of money creation “out of thin air” is all about. If the extra eight loaves of bread weren’t produced and saved, it is not possible to have more shoes without hurting some other activities, which are much higher on the priority lists of consumers as far as life and well-being is concerned. This in turn also means that unbacked credit cannot be an agent of economic growth.

Rather than facilitating the transfer of savings across the economy to wealth generating activities, when banks issue unbacked credit they are in fact setting in motion a weakening of the process of wealth formation. It has to be realised that banks cannot ongoingly pursue unbacked lending without the existence of the central bank, which by means of monetary pumping makes sure that the expansion of unbacked credit doesn’t cause banks to bankrupt each other.

We can thus conclude that as long as the increase in lending is fully backed-up by real savings it must be regarded as good news since it promotes the formation of real wealth. False credit, which is generated out of “thin air”, is bad news – credit which is unbacked by real savings is an agent of economic destruction.

Neither the Fed nor the US Treasury are wealth generators and hence they cannot generate real savings. This in turn means that all the pumping that the Fed has been doing recently cannot lift lending unless the pool of real savings is expanding. On the contrary the more money the Fed and other central banks are pushing, the more they are diluting the pool of real savings.

Yet most commentators are of the view that given the present fragile state of the financial system, the central bank and the government must intervene to prevent the collapse. But then how can the government and the central bank help in this regard? How can the central bank or the government generate more real savings?

The only thing that the government and the central bank can do is to redistribute real savings from other people and give it to banks. Now if the pool of real savings is still expanding this can “work” – and lending might flow again. If, however, the pool of real savings is falling then it will not be possible to increase the flow of productive, i.e. good, lending.

This article is based on a longer piece for Mises.org, published in October 2008: Good and Bad Credit

7 Comments

  • oh my god, always the same example of loaves of bread!

    I have this doubt: a system has got just 3 gold dollars in circulation. in the system we have just two guys A and B; A decides to sell its corn field to B for 3billions dollars (or 3000 billions… and so on) on simple credit, with no dollar transfer; in the following days, A will ask B some services, and will pay him with 3 dollars each time, which B will pay back A to reduce its debt, and over and over…

    well
    what is the relation between this potentially unlimited credit and the little amount of gold money in this economy? be it usd 300 credit vs 3 gold dollars, or 3million or 3billion… vs 3 gold dollars, does it make any difference?

    • Simon Bennett says:

      Under your suggested economy, B will have to remain fit, healthy, and ready for work for 2,739,726 years for him to pay back the loan of 3 billion gold dollars. A is therefore a cretin, as he will only get a tiny proportion of his loan repaid.

      For your economy to work you have to either have a maximum price of 3 gold dollars for the field, or fractional reserve banking system in which more “gold” dollars can be created out of thin air. If you have a fractional reserve banking system then 3 billion “gold” dollars = 3 gold dollars = the price of one corn field. One “gold” dollar is therefore worth one billionth of a real gold dollar.

      It is worth noting that 1 GBP, i.e. a pound sterling, used to be worth a pound of silver. This means that Britain’s “silver” pounds are now worth 1/432 = 0.0023 of a real silver pound.

  • Just under the heading “False Credit – an agent of economic destruction”, Frank Shostak claims that money created as a result of fractional reserve is “backed-up by nothing”. Not true. I imagine a good 90% of such money is backed up by real goods – property in nine cases out of ten. That is, banks are very wary of lending just on the basis of for example an entrepreneurs’ glowing description of his firm’s prospects: the bank will want “real savings” in the form of deeds of the entrepreneur’s house and/or place of business.

    The big problem with fractional reserve is that it leads to instability: it is pro-cyclical. Commercial banks create money just when they shouldn’t – e.g. in a boom – and largely on the back of rising property prices. Then they destroy money or “deleverage” just when they shouldn’t: in a recession.

    The faults which Shostak attributes to fractional reserve do exist I think, but they are caused by something slightly different: maturity transformation. The latter artificially reduces the cost of credit for borrowers because MT relieves lenders of the need to sacrifice consumption for a period that corresponds to the period of time for which borrowers want to borrow.

    Shostak then asks, “How can the central bank or the government generate more real savings?” Answer: they don’t and they can’t, but that doesn’t matter. I.e. no one is under the illusion that when a central bank prints money, “real savings” have expanded. But what does happen is that each household REGARDS is savings as having increased, which induces extra spending, which in turn hopefully gets us out of the recession.

    But of course the problem is that instead of channelling this new money into the pockets of ordinary households (i.e. Main Street) it’s gone into the pockets of the rich and Wall Street crooks. And the rich do not have a high propensity to spend when their income or assets increase in value.

  • Bennett,
    I gather you cannot understand the point. First: an example is an example, and A must not necessarily be cretin, he could have done a deal to assure his descendant a flow of real services by giving away the field. Your opinion is therefore really simplistic.
    Second and more important: two guys can freely decide to give away their asset for the promise of future payment, i.e. mere credit! It does no matter how much gold or paper money is in circulation! You can have just 5 dollars, and i can nevertheless sell you a car for 15000 dollars on your promise to repay me in the future with the money you will collect by your work. This is credit! This is credit economy! This is freedom of exchanging actual assets (or money) for future money! I can see there is still some “Austrian” who completely forgot Wicksell who is at the roots of Austian Economics (read it, it’s both a model of pure credit economy and a model of limited money with high velocity, Wicksell himself admits, the you must take a step further and understand that credit is a way to increase the velocity of money, not a way to create something ex nihilo).

    Your mistake in understanding the freedom of contracting credit is the same fault of orthodox Austrian who forget that fractional banking means a bank lending just part of the credit or money the depositor has given to her. As Vernon Smith pointed, money is a tool to free people from the accountancy of their economic relations with others. If we can have a system where the economic relation is certain, i.e. when you have certainty of your credit rights with no need of immediate monetisation, you can sell your assets with no money exchange, just on its promise, then transactions become, in magnitude, free from the constraints of hard cash availability.

    If there’s a problem in banking, is maturity transformation, which is en entrepreneurial activity: find how much technically sight-deposits are actually long term savings which can used to finance long term projects.
    Is it risk? Sure!!!! What entrepreneurial activity is risk-free?

    I see too much, misguided, attention of fractional banking, when the problem is a the root of money existence: Central Banks can generate it ex nihilo (private banks do generate nothing, they just improve money circulation).

    • Simon Bennett says:

      Leonardo

      I think you have completely missed the point. Credit arises when additional monetary units are added to the economy, not future promises. However, you are right in as much as I have no idea what you are talking about.

  • Bennett,

    you are right when you say that “certain credit” arises when additional money gets injected: the central bank issues new money, lends it to a bank, which gives new credit (which can become a sight deposit, then partly lent again and so on).

    But credit can be also just the result of a 101 relation:
    I sell you a car, and you don’t pay, hence I have a credit which you will repay with money in the future. This way, economic activity can expand independently from the availability of money. Therefore, when a bank lends its money, which gets used to buy stock, then gets deposited, then re-lent, and so on, it’s just a chain of credits whose links are contractual relations. It’s this will to offer credit which permits the expression of vast preferences and tunes relative prices automatically, and it can be reduced to simple “fast” money circulation, whatever the available hard cash is available.

    Then enters the Central Bank which distorts the numeraire by its printing, and this is the problem. Fractional reserve banking is just a way for money to keep on circulating in form of credit to make exchangers faster.

    Bagus wrote a paper demonstrating that 100% reserve does not solve the problem of business cycle. I add that for the orthodoxy time deposits got no problems of this sort, even though they can create a potentially unlimited chain of consecutive credits and transactions… We should understand then that FRB is not the problem: the problem is not the circulation of an asset or money, but a central bank ability to alter scarcity ratio of money. just this.

  • Wicksell teaches how it’s the interest rate which commands the money aggregate (hard cash and credit able to circulate – payment means). I think orthodoxy is still underating interest rates and overrating money availability in its explaination of trade cycles, thus losing sight on individual will to “lend” and “risk” as part of economy itself. Hayek said that it’s the heed you pay to interest rates instead of money supply which tells the depth of your knowledge of economics.

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