According to the popular way of thinking the subject matter of lending is banking activity. It is banks, so it is held that are responsible for the expansion of lending also known as credit. On this way of thinking given that the economic prosperity is associated with the increase in credit, banks are seen as an important factor in all this. However, is it the case?
The meaning of credit
For instance, take a farmer Joe that produced two kg of potatoes. For his own consumption, he requires one kg, and the rest he decides to lend for one year to a farmer Bob. The unconsumed one kg of potatoes that he agrees to lend is his real savings.
Note that the precondition of lending is that there must be real savings first. Lending must be fully backed up by real savings.
By lending one kg of potatoes to Bob, Joe agrees to give up for one year the ownership over these potatoes. In return, Bob provides Joe with a written promise that after one year he will repay 1.1kg of potatoes. The 0.1kg constitutes an interest.
What we have here is an exchange of one kg of present potatoes for 1.1kg of potatoes in a one-year time. Both Joe and Bob have entered this transaction voluntarily because they both have reached the conclusion that it would serve their objectives.
The introduction of money will not alter the essence of what lending is all about. Instead of lending one kg of potatoes Joe will first (sell) exchange his one kg of potatoes for money, let us say for $10.
Joe may now decide to lend his money to another farmer John for one year at the going interest rate of 10%. John the farmer in turn buys a piece of equipment with the borrowed $10, which lifts his production.
Observe that the introduction of money did not change the fact that real savings precede the act of lending. When a saver lends money, what he in fact lends to borrowers are final consumer goods that he did not consume.
Credit unbacked by real savings results in economic impoverishment
When credit is not backed by real savings, then no real savings have been exchanged in this mirage transaction. The borrower that holds the empty money, so to speak, exchanges them for goods and services.
What emerges here is an exchange of nothing for something, or consumption of goods, which is not backed up by a corresponding production. This leads to the diversion of real wealth from wealth generating activities towards the holders of credit, generated out of “thin air”.
Obviously, such types of credit undermines the production of real wealth. Needless to say that the weakening of the production of real wealth diminishes the borrowers’ ability to repay their debt.
Fractional reserve banking as the source of money out of “thin air”
Ordinary lenders will find it difficult to lend something that they do not have. However, things are different once we introduce into our analysis fractional reserve banking. The existence of the system of fractional reserve banking permits commercial banks to generate credit not backed by real savings i.e. the generation of credit out of “thin air.”
For instance, a farmer Joe sells his saved one kg of potatoes for $10. He then deposits this $10 with the Bank A. Note that the $10 are fully backed by the saved one kg of potatoes. Also, observe that Joe is exercising his demand for money by holding them in the demand deposits of the bank A. (Joe could have also exercised his demand for money by holding the money at home in a jar, or keep it under the mattress).
Whenever a bank takes a portion of deposited money without the owner of the deposit’s consent and lends it out, this sets in motion serious trouble.
Let us say that bank A lends $5 to Bob by taking $5 out of Joe’s deposit. Remember that Joe still exercises his demand for $10. He has unlimited claim over his $10. This means that whenever he deems it necessary he is entitled to take the $10 out of his deposit.
Also, note that no additional real savings back up the loaned $5. Again remember that Joe still has unlimited claim over his deposited $10.
Once Bob the borrower of the $5 uses the borrowed money he in fact engages in an exchange of nothing for something. The reason being because the $5 is not backed by any real savings – it is empty money.
What we have here is $15 that is only backed up by $10 proper. (Remember that the $10 are fully backed by one kg of potatoes – real savings).
Credit out of “thin air” causes the disappearance of money
When loaned money are fully backed by savings on the day of the loan’s maturity, it is returned to the original lender. Bob – the borrower of $10 – will pay back on the maturity date the borrowed sum plus interest to the bank.
The bank in turn will pass to Joe the lender his $10 plus interest adjusted for bank fees. To put it briefly, the money makes a full circle and goes back to the original lender. Note again that the bank here is just a mediator, it is not a lender so the borrowed money is returned to the original lender.
In contrast, when credit originates out of “thin air” and is returned on the maturity day to the bank, this leads to a withdrawal of money from the economy i.e. to the decline in the money stock.
The reason being because in this case we never had a saver/lender, since this credit emerged out of “thin air”. Using our example of bank making a loan of $5 to Bob, we must realize that the bank took the $5 out of Joe’s demand deposit without Joe’s consent to this.
Joe never agreed to lend the $5 to Bob since he continues to exercise unlimited claim over his deposited $10. (Remember that Joe saved the one kg of potatoes, which he in turn exchanged for the $10, and in turn deposited with the Bank A).
(Note that if Joe were to agree to lend his $5 to Bob then all that we would have here is a transfer of $5 from Joe to Bob. In this case, the $5 loaned money to Bob is fully backed by real savings. Remember that the $5 are part of Joe’s $10 deposit, which is fully backed by one kg of saved potatoes).
Now, when Bob repays the $5, the money leaves the economy since the bank is not required to transfer it to the original lender. There is no original lender here – the bank has created the $5 loan out of nothing. Again, when the bank generates a new deposit for $5 whilst real savings do not back this deposit – we do not have here any original lender/saver.
Credit out of “thin air” sets platform for non-productive activities
Observe again that this extra $5 of new money sets in motion an exchange of nothing for something. This provides a platform for various non-productive activities that prior to the generation of credit out of “thin air” would not have emerged.
As long as banks continue to expand credit out of “thin air”, various non-productive activities continue to expand. Once however, the continuous generation of credit out of “thin air” lifts the pace of real-wealth consumption above the pace of real-wealth production, the positive flow of real savings is arrested and a decline in the pool of real savings is set in motion.
Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to increase. (Please note that the heart of economic activity is real savings).
In response to this, banks curtail their lending activities and this in turn sets in motion a decline in the money stock. (Remember the money stock declines once loans generated out of “thin air” repaid and not renewed).
The fall in the money stock begins to undermine various non-productive bubble activities i.e. an economic recession emerges. (Note that non-productive activities cannot stand on their own feet. In order to support themselves they require the assistance of the credit out of “thin air”. The credit out of “thin air” diverts to them real wealth from real wealth producers).
According to the popular view held by many mainstream economists, a severe economic slump also known as an economic depression is on account of the sharp fall in the money supply. This way of thinking originates from the Chicago School championed by Professor Milton Friedman.
We suggest that depression is not caused by the collapse in the money stock as such, but comes in response to the shrinking pool of real savings on account of previous easy monetary policy.
The shrinking pool of real savings leads to the decline in the money stock. Consequently, even if the central bank were to be successful in preventing the fall of the money stock, this cannot prevent a depression if the pool of real savings is declining.
To conclude then, banks do not lend as such, they are merely facilitators of the lending of real savings. Banks facilitate the flow of real savings by introducing the ‘suppliers’ of real savings to the ‘demanders’. In this sense by fulfilling the role of the intermediary, banks are an important factor in the process of real wealth formation.
Once however, banks begin to engage in the lending activity by attempting to replace genuine real lenders/savers, this sets in motion the menace of the boom-bust cycle and economic impoverishment. Again, it must be realized that it is not possible to increase genuine credit without the enlargement in real savings.