Before a Bust, There Is Always a Boom (and Malinvestment)

An economic depression isn’t caused by a decline in the money supply per se, but results from a shrinking pool of savings made possible by a previous bout of monetary inflation

For most commentators lending is associated with money. However, is this the case?

When a saver lends money, what he/she in fact lends to a borrower is final consumer goods that he/she did not consume.   Therefore , what a lender lends to a borrower is savings  and not money as such.  

Take farmer Joe, who  produced two kilograms of potatoes. For his own consumption, he requires one kilogram, and the rest he agrees to lend for one year to  farmer Bob. The unconsumed kilogram of potatoes that Joe agrees to lend is his savings.  

By lending one kilogram of potatoes to Bob, Joe has agreed to give up for one year ownership over these potatoes. In exchange, Bob provides Joe with a written promise that after one year he will repay 1 . 1 kilograms of potatoes. The 0. 1 kilogram constitutes interest. Note that the existence of savings is the precondition for lending. There must be savings to fully right back the lending.  

What we have listed here is an exchange of one kg of present potatoes for 1 . 1 kilograms of potatoes in one year’s time. Both Joe and Bob have entered this transaction voluntarily, because they both reach the conclusion that it would serve their objectives.  

Using money doesn’t alter the essence of what lending is all about. In the place of lending directly the one kg of potatoes Joe can first exchange these potatoes for money, let us say for $10. Joe can then lend the $10 to Bob for one year at the going interest rate of 10 %. Note that money here fulfills not only the role of the medium of exchange but also the role of the medium of savings. Joe’s savings of one kilogram of potatoes are stored, so to speak, in the form of money.

Observe that the introduction of money did not change the fact that savings precede the act of lending. Remember that savings support individuals in the various stages of production. Hence, savings are the heart of economic growth. It follows then that the lending of savings fulfills an important role in the process of wealth generation. By lending his savings to Bob, Joe provides sustenance to Bob the borrower. This in turn makes it possible for Bob to engage in a wealth-generating activity.

Introducing Banking

Rather than searching for potential borrowers himself, Joe could approach an organization that focuses primarily on finding borrowers: a bank. The bank specializes in finding borrowers for individuals that are willing to lend their savings. The bank also specializes in finding lenders for people that are willing to borrow. From this  we can infer that the bank fulfills the role of an intermediary. (Note that banks, rather than fulfilling the mediator’s role, may also engage in direct lending through the use of their own equity funds or by borrowing the required funds).

In addition , the financial institution also offers a facility for storing money in demand deposits. An individual can exercise his/her demand for money by holding the amount of money in his/her wallet, holding it at home, or storing it as a demand deposit with a  bank. By storing, his/her money in a demand deposit someone retains an unlimited claim over the deposited money— it is his possession. (Note that the saved one kg of potatoes is stored in the form of a $10 demand deposit).

If the owner of the demand deposit were to decide to lend part of the stored money, then he/she would likely inform the bank of this by transferring part of the money stored in the demand deposit to a term deposit. (Note that what effectively is transferred here is part of the saved amount of potatoes that was stored by means of money, which was in turn stored with the bank as a  demand deposit).

Banks offer various lending instruments to potential lenders such as Joe through various term deposits. The bank offers Joe the option to lend his money for an extremely short period or a long one by allowing him to put his money in corresponding term deposits. For instance, if Joe decides to lend $5 for one year at the market interest rate he could transfer this amount to the one-year term deposit. This also  means that Joe has agreed to relinquish  ownership over the $5 for one year. Now  it’s up to the bank to find a suitable borrower. Observe that savings are fully back by lending here. Trouble, however , emerges once banks start  to interact in lending without the support of savings.

Lending Unbacked by Savings Results in Economic Impoverishment

Again, if Joe were to decide to lend $5 for one year, we would have a transfer of $5 from Joe’s demand deposit to a one-year term deposit. The cash in the one-year term deposit would then use out for one year. (The one-year term deposit of $5 backs the one-year loan of $5 here. )

Let’s consider a case when Bob approaches Bank A for a loan of $5 for one year. Bank A accommodates this request and lends Bob the $5 by placing the money in a newly established demand deposit. Also, note that in this case we did not have a transfer of $5 from the holders of demand deposits such as Joe to the one-year term deposit. Consequently the loan to Bob is unbacked by savings. In this case  Bank A has generated the $5 loan out of “ thin air. ” The financial institution here has established a demand deposit to the tune of $5 without the backing from savings.

Once Bob the borrower uses the unbacked money,   he is engaging in an exchange of nothing for something. This is because savings don’t back up the $5— it is empty money. In an unhampered market economy, a bank would run the danger of bankruptcy if it were to issue loans out of “ thin air. ” According to Murray N. Rothbard,  

As soon as the new money ripples out to other banks— the issuing bank is in big trouble. For the earlier and the more intensely clients of other banks come into picture, the sooner will severe redemption pressure, even unto bankruptcy, hit the expanding bank. 1

The reason for the likely bankruptcy is that the bank issuing these loans  does not have enough money to clear its checks during the interbank settlements. Consequently, in an unhampered market economy, without a central bank, competition between banks is likely to minimize lending out of “ thin air. ” On this Ludwig von Mises wrote that

[p]eople often refer to the dictum of an anonymous American quoted by Tooke: “ Free trade in banking is free trade in swindling. ” However , freedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it. It was this idea which Cernuschi advanced in the hearings of the French Banking Inquiry on October 24, 1865: “ I believe that what is called freedom of banking would cause a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any further. ” 2

It must be realized that the chances of bankruptcy increases when there are many competing banks. As the quantity of banks increases and the number of clients per bank declines, the chances that clients will spend money  from individuals that are banking with other banks will increase. This in turn increase the risk of a bank not being able to clear its checks if it  issues loans out of “ thin air. ” Conversely, since the number of competitive banks declines, that is as the number of customers per bank rises, the chances of bankruptcy diminishes. In the extreme case of one bank, it could practice the lending out of “ thin air” without any fear of bankruptcy.

The act of lending out of “ thin air” is becomes much more sustainable in the framework of a central bank. The central bank by means of the daily money supply management, i. e., monetary pumping, prevents banks from bankrupting each other.

According to Rothbard,

The Central Bank can see to it that all banks in the united kingdom can inflate harmoniously and uniformly together…. In short, the Central Bank functions as a government cartelizing device to coordinate the banks so that they can evade the restrictions of free markets and free banking and inflate uniformly together. 3

Lending out of “ Thin Air” Causes the Disappearance of Money and the Rise of Nonproductive Activities

When loaned money is fully backed by savings on the day of the loan’s maturity, it is returned to the original lender. Bob— the borrower of $5— will pay back on the maturity date the borrowed sum and interest to the lender. The bank in turn will pass to Joe the lender his $5 plus interest adjusted for bank fees. The amount of money makes a full circle and goes back to the original lender. Note again that the lender here is just a facilitator; it’s not a lender, so the borrowed money is returned to the original lender.

In contrast, when lending originates out of “ thin air” and is came back on the maturity date to the bank, this results in a withdrawal of money from the economy, i. e., to the decline in the money supply, this is because in this case we never had a saver/lender. Savings did not support the newly formed demand deposits here, so  there is absolutely no original lender to whom the loaned money must certanly be returned.

Observe that the $5 loan out of “ thin air” is a catalyst for an exchange of nothing for something. This sustains various nonproductive activities that previously would not have been possible. Provided that banks continue to expand lending out of “ nothing, ” various nonproductive activities will continue to flourish. Because of the continuous expansion such lending, the pace of wealth consumption will start surpass the pace of wealth production. The positive flow of savings will be arrested and a decline in the pool of savings will be  set in motion.

Without this wealth to guide them, various activities will quickly deteriorate and banks’ bad loans will start to increase. In response to this, banks will curtail their lending out of “ thin air, ” triggering  a decline in the money supply. A decline in the money supply will further undermine various nonproductive activities, and an economic recession will emerge.

According to a popular view championed by Milton Friedman, a severe economic slump, also known as an economic depression, emerges because of a strong decline in the money supply. 4   Therefore , it’s the duty of the central bank to pump massive amounts of money to prevent economic downturn. In fact , this is what the Ben Bernanke’s Fed did throughout the 2008 economic crisis.

However , an economic depression isn’t caused by a decline in the money supply as such, but is available in response to the shrinking pool of savings due to  the previous easy monetary policies. The shrinking pool of savings leads to the decline in economic activity and in turn forces the decline in the lending out of “ thin air, ” resulting in the decline in the money supply.

Consequently, even if the central bank were to be successful in preventing the decline in the amount of money supply, this would not prevent an economic depression if the pool of savings is declining. The heart of economic growth is the expanding pool of savings.

Again, a  bank’s power to generate loans out of “ thin air” is bolstered by central bank easy monetary policies. In the absence of such an institution, the likelihood of banks practicing lending out of “ thin air” is going to be very low.

Conclusions

Banks facilitate the flow of savings by introducing the suppliers  of savings to the demanders.   In this sense, by fulfilling the role of the intermediary, banks are an important factor in the process of wealth formation. Once, however , banks abandon their role as intermediary and start  to lend money not backed by savings, this sets in motion the menace of the boom-bust cycle and impoverishment.

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