OPINION

Frank Shostak

Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. 

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Popular thinking says that lending is banking activity. Banks are believed to be responsible for the expansion of credit. However, is this the case?

The Meaning of Credit

For instance, take a farmer, Joe, who produced two kilograms of potatoes. For his own consumption, he requires one kilogram, and the rest he decides to lend for one year to a farmer named Bob. The unconsumed one kilogram 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 kilogram of potatoes to Bob, Joe agrees to give up for one year his ownership over these potatoes. In return, Bob provides Joe with a written promise that after one year he will repay 1.1 kilograms of potatoes. The 0.1 kilogram constitutes an interest.

Here we have an exchange of one kilogram 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 have reached the conclusion that it would serve their objectives.

Now, the introduction of money will not alter the essence of lending. Instead of lending one kilogram of potatoes, Joe might first exchange (sell) his one kilogram of potatoes for money, let us say for ten dollars. Joe might then decide to lend his money to another farmer, John, for one year at the interest rate of 10 percent. The introduction of money did not change the fact that real savings precede the act of lending.

Credit Unbacked by Real Savings Results in Economic Impoverishment

When credit is not backed by real savings, no real savings can be exchanged in what is a mirage transaction. The borrower that holds the empty money, so to speak, exchanges it for goods and services. Instead, there emerges an exchange of nothing for something, or consumption of goods which is not backed up by a preceding production. This leads to the diversion of real savings from wealth-generating activities toward the holders of credit, generated out of “thin air.” Obviously, this type of credit undermines the production of real wealth, as weakening 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 fractional reserve banking. The existence of the system of fractional reserve banking permits commercial banks to generate credit not backed by real savings, generating credit out of “thin air.”

For instance, farmer Joe sells his saved one kilogram of potatoes for ten dollars. He then deposits this ten dollars with Bank A. Note that the ten dollars are fully backed by the saved one kilogram of potatoes. Also, observe that Joe is exercising his demand for money by holding it in the demand deposits of 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 deposit owner’s consent and lends it out, problems are created. For example, Bank A lends five dollars to Bob by taking five dollars out of Joe’s deposit. Remember that Joe still exercises his demand for ten dollars. He has an unlimited claim over his ten dollars. This means that whenever he deems it necessary, he is entitled to take the ten dollars out of his deposit.

Once Bob, the borrower of the five dollars, uses the borrowed money, he in fact engages in an exchange of nothing for something, the reason being that the five dollars are not backed by any real savings and are empty money. Instead, we have fifteen dollars that are only backed up by ten dollars proper. (Remember that the ten dollars are fully backed by the original one kilogram of potatoes.)

Credit out of “Thin Air” Causes the Disappearance of Money

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 ten dollars—will pay back on the maturity date the borrowed sum plus interest to the bank.

The bank will then pass to Joe, the lender, his ten dollars 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, 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, it leads to a withdrawal of money from the economy, a decline in the money stock. This is because in this case we never had a saver/lender since this credit emerged out of “thin air.” Using our example of the bank making a loan of five dollars to Bob, we must realize that the bank took the five dollars out of Joe’s demand deposit without Joe’s consent to this.

Joe never agreed to lend the five dollars to Bob since he continues to exercise an unlimited claim over his deposited ten dollars.

When Bob repays the five dollars, 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 five dollar loan out of nothing. Again, when the bank generates a new deposit for five dollars while real savings do not back this deposit, we do not have any original lender/saver.

Note that if Joe were to agree to lend his five dollars to Bob then all that we would have here is a transfer of five dollars from Joe to Bob. In this case, the five dollars of loaned money to Bob is fully backed by real savings. Remember that the five dollars are part of Joe’s ten dollar deposit, which is fully backed by one kilogram of saved potatoes. As a result, Joe gives up the ownership over five dollars for one year, and no extra money is generated.

Credit out of “Thin Air” Sets Platform for Nonproductive Activities

The extra five dollars of new money because of lending out of “thin air” sets up an exchange of nothing for something. This provides a platform for nonproductive activities that prior to the generation of credit out of “thin air” would not have emerged.

If banks continue to expand the credit out of “thin air,” nonproductive activities will expand. Once the continuous generation of credit lifts the consumption of consumer goods above their production level, real savings decline. Consequently, the banks’ bad loans start to increase.

In response, banks curtail their lending activities, leading to a decline in the money stock. (Remember, the money stock declines once loans generated out of “thin air” are repaid and not renewed.) The fall in the money stock undermines nonproductive activities, leading to an economic recession. (Nonproductive activities cannot stand on their own feet. To support themselves, they require “thin air” credit.)

Many mainstream economists believe an economic slump results from the sharp fall in the money stock. This way of thinking originates from the Chicago School, championed by Professor Milton Friedman. However, a slump is not caused by the collapse in the money stock but rather 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 successful in preventing the fall of the money stock, this cannot prevent a depression if the pool of real savings is declining.

Conclusion

Note that the precondition of lending is that there must be real savings first. Lending must be fully backed by real savings. Lending not backed by real savings leads to economic impoverishment.

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