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

Summary:
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 ...

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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 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 interest. Note that the existence of savings is the precondition for lending. There must be savings to fully back the lending. 

What we have here is 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. 

Using money does not alter the essence of what lending is all about. Instead of lending directly the one kilogram 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 percent. 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. Note 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 specializes in 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 individuals 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, could also engage in direct lending by using their own equity funds or by borrowing the required funds).

In addition, the bank also offers a facility for storing money in demand deposits. An individual can exercise his/her demand for money by holding the 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 an individual retains an unlimited claim over the deposited money—it is his possession. (Note that the saved one kilogram 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 quantity of potatoes that was stored in the form 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 a very short period or a long one by allowing him to place 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 is 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 engage 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 money in the one-year term deposit would then be lent out for one year. (The one-year term deposit of $5 backs the one-year loan of $5 here.)

Let us 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. As a result the loan to Bob is unbacked by savings. In this case Bank A has generated the $5 loan out of “thin air.” The bank 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 do not back up the $5—it is empty money. In an unhampered market economy, a bank would run the risk 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 sooner 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 actually 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 result in 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 longer.”2

It must be realized that the likelihood of bankruptcy increases when there are many competing banks. As the number 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 will increase the risk of a bank not being able to clear its checks if it issues loans out of “thin air.” Conversely, as the number of competitive banks declines, that is as the number of clients per bank rises, the likelihood 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 country 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 bank. The bank in turn will pass to Joe the lender his $5 plus interest adjusted for bank fees. The money makes a full circle and goes back to the original lender. Note again that the bank here is just a facilitator; it is not a lender, so the borrowed money is returned to the original lender.

In contrast, when lending originates out of "thin air" and is returned on the maturity date to the bank, this leads to a withdrawal of money from the economy, i.e., to the decline in the money supply, the reason being that in this case we never had a saver/lender. Savings did not support the newly formed demand deposits here, so there is no original lender to whom the loaned money must 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. As long as banks continue to expand lending out of “thin air,” 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 support them, various activities will start to 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 is the duty of the central bank to pump massive amounts of money to prevent economic depression. In fact, this is what the Ben Bernanke’s Fed did during the 2008 economic crisis.

However, an economic depression is not caused by a decline in the money supply as such, but comes 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 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 ability 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.

  • 1. Murray N. Rothbard, The Mystery of Banking (Auburn, AL: Ludwig von Mises Institute, 2008), p. 118.
  • 2. Ludwig von Mises, Human Action: A Treatise on Economics, scholar's ed. (Auburn, AL: Ludwig von Mises Institute, 1998), p. 443.
  • 3. Rothbard, The Mystery of Banking, pp. 133–34.
  • 4. Milton Friedman and Rose Friedman, Free to Choose: A Personal Statement (London: Macmillan, 1980).

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