Debt Creation and Inflation Part IV
June 3, 2006
This week, we will look at another aspect of debt creation and inflation, the “credit boom.”
Historically, economists have had a hard time understanding the combination of the monetary system and the credit system. There is a historical reason for this: in the 19th century, commercial banks were responsible for both. But that hasn’t been the case for about eighty years now. The monetary system and the credit system can be conceived as being largely independent, although in practice they intersect in some important places.
The monetary system is the process by which the currency is managed. Here we are concerned with the supply and demand of base money, which results in the value of the currency, and changes in the value of the currency. Got that? The ingredients are supply and demand of base money, and the result is the value of the currency. That’s the whole enchilada. Did I mention banks or credit creation anywhere? No, I did not. Today’s central banks, which are the issuers and managers of today’s currencies, are not involved in credit creation. They don’t make loans, or borrow money. We also recognize, from our previous discussions, that inflation and deflation are changes in the values of currencies, measured most easily by changes in currencies’ exchange value with gold, the Monetary Polaris.
The credit or financial system is a series of contractual agreements denominated in money. It is worthwhile to note that you can create credit “denominated” in other things than money. I’ll feed your dogs while you are on vacation, if you do the same for me in the future. This is a credit arrangement denominated in dog-feeding. The monetary equivalent, of course, is: “I will pay you money today if you pay me the money back in the future, plus interest.” Such credit arrangements are created freely by any two parties that decide they have something to offer each other. What does this have to do with the supply and demand of base money? It may result in some changes to the demand of base money, but has no effect on supply. Money is NOT created when credit is created. Note that I used both italics and boldface. That’s because this is very important. I’ll make it more clear:
Money is NOT created when credit is created.
Yes, I know that dozens of textbooks and roomfulls of economic theorists will argue otherwise. Yes, I know they have enshrined their fallacies in the concept of the “money multiplier.” But they are wrong. Nothing in the credit-creation process creates base money, which is the only kind of money there is. All monetary transactions take place with base money. Bank deposits are merely loans to banks, registered on bank balance sheets as a liability. Nothing inherent to the credit-creation process changes the value of the currency, although it may take place during (and certainly be affected by) changes in the value of the currency.
A currency can only three things: go up in value, go down in value, or do neither (remain stable). Do credit changes have any effects upon currency value? We see, as an example, that Britain maintained the pound’s value versus gold from 1698 to 1931. Did the British financial system expand during that time? While I have no figures handy, I note that if pound-denominated credit grew at a modest average annual rate of 4% per year, then during that 233-year period, credit would have grown by 9,306 times, or 930,500%. Is it not easy to see that credit growth had no effect on the value of the pound, which had the same gold value at the end of the period that it did in the beginning? Is it not easy to see that one reason the British financial system underwent such great expansion during the period is that the stable currency made it easy for borrowers and lenders to make credit arrangements with the confidence that one or the other wouldn’t get screwed through changes in currency value? Did you know that this is exactly the argument used by John Locke, in the late 17th century, in favor of a stable bullion value for the pound? Of course many booms and busts took place during this stable-currency period.
Do you see the difference now between the monetary system and the financial system?
Thus, it is entirely possible to have a credit boom with a stable currency. It is also entirely possible to have a credit boom in an environment of monetary deflation, as was the case in Japan in the late 1980s and the U.S. in the late 1990s. It is possible to have a credit boom in an environment of inflation, such as lending to emerging-market governments in the 1970s.
Indeed, one problem with inflation is that it makes it difficult for borrowers and lenders to work together. The most obvious symptom of this inability to work together is higher interest rates. Thus, generally speaking, credit tends to shrink in an inflation.
Let’s now look at the credit boom. What is a credit boom? It is characterized by large amounts of money lent on easy conditions. Just look at the recent boom in housing-related lending. Everyone is familiar with credit booms. As credit booms develop, a few phenomena tend to appear. Banks become more and more lax with their conditions for lending. Banks make money from lending, and thus are incentivized to do it, especially as their shareholders like to see the income statement rising from quarter to quarter. There is typically some sector of the economy for which, at that time, it becomes institutionally acceptable for bankers to make loans. This is the “lemming effect”: while lemmings as a whole are noted for their apparently self-destructive behavior (biologists say this is something of a myth, alas), no single lemming has ever been identified for criticism or censure. Whatever that sector of the economy may be, whether lending to foreign governments or commodities producers in the 1970s, or commercial real estate developers and leveraged-buy-out operators in the 1980s, or tech-media-telecom in the 1990s, or residential homeowners in the early 2000s, the result of “overlending” is “overinvestment.” The end result is that the last wave of lending, and the ventures or assets whose purchase/creation they financed, tends to be very high-risk/low return, and thus tend to go bust.
This is a sort of Platonic version of the credit cycle, which we all know only too well. The entirety of this credit cycle can happen in an environment of stable money. It may happen in an environment of monetary deflation. It may happen in an environment of monetary inflation. Certainly no monetary inputs (inflation or deflation) are necessary to make it happen.
What is the responsibility of the managers of a currency towards such a credit cycle? There is none. The responsibility of currency managers is to maintain a stable currency, which in practice means stable against gold. Let bankers throw themselves off the cliff. Big deal.
Such credit convulsions can have significant consequences for the economy as a whole, and thus the general welfare. Should the government step in from time to time to prevent this “credit bubble” from expanding further? Arguably, yes. But how? By increasing the standards of lending, which results in a reduction in the amount of lending. This could be done through suggestion or coercion of one sort or another.
But, it should NOT be done through the monetary system. With today’s system of floating currencies, central banks are able to affect the rate at which short-term loans are made. The Keynesian types love this effect because they imagine that they can offset recession by encouraging credit creation. This practice has been criticized often enough. But on the other side of the aisle, we have those who would use the same function of the central bank to suppress credit creation that they feel has become excessive. Thus, we have a debate about interest rate manipulation, whether the target rate should be higher or lower, rather than the proper debate, which is whether the central bank should be involved in interest rate manipulation at all.
If the central bank is not involved in interest rate manipulation at all, and follows a gold standard for example, then the central bank also has no role to play in either engendering (Keynesian) or suppressing (“Austrian”) credit booms.
It is becoming more apparent to many — another premonition? — that we are not only likely headed into a period of monetary turmoil, but that the end result of this monetary turmoil will be interest in returning to a gold standard. But that’s all you get: interest. If there’s nobody around who knows how to play this game, then obviously it will not happen, and we will suffer from floating currencies until someone finally gets their act together.