Money and Credit 2: Credit

Money and Credit 2: Credit
December 13, 2015

“Money and credit” have tended to be mishmashed together, but they are very distinct. This confusion stems from the common practice of banks in the past (mostly before 1914) to both issue currency and also make regular commercial loans, like banks today. However, it is best to think of them separately. They are separate today, as the currency issuer (central bank) is distinct from commercial banks. They were also separate in the past, when only bullion coinage was used as money. In practice, things are not so much different even when banking and currency issuance are combined in one institution, so it is easiest for me to think of them separately, and then apply that framework to the situation in which they are combined.

November 8, 2015: Money and Credit #1: Money
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“Credit” is just borrowing and lending. There isn’t anything more to it than that — no additional mystery. Specifically, “credit” is a contract. A promissory note or a bond is simply a legal agreement to make certain payments at certain times. They are agreements denominated in money (whatever that money may be), but they are not money themselves.

I have a more detailed discussion of what serves as “money” in our present monetary system in Gold: the Monetary Polaris.

read Gold: the Monetary Polaris.

The words “inflation” and “deflation” have no specfic meanings, and thus lead to all sorts of confusion. Although I have attached specific meanings to them in the past, for the purposes of precise discussion, I find it is better now to just avoid them altogether.

We know that there are certain conditions that follow from changes in currency value; or, at the very least, when there are capital controls and such, things which, in the absence of those capital controls, would lead to a change in currency value. This is what von Mises called the “money relation,” or the relative supply and demand for currency. In a gold standard system, the supply is constantly adjusted so that the “money relation” is unchanging, and thus the currency maintains a constant value at the gold parity. This is no different than the mechanisms of currency boards today, which also maintain currency values at fixed parities, not with gold but with other currencies like the dollar or euro.

Thus, a change in value in a currency comes about by some “money relation” which is different than that which would have produced a stable currency. This has nothing to do with borrowing and lending, but is the sole business of the currency issuer, like a central bank today.

We will assume for now that a currency is intended to maintain a gold parity, as these discussions will lead later to historical examples. Thus, either that parity is maintained; or it is not. Either way, it is very obvious. Sometimes (particularly during the Bretton Woods period), currency issuers are rather badly behaved, and don’t quite manage supply the way it should be managed to maintain the currency parity. The divergence is corrected via capital controls. However, even in this case, the divergence cannot be very large, or the capital controls will be overwhelmed. This was the case several times with the British pound or French franc during the 1944-1971 period, when attempts at a “domestic monetary policy” came into conflict with the gold parity policy, and currencies were devalued. Also, even when base money supply is not being managed properly to attain the fixed-value goal, the consequences do not really reach their full bloom until the currency indeed changes value. Thus, even when the parities are maintained via capital controls, the overall effect is mostly as if the currency was being correctly managed, until the capital controls fail and there is a devaluation.

In other words, if a currency’s value is fixed to gold with the help of capital controls, there really isn’t going to be very much monetary distortion (“monetary inflation” or “monetary deflation”), even if a central bank is being somewhat ill-behaved. (This does not take into account the possibility of changes in gold’s value itself.)

Now, it is certainly possible for there to be all sorts of credit silliness, within the context of a stable currency linked to gold. You could call this “credit inflation” or “credit deflation” if you wanted to, but as I said, that is probably more confusing than anything. Let’s say, for example, that lots of banks make loans to Florida property speculators. This raises the value of Florida real estate. Later on, those speculators go bust, and the value of the real estate declines. Banks then have huge amounts of bad loans, and also stop making any more new loans to property speculators. You could extend this example a little more widely, and find that the economy as a whole also rises and falls with the curve of speculation and lending. It is fairly safe to say that, when people spend a lot of money on something and also borrow money to do so, then whatever they are spending their money on will have some kind of credit-fueled expansion. This could be real estate speculation, or it could be education or defense spending. At some point, this lending could be cut off (typically after previous loans start to go bad), which would then lead to credit contraction and, also, contration in spending on that item, whatever it is.

For the most part, the currency issuer has no involvement in this process. There is no “central bank credit expansion.” If a currency is on a gold standard system, there is hardly anything a central bank could do to induce banks to lend one way or another. In practice, there are a few conceivable exceptions to this rule. For example, if the Federal Reserve today was going to replace all of its Treasury bond holdings with securitized student and auto loans, that could possibly allow expansion of student and auto lending. But, in practice such things are not very common, and also very obvious when they do happen. (I am for now omitting any influence a central bank might have as a bank regulator.)

Thus, there is no “money multiplier.”

An easy way to see this is to consider what would things look like if a currency consisted solely of gold and silver coins — as was commonly the case before 1650 or so, and banks existed for many centuries before then. Would a bank’s operations be different in any way? Besides a few inconveniences relating to transporting coinage, the answer is: no. Banks could still make loans on Florida property, and lose money on those loans, and stop making those loans, and all of the other things that banks do today.

Even in an environment of floating currencies, money (and thus central banks) has no direct influence on credit, in the sense of some kind of quasi-mechanistic “money multiplier.” There is certainly an influence, but it is all indirect. As the currency’s value goes up and down, it affects people’s decisions to borrow or lend money, and also their ability to pay it back. Also, the central bank may certainly influence interest rates, which have an effect upon borrowing and lending. That is the whole purpose of managing interest rates.

Banks’ lending is basically related to the availability of opportunities to lend, and also the availability of funds to lend. These funds are, in the first instance, deposits in the bank; and if that is not available, the bank could also borrow the money by other means, from interbank lending or bond offerings. The bank then looks at the asset side of the balance sheet, and decides what portion of that it would like to hold in the form of base money, including deposits at the central bank and vault cash. In a gold standard system, the central bank will accomodate this demand by banks to hold reserves (deposits at the central bank), within the context of the gold parity. In other words, just as the supply of banknotes and coins can expand or contract to any degree necessary to accomodate the demand for this form of money, within the context of the gold parity, so to the central bank will expand and contract the supply of bank reserves. In practice, bank reserves and banknotes are wholly fungible with one another, and amount to versions of the same thing.

Thus, the “money multiplier” has it all backwards. The amount of bank reserves does not drive lending. Rather, banks’ management of their assets drive the aggregate demand by banks to hold bank reserves, which is then accomodated by the central bank (in a gold standard system).

We see that all complaints about “credit expansion,” mostly by Austrian-flavored commentators, related to bank lending, not to the currency. Maybe banks are making excessive loans, which will cause a future revulsion in credit as the boom goes bust. This process can be tiresome and problematic. However, the currency might be perfectly fine, throughout this entire episode.

If the currency issuer is engaging in a destructive “credit expansion” the evidence of such is the decline in the currency’s value — in a gold standard system, a deviation from the gold parity; or, at the very least, a condition of overissuance that would result in a deviation if not for the imposition of capital controls and other heavy-handed coercion such as “foreign exchange intervention.” The currency issuer, to expand the base money supply, might conceivable make loans to banks, via the discount window for example. Thus, the total credit (lending) would increase–a “credit expansion”. But, currency issuers more commonly will purchase bonds in the open market, which does not increase the total amount of credit (bonds outstanding), but simply changes their ownership. Even in the case of aggressive discount lending, as was the case in late 2008 and early 2009, this lending is normally intended to be short-term in nature, and will naturally run off and disappear, or be replaced by bond holdings, as happened later in 2009.

In the extreme case, such as a hyperinflation, it is possible that “credit” could expand, because the central bank was buying so many government bonds that the government was able to increase its issuance of bonds by a large amount. Thus, more “credit.” This is what von Mises means when he talks about “credit expansion,” for example in Austria in the early 1920s, which he experienced firsthand. But, a lot of his admirers confused this with bank credit expansion in the context of a stable currency, in the process mixing up both currency overissuance and bank credit expansion into a confusing mishmash.

It is easy to see that, in the environment of a perfectly stable currency, closely approximated in practice with a gold standard system, that “credit expansion” has nothing to do with money. Money has nothing to do with “credit expansion.”

Related to this is a concern that influential bankers can cause economic boom and bust via manipulation of the currency and credit. Manipulation of the currency is certainly possible with a floating currency, which would be apparent as a rise or decline in currency value, in the foreign exchange market for example, or compared to gold. However, it is not really possible with a gold standard system. To the extent that this accusation has merit, this “expansion and contraction,” or “inflation and deflation” would likely be via bank credit.

Borrowers and lenders often have quite a lot of short-term credit. Borrowers (which include banks) rely on the expectation that they will not be asked to pay back all their borrowings on short notice. Even longer-term credit, such as long-term bonds and loans, often have covenants that allow repayment to be demanded on short notice if there is a worsening of the financial condition of the borrower.

Thus, banks, acting with nefarious collective intent, could conceivably cause financial chaos by letting existing loans mature and be repaid, and not making any new loans to allow refinancing of the short-term debt (and also long-term debt coming due). Borrowers would face bankruptcy, even if they were fundamentally sound. At the same time, the economy would convulse, so that even relatively sound businesses would find their revenues collapsing. Instead of spending money, everyone would be reducing expenditures to pay back their loans.

As the asset side of the balance sheet (lending) contracted, so too would the liabilities side (deposits), for the simple reason that the deposits would be used to pay back the loans. Even those who had no borrowing whatsoever would likely find, in the environment of economic difficulties, that their income (corporate or individual) was severely constrained, which would also lead to a drawdown of deposits, particularly in a time (the 1930s for example) when bank deposits were the principal avenue of savings and investment for the great majority of people.

This has nothing to do with the money. This is easy to see if you consider that exactly the same scenario would be possible even if gold and silver coins exclusively were used as money.

It would be hard to pin blame on banks, because it would be perfectly legitimate and expected for banks, in an environment of “financial chaos,” to take exactly those measures, without any need for nefarious collusion. Cause and effect would be hard to distinguish.