How (Central) Banking Really Works (Part II)

May 26 2015

In the previous part of this mini-series, we discussed how our bank balance isn’t money, but rather a form of credit (a loan to the bank that is redeemable on demand). In order to understand what money really is, we looked at the origin of money and the influence of central banking on money.

How (Central) Banking Really Works (II)

In the previous part of this mini-series, we discussed how our bank balance isn’t money, but rather a form of credit (a loan to the bank that is redeemable on demand). In order to understand what money really is, we looked at the origin of money and the influence of central banking on money. Nowadays, money is the central bank’s liabilities; meaning all currency plus commercial bank reserves held at the central bank. In this second part of the mini-series we will explain what a credit expansion is and why a central bank plays a key role in causing distress in our financial system.

The Role of the Banking System

In my book, there is a major difference between the definitions lending and credit expansion.

The main activity of the banking system is lending. When the demand for money rises (when people prefer to hold larger bank balances), banks are in the position to grant more credit due to the increased demand for bank balances (their liabilities).

As such, the banking system plays a major role in stabilizing the economy.

After all, consider the following scenario; when there are no banks, and people would like to increase their cash balance by 25% (for whatever reason), the increased demand for money (in the past, gold!) would have a major impact on the economy. It would cause a 'bad' deflation (a drop in the money supply) and an economic depression. Due to hoarding, cash would be 'taken out of circulation.'

In this scenario, all prices would have to be adjusted to the new money supply. All prices would have to drop. And as a result, businesses suffer.

But in a healthy and developed banking system, this doesn’t apply. We have such a system today in which we do not hold money, we hold credit instead. There are, after all, some advantages to holding credit that is instantly redeemable for money; mutual transactions can be settled in the books and we only have to carry a small piece of plastic into our wallets. But credit also involves a counterparty risk; we become dependent upon the solvency of the bank where our money is deposited.

What would happen if we change one assumption? Let’s say instead of no banks, one bank exists. And people would like to increase their cash balance — although this time in the form of bank balances — by 25%?

In this scenario, the bank is in a position to increase lending. The total supply of means of payment (money and bank balances in this case) does not change. Not all prices have to adjust. Some industries suffer (the industries where people spend less) and some industries prosper (the industries to which our bank grants credit). Economic activity changes direction, but its magnitude does not temporarily decrease. As a result, there is no general economic depression.

The Vital Distinction between Lending and Credit Expansion

To formulate things in a simple way; lending is good, credit expansion is bad. The banking sector was created to facilitate the lending of money; to function as an intermediary between savers and investors. Some people save, others use their savings to invest in future investments. This, in a way, creates a harmonious equilibrium.

Credit expansion exists to the extent that the volume of credit exceeds the demand for money. In other words, credit expansion takes place when banks are able to grant more credit than is justified on the basis of savers’ balances and checking account holders.

How Are Banks Able to Issue More Credit than Is ‘Justified?’

When the monetary basis of the real money supply is (relatively) stable, as was the case under the real gold standard (not the pseudo gold standard of the 20th century), banks are not able to grant more credit than the amount that people have saved.

But what has happened often before 1971? And what has become a sustained trend since 1971? The monetary basis has continually increased. Central banks’ balance sheets have steadily — sometimes slowly, sometimes rapidly — increased, especially since the beginning of this decade.

That’s the reason why the harmonious equilibrium has gotten out of balance.

Since 2000 we have experienced a 'credit frenzy;' not because bankers suddenly became inherently more evil, but because central banks started to increase the true money supply —the monetary basis — on a massive scale.

Central banks have created the perfect conditions for the largest recession since the Great Depression, and continue to do so over and over; a recipe for disaster.

The Austrian School of Economics Predicted the ’08 Recession

As some Austrian economists had already demonstrated in the 20th century, credit expansions — the bad version of lending — unavoidably lead to cyclical fluctuations in the economy (booms and busts). In other words, the well-known business cycle is caused by credit.

But more about that later.

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