There are two kinds of credit: that which would be offered in a market
economy with sound money and banking (true credit), and that which is made
possible only through a system of central banking, artificially low interest
rates, and fractional reserves (false credit).
Banks cannot expand true credit as such. All that they can do in reality
is to facilitate the transfer of a given pool of savings from savers (i.e.,
those lending to the bank) to borrowers.
Consider the case of a baker who bakes ten loaves of bread. Out of his stock
of real wealth (ten loaves of bread), the baker consumes two loaves and
saves eight.
He lends his eight remaining loaves to the shoemaker in return for a pair
of shoes in one-week's time.
Note that credit here is the transfer of ”real stuff,” i.e., eight saved
loaves of bread from the baker to the shoemaker in exchange for a future pair
of shoes.
Also, observe that the amount of real savings determines the amount of
available credit. If the baker had saved only four loaves of bread, the
amount of credit would have only been four loaves instead of eight.
Note that the saved loaves of bread provide support to the shoemaker. That
is, the bread sustains the shoemaker while he is busy making shoes.
This means that credit, by sustaining the shoemaker, gives rise to the
production of shoes and therefore to the formation of more real wealth. This
is the path to real economic growth.
Money and Credit
The introduction of money does not alter the essence of what credit is.
Instead of lending his eight loaves of bread to the shoemaker, the baker can
now exchange his saved eight loaves of bread for eight dollars and then lend
them to the shoemaker.
With eight dollars the shoemaker can secure either eight loaves of bread
or other goods to support him while he is engaged in the making of shoes. The
baker is supplying the shoemaker with the facility to access the pool of real
savings, which among other things also has eight loaves of bread that the
baker has produced. Also note that without real savings the lending of money
is an exercise in futility.
Money fulfills the role of a medium of exchange. Thus, when the baker
exchanges his eight loaves for eight dollars he retains his real savings, so
to speak, by means of the eight dollars.
The money in his possession will enable him, when he deems it necessary,
to reclaim his eight loaves of bread or to secure any other goods and
services.
There is one provision here that the flow of production of goods
continues. Without the existence of goods, the money in the baker’s
possession will be useless.
The existence of banks does not alter the essence of credit. Instead of
the baker lending his money directly to the shoemaker, the baker lends his
money to the bank, which in turn lends it to the shoemaker. In the process
the baker earns interest for his loan, while the bank earns a commission for
facilitating the transfer of money between the baker and the shoemaker.
The benefit that the shoemaker receives is that he can now secure real
resources in order to be able to engage in his making of shoes.
Despite the apparent complexity that the banking system introduces, the essence
of credit remains the transfer of saved real stuff from lender to borrower.
Without an increase in the pool of real savings, banks cannot create more
credit. At the heart of the expansion of good credit by the banking system is
an expansion of real savings.
Now, when the baker lends his eight dollars we must remember that he has
exchanged for these dollars eight saved loaves of bread. In other words, he
has exchanged something for eight dollars. So when a bank lends those eight
dollars to the shoemaker, the bank lends fully "backed" dollars, so
to speak.
False Credit: An Agent of Economic Destruction
Trouble emerges when instead of lending fully backed money, a bank engages
in issuing empty money (fractional reserve banking) that is backed by
nothing.
When unbacked money is created, it masquerades as genuine money that is
supposedly supported by real stuff. In reality however, nothing has been
saved. So when such money is issued, it cannot help the shoemaker since the
pieces of empty paper cannot support him in producing shoes — what he needs
instead is bread.
Since the printed money masquerades as proper money it can be used to
divert bread from some other activities and thereby weaken those activities.
This is what the diversion of real wealth by means of money out of "thin
air" is all about.
If the extra eight loaves of bread weren't produced and saved, it is not
possible to have more shoes without hurting some other activities, which are
much higher on the priority list of consumers as far as life and well-being
is concerned. This in turn also means that unbacked credit cannot be an agent
of economic growth.
Rather than facilitating the transfer of savings across the economy to
wealth generating activities, when banks issue unbacked credit they are in fact
setting in motion a weakening of the process of wealth formation.
It has to be realized that banks cannot pursue unbacked lending on an
ongoing basis without the existence of the central bank. The central bank, by
means of monetary pumping, makes sure that the expansion of unbacked credit
doesn't cause banks to bankrupt each other.
We can thus conclude that as long as the increase in lending is fully
backed by real savings it must be regarded as good news since it promotes the
formation of real wealth. False credit, which is generated out of "thin
air," is bad news since credit which is unbacked by real savings is an
agent of economic destruction.
Image Source: iStockphoto
