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"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
Click Here for the How Banks Work series
"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.
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