Does a Fall in Credit Lead to Deflation?

US credit is undergoing a major contraction. In the week ending October 14, US commercial-bank lending stood at $5,686.8 billion: a fall of 6.6% from the end of January.[1] Year on year, loans fell by 7% in October after declining by 5.8% in September. On the same basis of comparison, in October last year, loans increased by 6.6%.

There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.[2]

Through a progressive selection process, people settled on gold as money.

In today's monetary system, the money supply is no longer gold, but is instead coins and notes issued by the government and the central bank. Consequently, coins and notes ("cash") constitute the standard money that is employed in transactions. Goods and services are sold for cash.

At any point in time, part of the stock of cash is deposited in banks. Once an individual places his money in a bank's warehouse (making what is known as a "demand deposit") he is in fact engaging in a claim transaction. In depositing his money, he does not relinquish his ownership. No one else is expected to make use of it. Thus, when Joe stores $100 with a bank, he continues to have an unlimited claim on it and is entitled to take charge of it at any time.

Such deposits must be contrasted with credit transactions, in which the lender of money relinquishes his claim over the money for the duration of the loan. In this case, the lender is temporarily transferring his money to the borrower.

The distinction between a credit and a claim transaction is an important means of identifying the amount of money in an economy. Following this approach, one could easily note that, notwithstanding popular practice, money invested with money-market mutual funds (MMMF) should be excluded from the definition of the money supply. (Note that MMMF investments are included in M2.)

The problem of double counting is also not resolved by the money of zero maturity (MZM) measure. MZM includes all types of financial instruments that can be easily converted into money without penalty or risk of capital loss.[3] Its definition excludes all securities, which are subject to the risk of capital loss, and time deposits, which carry penalties for early withdrawal. Included in MZM are currency, demand deposits, traveler's checks, savings deposits, and deposits with money market mutual funds.

This definition doesn't identify money but rather various assets that can be easily converted into money. It doesn't tell us what money actually is and where money is located — which is precisely what a definition of money ought to do.

Now, when a depositor places his money in a savings or fixed-term deposit, he temporarily relinquishes his ownership over money. This, however, is not the case with demand deposits. As long as the bank does not use the money in demand deposits, it is backed 100% by the deposited cash.

However, if banks lend part of the deposited money, they create new demand deposits that do not have any cash backing. Since the created deposits can masquerade as proper representatives of cash, they should be included as part of the money supply. Consequently, once banks use deposited money, they set in motion an expansion of money out of thin air.

Mainstream thinking currently excludes government deposits held in banks and the central bank from the money supply. If the government taxes people by one billion dollars, money is transferred from their deposits to the government's deposit. In the mainstream, this is viewed just as if the money supply fell by one billion dollars. In reality, however, the money is now available for government expenditure, meaning that money held in government deposits should remain part of the definition of the money supply.

Incorporating all the above arguments, I define the money supply to include cash, demand deposits with commercial banks, and government deposits with banks and the central bank.

Correlation and Money-Supply Definition

Most analysts use money M2, or MZM in their analysis. Does it matter which type of money one uses? A correct definition of money is a must if one wants to get the right information from monetary indicators.

Now, even if popular definitions were to produce good historical correlations with various economic data, one runs the risk that these monetary measures will lead to misleading analyses on account of the fact that these definitions are flawed. (M2 and MZM include credit-transaction items.) The only criterion for confidence in a money-supply definition is whether it correctly identifies what money is and where it resides.

Once it is established that the definition is sound, one must stick to it, regardless of whether it is well correlated with some other economic data or not.

The final judge regarding the validity of a money-supply definition should not be statistical correlations as such but the economic soundness of the definition. The soundness of a definition, however, cannot be established by means of a statistical analysis but only by means of its theoretical soundness.

Deflation and Fractional-Reserve Lending

Contrary to popular thinking, deflation is not a general decline in prices of goods and services but a decline in money supply.

Note that when Joe lends his $100 to Bob via the bank, this means that Joe (via the intermediary) lends his money to Bob. On the maturity date, Bob transfers the money back to the bank and the bank in turn (after charging a fee) transfers the $100 plus interest to Joe. Observe that here money never disappears or is created; the original $100 is paid back to Joe.

Things are, however, quite different when Joe keeps the $100 in the bank warehouse or demand deposit. Remember that by keeping the money in a demand deposit, Joe is ready to employ it at any time he likes.

Now, if the bank lends Bob $50 by taking it from Joe's demand deposit, the bank will have created $50 of unbacked credit, out of "thin air." By lending $50 to Bob, the bank creates $50 of extra demand deposits. Thus, there is now $150 in demand deposits that are backed by only $100.

So in this sense, the lending here is without a lender. The intermediary, i.e., the bank, has created a mirage transaction without any proper lender. On the maturity date, when Bob repays the money to the bank, that money disappears. The money supply falls back to $100, dropping by 33%.

Hence an increase in credit out of thin air, all other things being equal, gives rise to an expansion in the money supply. A fall in credit out of thin air, all other things being equal, results in a contraction of the money supply.

So in this sense it is valid to argue that a fall in bank lending out of thin air contributes to the decline in the rate of growth of the money supply and thus to deflation.

Note that what matters here is not credit as such but credit that was created out of nothing. A fall in normal credit (i.e., credit that has an original lender) doesn't alter the money supply and hence has nothing to do with deflation. For instance, if Joe directly lent Bob his $100, when Bob repays the money we will have a fall in credit with no change in money supply.

Given the currently observed decline in commercial-bank lending, it is quite likely that commercial bank lending out of thin air has also fallen. However, even if we accept that this is the case, the fact that the money supply's rate of growth is still a positive figure implies that we still have inflation and not deflation.

In fact, in August this year the yearly rate of growth of the money supply stood at 14.7% against 1.8% in August last year. The main reason for this increase in the money supply despite banks' curtailment of credit out of thin air is the massive pumping of money by the Fed.

The yearly rate of growth of the Fed's balance sheet jumped from 2.9% in June last year to 152.8% in December. Note that apart from pumping money directly to commercial banks, the Fed has also been pumping directly to nonbank entities in the economy ($408 billion last December alone). It is this that boosted the yearly rate of growth of the money supply despite commercial banks' curtailment of their lending out of thin air.

A visible fall in the yearly rate of growth of the Fed's balance sheet is currently instrumental in a visible fall in the growth momentum of the money supply. The yearly rate of growth of the Fed's balance sheet fell to 25.5% so far in October from 110.5% in September and 125.2% in August. As a result, the yearly rate of growth of the money supply fell to 7.9% in October from 10.8% in September and 14.7% in August.

If the pace of pumping by the Fed were to slow down further, the curtailment of commercial banks' credit out of thin air could become the dominant influence on money supply. If this happens, then we will have deflation.

Conclusion

Contrary to popular thinking, it is not a fall in credit as such that is the key to deflation, but a fall specifically in credit created out of thin air. It is this type of credit, which commercial banks have created through fractional-reserve lending, that causes the decline in money supply, i.e., deflation. A fall in normal credit (i.e., credit that has an original lender) doesn't alter the money supply, and hence has nothing to do with deflation.

Despite the likely current fall in commercial-bank lending out of thin air, as long as the rate of growth of the money supply remains positive, one should talk about inflation rather than deflation.

However, as the pace of monetary pumping by the US central bank is starting to fall sharply, there is a growing likelihood that the fall in commercial-bank lending out of thin air will cause actual deflation.