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It may come as a
surprise to many, but the relative size of the US commercial-banking industry
has not declined following the so-called credit-market crisis, which
developed in the second half of 2007. On the contrary, it has increased since
then. While nominal GDP rose 4.2% from the second quarter of 2007 to the
second quarter of 2010, banks' total assets rose 18.4%.
In a recession
one would expect an unwinding of credit-financed investments that have turned
sour. Economically unsuccessful firms go out of business, malinvestment is
liquidated, losses reduce investor equity capital, and the cost of borrowing
increases, providing incentives for reducing overall indebtedness.
However, this is
not what happened in the banking industry as a whole. The Federal
Reserve, in an attempt to prevent the bank system from collapsing, supplied
any amount of base money that was deemed necessary to keep banks afloat. This
can be illustrated by the drastic increase in banks' base money holdings
since around the third quarter of 2008.
The Fed's
monetary policy tries to keep the balance sheet of the commercial banking
sector from shrinking. For a shrinking of banks' assets would be accompanied
by a decline in the credit and money supply — a development that is
widely seen as being harmful to production and employment growth.
However, this is
a severe, and actually fatal, misinterpretation of cause and effect. It is bank-credit
expansion that has brought about the trouble in the first place, and a
policy of ever lower interest rates, provoked by ever greater doses of credit
and money injections, is not going to solve the damage done but will actually
make matters even worse.
Fiat-Money Creation through Circulation Credit
Whenever
commercial banks extend loans to nonbanks (private consumers, firms, and
public-sector entities) in today's fiat-money regime, they increase the money
supply uno actu. Ludwig von Mises called this type of credit
"bank-circulation credit."
Bank-circulation
credit, which is associated with a rise in the money supply out of thin air,
causes malinvestment and boom-and-bust cycles. It causes all the evils that
are regularly associated with inflation: rising prices (and a corresponding
decline in the purchasing power of the money unit), a coercive redistribution
of income, and malinvestment.
However, what
happens if and when commercial banks are no longer willing to roll over
maturing loans, or borrowers wish to repay their bank debt? Such developments
— which are frequently labeled deleveraging and derisking — would
lead to a decline in the economy's fiat-money stock.
This is because
repaying bank loans basically means that the fiat money that has originally
been injected into the economy is literally leaving the economic system. And
if this happens, the inflation regime turns into a deflation regime.
Deflation in a fiat-money
system is of a different nature than in a commodity-money regime. To see
this, consider the gold standard. Here, the money supply may decline because
people decide to move gold from monetary to nonmonetary purposes.
Another reason
for a decline in the money supply is a correction of fraudulent banking.
Fraudulent banking means that banks issue money substitutes in excess of
holdings of money proper (gold). If clients demand redemption, banks default
on their payment liabilities. The outstanding money stock drops, as money
substitutes not covered by gold become worthless.
Deflation in a
gold standard comes to a halt once the outstanding claims on money proper are
brought back in line with the stock of money proper people have deposited
with banks. In other words, deflation makes the inflated money stock return
toward its rightful level.
In today's
fiat-money system, however, the inflated money stock cannot be brought back
toward any rightful level, as fiat money is created out of thin air via
circulation credit, not backed by any commodity whatsoever. There is no
equilibrium level the fiat-money supply could shrink toward.
"The Piper Must Be Paid"
Fiat-money
systems collapse once the increase in ever-greater amounts of credit and
money comes to a halt, let alone goes into reverse. Even a slowing down of
credit and fiat-money expansion causes economic trouble — as the
illusion fueling the credit boom breaks down. As Murray N. Rothbard noted,
Like the repeated
doping of a horse, the boom is kept on its way and ahead of its inevitable
comeuppance by repeated and accelerating doses of the stimulant of bank
credit. It is only when bank credit expansion must finally stop or sharply
slow down, either because the banks are getting shaky or because the public
is getting restive at the continuing inflation, that retribution finally
catches up with the boom. As soon as credit expansion stops, the piper must
be paid, and the inevitable readjustments must liquidate the unsound
over-investments of the boom and redirect the economy more toward consumer
goods production. And, of course, the longer the boom is kept going, the
greater the malinvestments that must be liquidated, and the more harrowing
the readjustments that must be made.[1]
However, couldn't
the central bank just keep the money supply unchanged, preventing it from
falling by, for instance, purchasing assets (bonds, stocks, etc.)? Such a
policy wouldn't do the trick. The ensuing slowdown of credit and money
expansion would, as Rothbard outlined forcefully, make the economic
production structure explode.
The market
interest rate would start moving from its artificially suppressed level
toward its natural level as determined by the societal time-preference rate.
This, in turn, would reveal that the economy — due to increases in
circulation credit and fiat money — has lived beyond its means.
Malinvestment will be revealed.
Credit losses
would rise as firms run up losses due to bad investment and consumers,
plagued by unemployment and declining incomes, default on their debt. Tax
revenues would decline, and governments, which chronically rely on debt
financing, would have to pay ever higher interest rates for rolling over
their maturing debt and financing new deficit-financed outlays.
That said, once
increases in fiat money slow down, come to a halt, or become negative, the
credit pyramid and the production structure it has created would start
disintegrating.
Inflation Temptation
Under a fiat-money
regime there is a great temptation for governments and their supporters
(protégés) to advocate a further increase in the fiat-money
supply — by arguing that a further increase in the fiat-money supply
(and a somewhat higher inflation) is the policy of the lesser evil as
compared to a breakdown of the economic and monetary order.
Many renowned
economists have argued that, because of political reasons, (hyper)inflation
rather than deflation will be the ultimate consequence of fiat money. Take,
for instance, Irving Fisher, who in his book The Purchasing Power of Money, its
Determination and Relation to Credit, Interest and Crises (1911) made an unmistakable statement regarding the
quality of fiat money: "Irredeemable paper money has almost invariably
proved a curse to the country employing it."[2]
A similar view
was expressed by Frank A. Fetter, who explicitly referred to the
political-economic dimension of inflation when he wrote in his book Modern Economic Problems (1926),
Once the issue of
political money begins to be excessive, its further limitation proves to be
most difficult. A result usually unintended is the derangement of business
and of the existing distribution of incomes. The rapid and unpredictable
changes in prices give opportunity for speculative profits, but injure
legitimate business. This incidental effect on debts and industry offers the
main motive to some citizens for advocating the issue of paper money. It is
peculiarly liable to be the subject of political intrigue and of popular misunderstanding.
It is this danger, more than anything else, that makes political money in
general a poor kind of money.[3]
Mises, in a 1952
addition to his book The Theory of Credit and Money (originally published in 1912), put forward an
explanation of why people opt for inflation in times of emergency.
The emergency
that brings about inflation is this: the people or the majority of the people
are not prepared to defray the costs incurred by their rulers' policies. They
support these policies only to the extent that they believe their conduct
does not burden themselves. They vote, for instance, only for such taxes as
are to be paid by other people, namely, the rich, because they think that
these taxes do not impair their own material well-being. The reaction of the
government to this attitude of the nation is, at least sometimes, directed by
the sincere wish to serve what it believes to be the true interests of the
people in the best possible way. But if the government resorts for this
purpose to inflation, it is employing methods which are contrary to the
principles of representative government, although formally it may have fully
complied with the letter of the constitution. It is taking advantage of the
masses' ignorance, it is cheating the voters instead of trying to convince
them.[4]
In his book Age of Inflation (1979), Hans F. Sennholz noted,
In the past, the
inflations were of relatively short durations, limited to periods of national
emergency when the central government was called upon to finance extraordinary
defense expenditures. After the end of hostilities monetary stability soon
returned as the emergency financing was abandoned. Today, public demand for
governmental services never abates, in wartime and in peacetime, but seems to
accelerate year after year. In fact, the more government spends on economic
and social objectives the louder the public clamor for more services seems to
become. Thus, the temporary emergencies that in the past gave occasion for
extraordinary defense expenditures and inflationary financing have given way
to a permanent emergency of social service and inflationary financing. It is
true that inflation can never be permanent, for it must come to an end with
the total destruction of the currency.[5]
The only chance
to prevent the exchange value of fiat money from collapsing altogether is a
return to sound money — a way that would start by reanchoring
fiat monies to gold, as outlined most prominently by Mises, Rothbard, and
Sennholz. However, limiting the damage done by the fiat-money curse is not a
technical problem in the first place. It is first of all a matter of
overcoming the political, economic, and sociophilosophical framework of our
time. As Mises noted,
The belief that a
sound monetary system can once again be attained without making substantial
changes in economic policy is a serious error. What is needed first and
foremost is to renounce all inflationist fallacies. This renunciation cannot
last, however, if it is not firmly grounded on a full and complete divorce of
ideology from all imperialist, militarist, protectionist, statist, and socialist
ideas.[6]
Notes
[1] Rothbard, M. N. (2006, 1973), For A New Liberty: A Libertarian Manifesto, 2nd ed., Ludwig von Mises Institute, p. 237.
[2] Fisher, I. (1922, 1911), The Purchasing Power of Money, its
Determination and Relation to Credit, Interest and Crises, New York: Macmillan, p. 78.
[3] Fetter, F.A. (1926), Modern Economic Problems,
2nd ed., New York, The Century Co., p. 53.
[4] von Mises, L. (1981), The Theory of Money and Credit, Liberty Fund, Indianapolis, p. 468. The quote was
taken from part four, "Monetary Reconstruction," which was written
in 1952 and first appeared in the 1952 American edition by Yale University
Press.
[5] Sennholz, H.F. (1979), Age of Inflation, Western Island, Belmont, Massachusetts, p. 62.
[6] Mises, L. (2006, 1923), "Stabilization of the
Monetary Unit — From the Viewpoint of Theory," in The Causes of the Economic Crisis, Ludwig von Mises Institute, Auburn, Alabama, p.
44.
Thorsten Polleit
Thorsten Polleit is Honorary Professor at the Frankfurt School of
Finance & Management.
This essay was originally published in www.Mises.org. By authorization.
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