Misconceptions about credit and borrowing
March 4, 2009 – 11:01 pm by JohnDemocratic politicians and bureaucrats, supporters of Obama’s stimulus spending and potential financial-sector interventions, and believers in Keynesian socialism in general are quite adamant about “getting credit flowing again” and easing the pain of businesses by getting people to buy more stuff. I’m starting to think a lot of their misconceptions originate from their confusion about the exact differences between money and wealth.
I encountered two Statists online recently who expressed similar Keynesian notions and I (finally) want to answer them.
The first was at Fark.com, which, in case you don’t remember, usually disturbs me because 99.9% of Farkers are absolutely intolerant, malicious, belittling, immature, ignorant State-worshipping socialists in the extreme. Maybe this describes the general population + the protection of online anonymity, but I can’t stand them either way. In other words, they provide great blagging material. I don’t know why I’ve found myself back there so often the last few weeks, but I guess that web page is like the New York Times for George Reisman or Sojourner’s for William L. Anderson: it’s an old stand-by that infuriates us and keeps us filled with more political-discussion material than we could ever completely exhaust.
In the discussion thread about this news article about credit card reform, some moran said this, and I promise he was being serious:
In the Western World we create money through a fractional reserve system, or FRS. An FRS creates money by a central bank lending money to commercial banks who in turn lend a fraction of it to consumers. The repeated lending of money creates commercial money in excess of the amount initially created by the central bank. When the commercial bank repays the central bank they are left with the newly created commercial money. In short the “loan” is how our economy grows and money is created.
So bragging about paying off your credit card every month or not having car payments sounds just as schmucky as people who claim they pay more then “their fair share of taxes” by ignoring the freeways they drive on, the police that keep their neighborhoods safe or the inspectors that try to keep their child from chewing on toys painted with lead.
You are not an island. Even if you have no debt, the abundance of convenience that you enjoy in western society DEPENDS on lending and usury by the REST of the population. What happens when people and companies stop borrowing or banks stop lending? Take a look at the current financial meltdown. Layoffs, states issuing IOUs on tax refunds, stocks running for some unknown bottom, 401k plans being halved, etc.
The only reason there are used cars to buy are because someone else bought it new and financed both it and the interest. The only reason their are houses for sale below market is because someones else took out a mortgage to have it built. The only reason you can bargain hunt for an iPod on craigslist is because someone else already paid Apple full price. If someone didn’t take the initial step none of these products would exist because companies have to sell new products to exist.
So while being debt free can put you in a better temporary situation compared to the overall economy it is hardly the moral or intellectual high ground so many people claim it to be. In fact you are more like a leech, thriving off the actions of others.
I think the only thing he got right was the first sentence: We create money through a fractional-reserve system. Not wealth, but money.
The second one was at Cork’s blag. Dylan Caron, a much, much smarter and more composed liberal Obama fan said,
Printing more money is obviously a terrible idea. And over consumption is just wasteful. But borrowing, and by that I mean loaning from banks, is really one of the only ways wealth is created, due to the fact that we run on a fractional reserve system. I urge you to look it up if you haven’t, it pretty much ends up that if our country’s wealth isn’t being artificially pumped, it cant survive.
On the contrary, if any country’s wealth goes on being artificially pumped, the economy and its currency must necessarily die.
Lending on credit depends upon something being saved by the lender in the first place. A banker is defined not as someone who lends money per se, but as someone who lends other people’s money. (This is distinguished from a capitalist or entrepreneur, who lends and invests his own money.) For a bank to lend person A’s money to person B, person A had to save up the money or save up a quantity of goods that are worth that much money beforehand. Except in our fractional-reserve economy with a central bank that can order all the dollar bills printed that it wants; then money can be given to all kinds of borrowers and create the illusion of 10 times the wealth that has really been saved!
Coincidentally, Peter Schiff wrote a recent article that addresses just these issues of saving and lending. I’ll quote it at length since he is a real economist and can explain things better than I:
The central tenets of Obamanomics appear to be that access to credit will enable people to borrow money to buy stuff, the spending will spur production and employment, and thus the economy will grow. It’s a neat and simple picture, but it has nothing whatsoever to do with how an economy works. The President does not understand that consumption is made possible by production and that credit is made possible by savings. The size and complexity of modern economies has obscured these simple concepts, but reducing the picture to a small scale can help clear away the fog.
Suppose there is a very small barter-based economy consisting of only three individuals, a butcher, a baker, and a candlestick maker. If the candlestick maker wants bread or steak, he makes candles and trades. The candlestick maker always wants food, but his demand can only be satisfied if he makes candles, without which he goes hungry. The mere fact that he desires bread and steak is meaningless.
Enter the magic wand of credit, which many now assume can take the place of production. Suppose the butcher has managed to produce an excess amount of steak and has more than he needs on a daily basis. Knowing this, the candlestick maker asks to borrow a steak from the butcher to trade to the baker for bread. For this transaction to take place the butcher must first have produced steaks which he did not consume (savings). He then loans his savings to the candlestick maker, who issues the butcher a note promising to repay his debt in candlesticks.
In this instance, it was the butcher’s production of steak that enabled the candlestick maker to buy bread, which also had to be produced. The fact that the candlestick maker had access to credit did not increase demand or bolster the economy. In fact, by using credit to buy instead of candles, the economy now has fewer candles, and the butcher now has fewer steaks with which to buy bread himself. What has happened is that through savings, the butcher has loaned his purchasing power, created by his production, to the candlestick maker, who used it to buy bread.
Similarly, the candlestick maker could have offered “IOU candlesticks” directly to the baker. Again, the transaction could only be successful if the baker actually baked bread that he did not consume himself and was therefore able to loan his savings to the candlestick maker. Since he loaned his bread to the candlestick maker, he no longer has that bread himself to trade for steak.
The existence of credit in no way increases aggregate consumption within this community, it merely temporarily alters the way consumption is distributed. The only way for aggregate consumption to increase is for the production of candlesticks, steak, and bread to increase.
One way credit could be used to grow this economy would be for the candlestick maker to borrow bread and steak for sustenance while he improves the productive capacity of his candlestick-making equipment. If successful, he could repay his loans with interest out of his increased production, and all would benefit from greater productivity. In this case the under-consumption of the butcher and baker led to the accumulation of savings, which were then loaned to the candlestick maker to finance capital investments. Had the butcher and baker consumed all their production, no savings would have been accumulated, and no credit would have been available to the candlestick maker, depriving society of the increased productivity that would have followed.
On the other hand, had the candlestick maker merely borrowed bread and steak to sustain himself while taking a vacation from candlestick making, society would gain nothing, and there would be a good chance the candlestick maker would default on the loan. In this case, the extension of consumer credit squanders savings which are now no longer available to finance other capital investments.
What would happen if a natural disaster destroyed all the equipment used to make candlesticks, bread and steak? Confronted with dangerous shortages of food and lighting, Barack Obama would offer to stimulate the economy by handing out pieces of paper called money and guaranteeing loans to whomever wants to consume. What good would the money do? Would these pieces of paper or loans make goods magically appear?
The mere introduction of paper money into this economy only increases the ability of the butcher, baker, and candlestick maker to bid up prices (measured in money, not trade goods) once goods are actually produced again. The only way to restore actual prosperity is to repair the destroyed equipment and start producing again.
The sad truth is that the productive capacity of the American economy is now largely in tatters. Our industrial economy has been replaced by a reliance on health care, financial services and government spending. Introducing freer flowing credit and more printed money into such a system will do nothing except spark inflation. We need to get back to the basics of production. It won’t be easy, but it will work.
Saving must precede lending. In case you’re interested in another Austrian economist’s explanation of the same concept, see these two essays by Frank Shostak. I think they explain things well, and I’m not aware of any glaring problems with them.
In order for our economy to experience real growth and to produce real, new, additional wealth, saving and production must increase and consumption, government spending, and inflation must decrease. The time-preferences of our culture must decrease drastically, and that applies to looking for solutions to this mess from the very government that created it.
When that Farker said commercial lending in excess of what the central bank initially created is how the economy grows and money is created (perhaps he meant wealth), he is dead wrong, as far as I understand. Lending at 9x or 10x the amount of wealth that was actually saved or deposited contributes to malinvestment and overconsumption and living beyond our means. It contributes to an artificial economy that is being exposed as the fraud that it is more and more with each passing year. Eventually, after businesses are started and buildings are built and people are hired and houses are purchased with that fractional-reserve credit that was created out of thin air by mathematics, it becomes apparent that a lot of them were poor investments because the wealth to pay for them doesn’t exist, anywhere. It never did! It wasn’t real wealth! It was just dollar bills and numbers on a balance sheet! Created by the central bank! It was the illusion of wealth in the form of easy credit and low interest rates.
More money or more credit isn’t wealth and it doesn’t represent real saving or real production. It represents inflation and it causes malinvestment. Look around you. Read the news. Listen to the radio. That was all done in a world of fractional-reserve banking and an economy managed by Ivy-league economists in the Treasury and Federal Reserve.
Wealth is created by foregoing present consumption, investing in the future, innovating and finding new market niches, pursuing profits by offering customers better products for lower prices, and by the profit-and-loss system of a free market. Creating credit from nothing is not part of that and naturally only destroys wealth in the end.
