Posted on 2020-01-21 19:53:00
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At the outset it should be understood that a cycle of bank credit leads to alternate booms and slumps and much debate has occurred over the years as to how to deal with it. This topic is becoming important again, since there are growing signs that the expansion of bank credit is faltering, a tendency for it to contract will follow and a business recession, or even worse, is now increasingly certain.
For many neo-Keynesians, the issue comes down to unpredictable private sector bank credit behaviour compared with more certain central banking control over base money. Some, such as the supporters of the 1935 Chicago plan, have argued that the way to deal with it is to introduce 100% reserve banking and to hand a monopoly of monetary creation to the central banks, targeting price stability, or simply managing a steady growth rate for money supply.
The Chicago plan was cooked up during the great depression, which was blamed by the inflationists on the gold standard. In the context of the controversy in the nineteenth century between the currency and banking schools the Chicago Plan was something of a hybrid, leaning towards the currency school but without the discipline of gold upon which the currency school based its proposition. Anyway, banking interests ensured the plan lay dead in the water.
It was also naïve, assuming that the relationship between the quantity of money and the general level of prices was simply mathematical, when we should know through empirical evidence and reasoned economic theory that it is not. There is enormous subjectivity in the general level of prices, reflected in relative preferences between the public’s desire for consumption relative to holding money. Furthermore, following the great depression, in debating these issues there was, and still remains, an unquestioned assumption that leaving any form of money at the mercy of free markets is dangerous and that it should be under the control of the state.
Aide-memoire: How bank credit is created
When a bank takes deposits onto its own balance sheet, it acquires possession of them and owes a debt to its depositors. Its balance sheet liabilities consist of the bank’s capital and what is owed to depositors and other creditors. Matching these liabilities are the bank’s total assets. The ratio between the bank’s own capital and its depositor liabilities is easily varied by the bank’s management. Technically, this can be done in one of two ways. Either a loan account with a matching deposit are created for a customer, so that the loan is offset by the deposit. Alternatively, a loan facility is made available, creating deposits as it is drawn down. Any imbalances at an individual bank are made up by deposits drawn from payments by other banks, or by borrowing from other banks through wholesale money markets.
Therefore, a bank can use possession of customer deposits to extend credit of its own creation. By expanding its balance sheet in this way, the gross income arising from the difference between loan charges and interest paid on deposits increases the ratio of earnings to the bank’s capital.
Equally, borrowers and depositors can cause the bank’s balance sheet to contract by the simple expedient of paying down their obligations, reducing their deposits. If a bank is to maintain an expanded balance sheet, it must repetitively find new business. Consequently, there is an inbuilt bias in favour of continual expansion of bank balance sheets and therefore of bank credit. But the expansion of credit distorts the price structure in the economy, lowering the cost of borrowing and discouraging savers from saving by reducing the time preference value of money.
Over time, an economy driven by bank credit expansion will move from being savings-driven, where investment capital for the wider economy is funded out of past profits and earnings retained as savings, to being driven by the creation of debt and matching deposits.
Putting aside the wishful thinking that bank credit can continue to expand on an even course in perpetuity, we should note that once an expansionary course is under way demand for bank credit starts off being less than the banks are prepared to finance. Spurred on by increasing banker confidence and growing bank competition for loan business, rates are then reduced to below where they would otherwise be in a savings-driven economy. This leads to an artificial boom that eventually generates more demand for credit than the banks are willing to provide, or are restricted from doing so by bank regulation.
When the banks call a halt to further credit expansion, borrowers can no longer fund their incomplete plans, and banks will want to protect themselves from the fallout by reducing loans and deposits to protect their own capital. The urgency of this change of course is due to the catastrophic impact on a bank’s own capital of an oversized balance sheet when bank credit expansion slows, stops and threatens to contract.
The consequence is a repetitive cycle of boom and sudden bust. (See here for a video further explaining the phenomenon).
The only way this can be prevented is to disallow the creation of bank credit in the first place, a solution so alien to today’s bankers and inflationist economists alike, that it is readily dismissed. The progression of successive cycles in Britain since the Napoleonic Wars, adopted increasingly by other jurisdictions has, for modern times, led to an end point in bank credit creation, where consumers have little or no savings left and the majority live on tick between salary payments. Having abandoned all forms of sound money in favour of fiat currency inflation, the creation of base money is now being accelerated in a final attempt by central banks to buy off the consequences of not just the current cycle of bank credit inflation, but all those leading up to it.
Nothing goes on for ever, so sooner or later the system that has flourished on the possession of depositors’ bank balances will end. A new system of banking will then be devised, and its success will require a return to sound money, money that cannot be created out of thin air on the whim of a commercial or central banker.
In the wider context of history, the current debate about the role and behaviour of banks has occurred in a moral and legal vacuum, ignoring issues which have been debated since ancient history. And it was the Romans who resolved it in the third century AD, differently from our modern assumptions...