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Good and Bad Credit

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10/16/2008Frank Shostak
Did Chairman Bernanke learn the correct lesson from the Great Depression?

On Wednesday October 8 the Federal Reserve, European Central Bank, and four other central banks lowered interest rates in an emergency coordinated bid to ease the economic effects of the financial crisis.

The Fed, ECB, Bank of England, Bank of Canada, and Sweden's Riksbank each cut their benchmark rates by half a percentage point. Furthermore, China's central bank lowered its key one-year lending rate by 0.27 percentage points. According to a joint statement by the central banks,

The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability. Some easing of global monetary conditions is therefore warranted.

The Fed's decision brought its benchmark rate to 1.5%. The ECB's main rate is now 3.75%; Canada's fell to 2.5%; the U.K.'s rate dropped to 4.5%; and Sweden's rate declined to 4.25%. China cut interest rates for the second time in three weeks, reducing the main rate to 6.93%. One day earlier the Reserve Bank of Australia had lowered its policy rate — the cash rate — by 1% to 6%.

Only a day earlier Federal Reserve Chairman Bernanke announced that the US central bank is ready to intervene in the commercial paper market. The Fed will now buy commercial paper issued by corporations — meaning the US central bank will make direct loans to corporations.

It seems that Bernanke is ready to push trillions of dollars to keep the monetary system alive.

Bernanke is of the view that a major reason for the Great Depression of 1930s was the failure of the US central bank to act swiftly to revive the paralyzed credit market. By "swift action," Bernanke means massive monetary pumping.

The Fed chairman continuously reminds us that at least he has learned the lesson of the Great Depression and will make sure that the error that the Fed made then will not be repeated again.

At the conference to honor Milton Friedman's ninetieth birthday, Bernanke apologized to Friedman on behalf of the Fed for not pumping enough money to prevent the Great Depression:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

(Milton Friedman and Anna Schwartz wrote that the key factor behind the Great Depression was the failure by the Fed to pump large doses of money.)

Central-bank policy makers have said that the key for economic growth is a smooth flow of credit. For them (in particular, for Bernanke) it is credit that provides the foundation for economic growth and raises individuals' living standards. From this perspective, it makes a lot of sense for the central bank to make sure that credit flows again.

Following the teachings of Friedman and Keynes, it is an almost-unanimous view among experts that if lenders are unwilling to lend, then it is the duty of the government and the central bank to keep the flow of lending going.

For instance, if in the commercial-paper market lenders are not there, then the Fed should step in and replace these lenders. The important thing, it is held, is that various businesses that rely on the commercial-paper market to keep their daily operations going should be able to secure the necessary funding.

Will the increase in money pumping by central banks unfreeze credit markets? Experts believe that this will do the trick. If the current dosage of pumping won't work, then the central bank must continue to push more money until credit markets start moving again, so it is believed.

It is true that credit is the key for economic growth. However, one must make a distinction between good credit and bad credit. It is good credit that makes real economic growth possible and thus improves people's lives and well-being. False credit, however, is an agent of economic destruction and leads to economic impoverishment.

Good Credit versus Bad Credit

There are two kinds of credit: that which would be offered in a market economy with sound money and banking (good credit); and that which is made possible only through a system of central banking, artificially low interest rates, and fractional reserves (bad credit).

Banks cannot expand good credit as such. All that they can do in reality is to facilitate the transfer of a given pool of savings from savers (lenders) to borrowers. To understand why, we must first understand how good credit comes to be and the function it serves.

Consider the case of a baker who bakes ten loaves of bread. Out of his stock of real wealth (ten loaves of bread), the baker consumes two loaves and saves eight. He lends his eight remaining loaves to the shoemaker in return for a pair of shoes in one week's time. Note that credit here is the transfer of "real stuff," i.e., eight saved loaves of bread from the baker to the shoemaker in exchange for a future pair of shoes.

Also, observe that the amount of real savings determines the amount of available credit. If the baker had saved only four loaves of bread, the amount of credit would have only been four loaves instead of eight.

Note that the saved loaves of bread provide support to the shoemaker, i.e., they sustain him while he is busy making shoes. This means that credit, by sustaining the shoemaker, gives rise to the production of shoes and therefore to the formation of more real wealth. This is a path to real economic growth.

Money and Credit

The introduction of money does not alter the essence of what credit is. Instead of lending his eight loaves of bread to the shoemaker, the baker can now exchange his saved eight loaves of bread for eight dollars and then lend those dollars to the shoemaker. With eight dollars, the shoemaker can secure either eight loaves of bread (or other goods) to support him while he is engaged in the making of shoes. The baker is supplying the shoemaker with the facility to access the pool of real savings, which among other things includes eight loaves of bread that the baker has produced. Note that without real savings, the lending of money is an exercise in futility.

Observe that money fulfills the role of a medium of exchange. Hence, when the baker exchanges his eight loaves for eight dollars, he retains his real savings by means of the eight dollars. The money in his possession will enable him, when he deems it necessary, to reclaim his eight loaves of bread or to secure any other goods and services. There is one provision here: that the flow of production of goods continues; without the existence of goods, the money in the baker's possession will be useless.

The existence of banks does not alter the essence of credit. Instead of the baker lending his money directly to the shoemaker, the baker lends his money to the bank, which in turn lends it to the shoemaker.

In the process, the baker earns interest for his loan while the bank earns a commission for facilitating the transfer of money between the baker and the shoemaker. The benefit that the shoemaker receives is that he can now secure real resources in order to be able to engage in his making of shoes.

Despite the apparent complexity that the banking system introduces, the act of credit remains the transfer of saved real stuff from lender to borrower. Without the increase in the pool of real savings, banks cannot create more credit. At the heart of the expansion of good credit by the banking system is an expansion of real savings.

Now, when the baker lends his eight dollars, we must remember that he has exchanged for these dollars eight saved loaves of bread. In other words, he has exchanged something for eight dollars. So when a bank lends those eight dollars to the shoemaker, the bank lends fully "backed-up" dollars so to speak.

False Credit Is an Agent of Economic Destruction

Trouble emerges however if, instead of lending fully backed-up money, a bank engages in fractional-reserve banking, the issuing of empty money, backed up by nothing.

When unbacked money is created, it masquerades as genuine money that is supposedly supported by real stuff. In reality, however, nothing has been saved. So when such money is issued, it cannot help the shoemaker, since the pieces of empty paper cannot support him in producing shoes — what he needs instead is bread. But, since the printed money masquerades as proper money, it can be used to "steal" bread from some other activities and thereby weaken those activities.

This is what the diversion of real wealth by means of money "out of thin air" is all about. If the extra eight loaves of bread aren't produced and saved, it is not possible to have more shoes without hurting some other activities — activities that are much higher on the priority lists of consumers as far as life and well-being are concerned. This in turn also means that unbacked credit cannot be an agent of economic growth.

Rather than facilitating the transfer of savings across the economy to wealth-generating activities, when banks issue unbacked credit they are in fact setting in motion a weakening of the process of wealth formation. It has to be realized that banks cannot relentlessly pursue unbacked lending without the existence of the central bank, which, by means of monetary pumping, makes sure that the expansion of unbacked credit doesn't cause banks to bankrupt each other.

We can thus conclude that, as long as the increase in lending is fully backed up by real savings, it must be regarded as good news, since it promotes the formation of real wealth. False credit, which is generated "out of thin air," is bad news: credit which is unbacked by real savings is an agent of economic destruction.

Fed and Treasury Actions Only Make Things Worse

Neither the Fed nor the Treasury is a wealth generator: they cannot generate real savings. This in turn means that all the pumping that the Fed has been doing recently cannot increase lending unless the pool of real savings is expanding. On the contrary, the more money the Fed and other central banks are pushing, the more they are diluting the pool of real savings.

Yet most commentators are of the view that, given the present fragile state of the financial system, the central bank and the government must intervene to prevent the collapse. But how can the government and the central bank help in this regard? How can the central bank or the government generate more real savings?

The only thing that the government and the central bank can do is to redistribute the real savings from other people and give it to banks. Now, if the pool of real savings is still expanding this can "work" — and lending might flow again — but the overall pool of real savings will weaken as a result of the transfer of real savings from the nonbanking sector to the banking sector. If, however, the pool of real savings is falling, then it will not be possible to increase the flow of lending.

Why Doing Nothing Is the Best Policy to Revive the Economy

Given the growing likelihood that the pool of real savings is in serious trouble, does this mean that the flow of credit will remain frozen? What can be done to unfreeze the flow is to allow the interest rate to find its own level.

With a weakening real economy, lenders will be willing to lend only at the interest rate that allows for higher risk and for the fact that less real savings is available, all other things being equal. At a much higher interest rate, the so-called financial crisis and the shortage of credit will vanish.

The problem then is not with the credit market as such but with the fact that the central banks are pushing massive amounts of money and trying to force interest rates artificially lower. This of course makes it even less attractive for lenders to enter the credit market. Hence the shortage (i.e., the credit crunch) is the result of the central bank not allowing interest rates to reflect the levels that are in line with the facts of reality.

Why then are authorities resisting market forces and allowing the crunch to persist?

Because if interest rates were allowed to be higher, many bubble activities would become unprofitable, and would cease.

Most of those in a position to influence policy are of the view that this would lead to a serious economic slump and therefore should not be allowed. Supporting bubble activities with easy money further impoverishes wealth generators and delays the prospects of a meaningful economic recovery. The pumping by the Fed will distort the interest-rate structure further and worsen the credit crunch. The best policy is for the Fed to do nothing as soon as possible. By doing nothing, the Fed will enable wealth generators to accumulate real savings. The policy of doing nothing will force various activities that add too little or nothing to the pool of real savings to disappear. This will make make the generation of wealth much more rewarding.

As time goes by, the expanding pool of real savings will work towards the lowering of interest rates. This in turn will provide a base for the further expansion of various wealth-generating activities. Therefore, the sooner the Fed stops tampering, the sooner an economic recovery will emerge.

If the pool of real savings is still growing, then doing nothing (and allowing the interest rate to reflect reality) will allow the recession to be short lived and economic recovery to emerge as fast as possible. (At a higher interest rate, various bubble activities will go belly up. As a result, more real savings will become available to wealth generators. This in turn will work towards the lowering of interest rates.)

We suggest that decades of reckless monetary policies by the Fed have severely depleted the pool of real savings. More of these same loose policies cannot make the current situation better. On the contrary, such policies only further delay the economic recovery.

By impoverishing wealth generators, the current policies of the government and the Fed run the risk of converting a short recession into a prolonged and severe slump.


Contact Frank Shostak

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.