It is generally held that bank credit is a major driver of economic growth. Hence, it would appear that, through an increase in the supply of credit, banks could strengthen the process of wealth generation. Without previous private savings, however, banks cannot simply extend credit. On the other hand, banks can expand credit out of “thin air” via inflation. This type of credit damages the wealth-generating process.
Take a farmer, Joe, who produced 2kg of potatoes. For his own consumption, he requires 1kg, and the rest he agrees to lend for one year to a farmer named Bob. The unconsumed 1kg of potatoes that he agrees to lend comes from his savings. By means of lending his savings to Bob, the lender supplies the means of sustenance to Bob the borrower. This makes it possible for Bob to engage in a wealth-generating activity.
The introduction of money—the medium of the exchange—does not alter the fact that savings are the precondition for lending. Instead of lending directly the 1kg of potatoes, Joe can first exchange these potatoes for money, let us say for $10. He then lends the $10 to Bob for one year at the going interest rate of 10 percent. The introduction of money did not change the fact that savings precede the act of lending.
The Introducing of Banking
Rather than attempting to find potential borrowers, Joe could approach an organization that specializes in finding borrowers—the bank. In addition to fulfilling the role of intermediary, the bank also provides a facility for storing money in demand deposits. Note that, in a sense, the Joe’s saved production of 1kg of potatoes is stored in the form of the $10 in demand deposit.
If the owner of the demand deposit were to decide to lend part of the stored money, then he is likely to inform the bank in this regard by transferring a part of the money stored in the demand deposit to a term deposit. What effectively is transferred here is a part of the saved quantity of production that was stored in the form of money in the demand deposit.
Lending, Unbacked Savings, & Economic Impoverishment
If Joe were to decide to lend $5 for one year, there would be a transfer of $5 from Joe’s demand deposit to a one-year term deposit. The money in the one-year term deposit can be lent out for one year. (The one-year term deposit of $5 backs the one-year loan of $5 here).
Now, consider a case when an individual, Bob, approaches Bank A for a loan of $5 for one year. Bank A accommodates this request and lends Bob the $5. The bank places the money in the newly-established demand deposit that Bob can now use. Also, note that we did not have the transfer of $5 from the holders of demand deposits such as Joe to the one-year term deposit. As a result, the loan to Bob is unbacked by savings. Bank A has artificially generated the $5 loan out of thin air. The bank has established a demand deposit to the tune of $5 without the backing of savings.
Once Bob, the borrower of the $5, employs the new money, he engages in an exchange of nothing for something. In an unhampered market economy, a bank runs the risk of bankruptcy with such activity. The bank does not have enough money to clear its checks if all the holders of demand deposits were to decide to withdraw their money.
Consequently, in an unhampered market economy, without the central bank, banks are incentivized to minimize inflation and credit expansion in order to prevent bank runs and bankruptcy. The likelihood of bankruptcy increases when there are many competitive banks. As the number of banks increases, and the number of clients per bank declines, the chances that clients will spend money on goods from individuals that are banking with other banks will increase. This, in turn, increases the risk of a bank being unable to clear its checks once the bank begins the practice of artificial credit expansion.
Conversely, as the number of banks declines, and as the number of clients per bank rises, the likelihood of bankruptcy diminishes. In the extreme case of only one bank, it can practice inflationary lending without any fear of bankruptcy. The act of inflationary lending and credit expansion will become a permanent occurrence in the framework of the central bank. The central bank—by means of the daily money supply management (i.e., inflation)—prevents banks from bankrupting each other. According to Rothbard,
. . .the Central Bank can see to it that all banks in the country can inflate harmoniously and uniformly together. . . . In short, the Central Bank functions as a government cartelizing device to coordinate the banks so that they can evade the restrictions of free markets and free banking and inflate uniformly together.
A Platform for Non-Productive Production
When loaned money is fully backed by savings, then, on the day of the loan’s maturity, it is returned to the original lender. Bob—the borrower of $5—will pay back on the maturity date the borrowed sum and interest to the bank. The bank will pass to Joe, the lender, his $5 plus interest, adjusted for bank fees.
In contrast, when lending originates via inflation and credit expansion and is returned on the maturity date to the bank, this leads to a withdrawal of money from the economy (i.e., to the decline in the money supply). When Bob repays the $5, the money leaves the economy since there is no original lender to whom the loaned money should be returned—the bank has generated the $5 loan out of thin air.
Observe that the $5 loan inflated out of thin air is a catalyst for an exchange of nothing for something. This provides the platform for various non-productive activities that, prior to the artificial credit expansion, would not have emerged. As long as banks continue this process, various non-productive activities continue to flourish. However, the pace of wealth consumption will also increase above the pace of wealth production.
All other things being equal, the positive flow of savings is arrested and a decline in the pool of the subsistence fund is set in motion. Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to increase. In response to this, banks curtail their inflationary lending and this triggers a decline in the money supply. A decline in the money supply begins to undermine various non-productive activities (i.e., an economic recession emerges).
According to a popular view championed by the head of the monetarists, Milton Friedman, a severe economic slump, also known as economic depression, emerges because of a large decline in the money supply. Therefore, it is the duty of the central bank to pump in a massive amount of money to prevent an economic depression.
However, an economic depression is not caused by the decline in the money supply as such, but comes in response to the declining pool of the subsistence fund because of the previous easy monetary policies. Consequently, even if the central bank were to be successful in preventing the decline in the money supply, this cannot prevent the economic slump.
Issuing loans that are unbacked by savings distorts time preferences and the structure of production. In a free market without the central bank, banks are likely to minimize such activity or it would be regarded as fraudulent.
Conclusion
Banks facilitate the flow of production and savings by introducing the “suppliers” of savings to the “demanders” for loans. In this sense, by fulfilling the role of the intermediary, banks are an important factor in the process of wealth formation. However, once banks start to lend money that is unbacked by private savings, this sets in motion the menace of the boom-bust cycle and an economic impoverishment.
