Economic growth and the credit myth
Gerard Jackson
The free credit myth is one of the oldest and certainly one of the most enduring of economic fallacies. The essence of the fallacy is quite simple: interest is a monetary phenomenon, that is, it is determined by the supply of and demand for money. Therefore interest can be virtually if not entirely eliminated by a continuous increase in the supply of money. Once interest has been eliminated society will enjoy an abundance of capital. It should now be clear that this view also sees the scarcity of capital as being artificially created in order to earn interest.
But who is responsible for this scarcity and the existence of interest? The answer, according to the monetary cranks, is that the banks have been given a monopoly of credit. Well, like every monopoly, it is claimed the banking system acts to restrict the supply of their product (credit) so as to artificially raise its price (interest) to consumers and businesses. The solution is abundantly clear (except to dreaded economic rationalists like myself, i.e., free marketeers) and that is for the government to use the central bank to bypass the monopoly banks and make credit freely available to governments or to others at very low rates or even free of any charge.
This myth springs in part from the fact that monetary cranks realise that technically banks are able to reduce the amount of interest on any credit they grant right down to their working expenses. From this they deduce that interest has been created by the monopoly position of the banks, otherwise the ‘price of credit’ would have been bid down to its working costs. These cranks have also observed that increases in the quantity of credit have the initial effect of lowering short term rates. This fact only confirms their belief that interest is a monetary phenomenon and can be easily eliminated by monetary means. Professor von Mises (a leading Austrian economist) rightly described this view as one “of unsurpassable naivety”. Yet it is one that Keynes preached. (Paper of the British Experts, 8 April 1943).
It should be obvious that according to this doctrine interest should not exist at all. Yet, if interest did not exist land could never be bought because the value of land would be equal to the entire sum of all of its future earnings. Only the existence of interest makes it possible to buy and sell land by discounting the sum of its future earnings. Interest is not and never has been the price of money — if anything, it is the price of time, a ratio of the value of present goods to future goods. It is “a category of human action”. It also determines the supply of and demand for capital goods. Not only do monetary cranks not understand this, so do a number of people who are paid to know better.
Monetary cranks are forever confusing credit with capital. Because they believe abundant credit would eliminate interest they then assume an equally abundant supply of capital would appear. But credit is not capital. As Professor von Lachman and so many others put it: “Capital is the material means of production. Capital comes from savings and savings are forgone consumption. ‘Gratuitous’ increases in credit are therefore not additions to savings.
When credit expansion gets under way the rate of interest is artificially lowered and that expands the demand for more credit. The situation then arises where investment exceeds savings: but this only means that we are suffering from inflation. The newly created credit did nothing to increase real savings. Eventually, in accordance with the social rate of time preference (society’s savings/consumption ratio), the additional spending created by the credit expansion will be spent by factors on consumption goods.
Increased consumer spending will then bid against the higher stages of production for resources; these stages will then find themselves caught in a price-cost squeeze. With prices rising, foreign exchange problems worsening, the current account deteriorating and stocks booming the central bank then feels impelled to impose a credit squeeze that eventually brings the boom to an end. It is sometimes argued, however, that so-called bubbles deflate once prices exceed what some call a “rational assessment of value”. This view overlooks the fact that bubbles are always preceded by ‘cheap’ credit. Moreover, there are basically only two ways to end a bubble: apply the monetary brakes or allow the boom to follow its course until hyperinflation destroys the currency, as was the case in Weimar Germany.
It is true, of course, that an asset boom could be terminated by expectations of a credit squeeze. It is equally true that a severe run on the banks would initiate a recession. But ‘expectations’ and ‘runs’ only strengthen the analysis that booms are generated by loose monetary policies. Another objection is that booms could not arise in a country whose banks are based on the giro system, as was the case in seventeenth century Holland when tulip mania broke out. Once a again an important point has been overlooked, which is that banks can have both demand deposits and giro accounts. Therefore giro banking and fractional reserve banking are not mutually exclusive.
The monetary cranks’ views can be easily summed up as:
1. Capital is abundant but is kept artificially scarce by interest.
2. Interest is created by monopoly banks to exploit the community.
3. Interest is a purely monetary phenomenon that can be eliminated by monetary expansion.
4. There really is a Santa Clause.
At least monetary cranks can be excused as economic illiterates but what are we to make of the great majority of economists who believe that central banks can promote economic growth by manipulating interest rates and the money supply? The difference between them and the monetary cranks is one of degree and not substance. After all, says the monetary crank, if the central bank can force down interest rates to stimulate the economy why can’t it eliminate interest altogether?
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 23 October 2006