Wednesday, October 7, 2009

The Dangers and Advantages of Credit Creation

Excellent article by Peter Warburton over at Gold Eagle,, that, although written in 2001, deals with many issues we are facing today. The central problem he addresses, especially as he came from a monetarist perspective, is the lack of connection between money expansion and inflation, the very issue at the center of the inflation/deflation debate today.

Warburton accounts for this puzzling phenomenon as due to the role of credit. The rise of the credit-based economy has radically changed the economic landscale since the 1980s. As he puts it, "On the one hand, it has enabled the monetary aggregates to grow much more slowly than the credit aggregates, helping to keep inflation lower. On the other hand, the non-bank credit avalanche has enabled a furious pace of fixed investment in physical assets that has promoted structural global excess capacity in virtually all manufactured products and exerted downward pressure on product prices."

In other words, credit is inherently non-inflationary, and it allows economic activity to the point of overproduction and oversupply, which is actually disinflationary.

Even though he was writting in 2001, Wharburton exactly describes the conditions of 2009, noting that monetary expansions are mainly caused by banking stress, as the troubled banks hoard the cash: "The more obvious are the system’s weaknesses, the greater is the fear of collapse and the larger the demand for liquidity within the financial markets. In these stressful episodes, it is the financial markets themselves that are the principal driving force behind the monetary expansion. Hence, there is relatively little monetary impact on the product and labour markets, that is, on prices and wages."

Thus, we have massive expansion of the monetary base without inflation, because the banks are just sitting on the money.

Wharburton posits that inflation due to monetary expansion is not to be found on the consumer price level, because it affects other sectors, especially in the value of the currency itself. The real price paid for over-expansion of credit is overproduction and malinvestment. The final outcome is debt deflation: "In the limit, the construction of excess capacity gives rise to debt default, as the idle portion of capacity does not earn an income and cannot service the debt that financed its construction." The result: "central banks preside over the creation of additional liquidity for the financial system in order to hold back the tide of debt defaults that would otherwise occur." Again, we witnessed this precisely as described.

The real cost of this credit destruction is paid by the currency: "The latent losses in the credit system, emanating from non-performing loans and defaulting bonds, represent a charge against the value of the currency, as surely as if the edges of the notes and coins had been trimmed away. " The main obstacle to realizing it, is that the debasement of any one currency is kept hidden by the fact that all national paper currencies are being debased in the same fashion.

Jubilee Analysis:

Credit creation is a form of resource allocation, functionally equivalent to money. In other words, a credit line allows you to purchase real labor and resources, in direct competition with cash purchasers. Thus, credit creation can drive up prices just like cash creation can. The advantage of credit creation over cash creation is the avoidance of hyper-inflationary effects, as credit is created and extinguished. The downside is the tendency towards malinvestment and debt-deflation when credit levels become too high.

This is THE fundamental issue flying right over the heads of the Hard Money types. The majority of money is not centrally issued. Sure, our currency is issued by the feds, but most money is functionally created by banks in the form of credit. The only way to eliminate the issuance of credit money by banks is to eliminate the system of fractional reserve banking.

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