By Dr Frank Shostak
By popular thinking banks are always ready to abide to increases in the demand for credit. Now, it is generally held that bank credit is a major driver of economic growth. Hence, it would appear that by abiding to increases in the demand for credit banks could strengthen the process of wealth generation. What do we mean by credit? To provide an answer to this it is necessary to ascertain the essence that drives credit.
We suggest that the heart of credit is real savings. It is the increase in real savings that determines the credit growth and not the increase in the demand for credit. Here is why.
Take a farmer Joe that produced 2kg of potatoes. For his own consumption, he requires 1kg, and the rest he decides to lend for one year to a farmer Bob. The unconsumed 1kg of potatoes that Joe has agreed to lend is his savings. Note, that the saved 1kg of potatoes provides 100 percent backup to the Joe’s loan to Bob. Joe’s savings is real – it is 1kg of potatoes.
By lending 1kg of potatoes to Bob, Joe agrees to give up for one year the ownership over these potatoes. In return, Bob provides Joe with a promise that after one year he will repay 1.1kg of potatoes. The 0.1kg constitutes an interest. What we have here is an exchange of 1kg of present potatoes for 1.1kg of potatoes in a one-year time.
The introduction of money does not alter the essence of what credit is all about. Instead of lending 1kg of potatoes Joe will first exchange the potatoes for money, let us say for $10.
Joe then lends the $10 to Bob for one year at the going interest rate of 10 percent. Observe that the introduction of money did not change the fact that real savings i.e., 1kg of potatoes precede the act of lending.
Note that money being the medium of exchange also fulfills the role of the medium of savings. By means of money, individuals’ channel real savings i.e., unconsumed consumer goods to other individuals’, which in turn permits the widening of the process of wealth generation. Thus, with the borrowed money Bob can exchange it for various consumer goods that will sustain him whilst he is busy doing other things.
According to Ayn Rand in “Egalitarianism and Inflation” 1974 A Signet Book p 131-132,
……. When a rich man lends money to others, what he lends to them is the goods which he has not consumed………..Credit means unconsumed goods, loaned by one productive person (or group) to another, to be repaid out of future production.
Banks as intermediary
Now instead of Joe lending directly his $10 to Bob, he can do it through a bank. The bank here fulfills the role of an intermediary. The bank also fulfills another service by providing the money storage facility.
Observe that individuals could exercise their demand for money by either holding the money with themselves or by placing the money in the bank storage known as demand deposits.
For instance, a farmer Joe sells his saved 1kg of potatoes for $10. He then deposits the $10 with the Bank A. Note that the $10 are fully backed by the saved 1kg of potatoes.
Now Joe decides to lend part of his deposited money – let us say $5 – to Bob via the mediation of the Bank A. As a result, the $5 are transferred to Bob’s demand deposit from the Joe’s demand deposit. By means of the loan of $5 Joe makes it possible for Bob to acquire various consumer goods. This provides the means of sustenance to Bob whilst he is busy for instance, maintaining his infrastructure.
The essence of unbacked by real savings credit
Whenever the bank abides by the increase in the demand for credit without an increase in real savings this leads to troubles ahead. For instance, the farmer Bob has approached the Bank A for a loan to the tune of $5. The Bank A abides by this request, whilst there wasn’t an increase in real savings, and places the $5 into the Bob’s demand deposit.
Once Bob the borrower of the $5 uses the borrowed money, he engages in an exchange of nothing for something. The reason being because the $5 is not backed by any real savings – it is an empty money.
Note again, that the loan to Bob resulted in the increase in the money supply by $5. Observe, that when loaned money is fully backed by real savings it is instrumental in the channeling of real savings thereby strengthening the wealth generation process. (It is instrumental in the exchange of something for something).
However, when nothing is backing up the loaned money it becomes instrumental in the channeling of illusion thereby weakening the wealth generation process. (It is instrumental in the exchange of nothing for something).
Observe that when the loaned money is fully backed by real savings, 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 day the borrowed sum plus interest to the bank.
The bank in turn will pass to Joe the lender the $5 plus interest adjusted for bank fees. Note that the bank here is just a mediator; it is not a lender so the borrowed money is returned to the original lender, which is in our case Joe.
In contrast, when lending is not backed by real savings and is returned on the maturity day to the bank, this leads to the withdrawal of money from the economy i.e., to the decline in the money stock. The reason being because in this case we never had a saver/lender, since we have here an unbacked by real savings credit. Again, when the bank generates new deposit for $5 whilst real
savings do not back up this deposit – we do not have here any original lender/saver to whom the $5 must be returned. Hence, the money will decline by $5 once it is repaid to the bank.
Unbacked by real savings credit sets platform for non-productive activities
Note again that the extra $5 of the new money sets in motion an exchange of nothing for something. This provides the platform for various non-productive activities that prior to the generation of unbacked by real savings lending would not have emerged, all other things being equal. As long as the banks continue to expand unbacked by real savings lending, various non-productive activities continue to expand. Once however, the continuous generation of unbacked lending lifts the pace of wealth consumption above the pace of wealth production, the positive flow of real savings is arrested and a decline in the pool of real savings 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 lending activities and this in turn sets a decline in the money stock. Remember the money stock starts to decline once the unbacked by real savings loans are repaid to the bank. The decline in the money stock begins to undermine various non-productive activities i.e., an economic recession emerges.
We hold that a proper free market – without the central bank and in the framework of the gold standard – will minimize banks’ lending unbacked by real savings. To avoid bankruptcy in the clearing of their checks, lending by banks that is not backed by real savings will likely vanish. In the free market banks most likely will only fulfill the role of intermediary. In a proper free market, no one would have to worry whether banks lending is fully backed by real savings or not. The free market will prevent the emergence of unbacked by real savings lending.
Summary and conclusion
We suggest that real savings is the heart of lending. The role of banks is to mediate between lenders and borrowers. Another important role that banks fulfill is to provide the money storage facility known as demand deposits. Trouble however emerges once banks are starting to engage in lending unbacked by real savings to accommodate the increase in the demand for credit. This in turn sets in motion the boom-bust cycle.
