So then, central banks stimulating the economy with cheap credit via ultra-low interest rates must necessarily be a bad thing for the economy?
If you keep this explanation in mind, it becomes very clear why, by contrast with the above process of healthy capital accumulation, when investments are financed not by prior genuine savings but by a process of artificial credit expansion, orchestrated by fractional-reserve banks and directed by the lender of last resort, or central bank, things go very wrong indeed.
Unilateral credit expansion pushed along by the central bank means that new loans are provided by banks and recorded on the asset side of their balance sheets, against new demand deposits that are created out of thin air as collateral for the new loans, and these new deposits are automatically recorded on the liability side of banks’ balance sheets. So new money—or I should say new “virtual money” because it only “materializes” in bank accounting book entries—is constantly created through this process of artificial credit expansion. In fact, only around 10% of the money supply of most important economies is in the form of cash (paper bills and coins), while the remaining 90% is this virtual money that only exists as written entries in banks’ accounting books. This is precisely what the Spanish scholars termed, more than 400 years ago, chirographis pecuniarum, or “virtual” money that exists only in writing in an accounting book.
It is easy to understand why credit expansions are so tempting and popular and the way in which they entirely corrupt the behavior of economic agents and deeply demoralize society at all levels. To begin with, entrepreneurs are usually very happy with expansions of credit, because they make it seem as if any investment project, no matter how crazy it would appear in other situations, can easily get financing at very low interest rates. The money created through credit expansions is used by entrepreneurs to demand factors of production, which they employ mainly in capital goods industries that are more distant from consumption. As the process has not been triggered by an increase in savings (with the consequent fall in demand for consumer goods), no productive resources are liberated from consumer industries, and the prices of commodities, factors of production, capital goods, and the securities that represent them in stock markets tend to grow substantially.
What you then have is the creation of a market bubble. Everyone is happy, especially because it looks as if wealth can be increased easily, with no prior sacrifice in the form of savings (deferred consumption) and honest, hard, individual work. Near the high point of the bubble, society seems to have moved into the so-called “virtuous circle of the new economy,” in which recessions seem to have been avoided forever. Investors are very happy looking at stock market quotes that grow day after day; consumer goods industries are able to sell everything they bring to the market at ever increasing prices; restaurants are always full, with long waiting lists just to get a table; workers and their unions see how desperately entrepreneurs demand their services in an environment of full employment, wage increases, and immigration; political leaders benefit from what appears to be an exceptionally good economic and social climate, which they invariably sell to the electorate as the direct result of their leadership and good economic policies; state budget bureaucrats are astonished to find that every year public income increases at double-digit figures, particularly the proceeds from value-added tax; and the whole show is artificially financed by credit expansion!
So, how long can this party last? How long can there continue to be a huge disconnect between the behavior of consumers, who do not wish to increase their savings, and that of investors—mainly financial institutions, which continuously increase their investments financed by the artificial creation of virtual money and not by citizens’ prior genuine savings? How long can this illusion that everybody can get whatever he or she wants without any sacrifice last?
In fact, not that long. The unhampered market is a very dynamically efficient process. Sooner or later it inevitably discovers (and tries to correct) the huge errors that have been committed. There is always a set of spontaneous microeconomic reactions that occur to halt and reverse the negative effects of the bubble years.
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- Previous section Fractional-reserve banking is the normal state of affairs. Even the new regulatory regime that is now being worked out stops far short of demanding 100% reserves. How then does this impact the economy negatively?
- Next section What are these microeconomic reactions that lead to the bursting of the cheap credit bubble?
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