Bank Credit — Friend or Foe?
Advocates of sound money place much of the blame for inflation on bank credit. Do away with the creation of bank credit, they say, and the destructive cycle of boom and bust will be cured. But is this solution practical, and is it the real inflation problem?
It may be an inconvenient fact, but commodity prices prove to be far more volatile under a fiat currency regime than they ever where under sound money and fluctuations in bank credit.
Understanding bank credit possesses a new urgency, given that this cycle of its expansion appears to be ending and the fiat world is heading for a periodic credit contraction. This article details how bank credit is created, how it has evolved and its role in fostering economic progress. We look at the alternative of banks of deposit, their history, and their practicality as a replacement for banking as we know it today.
We must be clear that there is a difference between cycles of bank credit, which so long as they are moderate can be tolerated, and state-induced inflation of the currency, which can be expected to lead to a permanent loss of a fiat currency’s purchasing power. In this context, are proposals to do away with bank credit taking a sledgehammer to crack the wrong nut?
On this subject, the Keynesian and Austrian economists disagree fundamentally. The conclusion of this article is that bank credit is economically beneficial, but it is state intervention in one form or another which has made it not just a driving force for economic progress, but unnecessarily destructive as well.
Bank credit is central to our monetary system[i]
Understand that money is gold and nothing else. Everything else is credit. These words were spoken by John Pierpont Morgan in his testimony before Congress in 1912. This was not just his opinion; he was stating a legal fact. That some governments have banned private ownership of legal money and that all central banks now refuse to exchange their notes for gold does not change the legal position.
It is credit that interests us here. Officially, it comes in two forms. There are bank notes, today issued by central banks but formally issued by commercial banks. These notes are a liability of the issuer and appear on a central bank’s balance sheet as such. And there is bank credit, the liability of commercial banks in the form of customer deposits, checking, or current accounts. Unofficially, it also exists in shadow banking and further credit goes unrecorded between individuals.
Limited by their creditworthiness, credit among individuals is an important economic factor. A father might tell his son or daughter that he will fund him or her through university. That is credit. A local shop might offer an account for valued customers, allowing them to pay monthly or even quarterly, rather than as they spend. Wholesalers offer retailers the facility to pay for goods a month after delivery, or even more — that is credit. The examples in our daily life are numerous. These informal or non-banking arrangements are a large part of working society, greasing the wheels of personal and business relationships. All this goes unrecorded in the monetary statistics. Given the ubiquity of credit, would it be right to entirely ban banks, who formalise credit arrangements, from creating credit benefiting trade?
The whole economy revolves on credit. In accordance with Gresham’s law, people hoard gold coin and spend currency and deposits. Gold coin does not circulate, even under a gold standard, because people realise it is superior money to notes and deposit money. It is there as a backstop to credit — bank notes and deposit accounts.
So far, we can probably agree there is little contentious in these statements. When we take the subject further the disagreements arise. Gold should no longer be part of a modern monetary system, argue neo-Keynesians and most monetarists. Credit expansion is the source of our troubles, argue others, particularly the Austrians.
The Austrian tradition is exemplified by the writings of Ludwig von Mises and Friedrich von Hayek. Mises observed the effects of inflation in Europe after the First World War, and in particular his native Austria. He understood why the crown collapsed and knew the remedy. Since then, he wrote extensively about the business, or trade cycle, undoubtedly caused by a cycle of bank credit expansion and subsequent contraction. But in all his writings, collectively running to over 7,000 pages, he mentions “bank credit” surprisingly little. I have counted only nineteen references, some of which are in content summaries and footnotes.
His lecture to the Vienna Congress of the International Chamber of Commerce on May 1933 is typical, when he stated that “The cause of the exchange rate’s depreciation is always to be found in inflation, and the only remedy for fighting it is a restriction of fiduciary media and bank credit”. Mises is, of course, correct. But nowhere in his comments, so far as I can see, does he recommend a complete ban on bank credit — only its containment.
Hayek devised a triangle to illustrate to his students at the LSE the consequences of an artificial lowering of interest rates — the consequence of credit expansion. Again, it is logical for the followers of these great men to conclude that credit must be banned if the purchasing power of currency is to be preserved. But we must acknowledge that a wholesale currency collapse through continual and accelerating debasement, such as that which afflicted Austria in 1922, is an entirely different matter from a cycle of bank credit.
The purpose of this article is to see whether banning bank credit is practicable. The timing is propitious, since we appear to be on the verge of another bank induced slump, this time of such potential severity that it could threaten the future of banking itself. If bank credit expansion has an economic role that can be justified, then its replacement could end up being less beneficial, particularly if the state takes the initiative in establishing a different banking system. If it does, we can be sure it would be designed to serve the state more than the productive economy.
Is there a practical alternative to bank credit creation?
Neo-Austrians put forward a simple proposition. That is, they recommend the ending of bank credit with banking being split into banks of deposit, where banks act either as custodians, the deposits remaining the property of the depositors, or as arrangers of finance to distribute savings to businesses in need of investment capital — never both. The world of circulating media becomes free of bank credit and from all the problems that it has created.
Before we tackle the subject proper, we should ask whether this is the nut we need to crack. Cycles of expansion and contraction of bank credit have existed for as long as we have statistical evidence, and yet we are still here and have a better standard of living than our forebears. But Figure 1 shows the consequences for the purchasing power of the pound under a sound money standard — the gold sovereign in the United Kingdom, where the circulating media has been dominated by bank credit.
With a time-lag, the price effect of changes in bank credit under a gold coin standard led to significant fluctuations in the general price level, the consequence of the expansion and subsequent contraction of bank credit — credit-driven booms and busts. The length of time whereby bankers seem to forget the consequences of excessive credit expansion for their own operations is roughly ten years, a periodicity which still holds today.
In the nineteenth century, government economic policy was broadly to mind its own business and to let events take their course. Interestingly, these fluctuations diminished over the century, during which time the underlying trend of bank credit outstanding expanded significantly on the back of collective wealth, trade, and technological progress. Clearly, growing financial sophistication of credit markets was having a beneficial effect, particularly following the Bank Charter Act of 1844 which in its framing omitted to recognise the potential of bank credit to destabilise the gold-backed currency.
Therefore, a question is raised as to whether fluctuations in bank credit are the evil neo-Austrians believe? Could it be that the greater evil is central banking endeavours to intervene: attempts that turned into efforts to manage demand for bank credit though interest rate policies from the late 1920s onwards? If so, then the neo-Austrians’ preferred solution whereby no bank credit is created is not so urgent a remedy. But this has still led many of them to recommend banks of deposit as a replacement for banks dealing in credit.
The problem with banks of deposit
The practicality of banning bank credit is rarely considered. In the form of both notes and deposit liabilities it is 100% of our circulating medium, and notes issued by the Bank of England represent less than 3% of the total, the rest being funded by bank credit. In the US, Federal Reserve notes represent 10% of the total, with significant quantities of them circulating outside the US. Therefore, a move to deposit banking with banks acting as custodians would eliminate nearly all our circulating media. That would mean a collapse in GDP, which is not “the economy” as erroneously supposed, but the total of qualifying transactions recorded in credit. No credit, no transactions.
In the past, banks have been constructed on the deposit principal in Venice, Amsterdam, and Nuremberg, among others. Small in themselves, these places were the centres of foreign commerce and large quantities of foreign coin of all sorts and denominations circulated, mostly worn and clipped. In order to remedy the inconvenience presented, the authorities in these cities instituted banks of deposit into which merchants paid coin from everywhere. Merchants’ accounts were credited with the proceeds of the bullion valued by weight deposited, and depositors were entitled to withdraw new coin on demand.
These banks professed to keep all the coin and bullion deposited with them in their vaults but converted into standard coin. The merchants with accounts at these banks had to pay the costs involved. One convenience was replaced by another inconvenience. And despite the sanctity of their non-profit mission, the banks of deposit in Venice and Amsterdam eventually advanced large sums to their respective governments which led to their ruin.
The lessons from the past are clear. Banks of deposit performed a specific function which is not required today. Nowadays, maintaining metallic coinage is a function of the mint which can be stored in safe deposit boxes. We do not have clipped coinage. And even if a gold coin standard was to be reintroduced, coins would rarely circulate anyway. The loss of credit interest and the administrative costs borne by the depositors would make banks of deposit an unattractive proposition.
Banks of deposit are not banks in the true meaning of the word. They are trustees or custodians. And in the absence of bank credit, presumably they would be vaulting bank notes and to a lesser extent coin. Bank notes are central bank credit, whether
Article from LewRockwell
