Wednesday, May 07, 2014

Turner Turns (8) Flawed Arguments for Credit Creation

Most economists assume that private credit creation by banks is the best way to ensure sufficient aggregate demand. Several reasons have been put forward to justify the need for credit creation. They are flawed but we need to understand them.

  1. Shortage of Savings
    One possible reason for credit creation might be a shortage of saving constraining capital investment. If people do not save enough, then economic growth could be slowed. Lack of savings is a seriously problem in many economies, but credit creation is not a solution.

    At the level of real activity, investment must be matched by savings. When an economy produces capital goods, there has to be forgone consumption as less consumer goods are being produced. If Robin Crusoe devotes time to making a net, he will have less time for fishing. He will have to consume less for a while, so he can build up a supply of fish to eat while he spends time making the net.

    In a complex economy, decisions about investment and saving are made by different people, so intentions about saving and investment could get out of line. Business might produce more capital goods than savers are willing to fund. If that happens, there will be a surplus of investment goods and a shortage of consumption goods.

    Creating credit might seem like a solution, but it is not. It actually makes the situation worse, because central banks adjust interest rates to encourage the banks to create credit. When the central bank controls interest rates, the price information that savers and entrepreneurs need to make good decision are distorted. It is better to let the interest rate adjust naturally until savings and investment comes into line. Quick money schemes have an appeal, but there is no escape from the need for saving.

  2. Lack of Nominal Demand
    The most common argument in favour of credit creation is that nominal demand is sometime insufficient to produce economic growth. Central banks believe they can increase growth by increasing the supply of money. This argument is flawed, because the demand does not cause production of goods and services. Rather production creates demand for the goods and services. This is summarised by Says Law, which says that supply of goods and services creates it own demand. In a barter economy, if I have produce something for exchange, that creates a demand for something that someone else has produced.

    In a complex economy, the wages and salaries and profits earned through the production process create the demand for the goods and services produced.

    Say claimed that production is the source of demand. One’s ability to demand goods and services from others derives from the income produced by one’s own acts of production. Wealth is created by production not by consumption. My ability to demand food, clothing, and shelter derives from the productivity of my labor or my nonlabor assets. The higher or lower that productivity is, the higher or lower is my power to demand other goods and services (Says Law).
    What can happen is that entrepreneurs make the wrong types of goods and services. They might produce to many cabbages when people are wanting more pumpkins. These problems are easily solved. Prices will adjust and businesses will adjust their production to clear the market. Credit creations just exacerbates the problem by making it seem as if there is demand for the things that people did not really want. This rewards the entrepreneurs who made bad decisions, which is like to make the situation worse in the future.

  3. Short Term Liquidity
    A common argument for allowing banks to engage in credit creation that liquidity is needed for markets to function.

    You cannot buy what I have produced, until you have sold what you have produced. However, Jack cannot buy what you have produced until I buy what he has to sell. Trade appears to be stymied.

    This is an old problem, but people have always found a problem to solve it buy offering credit to each other. All it takes to get trade moving is for someone to say to someone they trust, you can pay me when you have sold what you have produced. People do this all the time. Societies have found various ways to make sure trade take place, without the need for banks to create credit.

  4. Seasonal Finance.
    A common argument for increased money supply is that it is needed to finance seasonal production. This is an illusion. If I sow wheat in the ground, I will not reap a harvest until six months later. If I do not have any spare grain, then I have to get some grain from another person to avoid starving. That grain will not be available for someone else to consume. This shows that season activities, where production take a long time to be complete, has to be supported by real saving. Creating credit to for seasonal finance will distort supply and demand.

Not Needed
The accepted wisdom that credit creation is needed to foster economic growth is flawed. Credit creation, whether by banks or governments, is theft. It allows the people who get the created credit to buy something that really belongs to someone else. While economists are stuck with the idea that growth in nominal demand must be funded by credit creation, they will continue to create problems for their economy. The GFC is the most recent example.

1 comment:

theyenguy said...

One Of The Big Idea of the Last 50 Years was the contribution of Milton Friedman who proposed the Free To Choose Floating Currency Regime. President Nixon took the US off the Gold Standard, and the US became the International Reserve Currency, which enabled the US to rise to become the global hegemonic kick ass empire, beginning with the Vietnam War, replacing the former hegemon, that being the British Empire.

Another Big Idea were the schemes of Global ZIRP, which began when in 2008, when the US Fed traded out “money good” US Treasuries for Distressed Investments of all types, such as those traded in Fidelity Investments FAGIX Mutual Fund, and which provided the basis for global growth, and more importantly, to generate investment, in what would become the Summer Bloom and Fall Glory of the age of credit, that was underwritten by the Milton Friedman Free To Choose Architecture.

Now deleveraging and derisking out of World Stocks, VT, will stimulate Major World Currencies, DBV, and Emerging Market Currencies, CEW, to trade lower, beginning Kondratieff Winter where regional currencies, and non-dollar bartering, that is undollar currency regimes, will govern economic relations. A Ten Toed Kingdom of regional government of iron diktat and clay totalitarian collectivism, seen in Daniel’s Statue of Empires of Daniel 2:25-45, will soon replace the former two world empires. Debt deflation will stimulate Aggregate Credit, AGG, to trade lower, in a see-saw destruction of Equity Investments together with Credit Investments.

Trust in the US Fed’s purchases of 30 Year US Government Bonds, EDV, Ten Year Notes, TLT, and Mortgage Backed Bonds, MBB, has increased the supply of money needed to provide investment liquidity and produce economic growth. Peak Wealth has been achieved; it came via an awesome moral hazard based prosperity. Now, the investor’s risk appetite has turned to risk aversion, as investors fear that the Fed’s monetary policies have crossed the rubicon on sound monetary policy, and have made money good investments bad.

It’s Global ZIRP no more. The bond vigilantes are in control of interest rates globally, and will be calling the Interest Rate on the US Ten Year Note, $TNX, higher from 2.6%, as well as steepening the 10 30 US Sovereign Debt Yield Curve, $TNX:$TYX, seen in the Steepner ETF, STPP, steepening.
The world has attained peak wealth. Successful investing in the Pursuit of Yield Investments, such as PHO, GRID, PSP, IST, DBU, DRW, PGF, PUI, and the High Yielding Debt Investments, such as JNK, and HYMB is history