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. Shortage of Savings Lack of Nominal Demand
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.
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.
Shortage of Savings
Lack of Nominal Demand
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.
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.
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.