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The Importance of Real Lending

How banks' lending activities can lead to economic depression...

BANKS are an important factor in the process of real wealth formation, performing the role of an intermediary, writes Dr. Frank Shostak for the Cobden Centre.

Banks facilitate the flow of real funding by introducing 'suppliers' of real funding to 'demanders'. When a saver lends money, what he in fact lends to borrowers is final consumer goods he has not consumed. Credit then means that unconsumed goods are loaned by one productive individual to another, to be repaid out of future production.

For instance, a farmer Joe produced 2kg of seeds. 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 seeds that he agrees to lend is his savings. In short, the precondition of lending is that there must be savings first. This means that lending must be fully backed up by savings.

By lending 1kg of seeds to Bob, Joe agrees to give up for one year the ownership of this quantity of seeds. In return, Bob provides Joe with a written promise that after one year he will repay 1.1kg of seeds. The 0.1kg constitutes an interest.

What we have here is an exchange of 1kg of present seeds for 1.1kg of seeds in a one year's time. Is there anything wrong with this type of transaction? Not at all, both Joe and Bob have entered into this transaction voluntarily because they both have reached the conclusion that it would serve their objectives.

The introduction of money will not alter the essence of what lending is all about. Instead of lending 1kg of seeds Joe will first sell his 1kg of seeds for money, let us say for $100. Joe may now decide to lend his money to another farmer John for one year at the going interest rate of 10%. John the farmer in turn buys a piece of equipment, which lifts his production to 200 seeds in one year's time. Observe that the introduction of money didn't change the fact that real savings precede the act of lending.

Now, when credit is fully backed up by saving and in turn is employed in the production of real wealth, then everything is ok. However, when real savings do not back up credit then it means that no real savings have been exchanged in this mirage transaction. 

The borrower that holds the empty money, so to speak, exchanges them for goods and services. In short, what emerges is an exchange of nothing for something, or consumption of goods that is not backed up by a corresponding production. This leads to the diversion of real wealth from wealth-generating activities towards the holders of credit, which was generated out of "thin air".

Obviously such types of credit lead to the depletion, i.e. consumption, of real savings, which undermines the production of real wealth – what we then have here is an increase in money debt and a money supply and the weakening in the real wealth generation process. Needless to say, the weakening of the production of real wealth diminishes the borrowers' ability to repay their debts.

How is it possible that lenders can generate credit out "of thin air"? As we have already seen, ordinary lenders cannot lend something that they do not have. However, things are different once we introduce the central bank and fractional reserve banking into our analysis.

The existence of the central bank and the system of fractional reserve banking permits commercial banks to generate credit which is not backed up by real funding, i.e. the production of credit out of "thin air." 

For instance, a farmer Joe sells his saved 1kg of seeds for $100. He then deposits this $100 with the Bank A. Note that the $100 is fully backed up by the saved 1kg of seeds. Also, observe that Joe is exercising his demand for money by holding them in the demand deposits of bank A. Joe could have also exercised his demand for money by holding the money at home in a jar, or under his mattress.

Whenever a bank takes a portion of Joe's deposited money and lends it out it sets in motion serious trouble. Let us say that bank A lends $50 to Bob by taking $50 out of Joe's deposit. Remember that Joe still exercises his demand for $100. No additional real savings back up these $50. Once Bob uses the money he in fact engages in an exchange of nothing for something. This amounts to non-productive consumption of real wealth. What we have here is $150 that only backed by $100. (Remember, that $100 is fully backed up by 1kg of seeds – real savings).

Now, when loaned money is fully backed up by savings, on the day of the loan's maturity it is returned to the original lender. Thus, Bob – the borrower of $100 – will pay back on the maturity date the borrowed sum plus interest. The bank in turn will pass to Joe the lender his $100 plus interest adjusted for bank fees. To put it briefly, the money makes a full circle and goes back to the original lender.

In contrast, when credit is created out of "thin air" and returned to the bank on the maturity day this amounts to a withdrawal of money from the economy, i.e a decline in the money stock. The reason for this being that there wasn't any original saver/lender because this type of credit was created out of "thin air".

As long as banks continue to expand credit out of "thin air" various non-productive activities continue to prosper. Once however the extensive creation of credit out of "thin air" lifts the pace of real-wealth consumption above the pace of real-wealth production the positive flow of real savings is arrested and a decline in the pool of real funding is set in motion. 

Consequently, the performance of various activities starts to deteriorate and banks' bad loans start to rise. In response to this, banks curtail their lending activities and this in turn sets in motion a decline in the money stock. (Remember, the money stock declines once the loan that was generated out of "thin air" is repaid and not renewed). The fall in the money stock begins to undermine various non-productive bubble activities, i.e. an economic depression emerges.

Note that a depression is not caused by a collapse in the money stock as such, but comes in response to a shrinking pool of real funding on account of previous loose money. It is the shrinking pool of real funding that leads to the decline in the money stock. Subsequently, even if the central bank were to be successful in preventing a fall of the money stock, this cannot prevent a depression if the pool of real funding is declining.

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Built on anti-Corn Law radical Richard Cobden's vision that "Peace will come to earth when the people have more to do with each other and governments less," the Cobden Centre promotes sound scholarship on honest money and free trade. Chaired by Toby Baxendale, founder of the Hayek Visiting Teaching Fellowship Program at the London School of Economics, the Cobden Centre brings together economists, businesspeople and finance professionals to better help these ideas influence policy.

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