The Fallacy Of Persistent Credit Creation

Those who know the history of the Federal Reserve System are fairly acquainted with the idea of money elasticity. The latter half of the 19th century was marked by severe bank panics that occurred with an almost alarming frequency. Bank panics caused the public to remove "money" from banks in general, leading to a sharp contraction in liquidity for the banking system.

Since banks operated on a fractional reserve basis and were solely responsible for multiplying "money", this flow of currency away from the banking system in times of panic inverted the money multiplication process, creating systemic monetary contraction. That, of course, meant deflation and ultimately depression.

The contraction of the money supply was increasingly pushed as the predicate cause of economic depression. It was a simple idea, rife with enough real world plausibility to be easily accepted. Counteracting that decline of money, then, became the basis for this country's third official central bank in 1913. By making the money supply elastic, the Federal Reserve System in times of crisis could avoid the devastating consequences of bank failures inverting the money multiplier.

In the first years of the Great Depression the idea of money elasticity was directly challenged. The public, suffering through numerous bank closings just in 1930 and 1931, began to distrust the entire system regardless of whether it was warranted in individual bank cases or not. So the mass withdrawal of currency from the system began a period of drastic multiplier inversion. The Fed did what it thought was enough in terms of increasing the supply of "money" to the system, but ultimately the public's desire for safety overrode those centrally planned efforts. The money supply contracted, deflation took hold and the Great Depression resulted.

There was an obvious flaw in the system as it was set up at that point. Aside from the technological challenges to monitor the entire financial system in anything approaching real time, the fate of the banking system still rested in the hands of the public. Because the pyramid of fractional reserve banking rested upon a physical form of currency or money (in this case physical Federal Reserve Notes), the public directly controlled credit creation and the money multiplier. Indeed, it was not until the federal government ended the public's right to withdraw currency (with FDR's bank holiday) that the vicious cycle of monetary contraction ended (this is not a statement about the appropriateness of this action, only an observation of what actually occurred).

The justification for politically intervening into the private, contractual monetary affairs of citizens, just like the idea of money elasticity, contains enough real world plausibility to be palatable. The fearful emotion that drove deposit-holders to blindly withdraw currency from good banks and bad banks alike, causing failures in sound banking concerns as much as troubled entities, was obviously the largest contributing factor to the contraction of credit money. The public's unbridled right to withdraw or claim currency money is an impediment to money elasticity, giving rise to political expediency in taking away or ignoring the fundamental principal of banking itself - depositors' rights to access currency on demand.

So the basic, fundamental idea of counterbalancing a bank panic rests upon the political question of who has the authority to determine the proper course for individuals and the system, and perhaps break a contractual right to individual preservation. In other words, the central bank sees your right to withdraw currency as an anathema to its existence and mission of saving the banking system. Since the banking system is the vital link in the chain of events leading to depression, so they believe, your individual right to do what you think is best for you ends up creating the conditions for circumstances that are even worse for everyone .

This is a fallacy of composition type of situation - where what is best for individuals may not be best for the group. So the group always wins because a central bank knows more than you about what is best for the group. In this dynamic, however, the amount of power accrued to the central authority is both massive and ambiguous.

Central bank policy, modern monetary thought and mainstream economics all believe in this fallacy of composition and that central bank actions are right and appropriate in all cases. These ideas are reinforced in the public mind through the economics profession's adherence to mathematical models - no one wants to argue with "science". Using math as a cover of objectivity, the evolution of economic thought has brought forth the idea that credit and economic growth are irrevocably intertwined, and that reducing the first necessarily reduces the second. While that might be technically true, there is not enough discussion about whether activity predicated on credit is actually desirable.

What money elasticity is really about is whether or not the direction of credit production should always be up. Again, economics makes no distinction about quality of activity, only the quantity. If quantity is all that matters, increasing it should always be the answer and money elasticity is correct. But if quality is as important, then the flaw of blindly adhering to quantity becomes obvious at some point - usually when the prescriptions of increasing quantity do nothing to foster a healthy economic system, mystifying the clueless practitioners of money elasticity.

If we view economic activity from a qualitative standpoint (i.e., the housing bubble, like the tech bubble before it, was not likely "good" economic activity that a stable, sustainable foundation could be built from), then reducing "bad" activity should actually be a preferred policy for fostering sustainable long-term growth. From this qualitative standpoint, then, we actually see the central bank operating not as a foundation for economic stability, but as a method of preserving the preferred direction of credit (for reasons that are political, not economic).

Worse than that, though, central banks right now are attempting to recreate the worst aspects of the preceding economic episode. Through interventions in market prices and interest rates (under the cover of money elasticity), they are attempting to influence the behavior of individuals to undertake activities that are not in their own best interest simply because they believe in the fallacy of composition in another sphere. This fallacy supposedly extends beyond just bank panics to everyday economic life.

The central bank wants you to take on more debt, even though that might not be in your own best interest, because it believes that your impoverishment will eventually bring up the rest of the economic system. If everyone would just go back to recklessly spending and accumulating credit, disregarding entirely their own perceptions of their own financial condition, the global economy would apparently be fixed. A lot more incremental debt for you means more jobs for other people, so we all collectively win (though it is never really explained how you are better off yourself).

The one constant throughout all these various fallacies is the universal elevation of credit and money, and thus the supremacy of system over individual. An economy is no longer a collection of individual actions, it is a system that overrides individual desires and preferences (it has its own level of aggregate demand!). Fulfilling your economic duty is far more important than meeting your own needs and desires, especially since those desires are unappealingly subjective. Your biased opinions of how to live your own economic life are secondary considerations to the objective math of the larger economic system founded on constantly expanding debt (economic activity marginally based on debt is simply far easier to quantitatively control).

Indeed, the supremacy of credit stands out as perhaps the single largest fallacy unchallenged by modern conventions, morphing into a monetary expression of the economic system as a whole (economic philosophy has evolved into believing that if you create money in whatever form, people will then undertake activity - a backwards idea of the more natural expression of money as a tool to foster economic exchange, not create it). Every expression of banking evolution has served to undermine the "natural" constraints on credit production in favor of maximizing reserve fractions. These evolutions go unchallenged because authorities constantly tell us that banks are the economy, so every move toward unfettered expansion is good for the system.

First the gold standard held an exogenous and physical constraint (the money supply was governed by a quality or standard from outside the banking system). Next, the move to national currency removed the exogenous constraint, but left the physical constraint in place since fractional lending could be reversed by the public's emotional appetite for holding physical dollars under the mattress or buried in the backyard when needed.

Finally, the Basel conventions, starting in the late 1980's and taking advantage of technological innovation, removed even the physical constraints of credit creation. Bank fractional lending has become almost completely endogenous. Even in the bank panic of 2008 there were very few bank runs in the traditional sense, where the public removed actual, physical dollars from institutions. Fractional lending was not limited by the movement of physical cash between banks and the public like it was in the 1930's. What happened in 2008 (and again in 2011) was that banks refused to accept a uniform standard of collateral terms amongst each other. The public has largely been a spectator to all of this.

The change in Basel rules moved the fractional determination from the asset side (the amount of physical cash on hand) to the liability side (the amount of equity capital invested in a bank, including retained earnings), and in doing so moved the vast majority of the public outside the inner workings of the system - physical dollars are an anachronistic sideshow to the financial economy. Since physical cash is no longer the standard for banking, credit money becomes the sole object of intermediation, a significant change in the definition of money that has not been fully appreciated.

A system that runs on equity capital only needs to increase retained earnings and to take advantage of equity prices to expand credit money. Central banks that target interest rates will always create enough "cash" to fill banks' collective credit demand.

Retained earnings, however, are an accounting creation. So if retained earnings are the better part of the base of fractional lending, then the ability to creatively account for monetary flows becomes a paramount concern over the trivialities of real intermediation (actually advancing sustainable levels of credit to creditworthy obligors). That begets more financial innovation and creativity as it relates to accounting for risk and flows rather than increasing the productivity of money as it relates to the real economy.

So the bank panics of 2008 and 2011 are complete mysteries to the public, but are well known to those inside the system since they are all fellow travelers and practitioners. This has led to an unforeseen and ludicrous expansion of the original fallacy of composition - central banks now have to get banks to forego what they see as in their own best interest in the name of the system as a whole. Central banks are trying to allay fears within the banking system to get "money" flowing freely in the interbank markets.

So we see banks reluctant to lend to each other because they have all lent money to Italy. And they lent money to Italy and Greece because those countries offered them all the best way to maximize their equity capital in the aftermath of the mortgage bond re-evaluations of 2008. Lending to Italy and Greece had absolutely nothing to do with them and their impacts on the real economy, since credit creation is all about how credit assets fit within the internal limitations of equity capital and retained earnings.

The zero risk weighting of sovereign debt provides the fractional maximization, while the central bank belief in credit as always expanding provides just enough moral hazard to override any of the monumental doubts about the true risk of lending to extremely questionable borrowers. And of course this is all just an echo of the subprime mortgage system that preceded it. Is this system really the best option available for the global economy?

For all the mythology of central bank independence and the sustained efforts to show an objective, mathematical face, the quantity of money "toolkit" that central banks have employed in the past is wholly inadequate to the present endogenous system. The ability to print physical Federal Reserve Notes (or euros) or even digital expressions of Federal Reserve Notes does not supply money elasticity to the modern system.

Since the internal control is equity capital, the philosophy of money elasticity is now tied directly to ownership! And so authorities need Congressional approval to undertake TARP, a capital injection that functions in exactly the same way as printing money would have generations ago. In Europe, the fragmented political situation is preventing the European version of TARP, the EFSF, from accomplishing money elasticity through its own bank capital injections. Money elasticity has always been a political question; it is just now more obvious.

In the rush to implement the "credit is always good" philosophy of money elasticity, the underlying conditions were never fully prepared or even appreciated as to how the radical shift in bank realities since Basel might actually work. As is now pretty clear, there are real and complex political and philosophical questions about if, when, and how governments should actually "own" the means to credit production.

The bailout of banks over-invested in Italy is really a question of how far the system will go to preserve its ability to manage itself. Central banks cannot feign independence in the face of such questions, so they resort to the age-old fallback position that credit always equals economic activity. They take special care to make sure that politicians know that credit must always move ever higher.

There is something inherently wrong about a system that has to go this far to maintain itself. If nothing else, we should all ask if the people and banks that keep running from crisis to crisis are really the people we want managing our credit affairs. Perhaps they simply do not have the talent to be successful. But since so many of the "best and brightest" are running into the same existential problems at exactly the same time, the elusive answer to the crisis question might be more fundamental.

Perhaps the system of fractional lending without constraint is flawed at its core. Maybe money elasticity is just simply a way to override the more natural self-corrections embedded within an exogenous system, completely setting aside the canard of whether such a system is economically more efficient.

Maybe the fallacy of composition really extends in both directions. Central banks may think they know better than the public about financial affairs, and are therefore equipped to reduce individual rights, but it might also run the other way. Maybe the public is right to withdraw from a system that really does not benefit them (that the paradox of thrift is just another fallacy used to mathematically and "objectively" suppress self-preservation), and therefore the banks that likewise today do not want to participate are just natural extensions of that emotional urge for self-preservation.

Maybe the system should not always come first and that the system should rather benefit the individual actors that make up the system in the first place. Conceivably a system that generates this much desire to get out should be rethought in its utility to the larger questions that abound.

The removal of economic power from individuals has left open a pathway to what the modern central bank has become - exactly the kind of thing we were warned about in the 19 th and early 20 th centuries. Not only do central banks ensure money elasticity, they have now taken on the onerous and impossible tasks of actively managing economies. That was never supposed to have happened in what have nominally been known as "free market economies".

There was never supposed to be centralized control over interest rates and the systemic pricing of risk, let alone actual intrusions into bond markets, currencies and, in the case of the Bank of Japan, equities. This is far more than just regulating the oft-incoherent mess of free markets; it is a case study in how free economies can become co-opted by the soft "science" of bureaucratic control. Since when does Ben Bernanke, like Alan Greenspan before him, know how much debt you should accrue and how much of your paycheck you should spend?

The idea that credit is always good and should only increase is nothing more than economic cover for the politics of central economic authority. The debate over bailing out Italy or the European banks exposed to Italy is not really an economic question. At this point, the economics are really simple - there is just too much debt and not enough of a solid, unencumbered foundation to pay it all off.

Whoever was foolish enough to buy that debt, knowing these circumstances, should feel the wrath of market discipline, but that might be an indictment of the entire system.