Diagnosing the Disease

Spending ain’t spending, to paraphrase the old Castrol ad about oils.

Where government stimulus spending ends up, and how, are quite as vital as the spending itself. In the end, it’s no more immune to the logic of productivity than private investment, even though the primary goal will often be something quite different.

Unfortunately, discussions about the merits of stimulus spending often skate around this issue.

There’s another complication that also too rarely sees the light of day. Each credit induced boom generates its own combination of imbalances and unless government policy takes these into account, efforts to cope with the ensuing crisis will be kneecapped.

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Credit ain’t just credit, either.

By their very nature, booms generated by a fractional reserve banking system don’t result from the lending of genuine savings. Much of the credit produced is in effect ex-nihilo, literally “out of nothing”. Loans are made, recycled back into the banking system when spent and then for the most part lent out again in an endless cycle.[1] Out of it comes a rapidly expanding and intricately interlocked set of IOUs. The only constraints are the reserve requirements (if any) imposed on the system together with a need for continued loan demand.

In a non-fractional reserve system, money lent is no longer available to the lender until it’s paid back. The act of lending is literally the transfer of the use of those funds for the duration of the loan. Not so under our system. As depositors, we all retain access to most of our funds while they are at the same time lent out in the continuous process described above.

As a result, for as long as the credit expansion lasts we’re collectively misled into acting as if there were more resources available than in fact exist. Certain structural consequences must follow and these are common to every credit induced boom.

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