Let’s return to that earlier question: “What distinguishes good credit from its less helpful variants?” As will by now be apparent, this is a far trickier question than it first appears.
Credit is generally presumed to represent the recycling of savings. What, though, are savings?
Stripped of monetary mumbo-jumbo, they’re unconsumed production, what’s left over at the end of a period, whether bushels of wheat in a farmer’s silo, aluminium ingots in a smelter’s warehouse or a new and more efficient factory production line (one should really also include skills and education, but outside of intellectual property rights accounting for them becomes a little trickier).
In the simplest terms, savings provide the means by which activities beyond mere subsistence can be tackled, be that a new industrial process, more intensive farming, pure scientific research, a university degree or expanded patronage of the arts. Without savings, material progress isn’t possible.
While true savings are irrevocably rooted in the real world, some of the effective right to these savings in a non-barter economy is represented by money rather than the ownership (direct or indirect) of businesses, of actual goods or of other property rights. The net consequences of all the interreactions that go to make up a complex economy are, if you like, continually in part distilled into this common medium.
Anyone thereby left with funds above and beyond their immediate needs (that is, with savings) is also left with the choice of what to do with them. They can shove them under the proverbial mattress, invest them in some venture of their own, or lend them to someone who has a clearer immediate plan for their use.
If, for a moment, we imagine a world without banks the business of lending is straightforward. Someone with money to spare lends it at agreed upon terms and receives some appropriate IOU in return for handing over the cash. All being well, the money will in due course be repaid, with interest. Until then, the lender has entirely forfeited the use of those funds and the total amount of money in the economy is unchanged. Repeat the process as often as one likes and the principle remains the same.
Direct lending of this kind clearly qualifies as good credit. It serves the intended function of temporarily transferring the use of savings while at the same time leaving the overall monetary state undisturbed.
Introduce intermediaries who not only both borrow and lend as principal, but who also (as we’ve seen) create their own credit (and hence money) and things become far murkier. Not so much in terms of individual transactions as in the broader systemic effect.
Explaining why will take a little time, and the route may appear somewhat circuitous. There is, unfortunately, no shortcut that doesn’t also eviscerate understanding.
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Bank depositors (unlike our lender in the simple example above) don’t in any meaningful sense forfeit the use of their money. With call deposits, this is obviously so. Even non-call deposits, though, are usually accessible, albeit against the payment of some form of penalty. Few depositors view their funds as truly “locked up”. The decision as to how much cash to hold has therefore become much less pressing. Each of us can, in effect, “invest” some portion of our liquid funds for a small but guaranteed return and at the same time have them immediately to hand.
Although we now accept this state of affairs as entirely normal, it wasn’t always so. Indeed, it has been in the past (and still is for a some) a matter of heated contention. For a summary of the legal and practical aspects of this intriguing issue, see “A Critical Analysis of Central Banks and Fractional-Reserve Free Banking from the Austrian School Perspective” (Jesus Heurta de Soto)The case for the prosecution was succinctly put by Henry C. Simons (University of Chicago) in 1948:
“There is likely to be extreme economic instability under any financial system where the same funds are made to serve at once as investment funds for industry and trade and as the liquid cash reserves of individuals. Our financial structure has been built largely on the illusion that funds can at the same time be both available and invested—and this observation applies to our savings banks (and in lesser degree to many other financial institutions) as well as commercial, demand-deposit banking.” (Economic Policy for a Free Society (1948), p 320)
This bit of legerdemain, “that funds can at the same time be both available and invested”, takes us to the heart of the money illusion fostered by fractional reserve banking and all the consequences that follow, most of them unhappy.
The first is that the sum of money in the system is at once and directly increased: the recipient of loans based on call deposits clearly has the full use of those funds; the initial depositors, however, also view them as both theirs, and immediately available. To the extent that those funds recycle (through the credit creation process) into yet more call deposits and are in part lent again, and so on, this effective double counting mounts rapidly. An illusion of exaggerated resources results, and the actions of individuals and companies alter accordingly. Projects are undertaken, and economic decisions made, for which the savings and ongoing income capacity in reality do not exist. So long as the credit creation process continues, the dysjunction between the picture painted by this bounteous flow of funds and the actual underlying resources isn’t easy to discern. Only when the credit boom ends (whether voluntarily or not) is the true situation revealed, as we’ve so clearly seen in the last few years.
A second consequence is the increased fragility of the banking system as more and more of their funding becomes based on short-term at call (or effectively at call) deposits. One can of course argue that in a fiat money based system with a lender of last resort, this doesn’t matter so much, and at one level that’s true. However, as we’ve seen, this doesn’t preclude the onset of panic (consider Northern Rock in the UK, for example), and such emergencies certainly place great pressure on central banks to take rapid, and therefore potentially ill thought out, decisions. At such times, mature reflection and careful planning become impossible.
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Those who argue that the lending of call deposits should be illegal (and that they should therefore also not pay any interest) firmly believe this alone would go a long way toward eliminating the volatility and inherent fragility of the banking system. Under this sort of legal arrangement (in which call deposits are truly treated as a “deposit”, and not as a loan to the bank), only time deposits and others of fixed duration could be lent out. By itself, this wouldn’t eliminate the credit creation process (since the loans made based on fixed deposits would still be redeposited, some for fixed terms, and could therefore be lent out again), but it would certainly radically slow the process of credit and money creation.
When confronted with this idea, many (in particular free-market supporters) see it as an intolerable restriction of individual and commercial rights. Supporters argue it’s no such thing since it merely legally formalises an unavoidable economic truth, namely that funds can’t in fact at the same time be both available and invested, and that to attempt to do so radically distorts reality.
As noted earlier, this debate isn’t entirely dead, although it’s certainly (for now at least) entirely academic. Support is for the most part limited to some adherents of the Austrian School (and of Free Banking). It’s generally discussed in terms of the merits of a “100% reserve banking” and the article by de Soto mentioned earlier provides a decent overview of the whole debate.