After climbing to 12.2 percent in April last year, the yearly growth rate of combined commercial bank real estate and consumer and business loans plunged to –2.6 percent in early March.

For most commentators, an important factor in setting economic prosperity in motion is bank lending. Hence, this sharp decline in the yearly growth rate in bank loans raises the likelihood that US economic activity is under strong downward pressure. Consequently, most commentators are of the view that central authorities must provide the necessary support to strengthen bank-lending growth. However, is it true that bank lending is an important factor in economic prosperity?

For instance, farmer Joe, who produced two kilograms of potatoes. For his own consumption, he requires one kilogram, and the rest he decides to lend for one year to farmer Bob. The unconsumed one kg of potatoes that he agrees to lend is his real savings. This example is necessary in order to illustrate that for lending to take place there must be real savings first. Lending must be fully backed by real savings.

By lending one kilogram of potatoes to Bob, Joe agrees to give up ownership over these potatoes for one year. In return, Bob provides Joe with a written promise that after one year he will repay 1.1 kilograms of potatoes. The 0.1 kilogram constitutes interest.

What we have here is an exchange of one kilogram of present potatoes for 1.1 kilograms of potatoes in a year's time. Both Joe and Bob have entered this transaction voluntarily because they both have reached the conclusion that it would serve their objectives.

The introduction of money does not alter the essence of what lending is all about. Instead of lending one kilogram of potatoes, Joe will first exchange his kilogram of potatoes for money, let us say for $10.

Joe may now decide to lend his money to another farmer, John, for one year at the going interest rate of 10 percent. Observe that the introduction of money did not change the fact that real savings precede the act of lending.

Furthermore, it is not the act of lending as such that strengthens economic growth but real savings that support the borrower while he is busy upgrading his infrastructure. With the help of an enhanced infrastructure, the borrower of real savings can boost the production of his product.

Also, note that when a saver lends money, what he in fact lends to a borrower are final consumer goods that he did not consume.

Banks as Intermediaries

Now, instead of Joe directly lending his $10 to John, he can do it via an institution called a bank. The bank here fulfills the role of intermediary. For the services of mediating the transaction, the bank charges a service fee.

The bank also fulfills another important role by providing a money storage facility. (Observe that individuals can exercise their demand for money by either holding the money or by placing the money with the bank storage facilities, known as demand deposits).

Banks facilitate the flow of real savings by introducing the "suppliers" of real savings to the "demanders." In this sense, by fulfilling the role of intermediary, banks are an important factor in the process of real wealth formation. (Banks can also engage in direct lending by employing equity funds or borrowed funds).

For instance, farmer Joe sells his saved kilogram of potatoes for $10. He then deposits this $10 with Bank A. Note that the $10 are fully backed by the saved kilogram of potatoes. Also, observe that Joe is exercising his demand for money by holding it 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 keeping it under the mattress).

Now, if Joe decides to lend part of his deposited money—let us say $5—to John via the mediation of Bank A, his $5 will be transferred to John’s demand deposit from his demand deposit. Note that by being a mediator Bank A provides an important service to Joe the lender by introducing him to John the borrower.

The Essence of Credit out of “Thin Air”

Whenever a bank takes a portion of deposited money without the permission of the owner of the deposit and lends it out, this sets in motion serious trouble. Let us say that Bank A lends $5 to Bob by taking $5 out of Joe’s demand deposit. By lending the $5 to Bob, Bank A opens a demand deposit to Bob to the tune of $5. Note that Joe has never agreed to lend his money. Remember that Joe has an unlimited claim over his $5. Also, note that no additional real savings back the loaned $5.

Once Bob the borrower of the $5 uses the borrowed money, he in fact engages in an exchange of nothing for something, the reason being that the $5 is not backed by any real savings—it is empty money. What we have here is $15 of demand deposits that are only backed up by $10 proper. Also, note that an increase in demand deposits because of the loan to Bob results in the money supply increasing by $5.

When loaned money is fully backed by savings, on the day of the loan’s maturity it is returned to the original lender. Bob—the borrower of $5—will pay back on the maturity date the borrowed sum and interest to the bank.

The bank in turn will pass to Joe the lender his $5 plus interest, adjusted for bank fees. To put it briefly, the money makes a full circle and goes back to the original lender. Note, again, that the bank here is just a mediator; it is not a lender, so the borrowed money is returned to the original lender, which is in our case Joe.

In contrast, when credit originates out of "thin air" and is returned on the maturity date to the bank, this leads to a withdrawal of money from the economy, i.e., a decline in the money stock, the reason being that in this case we never had a saver/lender, since this credit emerged out of "thin air." Using our example of Bank A making a loan of $5 to Bob, we must realize that the bank took the $5 out of Joe’s demand deposit without Joe’s consent to this.

Joe never agreed to lend the $5 to Bob, since he continues to exercise unlimited claim over his deposited $10. (Remember that Joe saved the one kilogram of potatoes, which he, in turn, exchanged for the $10, and in turn deposited with Bank A).

Note that if Joe were to agree to lend his $5 to Bob, then all that we would have here is a transfer of $5 from Joe to Bob. In that case, the $5 in loaned money to Bob would be fully backed by real savings. (Again, the $5 are part of Joe’s $10 deposit, which originated in his saved kilogram of potatoes).

Now, when Bob repays the $5, the money leaves the economy, since the bank is not required to transfer it to the original lender. There is no original lender here—the bank has created the $5 loan out of nothing. Again, when the bank generates a new deposit for $5 which is not backed by real savings—we do not have here any original lender/saver.

Credit out of “Thin Air” Sets the Platform for Nonproductive Activities

Observe again that this extra $5 of new money sets in motion an exchange of nothing for something. This provides a platform for various nonproductive activities that prior to the generation of credit out of “thin air” would not have emerged.

As long as banks continue to expand the credit out of “thin air,” various nonproductive activities continue to expand. Once, however, the continuous generation 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 savings is set in motion. Consequently, the performance of various activities starts to deteriorate and banks’ bad loans start to increase.

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 loans generated out of “thin air” are repaid and not renewed). The fall in the money stock begins to undermine various nonproductive bubble activities, i.e., an economic recession emerges. (Note that nonproductive activities cannot stand on their own feet. They require the assistance of the credit out of “thin air.” The credit out of “thin air” diverts to them real wealth from real-wealth producers).

According to a popular view held by many commentators, the economic depression of the 1930s occurred because of a sharp fall in the money supply. This way of thinking originates from the Chicago school, championed by Professor Milton Friedman. The economic depression was not caused by the collapse in the money stock as such but in response to the shrinking pool of real savings on account of the prior easy monetary policy.

The shrinking pool of real savings leads to a decline in the money stock. Consequently, even if the central bank were to be successful in preventing the fall of the money stock, this cannot prevent a depression if the pool of real savings is declining.

Summary and Conclusion

Without real savings the act of lending cannot take place. The role of banks in lending is to mediate between lenders, i.e., savers, and borrowers. Another important role that banks fulfill is to provide money storage facilities known as demand deposits. 

Trouble, however, emerges once banks start to engage in lending unbacked by real savings; this gives rise to the expansion of credit out of “thin air.” This in turn sets in motion the menace of the boom-bust cycle. Again, contrary to popular thinking, it is not possible to increase credit without a prior increase in real savings. Any attempt to do so results in the expansion of credit out of “thin air.”