The End Of The Bank Credit Cycle

The economic consequences of cyclical expansion and contraction of bank credit are the reason for booms and slumps dating back certainly to the Napoleonic Wars and possibly before. Keynesian remedies, which owe their pedigree to the financial theories of John Law, have never succeeded in taming them.

This article ties Austrian business cycle theory to the cycle of bank credit. It explains how bank credit is created and customer deposits with it through double-entry accounting.

Central bank interest rate suppression has led to the virtual death of bank credit creation for the benefit of non-financial businesses. Instead, banks have grown their balance sheets to finance purely financial activities and speculation to compensate for reduced lending margins.

The cyclical contraction in bank credit is set to be greater than anything we have experienced since the Wall Street Crash of 1929—1932. The authorities’ attempts to defray this reality seems set to undermine the purchasing power of their currencies.

Introduction — the alure of monetary expansion

History is peppered with individuals who see a shortcut to an objective in all fields of human activity. Aesop even had a fable for it: the hare and the tortoise. The field of applied economics is no exception. Before modern times the poster-boy example was John Law, who in October 1715 presented a scheme for a bank “in the name of and for the account of the King” to the Council of Finances at the chateau de Vincennes. Law was inventing the central bank. He had convinced the duc d’Orleans, the Prince Regent, that there was an easy solution to the infant king’s debts inherited from his profligate father, Louis IV —the spendthrift Sun King. He would issue livres for specie and capitalize his bank on Royal debt, bought at a discount but valued at face. The economy would be stimulated, and he would reduce the interest burden on the billets d’état.

He was initially denied permission, but the following May Letters Patent were issued to him for a private bank, and Law was in business. The conversion to the Royal Bank — effectively operating in the name of the King — came later. There was no question about Law’s intellectual capacity and his ability to convince. And Law was followed two centuries later by a doppelganger Keynes, who unwittingly adopted the core of Law’s theories, and certainly much of his approach to money and economics.

In the wake of Keynes’s quick fixes, the study of the relationship between credit and business cycles become neglected. Rather than enquire into why a periodic slump occurred it was easier to just assume a cause. Keynes effectively declared that the free market fails because it is flawed. His solution was state intervention to correct it. And when economic aid from the state turned out to be only a temporary fix because the economy slumped again, the original assumption was never questioned: it simply prevailed, and the intervention was repeated and continues to be by his followers today.

Economists, commentators, and investors are all aware that cyclical factors affect both asset values and economic activity. Some investors swear by their favorite cycles. But in the field of economics, cyclical theory has been primarily associated with the Austrian school of economists, principally in Ludwig von Mises’s writings on trade-cycle theory and Friedrich von Hayek’s triangle. Today, these are collectively referred to as Austrian business cycle theory.

Austrian school explanations of booms and busts added significantly to our understanding and the links with fluctuating credit were examined and understood by both Mises and Hayek. And these cyclical failures are still clearly embedded in our economies. To revive this important subject, we must discard neo-Keynesian economic assumptions and return to basics, adapting and augmenting the Austrian school’s findings for modern times.

Hayek’s take on the business cycle

Hayek was famous for his description of the mechanism by which the regular business cycle occurred. He resorted to using a triangle to illustrate to his students at the London School of Economics the relationships between consumer spending, saving and the consequence for capital investment from changes in interest rates.

Hayek used this model to illustrate the effect of interest rates on the rate of savings and the consequences for business calculation, pointing out that capital was released in the form of increased savings by a fall in immediate consumption. It was subsequently explained thus:

“The number of stages of production that can be sustained by the market depends on the time preference of consumers. For instance, a reduction in time preference increases the supply of loanable funds and reduces the interest rate in the market, other things being constant. This increase in savings allows for extending the triangle by augmenting the financial capital needed to add stages of production. . . The Hayekian triangle offers a simplification of capital theory in order to emphasize particular features such as the effects of market interest rates on how long production takes in an economy.”

There are elements of this statement (which was not Hayek’s) that appear to be on weak ground. For example, the suggestion that a reduction in time preference (in other words, a reduction in interest rates, which in free markets amounts to the same thing without any time lag) increases savings. But surely, a fall in interest rates can be expected to have the opposite effect, diverting savings into consumption. Clearly, for this statement to be correct there must be other factors in play that override an expected supply/demand curve. The explanation is found in bank accounting practices, as will be explained later in this article.

Hayek’s triangle supposed that with increased investment being the consequence of reduced consumer spending, there is a shift in profitability from retail activities towards earlier stages of production. The increase in capital investment from greater savings was directed accordingly. And the reduction in time preference reduced the time penalty incurred for future production. Therefore, more roundabout methods of production became viable.

That manufacturing roundaboutness increased with the capital available was originally proposed by Eugen von Böhm-Bawerk, an earlier economist of the Austrian school, and for a time Austria’s finance minister. The triangle was Hayek’s attempt at explaining the relationship between investment, time and means of production. As an explanation it appears to have begun to be accepted before the economic establishment migrated to Keynesianism following the publication of Keynes’s General Theory, which broadly removed time factors from mainstream economics.

There is much detail to consider behind Hayek’s triangle, but there are contradictions within it to consider as well, and a contradiction in the theory of roundaboutness should be obvious to economists today. It fails to address an obvious fact revealed by modern logistics. Irrespective of changes in savings, by specializing in production improvements can always be expected in the combination of cost, quality, and reliability compared with a manufacturer undertaking all the manufacturing processes itself. Therefore, over time the final production of capital goods and consumer durables has increasingly become a process of assembly of pre-manufactured components from diverse sources. This evolutionary process has had little to do with changes in time preference, and more to do with the advantages of globalization.[ii] The Hayekian approach also ignores the benefits of scale to a specialist manufacturer making components for a wide range of assembling manufacturers, which would inevitably occur to readers of Adam Smith’s description of a pin manufactory in the first volume of his The Wealth of Nations.

Arguably, a second flaw in this approach is tagging the cycle as one of business activity. Ludwig von Mises described it as a trade cycle. Both descriptions are misleading in the sense that the cycle’s origin lies in bank credit. All economists would have profited by giving greater credence to the practicalities and consequences of bank credit creation in the global banking system that has existed since at least the 1844 Bank Charter Act in English law, and in England from the time of the early goldsmiths in London.

The roots and practicalities of modern banking practice

During the English civil war (1642—1651) goldsmiths took in deposits, paying 6% on the basis that these deposits became debts owed to depositors and therefore the goldsmiths’ own property to deploy and use as they saw fit to generate the promised return. It was from this practice that deposited savings became a bank’s debts owed to depositors (in Roman and English banking law a mutuum as opposed to a depositum), and their role in the expansion of bank credit became firmly established. As can be seen from the Latin, the term bank deposit for customer credit balances is plainly wrong.

Theorists assume that higher interest rates towards the end of the credit cycle alter the balance between savings and consumption by attracting more savings and less consumption. That is an error. From a banker’s point of view, higher interest rates are the consequence of increasing lending risk and reflects a desire to reduce the supply of credit. And through the process of double-entry book-keeping, a reduction to lending exposure is matched by a reduction to the principal source of balance sheet funding, which is the bank’s liability to depositors. Conversely, lower interest rates reflecting lower lending risk are the result of the banking sector’s desire to expand their loan books, and not as commonly supposed is driven by a surfeit of savings.[iii] This is why bank deposits increase early in the credit cycle, and at this point concurs with Hayek’s triangle; except the origin of deposits is not from consumers’ savings but the expansion of bank credit. The process of deposit creation is explained in more detail below.

It is the practicalities of bank accounting that drive the rise and fall in the quantity of deposits. This is the reverse of what the laws of supply and demand with respect to allocation of savings would suggest. The error is to regard interest rates are the price of money, a mistake that even underlies the monetary policies of central banks.

We can sum up the situation with an iron law of banking:

By lending money into existence, banks create deposits. Therefore, an increase or decrease in overall levels of deposit are not at the savers’ behest, but at that of the banks.

Far more constructive to an understanding of business cycles, in my view, is an approach that gets to their origin and without any doubt that is a cycle of bank credit expansion and contraction. Genuine savings do provide businesses with capital, but that is through direct channels, which may or may not be augmented by bank credit. Why changes in the amount of bank credit lead to a cycle of business activity must form the basis of our inquiry.

The form and impact of periodic credit contractions vary from cycle to cycle, and there are the distortions resulting from state interventions as well. But clearly — except to a hard-line Keynesian perhaps — there is an underlying cycle. And in the study of any cycle, we need a starting point. In anticipating that credit is involved, we must first describe an economic model with a constant quantity of money and credit, and the absence of state intervention as a reference point. And we will also assume that the purchasing power of money overall does not vary much because it is fundamentally sound.

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Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not reflect those of Goldmoney, unless expressly stated. The article is for general information ...

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