After climbing to 12.2% in April of last year, the annual growth rate of real estate, consumer and business loans from commercial banks plunged to –2.6% in early March.

For most commentators, bank loans are an important factor in setting economic prosperity in motion. Therefore, this sharp decline in the annual growth rate of bank loans increases the likelihood that US economic activity will be under strong downward pressure. Therefore, most commentators believe that the central authorities must provide the necessary support to strengthen the growth of bank lending. However, is it true that bank credit is an important factor in economic prosperity?

For example, farmer Joe, who produced two kilograms of potatoes. For his own consumption he needs a kilogram, and the rest he decides to lend to the farmer Bob for a year. The kilo of uneaten potatoes that he agrees to lend is his real savings. This example is needed to illustrate that for lending to take place, real savings must first be realized. Loans must be fully backed by real savings.

By loaning Bob a kilogram of potatoes, Joe agrees to relinquish ownership of those potatoes for a year. In return, Bob promises Joe in writing that after one year he will pay back 1.1 kilograms of potatoes. The 0.1 kilogram constitutes an interest.

What we have here is an exchange of one kilogram of current potatoes for 1.1 kilograms of potatoes in a year. Joe and Bob both entered into this transaction voluntarily, as they both came to the conclusion that it would serve their purposes.

The introduction of money does not change the very essence of what a loan is. Instead of loaning a kilogram of potatoes, Joe will first trade his kilogram of potatoes for cash, say $ 10.

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

In addition, it is not the act of loan as such that strengthens economic growth but real savings that support the borrower while he is in the process of modernizing his infrastructure. With the help of a strengthened infrastructure, the real savings borrower can boost the production of his product.

Note also that when a saver lends money, what he is in fact lending to a borrower is final consumer goods that he has not consumed.

Banks as intermediaries

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

The bank also fulfills another important role by providing a facility for the storage of money. (Observe that individuals can exercise their demand for change by holding the money or placing the money in the bank’s storage facilities, called demand deposits).

Banks facilitate the flow of real savings by presenting the “providers” of real savings to the “applicants”. 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 loans by employing equity funds or borrowed funds).

For example, farmer Joe sells his saved kilogram of potatoes for $ 10. He then deposits this $ 10 with Bank A. Note that the $ 10 is fully backed by the kilogram of potatoes saved. Also, note that Joe exercises his demand for money by holding it in the sight deposits of Bank A. (Joe could also have exercised his demand for money by keeping the money at home in a jar, or by keeping it under the mattress).

Now, if Joe decides to lend some of his deposited money – say $ 5 – to John through Bank A’s mediation, his $ 5 will be transferred to John’s demand deposit from his demand deposit. Note that as a mediator, Bank A is providing an important service to Joe the Lender by introducing him to John the Borrower.

The essence of “Thin Air” credit

Whenever a bank takes a part of the deposited money without the authorization of the owner of the deposit and lends it, it triggers serious problems. Suppose Bank A lends Bob $ 5 by taking $ 5 from Joe’s demand deposit. By lending the $ 5 to Bob, Bank A opens a demand deposit to Bob in the amount of $ 5. Note that Joe never agreed to lend his money. Remember, Joe has an unlimited claim on his $ 5. Also note that there is no additional real savings to repay the $ 5 loaned.

Once Bob the $ 5 borrower uses the borrowed money, he is in effect engaging in a nothing-for-something swap, the reason being that the $ 5 isn’t backed by actual savings – that’s empty money. What we have here are $ 15 of demand deposits which are only guaranteed by $ 10 proper. Also note that an increase in demand deposits due to the loan to Bob results in an increase in money supply of $ 5.

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

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

On the other hand, when the credit comes from “nothing” and is returned on the due date to the bank, this leads to a withdrawal of money from the economy, that is to say a decrease in the mass. monetary, the reason being that in this case we never had a saver / lender, because this credit was born from “nothing”. Using our example of Bank A making a $ 5 loan to Bob, we must realize that the bank took Joe’s $ 5 demand deposit without his consent.

Joe never agreed to loan Bob the $ 5 because he continues to exercise an unlimited claim on his deposited $ 10. (Remember Joe saved the pound of potatoes, which he in turn traded for $ 10 and in turn deposited in Bank A).

Note that if Joe agreed to lend his $ 5 to Bob, then all we would have here is a $ 5 transfer from Joe to Bob. In this case, the $ 5 in cash loaned to Bob would be fully secured by actual savings. (Again, the $ 5 is part of Joe’s $ 10 deposit, which comes from his saved kilogram of potatoes).

Now when Bob pays back the $ 5, the money leaves the economy, since the bank is not obligated to transfer it to the original lender. There is no original lender here – the bank created the $ 5 loan from scratch. Again, when the bank generates a new $ 5 deposit that is not backed by actual savings, we do not have an original lender / saver here.

Thin Air Credit Sets Platform for Unproductive Activities

Watch again that that extra $ 5 of fresh money sets in motion a nothing-for-something swap. This provides a platform for various unproductive activities which, before the generation of credit “out of thin air” would not have seen the light of day.

As long as the banks continue to expand credit “from nothing”, various unproductive activities will continue to expand. However, once the continued generation of credit from ‘nothing’ raises the rate of consumption of real wealth above the rate of production of real wealth, the positive flow of real savings is stopped and a decline of the real savings pool is set in motion. As a result, the performance of different activities begins to deteriorate and bad loans of banks begin to increase.

In response to this, banks cut back on their lending activities, which in turn triggers a decline in the money supply. (Remember, the money supply decreases once the loans generated by “nothing” are repaid and not renewed). The decline in the money supply begins to undermine various unproductive bubble activities, that is, an economic recession occurs. (Note that non-productive activities cannot stand on their own. They need the help of “nothing” credit. “Nothing” credit diverts real wealth to them from producers of real wealth).

According to a popular view shared by many commentators, the economic depression of the 1930s occurred due to a sharp decline in the money supply. This way of thinking comes from the Chicago school, championed by Professor Milton Friedman. The economic depression was not caused by the collapse of the money supply per se, but in response to the shrinking of the real savings pool due to earlier easy monetary policy.

The decrease in real savings leads to a decrease in the money supply. Therefore, even if the central bank succeeds in preventing the fall in the money supply, it cannot prevent depression if the real savings pool decreases.

Summary and conclusion

Without real savings, the act of loan cannot take place. The role of banks in lending is to act as an intermediary between lenders, ie savers, and borrowers. Another important role of banks is to provide money storage facilities called demand deposits.

Problems arise, however, once banks begin to engage in loans without being backed up by actual savings; this gives rise to credit expansion from ‘nothing’. This in turn triggers the threat of the boom-bust cycle. Again, contrary to popular thought, it is not possible to increase credit without a prior increase in actual savings. Any attempt in this direction results in an expansion of credit “to nothing”.