In a previous blog, I defined the basic terms of economic analysis: assets, liabilities, debt, capital, and production. In the second part of this series, it’s time to introduce the complicating factors of the banking section.
As we defined last time, debt is a liability that must be paid from future production. Assets/savings are properly represented either by unconsumed economic goods; the reason we adopt this strict definition is because you can’t store a service and because we need to differentiate between the real savings of a society and money. If money is itself an unconsumed economic good, as it is with all forms of commodity money, then there is no difference. If, however, the money is issued by fiat, then it is functioning merely as a medium of exchange between members of a society who seek to exchange some of theirs production for the benefits of other’s production.
I’m sure astute readers will notice I’ve left services out of the above discussion. That’s not because they are not valuable, but only because they can ultimately only be paid for out of someone’s production. Sure, I may render a service to someone else who herself only derives income by way of providing services, but one can not base a society of services alone: real goods must enter the equation at some point or we’d all starve to death. That’s why I’m saying that ultimately, services must be paid for out of production.
Now enters fiat money into the picture. By law, it must be accepted as money, and it has a certain par value for the trade of goods and services. If the money supply is fixed at a certain level, then good and services should trade in fairly stable range; in fact, because technology lowers production costs, we should see money gain purchasing power of time. If, on the other hand, money is printed by fiat and injected into the system, then you will start to see price distortions. The price distortions will start in roughly the area that the new money entered the system, but over time it will cause an across the board increase in prices. This is because the purchasing power of each unit of the fiat money is being diluted by the introduction of each new unit of fiat money.
In modern societies, the banking system serves as the introduction point of new money into the system. This is because banks have the power to create money when the make loans. Contrary to popular belief, banks do not loan out the money that their depositors have left with them. Instead, they these deposits as the basis to make a far higher number of loans. A typical modern bank typically has $1 in depositor money for every $10 it has in outstanding loans. Because of this ten-to-one gearing, banks are the basic inflationary engines of modern society. The money that they create pushes up the price of goods and services that that money chases. This is why the real estate market was appreciating so rapidly in recent years; banks were created money and loaning it to people to buy houses and it driving the market higher.
Two things should stand out to anyone who gives this situation serious thought that:
- Banks are inherently insolvent because at any given time they have far more liabilities in terms of “on demand” deposits than they can meet.
- The inflationary situation that banks create can not be sustained indefinitely because banks are not adding to the stock of real wealth (that is, real goods) in any way. Eventually, the system must collapse in what we term a deflationary bust.
Deflationary busts can only follow after a credit driven expansion. Typically they feature falling prices because credit money is no longer being introduced with nearly the rapidity as before and so less money is”chasing” economic goods and services as before.
This is where we are today. Banks are failing because the value of the loan books have been devalued because the quality of the loans they were making has grown increasingly poor- a classic symptom of a credit expansion that is long in the tooth. Politicians, bankers, and financial pundits are all focusing on the health of the banking industry because, as previously mentioned, banks are the engine of inflation. The thinking goes that if banks were somehow made to create money as the did before, then things would return to the way they were. This is way all attention is on the banking sector and why Barack Obama featured it so prominently in his recent speech.
Ben Bernanke is working closely with the US Government to introduce a staggering amount of money into the system. The primary mechanism of this money creation is that the central government will run a large deficit and the Federal Reserve will loan all of the needed money into existence. These actions are designed to create inflation and I am certain that they will succeed. Others are not so sure.
This is where the situation gets complicated. Everyone can understand that the purchasing power of each unit of a currency is reduced in rough proportion to the amount of the amount of new money brought into the situation. What is harder to predict is what specifically will happen in our situation. As there are many arguments to consider, I’m leaving this question for the third and final installment of this series.
Till then, thank you for reading.