Credit Expansion and Inflation¹

The money supply is unstable because governments can create fiat money at will and banks create uncovered money substitutes, meaning banks keep less than 100% reserves.  Those who receive the new money first, before the PPM has adjusted to the new supply, benefit.  They can trade over-valued money for goods until the new supply/demand equilibrium is reached.  People living on savings or a fixed income are hurt the worst as their costs rise but their nominal wealth remains constant.  Their real share of the money supply decreases.

Bank credit expansion, extending loans not backed by 100% reserves, is, like the creation of fiat money, a form of wealth redistribution.  Credit expansion can have worse consequences than money creation, and the problems often appear far after the act.  The benefits, however, quickly become manifest.

Inflation, including both credit expansion and fiat money creation, produce winners and losers as a new PPM equilibrium is established, depending on when each person receives the new money.  Permanent winners and losers are also created by the new equilibrium.  Each person has a unique spending pattern.  The uneven distribution of the new money, both in space and time, will cause permanent changes in relative goods prices.  This will cause permanent changes in many individuals’ consumption/investment proportions, and some will have to either buy goods which are relatively more expensive or will change their goods purchased.

Credit expansion lowers the loan rate of interest as more savings appear to be available to borrow.  This would seem to reflect a lowering of societal time preferences.  In fact, time preferences have not changed, and the loan rate and natural rate diverge.  The inflationary credit expansion has negative consequences apart from setting off the business cycle, which will be described below.  Savings, which appear to have grown, are actually hurt as savers, creditors, are repaid in devalued money.  Inflation causes capital consumption as businesses believe profits have risen and under-invest in terms of the new PPM.  These profits will appear to have risen most in the most capital-intensive businesses, since the greatest proportion of investment has been done under the old PPM but the profits appear in inflated money.  Real profits remain unchanged, but nominal profits, appearing high, attract new investment into these sectors.  Apart from investing in production above demand, investment is diverted from production which is demanded by society.  This is not understood at the time, which leads to the next step in the development of the business cycle.

Saving, Investment, and Interest Rates in the Free Market

In the free market, as the investment to consumption ratio goes up due to lowered time preferences, the prices of consumer goods fall and producer goods rise.  Goods of the lowest orders fall the most and those of the highest orders rise the most.  The structure of production is lengthened and efficiency increases as investment flows to the higher stages of production, along with labor and non-specific factors of production.  The lengthening of the production process entails more stages of production.  At the same time, the price differentials between these stages narrow.  A lower return per stage is earned in more stages of production.  This means that the natural rate of interest decreases, and this leads to a decrease in the loan rate as well.

This increase in investment, made possible by actual lowered societal time preferences and the resultant increase in available savings on the loan market, allows for a more efficient production process.  This efficiency eventually pays off in the form of more and cheaper consumer goods on the market.  Everyone’s real income increases.

There is no room for a business cycle to develop in the case just described.  Investment has been coordinated by capitalists and entrepreneurs with the information coming from the loan market.  This is turn has been a reflection of the natural rate of interest and lowered societal time preferences.  Credit expansion, while providing similar signals at first, leads to a very different scenario.

The Start of the Business Cycle

As banks extend loans not backed by reserves, the money supply increases and interest rates fall.  This fall is not, however, due to a lowering of societal time preferences.  Businesses borrow at the new, lower rates and buy capital goods and factors of production.  These resources are put to use in the higher stages of production, narrowing the price differentials between stages.  As in the first case, prices rise the most in the highest stages of production.  The difference now is that the lower interest rate which has led to the increased investment has not been matched by lower time preferences and higher savings.  Total money income was unchanged in the first case as the higher spending on the higher stages of production was offset by lower spending in the lower stages.  Also, the lengthened production structure was offset by the narrowed price differentials between stages.  Here, however, total money income increases as newly created money enters the production structure.  The lengthened production structure is not accompanied by a narrowing of the price differentials between stages because spending on consumer goods has not decreased and caused a fall in the prices of lower order goods.

The receivers of the newly created money allocate their spending based on their time preferences.  Businesses have over-invested in the higher stages of production and under-invested in the lower stages.  They were misled by the lower interest rates.  Societal time preferences and the new investments don’t match.  The savings required for sustaining the new production structure are not actually there.  The consumption/investment allocations of the public remain unchanged from where they were before the credit expansion, and the loan rate of interest is pulled back up toward the natural rate.

The prices of the goods used in the higher stages fall and the goods used in the lower stages rise back towards their levels seen before the credit expansion as the consumer demand for the new production structure is seen to not exist.  Time preferences are actually higher than the credit expansion led borrowers to believe.  The savings were never really there.  The credit expansion did not increase capital investment, it simply shifted investment to a longer production structure which was not matched by societal preferences.  The newly created money simply transferred purchasing power to the borrowers from everyone else.  The investment was financed via wealth transfer, not real, voluntary savings.

To summarize, consumers, who eventually receive the newly created money, spend according to their time preferences, which are higher than the credit expansion loan rates would make them appear.  Consumer goods prices rise as the new money is spent purchasing them, and the producer goods begin to fall as soon as there are no new loans based on credit expansion to bid them up.  The old spreads between higher and lower order goods return, and the new investment is seen to be a mistake.  Prices have risen for all goods as the PPM has decreased, but the relative prices return to pre-inflation levels, with some changes as described in the previous section on the PPM.  Societal time preference has also been altered due to the change in the PPM, but the new equilibrium approaches the old.  The business cycle elucidates the nature of the relation between the money supply and interest rates and how their manipulation affects the economy.  An increase in the money supply through credit expansion cannot permanently lower interest rates; it can only do so temporarily and at the cost of economic distortion.

Some Other Effects of the Credit Expansion

The downturn and depression phase of the cycle is really the beginning of the recovery from the harm caused during the boom.  Any actions that government may take to lessen the depression’s effects would only lead to its prolongation.  Only further credit expansion can prolong the boom period, and the further it is prolonged, the worse its effects will be.  The longer the credit expansion phase lasts, the worse the economic distortion and the resulting correction will be.  Scarce resources are misdirected during the boom, and society becomes poorer, though the opposite seems true at the time.

The expanding money supply and decreasing PPM will lower the demand to hold money, and people will begin buying goods in anticipation of continued rising prices.  If the dishoarded money flows to higher order goods, then profits will be lowered as the differentials between higher and lower stages become smaller.  This will further lower the loan rate below the natural rate, and the correction phase will be worse.

Deflation often occurs during the correction as credit contraction sets in.  This will allow for prices between goods of different orders to widen and return to levels in accordance with the natural rate of interest.  But whereas during the boom phase businesses were fooled by inflation into believing their profits were higher than they actually were, the same accounting error leads them to believe that profits are lower than they really are during deflation.  This will lead to more saving than would otherwise occur, which will help lessen the effects of the capital consumption that happened during the inflationary period.

1.  See Chapter 12, Section 11 in Rothbard’s Man, Economy, and State.