Objectives of Credit Expansion
Credit expansion is the policy where the central bank produces additional money in order to purchase debt from the government or from entrepreneurs, such as banks. In a system where gold is used as money there exist strict limits for money producers when it comes to credit expansion, due to the natural scarcity of the precious metal. In a fiat money system there are no natural limits on the amount of additional money produced. As a result, the interest rate for additional credit transactions drops.
The policy of credit expansion is broadly accepted as a measure to make people prosperous.
It is its declared objective to make credit abundant. New credit is said to spur business activity, capital becomes inexpensive, entrepreneurs can borrow more money for investments, commerce flourishes and soon all of society is permeated by the magical boon that the credit boom bestows upon it. Everyone is supposed to enjoy all the consumer goods they have been longing for under the stingy policy of tight credit.
This idea is based on the substantially flawed assumption that capital can be created out of nothing. Capital can only exist when factors of production are produced. Every investment necessitates the use of factors of production that turn out more or higher valued goods after a roundabout process rather than consuming fewer or less valuable goods immediately. Factors of production can only exist if people have generated savings. Savings are generated if one forgoes immediate consumption for the prospect of future consumption. Foregoing present consumption can only be feasible if one considers the future remuneration he gets in return more valuable than the immediate consumption he forgoes. This is what is called time preference. Time preference is expressed on the market in the form of interest rates.
This causality ensures that market interest rates always provide an indication of the time preferences of the individuals in that market, and hence the willingness to forgo present consumption of consumer goods for future consumption of goods created by new factors of production. While prices give entrepreneurs an indication as to which consumption goods are desired more and which less at a specific moment in time, interest rates provide a measure as to when they are desired or needed in the future. It creates an environment where entrepreneurs have an incentive to fulfill demands based on value preferences and time preferences at any given point in time.
The Effects of Credit Expansion
It is now necessary to examine what the process of credit expansion entails. The central bank that creates money does not own any capital, it does not create factors of production. The only thing it channels into the market is fiat money.
Before examining the purchase of credit instruments it makes sense to take an intermediary step and look at the simple purchase of consumption goods. For example, if it were to purchase houses with the newly printed money, its governing board could decide to supply the homes to all its officials. They will be able to enjoy the houses before their prices rises and hence they will not be available to other would-be buyers who would have purchased them at a lower price that would have represented their value preferences. The entrepreneurs selling the homes, too, benefit because they are the first ones to receive the new fiat money and get to spend it before other prices go up and before others get to spend it. Those who receive the new money later will suffer from the prices that have already gone up. While on the market, people can only buy goods when producing demanded goods in return, and while all transactions are based on voluntary exchange and value preference, the central bank does not act under these constraints. Its fiat money can be produced cheaply and the government enforces its acceptance and outlaws competition. Goods are hence violently withdrawn from those who actually produced demanded goods in exchange and end up in the hands of those who didn’t. Now, entrepreneurs will begin producing more homes, while withdrawing factors of production from other, more urgent, uses. If this plan were to be carried out to completion, at one point the majority of entrepreneurs would employ workers and resources in the production of houses for those who printed and enforced the money while a shortage of other demanded goods for all other individuals would ensue.
The equivalent, however, occurs in the sphere of time preference if the central bank purchases debt on the market. People who demand credit on the market issue credit instruments such as merchant bills, governments issue government bonds and bills. The credit instruments purchased by the central bank will go up in price after each additional purchase, interest rates drop as a tendency. Other providers of credit on the market whose time preferences were matched by the credit instruments offered will abstain from entering into the corresponding credit transaction. Now the central bank has withdrawn future money from the market that would have gone to those who were outbid by it in the process of purchasing the debt. They were not able to enter into a transaction that would have represented their time preferences.
On top of that, the interest rates for the loan contracts purchased drop below the market rate that represents actual time preferences of those operating in the market on a voluntary basis. This has the effect that the entrepreneurs’ assessment of time preferences is skewed. They think that present goods against future goods are valued less than actual voluntary time preferences warrant. Those roundabout projects, that were not being embarked upon, because interest rates indicated time preferences in favor of less roundabout projects (whose goods would be consumable earlier) now appear to be feasible. Entrepreneurs begin embarking upon more roundabout projects that yield an output in the farther future. At the same time they set aside those less roundabout projects which the market interest rates would have induced them to begin, had the credit expansion not taken place. The result is now precisely that consumers are again not supplied with products as desired as per their time preference.
The Credit Boom
Since no additional capital has been created via real savings, prices for factors of production used for the longer term will rise. The stock market, it being the main market for factors of production, will see a price increase, primarily in those stocks for businesses whose projects yield a later output. In particular, a lot of businesses incorporate, that are currently not producing anything, nor plan to produce immediately, but are rather aiming to turn out goods a few years down the road, after spending time on roundabout research and production processes. As a tendency, the labor force of society becomes employed in roundabout, long-term projects.
The same holds true if the credit instruments that are purchased are largely used to finance a specific consumption good, such as owning a home. By purchasing home credit instruments, the central bank will create an environment where many individuals who have not produced enough to exchange against a home will nonetheless obtain a home. Prices of homes will rise since the credit expansion has not at all expanded the amount of homes produced on the market. It is only after this initial expansion that more and more entrepreneurs will begin employing more and more workers in the home construction business.
The Credit Crunch
The labor force, however, at the same time represents the bulk of the consumers whom those products are intended to be produced for. But their time preferences have not changed in reality. While being employed in very roundabout projects and processes, they still desire present goods over future goods more strongly than the entrepreneurs expected based on the lowered interest rates. After the credit expansion is completed, consumer spending and saving habits will not be in line with those expectations. They demand more present products than are available and hence bid up their prices. Due to their shortage, an overall tendency towards rising prices for present consumption goods, such as food and gasoline, ensues. People will need most of their money to buy these consumption goods and hence cut back on spending it elsewhere or making it available in credit transactions. Market interest rates will now readjust in accordance with real time preferences again, based on real savings. They will move up to the market level again. Incorporation of companies with overly roundabout projects will decline. Some entrepreneurs, who are in the middle of overly roundabout projects will not immediately realize this. They will keep employing factors of production in these projects.
However, when they announce their new earnings expectations they will have to take into consideration the fact that most consumers will not have enough money left to purchase their products. They will have to let the capitalists know that their capital will not yield the return expected. This will cause a downward pressure on the prices of those factors of production used for overly roundabout processes. Correspondingly the prices for shares in such companies decline. They will be sold at prices that reflect true time preferences again. However, the time that resources have been employed in overly roundabout projects has been wasted. The true yield of their output did not match the capitalists’ expectations. The capitalists have suffered a loss.
Some of the factors of production and workers will have to be released from their current employment and need to be employed in new lines of production where they contribute towards the production of more urgently demanded consumer goods. Flexible resources will be aligned accordingly and the supply of those goods will increase again and hence their prices will drop back to market levels. Other resources however, which are fixed and specific to one particular project and are merely half finished may be forever lost, in particular this will be the case for huge construction or manufacturing projects that involve the erection of factories, machinery, etc. which have turned out to be useless. A credit contraction will occur and the money supply will be reduced to lower levels in a healthy deflationary process which induces people to save and spend as time and value preferences mandate. The market, once again, returns from an inflationary, regressive resource misallocation to progress and a move toward market equilibrium.
Depending on the amount of excess credit channeled into the market and depending on the duration of the credit expansion, the repercussions can be anything between mild and disastrous.
It is a fact that the correction of the allocation of labor and other factors of production is highly unpopular with the populace. As a rule, individuals, in particular entrepreneurs from businesses employed in unprofitable lines of production, will be in favor of continuing the credit expansion. The positive term “correction” will be replaced by the unpopular word “recession”. A prudent government should not fall for this fallacy. If the process of readjustment is not hampered with, the problems caused by the credit expansion will be within limits. The market will quickly recover, albeit, at a level that is less desirable than where it could have been at without credit expansion. If, however, the government doesn’t allow for the correction to occur, the misallocation of factors of production will be kept up and aggravated until it all culminates in a devastating collapse.
The objective of credit expansion, namely to ensure that more capital is generated in order for the market to provide more of what consumers demand, fails. In fact, it has the opposite effect. It skews the entrepreneurs’ judgment and makes them align resources to produce products that consumers are not demanding and makes them use factors of production for processes that turn out products later than consumers are demanding them while withdrawing them form those production processes that would have been in compliance with consumers’ time preferences.
The policy of credit expansion has been pursued by governments time and time again. It has become prevalent in the United States under President Woodrow Wilson after the establishment of the Federal Reserve Bank under the Federal Reserve Act during the Christmas Holiday of December 1913. Since then, it has caused major credit booms and crunches in the form of asset booms and subsequent crashes and economic booms and subsequent recessions. In particular this has been the case in the years of 1929, 1987, and 2001, and will be visible in 2008 and the following years. It has always precipitated precisely the effects outlined above. Its workings and effects have been fully explained by this theory of the business cycles. No one has ever refuted the correctness of this theory.
Yet, to date economists and politicians appear completely riddled as to what causes booms and crashes. It is claimed to still be a matter of discussion amongst experts. It has been attempted to impute it upon humans’ greedy nature and natural exuberance. Whenever a crisis emerges the pundits, experts, central banks and politicians will try and regulate the market to stave off the impending crunch. They forget or don’t have the intellectual capacity to understand that it has been their own policy that has caused the crisis in the first place.
As long as the central banks keep pursuing this policy, there is no need to be surprised when the next credit crunch occurs. Neither is there any need to be surprised about the fact that all countermeasures taken by the government will turn out to be utter failures that will accomplish nothing but aggravate the crisis. For if the cause of the problem has been too much government intervention, then more government intervention will only add to it.
Update: I refined the process and added much more detail in the post The Business Cycle.