the problem of fractional reserves banking, parts two and three

8/3/2019 The Problem of Fractional Reserves Banking, Parts Two and Three

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The Problem of Fractional Reserves Banking, Part 2

The Money Multiplier

The practice of creating new bank deposits from thin air has large economic

effects. It is important to recognize that from a practical standpoint, depositmoney in demand deposits at banks is part of the money supply. It matters notif money circulates in the form of banknotes and coins or is deposited indemand deposits demand deposits are a perfect money substitute, which isto say, they are money. We have previously commented on measures of themoney supply and provided links to the various methodologies attempting tomeasure it in 'Monetary conditions in the US', but for this article it is enough tostate, money is the medium of exchange, and every form of money or moneysubstitute that performs this function from the viewpoint of the individualactors in the economy is ipso facto money.

We want to first look now at the extent to which fractional reserve banking canincrease the supply of money from thin air. A simple assumption we can use asour starting point (it makes the calculation easier) is that banks, afterobserving the behavior of depositors for a while, decide that a 10% reserve issufficient to cover all withdrawal demands in the 'normal course of business'(this is to say, the course of business prior to the advent of the economic crisisthat the credit expansion will inevitably create).

It is important here to consider that when banks extend loans backed by a

fraction of an original deposit they have received for safe-keeping, they createa new deposit. This new deposit money then will be spent by the borrower, andthereafter becomes a deposit liability either at the same bank that extendedthe loan, or some other bank where the recipient of the spent money has ademand deposit account (some of the deposit money may also remain unused,and thus remain at the bank). This new deposit can then once again be used tocreate an additional deposit, once again keeping only the 10% fraction inreserve.

This process naturally can be continued ad infinitum. If there were only one,

monopolistic bank in existence, it would have an easy time of engaging in thispractice, since it could rest assured that all newly created deposit money willbe redeposited with it. However, the mathematical end result of fractionallyreserved deposit creation is essentially the same, whether a singlemonopolistic bank or a system of several banks is involved (for details on thissee the previously referenced 'Money, Bank Credit and Economic Cycles', J.H.De Soto, chapter 4, 'The credit expansion process').Consider now a deposit of 100,000 units of money (let us say, 'dollars') in asmall bank, that is used to expand credit at a 10% reserve ratio. If the entirenewly created money leaves the bank, it will be able to add fiduciary media of

90,000 dollars (90% of 100,000). If only 20% of these 90,000 dollars remainwith the bank, it can expand deposits by 109,756 dollars (or 22% more).
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This can be shown mathematically as follows:

If the reserve ratio is R, the originally deposited money D, and the remainderof newly created deposits remaining with the bank is K, then in the case ofK=0, the credit expansion X would simply be given by the formula X=D (1-R).In the case of K=0,2 (i.e. 20% of the new deposit money remains with the

bank), the formula for credit expansion would be: X=D(1-R)/1-K(1-R). Thereserve ratio and the percentage of newly created deposit money remainingwith the bank influence the bank's credit expansion possibilities greatly thesmaller R and the bigger K, the more new credit money can be brought intoexistence. In the case of a monopolistic bank with K=1 (this is to say, allnewlycreated deposit money remains with the bank or is redeposited with it), whichlends out 90% of every newly created deposit (starting with the originaldeposit of 100,000 dollars and using a reserve ratio R of 10%), reiterating theprocess begun with the initial deposit again and again, a sequence of the form

D+D(1-R)+D(1-R)+D(1-R)+D(1-R)+D(1R)...== 100,000(1+0.9+0.9+0,9+0,9+0,9...)

describes the total of the bank's deposits that will result from the process. Inshort form we get

D/1-(1-R), or 100,000/1-0,9 = 100,000/0,1 = 1,000,000.

This means that in fact an original deposit of $100,000 has resulted in thecreation of $900,000 in additional deposit liabilities , i.e. the amount of

fiduciary media issued by the bank is exactly 9 times of the original deposit.Putting it differently, the total amount of money has increased ten-fold. Itturns out that the same result is obtained in a system of banks with K= anynumber < 1, or a system of banks where K=0.

The formulas for the calculation change slightly, but the end result remains aten-fold expansion of deposit money from the original deposit if the reserveratio R is 10%. In the real world, banks tend to expand credit simultaneously,so that any reduction in cash at an individual bank from money that is flowingout, will soon be covered by the money flowing in due to the other banks

engaging in the same credit expansion process.

This theoretical expansion of credit and fiduciary media is obviously highlydependent on the reserve ratio, but also on the amount of money incirculation. To the extent that deposit money is removed from the bankingsystem in the form of bank notes circulating outside of the banks, their creditexpansion will be curtailed. This curtailment effect is very large, which explainswhy Sweden's banks are such eager supporters of the bureaucratic drive toeliminate cash, which we talked about in our articles on the discussionregarding a cash ban for a variety ofspurious reasons in Sweden.

To demonstrate the size of this effect, if only 15% of the newly created depositmoney is withdrawn in the form of currency, the putative size of the creditexpansion with a 10% reserve ratio and an initial $100,000 deposit would
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decline from $900,000 to $261,702 (rounded). Money that leaves the banks inthe form of currency therefore has an effect that is similar to increasing thereserve requirement, or a voluntary increase of bank cash reserves.

The Failure of the Centrally Planned Monetary System

A large increase in bank cash reserves can in fact be observed as a result ofthe 2008 crisis that would have absent a central bank and state-guarantees of'toxic' bank assets led to the obliteration of a large number of the de factoinsolvent fractionally reserved banks (see the chart below). This explains whythe Federal Reserve is so eager to expand the money supply by cutting theadministered overnight interest rate to zero and engaging in practices such as'quantitative easing', i.e. the monetization of both government and mortgagedebt securities. If not for these measures, the biggest deflationary contractionof the money supply since the Great Depression would have undoubtedlyoccurred by now.

As it is, the Fed's modus operandi of pumping money into the commercialbanking system which then hoards these excess reserves by depositing themback at the central bank, does little to stimulate inflationary bank credit, atleast not yet.

Excess Reserves held by commercial banks at the Fed previously, during the boomand incessant credit expansion, these were held as close to zero as possible. Now thebanks have become careful and are keeping these reserves at hand as their assetsdeteriorate in value and they are concerned about the concomitant decline in theircapital ratios. The Federal Reserve also has begun to pay interest on bank reservesheld with it , which gives banks an extra incentive to park such large amounts ofreserves with the Fed. You could call the above chart 'the echo of a deflationary

crash'. At the same time, it represents the 'seeds of the next inflationary creditexpansion'.


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It needs to be noted here that the formulas above merely serve to illustratehow much credit expansion is possible, given a certain amount of originaldeposits and a certain reserve ratio. Looking back at the acceleration of thecredit boom from the mid 90's onward, we know that the introduction ofsweeps (see: 'Inflationary Deception' by Charles T. Hatch, pdf) dramaticallyreduced effective reserve requirements and gave the creation of additional

fiduciary media a shot in the arm it certainly didn't need. This is also why therewas an enormous amount of monetary inflation while bank reserves held at theFed effectively stagnated.

The financial system became ever more creative in keeping the credit boomgoing. After the Federal Reserve and the ECB dropped their administeredinterest rate to an artificially low level during the 2001-2002 recession,keeping them low for a prolonged period of time, the banks began to exploreever more avenues for profiting from the spread between short and long terminterest rates. Securitization of loans made it possible to extend more and

more credit to an increasingly less creditworthy pool of borrowers.

Special purpose vehicles were set up that financed themselves in thecommercial paper markets and in turn held CDO's containing mortgage-backedsecurities. Such securities in SPVs were held off bank balance sheets so as tonot have a detrimental effect on the regulatory capital ratios of the bankssponsoring them. However, in order to make it possible for these SPVs toattract funding in the CP market, the banks furnished 'liquidity guarantees' tothe vehicles, thereby increasing their risk profile to the same extent that wouldhave pertained had the securities held by the SPVs remained on the bank's

balance sheet in the first place.If we look at the behavior of money TMS over the long boom, we see thatevery short term crisis was met with an even bigger expansion of credit.
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The growth of the true money supply during the great boom as can be seen, theinevitable crises of the fractionally reserved banking system have been met with evergreater expansions of money and credit. Note especially the expansion of moneyfollowing the 1990-1991 and 2001-2002 recessions and the most recent bustbeginning in 2008.

Ludwig von Mises' assertion that

The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantitiesof fiduciary media are no longer thrown upon the loan market.(Human Action, p.552, ch. XX, 5 , 'The Effects of Changes in the MoneyRelation')

has been confirmed by what has actually happened. The credit expansionindeed accelerated ever more, with every short term bust met with additionalcredit creation, thus creating a giant boom that went through several stages asthe newly created money percolated through the economy. It came to an endonce short term interest rates rose back to the level they had been at prior tothe credit expansion, with the yield curve inverting and making the 'borrowshort, lend long' trade unprofitable. Mises further states (ibid.):

But it [the boom] could not last forever even if inflation and credit expansionwere to go on endlessly. It would then encounter the barriers which preventthe boundless expansion of circulation credit. It would lead to the crack-upboom and the breakdown of the whole monetary system.

Ludwig von Mises: The wavelike movement affecting the economic system, therecurrence of periods of boom which are followed by periods of depression, is theunavoidable outcome of the attempts, repeated again and again, to lower the grossmarket rate of interest by means of credit expansion. There is no means of avoidingthe final collapse of a boom brought about by credit expansion. The alternative is onlywhether the crisis should come sooner as the result of a voluntary abandonment offurther credit expansion, or later as a final and total catastrophe of the currency

system involved. (Human Action, p. 570).
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The latter quote explains the 'counter-cyclical policy' behavior of the centralbank, which attempts to counter-act budding 'inflation expectations', this is tosay a realization by the public that the inflationary policy is permanent. Werethe public to realize that the purchasing power of the money unit is condemnedto fall ever more swiftly, it would lower its demand for money and flee intohard assets, trying to get rid of cash balances as quickly as possible.

Modern 'independent' central banks are supposed to counter-act this tendencyof a credit expansion to turn into a crack-up boom and total collapse of themonetary system by 'tapping the brakes' at opportune moments, this is to say,before the public becomes worried enough about the declining purchasingpower of money that it begins to reject the money the central bank issues.

The frog is to be boiled slowly in other words in this endeavor, the centralbank directed fiat money system has been quite successful in e.g. the US,where the US dollar has lost roughly 97% of its purchasing power since the

third central bank was established in 1913, with a complete repudiation of thecurrency not having occurred as of yet.

This decline in the dollar's purchasing power is by the way an indication of thesize of the excess profits that the fractionally reserved banking system and the'invisible tax' the State have diverted to themselves in the course of the centralbank's operations.

Given that the financial crisis of 2008 and the subsequent economic contractionhave been recognized as the biggest bust of the entire post WW2 period, which

is to say the biggest bust since the Great Depression, it has become evidentthat the central bank - directed centrally planned financial system has in factfailed. Note that central banks were ostensibly established in order to preventeconomic cycles, by guaranteeing the liquidity of the fractionally reservedbanks during crises and by steering the volume of money issuance in a'scientific manner' according to the precepts of the 'price stability policy'.

When the crisis of 2008 broke out, supporters of statist doctrines were quick todenounce the crisis as a 'market failure' and a 'failure of deregulation andliberalization of economic activity', a view which we have already criticized in 'A

Failure of Capitalism?' and 'Greenspan is shocked'.

It should be self-evident that given the fact that we have a central bank and ahighly regulated, centrally planned financial system that has been erectedunder the pretense that it would be able to avert economic downturns andkeep the boom going forever, that the system has failed by its ownstandards. The notion that the centrally planned money system would be ableto deliver this mythical 'eternal boom' was indeed a widespread belief, asevidenced by the late Rudi Dornbusch , a Monetarist (i.e., Keynesian-in-drag)economics professor at the MIT, naively asserting in 1998: 'We won't have a

recession because the Fed doesn't want one'). Here are a few of Dornbusch'spertinent quotes from his 1998 essay 'US recession? No, thank you':
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Not to worry, this expansion will run forever; the US economy will not seea recession for years to come. We dont want one, we dont need oneand therefore we wont have one.The reason is never mind how theexpansion is threatened, we have the tools to keep it going. [.]

None of the postwar expansions died of natural causes, they were all bemurdered by the Fed. [.]

The situation today, deep into the second longest expansion, is quite differentin two respects: First, there is no inflation and hence natural causes of deathrather than the Fed will have to bring the economy to a stand still. Second, thegovernments coffers are overflowing with budget surpluses. Thus, monetaryand fiscal are there to keep the party going in a way we have not seenfor ages. Our current policy team believes in their potency and theywont hesitate to bring them into the battle for continued expansion.

The late MIT economics professor Rudiger Dornbusch: believer in the eternal boom,just as long as the central bank doesn't 'murder it'.

This corresponds to the erroneous Keynesian belief that artificial credit boomscan be sustained in perpetuity by an interventionist state, and the equallywrong belief that one of the effects of inflation the decline in the moneyunit's purchasing power is the correct definition of inflation. However,inflation is the increase in the supply of fiduciary media, and its mostpernicious effect is not necessarily only the loss of the money unit's purchasingpower more generally, but the distortion it imparts to relative prices along theeconomy's production structure.

Furthermore, during economic cycles such as those observed in the 1920's and1990's, when strong productivity growth would normally lead to sharp declinesin the general price level, the debilitating effect of inflationary policy on themoney unit's purchasing power is simply masked the policy of 'price stability'is in reality a policy of massive inflation during such time periods.In any case, the system has evidently failed to avert the collapse of the boom just as the Austrians alone among all economic schools of thought predicted would eventually happen.

The question then becomes, why were Austrian economists able to predict thisfailure while the large bulk of mainstream economists failed to do so?


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The Problem of Fractional Reserves Banking, Part 3

A Theory of Capital

Time, Savings and Economic Progress

The economics of Keynes and the Chicago monetarist school are historicaloutgrowths of a school of economic thought that has remained curiouslyuntouched by the revolution of subjectivist economics that began with thepublication of 'Grundstze der Volkwirtschaftslehre' ('Priniciples of Economics')by Carl Menger in 1871.

Menger is the founder of the Austrian school, and his work completelyrevolutionized the understanding of value, utility, money, exchange, prices andmarket processes. It is possible that the language barrier played a role in the

slow acceptance of this new theory in the English-speaking world, but for thepurpose of this article suffice it to say that Menger was the first author torecognize that there are goods of different order, by differentiating betweenlower order goods (consumer goods) and higher order goods (capital goods).

The major difference between the Keynesian and Monetarist approach toeconomics and the Austrian approach is indeed the complete lack of a theoryof capital in the former, which regard capital as a mythical homogeneous fundthat sort of self-replicates. This mechanistic conception, which looks ateconomic activity as a simple circular flow model between aggregates and

disregards the factor of human action and the concept of the inter- and intra-temporal coordination of production, is unable to explain the recurrence ofbooms and busts, and thus unable to predict them.

The concepts underlying the Austrian capital theory are easily grasped byconsidering the example of Robinson Crusoe on his island, first used by Eugenvon Bhm-Bawerk in 'Kapital und Kapitalzins: Positive Theorie des Kapitals' in1889 ('Capital and Interest: A positive Theory of Capital') and later also usedby Murray Rothbard in 'Man, Economy and State'. The example illustrates thebasic tenets ofpraxeology (the study of human action), and can be viewed as

the initial building block of the theory of capital. It goes as follows:

Robinson arrives on his island, and initially his only means of subsistence areedible berries which he collects by hand. In other words, Robinson possessesno capital, and is engaged in the production of a lower order, or consumptiongood. There is a single stage of production, the collection of berries. It takeshim eight hours per day to collect enough berries to ensure his survival.

After some time of doing this, Robinson's inner entrepreneur awakes and hehas an idea: suppose, he thinks, I were to fashion a wooden stick a few meters

long. I could then collect berries currently out of reach, as well as speed up theberries collection process by striking the berry bushes with more force than Ican currently do by hand. He reckons that in this manner, he could easily
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double his production of berries.

However, there is a problem: making the stick takes time time during whichhe must interrupt his daily berry collection activity. What shall he eat?

It becomes evident that in order to make the stick, Robinson will first have to

make a sacrifice and save some of his current production. If for instance thestick making process takes five days, he will have to save enough berries tosustain him for five days. At this moment, Robinson faces a choice on hispersonal scale of values: namely whether or not he is prepared to forego someof his present consumption in exchange for the promise to be able to consumemore in the future.

Since attaining his future goal of being able to produce more berries in thesame time interval (or the same amount of berries in a shorter time interval)requires a sacrifice, he must attach a higher value to the attainment of this

future goal than to his present consumption.

A present good is always more valuable to an economic actor than a futuregood the ratio between these two evaluations the value assigned to apresent good compared to that assigned to the future good, is the natural, ororiginary rate of interest. It is also evident that no economic progress canoccur in terms of Robinson's berries collection enterprise, unless he decides tosave.

We can furthermore state: if Robinson decides on adding a stage of production,

i.e. the production of a higher order, or capital good, namely the stick, he isengaging in a more time-consuming production process than previously.Robinson is about the lengthen the structure of production, by adding onestage (the stick production) to it. This time element is very important.

Note here that Robinson is faced with the problem of inter-temporalcoordination: he must correctly estimate the time it will take to fashion thestick, so that he saves enough berries to be able to see the process through.

Robinson Crusoe, pondering the creation of a capital good. Shall I fashion a stick?


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The entire principle of capital theory is embodied in this example: in order toachieve a future goal that the actor values more highly than his presentconsumption, he must save enough of his present consumption to be able toengage in a more lengthy, but ultimately more productive, production process.It is the combination of saving and entrepreneurial activity that makes themore complex and longer, but ultimately more productive processes of

production possible. The more stages are added to a production process, themore time consuming and the more productive it will become.By engaging in the production of the stick Robinson will ultimately be able, dueto his higher productivity in the berry collection enterprise, to attain other, atpresent (i.e., prior to the making of the stick) still further away, evenimpossible goals. Since he will be much more productive once the stick hasbeen produced, he will have more time which he can in turn spend withachieving other objectives, such as fishing to vary his diet, or building a hut tobe protected from inclement weather.

We can already see by this simple example that capital is not just a monolithicblob: its creation takes time, saving , entrepreneurial activity and an inter-temporal coordination effort. What is also evident is that what is initially savedare the unconsumed final goods from prior production this is to say, realresources that are required to sustain the persons engaged in the production ofthe capital good during the time period the production takes place. We canstate: there can be no economic progress without saving.

Carl Menger: Author of 'Principles of Economics' and founder of the Austrian School.

The GDP Accounting Fallacy

In the modern market economy, a lattice-work of highly complex productionstructures and plans of enormous length are in place, constantly adapted by

entrepreneurs and capitalists based on their expectations of the future and theinformation imparted by prices. It is noteworthy in this context that themodern conception of a nation's total economic output, or GDP (Gross


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Domestic Product) , simply ignores all the stages of production that take placeprior to final goods output. Calling it a 'gross' product is in fact a seriousmisnomer. As George Reisman explains in 'Standing Keynesian GDP on itsHead: Saving, not Consumption as the main Source of Spending':

Productive expenditure, the sum of the expenditures for capital goods and

labor by business firms, almost certainly not only exceeds consumptionexpenditure but does so by a wide margin. The truth of this proposition can beinferred from common knowledge about the size of business profit margins.

As it were, the truth of this assertion can be confirmed by looking at the BEA's'Gross Domestic Product by Industry Accounts'. As can be seen by these data,the total of economic output by private industry during 2008 (the most recentyear for which the statistics are current) amounted to $23,5 trillion far morethan the official GDP of roughly $13,5 trillion. Another revelation, which will bestartling for most readers, is the fact that the by far biggest sector of the

economy in terms of gross output is the manufacturing sector.

As Reisman further states:

[...]Keynesian macroeconomics is literally playing with half a deck. It purportsto be a study of the economic system as a whole, yet, in ignoring productiveexpenditure, it totally ignores most of the actual spending that takes place inthe production of goods and services. It is an economics almost exclusively ofconsumer spending, not an economics of total spending in the production ofgoods and services.

In fact, contrary to the popular assertion that 'consumer spending represents70% of economic activity' the truth is that consumer spending representsprobably no more than 35% to 40% of all economic activity. The popularconsumption-focused conception of the economy has the great disadvantageof giving respectability to the Keynesian 'under-consumption' theory, andleading to economic interventionism focused on increasing consumption as apanacea against the economic slump.

As Reisman notes, the bulk of spending in the economy in fact depends on

saving:

In Keynesian economics, saving appears as mere non-spending. This isbecause essentially the only spending that Keynesian economics recognizes isconsumer spending. Thus, if funds are earned and are saved rather thanconsumed, it appears to Keynesians that they are simply not spent, i.e., arehoarded. It is on this basis that Keynesian economics describes saving as a"leakage." Yet the truth is that the only way that funds expended in thepurchase of consumers' goods can ever subsequently show up as productivespending for capital goods and labor is if and to the extent that the business

recipients of those funds donot

consume them. Only bysaving the funds inquestion can they have them available to make productiveexpenditures of any kind. Productive expenditure depends on saving.
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This can be illustrated further by looking more closely at the structure ofproduction.

The Structure of Production

In order to better understand the economy's structure of production, we willmake use of the construct of the 'evenly rotating economy' (ERE). MurrayRothbard explains this concept in 'Man , Economy and State' as useful forelucidating economic theory, in spite of the fact that it is not representative ofthe ever-changing, dynamic real life economy. The ERE is an economy in whicha 'state of equilibrium' pertains, a state toward which all economic activitystrives, but which can in real life never be attained, as the circumstances,expectations, plans etc. of economic actors, and the data available to them

constantly change. As we have previously mentioned, the economy is betterunderstood as an organism rather than a machine, an organism made up ofindividuals whose interplay of economic activity creates a spontaneous order.Nevertheless, the ERE has its uses as a construct that allows us to betterexplain the processes of the market economy.

According to Rothbard:

After data work themselves out and continue without change, the rate of netreturn on the investment of money capital will, in the ERE, be the same inevery line of production. If capitalists can earn 3 percent per annum in oneproduction process and 5 percent per annum in another, they will ceaseinvesting in the former and invest more in the latter until the rates of returnare uniform. In the ERE, there is no entrepreneurial uncertainty, and the rateof net return is the pure exchange ratio between present and future goods.This rate of return is the rate of interest. This pure rate of interestwill beuniform for all periods of time and for all lines of production and will remainconstant in the ERE.

In short, in the ERE we leave entrepreneurial profit the ultimate motivator ofentrepreneurial activity out of the depiction of the production structure ,which means that the profit accrued at every stage of production equals thenatural interest as dictated by time preference. Before we proceed to thediagram depicting the production structure, a few more explanations.

As we have seen in the Robinson Crusoe example, savings make it possibly toexpand the production structure by adding new stages to it that producehigher order, or capital goods. The further removed a stage is in time from thefinal, or consumer good, the higher the order of the goods produced at thatstage. Evidently, is is the size of the pool of savings this is to say the pool ofunconsumed production that dictates how many stages can be profitably


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added to the production structure. Since a longer production process consumesmore time, it requires a larger pool of unsold final goods to sustain it and bringit to a successful conclusion at the end of which there will be a larger outputof consumer goods than was possible prior to the lengthening of the productionstructure.

We see from this how the time schedules of consumers and producers arecoordinated by time preference. A lower time preference will result in moresavings being available, which allows for more time-consuming and ultimatelymore productive production processes to be engaged in.

There will be more present goods available that capitalists can pay to theoriginal factors (land and labor) in exchange for the future goods that thesefactor produce. A lower time preference means also a lowering of the naturalinterest rate, which is to say that future goods are higher on the value scale ofconsumers than present goods than they were prior to their decision to engagein more saving.

We can also see from this whywhen this happens (i.e., the amount of savingsincreases and the natural interest rate falls), the investment in stages furtherremoved in time from final goods becomes more profitable. The present valueof a durable capital good is the discounted value of its future rents, so that itspresent value increases the lower the interest rate is that is used in thediscounting process. Thus the profits attainable in the stages of productionfurthest removed in time from the final goods stage rise when the naturalinterest rate falls.

At the same time, the decision of savers to defer some of their presentconsumption in favor of saving will exert downward pressure on the prices ofconsumer goods and make the stages of production closer to consumptioncomparatively less profitable. This enables the release of resources employedin these stages to the now more profitable stages further away fromconsumption, which due to their higher profitability can bid resources awayfrom the lower order stages.

The diagram of a production structure in the ERE below is taken from JesusHuerta de Soto's book 'Money, Bank Credit and Economic Cycles'.
http://www.amazon.com/Money-Bank-Credit-Economic-Cycles/dp/1933550392/ref=sr_1_1?ie=UTF8&s=books&qid=1278881531&sr=1-1http://www.amazon.com/Money-Bank-Credit-Economic-Cycles/dp/1933550392/ref=sr_1_1?ie=UTF8&s=books&qid=1278881531&sr=1-1


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Outline of a 5 stage production structure in the ERE the right hand side columndepicts the profits earned by capitalists at each stage of the production process, whichin the ERE equals the rate of interest and is the same at every stage (in this caseabout 11% p.a.). The top row shows the net amounts earned by the owners oforiginal factors (land and labor) of production at every stage. The 70 units of incomeaccruing to the original factors plus the 30 units earned in toto bycapitalists/entrepreneurs add up to the monetary value of the final goods in the lowestorder stage at the bottom. In GDP accounting, only the 'value added' as embodied inthe final goods is counted (i.e. the 100 monetary units of total net income, equalingthe amount of consumption of final goods). However, we can see here that the totalvalue of present goods advanced by entrepreneurs over the course of the entire 5stage process depicted above amounts to 270 monetary units. Thus the total grosseconomic output is 270 units in advancement of present goods plus the net income of100 units (i.e. the value of the final goods). In short, the gross output amounts to 370monetary units. The entire value of intermediate inputs is simply not considered inGDP accounting.

In the above context, George Reisman has demonstrated that it is in factmathematical nonsense to assert that the value of final products countsanything but the value of these products themselves. In his appropriatelyentitled essay The Value of final products counts only itself(pdf), which wehighly recommend for further reading, Reisman states:

The value of final products counts only itself and not the value of so-calledintermediate products. The prevailing, contrary belief entails a twofold violation

of the laws of mathematics namely, the impermissible discarding of essentialterms of equations and then the addition of the remainders of equations thatare mutually exclusive and therefore not properly subject to addition. It
http://www.capitalism.net/articles/Reisman%20AJES%20Article--AJES.pdfhttp://www.capitalism.net/articles/Reisman%20AJES%20Article--AJES.pdfhttp://www.capitalism.net/articles/Reisman%20AJES%20Article--AJES.pdf


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follows that in order to count the values of the so-called intermediateproducts, one must go out and count them, because they are notcounted in the value of the final product. Despite prevailing belief,counting the value of intermediate products does not representdouble counting.

We see that the fixation on 'under-consumption' and increasing 'consumerspending' that underlies much of today's economic policy is entirelyunwarranted. It is saving, rather than consumption, which enables a higherstandard of living.

George Reisman: the economy consists of much more than just consumption

The pernicious effect of credit expansion

It should also be clear from the above that there is a fundamental differencebetween the effect voluntary saving of preceding production has on theeconomy and the effect exerted by an expansion of the credit and moneysupply. By increasing the amount of fiduciary media , the banking systemcreates the illusion that there are more savings available than there are inreality. As soon as 'money from thin air' is used in exchange, we can say anexchange of 'nothing for something' is taking place, since there is no precedingsaved production that is 'backing' this new money.

Newly created deposit money does not enter the economy all at once and atevery point simultaneously. If that were the case, the effect would be 'neutral' all prices would rise by the same amount simultaneously. We would certainlyall be aware that we have not truly become richer if the amount of our cashbalances were to double overnight and all prices were to double concurrently,but it would be easy to adapt to this new circumstance.

However, the appearance of additional amounts of money from thin air, byartificially and temporarily lowering the market interest rate below the natural

rate, leads to a distortion of relative prices within the economy's productionstructure. Stages of production further away from final goods suddenly appearmore profitable, and investments in these stages will accordingly be


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undertaken. However, since there were no real, voluntary savings added, thetime preference of consumers has not changed, and the seeming profitabilityof these new investments is in reality a mirage.

The necessary sacrifice of saving, which allows more present goods to beadvanced to original factors in exchange for future goods has not taken place.

The real resources necessary to sustain the new investment projects thus donot exist. A boom ensues, but the boom actually impoverishes us, as capitalmust in effect be consumed to keep it going. The investments undertaken onthe basis of the credit expansion will sooner or later be revealed asmalinvestments.

Once the artificial boom ends, entrepreneurs are faced with having to redirect(where possible) or liquidate the malinvested capital. The bust is actually theprocess of recovery it is the time when the structure of production isrearranged to once again properly coincide with the true wishes of consumers.

More money from thin air doesn't make us any richer. When additional fiduciary media

are created from thin air, this does not change the amount of real savings or theamount of capital goods in existence. It only sets a boom with the attendantmalinvestments in motion, and real capital will be consumed.

H. Blasnik, 2010

the problem of fractional reserves banking, parts two and three

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