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Source link: http://archive.mises.org/10932/does-a-fall-in-credit-lead-to-deflation/

Does a Fall in Credit Lead to Deflation?

October 29, 2009 by

It is not a fall in credit as such that is the key to deflation, but a fall specifically in credit created out of thin air. It is this type of credit that causes the decline in money supply, i.e., deflation. FULL ARTICLE by Frank Shostak


pravin October 29, 2009 at 8:53 am

much more clearer than shostak’s last article on the issue.now that we have spoken of what constitutes real money supply(sans MMMF etc),are there measures for ‘credit’ as well.in particular credit out of thin air?

the deflationists like steve keen and mish shedlock are basing their arguments on credit deflating .lots of numbers are being bandied about -all of them show that ‘credit’ deflating is more than money supply being inflated by the fed.

now if there were a measure to differentiate between the credit that exists out of thin air and the credit that exists normally (backed credit -mmmf/savings deposit etc),then we are cooking with gas. otherwise Mish and Shoshtak are talking past each other .not a good thing for the rest of us.

Matt Ford October 29, 2009 at 10:06 am

Interesting piece, but a couple of question:

If banks can pyramid capital 10 to 1, then doesn’t it stand to reason that a substantial portion of credit that has been created is in fact of the ‘out of thin air’ type?

Re credit of the ‘backed’ variety, if I loan you money and you default on the loan, then we have a decrease in the money supply, don’t we? In other words, a decline in ‘backed’ credit seems still capable of signifying deflation.

Nathan Mayer October 29, 2009 at 10:08 am

“Re credit of the ‘backed’ variety, if I loan you money and you default on the loan, then we have a decrease in the money supply, don’t we? In other words, a decline in ‘backed’ credit seems still capable of signifying deflation.”

but someone would still have the money, no? It doesn’t disappear.

And Pravin – look up Shostak’s 2004 article “How Healthy Are the Banks?”

Albert D. McCallum October 29, 2009 at 10:33 am

The above article is the best I have seen on money supply. I have long believed the calculations of money supply double counted. Loans by commercial banks don’t create money. They only transfer it.

I do take some exception to your suggestion that commercial loans of demand deposits create money out of thin air. The bank loans real money. By doing so the bank gives up it ability to repay its depositors. In effect the bank has forced the depositor to make a loan that he didn’t choose to make. If all depositors demand their money the bank couldn’t pay.

This process didn’t create any money, out of thin air or otherwise. It did increase the calculated money supply out of thin air. That is because of the errors in calculating the money supply.

Bank deposits aren’t money supply to the extent that they exceed the banks available reserves. When a bank holds one dollar and promises 10 people they can instantly withdraw that dollar, there is still only one dollar of real money supply. M1, M2 and M3 include money that simply doesn’t exist. Bank credit is a better measure of money spent than of money available to spend.

Shay October 29, 2009 at 10:38 am

In one example, Joe deposits $100 in the bank (demand deposit) which then loans $50 of this to Bob. This creates $50 out of thin air and inflates the money supply. When Bob repays the bank, this $50 disappears and the money supply deflates again.

A nice symmetry seems to be when someone hoards money away for years. It is effectively removed from the money supply, resulting in (slight) deflation. But when brought back out and spent years later, it re-inflates the money supply.

Anyway, this seemed a similar (though opposite) situation that helps me understand the one with the bank, with the critical distinction of course that the hoarder isn’t counterfeiting, while the bank is.

DD October 29, 2009 at 10:50 am

Albert D. McCallum ,

“I do take some exception to your suggestion that commercial loans of demand deposits create money out of thin air.”

This is too bad for you because you missed a major point of this article; to distinguish between demand deposits and time deposits.

In fact, demand deposits in the process of credit expansion through the entire banking system are created “out of thin air” by a multiplyer factor of 1/R where R is the required reserve ratio.

Tim B October 29, 2009 at 11:53 am

Why shouldn’t excess reserves also be considered money? A deposit creates a dual claim to a percentage of the cash deposited. The depositor claims ownership and the bank claims ownership by adding that amount to its excess reserves. The bank can “spend” that money on a loan asset, or choose to hold that money in its excess reserves. Money held in a bank’s excess reserves serves the same purpose as money under someone’s mattress – as a hedge against future uncertainties. A bank with 90% excess reserves will spend that money differently than a bank with 10% excess reserves. This is a bit of a chicken and egg argument, but I think it is more correct to state that a dual claim, and thus new money, is created at the moment of deposit, not at the moment of lending.

This avoids the messiness of saying that money is destroyed when someone makes a loan payment. With excess reserves counted as money, the only way to destroy FRB-created money is for a depositor or the Fed to withdraw it from the banking system as cash. This destroys the bank’s dual claim to that amount of cash.

Much of the Fed’s new money has ended up in the excess reserves of banks. Without these excess reserves many of these banks would collapse, so these excess reserves are functioning as cash on the balance sheets of the banks.

Albert D. McCallum October 29, 2009 at 12:16 pm

I agree with most of what Tim B. says. On one point I disagree. “and thus new money, is created at the moment of deposit, not at the moment of lending.”

New money isn’t created either time. Cash is transfered from the depositor to the bank. The making of a bank deposit, or loan, doesn’t create money. It only changes who controls the money.

Andras October 29, 2009 at 12:21 pm

When you are a heretic do not stop half way.
In a credit based economy you can hardly separate whether the origin of money is out of thin air or not.
Credit will dissappear only through default as the FED does not dare to do it any longer. Paper shuffling has its limitations. The FED does not even allow for mark to market accounting any more as they know that would show the real situation, overwhelming deflation leading to the end of this financial regime.
I guess the moment of truth will come when the Too Big To Fail banks default then we will see whether we end up with (hyper)inflation or (hyper)deflation (or both if electronic and paper money separates). Actually, similar duplication happened during the fall of the communists in the Eastern Block.

Tim B October 29, 2009 at 1:05 pm

I agree with your statement. We’re really talking about two “layers” of money supply. There is the “legitimate” money supply consisting of physical cash dollars outside of the banking system, bank vault cash, and bank reserves held on account at the Fed (both excess and required reserves). This is what you’re referring to, and you are correct that this is the “real” supply of money that would remain after a banking system collapse (or a return to 100% required reserves).

As long as the fractional reserve banking system is allowed to exist, the dual claims of depositors act as money as well. So depositor’s claims not backed by required reserves constitute an “illegitimate” money supply, that is used the same way as legitimate money. Legitimate plu illegitimate money is the money supply that Shostak is talking about. Whether or not this is the most relevant measure probably depends on what you’re using the money supply number for.

I don’t know which category the government deposits fall under. I suppose they would be in the “legitimate” category, since no bank has a dual claim to them.

Obviously there’s nothing legitimate about any of this, but that’s the best term I could come up with.

gaius marius October 29, 2009 at 2:03 pm

if i read shostak correctly, he’s essentially saying that nontransactional deposits do not create money because the depositor doesn’t consider himself to have the money anymore. therefore, no money is created.

all deposits are bank funding. regulation D delineates the reserve requirements for deposits.

see table 1. banks are effectively required to reserve 10% of transactional deposits, held either as cash or reserves with the Fed; they are not required to reserve anything against non-transactional deposits.

if all banks in a system opened only non-transactional deposit accounts, there would be effectively unlimited money creation. as the credit capacity of the system is the inverse of the reserve requirement, such a system could create an infinite amount of loans and therefore infinite money. the smaller the component of non-transactional deposits in the system, the lower the credit capacity.

i find it difficult to follow how shostak’s thought experiment convoluted this banking regulatory reality into deducing that non-transactional deposits do not create money. that seems to me a misunderstanding of how fractional reserve banking works. they are in fact much more powerful than transactional deposits in their capacity to fund loans and therefore create income and deposits. this is why banks have been merciless about sweeping deposits into non-transactional accounts, and why required reserves have been declining since 1995 even as overall balance sheet has exploded.

and of course the banking system is not reliant solely on deposits for funding. most major banks utilize wholesale funding as well, which also carries no reserve requirement.

increases in the proportion of transactional deposits (ie those which must be reserved against) in comparison to all funding raise the effective reserve rate and reduce the capacity of the system to fund loans. so, even if the overall level of deposit funding remains constant, as demand deposits rise (as they have) where non-transactional deposits and wholesale funding fall (as they have), the capacity of the system to fund loans is diminished. of course the systemic funding level hasn’t remained constant, and this is observable now in the converse intensifying decline of total loans and leases at commercial banks as well as the incredible collapse of financial commercial paper.

Albert D. McCallum October 29, 2009 at 2:57 pm

I am responding to several postings at once. The basic question is, What is money? Money and credit aren’t the same thing. Fractional reserve banking (FRB) multiplies credit, but not the supply of money. In fact FRB decrease the supply of available money. With 10 percent reserve, 10 percent of the money disappears into bank vaults with each loan. If all money were deposited and then loaned subject to reserve, eventually there would be no money left in circulation. It would all be held as reserves. The system would be in gridlock until someone repaid a loan. But, with no money in circulation, How could anyone repay a loan?

Hayek stated that to understand money we must start with barter. Consider a banking system based on apples. “A” deposits 10 apples. The bank loans 9 to “B” who pays them to “C”. “C” then deposits them in a bank which loans 8 apples to “D.” This continues, loaning only whole apples, through the last loan of one apple. How many apples have been created? The depositors now have a total of 55 apples credited to their accounts. Still there are only 10 apples.

Suppose that all of the loans were made by individuals who had no reserve requirements. Each could loan the full 10 apples each time. A hundred loans would create deposits of 1,000 apples. This could go on forever.

The so called multiplier effect counts the apple each time it is spent. It doesn’t count the number of apples available to spend. The same is true for money in FRB.

There are reasons to be interested in the total amount of deposits and loans. These totals tell us little or nothing about the supply of money available to spend.

The only ways that all depositors can get their money at once is for all loans to be repaid, or for the government to create new money. I submit that the real money supply is the total amount available for spending at anyone time. M1, M2 and M3 (if anyone is still calculating it) grossly over state the supply of spendable money. Granted each depositor believes he can withdraw and spend his money. I believe that we all know that this is impossible.

Patrick Barron October 29, 2009 at 3:42 pm

One more thought. I think it should be clear from my idealized banking system that it is fractional reserve banking that is the cause of the boom/bust business cycle. The money supply can expand out of thin air when the Fed adds to reserves or reduces the reserve requirement, as it has done consistently for decades. Eventually, credit expansion touches off the Austrian business cycle. This is impossible under a 100% gold standard (no fractional reserves, just fully backed by gold 100%)for demand deposits, with savers assuming all the risk of entrusting their investable funds to the banker, whose business depends upon his reputation for good judgement and the size of his capital account as a buffer against loan losses.

Dick Fox October 29, 2009 at 4:03 pm

Frank Shostak has written many great articles but when he slips away from Mises into his Austrian monetarist, Quantity Theory, money crank mode he loses me. The question he attempts to answer doesn’t really make any sense. Credit may or may not lead to deflation.

Shostak paints himself into a corner the moment he attempts to define money. When he uses such terms as “part of the stock of cash,” or “part of the money supply” he defeats himself because he cannot determine which part is money supply and which isn’t.

He states, “The crux of identifying what must be included in the definition of the money supply is the distinction between claim transactions and credit transactions.” This may be close to the truth when attempting to define the money supply, though it still doesn’t solve the “part” problem, but in truth, whether credit or claim, it makes no difference if the money in question is NOT in circulation. Credit money buried in the back yard is just as useless as claim money buried in the back yard. Such “money” is actually not money if it is not used in exchange. What makes it money is its use not its identity.

Shostak states he will “define the money supply to include cash, demand deposits with commercial banks and government deposits with banks and the central bank” but just as the government cannot reasonably quantify these amounts, even having trouble defining or even finding them (domestic cash versus foreign cash), neither can Shostak.

Shostak then tells us “deflation is not a general decline in prices of goods and services but a decline in money supply.” It is neither. Inflation/deflation is defined only by the money supply to Quantity Theory adherents and monetary quacks. Deflation as defined by Mises is determined by the QUALITY of money not its supply – by the exchange value of money.

Shostak gives us an example of money “creation” out of “thin air” but this creation is only valid if the bank actually issues money in excess of deposits. If the bank lends money deposited in the bank and then that money is deposited back in the bank then the money just sits in the bank vault, the money is actually removed from the active money supply no matter what accounting entries the bank makes.

The bottom line is that no matter how many pages Shostak writes he cannot define money supply or tell us how to arrive at a reasonable money supply number.

Additionally he totally ignores money demand in his analysis.

What Shostak misses is that if the QUALITY of money is maintained, a “fall in credit” with have no inflationary or deflationary impact. A rise or fall in credit will be driven by fiscal events depending on the market, as it should be.

So the important question is “how do you maintain the quality of money?” There is no perfect answer to this question, but the best solution that men have found over centuries of experimentation is the price of gold. If the price of gold is maintained a stable quality of money will be maintained as well as is possible. The price of gold takes into account the “part of the stock of cash” as well as the “part of the money supply.” Additionally, it will take into account the demand for money. Something Shostak totally ignores.

DD October 29, 2009 at 4:48 pm

Albert D. McCallum,

No offense, but you really don’t know what you’re talking about.

Demand deposits, by means of check book money, debit cards, or whatever, are accepted as money substitutes. Clearance mechanisms allow these substitutes to circulate without reducing the actual cash reserves of the banks. The Fed is a clearance house! These money substitutes are being exchanged for real goods and services, as if they were cash. Therefore, the the original depositor does not relinquish his ability to use that money for exchange. This money is then further multiplied by the credit expansion process. $100 of cash deposited in a bank leads to new $900 of demand deposits, all of which are circulating by means of fiduciary media. Money is created out of thin air!

Tim B October 29, 2009 at 5:32 pm

gaius marius – I think you understood Shostak correctly. Nontransactional deposits are not transactional – i.e. they are not money. Money can be transacted on demand. A nontransactional “deposit” is actually the purchase of an asset. This asset must be “resold” for cash before the amount of cash deposited can be used in exchange by the depositor. The depositor does not have a claim to that cash during the time period of the non-transactional deposit. Thus, no dual claim has been created to the amount of physical cash deposited. The only things that increases the money supply are printing new physical cash and the creation of a dual claim to PRESENT ownership of the same physical cash.

If all banks opened only non-transactional accounts, there would be no new momey creation. This is what a 100% reserve system would be. There could be credit expansion as people with lower time preference lend cash to people with higher time preference through the purchase of loan assets, i.e. non-transactional deposits. If I loan you $10 at 3%, you loan $10 to Albert at 4%, and he loans $10 to Shostak at 5%, we have not created $20 of new money. The three of us have purchased non-transactional loan assets totaling $30, and Shostak has the original $10 of cash to spend. This credit expansion has no theoretical limit, although market forces and interest rates would tend to place a practical limit on leverage in the system. In fact, a highly leveraged system could theoretically be sustainable if the time structure of debt was correctly matched to the time-structure of assets and default risk was correctly predicted.

Albert – I’ll say again that I agree with you, but in a FRB system it is possible to define a second form of money supply that includes unbacked demand deposits. In your example, A,B,C, and D could continue to transact with each other based on their deposit account balances as long as no one withdrew their apples from the bank. Their account balances would just be marked up and down accordingly. Thus their unbacked deposit account balances perform as money as long as this system is not challenged.

dick fox – What is the difference between an increase in the quality of money and a general rise in prices? Isn’t the exchange value of money defined by what it is exchanged for, i.e. goods and services?

Mike Sproul October 29, 2009 at 6:09 pm

Suppose a landowner rents out his land, and collects rent in silver bullion. When he buys groceries, he pays for them by writing “IOU 1 oz.” on a piece of paper. Since he himself accepts these IOU’s in payment of rent, people will accept them, and they can, in principle, circulate as money. Those IOU’s are clearly not created ‘out of thin air’. They have value because they are backed by his land, even though the landowner might never actually redeem them for silver.

Replace the words “rent” with “taxes”, and “Landowner” with “government”, and you have a pretty good description of how modern paper currencies are issued. They are backed by the assets of the entity that issued them. They are not created out of thin air.

Eric October 29, 2009 at 10:01 pm

I think it is easier to think about the money supply if one considers the world market to be a closed auction wherein people come with a fixed amount of cash and there is a fixed number of goods to be auctioned off.

The total amount of money available for bids is then the money supply.

Suppose I give my wallet to my friend to merely hold while I start bidding on an item. The total available for bidding has not changed. If, however, my friend ALSO starts bidding on items, using the money in my wallet to back up his offer, then there is now twice as much bidding going on but only my bid is really valid. This is analogous to what happens with a demand deposit.

Thus with a demand deposit, when the deposit is made, the amount of bids still remain constant. However, as soon as that money is lent out, the same money can be used twice to bid for other goods. The total available for bidding has increased; or in other words, the money supply has increased.

In a credit transaction, the ability to bid is simply transferred from one to another. If I agree to stop bidding while my friend makes bids using the money in my wallet, then this is a credit transaction.

Of course, in the real world, new goods are created, and others are destroyed (consumed). But at any one instant in time, the world is like the closed auction.

Alex October 30, 2009 at 11:08 am

Definitions are used for purposes of accurate communication. A car is defined accurately for all of us, so that when we say to someone about to cross a road, “Look out, a car is coming” the person reacts appropriately. If, instead, some of us define cars to be puff balls, there could be problems when someone says, “Look out for the car.”

So when defining ‘money’ we must do so for the purpose of accurate communication in mind. When we say ‘money’, do we want to communicate the amount of circulating cash plus demand deposits, Frank Shostak’s definition -the amount of the right hand side of the Fed’s balance sheet (the monetary base) plus bank demand deposits created by the banking system-or some other measure? Unfortunately, money presently has many different definitions, and I can’t see how saying that I think that this or that one should be the only definition of money is helpful, unless you can get everyone to agree, so that that particular definition becomes universal.

It would seem to me, therefore, that when using the word ‘money’ in an economics discussion, one should simply state what measure he or she is employing. Doing so will then make for accurate communication.

mpolzkill October 30, 2009 at 11:17 am


Agreed. For instance: May it be resolved that Federal Reserve coupons forced on us through legal tender laws always be referred to as “legal funny money”.

Michael A. Clem October 30, 2009 at 1:10 pm

Suppose a landowner rents out his land, and collects rent in silver bullion. When he buys groceries, he pays for them by writing “IOU 1 oz.” on a piece of paper. Since he himself accepts these IOU’s in payment of rent, people will accept them, and they can, in principle, circulate as money.
People might be glad to pay him in IOU’s in payment for rent, but that doesn’t necessarily mean that people will accept them for other things. The grocer might prefer to have the silver instead of the IOU.
In any case, it is the silver that is the money, and the IOU would be like a silver certificate–a money substitute. Trading the IOU’s is essentially the same as trading in silver. If people don’t care about the silver, but only cared about the IOU’s, then the IOU’s would be money, and the silver is merely a mechanism controlling the supply of IOU’s in the economy (because we all know that no one would write IOU’s for more than the amount of silver they own, right?).
Thus, the assets only matter if the assets are the actual money. This is not the case in our current society. Federal Reserve Notes are money, not the assets “backing” them. Federal Reserve Notes are not a money substitute.

Alex October 30, 2009 at 1:39 pm

Mike Sproul and Michael Clem:

Federal Reserve notes are Federal Reserve notes. Everyone knows what these things are and that these things can be used to make loans or buy stuff. There is no communications problem when we use the term Federal Reserve notes. Likewise, there is no communications problem when we use the term “demand deposits”. Why not use unambiguous words rather than ambiguous words, like money (ambiguous because people define money differently)?

Gerry Flaychy October 30, 2009 at 8:43 pm

Nowadays, there is ‘money’ in the form of central bank notes and coins, and ‘money’ in the form of «money substitute». This last one can be used as ‘money’, that is to say, can be used as a general intermediary of exchange in market transactions.

When we deposit a certain amount of central bank notes and coins in a bank, this amount is inscribed in a bank account in our name, say, a demand deposit account.

Then, this «account-money» can be used as an intermediary of exchange in market transactions i.e. as ‘money’, instead of central bank notes and coins.

«Account-money» is a money substitute, but it is also called ‘money’, particularly when we speak of money supply.

Helen December 2, 2009 at 3:29 pm

Thank you Eric, that is a very interesting analogy. Mish Shedlock recommended this video (the first in a 5 part series) about how banks create money out of thin air. It is informative, if a bit long.

What is trully important to me personally, is not how much money I have, but what I can buy with it. No matter how much real, fiat money the government prints, it will not raise my standard of living. Also, you can not spend your way out of debt. When will the Fed understand this?

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