[This article is excerpted from chapter 20 of Human Action: The Scholar's Edition.]
In dealing with the consequences of credit expansion we assumed that the total amount of additional fiduciary media enters the market system via the loan market as advances to business. All that has been predicated with regard to the effects of credit expansion refers to this condition.
There are, however, instances in which the legal and technical methods of credit expansion are used for a procedure catallactically utterly different from genuine credit expansion. Political and institutional convenience sometimes makes it expedient for a government to take advantage of the facilities of banking as a substitute for issuing government fiat money.
The treasury borrows from the bank, and the bank provides the funds needed by issuing additional banknotes or crediting the government on a deposit account. Legally the bank becomes the treasury's creditor. In fact the whole transaction amounts to fiat-money inflation.
The additional fiduciary media enter the market by way of the treasury as payment for various items of government expenditure. It is this additional government demand that incites business to expand its activities. The issuance of these newly created fiat-money sums does not directly interfere with the gross market rate of interest, whatever the rate of interest may be which the government pays to the bank. They affect the loan market and the gross market rate of interest, apart from the emergence of a positive price premium, only if a part of them reaches the loan market at a time at which their effects upon commodity prices and wage rates have not yet been consummated.
Such were, for example, the conditions in the United States in the Second World War. Apart from the credit-expansion policy, which the administration had already adopted before the outbreak of the war, the government borrowed heavily from the commercial banks. This was technically credit expansion; essentially it was a substitute for the issuance of greenbacks.
Even more complicated techniques were resorted to in many countries. Thus, for instance, the German Reich in the First World War sold bonds to the public. The Reichsbank financed these purchases by lending the greater part of the funds needed to the buyers against the same bonds as collateral. Apart from the fraction which the buyer contributed from his own funds, the role that the bank and the public played in the whole transaction was merely formal. Virtually, the additional banknotes were inconvertible paper money.
It is important to pay heed to these facts in order not to confuse the consequences of credit expansion proper and those of government-made fiat-money inflation.