Does credit expansion through fractional reserve banking increase investments and living standards?

If credit expansion could possibly increase investments it would be through forced savings, but savings that are forced lowers the livings standards as they are not voluntarily taken.

In a free market without any government intervention, all individual actions are voluntarily and increases of the standard of livings are therefore true.

But apart from this very fact, do credit expansion increase investments and physical output?

No, the prerequisite for increased investments are true savings that are financed by postponing consumption and factors of production are thereby released from producing consumption goods to produce capital goods which in the future will increase the output of consumption goods.

What actually credit expansion does is to distort the markets and produce the business cycle. This will make investments more risky and also waste resources (malinvestments) and this in turn will lower physical output and living standards.

Björn Lundahl

Roger:

“Clayton: “The final point I want to be very clear about is the fall in the real interest rate due to monetary infustions.”

I think we have a problem with definitions here. The real interest rate is the nominal interest rate (the posted one) minus a figure for price inflation. So if the posted interest rate is 8$ and prices have increased 3%, then the real interest rate is 5%. The natural rate, according to neo-classical econ, is the interest rate that causes neither price inflation nor price deflation.

However, in Austrian econ, the natural rate is the interest rate that would exist without banks monkeying with the money supply, and it’s based on the time preference of capitalists, as Dr. Reisman points out. It has nothing to do with shoeleather or “rate of interest = rate of services – rate of price loss.” The time preference of capitalists determines the rate of profit which in turn determines the interest rate.”

Roger, “rate of interest = rate of services – rate of price loss” is a tautology that must apply to any good. We would be willing to give up a good for a value equal to the net real services that good produces.

For gold, the value we obtain from having the gold in our hand is the value of the ostentation services minues the fall in real value of the gold. If we can get this value “in interest”, we’d be willing to give the gold to someone else. This is a real rate of interest because it’s the real return in the good.

Money is no different. We’re willing to forgo the physical posession of our money if the interest rate is equal to the services we obtain less the fall in the value of our money.

This is “by definition” in the praxelogical sense. This also illustrates the difference between the physical return on assets (the rate of services) and the interest rate (via the change in prices) that is common in Austrian lingo though rarely detailed out.

Now, if the interest obtained on one good is larger than the interest on another, we’d expect the relative price of the goods to adjust to restore equilibrium. This can occur in two places, the current exchange rate can adjust or the future exchange rate can adjust. If we assume that the future exchange rates are fixed as the discounted stream of future services, this adjustment must occur in the present prices.

Either a fall in prices on the low interest good will decrease the change in prices (increasing the interest rate in our tautology) or a higher price on the high interest good will increase the price change (lowering the rate of interest in our tautology). This should be an instantaneous calculation, but in a world of sticky prices it is not (as clearly is true in our world or the natural rate would be instantaneously restored by bouts of instant and notable inflation due to changes in money supply).

Until this price change happens, however, the praxelogical rate of interest on a good (the interest required to give up the good at the current price) is defined and can be different from the natural rate.

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What should happen in a large network is that all goods should adjust prices and settle on the natural rate. This would be true of money like any other good. The price of money should fall quickly to restore balance. This fall in the price of money (or faster fall in a constant inflation scheme) would force an inflation targetting central bank to slow monetary expansion and restore the natural rate.

Consequently a successful inflation targetting central bank will maintain the natural rate and create no misallocation or distortion… period. What is left, then, is whether or not a central bank can do this with the right theory and, in a world of sticky prices, how much distortion will occur (or be prevented) by their attempts to do so.

In my bookshelf I found an old book and looked into it “Dollars and Deficits, Inflation, Monetary Policy and the Balance of Payments”, by Dr. Milton Friedman published in 1968, chapter two, page 76:

“I cannot forbear a minor digression at this point. For a long time I have been a proponent of 100% reserve banking. Under this system, the depositary activities of banks would be separated from their lending and investing activities, and the depositary institutions would serve as pure warehouses of funds. For every dollar of deposits, they would be required to hold a dollar currency or its equivalent. Those of us who favour this scheme are accustomed to being labelled “unrealistic”; to being told that we are proposing a reform that has no chance of adoption and would require utterly impractical changes in the banking system if it were adopted.”

It seems that Milton Friedman gave up this idea of 100% fiat money reserve standard and instead proposed a monetary rule as this standpoint was more politically feasible.

Björn Lundahl

Clayton: “Money is no different. We’re willing to forgo the physical posession of our money if the interest rate is equal to the services we obtain less the fall in the value of our money.” and “…’rate of interest = rate of services – rate of price loss’ is a tautology

That is true only if by the “services we obtain” you mean future consumption. Otherwise it makes no sense at all.

Clayton: “For gold, the value we obtain from having the gold in our hand is the value of the ostentation services…”

What in the world is ostentation services? The only reason to hold gold as money, or any money, is if you need it to pay current expenses.

Clayton: “Now, if the interest obtained on one good is larger than the interest on another…”

Interest is paid on money, not goods. Investment goods can have an ROI, but no one calls that interest, and it has nothing to do with interest. You seem to be very confused.

Clayton: “This also illustrates the difference between the physical return on assets (the rate of services) and the interest rate (via the change in prices)…”

Austrian econ makes it very clear that the two have nothing to do with each other. Austrian econ equates interest with profit, not return on assets.

Clayton: “Consequently a successful inflation targetting central bank will maintain the natural rate…”

Your thinking and definitions don’t follow any established system of econ, neither Keynesian, neo-Classical, monetarist or Austrian. It seems as if you’re trying to create a new branch of econ. No one uses “natural rate” of interest as you do. I gave the definitions of the prominent schools above. Creating new definitions of commonly used words does not help at all. I’ll repeat the Austrian definition of “natural rate”: It’s that rate that conforms to the time preference of capitalists and is most clearly recognized when the money supply remains constant.

As I wrote before, inflation targeting by the Fed has caused massive monetary inflation, even though price inflation has been mild or non-existent. That happens because under a constant money supply, prices will decline when productivity increases. So if prices don’t increase when productivity increases, then the Fed is pumping too much money into the economy and causing the boom that leads to the bust. Even worse is that the Fed’s “basket” of goods doesn’t include assets, such as the stock market, where price inflation resulting from monetary inflation first appears. The 1990′s provides a great example. The Fed met all its inflation targets and price inflation was very mild by modern standards. However, the stock market soared as a result of the Feds massive pumping of money into the system. As a result, there was a great transfer of wealth to the early receivers of the Fed’s new money (those who purchased stocks early) from the late receivers of the money, just as Austrian econ predicts.

Dennis

”To think that real wealth can be created by increasing the quantity of the medium of exchange is one of the most widely believed and pernicious fallacies in all of economics.”

Yes true, it is totally erroneous.

Björn

“1. Without an increase in the money supply, no mechanism exists to cause a general rise in the price level. The neo-schools talk about shocks causing price inflation, and they give the rapid rise of oil prices in the 1970′s as an example. But logically, if the money supply is constant and a shock occurs in one or two products, then people will spend more for those higher priced products, and leaving them less to spend on other products. As a result, the prices of other products will fall and cancel out the effects of the higher priced products and no net increase in prices would happen. What could cause people to demand more of most products across the board? Where would the suddenly get the money to do so? Only through an increase in the money supply.”

… and some other quotes I won’t repeat

“Ostentation services” is the value of gold jewelry. Ostentation (from answers.com): “Pretentious display meant to impress others; boastful showiness.” If gold is being used in money then its services are shoe-leather services (or other forms of efficiency) vis a vis a barter system. This value or these services justifies taking gold from its ostentation or industrial uses and placing it in services as money. While there are many examples of transaction efficiences offered by money, I’ve typically heard them referenced as “shoe-leather” as a way of categorically capturing the real savings (in valuable time) experienced by the economic participants.

To your direct question about prices changes w/o changes in the quantity of money:

Greater levels of exchange in the economy can increase the amount of shoe-leather services that money can potentially produce. If the quantity of money is fixed, this would increase the per-unit services generated by money (and thus the value of money). Other schools speak of an increase in the demand for money that increases its value. I’m indifferent to your phrasing as I believe the two approaches can be relatively easily equated.

Using a simple example, imagine everyone in the world wants to hold $100 in cash in their pocket to optimize their trading costs and that there is just enough cash in the economy to allow this to happen. Now, we double the number of poeple in society without touching the money supply. Each person can no longer keep $100 in their pocket because there isn’t enough cash to go around. The best they can do is to go to the bank more often, taking $50 out each time, but this generates additional shoe-leather costs (losses in efficiency due to the incremental and suboptimal travel time now being invested). If, instead, the purchasing power of the unit of money were to double, they could each maintain the same real value in their pockets (albeit now $50 nominal) and obtain the same reduction in shoe-leather costs (what I call shoe-leather services).

Naturally, the reverse is possible. While it would seem unlikely in the current world of increasing population and increasing transaction quantities, the ability to make payments on credit cards could, if it occured fast enough, generate the opposite effect by reducing the shoe-leather services of cash and thus the “demand for money”.

Further, if you assume that the shoe-leather services are present services (or more accurately a perpetual stream of services) and that money is valued as a discounted stream of these services, a fall in the interest rate would increase the value of money (thus decreasing prices). An increase in the interest rate would decrease the discounted value of these services, decrease the value of money, and increase prices. This is exactly what happens to bond prices (imagine if one bond was the unit of account instead of $1). Again, the aforementioned type of behavior without changing the quantity of money.

I realized my statement was going to seem counter-intuitive if I didn’t clairfy:

“An increase in the interest rate would decrease the discounted value of these services, decrease the value of money, and increase prices. This is exactly what happens to bond prices (imagine if one bond was the unit of account instead of $1). Again, the aforementioned type of behavior without changing the quantity of money.”

In this statement I refer to changes in the natural rate not changes in the rate of interest on money. Of course the opposite effect happens when the interest rate on money changes (while the natural rate remains fixed).

Apart from wages I do not consider “sticky pricing” as any problem at all in a free market economy.

Labour unions privileges should be removed and the “philosophy” that it is wrong to cut wages when it is needed should be fought.

Economists generally do not have a definition of what a free market economy is (definition of property rights) and very often criticise the market economy when they really should instead criticise the government and its regulations.

Free trade and deregulations should also increase competition.

Björn Lundahl

Well, I found here some support for my views by Murray Rothbard.

The Case for the 100 Percent Gold Dollar:

“In this monetary system emerging on the free market, no one can create money out of thin air to acquire resources from the producers. Money can only be obtained by purchasing it with one’s goods or services. The only exception to this rule is gold miners, who can produce new money. But they must invest resources in finding, mining, and transporting an especially scarce commodity. Furthermore, gold miners are productively adding to the world’s stock of gold for non-monetary uses as well.

Let us indeed assume that gold has been selected as the general medium of exchange by the market, and that the unit of account is the gold gram. What will be the consequences of complete monetary freedom for each individual? What of the freedom of the individual to print his own money, which we have seen to be so disastrous in our age of fiat paper? First, let us remember that the gold gram is the monetary unit, and that such debasing names as “dollar,” “franc,” and “mark” do not exist and have never existed. Suppose that I decided to abandon the slow, difficult process of producing services for money, or of mining money, and instead decided to print my own? What would I print? I might manufacture a paper ticket, and print upon it “10 Rothbards.” I could then proclaim the ticket as “money,” and enter a store to purchase groceries with my embossed Rothbards. In the purely free market which I advocate, I or anyone else would have a perfect right to do this. And what would be the inevitable consequence? Obviously, that no one would pay attention to the Rothbards, which would be properly treated as an arrogant joke. The same would be true of any “Joneses” “Browns,” or paper tickets printed by anyone else. And it should be clear that the problem is not simply that few people have ever heard of me. If General Motors tried to pay its workers in paper tickets entitled “50 GMs,” the tickets would gain as little response. None of these tickets would be money, and none would be considered as anything but valueless, except perhaps a few collectors of curios. And this is why total freedom for everyone to print money would be absolutely harmless in a purely free market: no one would accept these presumptuous tickets.

Why not freely fluctuating exchange rates? Fine, let us have freely fluctuating exchange rates on our completely free market; let the Rothbards and Browns and GMs fluctuate at whatever rate they will exchange for gold or for each other. The trouble is that they would never reach this exalted state because they would never gain acceptance in exchange as moneys at all, and therefore the problem of exchange rates would never arise.

On a really free market, then, there would be freely fluctuating exchange rates, but only between genuine commodity moneys, since the paper-name moneys could never gain enough acceptance to enter the field. Specifically, since gold and silver have historically been the leading commodity moneys, gold and silver would probably both be moneys, and would exchange at freely fluctuating rates. Different groups and communities of people would pick one or the other money as their unit of accounting.

Names, therefore, whatever they may be, “Rothbard,” “Jones,” or even “dollar,” could not have arisen as money on the free market. How, then did such names as “dollar” and “peso” originate and emerge in their own right as independent moneys? The answer is that these names invariably originated as names for units of weight of a money commodity, either gold or silver. In short, they began not as pure names, but as names of units of weight of particular money commodities. In the British pound sterling we have a particularly striking example of a weight derivative, for the British pound was originally just that: a pound of silver money. “Dollar” began as the generally applied name of an ounce weight of silver coined in the sixteenth century by a Bohemian, Count Schlick, who lived in Joachimsthal, and the name of his highly reputed coins became “Joachimsthalers,” or simply “thalers” or “dollars.” And even after a lengthy process of debasement, alteration, and manipulation of these weights until they more and more became separated names, they still remained names of units of weight of specie until, in the United States, we went off the gold standard in 1933. In short, it is incorrect to say that, before 1933, the price of gold was fixed in terms of dollars.

Instead, what happened was that the dollar was defined as a unit of weight, approximately 1/20 of an ounce of gold. It is not that the dollar was set equal to a certain weight of gold; it was that weight, just as any unit of weight, as, for example, one pound of copper is 16 ounces of copper, and is not simply and arbitrarily “set equal” to 16 ounces by some individual or agency. The monetary unit was, therefore, always a unit of weight of a money commodity, and the names that we know now as independent moneys were names of these units of weight.”

http://mises.org/daily/1829

Björn Lundahl

Bjorn: “Apart from wages I do not consider “sticky pricing” as any problem at all in a free market economy.”

You’re right. Neo-Keynesians and neo-Classics had to come up with some reason for business cycles, so they invented the sticky prices/wages idea. According to the neos, shock happen, like acts of God with no explanation. Prices and wages should adjust and eliminate the effects of the shocks but they don’t. Therefore the rationale for sticky wages/prices. Of course, with banks manipulating the money, there would be no “shocks” and therefore no need for price/wage adjustments.

The Neo’s absolutely refuse under any circumstances to even consider the notion that fractional reserve banking might be a problem. But we’re making progress. Some of the economists at the Fed Reserve of San Francisco write as if they’re at least familiar with the ABCT. Also, I read recently that the head of the Euro central bank stated that it’s ridiculous to think that money has no effects on the real economy.

Here’s an interesting quote from Hayek in The Fatal Conceit:

“Money, the ver ‘coin’ of ordinary interaction, is hence of all things the least understood and – perhaps with sex – the object of greatest unreasoning fantasy; and like sex it simultaneously fascinates, puzzles and repels. The literature treating it is probably greater than that devoted to any other single subject; and browsing through it inclines one to sympathize with the writer who long ago declared that no other subject, not even love, has driven more men to madness. ‘The love of money’, the Bible declares, ‘is the root of all evil’ (I Timothy, 6:10). But ambivalence about it is perhaps even more common: money appears as at once the most powerful instrument of freedom and the most sinister tool of oppression. This most widely-accepted medium of exchange conjures up all the unease that people feel towards a process they cannot understand, that they both love and hate, and some of whose effects they desire passionately while detesting others that are inseparable from the first.

“The operation of the money and credit structure has, however, with language and morals, been one of the spontaneous orders most resistant to effort at adequate theoretical explanation, and it remains the object of serious disagreement among specialists.”

So my conclusion is that inflation targeting will and has produced a greater economic stability compared to none targeting as during the 70s. As long as the demand for money is relatively stable, the growth rate of the money supply will also be fairly stable and malinvestments will to a certain degree be maintained. The relative stability is, in other words, sustained because of a relative stable growth of the money supply and not because of the inflation target of about 2 percent. Let us hope that the demand for money in the future also will be quite stable.

Inflation targeting is therefore a very bad substitute for a 100 percent gold money reserve standard as it causes misallocations and will not be a true guarantee against economic bubbles. The economy will not either be depression proof. I think it is “fair” to say and believe that depressions won’t be probable as the demand for money will not decrease in a manner that I have already mentioned as at least possible and which could and should, under a regime of inflation targeting, be counteracted by even bringing the growth of the money supply to a halt. But you cannot be 100 percent sure of it.

To bring the growth rate of the money supply to a halt is only a good thing if the ambitions of the central banks are to, once and for all, liquidate all malinvestments but will not be a good thing if the ambitions are not those and would the growth rate of the money supply be brought to a halt under a regime of inflation targeting, central banks would probably abandon inflation targeting when the depression starts and begin to inflate again, believing that something is inherently wrong with the free market economy and that their actions are needed for these “special circumstances”. As a “secondary policy”, central banks are also, under a regime of inflation targeting, obliged to ”keep an eye on” unemployment and the growth rate of the GNP and as those variables would react in a not wishful manner because of the fact that the money supply is not growing, they are obliged to inflate again.

Björn Lundahl