Free Market Watch - December 2008

Artificial Credit

Bad monetary policy from Washington, D.C.

by Steven Miller

There is a simple reason why banks have been so reluctant to loan to other banks. More than anyone, bankers know what banks do.

Fractional-reserve banking, after all, is the business of legally lending out money one does not have, all the while hoping that large numbers of your depositors do not show up at the same time demanding their money.

In the short term, it typically works out okay for the banks, as people do not usually show up all at once. Ultimately, however, banks and banking systems eventually get into trouble. Bank runs and financial panics then ensue.

During the 19th century, the U.S. averaged a financial panic every 20 years. In each case, the cause was federal or state governments “monkeying” with the banking business, making it legal for banks who presented themselves to depositors as full-reserve institutions to operate with only fractional reserves. As is regularly the case, politicians colluded with wheeler-dealer bankers to allow the latter to skirt fraud laws and inflate credit by issuing loans not backed by bank reserves or — what is essentially the same thing — inflating the currency by printing money (i.e. promises to pay gold or silver on demand) not actually backed by precious metals.

What most politicians never understand, however, is that the leveraging and inflating of bank reserves may initially produce a boom, but it must also end with an equivalently severe economic contraction. Because artificial, bank-created credit is essentially counterfeit capital, i.e., counterfeit savings, it misrepresents the true level of genuine investment capital, or built-up savings, available in an economy and thus misleads business people —by misinforming them as to the actual ability of the economy to support their entrepreneurial projects.

Thus, artificial, bank-created credit necessarily produces a disproportionately large number of bad investments. Entrepreneurs’ time, energy, financial resources and workers’ labor get directed into producing goods and services for which there is no real demand. For a contemporary example, think of all the homes built during the housing mania now sitting empty and unwanted.

As investments made during the boom increasingly reveal themselves as unsustainable, people are recognizing that somehow they were misled. Wiser individuals start cutting their investment losses by extracting their money, others follow and the entire economy starts the painful readjustment to reality.

In each such boom-bust cycle, the collusion between politicians and funny-money bankers produces massive economic trauma and a huge amount of waste, measured in the time, energy, labor and savings of millions of American workers.

Although the Federal Reserve System was sold to the public as a way to bring “stability” to the banking system and prevent future financial panics, its record is just the opposite. Since the Fed’s creation in 1913 it has presided over the crashes of 1921 and 1929, the Great Depression of the 1930s, the recessions of 1953, 1957, 1969, 1975, 1981 and 1991, the internet bubble, the housing bubble and, most recently, the commodities bubble.

This record was entirely foreseeable because the Fed’s real objective — widely discussed at the time by the bankers and politicians who pushed hardest for its formation, and well documented by subsequent historians — was to establish a nationwide banking trust, or cartel, that could inflate money and credit at will.

The Fed has accomplished that objective many times over. Today, it regularly prescribes more artificial credit as the “cure” for the ills that its last binge of artificial credit produced. And hardly anyone blinks.

The economic contraction seen by Nevada and America is almost certainly, just the beginning.

Steven Miller
Steven Miller is policy director for the Nevada Policy Research Institute.