Friday, 3 October 2008

Explaining the "credit crunch"

I've been a little surprised that George Reisman hasn't commented at his blog on all the recent financial turmoil, but the more I read the more I wonder whether he's simply resisting the urge to say "I told you so" -- because he has.

So let me do it for him by republishing just some of what he's had to say.

Back in his 1996 book Capitalism he summarises what we've seen happening  these last few years -- the boom -- the prosperity delusion -- using your house like an ATM -- the "reversal of safety" -- the malinvestments -- the destruction of capital ... and then the inevitable bust -- the decline in stock markets -- the credit crunch -- the collapse of local finance companies as their "business model" failed -- the decline in commodity prices -- the credit crunch again -- the onset of depression -- and the cause of it all ... the inflation of credit over recent years.

What he's describing is an "inflationary depression," something in which we're already up to our frilly knickers.   It's not a failure of free markets, as Roger Kerr says that idea doesn't even pass the laugh test, it's a failure of politicians and policymakers to understand the damage their intervention does to markets.

It's a shame so many mainstream economists still don't get it -- in fact, as Reisman and other students of Ludwig von Mises have pointed out for many years, they've largely been the cause of the problem

Mainstream economists, and mainstream commentators like the risible Brian Fallow, think all will be well just as long as the credit spigot at the central bank remains turned on -- but they're never truly understood where credit actually comes from, which is real savings.  Their ignorance is a result of the total failure of mainstream economics to integrate their "microeconomics" and their "macroeconomics," leaving theories about the latter floating about in the breeze like a hydrogen-filled balloon just waiting to catch light and spray destruction over real economic activity.

For anyone who wants to get their head around the crisis that will define the next decade, I urge to you get your head around what economists like Reisman have been saying for years, some of which I've reprinted below from his book.  For Reisman's whole discussion I recommend Chapter 19 of his book, 'Gold & Inflation' [the whole book is online at George's website ], of which the section below is the most directly topical to current events  -- and remember that "inflation" as accurately used here by Reisman means not the symptom of across-the-board price rises, but the cause of those rising prices: a rise in the quantity of money, usually because the central banks have had their printing presses running again.

Printed money is backed by nothing more than the goods that already exist, and every new dollar lies as a claim on future production.  It acts as a drain on real capital formation.   The more money that's printed, the more  capital formation is eroded -- the signs are there for many years for anyone who knows what they're looking for (see for example Misesians Mark Thornon, Stefan Karlsson, Anton Mueller, Thorstein Polleit (and again), and Robert Blumen).  The first public sign of the inflation-induced collapse of the bubble appears in the stock market -- this is also the first time mainstream economists realise there's a problem, and it's cause by the effects of the inflation itself:

    The fact that inflation undermines capital formation has important implications for the performance of the stock market. In its initial phase or when it undergoes a sufficient and relatively unanticipated acceleration, inflation in the form of credit expansion can create a
stock-market boom. However, its longer-run effects are very different. The demand for common stocks depends on the availability of savings. In causing savings to fail to keep pace with the growth in the demand for consumers’ goods, inflation tends to prevent stock prices, as well as wage rates, from keeping pace with the rise in the prices of consumers’ goods...
    At some point in an inflation, business firms that are normally suppliers of funds to the credit markets—in the form of time deposits, the purchase of commercial paper, the extension of receivables credit, and the like—are forced to retrench and, indeed, even to become demanders of loanable funds, in order to meet the needs of their own, internal operations. The effect of this is to reduce the availability of funds with which stocks can be purchased, and thus to cause stock prices to fall, or at least to lag all the more behind the prices of consumers’ goods.
    When this situation exists in a pronounced form, it constitutes what has come to be called an “inflationary depression.” This is a state of affairs characterized by a still rapidly expanding quantity of money and rising prices and, at the same time, by an acute scarcity of capital funds. The scarcity of capital funds is manifested not only in badly lagging, or actually declining, securities markets but also in a so-called credit crunch, i.e., a situation in which loanable funds become difficult or impossible to obtain. The result is widespread insolvencies
and bankruptcies.

The other result is the sight of mainstream economists running around with their heads cut off attempting to explain what, to them, is inexplicable: a "credit crunch" when the central banks' credit spigot is still pumping out paper (more than two-trillion dollars worth in recent weeks).  You see, eighty years after the first central-bank-induced inflationary depression, they still don't understand the cause of that one, or yet the cause of this one.  See if Reisman's description of the process sounds familiar:

Inflation as the Cause of Depression & Deflation
    Inflation, especially in the form of credit expansion, sets the stage for financial contractions and deflations— i.e., for depressions. It does so in several, related ways.
    It undermines the perceived need and the desire to own money balances.  As a result, it causes a more rapid spending of money ...
    [This occurs] in large part because credit expansion creates the prospect of being able to obtain the money needed to make purchases and pay bills, easily and profitably through borrowing. The prospect of loans manufactured out of thin air by the banking system is
substituted for the holding of actual money...
    These mechanisms are reinforced by the fact that after a while inflation -- even in the form of credit expansion -- raises interest rates...
    The other side of spending, of course, is people’s revenues and incomes, since one man’s spending is an-other man’s receipts. Obviously, in superinflating the volume of spending in the economy, inflation also super-inflates people’s revenues and incomes.
    Inflation also does something else. It encourages people to pile up a mass of debt that they can pay only so long as their revenues and incomes hold up—indeed, only so long as their revenues and incomes go on increasing. Inflation in the form of credit expansion encourages
borrowing by holding down the rate of interest in relation to the rate of profit. It makes borrowing exceptionally profitable; and the more so, the more leverage the borrowing

Sounding familiar so far?  Just to summarise: inflation of credit, ie., of the money supply, "does two critical things. It super-inflates people’s revenues and incomes, while making them correspondingly illiquid, and it leads them to pile up substantial debts against those revenues and incomes."

Now, let's bring on to the stage both the banks and the bailout, and the reason bankers and Ben Bernanke have been losing their hair, and their shirts:

    This alone must set the stage for a depression if and when inflation [of the money supply] stops. Because then the causes of the reduced demand for money balances are removed. At
that point, people start trying to rebuild their cash holdings. As a result, spending and the velocity of circulation fall, with the further result that people’s money revenues and incomes fall. The effect of this, in turn, is that they cannot pay their debts. A substantial number of business and personal bankruptcies occurs.
    The consequence of this, of course, is that the assets and capital of banks which have lent to such borrowers is correspondingly reduced, and many of them also fail. The failure of banks, of course, causes the money supply actually to be reduced, since [in fractional reserve banking] the banks’ outstanding [current account] deposits are part of the money supply. The reduction in the money supply then leads to a further decline in spending, revenue and income, and thus to still more bankruptcies and bank failures. The process feeds on itself ...  The reduction in the quantity of money can be avoided only if the government is prepared to create additional fiat standard money to whatever extent may be necessary to guarantee the fiduciary media of the
failing banks. But this lays the foundation for a still greater expansion in the supply of fiduciary media in the future.

And so we hear the cry, 'Bring on the bailout!'  In other words, more of the same poison that caused the problem in the first place: more paper money pouring off the government's printing presses.  The whole process is like a giant pyramid scheme, with the pyramid inverted and resting on that printing press in Ben Bernanke's basement.  "This," says Reisman, "is the essence of the inflation-depression process.  The critical factors are: artificial inducements to illiquidity and to a corresponding superinflation of revenues and incomes; the piling up of a mass of debt against these superinflated revenues and incomes; and then a contraction in spending, revenues, and incomes following the
end of the inflation. The contraction phase leaves people with no means of paying the mass of debt they have accumulated, and can operate to produce a self-reinforcing downward spiral of deflation of the money supply."

And now we come to the "credit crunch," exacerbated by efforts to stop prices falling and minimum wage laws set in a different economic environment:

     The inflation-depression process is reinforced by the fact that inflation in the form of credit expansion causes malinvestments—investments which are profitable only on the basis of inflation itself. When the inflation comes to an end, the unprofitability of the malinvestments is
    The onset of the depression is precipitated by the fact that inflation and credit expansion undermine the avail-ability of real capital and thus of credit, too, in real terms.
    In particular, when credit expansion stops, a “credit crunch” develops. This is because the existing capital funds of many enterprises are made inadequate by the rise in wage rates and materials prices caused by the previous injections of credit in the form of new and additional money. The consequence is that firms requiring credit turn out to need more credit than they had planned on, while those firms normally supplying credit turn out to be able to supply less than had been counted on, and may even need credit themselves in order to meet the requirements of their own internal operations at these higher wage rates and prices. Thus, as the need for credit surges and as suppliers of funds become demanders of funds, or at least supply less funds, firms that had counted on borrowing money, or on refinancing their existing
borrowings, find that they are unable to do so.

It's not that "credit has dried up" from the central banks as so many contemporary reports would have you believe -- see Jeffrey Tucker's graphs and Rebert Higgs' report at The Independent Institute exploding this particular myth -- it's just that so much of that credit is now needed to fuel the daily fires of business, to just keep the accounts books ticking over, that little is left for the likes of Craig Norgate to effect Wrighton's merger with Silver Farms.

Nonetheless, we're going to see "credit crunch" after "credit crunch," as the amount of credit needed top keep those account books ticking over only keeps increasing as the emergency measures keep accelerating; you could almost say a "credit crunch spiral":

These results can occur not only when inflation [of the money supply] stops, but also when it merely slows down or even when it fails to accelerate sufficiently. To postpone the onset of a
credit crunch, it becomes necessary to provide the victims of previous credit expansion with additional funds, in order for them to be able to pay the higher wage rates and materials prices caused by the previous credit expansion.
    Then still further inflation and credit expansion become necessary in order to overcome the resulting inadequacy of the funds of still others, possibly including the funds of the initial recipients of credit expansion, who perhaps are now themselves faced with unexpected in-creases in wage rates and materials prices. If at any point, the necessary additional credit expansion is not forthcoming, a credit crunch develops. If it is forthcoming, people soon begin to borrow on a larger scale, in anticipation of the possible inadequacy of funds in the face of
higher wage rates and materials prices. If that additional demand for loanable funds is not met by still more credit expansion, the result is a credit crunch at that point. If it is met by still more credit expansion, the result is a still greater increase in wage rates and materials prices, which nullifies the value of the greater borrowing and requires still more credit expansion to avoid the onset of a credit crunch. Whenever the necessary additional credit expansion
is not forthcoming, some firms find that they lack the funds they require, and thus [another] credit crunch develops.

Now, you might object that wage rates and material haven't been rising, so Reisman's analysis is incorrect.  But as he explains, "it should be realized that in order to produce a 'credit crunch' and the onset of a depression, it is not necessary that credit expansion result in an actual rise in wage rates and materials prices. It is necessary only—as is inescapable—that it make wage rates and materials
prices higher than they would otherwise have been. If wage rates and materials prices fail to fall, or fall by less than they would otherwise have done, the effect is still to render existing capital funds less adequate than they would otherwise have been and to create a need for more capital funds than would otherwise have been the case."  Let me just repeat the crucial lines above describing our present situation, the beginning of an “inflationary depression.”

This is a state of affairs characterized by a still rapidly expanding quantity of money and rising prices [that is, rising ahead of what they would be without the credit inflation] and, at the same time, by an acute scarcity of capital funds. The scarcity of capital funds is manifested not only in badly lagging, or actually declining, securities markets but also in a so-called credit crunch, i.e., a situation in which loanable funds become difficult or impossible to obtain. The result is widespread insolvencies
and bankruptcies.

Remember, this was written in 1996. It must take a manful effort for Reisman not to say "I told you so" ... but he did.


  1. PC,
    You are right, Professor Reisman has been saying this for years - but few listened.
    The reason that he has not been commenting is because he is on a well deserved cruise. I understand he is back in a few days. I look forward to his comments as always.

  2. You're correct about the laughable Brian Fallow. What a statist prick! I write rude emails to him. Especially about carbon trading.
    Rod Oram's another I hate.


  3. What's the difference between, Brian Fallow, Rod Oram's and Gareth Morgan when they're being asked to comment on economic/financial issues?

    Gareth Morgan knows what's he talking about, while Brian Fallow and Rod Oram talk of what they don't know about.

  4. "What's the difference between, Brian Fallow and Rod Oram?"

    Ooh, I know this one.



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