Answer True or False to each question. I’ll give the answers (and the reasoning behind them) in the comments at midday.
- Gross Domestic Product (GDP) measures a country's total economic activity. T or F?
- Consumer spending represents around two-thirds of the economy. T or F?
- If prices are stable, that means there is no inflation. T or F?
- Money is a creation of government. T or F?
- A period of gently falling prices is a bad thing. T or F?
- Before the Reserve Bank/Fed/Bank of England was created, the world was wracked with inflations, booms and busts. T or F?
- Economics is a "value-free" science. T or F?
- Saving takes money out of the economy. T or F?
- Interest rates are set by the Central Bank. T or F?
- A good war is good for the economy. T or F
- Government spending pumps up an economy in depression. T or F?
- Banks are inherently bankrupt. T or F?
These aren’t trick questions, but you will have to think carefully—particularly if you get your economics from the likes of Rod Oram, Paul Krugman or Alan Bollocks.
UPDATE, WITH ANSWERS (No peeking!):
1. GDP measures a country's total economic activity. T or F?
FALSE: So-called "Gross" Domestic Product is actually much closer to a country's nett product than a gross product.
Since it only counts final goods and services instead of the goods and services used to produce those goods--for example, it only counts bread, but not the flour, water, wheat and yeast used to make it and still being produced; it only counts what comes out of car factories, and not the products of mines, foundries and steel mills --it is, in actual fact, not a gross figure at all but actually a highly "netted" figure.
And since what this figure largely excludes is business-to-business spending, what it conceals is the largest source of spending in any economy, --says George Reisman, business-to-business spending "is analogous to an iceberg, nine-tenths of whose volume is concealed beneath the surface" by the way GDP is measured.
Reisman and other Austrian economists like Mark Skousen, Gerard Jackson and Richard Johnsson favour instead a measure called either Gross Domestic Revenue or Gross Domestic Expenditure, which is less susceptible to manipulation by government. It turns out that Gross Output (a similar figure used by the US Bureau of Economic Affairs, BEA) is about twice the size of so-called "Gross" Domestic Product. In the US in 2002, for example, Gross Output according to the BEA amounted to $18.7 trillion, while GDP equalled just $10.6 trillion.
2. Consumer spending represents around two-thirds of the economy. T or F?
FALSE: This shibboleth will be heard everywhere, but it's just one more error created by confusion over what exactly is measured by the GDP figure.
This is the ridiculous idea that you can still hear trotted out by morons on nearly every news broadcast when retail figures are announced; the fatuous nonsense that fuelled the likes of Kevin Rudd’s shopping subsidies lat year ($1000 cheques backed by thin air which most Australians sensibly saved); the absurd idea behind Helicopter Ben Bernanke’s speech boasting he has “a technology called the printing press” that is the salve for every problem; the fallacy that fuels a thousand calls for stimulunacy, a hundred-thousand for “a boost” in “aggregate demand,” and should have sunk the reputations of everyone who went along.
Though it's hidden in the "netted out" arithmetic of the GDP, by far the majority of spending and income payments in the economy are not consumer spending at all but productive spending, i.e., spending for the purpose of making sales, i.e., business-to-business spending. In other words, for the stuff that really does make the economy go round.
Mark Skousen estimates that the business-to-business spending largely ignored by the GDP figure (i.e., productive consumption) can represent nearly two-thirds of economic spending; whereas consumer spending represents only about 30 percent.
Which means, when you think about it, that it's not “aggregate demand" that drives an economy at all, (as Mr Keynes and his modern-day followers would tell you) it's real supply--which makes sense when you realise that all demand is always and everywhere paid for out of production. Someone's production.
So in short, we're not all going to die if consumers stops spending. Instead, we might actually have a chance to build up savings and investment. Which is what really does drive an economy.
3. If prices are stable, that means there is no inflation. T or F?
FALSE: Inflation can be hidden just as easily behind stable prices as it can be seen when prices are exploding.
Remember that inflation does not simply mean rising prices. More accurately, it refers to the cause of widespread price rises, which is a large increase in the quantity of money in the broader sense that serves to dilute the purchasing power of the monetary unit.
The fact is that rather than protecting an economy, attempting to keep prices stable simply distorts important price signals, causing economic dislocations.
When productivity is high and supply is increasing, even mainstream economics tells us that prices should come down. And when things are going poorly and supply tends towards diminishment, even mainstream economics recognises that prices will tend to rise. It is the meddling with these very price signals by central banks (in the name of price stability) that leads to all the economic dislocations that lead to economic chaos.
The most disastrous of these dislocations occurred in the twenties and the 2000s, both times in which increasing productivity (and, in the 2000s, the rise of Chinese production) was making consumer goods cheaper and cheaper. As Huerta de Soto writes in his book Money, Bank Credit & Economic Cycles:
“The absence of a healthy ‘deflation’ in the prices of consumer goods in a period of such considerable growth in productivity as that of recent years provides the main evidence that the monetary shock has seriously disturbed the economic process.”
But instead of being able to enjoy these cheaper prices, the Central Bank oversaw instead an enormous expansion of the money supply that kept prices up---an expansion that consisted of little more than mountains of cheap credit being flushed through the credit markets and into more and more malinvestments; cheap credit that in the twenties spilled over into the stock market (to fall to ground in 1929) and in the 2000s was mostly directed into housing markets, leading to everyone thinking they could use their house like an ATM machine.
Which they couldn't. Economically speaking, their houses were more like malinvestments than genuinely productive investments.
As the saying goes, "Stabilisation is Chaos."
Just to make the point more plain: the pursuit of so called “price stability” (which generally involves a fair degree of meddling with CPI definitions) provides neither an anti-inflationary panacea (particularly not when housing prices are booming at a time of so-called stability) nor a sound guide to what interest rates should be. M.A. Abrams makes the point clearer:
“In an economically progressive community (that is, one where the real costs of production per unit are falling and output per head is increasing), any additions to the supply of money in order to prevent falling prices will be hidden inflation; and in a retrogressive community, (that is, one where output per head is diminishing and real costs of production are rising), any
contraction of the supply of money in order to prevent rising prices will be hidden deflation. Inflation and deflation can occur just as well behind a stable price level as when the price level is rising and falling.”
The proper policy prescription is not to tinker with the economy by trying to keep prices stable, but instead to keep the hands off altogether, and simply to keep the money supply stable.
4. Money is a creation of government. T or F?
FALSE: Money originated in the economic activity of people buying and selling in a barter economy, and realising eventually that even if you didn’t like or use a particular commodity yourself, if everyone else seemed to like it then that was a good commodity to have.
Yes, it’s true that governments now print the money bills you hold in your wallet, but that’s simply because monarchs over history took over what was already happening naturally because they saw a way to literally clip the ticket.
As Carl Menger thoroughly explains, money itself was originally a “hard” commodity that evolved out of the direct exchange of the barter system; it evolved because folk realised even if other folk didn’t want to exchange their wheat for your fish, you might be able to trade your fish for something more highly saleable and much less perishable. Thus did the likes of tobacco, cows, salt, beer, wampum, cowrey shells, silver and gold at different times and places take the place of the commodity used to effect this “Indirect exchange.” [Doug French explains the Origin of Money in more detail in this presentation at the recent Mises University.]
So money originally was originally a hard commodity that was chosen because it was both highly saleable and it held its value. Now it’s a piece of paper that is only highly saleable because the government tells us that it’s all we’re allowed to use for buying and selling. And as for holding its value . . .
But you might object that government creates money today. Well, even in the present day, government isn’t the largest creator of money. While it certainly is the largest owners of the printing presses that print paper money, the largest creator of money these days is actually the banks, who under the fractional reserve banking system create money out of thin air simply by the push of a computer key, without even going to the effort of running any printing presses at all. And as we’ll see later on, the amount of all that electronic money swamps the paper money on which it’s leveraged . . .
5, A period of gently falling prices is a bad thing. T or F?
FALSE: In fact, a period of gently falling prices is a period in which everyone is getting gently wealthier, because with the same amount of money in their pocket, they are able to buy more and more.
The idea that gently falling prices, what know-nothing economists call deflation is a bad thing is is one of the most pernicious ideas ever put into an economic textbook. Because what’s most important in this context is knowing why prices are falling. There may be three reasons.
Imagine first a place where producers are surging ahead and everyone’s benefitting – a place where technology is making more and more and better products; where ever-improving agricultural techniques mean food is coming out of the ground in ever-increasing amounts; where radically improved construction techniques (and the absence of town planners) means access to housing is getting easier and easier; where new inventions and new technologies are making travel easier and cheaper…
This would be a great place to be, wouldn’t you think? It would be, because everything would not just be becoming more increasingly abundant, it would also be becoming cheaper. Andrew Bernstein summarises the point:
“There is only one method to generate a sweeping prosperity in a specific nation or across the globe: create a colossal supply of consumer goods relative to demand for them, which thereby lowers the price of vital goods and so facilitates raising real wages.”
This is what real prosperity actually looks like: goods becoming more abundant, meaning the price of goods becomes ever cheaper; meaning that because the value of every dollar in your pocket is becoming more valuable, so too is the value of every dollar in your pay cheque: meaning that real wages are actually increasing. This is what real prosperity actually looks like, just like the prosperity enjoyed in Britain and NZ in the period from 1860 to 1914 as the years of the earlier Industrial Revolution bore fruit [click to enlarge]:
A period that (because of the periods of falling prices), know-nothing economic historians still refer to as periods of recession. (Wouldn’t you like to have one of those recessions now?)
Imagine now a place like ours that really is going through bad times. As George Reisman explains in times such as this falling prices, far from being deflation, are actually the antidote to deflation. They are the antidote, he explained,
“because they enable the reduced amount of spending that deflation entails to buy as much as did the previously larger amount of spending that took place in the economic system prior to the deflation.”
Reisman calls this misunderstanding about the connection between deflation and falling prices one of the most pernicious and persistent economic fallacies. Like its destructive mirror-image inflation, deflation is not a measure of a change in prices; it’s more accurately measure of a fall in the money supply. And whatever the government and its central bankers tell you about them protecting the money supply, the only way to ensure your money supply doesn’t collapse is to use a hard commodity as your money, without making any new money on top of that. Which in contemporary terms means a gold money (because all the gold in the world ever mined still exists) with no fractional reserve banking leveraged on top.
Because as you can see from the period in New Zealand after the Reserve Bank was created, far from making every dollar in your pay cheque worth more, with every one of the billons of new dollars they printed they made it worth less.
6. Before the Reserve Bank/Fed/Bank of England was created, the world was wracked with inflations, booms and busts. T or F?
FALSE: See question five above.
However, if you mentioned one of the ten biggest economic blunders in history, I’ll allow you a bonus point.
History in fact shows that when the world was wracked with inflations, booms and bust, it was always a government or a monarch (or their agents) at the back of it. From the Tulip Mania to John Law’s inflationary wreckage that he persuaded Louis XIV to inflict on France to the inflation that wracked Zimbabwe and Weimar Germany—not to mention the Great Depression and the present crisis—all can be laid squarely at the feet of the central monetary powers who still for some reason, are seen as paragons of probity.
Central banks “fix” inflation? Pah. It’s them who create it.
7. Economics is a "value-free" science. T or F?
FALSE: Choosing between competing values is actually the very beginning of economic activity—and the beginning of economic understanding.
Reality doesn’t allow us to eat our cake and have it too. As adults, we understand that. As adult economists, we understand that too--we understand that economic activity begins by choosing between competing actions—”acting man” choosing on the basis of which action he values most—either eating the cake, or baking one-hundred cakes, selling them and buying a delivery truck with the proceeds.
"Value" itself is best defined as what one acts to gain or keep. This is the very starting point of economics—with “acting man,” acting to achieve his values.
Economics is all about values. Take the famous double-thank-you moment of trade. You sell me a beer for five dollars because you value my five dollars more than you value the beer; whereas I value your beer more than I value the five dollars. We’re both happy because we’ve come out ahead in our respective value scales.
Economics is all about values. It’s through a multiplicity of exchanges like that one that economic valuations themselves are set. And it’s through economic activity like exchange and production that resources are produced and discovered, and brought into ever higher-value use.
Economic activity itself is inherently value-laden. It requires recognition not just of individuals’ own differing valuations of goods, but the understanding that the job of production begins with the realisation that goods have objective value. in his “General Theory of the Good,” the founder of Austrian economics, Carl Menger, all but makes this point explicit. In describing what four things must be simultaneously present in order for a thing to become a good, or, as he often puts it, have “goods-character,” he writes:
“If a thing is to become a good, or in other words, if it is to acquire goods-character, all four of the following prerequisites must be simultaneously present:
1. A human need.
2. Such properties as render the thing capable of being brought into a causal connection with the satisfaction of this
3. Human knowledge of this causal connection.
4. Command of the thing sufficient to direct it to the satisfaction of the need.”
What he describes here is the very stuff of value creation.
Economic activity is all about the creation of values.
Furthermore, it’s essential to understand that economic activity itself not only in undertaken in defence of human values--specifically the value and prosperity of human life—it relies on specific life-giving human values to take place.
It requires the freedom for people to make and carry out their choices.
It requires the rule of law so those choices once made my be protected, and with them to the successful results (if any).
It requires respect for reason and rationality, the principle value undergirding all other values, and all successful human production.
Economics is not value-free.
8. Saving takes money out of the economy. T or F?
FALSE: Rather than taking money out of the economy, savings are in fact the source of the largest amount of spending in the economy.
Thinking that saving withdraws money from the economy is yet another error brought about by the economic confusion of the GDP delusion .
Saving does not mean putting you money under your bed. It simply means deferring today's consumption until a later date.
If you’re a consumer, that might leaving one's saved resources available to be put to productive use by someone else in the meantime—which in a sane world means giving it to a bank to lend out to someone who will put it (hopefully) to good use.
If you’re a producer, that means putting the resources you would have otherwise have consumed (maybe by buying that yacht, or by funding all your ex-wives) back into your production instead—either by buying new producer goods, paying rents and the wages of your workers, or by investing in new capital goods.
“This is the meaning of the concept ‘investment.’ If you have wondered how one can start producing, when nature requires time paid in advance, this is the beneficent process that enables men to do it: a successful man lends his goods to a promising beginner (or to any reputable producer)—in exchange for the payment of interest. The payment is for the risk he is taking: nature does not guarantee man’s success, neither on a farm nor in a factory. If the venture fails, it means that the goods have been consumed without a productive return, so the investor loses his money; if the venture succeeds, the producer pays the interest out of the new goods, the profits, which the investment enabled him to make.
“Observe, and bear in mind above all else, that this process applies only to financing the needs of production, not of consumption—and that its success rests on the investor’s judgment of men’s productive ability, not on his compassion for their feelings, hopes or dreams.
“Such is the meaning of the term ‘credit.’ In all its countless variations and applications, ‘credit’ means money, i.e., unconsumed goods, loaned by one productive person (or group) to another, to be repaid out of future production. Even the credit extended for a consumption purpose, such as the purchase of an automobile, is based on the productive record and prospects of the borrower. Credit is not—as the savage believed—a magic piece of paper that reverses cause and effect, and transforms consumption into a source of production.
“Consumption is the final, not the efficient, cause of production. The efficient cause is savings, which can be said to represent the opposite of consumption: they represent unconsumed goods. Consumption is the end of production, and a dead end, as far as the productive process is concerned. The worker who produces so little that he consumes everything that he earns, carries his own weight economically, but contributes nothing to future production. The worker who has a modest savings account, and the millionaire who invests his fortune (and all the men in between), are those who finance the future. The man who consumes without producing is a parasite, whether he is a welfare recipient or a rich playboy…”
..or a once-popular president.
It’s a fact (even though it doesn’t show up at all in the GDP figures) that business-to-business spending is overwhelmingly the greatest source of spending in the economy, and all of that productive spending is paid for out of savings, i.e., out of deferred consumption.
And this figure is huge! It is, explains George Reisman,
"an amount equal to the sum of all costs of goods sold in the economic system plus all of the expensed productive expenditures in the economic system. It is these costs which must be added to GDP to bring it up to a measure of the actual aggregate amount of spending for goods and services in the economic system... And because productive expenditure is the main form of spending, most spending in the economic system depends on saving. Even consumption expenditure depends on saving, inasmuch as saving is the basis of the payment of the wages out of which most consumption takes place."
Which means that it's not consumer spending that drives the economy at all: it's saving.
Read more here: “Saving Not Consumption as the Main Source of Spending”
9. Interest rates are set by the Central Bank. T or F?
FALSE: Yes, the Reserve Bank’s “Official Cash Rate” is set by Alan Bollocks with a view to “price stability,” but real interest rates are actually set by people’s natural “time preference.” The dislocation between this natural time preference and the rate dictated by the government’s central banker is the largest cause of the market dislocations that cause the boom and bust cycle.
According to mainstream economic models, interest rates can't do their job on their own -- they are governed by irrational "animal spirits" (yes, this is the sort of 'thinking' on which the mainstream economic models are based) -- and they require the likes of Alan Bollocks and Ben Bernanke to do the job for them with calculations like this one, in which the interest rate, r=p + 0.5q +0.5 (p-2) +2, and p is defined as the inflation rate over the previous year, and q represents a notional figure based on guessing what 'full output' looks like.
Elegant, huh? The figures '2' appearing there, by the way, indicate the banker's nominal inflation target of two percent. The guess never gets any better than a guess.
If you've ever wondered why economies experience severe business cycles -- lurching cyclically from boom to bust, from inflation to stagflation -- then the heart of the answer lies in the failure of this flawed economic model. Specifically, in the difference between the interest rates brought down from the the mountain (or received from their calculators) by the likes of St Bollard, St Greenspan and St Bernanke, and the 'natural interest rate' that would be set by the market if interest rates and the money supply weren't being meddled with by the likes of these beatified few.
Because the 'natural' interest rate is not set by central bankers at all. In fact, it's not even set by bankers of any kind. It's set by the natural time preference for money of numerous individuals, as shown by their spontaneous decisions to save or consume or invest.
Time preference is simple to explain, but profound in its implications. It is simply a measure of how much I prefer present satisfaction to future satisfaction, as demonstrated by my own actions. It’s pretty certain that every drinker is going to prefer a beer now than one or two next week—or even two or three next year. That’s time preference—a preference for something now over more of it later. And despite what Alan Bollocks and Ben Bernanke say, it’s that simple equation that really drives real interest rates.
If I demonstrate by taking out a loan that I prefer $100 dollars now to $110 one year from now, then that suggests a 'natural' interest rate of ten percent, as demonstrated by my own demonstrated time preference. If I find a lender willing to forego his own consumption of that $100 for one year on the basis that he will receive my $110 in a year, then he has demonstrated a mutually reciprocal time preference.
It is on simple decisions such as this on which a rational market is based.
The natural market interest rate is simply the sum of all such preferences shown by borrowers and lenders across all markets. If coordinated through the voluntary choices and actions of individual actors, it results in the necessary constraints and incentives to keep savings in line with investment spending, and the production of consumption goods in line with consumption.
That is, it provides the price signal given by buyers themselves as to what their future demand will be. Higher natural interest rates means more plans to spend on consumer goods now. Lower interest rates means more plans to save now to buy more consumer good later, which means more investment capital available now (through savings)to produce the increased amount of capital goods needed now to make more consumer goods in the future.
Thus does the natural rate of time preference harmonise the actions and future plans of producers and consumers.
This is not based on wishes issued by central bankers, but on people's demonstrated willingness to forego present consumption. Left alone, instead of being used to further the political goals given to the world's central banks, interest rates can do their "growth governing" job - if, and only if, they are allowed to.
It’s the difference however between these real or natural interest rates and the ones that Alan and Ben set that drive all the dislocations, as Gene Callahan explains:
“What the central bank tampers with is the outcome of the consumers' "votes" on time preference, which is the natural (originary) rate of interest. Consumers' time preferences tell us how much capital will become available through consumers' saving... When the central bank artificially lowers the rate of interest, entrepreneurs make their plans believing that consumers are willing to delay consumption and save more than they really are.
This is where things start getting out of whack; and it’s where the problems really start. Sustainable growth comes from recognising people’s natural and demonstrated time preferences to allocate capital between consumer spending and investment. Unsustainable growth is the inevitable result of trying to fake it.
And if you want charts with that, like the one above only with moving parts, then check out Roger Garrison’s excellent Powerpoint presentation
10. A good war is good for the economy. T or F?
FALSE: In real human terms war is nothing but destruction. In real economic terms, just the same.
There are usually two arguments used to justify this dangerously destructive notion. The first is that the production of war goods somehow stimulates an economy in depression. The second, sometime used to explain the reason for Germany’s and Japans post-war prosperity, is that the destruction of old infrastructure brought about by war stimulates the construction of new and more efficient infrastructure, releasing something called “backed-up demand.”
Both of these nostrums are as absurd as they are dangerous.
However they are paid for—and in most wars including recent ones, wars are usually paid for either by borrowing or printing money--war goods themselves are not like producer goods, (which are used to make sales and so generate further economic activity); instead they are more like consumer goods in that once they are used up all the “good” they have done is all gone.
In fact, the situation is even worse, because the consumer goods at least provide some pleasure or sustenance while being consumed; war goods however are simply shot into the ground, or into cities, or into other human beings—the only good that might be done is in those few cases when the right targets are chosen to shoot at, but in that case any benefit comes about by the destruction of people who have your own destruction as their stated goal, not because of the creation of trillions of dollars of war goods.
The second fallacy relied upon--that a country “starting from zero” again has an economic advantage over those still “encumbered” by aging and inefficient infrastructure—is equally destructive, and equally wrong. It’s just another example of our old friend the Broken Window Fallacy (a fallacy every sound economist should know by heart). As Henry Hazlitt pointed out,
“if this were really a clear net advantage, Americans could easily offset it by immediately wrecking their old plants, junking all the old equipment. In fact, all manufacturers in all countries could scrap all their old plants and equipment every year and erect new plants and install new equipment.”
Read Henry Hazlitt’s thorough debunking of this whole fallacy in his short and pithy piece from his book Economics in One Lesson, The Blessings of Destruction.
11. Government spending pumps up an economy in depression. T or F?
FALSE: This is yet another fallacy consequent upon the GDP DELUSION, which allows know-nothing economists to use government spending to pump up the GDP figure, while ignoring where the resources represented by that spending are paid for, i.e., out of the business-to-business spending that would have happened if the government spending hadn’t, but which is not measured by the official GDP figures.
The apostles of using government spending to “stimulate” an economy don’t just call for spending. They call for truckloads of spending. Even the trillions of dollars already pissed against the wall in the world’s biggest ever golden shower--The Biggest Bill in the History of the World, and still counting--are still not enough for the likes of Paul Krugman, who calls for more and more and still trillions more. All to be paid for out of deficits.
But the real truth evaded by Mr Krugman and his Keynesian conferes is that "Government cannot create genuine spending power; the most it can do is to transfer it from Smith to Jones. If the Treasury sends a stimulus check to Jones, the money comes from taxes, from borrowing, or is newly created"
It’s not just that government spending itself is bad, which it is. Government spending is not productive spending; what it spends it spends almost entirely on consumption. Explains George Reisman,
“In the same sense as a housewife, the government is not a producer but a consumer, who is dependent upon producers. All of its physical production, like hers, is in the last analysis a consumptive production. It is a production which cannot replace the means with which it began ... a production which leaves the government poorer by the amount of funds it has expended. In order to continue the activity, resort must be had to an external source of funds -- in the government's case, the taxpayers or the printing press.”
Government spending always has to be paid for. Deficits even more so—when even taxes aren’t enough to pay for the government’s consumption, resort is always had to either borrowing or the printing press, both of which actions withdraw resources from genuine producers.
The effect of all this 'investment-that-isn't' by governments is not to “pump” anything up apart from the deficits, while making possible the wholesale consumption of real assets that had been produced by producers, (with the price of producer goods having been pushed up by government spending).
The net result is that the whole economy is poorer by the extent to which taxpayers' potential for genuine investment and sustainable profits is curtailed by make-believe investments and the slow consumption of our seed corn.
12. Banks are inherently bankrupt. T or F?
TRUE: Under the modern fractional reserve banking system, if a bank with 100 customers had all 100 show up to get their original savings out, only two of them would be successful. This is the chief reason modern banks are so inherently unstable.
The fractional reserve banking system is a system devised to allow bankers (and governments)to eat your cake while still counting on it for future consumption.
When you “lend” your money to a bank by opening an account there, in which you put let’s say $1000, you may or may not realise that this allows the banking system to create (under current laws) around fifty times that amount as loans. Thus, under the magic of the fractional reserve banking system (in which the “real reserve” of cash is but a fraction of the “fiduciary” money created on top of that) your $1000 of fresh funds becomes around $990 dollars of your money being loaned out, and $49,000 of credit created out of thin air.
Which means banks are lending out vastly more than the pool of real savings against which all that lending is actually backed.
Which means that there are actually multiple claims on each dollar still contained in the bank itself.
Which means (if you’re watching the magician closely) that it’s here that inflation actually enters the whole system: via newly created credit leveraged on the back of a much smaller amount of notes and coins.
Which means too that when things go tits up, banks are lending our vastly more money than they can actually repay to their savers.
“Stimulus” like this is a way governments and bankers fake prosperity. It's a way of 'putting a penny in the fusebox,' allowing economic activity to artificially expand and to keep expanding, yet just as putting a penny in your fusebox now only makes the eventual explosion of your whole circuit board more likely, so too does the cheap 'socialised financing' of fake credit presage a more serious meltdown.
And it gets worse. It gets worse because this process of creating what George Reisman calls counterfeit capital—a process limited only by the bank’s capital requirements and the number of people willing to borrow at the rates set by
the economic dictator Alan Bollocks—is actually in and of itself the primary cause of the dislocations that cause economic booms and busts. You see, Austrian economists understand two relevant things here that mainstreamers don’t:
- The first result of debt-based monetary expansion is that those borrowers who are ‘first in’ get first use of the new money before the inflationary results of that monetary expansion are noticed through the rest of the economy. But the inflation of prices in the class of assets in which the new debt is invested is inevitable – even if it is confused for “growth” and “prosperity” instead of simply price inflation.
- The reason for the inevitable bust is not simply that these asset prices are inflated beyond real values. It’s that the phoney credit expansion cannot continue indefinitely; and neither do the resources exist to allow all the projects that the money has been borrowed during the expansion to be completed.
As Warren Buffett is supposed to have said, "It's only when the tide goes out that you learn who's been swimming naked." Those loans that were made and debts that were incurred which otherwise would not have been made or incurred are what intelligent economists recognise as malinvestment (a misallocation of resources often following a period of artificially excessive credit). They are chickens searching for somewhere to come home and roost once colder economic winds start blowing. The headlines you've been reading in recent days and weeks is the sound of their feathers flying overhead as their financial perches collapse.
And when the “rapid growth” of a credit-created boom turns quickly into a debt-based bust, the first ones to be found swimming with their bollocks out are the banks (a big “Hi there!” to Northern Rock and the boys at Citibank and Bank America), who have lent out way more than they can ever recover; and the next ones to be dumped on is everyone else, because the money supply (which was created on the back of all that bad credit) now wants to contract—and the banks now want taxpayers to bail them out.
Thus we find that fractional reserve leads to inflationary boom which leads to inevitable bust which leads to inevitable deleveraging which (these days) leads to trillion-dollar bank bailouts—which leads to the same thing starting over, and both taxpayers and savers getting screwed.
Which is why it’s not just banks that are inherently bankrupt under a fractional reserve banking system. So too is the economic theory behind it.