On Wednesday October 8 the Federal Reserve, European Central Bank and four other central banks lowered interest rates in an emergency coordinated bid to ease the economic effects of the financial crisis. The Fed, ECB, Bank of England, Bank of Canada and Sweden's Riksbank each cut their benchmark rates by half a percentage point. Furthermore, China's central bank lowered its key one-year lending rate by 0.27 percentage point. According to a joint statement by the central banks

The Fed's decision brought its benchmark rate to 1.5 per cent. The ECB's main rate is now 3.75 per cent; Canada's fell to 2.5 per cent; the U.K.'s rate dropped to 4.5 per cent; and Sweden's rate declined to 4.25 per cent. China cut interest rates for the second time in three weeks, reducing the main rate to 6.93 per cent. Day earlier the Reserve Bank of Australia had lowered its policy rate -- the cash rate -- by 1 per cent to 6 per cent.

Only a day earlier the Chairman of the Fed Bernanke announced that the US central bank is ready to intervene in the commercial paper market. The Fed will now buy commercial paper issued by corporations -- meaning the US central bank will make direct loans to corporations.

It seems that Bernanke is ready to push trillions of dollars to keep the monetary system alive.

Bernanke is of the view that a major reason for the Great Depression of 1930s was the failure of the US central bank to act swiftly to revive the paralysed credit market. By swift actions Bernanke means massive monetary pumping. The Fed Chairman continuously reminds us that at least he has learned the lesson of the Great Depression and will make sure that the error that the Fed made then will not be repeated again. At the Conference to honour Milton Friedman's ninetieth birthday Bernanke apologised to Friedman on behalf of the Fed for not pumping enough money to prevent the Great Depression.

(Milton Friedman and Anna Schwatrz wrote that the key factor behind the Great Depression was the failure by the Fed to pump large dosages of money).

In their various statements central bank policy makers have said that the key for economic growth is a smooth flow of credit. For them, in particular Bernanke, it is credit that provides the foundation for economic growth and raises individuals living standards. So from this perspective it makes a lot of sense for the central bank to make sure that credit flows again.

Following the teachings of Friedman and Keynes it is almost the unanimous view of most experts that if lenders are unwilling to lend then it is the duty of the government and the central bank to keep the flow of lending going. For instance, if in the commercial paper market lenders are not there then the Fed should step in and replace these lenders. The important thing, it is held, is that various businesses that rely on the commercial paper market to keep their daily operations going should be able to secure the necessary funding.

Will the increase in money pumping by central banks unfreeze credit markets? Experts believe that this will do the trick. If the current dosage of pumping won't work then the central bank must continue to push more money until credit markets start moving again, so it is held. Now it is true that credit is the key for economic growth. However, one must make a distinction in this regard between good and false credit. It is good credit that makes real economic growth possible and thus improves people's lives and well being. False credit however, is an agent of economic destruction and leads to economic impoverishment.

Good credit versus false credit

There are two kinds of credit: that which would be offered in a market economy with sound money and banking (good credit) and that which is made possible only through a system of central banking, artificially low interest rates, and fractional reserves (false credit). Banks cannot expand good credit as such. All that they can do in reality is to facilitate the transfer of a given pool of savings from savers (lenders) to borrowers. To understand why, we must first understand how good credit comes to be and the function it serves.

Consider the case of a baker who bakes ten loaves of bread. Out of his stock of real wealth (ten loaves of bread), the baker consumes two loaves and saves eight. He lends his eight remaining loaves to the shoemaker in return for a pair of shoes in one-week's time. Note that credit here is the transfer of 'real stuff' i.e. eight saved loaves of bread from the baker to the shoemaker in exchange for a future pair of shoes.

Also, observe that the amount of real savings determines the amount of available credit. If the baker had saved only four loaves of bread, the amount of credit would have only been four loaves instead of eight. Note that the saved loaves of bread provide support to the shoemaker i.e. it sustains him while he is busy making shoes. This means that credit, by sustaining the shoemaker, gives rise to the production of shoes and therefore to the formation of more real wealth. This is a path to real economic growth.

Money and credit

The introduction of money does not alter the essence of what credit is. Instead of lending his eight loaves of bread to the shoemaker, the baker can now exchange his saved eight loaves of bread for eight dollars and then lend them to shoemaker. With eight dollars the shoemaker can secure either eight loaves of bread or other goods to support him while he is engaged in the making of shoes. The baker is supplying the shoemaker with the facility to access the pool of real savings, which among other things also has eight loaves of bread that the baker has produced. Also note that without real savings the lending of money is an exercise in futility.

Observe that money fulfils the role of a medium of exchange. Thus when the baker exchanges his eight loaves for eight dollars he retains his real savings so to speak by means of the eight dollars. The money in his possession will enable him, when he deems it necessary, to reclaim his eight loaves of bread or to secure any other goods and services. There is one provision here that the flow of production of goods continues. Without the existence of goods the money in the baker's possession will be useless.

The existence of banks does not alter the essence of credit. Instead of the baker lending his money directly to the shoemaker, the baker lends his money to the bank, which in turn lends it to the shoemaker. In the process the baker earns interest for his loan, while the bank earns a commission for facilitating the transfer of money between the baker and the shoemaker. The benefit that the shoemaker receives is that he can now secure real resources in order to be able to engage in his making of shoes.

Despite the apparent complexity that the banking system introduces, the act of credit remains the transfer of saved real stuff from lender to borrower. Without the increase in the pool of real savings, banks cannot create more credit. At the heart of the expansion of good credit by the banking system is an expansion of real savings.

Now, when the baker lends his eight dollars we must remember that he has exchanged for these dollars eight saved loaves of bread. In other words, he has exchanged something for eight dollars. So when a bank lends those eight dollars to the shoemaker, the bank lends fully 'backed-up' dollars so to speak.

False credit an agent of economic destruction

Trouble emerges however if instead of lending fully backed-up money, a bank engages in issuing empty money (fractional reserve banking) that are backed-up by nothing. When unbacked money is created, it masquerades as genuine money that is supposedly supported by a real stuff. In reality however, nothing has been saved. So when such money is issued, it cannot help the shoemaker since the pieces of empty paper cannot support him in producing shoes -- what he needs instead is bread.

Since the printed money masquerades as proper money it can be used to "steal " bread from some other activities and thereby weaken those activities. This is what the diversion of real wealth by means of money out of "thin air" is all about. If the extra eight loaves of bread weren't produced and saved, it is not possible to have more shoes without hurting some other activities, which are much higher on the priority lists of consumers as far as life and well being is concerned. This in turn also means that unbacked credit cannot be an agent of economic growth.

Rather than facilitating the transfer of savings across the economy to wealth generating activities, when banks issue unbacked credit they are in fact setting in motion a weakening of the process of wealth formation. It has to be realised that banks cannot ongoingly pursue unbacked lending without the existence of the central bank, which by means of monetary pumping makes sure that the expansion of unbacked credit doesn't cause banks to bankrupt each other.

We can thus conclude that as long as the increase in lending is fully backed-up by real savings it must be regarded as good news since it promotes the formation of real wealth. False credit, which is generated out of "thin air", is bad news -- credit which is unbacked by real savings is an agent of economic destruction.

The Fed's and Treasury actions only make things worse

Neither the Fed nor the US Treasury are wealth generators and hence they cannot generate real savings. This in turn means that all the pumping that the Fed has been doing recently cannot lift lending unless the pool of real savings is expanding. On the contrary the more money the Fed and other central banks are pushing the more they diluting the pool of real savings.

Yet most commentators are of the view that given the present fragile state of the financial system the central bank and the government must intervene to prevent the collapse. But then how can the government and the central bank help in this regard? How can the central bank or the government generate more real savings?

The only thing that the government and the central bank can do is to redistribute the real savings from other people and give it to banks. Now if the pool of real savings is still expanding this can "work" -- and lending might flow again. However, the overall pool of real savings will weaken as a result of the transfer of real savings from non-banking sector to banking sector. If however, the pool of real savings is falling then it will not be possible to increase the flow of lending.

Why doing nothing is the best policy to revive the economy

Given the growing likelihood that the pool of real savings is in serious trouble does it mean that the flow of credit will remain frozen? What can be done to unfreeze the flow is to allow the interest rate in the credit market to find the right level. With a deteriorating pool of real savings and a falling real economy lenders will be willing to lend at the interest rate that will allow for higher risk and for the fact that less real savings is available, all other things being equal. At a much higher interest rate the so-called financial crisis and the shortage of credit will vanish.

The problem then is not with the credit market as such but with the fact that the central banks are pushing massive amounts of money and trying to force interest rates artificially lower. This of course makes it even less attractive for lenders to enter the credit market. Hence the shortage i.e. the credit crunch, is the result of the central bank not allowing interest rates to reflect the levels that are in line with the facts of reality.

Why then authorities are resisting market forces and allow the crunch to persist? If interest rates were allowed to be higher many bubble activities would go under. Most experts are of the view that this would lead to serious economic slump and therefore shouldn't be allowed. By supporting bubble activities with easy money all that one does is further impoverish wealth generators and delay the prospects of a meaningful economic recovery. The pumping by the Fed will distort the interest rate structure further and worsen the credit crunch.

The best policy is for the Fed to do nothing as soon as possible. By doing nothing the Fed will enable wealth generators to accumulate real savings. (The policy of doing nothing will force various activities that add nothing to the pool of real savings to disappear. This will make the life of wealth generators much easier). As time goes by the expanding pool of real savings will work towards the lowering of interest rates. This in turn will set a platform for the further expansion of various wealth generating activities. So the sooner the Fed stops with the tampering the sooner an economic recovery will emerge.

Now if the pool of real savings is still growing then by doing nothing and allowing the interest rate to reflect the facts of reality the recession can be short-lived and economic recovery will emerge in no time. (At a higher interest rate various bubble activities will go belly up. As a result more real savings will become available to wealth generators. This in turn will work towards the lowering of interest rate).

We suggest that decades of reckless monetary policies by the Fed have severely depleted the pool of real savings. So again more of the loose policies cannot make the current situation better. On the contrary such policies only further delay the economic recovery.

Conclusion

Last Wednesday most major central banks aggressively lowered interest rates to revive credit markets and kick-start the world economy. We suggest that pushing more money cannot fix credit markets. The main problem is the depleted pool of real savings. Neither central banks nor government actions can replace non-existent real savings -- the key for real economic growth.

The best policy is for the Fed to do nothing as soon as possible. By doing nothing the Fed will enable wealth generators to accumulate real savings. (The policy of doing nothing will force various activities that add nothing to the pool of real savings to disappear. This will make the life of wealth generators much easier).

By impoverishing wealth generators the current policies of the government and the Fed run the risk of converting a short recession into a prolonged and severe slump.

_____

© 2008 Frank Shostak

ABOUT THE AUTHOR

Frank Shostak is a former professor of economics who is now M. F. Global's chief economist.

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Did Bernanke learn the lesson of the Great Depression? by Frank Shostak

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