[Anonymous]

I am trying to understand the difference between good and bad credit. How is it that real savings from savers (lenders) is any different from artificial credit from a Central Bank? I mean, I understand that there HAS to be a catch from just printing money and giving it to banks through bond purchases. But how? I know there is a catch, but how? And how does that cause the bust? I understand how the boom comes about, but how does a bust come if a bank’s reserves show plenty of savings because of the easy credit by the Fed?

I tried reading the “Good and Bad Credit” article on mises.org by Frank Shostak. But something still isn’t clear for me. Can someone please explain? Thank you.

[jmherbener]

The unhampered market generates an integrated system of production in the form of a division of labor. The goal of the system is to economize the use of resources for everyone who participates., i.e., to satisfy higher-value consumption ends of people using lower-cost means. The market makes this possible via economic calculation, i.e., the computation by entrepreneurs of net income (Net Income = Revenue – Cost) and net worth (Net Worth = Assets – Liabilities). Each production process that generates sufficient net income is economizing (or Good) and each production process that generates insufficient net income is not economizing (or Bad). Each investment that generates sufficient net worth is economizing (or Good) and each investment that generates insufficient net worth is not economizing (or Bad).

The market system of production is integrated by the structure of prices. Consumer demands generate prices for consumer goods which provide revenue to entrepreneurs who supply them. Entrepreneurs use the revenue to demand factors of production which generates prices for the factors of production in accordance with their productivity in aiding the production of consumer goods. Prices of producer goods generate income for their owners. Consumers use the income to demand consumer goods. In this way, the price structure is integrated.

Now suppose the government establishes fiat money and begins printing it and spending it on consumer goods. Because it is not based on the earning of income from producing in the division of labor, this spending is a foreign element to economizing. It makes production of some lines profitable without them being economizing and others unprofitable without them being non-economizing.

The issue of fiduciary media by banks is similar. Savers have their time preferences satisfied by lending a portion of their income, which they earned by producing on the market. Investors borrow the funds provided by savers. The trade of present money for future money determines the interest rate at the level that clears the market. Investors then use the funds to buy assets which have value in economizing. Fiduciary media is foreign element to economizing. It increases the supply of funds to lend without the funds coming from the income of producers. Investment projects will be undertaken that are not economizing and others that are economizing will not be undertaken.

The bust follows the boom because after the newly-issued fiduciary media is borrowed and spent to buy assets in the different lines of investment, it is then paid to producers and becomes their income. At that point, the newly-issued fiduciary media is integrated into the market. But that implies that the capital structure artificially built up by the issue of fiduciary media is no longer profitable and must be liquidated.

Take a look at the early chapters of Murray Rothbard’s, America’s Great Depression for a good overview of Misesian business cycle theory:

http://mises.org/rothbard/agd.pdf

[murphy560]

Professor Herbener, following your excellent explanation of booms and busts can one say with confidence that with the recent unprecedented issue of fiduciary media, unprecedented running up of the monetary base, unprecedented lowering of interest rates for an unprecedented amount of time by the Federal Reserve, that the bust that will no doubt follow will be unprecedented in world history or is it more complex than that?

[jmherbener]

The complicating factor is whether or not the Fed can remove the enormous excess reserves that its policy has generated from banks before the banks issue fiduciary media by creating credit on the basis of these reserves. Here are the numbers:

On 8/1/08, Total Reserves were $46 b, Excess Reserves $2 b, and the money stock $6,408 b.
On 9/1/13, TR were $2,334 b, ER $2,214, and the money stock $10,215 b
The ratio of money stock to TR on 8/1/08 was 140. Each dollar of reserves supported $140 of money stock.
At the same ratio, the money stock today would be $326,760 b. That is the potential inflation in the system.

Here is Bernanke on how the Fed plans to counter this inflationary potential:

http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm

And here is Bob Murphy’s response:

http://mises.org/daily/5110/

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