When trying to differentiate the positive from the negative impacts of modern banking on todays complex economy, we have to understand the mechanics behind the process itself. And by process, I mean the way the intermediary institution of banking operates.
We shall, first of all, separate two very distinct, but in the evolutionary banking process, blurred phenomena. One is deposit banking and the other loan banking. Well shall focus only on loan banking. Deposit banking is the art of safekeeping ones possession. In this case, the possession is money. In loan banking, the accumulated funds are loaned out of the bank to an entrepreneurial endeavor.
In this second case, funds are shifted from the saver to the lender, leaving the bank for an agreed upon time. In any case, these funds that leave the bank cannot be redeemed at any time at their nominal value. The funds shall be relinquished only after the term of the saved funds at interest only if the mirror image of the savings – the loan, is to be returned to the bank. The bank is rewarded for its services as an intermediary and the saver is rewarded with additional purchasing power with which he/she can purchase additional goods and services (more than if the saved funds were consumed at the beginning).
The question we pose is: What happens when the entrepreneur defaults on his loan in an inflationary banking system, and one in an noninflationary banking system?
In the first case, diverted funds which are legitimately loaned out. What this means is that funds are diverted from legitimate savings and NOT from deposits which are redeemable on par. If for example, these funds are saved for a 3 year period and loaned out for exactly the same period, the money supply hasn’t expanded nor contracted. It remains the same, just the term structure of accumulated resources are utilized in a different manner. If the entrepreneur overestimates his future revenue stream, he is in trouble, and unable to return the loan. In this case, any capital goods that are diverted to his/her project will be lost as they do not successfully fulfill the consumer demands along the structure of production.
These capital goods, to be of any use must be firstly liquidated to have any meaningful purpose. This usually involves high conversion costs, trapped idle resources and a lower standard of living. The lower standard of living is reflected in higher nominal wages as the funds flow back to the stage of production closest to consumption. With more units of exchange a deficient amount of goods can be purchased to satisfy greater desires, as the resources are trapped (momentarily or permanently) in useless lines of production. Society does get poorer in this case, but there is NO business cycle, NO contraction in the money supply.
The second case is when the commercial banks flush with excess reserves from the central bank decide to expand demand deposits in the economy, by pyramiding on a fraction of cash deposits. This exerts an artificial impact on the economy’s structure of production. An inflationary loan adds “shadow” savings in the economy as a fake euphoria (optimism) enters the economy. Capital goods rise in price as well as the general price level, and unlike the previous example, inflation exerts its negative influence on the productive structure. A loan that defaults in this sort of environment will exert a negative cascading effect on the entire economy, because, just as easily as new loans are brought into existence through credit expansion, the elasticity of the money supply reverses and collapses in on itself leaving a POORER capital structure than before. The loan itself will default if not for an ever accelerated dose of monetary expansion than before. If it happens sooner than later, not only will their be losses on the created loan, but a depleted capital structure as capital consumption is also experienced as the malinvestments are worked through.
This is a rough exposé of what happens in different systems. To fully understand this process is to thoroughly grasp capital theory and the impact of credit expansion on intertemporal preferences among the various economic actors. I would suggest reading Jesus Huerta de Soto’s masterpiece – Money, Credit and Business Cycles and for a short treatment of this subject: A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis by Joseph Salerno.
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