The difference between the effects of a legitimate default on a loan issued by an inflationary banking system and a noninflationary banking system

 

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.

Two wrongs don’t make a right

 

The following excerpt is from Euro Pacific Capital’s website and is authored by Peter Schiff.

Peter is one of the few CEO’s and respected businessmen in the financial spectrum who correctly called the housing collapse and testified on a Senate subcommittee regarding additional loan guarantees provided by the FHA for multifamily housing. The following can also be found as a video clip on Youtube.

“I was invited to testify about the Federal Housing Administration's (FHA) policy in the apartment lending market. Although this was a fairly narrow issue, I told the congressmen the same thing I did last year when I was invited by a different subcommittee to testify about job creation: government programs don't solve problems, they just create new ones. While I thank the Committee for inviting me, I believe the congressmen may have gotten more than they bargained for. […]

The subcommittee was considering whether to expand the activity of the FHA to insure loans for multi-family (apartment) buildings. The mechanism to achieve this was to extend FHA guarantees to pools of collateralized mortgages backed by multi-family residential housing units.

I have absolutely no objection to the idea that a healthy rental housing market is needed. However, I believe that market forces are sufficient by themselves to create it. The average American family now only has $7,000 worth of savings, which would not be nearly enough to afford a 20% down payment on the average American house. This means that most Americans should be renters and not owners. […]

Normally, these simple facts would attract investment capital to build affordable rental properties. However, these forces have been blunted by Federal tax and housing policies that have exaggerated the economic benefits of home ownership and have drawn excessive amounts of investment capital into that sector. To correct the distortions, the Subcommittee was considering, you guessed it, more distortive regulations. It never occurred to them to simply scale back the original regulations that are the root of the problem.”

Government officials liken the idea that whenever there is a problem that cannot be serviced immediately by the free market, they have to jump in and make a utter and complete mess regarding the “apparent” problem at hand.

Taking money from John to give to Jim and dismantling the capital structure in the process

 

There is really no end to the constant political influence of our representatives when the economy (locally or on the state level) is concerned. The next headline comes from www.zagrebancija.hr.

In the article which is making headlines all across Zagreb, a massive government spending program is being initiated. The following picture that was taken shows the construction team in place already demolishing the previous meadow. This meadow is adjacent to the National Library Building. The meadow is really huge and one of its purposes used to be walking dogs, recreational walks and the such.

 

Our great major, Mr. Bandic has decided to implement a 20 million HRK project to build a fountain. Yes, that’s not a typo – he is spending 20 million HRK ( = $3,6 million) to build a fountain.

Now, a typical Keynesian economist will say that the G in GDP = C + I + G + (X – N) is government spending, and an increase in this variable will lift the national income statistic and give a boost to GDP. Arithmetically, this is true; economically, this makes no sense. The government in its infinite wisdom has decided how to spend my money and transfer this purchasing power to the construction company which I am sure got a deal with a large premium over the market. The building materials and labor hours will be wasted in the process and the lost factors of production and resources will be diverted from either home building, sewage construction or just used as idle capital stock as an insurance in case of future economic need for real purposes.

An economy doesn’t grow by spending money. Especially in this way when to generate this growth, you have to take the resources from the economy and implement such a project. In essence, this pork barrel project is nothing but a large shell game. A wasted resource is undermining the capital structure of the industries that need these resources, creating a permanent loss for the local government budget.

The main point is, spending money doesn’t do anything. Its resource utilization that matters. Why not build 1000 fountains? Because it makes no sense. This so called meritorious good benefits only the individuals that have a direct contact with this good or service. In this case, only the construction workers that will get a boost to the detriment of the rest of fellow Zagrebites and the politicians are ensured a sure vote.

Present goods in form of money are wasted in such projects and society therefore gets poorer.