Chapter 5: Bank Credit Expansion and Its Effects on the Economic System

In the previous chapter we explained how the monetary bank-deposit contract with a fractional reserve leads to the creation of new money (deposits) and its infusion into the economic system in the form of new loans unbacked by a natural increase in voluntary saving (credit expansion). In this chapter we will focus on the effects of credit expansion on the economic system. We will analyze the distortions the expansion process causes: investment errors, credit squeezes, bank crises and eventually, unemployment and economic recessions. First, however, we must examine in detail both the theory of capital and the productive structure of a real economy, since a clear grasp of both is essential to understanding the processes triggered in the market by banks’ concession of loans not derived from a previous increase in voluntary saving. Our analysis will reveal that the legal concept which concerns us (the monetary bank-deposit contract with a fractional reserve) does great harm to many economic agents (and to society in general) inasmuch as it is the principal root of recurring economic recessions. Moreover we will show that because credit expansion precipitates economic and bank crises, it renders the “law of large numbers” inapplicable in banking and therefore makes it technically impossible to ensure the completion of banks’ fractional-reserve operations. This fact acquires great significance in light of the inevitable emergence of the central bank as a lender of last resort, which we will explore in depth in a later chapter. We will begin by explaining the processes spontaneously set in motion in an economic system when new loans originate from a voluntary increase in society's real saving; then in contrast and by comparison it will be easier to understand what happens when banks create loans ex nihilo through a process of credit expansion.