There is an even larger crisis looming on the horizon.  You think the credit situation is bad now…..just remember it can always get worse.

“Credit” is the exchange of goods received in the present for goods paid back in the future. A person is said to have “credit” if he is able to receive goods today and can pay back later, plus interest. (A “credit” entry in bookkeeping has a different (and opposite!) meaning from that used in economics. You indicate a bookkeeping credit when you sell goods and receive cash.) Banks extend credit to borrowers, which means they enable borrowers to get goods at present and repay in the future. But in real effect, the banks being only intermediaries, the ultimate credit is extended by the depositors of the banks.

Money is a type of credit, since with the buyer obtains goods in the present and the seller does not get immediate goods but tickets for goods he will get in the future. Money is essentially transferable credit.

Banking is normally done with “fractional reserves.” Reserves are stocks of money. They are fractional because only a fraction of deposits is kept by a bank, the rest being loaned out. Banks can therefore expand the money supply beyond the base of cash. You put $100 in the bank, and if the reserve ratio is 10%, the bank only keeps $10 in its vault, and loans out the other $90. It figures that it is unlikely for all depositors to come in and demand all their money at once. Central banks typically set reserve requirements for a country’s banks.

This $90 loaned out gets deposited in some bank. That bank in turn keeps $9 and loans out the other $81. This goes on and on until out of the original $100, we now have $1000 of deposits created from all that lending if none of the extra money is held as cash. This is not a problem so long as 1) depositors are informed of the policy (hence it is not fraud), 2) they money loaned is eventually repaid; 3) there is little or no inflation of the cash base.

Unfortunately, conditions #2 and #3 have not been the case. Central banks have expanded the monetary base, which the banks then expand many times more through loans. Also, during recessions, many borrowers cannot repay their loans. Then many banks fail, since depositors are not able to get their cash back. The solution is not to eliminate fractional reserves (though some banks may do this and advertise themselves as extra-safe) but to eliminate conditions (2) and (3) by switching from coercive central banking to free banking (to be explained in a later post).

Now the beast is exposed.  The assumption that the money borrowed will be repaid is the problem.  Debt is NOT being repaid and the banks do not have the funds to meet demands from depositors.  The subprime problem broke a tenet of banking–lend to responsible borrowers.  The easy credit in the card market also breaks this tenet.  The lenders working from a position of greed have brought the markets to the point of breaking and yet the government is rewarding them for their ill advised actions.

A special thanks to Dr. Fred E. Foldvary for his ideas and writings that are part of this post.

Yes, Irene that is the name of that tune.